Philippines: Legal Framework for the Proposed Restructuring of the Philippines Electricity Sector

The Electric Power Industry Reform Act of 2001 (Republic Act No. 9136), which establishes a framework for the restructuring of the power sector and the privatisation of the National Power Corporation (NPC), was enacted by the Philippines congress on 8 June 2001 and came into force on 26 June. It is the culmination of seven years of congressional debates, court cases and nation wide consultations.

The Act has three objectives:

On October 1 2001, the first domestically produced natural gas was piped onshore from the Malampaya field, marking the birth of the Philippines offshore gas industry. This new province will reduce the power sector’s reliance on imported oil by firing 2,700 MW of new capacity. The government hopes that the Act will also open the way for development of the country’s geothermal, biomass and hydro generation potential.

It is hoped that the introduction of a wholesale spot market and competition in the generation sector will lower electricity prices. In anticipation of this, Section 72 of the Act required an immediate 30 centavos (0.5 U.S. cents) per kilowatt hour cut in retail tariffs.

Two tranches of development loans dedicated to Philippines power reform which were conditional on the Act’s taking effect will now be released. New bilateral finance has also been obtained for the country’s grid inter-connection programme.

After a period in which the Philippines had fallen behind its neighbours with plans for power sector liberalisation, it now finds itself – due, at least in part, to delays elsewhere – back in the forefront of Asean reform in this area.

The key factor in overcoming opposition to the Act was the decision by President Macagapal Arroyo’s new Economic Planning Secretary, Dante Canlas, to order an immediate tariff reduction for retail consumers. Secretary Canlas calculated that, at the reduced tariff level and taking into account the Php 200 million stranded costs that the government is committed to absorb, the sale of NPC assets and the restructuring of its debt. should generate enough to pay any remaining stranded costs. NPC’s total stranded costs are thought to exceed Php 270 billion (US$ 5.7 billion).

The Government could hardly wait any longer before tackling NPC’s financial problems. In mid-September NPC announced that it was delaying its plans to raise US$400 million abroad. As NPC debt is government guaranteed, NPC’s parlous financial condition weakens the country’s foreign exchange position when the global economy is already putting pressure on the balance of payments.

One source of NPC stranded costs is its existing commitments to buy power from IPPs.

Section 68 of the Act requires power purchase agreements ("PPAs") with the IPPs to be reviewed and, where NPC is experiencing substantial losses as a result of onerous contract provisions, renegotiated. All PPAs will be reviewed by an inter-agency committee chaired by the Secretary of Finance and including the Department of Justice and the Director General of the National Economic Development Authority. The committee will recommend that the arbitration clauses in the PPAs be invoked where it finds clauses that are "grossly disadvantageous" to the Philippines party.

In some ways, this could not come at a worse time. The negotiations are set to take place against the background of a projected shortfall in electricity supply that will grow from 2006 to crisis level in 2009 if no new capacity is built. The government has achieved a modest reduction in costs of purchased power from IPPs in the past year, although NPC’s accounts suggest that the savings will make little headway into NPC’s mountain of debt.

The diagram on the next page shows the post-reform structure of the power sector, including the division between competitive (supervised) and monopoly (regulated) businesses.

Unbundling: The regulatory reforms focus primarily on ensuring fair and open access to NPC’s transmission system and the unbundling of its generation and transmission businesses. Initially NPC will separate its generation costs from its transmission and distribution charges. By 2003, it is envisaged that the high voltage transmission network will be privatised and transmission costs will be unbundled from distribution wheeling rates.

Price transparency: By choosing vertical de-integration, the Philippines reform model is designed to hinder cross-subsidisation and make pricing more transparent.

Attracting an international strategic investor to take up the 40% tranche of the National Transmission Company ("NTC") that is for sale early next year will be an important step in reforming the transmission sector. Distribution will is also scheduled to be privatised by 2003.

Competition: The generation sector already has considerable foreign participation through its IPP programme. Many of these IPPs will look for opportunities to acquire generating capacity not subject to long term PPAs which can participate in the deregulated market. Further opportunities will arise as a result of the accelerated privatisation plans for NPC’s geothermal plants.

Access to capital: Deregulation of the generation and supply sectors seeks to achieve two things:

1. to allow utilities to raise finance for investment at an acceptable cost; and
2. to provide incentives for efficiency in operation, pricing, investment and innovation.

Market power: Although the Act applies ownership caps on involvement in the generating sector, there may still be opportunities to exercise market power in the new environment. The IPPs are heavily focused on the Luzon grid and, pending completion of expensive grid link-up schemes and the "O Ilaw" rural electrification program, will remain large relative to the total capacity of that grid. The 1200 MW coal-fired plant at Sual represented about 10% of the total capacity of the Luzon grid when it came on line last year; 200 MW of its capacity is not contracted to NPC and could have a big influence on the market price of power.

Experience suggests that efficiency of a liberalized energy sector depends more on the form of regulation than ownership.

Productivity: Experience in the UK and Norway suggests that the productivity of publicly owned entities will increase if they are forced to compete. Two or three generators are often cited as the minimum number to allow effective competition on a national scale. The Philippines reforms allow for four.

Privatisation: By introducing a new regulatory regime for the power sector, coupled with the commercialisation of NPC’s existing capacity in a competitive environment, the government clearly hopes to pave the way for a successful privatisation of NPC.

At first sight, the proliferation of regulatory agencies, the Department of Energy ("DOE"), PSALM Corp., the new Energy Regulatory Commission ("ERC") and the Joint Congressional Power Commission, is a recipe for confusion. However, in principle, there are distinct advantages to the new system.

Impartiality: By removing the congressional commission from the direct regulation of the industry, the process is largely de-politicised.

The commission can focus on safeguarding the legal and constitutional integrity of the reforms, including the rights to ownership in, and transferability of, the underlying assets.

Transparency and credibility: The regulatory split between the ERC and DOE gives the process:

1. transparency, in that the ERC is a newly constituted body specifically set up to issue generation certificates, supply licenses and promulgate the operational rules that will govern the activities of market player; and
2. credibility, in that an entity with proven institutional capacity will be responsible for the overall policymaking and direction of the reforms.

The advantage of licenses: The Philippine reforms, like the UK model, do not provide highly prescriptive legislation but rather rely on a flexible system of licenses for industry participants that will clearly spell out the rights and obligations of the holder. The underlying principle is that these rights and obligations can be defended or enforced in the courts. This underlines the two points above.

Quasi-judicial powers: The ERC has jurisdiction over disputes relating to access charges, wheeling rates, cross-subsidies, anti-competitive behaviour and the abuse of market power. Its role is similar to that of France’s combatative electricity regulator, the CRE, which has been prepared to take the government head-on in exercising these powers. The ERC’s duties are backed up by the power to impose fines, price controls, issue injunctions and divestment or tracing orders.

The electricity market is intended to operate primarily through bilateral contracts, but the contracts market is supported by a mandatory spot market, which identifies and sets the price of variations from the quantities of electricity transacted under contracts.

However, the government expects generators to trade more substantial amounts of uncommitted capacity on the wholesale market. Evidence for this has been put forward in the trading figures of NPC’s existing One Day Power Sales scheme which has been operating in the Metro Manila area for three years.

The Act commits the DOE to setting up an independent market operator (an "IMO") whose governing board will be comprised of stakeholders. Whilst this structure should encourage participation in the market because:

1. it will give private investors the assurance that they have some influence in the decision-making process that may affect the value of their investments;
2. if the non-stakeholder model were chosen it might otherwise prove difficult to find knowledgable individuals who were truly independent; and
3. it is possible that non-stakeholders would be viewed as susceptible to capture,

a similar governance structure was severely criticised by the US Federal Energy Regulatory Commission as contributing to the collapse of the California electricity market because the governing boards were prevented by conflicts of interest from dealing effectively with the growing crisis. It has now been replaced with a board a majority of whose members are independent of any industry group.

The Act does not set out the detailed rules for the governance of the IMO. These will be contained in rules that the DOE intends to promulgate in the next month or so. It must be hoped however that:

1. there are no more than 7 to 9 board members to ensure efficiency in decision-making;
2. the voting rules ensure that no 1 or 2 classes can control board decisions;
3. the IMO board has real decision-making authority; and
4. that the regulator (the DOE in this case) must be able to step in where there is a deadlock in decision-making.

Much has been made of the US$2.5 billion flagship Malampaya project and the birth of the gas industry in the Philippines. The Philippines has an interesting capacity mix: 14.68% geothermal, 18.10% hydro, 15.59% GT/Combined Cycle, 21.18% oil-based and 30.45% coal. There is hope of other offshore possibilities but it is unlikely that there will be a substantial shift in the capacity mix any time soon.

Price analysis studies in deregulated markets suggest that markets dominated by fossil fuel technology tend to have higher price volatility than those with predominantly hydro power. The government appears to believe that hydro has a future in any case and section 37(e)(i) of the Act empowers the DOE to encourage the development of hydro resources. Rufino Bomasang, President of the Philippine National Oil Corporation has produced a report claiming that the Cordillera region of Luzon (which is a subsistence farming area) has capacity to harness 950MW of energy. The area is already home to three unpopular hydro projects and this is certain to cause political head-aches for the government.

The government has consulted widely in preparing the Act. It has moved quickly to put together its regulatory teams, to develop the operational rules and codes and, in particular, to ensure that a wholesale electricity market is up and running next summer. The power reforms are central to the new administration’s economic plans and it looks likely to commit significant resources to ensuring their success. A return to the brown-outs of the past would be a disaster for the economy.

Privatisation should open more opportunities for foreign companies. Recent press reports suggest that the competition to purchase a 40% stake in the National Transmission Corporation could raise Php 135 billion (US$2.7 billion) has attracted interest from major players worldwide. The privatisation of distribution and generation businesses are intended to follow by 2003.

The success of these privatisations and the outlook for growth in the generation sector will depend, in good part, on the regulators’ performance in their first year.

"© Herbert Smith 2002

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