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Long Term Contracts in the Polish power sector Origins, present situation, perspectives of solution

Origins

At the beginning of the nineties of the last century the Polish power sector has entered a period of structural reforms aimed at adjusting it to the requirements of general market reform of the Polish economy. As a result the energy sector faced the necessity to start a huge investment program with a purpose of liquidation of a long-time negligence, specially in the efficiency of generation and environmental protection. In both fields, a strictly centralised sector of economy, including power stations and combined heat and power stations, managed by the command system and almost completely dominated by the state owned property, had to undertake significant efforts to adopt both economic parameters (especially efficiency of generation) and the environmental standards in order to follow Poland’s obligations and the emerging market environment.

The scope of necessary investment and financial means reaching a few billion dollars would significantly exceed the potential of power generators. We must remember that investment means at their disposal were generated in a system where the price level was not a result of economic realities but of an arbitrary administrative decision lowering energy prices, first of all due to historical social pressure. Necessary investments had to face world market prices of mostly imported modernisation and environmental protection equipment. They had to be covered mainly by external sources. The emerging banking sector was too weak to take a risk to finance such huge investment without proper security measures. Worn–out, obsolete and of low market liquidity generation assets owned by the power undertakings, could not be a base for a sound pledge. Also securing credits on new assets only was not acceptable and satisfactory for the banks. When describing the situation about 1993 we must also take into consideration low level of banking competition and very high demand versus low supply on the Polish credit market. Also the lack of proper knowledge of the mechanisms of international credit market among the managements of the Polish energy undertakings and distrust of financial circles as to the future of the energy sector in Poland were the most serious obstacles in searching for international financing sources.

When the program of long-term contracts was being prepared it was assumed that the revenues from energy sales obtained by units involved in the contracts would cover credit obligations resulting from the above mentioned scheme.

Taking into consideration methodological difficulties resulting from a necessity to prepare a many-year projection of energy prices, it was de facto decided, that the Polish Power Grid Company would purchase obligatory amounts of energy covered by contracts at prices securing repayments of credits. The solution adopted passed a responsibility to repay the credits from the energy companies to final customers, via the Polish Power Grid Company S.A. The most important shortcoming of this solution was an assumption that the energy prices would cover costs of generation and credit without being an incentives to improve efficiency. It seems that this arbitrary attitude in the pricing methodology was the most serious mistake in scheme construction. Prices were regarded more as elements of internal planning rather than as external parameters created by the market.

Generally in the long term contracts the following principle was adopted: The Polish Power Grid Company S.A. was obliged to buy from involved generators specified quantities of capacity and electricity at the prices where fixed generation costs (exploitation, repairs, salaries and financial costs of investment) would be covered by capacity payments, and variable costs (fuel, environmental protection, etc) would be covered by electricity payments. Long term contracts became a pledge for credits which reached about PLN 17 bln. The longest credit was to expire in 2027 and the accumulation of payments would reach the peak in the middle of the decade.

Consequences for the sector

Arbitrary actions of the sector, methodological mistakes and lack of coherent approach to the contracts led to the situation when diversification of prices did not reflect real market conditions and, as a result, many contracts became a tool of subsidising inefficient activity.

Long term contracts established economic conditions for the generation of most energy in Poland (from about 75% of energy at the end of nineties to about 45% in 2005). The existence of these contracts became, according to numerous experts, the main obstacle in the introduction of market mechanisms in Poland. Comfortable market situation of the generators with the highest share of contracted energy was not a result of a growth of economic efficiency but of “quasi – administrative” decisions. The pressure of the sector led to significant increase of the volume of contracted energy, from primarily set at 30% to almost 75%. The capacity of the national power system increased by about 3000 MW, what seems to be unjustified when compared with capacity of around 10 000 MW (about one third of the system) of the units involved in the long term PPAs. Moreover, according to many experts, long term contracts guaranteeing stability became a factor imposing stagnation, successfully blocking necessary restructuring processes in the sector (including privatisation).

Summarising the importance of the long term contracts from today’s point of view one can not overlook the positive aspects of the scheme, first of all the realisation of majority of material aims in the field of environmental protection. Therefore, the critical view on the long-term contracts should not only analyse the realisation of assumed goals but also ways of their execution and their excessive scope.

Ways of solution

Already in the years 1996 – 1997, during the discussion on the introduction of the Energy Law into the national legislative system numerous opinions voicing the necessity to liquidate contradictions between pro-market solution provided for in the Energy Law and the existence of long-term contracts appeared. This tendency was strengthened after the adoption and implementation of the Energy Law by the legislator and emerging gradual integration with the European Community power sector and absorption of market solutions existing there.

The first proposals were prepared by the power sector itself and according to overwhelming majority of external experts they were focused on the protection of generators’ interests at the expenses of customers and the state owner. It became also clear that due to the scale of the problem it could not be solved within the sector. The reasons were as follows:
- the necessity of capital flow from external sources,
- absolutely necessary monitoring of costs by the state apparatus, which would cope with excessive costs of the operation, first of all at the expense of customers,
- a must to combine liquidation process with a program of sector restructuring,
- a need to limit excessive rise of prices or potential implementation of a protection program.

The first internally coherent program proposed the restructurization of the contracts through voluntary cession of contracts to distribution companies. It was assumedthat they would be able to take the whole of the contracts over, or at least, a significant part of them. Participation of distribution companies to which the involved power stations were connected was taken into consideration. Due to high prices at the beginning of the functioning of the contracts, distribution companies were not particularly interested in this operation.

The next program drawing public attention was voluntary System of Compensation Fees, prepared by the Regulator. The scheme assumed introduction of the system where energy generated by producers covered by the long-term contracts would be sold at market prices, and those generators suffering losses resulting from differences between market and contractual prices would be fully compensated. According to this program a joint stock company was to be created to run, under the supervision of the Regulator, necessary settlements. The system was not implemented mainly due to legal and taxation obstacles. It was difficult to classify compensations for generators (the definition of legal and trade relations between the joint stock company operating the system and the generators was extremely difficult to elaborate). Also the Minister of Finance did not precisely define his position on the VAT issue. The implementation of the system was finally abandoned in 2001.

The draft program which followed was called “securitisation” of long term contracts, elaborated by external experts. The project assumed obligatory expropriation of generators with long term contracts and repaying proper compensations. The funds for the compensation were to be collected through the emission of eurobonds by a specially established joint stock company. The obligations would be repaid by revenues from so called Restructuring System Fee, incurred by all customers along the transmission fee. The scheme was to be supervised by the Regulator. However legal problems appeared again. They were linked mostly with expropriation procedure. Also a prognosis of cash flow covering at least 20 years needed to be elaborated. Taking into consideration high level of uncertainty referring to the prices forecasted, changes in the demand and supply and the influence of competition on the emerging European Internal Energy Market, it was not an easy but rather a risky job.

Moreover, the European Commission acknowledged that a single repayment of compensation, without taking into account further moves of prices is not a proper solution, which could be classified as prohibited public aid.

Changes which were introduced after numerous discussions partly gave consideration to objections presented by interested parties. The principle of voluntary participation was accepted. The generators were to receive financial means to cover stranded costs of basic amount together with correction indicators, depending on market prices, used by a given generator. The adopted solution corrected the size of repaid stranded costs by a difference between financial forecasts and real results. When a generator would achieve a surplus he would be forced to return it, with the principle that the amount of a return could not be higher than already paid basic compensation and the amount of compensation could not be higher than a priori fixed maximum value.

It is forecasted however that this year generation covered by the long-term contracts will be decreased to about 48 TWh which constitutes about 45% of total energy sold. It will still be the biggest obstacle in the creation of the competitive energy market. For the time being the program of liquidation of long-term contracts is subject to numerous discussions and analyses. The compensations would be paid annually, and the Transmission System Operator would bear responsibility for the organisation.

General evaluation of the long term contracts requires a balanced approach to the results they brought, both positive and negative. Some of the positive aspects are the decrease of environmental pollution by the power generators, impossible to obtain without credits secured by the contracts, and modernisation effects. Negative aspects include uncontrolled growth of credits resulting in passing financial burdens on customers, slowing down restructuring, keeping the “old system” in the sector and blocking of the market development.

Similar long-term contracts and connected stranded costs appear in many other European Union member states as well. The solution of the problem is facing effective resistance from the side of some interest groups (profiting from the PPAs), what significantly delays real implementation of the Pan – European Internal Energy Market.

05.08.2008

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