“Top 10 business risks in power and utilities” by Ladislao Z. Avila (October 18, 2010)

SUITS THE C-SUITE By Ladislao Z. Avila, Jr.
Business World (10/18/2010)

This article continues our series on the major risks facing businesses around the world, as outlined in the Ernst & Young Business Risk Report 2010. For the power and utilities industry, an area of significant concern is the shift in the costs, and accessibility of capital.

Because of the recent economic challenges that have affected business globally, many industries have postponed major capital projects. The Philippine power generation sector, however, does not have this option as it stands on the verge of a massive capital deployment that cannot wait. The country critically needs better access to power, gas and water in order to sustain its economic growth.

In 2009, the country’s installed power generating capacity totaled 15,610 megawatts (MW), of which total dependable capacity was only 13,319 MW or 85.3%.

The Department of Energy’s Power Development Plan for 2009 to 2030 states that around 17,000 MW of new power generating capacities will be needed to meet the increasing electrical power demand and reserve requirements of the country.

Of this, only 1,338 MW will come from already-committed power projects from various proponents, including coal-fired, geothermal and hydroelectric power plants. The remaining capacity requirements remain open for private sector participation.

Based on industry experience, the total cost of constructing a power plant ranges from about US$1.5 million to US$2.5 million per MW of capacity, depending on the type of fuel to be used.

From these figures, it can be projected that at least US$31 billion must be invested between 2010 and 2030 to cover the basic demand for power, with perhaps billions of US dollars more needed over time to rehabilitate aging power plants. This is a massive capital expenditure outlook for the power industry.

Success, therefore, will come down to sourcing and deploying capital efficiently. This means keeping the cost of capital as low as possible and keeping construction costs, acquisition and rehabilitation costs, and schedules under control. This is no small feat given the recent volatile economic environment, and the inherent engineering, technical, and natural risks involved during construction or rehabilitation. Certain emerging projects have never been done before; these therefore contain the risk of “first of its kind” costs and delays. These include projects in wind and solar energy, among others.

So what can be done to manage capital-related risks? To improve their ability to bring projects in on time and on budget, power generating companies must address three key areas: funding, contract risk, and construction risk.

Funding

Capital markets have improved since the worst of the credit crunch, but securing funding at a reasonable cost can still be an issue and a challenge (for the scale of the investments required). For the most part, funding costs relate to the interest cost on borrowings obtained to finance or refinance the construction, acquisition and rehabilitation of power plants, and any future foreign exchange losses (net of gains) related to such borrowings.

These costs may be avoided by tapping equity markets that can significantly improve the efficiency of funding. Power generating companies must continue to attract and sustain investor confidence to enable them to tap the equity market, initially or in the future as needed.

With respect to the debt market, the ability to obtain the highest ratings from credit rating agencies can reduce interest costs and improve the efficiency of borrowings. Therefore, power generating companies must continue to sustain creditor’s confidence in their business models, investment strategies, and in their ability to compete effectively and efficiently.

Contract risk

One cannot overstate the importance of structuring contracts so that risk is allocated to the party best able to manage it. Power generating companies typically use a complex network of contractors for major projects, and there is significant potential to release value locked up in underperforming contracts. Contractors’ incentives should be aligned with the project owners’ objectives. Benchmarking can be used to identify underperforming contracts as well as to negotiate contractual or regulatory settlements.

Construction risk

Some of the most common risks during construction result from a lack of flexibility. Delays will occur, but they matter less when they are expected and planned for. This makes it vital to choose experienced project managers who will understand the capabilities and limitations of their contractors, and anticipate where bottlenecks are likely to occur.

Access to manpower may also be an issue. With the projected increase in construction and rehabilitation activities under the Power Development Plan, there can be a real risk of power and utilities companies competing for a limited supply of qualified technical professionals and engineers.

Controlling costs on major projects will be critical to the success of power and utilities companies. The immense scale of the capital outlays means that capital efficiencies will take on a new importance. Those who adopt leading practices to address financing, contract and construction risks will be better positioned to deliver projects successfully. After all, the Electric Power Industry Reform Act of 2001 (EPIRA) aims to provide a fairer and more competitive landscape in the power industry, and improve the Philippine power sector by ensuring and accelerating the total electrification of the country.

As the country’s power supply situation stabilizes, pressure from consumers, industries and the government for more reasonable and competitive power rates will continue to mount. Those with efficient overall cost structures will be in a better position to face the risks of a highly-competitive market and continue to be successful and profitable. They will also remain relevant to the country’s efforts towards economic growth and social development.

(As of publication, Ladislao Z. Avila, Jr. is an Assurance Partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.