Robert Thomas Crow

Visiting Scholar, Asia/Pacific Research Center, Stanford University
(650) 343-7615 [email protected] (650) 375-1560 (fax)

June 21, 1999

I. Background

Prior to the onset of the East Asian currency crisis in mid-1997, foreign direct investment in electric power in developing countries appeared to be a robust market that was destined for continuous growth. The effects of the crisis are well-known – serious contractions of output in 1998 in Thailand, Indonesia, Malaysia and South Korea and a severe deceleration of growth in the Philippines. In 1999, Brazil was also forced to float its currency and appears to be contracting, along with continued contraction in Indonesia and perhaps Malaysia. Of the major developing countries, only China, Taiwan, India and Mexico appear to have thus far avoided severe deceleration of growth.

Accompanying the financial turmoil and contraction, foreign direct investment in developing countries has also slowed significantly. This especially seems to have been the case in investment in private infrastructure in general and electric power in particular. Moreover, independent power projects (IPPs) that had come into service (particularly in Indonesia and Pakistan) have been faced with government demands to renegotiate their power purchase agreements (PPAs). The principal causes for these demands are falling demand and rapidly rising tariffs (largely indexed to the foreign exchange rates of the countries of the principal investors).

Particularly in Indonesia, where the decline in GDP was probably on the order of 15% in 1998 and perhaps another 5% in 1999, macroeconomic conditions alone might explain the collapse of the IPP market. However, it may also be that macroeconomic collapse merely hastened the demise, or at least the overhaul, of a way of structuring IPP markets that already had severe flaws. For example, the World Bank convened a conference at Cartagena, Colombia in May 1997 (before the East Asian currency crisis) that focused on the public risk being undertaken in private infrastructure. The contributors identified a number of issues in the way private infrastructure projects are put together -- including the government’s role as guarantor, the financial structure of PPAs, and the degree of competition – that they opined to require significant, if not radical, change for IPPs to be viable from a public perspective. (Irwin, et al) Their general conclusion was that the current paradigm was at best sub-optimal and at worst unsustainable. There was also a consistent suggestion running through the contributions that a new paradigm could not emerge without the host countries undertaking fundamental, broad-scale economic and institutional reform.

The purposes of this paper are to raise questions rather than answer them and to stimulate discussion of whether the questions raised are the right ones. A key requirement for research is that it be thorough in understanding and representing all of the major stakeholders in IPPs and their services – developer/investors, power purchasers, governments as representatives of the general public interest, private lenders, multilateral lenders, and suppliers of goods and services. No projects can be successfully launched without broad agreement of all of the stakeholders and their diverse interests. Thus, a pragmatic, multidisciplinary approach is required for research that will have a meaningful impact on private and public decision-making.

 II. The Old Paradigm

IPP agreements are complex and varied. Thus, characterizing a paradigm may do some violence to the diversity that constitutes reality. Nonetheless, particularly in developing countries, an archtypical "old paradigm" IPP structure includes the following:

o A stand-alone development corporation owned principally by large corporations from prosperous countries

o At least 60% financed by debt

o Limited-recourse debt financing, secured by a long-term, take-or-pay power purchase agreement (PPA)

o A PPA with foreign exchange rate and/or inflation protection with a publicly-owned distribution entity

o A central government guarantee that the distribution entity will live up to its obligations under the PPA

o Other central government guarantees (covering convertibility risk , transfer risk, foreign exchange rate risk, and other risks) which create unfunded contingent liabilities for the central government

o Political risk insurance provided by private insurers, investors’ national governments, or the Multilateral Investment Guarantee Agency (MIGA)

One archtypical disaster scenario for the old paradigm has largely been played out over the past two years, particularly with Indonesian IPPs. It consists of the following elements:

o A severe contraction of the economy, leading to less demand for power than the distribution entity is committed to buy under the PPA

o Serious foreign exchange rate depreciation, coupled with an agreed tariff in the PPA that is tied to the investor’s national currency

o A distribution entity that is pressed to functional bankruptcy by the high local-currency cost of IPP power and declining demand due to the economic crisis

o A central government whose finances have deteriorated due to revenue loss from the economic contraction and pressing needs for expenditure to relieve the misery caused by the contraction

The results of this disaster scenario are:

o Ultimate customers’ hardship due to the economic contraction is compounded by rapidly escalating local-currency tariffs

o Distribution companies cannot live up to the terms of the PPA because of the lack of expected demand

o The central government cannot live up to its contingent liabilities

o The IPP does not earn enough revenue to cover its loans, much less a return on equity

o Lenders (having limited recourse to the investors’ balance sheets) acquire bad debt

The ship sinks with all hands.

III. The New Paradigm

The new paradigm is to move agreements toward conventional market terms, shifting risk to the investor/developers and lenders of the private sector. It includes the following elements:

o IPP developers that are sufficiently large as to be able to manage risk through a diversified portfolio of investments

o IPPs that sell power on a competitive spot market rather than through PPAs

o Private distribution entities that are free of central government interference, motivated by profits, and therefore efficient. Such entities will be shrewd enough to avoid disadvantageous PPAs and instead buying power from IPPs on a competitive spot market

o Purely commercial transactions between private entities that eliminate the government’s role in providing commercial guarantees

o Solid macroeconomic policy and financial and regulatory laws and institutions that provide healthy economic growth and foreign exchange stability, thus reducing the requirements for governments to undertake guarantees concerning foreign exchange rates, interest rates, transferability, etc.

The new paradigm raises a number of questions. One of the foremost is the role of electric power in the development of countries whose economies are largely pre-industrial. It has been forcefully contended that the externalities of increasing power supplies, particularly to poor people in poor countries, are significant. Some of the effects of rural electrification in the United States beginning in the 1930s, for example, were improved public health (through increasing adequate supplies of clean water, improved food storage, and improved diet), reduced burdens on women for household chores, improved infant mortality, and reduced pressures on urban areas of rural-urban migration. (Clayton, pp. xiii-xvi) In particular, as long as the marginal social benefits of electrification exceed the marginal private revenue and marginal social cost (including private cost), there will be underinvestment in electric power relative to what is socially optimal.

The World Bank, the Asian Development Bank, the Inter-American Development bank, and national development assistance agencies have provided significant financial support to public-sector electric power development. This, too, suggests a belief that positive externalities play a larger role in the social value of a power plant than in that of a soft drink bottling plant or a petrochemical complex. Thus, due to the presence of externalities, government might have a more important role in the private provision of electric power capacity than is suggested by the new paradigm.

A second question is whether the institutional conditions of the new paradigm permit private electric power development in most developing countries. Faulty macroeconomic management and inadequate laws and institutions in general are hallmarks of underdevelopment. If countries had remedied these problems, they might no longer be underdeveloped. Reform to eliminate these problems involves far bigger stakes than electric power and has proven to be very difficult. Does this limit countries with inadequate laws and institutions to a choice between public power and no power?

A third question is whether the experience of developing countries in the post-1997 period is an indicator of the need for a new paradigm or whether private power would been impacted by macroeconomic events regardless of whether the new paradigm had already been in place.

Thus, as attractive as the new paradigm appears to be, it may still have serious problems. In order to determine what paradigm will emerge – if indeed any paradigm will dominate – involves serious research to disentangle the various forces that have impacted foreign direct investment in private power in the post-1997 period. This would seem to be a precondition for determining what kind of contractual and institutional arrangements could best balance the objectives of all stakeholders in the IPPs of the future.

IV. Questions Concerning the Interpretation of IPP Experience in the Post-1997 Record

What Happened?

One of the first issues that must be addressed is the extent of project failure associated with foreign direct investment in IPPs in developing countries in the post-1997 period. Project failures (in the sense of severe damage to at least one of the classes of stakeholders) are by no means unique to his period. However, these failures did not reach a sufficiently intolerable rate as to threaten the entire market, as has been suggested by the post-1997 experience. What is less clear is whether project failure is systemic, occurring throughout developing countries, or whether it is limited to relatively few high-profile cases, such as those in Indonesia. It is also not clear how many new projects have succeeded under the old paradigm in the post-1997 period.

The Role of Economic Force Majeur in Project Failure

One of the key questions concerning foreign direct investment in private power in developing countries in the post-1997 period is whether investment under any paradigm could have withstood the economic contraction set off by the East Asian currency crisis. It would seem that what has happened might be regarded as the macroeconomic equivalent of force majeur. Certainly, the macroeconomic conditions (including exchange rate depreciation) that befell several countries of East Asia and Latin America would seem to fall under the definition of force majeur as "those risks which result from events beyond the control of the parties" to IPP agreements. (Nevitt, p. 19)

Although the concept of force majeur is typically thought of as events that trigger insurable casualty losses (such as natural catastrophes) and some insurable non-casualty losses (normally related to political and social disturbances), it seems functionally related to economic events as well. Three major types of economic force majeur (hereafter referred to as EFM) come to mind:

o Severe foreign exchange rate depreciation, as experienced by Indonesia, Malaysia, the Philippines, South Korea and Thailand in 1997 and Brazil in 1999

o Catastrophic macroeconomic conditions, such as declines in year-to-year growth rates of real GDP of 10% or more and/or severe inflation, as happened to several of the countries mentioned above

o Unpredictable structural change, such as the intense focus on energy efficiency in the U.S. in the wake of the two 1970s oil shocks and the backlash against nuclear power in the wake of the Three-Mile Island event in 1979

Conventional force majeur risks tend to be project-specific and uncorrelated with each other. Thus, they are insurable, either through formal insurance purchases or self-insurance by diversification. EFM, however, is systemic on a national or even multi-national basis. It would seem to be more difficult to insure against through purchased insurance or self insurance. One issue for the future, regardless of the paradigm, is who takes EFM risks. Another is how to salvage investments if EFM does strike, allocating costs and benefits equitably and efficiently to all stakeholders.

Some insight may be afforded by the experience of the U.S. in the 1980s with regard to reactions to "rate shock" on the part of electricity customers who were called upon to pay for expensive power plants that were not needed due to an abrupt deceleration of demand. A simplified account of this situation is as follows:

o In the wake of the first oil shock in 1973-74, electricity demand slowed significantly from the "ten-year doubling rate" (7% per year) of the previous decades (thought by utility executives and regulators to be virtually a law of nature) to slow growth (2-3% per year or less) thereafter.

o Utilities were building power plants, which have long gestation periods, in anticipation of 7% per year growth. Many of these were nuclear plants (which have especially long gestation periods as well as high capital costs). Several were started after 1974 because it was believed that the slow growth of the mid-70s was an aberration.

o The Three-Mile Island event triggered a wave of new nuclear safety requirements that caused expensive delays and retrofits to nuclear plants in existence and under construction.

o The utilities and their regulators had a compact that insured that utilities would be able to recover their capital costs plus a reasonable rate of return on investment, as long as such investment was deemed to be "prudent."

Reasonably stable electricity prices depended on predictable capital costs and a high rate of capacity utilization. Neither of these conditions obtained in the early 1980s because of the EFM events of structural change in demand and escalating construction costs of nuclear power plants. Hence, rate shock.

Although it would be inappropriate to draw facile parallels between two countries and circumstances as different as Indonesia and the US, nonetheless the two countries have three common ingredients:

o Rate shock (due to foreign exchange depreciation in Indonesia and rising capital costs in the US)

o Excess capacity due to inability to anticipate lower-than-expected demand (due to macroeconomic factors in Indonesia and structural change in the US)

o Inadequate revenue on the part of those who invested in new capacity in both countries

What lessons can be learned from the US in the 1980s that would apply to impacted countries? Are there reasonable ways to mitigate the damage, such as changes in the timing of revenue recovery? What is the proper role of government? Of multilateral institutions? Investigation of successes and failures in the U.S. with respect to rate shock would seem to be productive for possible suggestions pertinent to mitigating the situation today and structuring agreements in the future.

Lessons learned from other times and places notwithstanding, what mechanisms to mitigate the potential damage of EFM can or should be put into an emerging paradigm for foreign direct investment in private power? Who is best able to bear EFM risk? How should that risk-bearing be structured?

Another question is whether those projects that have failed would have done so in any case in the face of the post-1997 EFM, regardless of how they were structured. Would the only difference in the outcome be a shift in the allocation of risks? Perhaps the failed projects would not have been built at all under the new paradigm, and perhaps others (successful or not) would not have been built either. Would that have been a preferable outcome?

The Role of Structural Failure of the Old Paradigm

One of the questions that should be addressed is whether the old paradigm actually broke down at a greater rate in the post-1997 period than before. If so, does that suggest fatal structural flaws in the old paradigm or simply that projects were overwhelmed by EFM? One way to shed some light on this question is to see what has happened to foreign direct investment in IPPs in countries such as India, China, Mexico and Taiwan. While damaged by the worldwide contagion of financial uncertainty, they did not suffer to the degree of the most seriously impacted countries. Are projects still successful in the sense of all stakeholders being satisfied under the terms of their agreements or at least impacted only by risks that they voluntarily assumed and that are at least partially under their control? A comparison of what happened in crisis countries with what happened to non-crisis countries at similar stages of economic development would seem to be appropriate and illuminating. If projects under the old paradigm are proceeding in non-crisis countries, then it suggests that the paradigm is not the principal problem.

V. Considerations for the Emerging Paradigm(s)

Whatever paradigm emerges will have to address a number of considerations to be successful in the sense of attracting foreign direct investment ,having agreements hold together without creating undue distress to ultimate customers, and avoiding unacceptable contingent liabilities for governments.

 Stakeholders and Their Stakes and Risks

One of the principal characteristics of foreign direct investment in private power is that stakeholders and their interests are numerous and varied. For such investment to be successful, or even to happen at all over the long run, the interests of all stakeholders must at least be satisfied, if not to the same degree.

Developers/investors must be able to obtain a risk-adjusted rate of return at least as high as they can obtain elsewhere. This simple truth masks a number of complicated issues. One is the role of portfolio diversification. It has been suggested that large, multinational investors can accept lower returns than might be suggested by the riskiness of a given project on a standalone basis. However, given the size of IPP investments, how many corporations are large enough to have more than a few in their portfolio? Moreover, the size of an IPP investment typically means that even the largest corporations develop special-project companies that are deliberately isolated from the balance sheets of their parents. Thus, while an IPP project may look like one among many investments by a large corporation, functionally it is one of a few. In fact, it may be one of a kind in a special-purpose company formed by its large parents. Even if large multinationals regard an IPP as one among many of its investment portfolio, to what degree would the size of the projects limit the number of players who could look at them from this perspective, thus limiting competition?

Risk adjustment of returns sought by developer/investors also implies that the nominal returns, and therefore the costs to transmission and distribution (T&D) entities and ultimate customers, are higher if the owners take more risks. Thus, guarantees -- in one form or another -- allow supplied capacity to be greater and tariffs lower. The cost of guarantees, however, is that the risk is shifted from the investor/developer to the guarantor.

T&D entities in many developing countries are state-sponsored, often with little independence from political direction or pressure. In addition, they are also often placed in a position in which they are the executors of political and social objectives through subsidization of tariffs of particular classes of ultimate users and have constraints against raising overall tariffs to a level that will cover their costs.

Granting long-term PPAs to IPPs puts such T&D entities "between a rock and a hard place" -- an uncomfortable (sometimes-untenable) middle ground between their obligations under the PPA and the political pressure of ultimate customers and their political representatives to keep tariffs low. However, if they refuse to take the risks associated with the PPA, investors may be unwilling to take the market risk associated with a project, and power supply would be inadequate. A common result is that public T&D companies are not financially sound enough to stand behind their PPAs. This increases risk for developer/investors and restricts supply, unless the T&D entities are backstopped by central government guarantees.

Another issue is whether public T&D companies have the incentives and the expertise necessary to negotiate equitable agreements with sophisticated multinational companies. On the one hand, it is thought, the naivet� of such entities leads them to negotiate agreements that are unfavorable to their ultimate customers. On the other hand, fear of being exploited may keep them from negotiating any agreements that might interest developer/investors, leading to ultimate customers not having power supply that they would be willing to pay for. An open question is whether the privatization of T&D entities would make a major difference in the amount of capacity supplied by IPPs, the terms under which is supplied, and the revenues necessary to entice it.

Ultimate customers’ and regulators’ interests are to have power supply that is some combination of available, reliable and cheap. Although there is increasing institutionalization of competition at the retail level, ultimate customers’ interests are typically represented by regulatory bodies or by state-owned T&D companies. One issue is how well ultimate customers understand the trade-offs between "available and reliable" and "cheap." Another is how well their interests are protected, either by state regulatory intervention or by a completely competitive market (which may entail sufficient risk for developer/investors that they will provide less than the socially optimal investment in generating capacity and at a higher price).

Governments and multilateral development agencies are important stakeholders in that they may be guarantors, lenders or investors – or all three. In addition, they are perhaps the most efficiently responsible entities for identifying and coping with externalities.

As guarantors, they take on contingent liabilities that are often not represented in government accounts until they have to be paid. Because they are not explicitly represented, it is seldom known whether the associated risks are adequately provisioned. This is particularly the case for systemic risk, such as EFM.

Governments and multilaterals as investors have many of the same considerations as private developer/investors, as discussed above. (The interests of lenders are discussed below.) In addition, however, governments may have a conflict of interest in that they are representing the public good, which may not be congruent with their roles as investors seeking the maximum return on investment or lenders seeking a agreed return. To the extent that they do represent the public good, they may be in conflict with the objectives of their private partners. How do government and multilaterals reconcile these conflicting interests?

As indicated above, the presence of externalities means that the marginal social benefits of electricity supply may often exceed the marginal private benefits and marginal social costs, particularly for pre-industrial agriculture and the urban poor. To the extent this is the case, application of private investment criteria will lead to under-supply of new generating capacity. In addition, government has a role in correcting for negative externalities of electricity supply, such as air pollution.

The issue of positive externalities implies economically justifiable subsidization, a burden often forced on T&D entities rather than borne by general government. To the extent that T&D entities undertake this responsibility, it implies inefficient pricing, particularly if there is cross-subsidization of some classes of ultimate customers by others. In addition, cross-subsidization is not transparent – another reason that government should be responsible for the compensation of positive externalities. Given this, how likely is it that the burden of subsidies can be shifted to where they belong?

Commercial lenders, including bondholders, have only downside project risk. This is incurred when developer/investors cannot meet their debt obligations. Inasmuch as IPPs are typically highly leveraged and lenders have limited recourse to parent companies’ balance sheets, lenders are exposed to significant project, market, political and EFM risks. Thus, guarantees have been important to lenders, as have predictable economic and institutional environments.

Suppliers, including engineer-constructors, equipment providers, and fuel suppliers have obvious stakes in the IPP being completed and financially successful. Project cancellation, in particular, is a risk for engineer-constructors and equipment providers. They also take on completion guarantees regarding timing, cost and operational reliability. Moreover, they also frequently have developer/investor risks, inasmuch as they often have significant equity stakes in IPP projects.

 Who Takes Economic Force Majeur Risks?

The 1997-1999 period has been one in which virtually no developing country has gone untouched by financial contagion and the damage to real economies that it has caused. Although no one knows when or if such a period will recur, the fact that it happened once will intensify future concern with EFM and with determining which stakeholders should bear EFM risk.

A general principle of risk allocation is that risks should be borne by those who can best control them. Who controls EFM risk? As far as macroeconomic and exchange rate stability risks are concerned, these can only be controlled, even in principle, by central government. Yet, at the onset of the East Asian financial crisis, those countries most affected were pursuing what appeared to be sound fiscal and monetary policies. The principal problems came from the private sector’s borrowing too much, in the wrong currencies, and with mismatched time structures of borrowing and lending. In retrospect, better prudential regulation of the financial sector by central governments might have prevented the crisis, but it did not seem to be a major consideration at the time. So, who could have controlled this risk and who should have taken it? Similar questions were asked in the wake of the sudden slowdown of electricity demand in the U.S. in the 1970s. Allocating EFM risk will be an important issue in the future, and it is by no means clear how it will be handled.

 How Will Externalities be Handled?

The principles for handling externalities are fairly clear. Making them operational is another matter altogether. First, the very non-market nature of externalities makes them extremely difficult to measure. Thus, invoking externalities when a project fails a market test may be either a legitimate concern or the first refuge of scoundrels. Potential externalities should be identified and quantified to the extent possible. To the extent that they cannot be quantified, they can at least be subject to relatively transparent political judgment. At a minimum, whatever subsidies are appropriate to compensate for externalities should be decided on the best information that can be documented.

Of course, they can be simply ignored. However, if they are real (albeit unmeasurable) then private investment in IPPs will be less than optimal to the extent that marginal social benefits exceed marginal social costs, as discussed above. This implies that the public sector will have to invest more than would have been the case had an appropriate subsidy compensation scheme been in place, if power supplies are to be adequate.

The obvious next question is what is "an appropriate subsidy compensation scheme?" An answer to this question must meet two important criteria: it must be economically efficient, and it must be amenable to implementation. Unfortunately, it appears that both of these criteria are seldom met, with considerations of implementation frequently dominating considerations of efficiency. The most common subsidy compensation scheme, as mentioned above, is subsidization and cross-subsidization of rates by T&D entities. The result is almost certainly economic inefficiency due to distorted relative prices, perhaps compounded by the inefficiency of financially insolvent T&D entities. Some other possibilities are:

o Direct payments to the IPP to meet its revenue requirements in return for lower wholesale tariffs (with the attendant perception of a poor central government subsidizing rich multinational companies)

o Direct payment to members of the classes of ultimate users deemed to be appropriate targets of subsidization

o Payments to the T&D entities

One principle that does seem clear is that compensation for externalities should be a matter for general government expense, not for T&D entities.

 Is Busbar-to-Meter Competition a Sufficient Condition for IPPs to Provide Adequate Capacity at a Reasonable Price?

An important element of the new paradigm is private competition from the generating station’s busbar to the ultimate customer’s meter. The leap from their current situation to complete privatization would be enormous for most developing countries. Although IPPs are common, completely private, unregulated, competitive T&D is not. Where it does exist – the U.K., California, Chile and New Zealand – it is not clear that the experience is wide and deep enough to come to any firm conclusions. In particular, it is not clear how enticing this environment will be for developer/investors that would have to operate on a spot market, with so-called "merchant" plants.

A precondition for a perfectly competitive market is many buyers and many sellers. If this scissors has only one blade, it will not cut. In particular, it seems unlikely that developer/investors will compete for only one customer on a spot-market basis – be it private or public. Once merchant plants have capacity in place that is adequate to meet demand, ultimate customers (either directly or through T&D entities that reflect their interests) would be able to drive wholesale tariffs down toward the plants’ short-run marginal costs – just enough to keep them running but not enough to cover fixed costs, much less a return on investment. The supply of developer/investors willing to invest in such an environment is probably not sufficient to add much capacity.

The flip side is that if there is not enough capacity in place to satisfy demand, merchant plants can price as monopolists (until other developer/investors enter the market). However, the threat that political intervention would prevent them from doing so puts a cap on tariffs (and therefore returns) but still exposes them to the risks discussed above – a situation that compares unfavorably to electric utilities building power plants under conventional regulation in the U.S. The only way out of this box is to have a well-integrated transmission system that allows merchant plants to sell to many buyers and to have the institutional mechanisms in place for smooth and efficient transactions. Most developing countries would appear to fall short of either condition. The challenge, then, is how to structure the environment for IPPs that maximizes the advantages of competition, subject to the constraint of sufficient incentives for developer/investors to add capacity.

 Can PPAs be Made More Flexible Without Causing Unacceptable Damage to Some Stakeholders?

One possibility that should be explored for future PPAs (if indeed there will be PPAs under whatever paradigm emerges) is whether there are ways to add flexibility to their terms that can better accommodate EFM. For example, current rate shock and/or T&D entities’ revenue deficiencies might be mitigated in return for larger-than-otherwise tariff increases in the future, when macroeconomic and electricity demand conditions have recovered. U.S. experience with rate shock and addressing utility revenue requirements might shed some useful light on available options.

 Is Privatization of T&D Entities Necessary or Sufficient for Efficient Provision of IPP Service?

Privatization of T&D entities has important theoretical advantages over publicly-owned entities in terms of incentive-driven efficiency. The theoretical appeal is enhanced by the generally poor record of publicly-owned T&D entities in many if not most developing countries. However, given other priorities and political opposition, it may be some time before many developing countries give serious consideration to privatization of T&D. When they do, they will carefully balance economic benefits with potential political costs. One topic that should be examined is whether the problem is with public ownership per se or with problems that can be remedied in a public-sector framework.

In the U.S., for example, public ownership of distribution appears to be alive and well in Nebraska (the entire state), Los Angeles, Seattle, San Antonio and Sacramento (to name a few major cities), a number of smaller cities, and over 900 rural electricity cooperatives. While it is true that many have access to inexpensive, government-sponsored generation, many have also added incremental capacity through agreements with IPPs. They do not seem to be unduly inefficient and appear to be financially solid. The difference between these distribution entities and those of developing countries seems to be in governance, incentives and competence. In the U.S. these entities are typically independent of short-term electoral politics, required to be financially self-sustaining, and have been able to attract adequate expertise.

Moreover, privatization of T&D companies may simply shift corruption and political influence, not remove it. Until sophisticated institutional arrangements are in place to give each retail customer a choice of which IPP from which to purchase power, T&D entities will remain in monopoly positions and thus have to be regulated. Regulators are likely to be subject to the same political pressures and temptations as publicly owned T&D entities.

Thus, publicly owned T&D entities may be no more effective than private distribution companies, but it is not clear that they need to be worse. The possibility that reformed public T&D entities may be adequate to efficiently represent ultimate customers in forming agreements with IPP should not be dismissed automatically. However, careful institutional design would be necessary to shield public T&D entities from political influence.

 VI. Scenarios for the Emerging Paradigms

These nine scenarios are an attempt to cover the range of possibilities, but it is clear thatsome are more plausible than others. For example, "Developer Heaven" might be so attractive to developers that power purchasers and/or governments would be able to offer less attractive tariffs and/or shift risk from themselves and still have an adequate number of developers competing for the available capacity. However, governments could decide to sustain "Developer Heaven" for a while in order to assure that it had enough qualified bidders to meet its capacity needs. At the other end of the spectrum, "Developers Need Not Apply," there would be little reason for developers to show any interest. Any new capacity that would be added in this environment would probably have to be publicly owned, regardless of official policy. In general, the lower left of this table would not be likely to attract many developers; while in the upper right, governments and purchasers might question whether they are offering too rich a deal.

Of the other extreme positions, "Can’t Afford to Not be There" may be realistic because if a market is big enough, firms may be willing to take significant risk in order to establish footholds that may prove to be profitable in a less risky future. For foreign direct investment in general, China is often cited as such a case. The "Nice Place to Visit…" scenario is realistic in that, while its low growth may not warrant sustained marketing and business development, it is an environment that is attractive on an opportunistic basis.

Thus, the questions of the future of foreign direct investment in private power will be how far upward and/or to the right must environments be to attract development that will be supported by lending. Until developing countries regain sustained economic growth, the answer will remain uncertain. What is clear is that all stakeholders – developers, purchasers, lenders, governments and multilateral development agencies – must have a much clearer idea of their own and each other’s interests if foreign direct investment in private power is to achieve the private and social potential of which it is capable.

Brown, D. Clayton (1980). Electricity in Rural America: The Fight for REA. Westport, Conn.: Greenwood Press

Irwin, Timothy, Michael Klein, Guillermo E. Perry, and Mateen Thobani (1997). Dealing With Public Risk in Private Infrastructure. Washington, D.C.: The World Bank

Nevitt, Peter K. (1983). Project Financing (fourth ed.). London: Euromoney Publications

Appendix: Elements of a Research Program

The discussion above indicates the crosscurrents and complexities of identifying what will come next in the market for foreign direct investment in IPPs. Insight on whether the new paradigm, the old paradigm, a paradigm that has not yet been considered, or some combination of the three will emerge can be best achieved by a comprehensive research program. Such a program would take account of the interests of each class of stakeholders, emerging trends in public policy and private practices, and lessons learned from experience. This section presents some ideas on the content of a research program that would clarify the issues, analyze evidence, and present a vision of the paradigm(s) concerning foreign direct investment in IPPs that is likely to emerge.

What are the Important Issues Concerning Foreign Direct Investment in IPPs? Who Says So?

To date, it appears that most of the analysis and literature on foreign direct investment in IPPs has been written from the perspective of one stakeholder or another. An important task is to get some agreement among stakeholders on what issues are most important. This can probably be accomplished best by collecting and distilling the various points of view in a systematic, consistent, integrated framework. Without a comprehensive view from the stakeholders themselves about what is important, discussion of new paradigms or retention of old ones will remain theoretical and speculative; for unless all stakeholder interests are satisfied, there will be no IPP investment. One approach to identifying the most important issues is to convene a panel of senior representatives of stakeholder interests and query them through a structured interview process. Once the most important issues are identified, attention can be focused on what are agreed to be the most important problems in successfully launching and running IPPs to the satisfaction of all stakeholders.

Lessons from Experience

By now, many IPP agreements have been struck in developing countries, and it is possible to get some insight on how well they have succeeded. All of these to date, however, appear to be structured according to the old paradigm. As of June 1999, the author does not know of any IPPs that have been built on a merchant base in developing countries. Nonetheless, even if limited to the old paradigm, a systematic investigation of what kinds of agreement structures have worked and what kinds have not should be useful. It would be likely to shed light on which elements of the old paradigm contribute to success (and should thus be retained) and which contribute to failure (and should be replaced). This knowledge could assist efforts, such as that of the World Council on Infrastructure Development, to develop standardized terms that would remove much of the uncertainty and cost of the IPP development process on the part of all stakeholders.

A survey of IPP projects, using the issues identified by the panel of stakeholders, might be used to see the extent to which these issues were addressed and with what success. This would provide a factual basis to support the structured interviews of stakeholders or identify issues that need further investigation. To the degree possible, the results of such a survey should be quantified. However, much of the most important information is likely to be qualitative, posing a challenge to transforming it meaningfully into data that can be tabulated, cross-tabulated and analyzed. Information that defies meaningful quantification should still be collected and analyzed to complete the picture of what can be learned from past experience. At a minimum, it is likely that analysis of the results of such a survey would produce evidence on the efficient allocation of risks, the role and structure of guarantees, on coping with EFM, incentives and controls to insure efficiency and equity, and other issues.

The Public Policy Environment – What Is Necessary and/or Sufficient?

A fundamental question is what kind of public policy environment on the part of developing countries will be necessary to support a healthy IPP market in the future. One question is whether the post-1997 financial crises in developing countries will lead to the kind of reforms that will be necessary. For example, will there be new, effective financial supervisory institutions that could prevent a recurrence of the over-extension of private foreign indebtedness that touched off the crisis in Southeast Asia and South Korea in 1997? Such reforms would go a long way to mitigate EFM risk.

The policy framework under which T&D entities will work is also critical. Obviously, a developer/investor is unlikely to be attracted to a market in which its T&D customer must maintain retail pricing policies that make it financially unable to support obligations under its PPA. Until reform of T&D entities is in place – either through privatization or through public sector reform – investors and lenders are likely to continue to insist on central government guarantees that protect them from failure to live up to the terms of PPAs. The rub, of course, is that those countries that can least afford to assume contingent liabilities from guarantees are likely to be those where investors are most likely to insist on them.

How will the emerging paradigm address the trade-offs between saving public funds by having the private sector build socially desirable electricity generating capacity and the contingent liabilities that government must assume to attract that investment? Certainly transparency and improved government accounting practices would help the information and accountability behind these decisions, but the decisions must still be made.

Other important questions concern what subsidies are paid by whom and to whom and identifying the charter, power and independence of regulatory authorities – particularly vis-�-vis private T&D entities.

Another issue is whether the emerging paradigm will require privatization of T&D entities as a necessary or sufficient condition for efficiency. As indicated above, in the U.S. at least, public power seems to be a viable alternative. What must change as to governance, talent and independence for public entities in developing countries to maintain an environment for successfully attracting IPP investment? Is this a viable alternative to privatization? Where privatization of T&D does take place, what new regulatory bodies are required? What must be done to insure that they exercise their duties in a socially responsible way with respect to their obligations to both ultimate customers and developer/investors?

The public policy questions raised above would seem to be amenable to review of the literature relating to the pertinent issues – including similar experiences in developed as well as developing countries. An attempt should be made to develop some general principles of what is required to build a public policy environment toward foreign direct investment in IPPs that meets the interests of all stakeholders.

Identifying the Emerging Paradigm(s)