Annual capacity payments to private power producers are six times higher than Pakistan’s annual healthcare budget, yet nearly half of the power capacity remains unused. What explains this phenomenon?
Based on “The Economic Costs of Lopsided Power Contracts: Evidence from Pakistan,” by Sugandha Srivastav, Tim Dobermann and Faraz Hayat.
Access to electricity is critical for economic development, yet citizens around the world are being priced out of the market. In today’s episode of VoxDevTalks, Tim Phillips speaks to Sugandha Srivastav about how corruption and incompetence in designing power contracts has led to huge economic costs in Pakistan.
Electricity is key to economic development
Ensuring an accessible and affordable electricity supply is crucial for a country's development. However, in many developing nations, electricity remains unaffordable for a significant portion of the population. This can be partly explained by who is producing the electricity.
“Essentially, it is a motley crew of independent power producers whose ultimate investors can range from those coming from Saudi Arabia to some being very local, to even Chinese investment.”
The lack of affordability can also be attributed to the fact that power contracts have often not been procured through competitive processes, meaning they may not necessarily provide the best value for money.
The history of power contracts in developing countries
In the 1990s, most low- and middle-income countries operated publicly owned and managed power sectors. Nations such as India, Pakistan, and Indonesia chose to open their economies to private investments. However, external investors perceived these investments as highly risky. To encourage private investment, the governments of these countries had to provide various forms of guarantees.
What are Purchase Power Agreement?
The contracts established between governments and independent private power producers are known as Power Purchase Agreements (PPAs). In Pakistan, the standard format of PPAs follows a cost-plus model, which guarantees that if production costs increase for the power producer, the government will automatically cover the additional expenses.
A second key feature of these contracts is capacity payments, where the government pays the independent producer a fixed monthly amount regardless of how much electricity is actually purchased, even if demand is insufficient to utilise the supply produced.
Additionally, these contracts are typically long-term, often spanning 25 to 30 years, locking the government into these commitments for decades.
Finally, governments provide further guarantees, such as ensuring all payments are made in US dollars, even in situations where the country faces a shortage of foreign exchange reserves. These features all provide perverse incentives for the private producers.
“The irony here is that even though public funds are being used to support the purchase of power, the public does not know under what contractual terms their money is being spent.”
Pakistan was an exception as the information on these contracts was available on their website. As part of her research with Tim Dobermann and Faraz Hayat, they undertook a massive forensic exercise, meticulously reviewing thousands of PDF documents to determine how much Pakistani citizens were paying to independent power producers.
“It turns out to affect more than half of the planet’s population…these PPAs in this format, are across Indonesia, India, China, Ghana, Zambia, Nigeria.”
The scale of the problem in Pakistan
The annual capacity payments, the large, fixed lump-sum payments, are six times greater than Pakistan’s annual healthcare budget, yet nearly half of the power capacity remains unused. This inefficiency stems from the poor incentives created by these contracts. Private power producers are not concerned with how much power they generate since they receive fixed monthly payments regardless of actual sales.
These contracts result in "an extremely lopsided distribution of risk," with nearly all the burden falling on the public. This approach sharply contrasts with a fundamental principle in contract law, which emphasises the need for an equitable distribution of risk in long-term agreements.
How do these contracts encourage cheating?
The cost-plus nature of these contracts creates strong incentives for firms to manipulate receipts and inflate costs. By comparing audit reports with the financial statements reported by power firms, significant discrepancies have been identified. This highlights how cost-plus contracting fosters opportunities for dishonesty and fraud.
These issues are further compounded by the lack of competitive procurement processes at the outset. Without such competition, firms have little motivation to source coal from the most cost-effective suppliers. Instead, power plants often prioritise patronage, choosing suppliers based on connections rather than securing the best value for money.
How do these contracts affect the Pakistani economy?
The debt incurred from paying these contracts amounts to 5% of Pakistan’s GDP, with one-fifth of this debt owed to China. Many of the Chinese contracts were established under the Belt and Road Initiative, with the initial assumption that the International Monetary Fund (IMF) would act as a backstop for this debt, creating a moral hazard. However, given that these contracts offered some of the highest returns on equity, the IMF declined to bail out this portion of the debt.
‘If a foreign entity comes in and it knows the IMF is always the last resort and will bail it out, then as a lender, you’re not afraid to charge conditions that can result in default.’
Both competence and corruption were at play in these contracts
Firstly, in 2015, coal contracts were signed for a 30-year term, coinciding with the year solar energy became cheaper than coal. This is a sign of incompetence as the government locked in higher electricity costs for an entire generation without properly analysing the financial implications. Additionally, Pakistan has to import coal but would not have needed to import solar – this demonstrates further incompetence with regards to currency and import risk.
Secondly, at the core of this issue lies corruption. Many textile firms are also the major owners of power plants. Textile firms rank as the largest beneficiaries of electricity subsidies. By occupying roles as both producers and consumers of electricity, these firms are positioned to extract substantial rents from the system.
‘when you do privatisation without the appropriate governance reforms, then actually privatisation can be used as a mechanism to move money from the public coffers to vested interests, not just in Pakistan, but also in Indonesia, in India and Ghana and Zambia.’
Policy implications for designing contracts
Preventing the formation of such contracts requires the establishment of robust institutional safeguards and regulatory frameworks to ensure that governments negotiate in the best interest of their citizens. Transparent, competitive procurement processes and accountability mechanisms are essential to avoid locking in deals that prioritise private gains over public welfare.
These contracts also have significant implications for achieving net-zero emissions. A substantial portion of coal production is tied to these long-term, multi-decade agreements, making it nearly impossible to phase out coal and transition to cleaner energy sources within the required timeframe. Without revisiting and restructuring these contracts, net-zero goals will remain out of reach.