The Economics of Electric Energy: IPPs, the PPA, and the Electric Power Industry Reform Act (EPIRA)

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The Economics of Electric Energy: IPPs, the PPA, and the Electric Power Industry Reform Act (EPIRA)

  1. 1. ATENEO DE MANILA UNIVERSITY Graduate School of Business Economics for Managers TERM PAPERThe Economics of Electric Energy: IPPs, the PPA, and the Electric Power Industry Reform Act (EPIRA) November 7, 2011 Submitted to: Enrico C. Mina, DBA Submitted by: Quizon, Louie Mark R.
  2. 2. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011I. Introduction The Philippine Electric Industry has developed and evolved from being a state monopolyto a deregulated and private industry. But this transformation however, did not come withoutmuch controversy, criticism, and concern. From the imposition of EO 215 (Executive Order 215)in 1988 to the Electric Power Crisis Act in 1993, the BOT (Build-Operate-Transfer) Law in 1994,and then the EPIRA (Electric Power Industry Reform Act) of 2001, the benefits of private firm-produced electric power has not yet been felt by the people. The efficiency promised by theEPIRA has not yet been realized. This research paper aims to investigate the accrued effects ofthe electric power industry reforms since 1988 to the Philippine economy. As of February 7, 2011, the Philippines has surpassed Japan in having the mostexpensive electricity rates in Asia1.This should come as no surprise since the electricity rates inthe Philippines has long been regarded as one of the highest in Asia. How this came about isarguably not that much unexpected. This paper shall discuss the various reasons why ourelectricity rates are very high and why this should be a cause for economic concern.1 “Study shows Phl has the highest electricity rates in Asia.” The Philippine Star Website. October 10, 2011 Ateneo Graduate School of Business 1
  3. 3. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] Table 1: Retail Electricity Tariffs across Selected Asian Countries June 1998 (in Php)Source: Myrna Velasco, Surviving a Power Crisis (2005) from The Philippines Electricity Market Investment Context Figure 1: Residential Retail Electricity Tariffs, Selected Asian Economies (USc/KWh), 2010 Source: Arangkada Philippines: A Business Perspective 2 Ateneo Graduate School of Business
  4. 4. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011 Figure 2: Industrial Retail Electricity Tariffs, Selected Asian Economies (USc/KWh), 2010 Source: Arangkada Philippines: A Business Perspective The discussion will start from the origins of the Philippine IPPs (Independent PowerProducers) leading to the rationale behind the PPA (Purchased Power Adjustment), thenfollowed by the various reforms under the EPIRA. The paper then details the economic effectsof the implementation of the EPIRA and the Wholesale Electricity Spot Market (WESM), thepresent state of competition of the Philippine Electric Industry and how it is affecting the highelectricity rates that the Philippines have been facing. Finally, the reasons why electricity ratesare high will be presented as well as some recommendations on how to mitigate itsmacroeconomic effects. Ateneo Graduate School of Business 3
  5. 5. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)]II. Thesis Statement The existence of the IPPs and the PPA has been justified by the state of the economyand budget deficit position of the government during the early 1990s but the over-commitmentto the IPPs contributed significantly to the high electricity prices during the late 1990s. Together with the IPPs and PPA, the Philippine Electric Industry’s transition frommonopoly to oligopoly is the primary cause why our electricity prices today are the highest inAsia, notwithstanding other factors such as taxes, the transmission system, and dependence onimported fuel.III. BodyIndependent Power Producers – History and Rationale(Woodhouse, 2005)EO 215 During the first Aquino administration, it has been forecasted that there will be anelectric power shortage. This prompted the government to pass EO 215. This order effectivelyended NPC’s (National Power Corporation) monopoly in the country by allowing privatecompanies to build power plants and supply power to NPC and the local distribution utilities.Table 2 shows the electric power industry sector ownership. 4 Ateneo Graduate School of Business
  6. 6. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011 Table 2: Electric Power Industry Sector Ownership Source: Woodhouse, E. J. (2005, June). The Philippines Electricity Market Investment Context According to the World Bank, this has been one of the first public-private partnerships(PPP) done by the Philippine government. During this period however, only Hopewell’s NavotasI power plant project reached financial closure and was commissioned in 1991.Electric Power Crisis Act and the BOT Law The effects of the deficiency on added power plant capacity brought by EO 215culminated during the Ramos administration. In 1992, the lack of added capacity resulted torolling blackouts. Because of this, in 1993, Congress passed the Electric Power Crisis Act thatauthorized the executive branch to contract IPPs on a fast track basis. Since it was on a fasttrack basis, most of the IPPs that were contracted have generating capacities that were basedon combustion turbines and diesel engine technologies. It is important to note that thesepower plants have short construction times compared to other technologies like coal thermaland hydroelectric and that these power plants have low capital costs and can be operationalwithin a year. These power plants however, have high operating costs. Ateneo Graduate School of Business 5
  7. 7. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] Although these power plants became quickly available to address the electric powershortage, these plants were dispatched as base load units (ran 24 hours a day) rather than theirtypical use as peak units (only during peak hours) making the overall dispatching of powerplants very expensive. Based on the economic dispatching of generating units, diesel andcombustion turbines (different from combined cycle technologies) should be dispatched onlyduring peak hours because of their high heat rates (BTU per kWh, a measure of efficiency) andhigh operating costs2. Figure 3 shows the typical demand curve that is unbundled according to base,intermediate, and peak. Each classification of demand ideally uses particular set generatingunits that would result to a lower overall cost. Baseload power plants typically include nuclear,geothermal and coal. Intermediate power plants are combined cycle gas turbines that run onnatural gas. Peaking plants include combustion turbines, diesel, and sometimes hydroelectric.This is the economic dispatching of power plants. Figure 3: Illustrative Load (Demand) Curve Source: Stan Kaplan, CRS Report on Congress: Power Plants: Characteristics and Costs, November 13, 2008 2 Stan Kaplan, CRS Report on Congress: Power Plants: Characteristics and Costs, November 13, 2008 6 Ateneo Graduate School of Business
  8. 8. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011 When the power crisis ceased, high economic and demand growth was projected so IPPcontracting continued. These power plant projects include large baseload plants like Sual (1200MW), Pagbilao (700 MW), and hydroelectric and natural gas plants such as Ilijan became onlinein the late 1990s.Nature of the IPP Contracts IPPs that are operational during 1988-2001 sell their output energy either to thegovernment (through NPC, PNOC, or NIA) or to distribution utilities such as MERALCO. Theiroperations are covered by contracts that can take the form of either a Power PurchaseAgreement or an Energy Conversion Agreement in which the government purchases fuel andpays the IPP for the electrical conversion of that fuel. The nature of these contracts is such that all risks except the construction and operationof the power plants are shouldered by the government. Given the power situation at that time,the government was of no position of strength and therefore had to make the contractsattractive to the investors. The common elements of the risks that are assumed by thegovernment include: Market Risk o This refers to the MEOT (minimum energy off-take typically in the range of 70- 85% of power plant capacity factor) in which NPC can pass to the consumers, the costs attributed to the take-or-pay provisions. This means that consumers would have to pay for power that they did not actually consume Ateneo Graduate School of Business 7
  9. 9. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] Fuel Risk o The ECAs have this provision in which the price and availability risk are passed on to consumers Foreign Exchange Risk o Most IPP contracts have dollar-denominated components on fees and the risk of the Peso-Dollar exchange rate is also passed-through Other Payments o Pass-through payments involving cost recovery and operations and maintenance Sovereign Guarantee o Most IPP contracts are backed by a sovereign guaranteeEffects of the IPP Contracts(Woodhouse, 2005)Asian Financial Crisis The Asian Financial crises proved to be a blow for the Philippine government andelectricity consumers because the IPPs were contracted based on a very high GDP growthforecast by NPC. GDP growth is a good indicator for electricity demand growth. According tothe Power Sector Study of the World Bank, during that time, NPC based its projections on a highforecast of 12% while the World Bank used a more conservative approach and used the 9.5%figure. Figure 4 shows Philippine’s historical GDP and it shows the steep drop in output duringthe Asian Financial Crisis. Actual demand against projected demand is seen on Figure 5 and italso includes the annual levels of installed and dependable capacity of generation. 8 Ateneo Graduate School of Business
  10. 10. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011 Figure 4: Philippine historical real GDP and GNP growth rates, 1981-2009Source: Joint Foreign Chambers of the Philippines, The Philippine Economic Landscape in 2010: Faster Growth is Essential Advocacy Paper, December 2010 Figure 5: Electricity Demand and Supply Profile (1986-2001) Source: Vince S. Perez, The Philippine Electricity Sector, DOE June 24, 2002 Ateneo Graduate School of Business 9
  11. 11. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] Because of the fall in GDP, electricity demand fell and there was a huge oversupply ingeneration capacity. This resulted to higher per KWh electricity ratesthat NPC is paying becauseof the take-or-pay provision of the contracts. And since this is a pass-through provision,consumers were burdened for paying electricity that was not consumed.Devaluation of the Peso The devaluation of the Peso worsened the electricity price situation because of theforeign exchange risk provision in the IPP contracts. In addition, since the Philippines has noextensive domestic reserves of fuel, NPC had to import most of its fuel needs. Figure 6 illustrates the historical foreign exchange rate of the Peso relative to the Dollar.The Asian Crisis resulted to a huge devaluation of the Peso. As long as we have IPP contractsthat have dollar-denominated payments and imported fuel, electricity prices will remain at riskof the foreign exchange rate. Figure 6: Historical foreign exchange rate (Php/$) Adapted from: BangkoSentralngPilipinas Website, Online Statistical Interactive Database, October 16, 2011 10 Ateneo Graduate School of Business
  12. 12. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011Purchased Power Adjustment (PPA)(Department of Energy) The PPA is the automatic cost recovery system to cover for the adjustments in cost notincluded by the basic rate of NPC. To state it in another way, the PPA is the mechanism thatNPC uses to pass to the consumers all the various risks borne by the government in all of its IPPcontracts. These include the risks in minimum energy, fuel procurement, and foreign exchange. The PPA is charged by the distribution utilities or electric cooperatives like MERALCOand BENECO and just mirrors what NPC is charging these utilities and cooperatives. What NPC ischarging are all the adjustments based on the risks and indexation provisions in NPC’sgeneration costs and IPP contracts. NPC’s cost recovery adjustments are generally divided into two parts: the FPCA (Fueland Purchased Power Cost Adjustment) that covers the minimum off-take and fuel risks, andthe FOREX (foreign exchange) which covers the foreign exchange risk. Figure 7 illustrates NPC’scharges. Figure 8 on the other hand, shows what NPC adjustments look like for the customersof MERALCO. Ateneo Graduate School of Business 11
  13. 13. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] Figure 7: NPC Charges and their Purpose Source: Vince S. Perez, The Philippine Electricity Sector, DOE June 24, 2002 Figure 8: NPC Charges translated to the Distribution Utility Source: Vince S. Perez, The Philippine Electricity Sector, DOE June 24, 200212 Ateneo Graduate School of Business
  14. 14. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011The Burden of PPA Because of the multitude of risks that are passed on to the consumers, the effects havebeen so far condemning. The Asian Crisis taught us how expensive NPC’s generation rate canbe. Recall that during the Asian Crisis, the Philippines experienced a slowdown in demandwhich meant a higher rate because of the minimum off-take IPP provision. In addition, thedevaluation of the Peso also contributed to the rate increase because of the FOREX componentof the PPA. Figure 9 shows how the PPA grew over time. Figure 9: NPC Charges translated to the Distribution Utility Source: Vince S. Perez, The Philippine Electricity Sector, DOE June 24, 2002 Ateneo Graduate School of Business 13
  15. 15. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)]EPIRA (RA 9136)(Philippine Electricity Market Corporation, 2005) Despite the PPA, NPC did not succeed in passing on to the consumers all its costs. Asidefrom the fact that in 2000, NPC had around $6.6 Billion in outstanding loan facilities of which50% is US dollar denominated and 45% is Yen denominated3, regulation prevented NPC frompassing on to consumers all of its PPA adjustments. With the ballooning deficit of the government and the intent to privatize the hugecapital expenditures and risks of the electric power industry, the government pushed for areform in the electric power industry. This came into fruition in 2001 when Congress passed theEPIRA or the Electricity Power Industry Reform Act. The EPIRA has the following objectives: Ensure the quality, reliability, and affordability of the supply of electricity Ensure transparent and reasonable prices of electricity in a free and competitive market Enhance the inflow of private capital and broaden the ownership in the power generation, transmission, distribution and supply sector To assure socially and environmentally compatible energy sources and infrastructure To promote the utilization of indigenous, new and renewable energy resources in power generation in order to reduce dependence on imported energy3Woodhouse, E. J. (2005, June). The Philippines Electricity Market Investment Context 14 Ateneo Graduate School of Business
  16. 16. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011 Provide an orderly and transparent privatization of NPC assets and liabilities To accomplish all these objectives, the electric power industry needs to berestructured.The restructuring mainly involves the separation of the competitive and themonopolistic components of the industry. The competitive components of the industry are thegeneration and retail sectors while the monopolistic components are the transmission anddistribution systems. EPIRA also involves the unbundling of electricity tariffs to ensuretransparency. Before restructuring, there are basically just three sectors in the industry. These are thegeneration, transmission, and distribution sectors. Figure 10 illustrates the electric powerindustry before EPIRA while Figure 11 shows the new structure. The retail function has beenhandled by the distribution sector. It will be opened up to Retail Electricity Suppliers (RES) once“Open Access” has been put into commercial operations. Figure 10: Electric Power Industry Before EPIRA Source: L. Quizon, “EPIRA Report”, Trans-Asia Oil and Energy Development Corporation, January 28, 2008 Ateneo Graduate School of Business 15
  17. 17. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] Figure 11: The New Electric Power Industry Structure Philippine Electricity Market Corporation. (2005). WESM Commercial Operations Training Module 1. For the new industry structure, the EPIRA declares the generation of electric powercompetitive and open and shall not be subject to regulation by the ERC (Energy RegulatoryCommission). The transmission and distribution sectors will still be subject to the ratemakingpowers of the ERC. The supplier sector, or the retail sector, is also not regulated althoughentities under this category will be required an ERC license. Along with the industry restructuring, the EPIRA created the National TransmissionCorporation (TRANSCO) which shall assume the electrical transmission function of NPC.TRANSCO is the lone entity in the transmission sector. Another entity, the Power Sector Assets and Liabilities Management (PSALM)Corporation, is also created by the EPIRA to administer the privatization of all disposable assetsof NPC (including TRANSCO) except SPUG (Small Power Utilities Group). PSALM is alsoresponsible for liquidating all financial obligations and stranded contract costs of NPC. 16 Ateneo Graduate School of Business
  18. 18. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011 The EPIRA has provisions on cross-ownership between sectors of the industry, marketpower abuse, and competitive behavior. According to this law, no generation company ordistribution company shall be affiliated with the transmission sector entity TRANSCOor itsconcessionaire (now National Grid Corporation of the Philippines or NGCP). Aside from breaking the state monopoly, the EPIRA was envisioned to transform theindustry into a more competitive marketplace. Aside from deregulating generation and supply,the law also established the Wholesale Electricity Spot Market or WESM to achieve this aim.WESM The Wholesale Electricity Spot Market was established to provide the mechanism forreflecting the true cost of electricity outside of bilateral contracts. The aim of the WESM is toestablish a competitive, efficient, transparent, and reliable market where: A level playing field exists among WESM Participants Trading of electricity is facilitated among WESM Participants within the Spot Market Third parties are granted access to the power system Prices are governed as far as practicable by commercial and market forces Efficiency is encouraged Ateneo Graduate School of Business 17
  19. 19. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)]The basic features of the WESM are: Gross Pool o All energy transactions are scheduled through the market Net Settlement o Bilateral Contract quantities transacted in the pool can be settled outside of the market Locational Marginal Price o Marginal price computed at each node or location to reflect transmission loss and/or congestion Reserve Co-Optimization o Reserve and energy offers are scheduled at the same time Demand bids o Customer’s choice to buy energy lower than a specified price Mandatory Market o EPIRA mandates procurement of at least 10% from the market for distribution utilities and electric cooperatives 18 Ateneo Graduate School of Business
  20. 20. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011How the WESM Works The WESM basically allows the price and electricity volume to be determined throughthe interaction of supply and demand “on the spot”. Since electricity cannot be stored,transactions should be done in real time. A basic illustration is showed in Figure 12, where themarket-clearing price (MCP) and the market-clearing volume (MCV) are determined by marketforces. Figure 12: Basic Illustration of MCP and MCV Philippine Electricity Market Corporation.(2005). WESM Commercial Operations Training Module 1. The market bids (demand) and offers (supply) are actually arranged in MW (megawatt)energy blocks. The supply and demand curves look like step ladders as shown in Figure 13. TheWESM also determines the actual merit order of dispatch of the generators. The generatorsthat offer the least will get to be dispatched by the system first. The market clearing price is theprice that would be paid by all customers and paid to all generators. The cheapest plants willhave the incentive of having a bigger producer surplus. Ateneo Graduate School of Business 19
  21. 21. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] Figure 13: WESM Demand/Supply Curves and Dispatch Scheduling Philippine Electricity Market Corporation.(2005). WESM Commercial Operations Training Module 1. The current market, however, does not include demand bids yet. The unavailabilty ofcustomers’ historical metered demand makes it difficult for them to make meaningful bids, thatis why until now, demand bids are not yet in effect4. But note that electricity demand is like demand for oil. It is highly inelastic. Meaning, atany given point in time, we can assume that demand is a vertical line and the intersection of thesupply energy blocks and demand determines the market clearing price. The market clearingvolume will always be equal to demand. An example is shown in Figure 14. Suppose that the demand for a given trading intervalis 400 MW. Generator A offers 100 MW at a price of 1000 Php/MWh. Generator B offers 250MW at 1500 Php/MWh and Generator C offers 500 MW at 2000 Php/MWh. The generators willbe dispatched according to merit order (cheapest plants will be dispatched first) until supplymeets demand. In this case, only 50 MW will be taken from Generator C and Generator C is the4Philippine Electricity Market Corporation. (n.d.). WESM Faqs. Retrieved October 21, 2011 20 Ateneo Graduate School of Business
  22. 22. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011marginal clearing plant or just simply, marginal plant. The market clearing price is 2000Php/MWh and this is the same price that would be paid to Generators A and B. Figure 14: Supply/Demand Interaction without Demand Side Bidding Philippine Electricity Market Corporation.(2005). WESM Commercial Operations Training Module 1. The WESM is fairly simple and theory suggests that if an electricity market iscompetitive, the spot market will encourage efficiency and lower prices. But will this systemwork if the industry has a high market concentration? We now turn to this and examine thecurrent industry concentration. Ateneo Graduate School of Business 21
  23. 23. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)]Market Concentration and Oligopoly Almost every time that MERALCO raises its generation charge, very seldom do you nothear that WESM played a vital role. Last June 7, 2011, Meralco again raised its generationcharge with WESM as one of the reasons for the increase.5 The WESM provides an avenue for buyers and sellers of electricity to trade electricitylike a commodity. In a perfectlycompetitive setting, the WESM like any other commoditymarket, should demonstrate efficiency in which electricity is allocated at the least possible cost.However, like in many cases, the WESM is imperfect. The generation sector, according to the Market Assessment Group of the PhilippineElectricty Market Corporation (PEMC), has an industry concentration that is between themoderate and high levels depending on the measurement used (based on registered capacity,offered capacity, actual generation, etc.). Market concentration is measured using the Herfindahl-Hirschman Index or HHI. HHI isthe standard measure of industrial concentration used by the United States since 1982 6 and isadapted by the Market Assessment Group of PEMC as one of the ways to measure competitionand assess the spot market condition. The HHI is calculated by expressing the market share ofeach firm in the industry as a percentage, squaring these figures, and summing. 75 Manila Electric Company. (2011, June 7). News and Updates. Retrieved November 1, 2011, from Meralco6 Liberty Fund, Inc. (n.d.). Industrial Concentration by William F. Shughart II. Retrieved November 1, 20117 Case, K. E., Fair, R. C., & Oster, S. (2009). Principles of Economics (9 ed.). Jurong, Singapore: Prentice Hall. 22 Ateneo Graduate School of Business
  24. 24. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011 In the WESM, an HHI of below 1000 indicates no concentration. An HHI of between1000 and 1800 is moderately concentrated. An HHI that is between 1800 and 2500 indicates aconcentrated market while an HHI that is above 2500 is highly concentrated. The generation sector is currently dominated by four firms: First Gen Corporation of theLopez group, Aboitiz group, and San Miguel Corporation, and PSALM Corporation. Figure 15shows the market share of the generation sector suppliers of the Philippines. Figure16illustrates the major suppliers’ historical market share by registered capacity while Tables 3-4shows the Major Participant grouping for Luzon and Visayas indicating the affiliation of thegeneration companies. Figure 15: Market Share of Generation Sector Suppliers by Dependable Capacity Source: “Strategic Planning Presentation 2011” Trans-Asia Oil and Energy Development Corporation, October 2011 Ateneo Graduate School of Business 23
  25. 25. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] Figure 16: Share of Registered Capacity by Major Participant July 2009 to June 2011 Source: Philippine Electricity Market Corporation. (August 9, 2011). 5th Annual WESM Participants Meeting: Market Assessment. Quezon City From 2009 to 2010, the market share of PSALM has gradually decreased. This isreflective of the decrease of the monoplostic market share of NPC. The decrease of NPC’s, orPSALM’s in this case, market share is the result of the sale of NPC’s generation assets. The 24 Ateneo Graduate School of Business
  26. 26. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011assets have been acquired by various industry players including new entrants such as SanMiguel Corporation. As PSALM’s dominance decreased, a new market power emerged. Excluding PSALM, thelargest suppliers are First Gen Corporation, the Aboitiz group, and San Miguel Corporation. Theonce monopolistic structure of the industry has produced a new kind of imperfect marketstructure: Oligopoly. Oligopoly is a form of industry structure characterized by a few dominant firms. Marketconcentration tends to lead to pricing that is above marginal cost at equilibrium and output isbelow the efficient level8. Just how concentrated is the generation sector? Figure 17 shows theHHI by Luzon major participants from June 26, 2009 until December 25, 2010. The year 2009shows the dominance that PSALM is enjoying during that time and as generation assets weresold, the market share of other participants grew and it resulted to a decrease in industryconcentration. However, if the measurement is based on registered capacity that is net of outage,offered capacity in the market, actual generation and spot market transaction, the HHI level willreach the concentrated to highly concentrated level. Figure 18 shows the HHI of the Luzon gridfrom June 26, 2009 to December 25, 2010.8Case, K. E., Fair, R. C., & Oster, S. (2009). Principles of Economics (9 ed.). Jurong, Singapore: Prentice Hall. Ateneo Graduate School of Business 25
  27. 27. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] Table 3: Major Participant Grouping: Luzon (July 2010 – Jun 2011)Source: Philippine Electricity Market Corporation. (August 9, 2011). 5th Annual WESM Participants Meeting: Market Assessment. Quezon City Table 3: Major Participant Grouping: Visayas (July 2010 – Jun 2011)Source: Philippine Electricity Market Corporation. (August 9, 2011). 5th Annual WESM Participants Meeting: Market Assessment. Quezon City 26 Ateneo Graduate School of Business
  28. 28. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011 Figure 17: Herfindahl-Hirschman Index based on Registered Capacity (Jun 26, 2009 – Dec 25, 2011) Source: Philippine Electricity Market Corporation. (August 9, 2011). 5th Annual WESM Participants Meeting: Market Assessment. Quezon City Figure 18: Herfindahl-Hirschman Index based on Various Scenarios (Jun 26, 2009 – Dec 25, 2011) Source: Philippine Electricity Market Corporation. (August 9, 2011). 5th Annual WESM Participants Meeting: Market Assessment. Quezon City Ateneo Graduate School of Business 27
  29. 29. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)]Residual Supply Index The residual supply index (RSI) provides a measure of the degree of pivotal supplierpower based on fundamental economic intuition9. The pivotal suppliers are the suppliers whocan raise the market price substantially by withholding generation capacity10. The RSI measuresthe collective capacity of all generators as a percentage of total demand but excluding thelargest generator or supplier. A measure of below 100% indicates that the largest supplier ispivotal. The lower the value, the higher is the pivotal power of the pivotal supplier. Figure 19 shows the RSI of the market between June 26 to December 25, 2010. In thisperiod, pivotal power is above 60%. Figure 19: RSI for WESM based on Offered Capacity (Jun 26, 2009 – Dec 25, 2011) Source: Philippine Electricity Market Corporation. (August 9, 2011). 5th Annual WESM Participants Meeting: Market Assessment. Quezon City9Brandts, J., Reynolds, S., & Schram, A. (2011, January 31). Pivotal Suppliers and Market Power10 Genc, T., & Reynolds, S. (n.d.). Supply Function Equilibria with Pivotal Suppliers 28 Ateneo Graduate School of Business
  30. 30. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011Pivotal Supplier and Price Setting Frequency Besides the market abuse case against PSALM that was filed by PEMC’s board oftrustees (a 73% increase in prices but ERC junked the case on June 6, 2007 because of lack ofevidence), there has been no filed complaints against market abuse. Because of the highconcentration and RSI of the market however, it is very possible that some market power isbeing exercised by the firms who hold the largest market shares. There are two measures of market power. One is the Pivotal Supply Index in which aparticular supplier (the pivotal supplier as discussed earlier) has an integral role in supplying thedemand for electricity at any time. If the pivotal supplier chooses not to generate, then theremay be adverse effect in market that would raise the clearing price. In fact, market power dueto the presence of pivotal suppliers has been documented to contribute to high prices andinefficiency in wholesale electricity markets and is a significant concern for public policy towardthe electric industry11 The next measure is the Price Setting Index. It measures the frequency of market-clearing price setting of a particular supplier. If a supplier is both a pivotal supplier and pricesetter above marginal cost, then you have an exercise of market power. Table 4 shows the Pivotal Supply Index of the power plants from July to December2010. This research will only concentrate on Luzon for simplicity. The values are the percent ofthe time each month that a power plant is considered a pivotal supplier. Table 5 shows the11 Brandts, J., Reynolds, S., & Schram, A. (2011, January 31). Pivotal Suppliers and Market Power Ateneo Graduate School of Business 29
  31. 31. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)]average percent of the time that the power plants of the three major generator groups namely,San Miguel, Aboitiz and First Gen have been considered as pivotal suppliers. Table 4: Pivotal Supply Index Luzon based on Offered Capacities (July – Dec 2010) Source: Philippine Electricity Market Corporation. (August 9, 2011). 5th Annual WESM Participants Meeting: Market Assessment. Quezon CityTable 5: Average Percentage of being Pivotal Suppliers of the three Major Participants (July – Dec 2010) Major Participant Average Percentage San Miguel 42.31 Aboitiz 26.19 First Gen 29.27 Adapted from: Philippine Electricity Market Corporation. (August 9, 2011). 5th Annual WESM Participants Meeting: Market Assessment. Quezon City 30 Ateneo Graduate School of Business
  32. 32. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011 Taking the average of all the power plants of the three major participants, we can seehow their sizes influence the dependence of the Luzon grid to their power plants. In Table 5, ofall three major participants, San Miguel has the highest average percentage of being a pivotalsupplier. Table 6 shows the Price Setting Frequency Index of the Luzon power plants from July toDecember of 2010. The values here only shows the instances where the market clearing price isabove Php 5 per KWh or Php 5000 per MWh. Table 7 on the other hand, reflects the averagepercentage of the time that the power plants of the three major participants have set the pricein the spot market. Table 6: Price Setting Frequency Index July – Dec 2010 (Php 5000 per MWh and above) Source: Philippine Electricity Market Corporation. (August 9, 2011). 5th Annual WESM Participants Meeting: Market Assessment. Quezon City Ateneo Graduate School of Business 31
  33. 33. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] Table 7: Average Percentage of being Market Price Setters for the three Major Participants (July – Dec 2010) Major Participant Average Percentage San Miguel 5.97 Aboitiz 5.65 First Gen - Adapted from: Philippine Electricity Market Corporation. (August 9, 2011). 5th Annual WESM Participants Meeting: Market Assessment. Quezon City Table 7 shows that at the price range of above Php 5000 per MWh, only San Miguel andAboitizhave set the price in the market. With the market hovering between the concentration levels of moderate to high andthe residual supply index falling below the level of 100% at least 60% of the time between Julyto December 2010, it is quite possible that some market power has been exercised. The pricesetting frequency of the three largest pivotal suppliers sets a warning for Market SurveillanceCommittee to continue their monitoring for market power abuse. The data presented however, is not enough evidence that market power has indeedbeen exercised. But the values clearly show that the present industry structure where you havea moderate to high industry concentration is very prone to market power abuse and there is ahigh probability that it can be exercised. That is if it has not been exercised yet. So far, there has been no word yet if the Market Surveillance Committee of PEMC hasproven market power abuse of the three largest suppliers. But this intensifies the call for themto keep a closer look on these suppliers. 32 Ateneo Graduate School of Business
  34. 34. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011IV. ConclusionWhy Philippine Electricity Rates are high(Woodhouse, 2005)(Freedom from Debt Coalition,2009) The IPP structure that resulted to the PPA, and the oligopolistic structure of thegeneration sector are the top reasons why electricity rates in the Philippines are now thehighest in Asia.The following is a list of why the electricity rates in the Philippines are high.1. The Oligopolistic Structure of the Generation Sector The market concentration of the generation sector clearly indicates that the sector isoligopolistic in structure. Although the evidence is not complete in proving that the largestsuppliers are exercising market power, economic theory suggests that in any oligopoly, there isa tendency that the resulting price is higher than that of the perfectly competitive market andoutput is below the efficient level. This structure is also prone to tacit/explicit collusionbetween participants2. Structure and Implementation of the IPP program Because of the risks that were eventually passed on to the consumers, the PPA becamevery expensive and has now been comparable to the base rate charge. The rapid build-out ofthe peaking power plants, the minimum off-take requirements, and foreign exchange risk hasincreased the cost of electricity substantially. Ateneo Graduate School of Business 33
  35. 35. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)]3. No Extensive Domestic Reserves of Fuel With the exception of our natural gas requirements which is supplied domesticallythrough the MalampayaDeepwater Gas-to-Power Project (which is operating at near capacity),our requirements for coal and oil have to be sourced from foreign countries. Transportationcosts plus the foreign exchange rate can significantly increase the cost of fuel needed toproduce electricity.4. Transmission Infrastructure The transmission system investment is relatively higher in the Philippines compared toother countries primarily because of the challenge of transmitting electricity over hundreds ofdispersed islands. Inter-island connections are typically connected through submarine high-voltage DC systems. The cost is made worse because of the need to build transmission linesthat can withstand earthquakes and tropical storms.5. Lack of Local Capital Markets The lack of local capital markets has resulted to firms and even the government itself, toborrow abroad for most of its finance.6. The Country’s Electricity Demand Curve is “Peaky” Compared to other Countries The lack of a strong industrial electricity base demand on a 24-hour basis does not helpin reducing the cost of installing generating facilities to cover the peak demand. 34 Ateneo Graduate School of Business
  36. 36. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 20117. No Domestic Source of Equipment As with coal and oil, almost all major equipment used to produce and transmit electricpower must be sourced abroad and is exposed to foreign exchange risk.8. EPIRA allowed the existence of Distribution Utilities sourcing its electricity requirements fromits sister IPPs Critics argue that the EPIRA “had” to be crafted to accommodate some of the existingindustry structure before 2001. One of which is the cross ownership of generation anddistribution companies. We have MERALCO and First Gen in Luzon and VECO and Aboitiz Powerin the Visayas. According to the Freedom from Debt Coalition (FDC), MERALCO pays its IPPsmore than what it would have paid NPC if it bought the electricity from NPC. Anothercontroversial topic of this structure is the existence of a similar “take or pay” provision ofMERALCO’s contract with First Gen, which the Lopez family both have shares with.9. Value-Added Tax (VAT) VAT now includes oil and electricity. The consumption tax regime before exempted oiland electricity because of its “socially-sensitive” nature, meaning raising its prices will raise theprice of other commodities. Another controversial application of VAT is on system loss. System loss is electricitywhich had been generated but not used such as line losses (natural losses of electricity in linesthat are converted to heat), pilferage, and station use. Ateneo Graduate School of Business 35
  37. 37. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)]10. Royalty Taxes on Indigenous Fuel Sources According to the July 3, 2009 press release of the Senate of the Philippines by SenatorJuan Ponce Enrile, royalty taxes have amounted to 1.79 Php/KWh. This is eight times higherthan the importation tax of oil and coal which is not higher than 0.22 Php/KWh. There have been calls by various stakeholders to scrap or at least reduce the royalty taxon natural gas. According to Dr. Francisco Viray, President and CEO of Trans-Asia Oil and EnergyDevelopment Corporation and former Energy Secretary, proceeds from the royalty tax can beused to subsidize the electricity costs of the industries that are vital to the macro-economy,such as export industries so they can be competitive.V. Recommendation To lower electricity rates, the following should be considered:1. Increase GDP to increase electricity demand To counter the effects of the generation sector’s oligopoly structure, the governmentshould introduce other incentives to spur growth in GDP that would increase the demand ofelectricity. Although it may seem at first that increasing GDP to lower the electricity rates is a“chicken and egg” situation, the government can use proceeds from the VAT and royalty taxesto create incentives for firms to increase their output. The incentives can be in the form of 36 Ateneo Graduate School of Business
  38. 38. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011subsidized electricity rates so their products can be more competitive especially against foreigncompetitors. With electricity subsidies, the government can encourage investment and thus increaseGDP. The resulting increase in demand for electricity will not only improve the demand curve ofthe country which can lower the per KWh cost of covering the facilities to cover the peakdemand, but it can also dilute the market share of the largest suppliers of electricity. Withincreased demand, other competitors can increase their market share and can thus lead to anindustry with a lower HHI. A lower HHI is needed to achieve a market structure that is closer toperfect competition.2. Remove oil and power from VAT coverage If proceeds from VAT cannot be used to subsidize targeted industries, it should beremoved. According to the FDC, removing the VAT will effectively reduce electricity rates by atleast 0.80 Php/KWh. With this reduction, firms will be more competitive and households canincrease their consumption thereby increasing GDP.3. Renegotiate IPP contracts Although this has been done before, a new agreement is still possible to lower theimpact of the PPA.4. Encourage investments in natural gas and geothermal power projects Ateneo Graduate School of Business 37
  39. 39. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE November 7, 2011 ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] The success of the Malampaya project automatically provides a bright picture for thefuture of oil and gas exploration in the country. Government should craft policies that wouldfurther encourage oil and gas exploration and infrastructure investments. The Philippines is very rich in geothermal resources and this should be optimized.Currently, the country is the second largest producer of geothermal power next to the UnitedStates. With investments in natural gas and geothermal power, the Philippines can effectivelydecrease its dependence on imported coal and oil and this could help lower electricity rates.VI. BibliographyBangko Sentral ng Pilipinas. (2011, October 16). Online Statistical Interactive Database. Retrieved October 16, 2011, from Bangko Sentral ng Pilipinas: http://www.bsp.gov.ph/dbank_reports/ExchangeRates_1_rpt.asp?frequency=Annual&range_fr om=1988&range_to=2011&conversion=AverageBrandts, J., Reynolds, S., & Schram, A. (2011, January 31). Pivotal Suppliers and Market Power.Case, K. E., Fair, R. C., & Oster, S. (2009). Principles of Economics (9 ed.). Jurong, Singapore: Prentice Hall.Department of Energy. (n.d.). The Purchased Power Adjustment (PPA). Retrieved October 15, 2011, from DOE Portal: The official website of the Philippine Department of Energy: http://www.doe.gov.ph/faqs/ppa.htmEnergy Regulatory Commision. (n.d.). Retrieved October 17, 2011, from Energy Regulatory Commision Website: http://www.erc.gov.ph/pdf/811_pub-icera.pdfFreedom from Debt Coalition. (2009). Dark Power Rising. The Philippine Power Industry Nine Years under EPIRA (RA 9136) (1 ed., Vol. 13). PAID (People Against Immoral Debt). 38 Ateneo Graduate School of Business
  40. 40. [THE ECONOMICS OF ELECTRIC ENERGY: IPPS, THE PPA, AND THE ELECTRIC POWER INDUSTRY REFORM ACT (EPIRA)] November 7, 2011Genc, T., & Reynolds, S. (n.d.). Supply Function Equilibria with Pivotal Suppliers. Retrieved November 7, 2011, from Cite Seer X Beta: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.72.2804&rep=rep1&type=pdfJoint Foreign Chambers of the Philippines. (2010, December). Retrieved October 16, 2011, from http://www.investphilippines.info/arangkada/wp-content/uploads/2011/06/The-Philippine- Economic-Landscape-in-2010-Faster-Growth-is-Essential.pdfJoint Foreign Chambers of the Philippines. (n.d.). Background (power). Retrieved October 15, 2011, from Arangkada Philippines: A Business Perspective: http://www.investphilippines.info/arangkada/infrastructures/power/background-power/Joint Foreign Chambers of the Philippines. (n.d.). sss.Kaplan, S. (2008, November 13). Federation of American Scientists. Retrieved October 16, 2011, from http://www.fas.org/sgp/crs/misc/RL34746.pdfLiberty Fund, Inc. (n.d.). Industrial Concentration by William F. Shughart II. Retrieved November 1, 2011, from Library of Economics and Liberty: http://www.econlib.org/library/Enc/IndustrialConcentration.htmlManila Electric Company. (2011, June 7). News and Updates. Retrieved November 1, 2011, from Meralco Official Website: http://www.meralco.com.ph/pdf/newsandupdates/2011/NW03011.pdfPerez, V. S. (2002, June 24). Retrieved October 16, 2011, from DOE Portal.Philippine Electricity Market Corporation. (2005). WESM Commercial Operations Training Module 1.Philippine Electricity Market Corporation. (August 9, 2011). 5th Annual WESM Participants Meeting: Market Assessment. Quezon City.Philippine Electricity Market Corporation. (n.d.). WESM Faqs. Retrieved October 21, 2011, from Wholesale Electricity Spot Market: http://www.wesm.ph/page.php?p=80Senate of the Philippine. (2009, July 3). Press Release. Retrieved November 6, 2011, from Senate of the Philippines: http://www.senate.gov.ph/press_release/2009/0703_enrile1.aspWoodhouse, E. J. (2005, June). The Philippines Electricity Market Investment Context. Retrieved October 15, 2011, from Stanford University: http://iis-db.stanford.edu/docs/59/Philippines.pdf Ateneo Graduate School of Business 39

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