Power play

Poland's electricity market continues to be hampered by long-term contracts and stalled privatizations.
By : Leo Broomfield

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   The government set itself a daunting task when it decided in 1997 to liberalize and privatize the power sector simultaneously. The move was driven by the need to meet European Union (EU) liberalization criteria as the EU’s internal power market opens up in 2003, but also by a desire to introduce real competition into a sector crying out for change.

   But moves toward a more open electricity market have foundered on the failure to resolve a number of problems, with the key failure impasse on how to dissolve long-term contracts signed in the 1990s between grid operator Polskie Sieci Elektroenergetyczne (PSE) and the country’s 36 generators. Added to this, privatization has almost ground to a halt and there is a lack of resolution of various regulatory questions, delayed and confusing implementation of technical market mechanisms and the determination of many in the sector to resist change.

   The long-term power purchase agreements take up about 65% of all power bought and sold in Poland. They are priced on average about 25% higher than power traded on the short-term bilateral market – operated between generators and distributors – the Polish Power Exchange (PPE), and the balancing market – run by the PSE. Market insiders said the contracts stifle competition and are the main obstacle to the opening up of the market and the success, in particular, of the power exchange.

   “We may even have to start the process of resolving the long-term contracts from scratch if the present pessimism in the sector continues,” said an Economy Ministry official who chose to remain anonymous. The source said the sticking point in moving ahead with resolving the contracts was the lack of legal interpretations from the Finance Ministry. “But the Finance Ministry has had its hands full recently and the new government will have the same problems with the budget,” the source said.

   What the future holds

   The Democratic Left Alliance (SLD), winner of the Sept. 23 elections, has said little so far about its plan for the power sector. But leading figures have hinted at a change in the privatization strategy and stepping up dissolution of the long-term contracts. “There is no real power market in Poland at the moment,” said the probable next treasury minister, Wiesław Kaczmarek, last week. “That will come only when Poland joins the EU. But we must deal with the long-term contracts.”

   An indication of the weakness of the liberalized power market and the extent to which the SLD must go toward liberalizing it is the failure of the exchange. The market was set up in June 2000 along the lines of other European exchanges trading in day-ahead power. It was heralded as the engine that would drive the sector into the bright light of unregulated power trading and was expected to take up to 20% of the total power traded in Poland by the start of 2001. The remainder was to be traded mainly on shorter-term bilateral contracts and a small percentage mopped up at higher prices on an hourly coordinated balancing market. PSE was to be fully removed from the wholesale trade in power and would administer the transmission system. The exchange’s success or failure, analysts said, would reflect the success – or failure – of the power sector’s ability to liberalize. With the exchange currently bumping along with about 3% of all power traded the answer is clear.

   “To put it simply, nothing is happening with resolving the long-term contracts,” says Jacek Brandt, deputy president of the PPE. “We are still in the same place as before. This is very disappointing, but we expect the process to speed up after elections.”

   The problem of weak competition in the industry stems from the fact that most of Poland’s generators took out large loans in the 1990s to finance investments to upgrade to EU environmental standards. Banks offered loans on the basis that PSE – in other words, the state – would underwrite them in locked-in contracts over many years.

   Of the 36 power plants, nearly two-thirds are more than 20 years old and many fear that competition – both domestic and international – will run them out of business. And with privatization stalling and foreign investors keen to get into the more lucrative distribution sector rather than generation, many believe they would not be able to sustain the level of investment necessary to survive. The Economy Ministry estimates that modernization costs may total zł. 38 billion ($9 billion) by 2010, while industry sources said the figure could run as high as $50 billion during the next 10-15 years. The Economy Ministry estimates the total value of the long-term contracts at zł. 11.5 billion ($2.7 billion).

   SOK it to ‘em

   In 1997, the government began to consider ways of cancelling the long-term contracts without upsetting the cash flows of the major power generators and the nation’s power supplies. Various options as to how to open up the market were on the table at the Economy Ministry, the most widely accepted being a compensation system known as System Opłat Kompensacyjnych (SOK).

   Under SOK, the financial side of existing long-term contracts would be refooted, with the option being left open for the companies not to sell to PSE. Those then selling on the open market below a fixed reference price would be compensated from a fund collected and allocated by PSE from those selling above the reference price. SOK would be a temporary solution to allow generators to retain guarantees of income while being able to rethink their sales strategies.

   To guarantee generators there would be no drop in income as a result of removing the long-term guarantees – and also to assure the banks that lent them the money to finance pro-ecological investments – the Energy Regulatory Authority (URE) was to set tariffs for distribution companies’ sales to end users, who would then pass on extra costs to the consumer.

   The compensation system was slated to go into operation in three stages – the first in July this year – through the renegotiation of contracts for the nation’s largest and cheapest generator, Elektrownia Bełchatów, plus Elektrownia Opole, Elektrownia Jaworzno III and Zespół Elektrowni Dolna Odra. Combined, they make up around 30% of the total value of the long-term contracts, with Bełchatów comprising around two-thirds of this figure. But Bełchatów pulled out of the first phase and the others have since hesitated.

   Almost 100% of Elektrownia Opole’s power is tied up in long-term contracts signed through 2012. The contract underwrites about zł. 5 billion ($1.1 billion) in credit payments. Jaworzno III has most of its power tied up in contracts through 2008 and 12-15% through 2012. Both contracts underwrite credit of about $100 million. In 1997 Elektrownia Opole saw its zł. 5 billion ($1.1 billion) debt restructured by the Finance Ministry and the Economy Ministry in concert with the National Bank of Poland (NBP). Opole is one of the biggest debtors in the power generation sector, but it is also one of the lowest-cost producers.

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   Business as usual – delays

   Many within the industry warn that SOK may now take months longer than planned, for several reasons. The 1997 energy law and its 2000 amendments do not oblige producers to renegotiate their long-term contracts with PSE. Because the long-term contracts assure them a steady – and high income – many are not inclined to participate in SOK. Also, some analysts said PSE may not want to renegotiate the long-term contracts because of its large income from wholesale trade. Banks also tend to see the long-term contracts as guarantees of money lent from 1993-1998 to power plants to finance environmental improvements. Banks are afraid of an unnecessary risk if they don’t have guarantees from the URE, the government’s energy watchdog, that their investments will be secure.

   “Banking consortia are afraid of being caught out if the reference price falls too far and compensation payments grow beyond what they’re expected to,” said Mirosław Duda, adviser to the URE’s president. “But they shouldn’t be.”

   Many analysts also said that a half-hearted application of SOK may lead to higher prices, greater conservatism in some sectors of the industry and increased risk for all involved. “The gap between long-term contract prices and the reference price must be paid to every generator to cover their costs,” said Jacek Musiał, of industry agency DGA. “Money for financing this gap will come from distribution companies, which will fund this by passing the costs on to the end user – the consumer.”

   Tadeusz Kowalak, director of tariffs at URE, said he expected the average price of electricity to stabilize around zł. 110 per megawatt hour (MWh) after the full introduction of the system. The average compensation at this price, he said, would be about zł. 14 per MWh.

   The key question for many analysts is who should bear the risk. Banks such as Łódzki Bank Gospodarki, Powszechna Kasa Oszczędnoœci Bank Polski (PKO BP) and Germany’s Commerzbank want to know if they will be guaranteed against any changes in the law that may be necessary. Some critics of SOK warn that some companies may make the system unworkable by acting as spoilers.

   Analysts said the two crucial financial problems with the present version of SOK lay in prices and volumes, such as what would be calculated and by whom. Also unclear to many analysts is the time period that SOK would be operative. All of these impact the risk exposure and cash flows of power plants that enter into SOK as well as the banks that lent money to them on the back of their long-term contracts. The main problem area is whether return on capital would be included in justified costs. As the contracts are priced at zł. 120-zł. 180 – higher than the market purchase price – the regulator knows it cannot force banks to accept a rapid deterioration in its credit profiles.

   Furthermore, most of the borrowing by generators was via syndicated loans from multiple banks, owing to the large sums needed. This means every negotiation has several players, meaning a further delay. This also means generators may have to look for new sources of refinancing and possibly spur a round of big bond issues. The other possibility would be for foreign investors to assume responsibility for the loans, but that might mean the treasury accepting knockdown prices in privatizing them.

   Rumors abound within the industry that PSE, URE, and certain government ministries have either been dragging their feet on or actively engaged in undermining the liberalization and deregulation of the sector. Analysts said the key political conflict is between PSE and URE. They said they cannot see eye-to-eye at the highest levels. “PSE wants to keep its hand in the game, while URE is accused of harboring anti-market tendencies and sympathies with the leftist opposition,” said one commentator who wished to remain anonymous. Talks between PSE and URE broke down in the summer. The Economy Ministry, Finance Ministry, Treasury Ministry, anti-monopoly office and the government’s energy regulatory office were also involved in discussions.

   Cat-and-mouse struggles between the Treasury and Economy Ministries over the pace of the sector’s privatization this year have also added to suspicions that the invisible hand of the market is still firmly in the grip of the command center. Critics point to the complex and interwoven political, regulatory, technical and logistical problems associated with opening up what was until very recently a centralized structure inherited from a communist-era command economy not so keen on consumer choice. Others said these are problems the rest of Europe has also not fully dealt with and the Polish example is not unusual.

   Marek Zerka, PSE deputy president, said last week that if SOK falls through, URE may consider increasing the amount of power on the free market (that is outside of the long-term contracts) by reducing the must-take obligations of distributors. “SOK has no fathers anymore and could well fade away” Zerka said. “There are various alternatives on the table, but which one is best only time will tell.”