Pakistan’s energy sector stands at a crossroads, crippled by a circular debt of almost Rs6 trillion as of now — a crisis threatening the country’s economic and energy security. Circular debt is the amount that the power purchaser cannot recover from electricity distribution companies (Discos) and subsequently fails to pay to the independent power producers (IPPs). Although the circular debt emerged in 2006, its seeds were sown in the 1990s when Pakistan entered into short-sighted agreement with IPPs.

The introduction of IPPs and circular debt is deeply intertwined — policymakers agreed to the conditions of the IPPs without evaluating their long-term implications for the power sector. Through power purchase agreements (PPA), IPPs were incentivised with guaranteed returns and capacity payments, regardless of electricity usage.

Capacity payments require the power purchaser to pay even when the energy produced is not supplied to the national grid, ie, the contract is forged on a take-or-pay basis. Recently, there have been petitions filed in the Supreme Court wherein the petitioners have prayed that the Power Policies of 1994, 2002, and 2015 be declared null and void as the PPAs and the implementation agreements (IA) were entered into without competitive bidding and any rational basis, which have been accepted by the apex court for hearing.

While IPPs have been crucial to meeting the country’s energy needs, their role must evolve to align with the sector’s financial realities

Given the dispute resolution clauses in those agreements and waiver of sovereign immunities as provided in the policies, will the apex court be able to declare them null and void, overriding the party autonomy principle?

The exorbitant cost of electricity generation by IPPs stems from their autonomy in fuel procurement, with a significant portion of Pakistan’s energy mix relying on imported fuels like coal and furnace oil. This reliance has led to inflated generation costs and exposed the country to volatile international prices thereby increasing the cost of electricity and making it onerous for its citizens to afford electricity.

Since the power purchaser cannot collect the amount from the consumers of electricity, it defaults on its payments to the IPPs. Under a guarantee agreement with the government of Pakistan, the government becomes liable if the power purchaser defaults. When payments remain unpaid, IPPs invoke dispute resolution mechanisms, often forcing the government into expensive arbitration proceedings and putting a substantial burden on the public exchequer. Resolving this conundrum is paramount for ensuring energy security, economic stability, and restoring investor confidence.

The ripple effects of circular debt are far-reaching, impacting investors, operations of the IPPs, and eventually the consumers. Investor confidence erodes when payment delays or government refusals to honour guarantees force disputes into arbitration. Persistent issues risk deterring future investments, potentially leaving Pakistan vulnerable to energy crises.

Operationally, IPPs face cash-flow constraints, limiting their ability to procure fuel and maintain operations. Meanwhile, rising electricity tariffs due to circular debt disproportionately burden households and industries. In Pakistan, the dicta laid down by the Superior Courts considers access to electricity as a fundamental right, raising questions about whether unaffordable electricity in Pakistan violates consumers’ fundamental rights — another situation ripe for litigation.

The primary need of the hour is the restructuring of the power sector and privatisation of the power purchaser. Pakistan must negotiate with IPPs to amend PPAs, as privatisation or restructuring of power purchasers constitute events of default in the existing agreements. The government should take IPPs into confidence to avoid potential disputes while revising extravagant concessions granted to them.

Further, the PPAs should be based on the take-and-pay model rather than the current take-or-pay model so that the power purchaser does not have to make capacity payments when there is no demand or electricity is not supplied to the National Grid.

In 2020, Pakistan signed several memoranda of understanding with IPPs to reduce the financial burden on the power sector. While promising, these memoranda of understanding require the National Electric Power Regulatory Authority’s approval and the consent of IPPs’ lenders. Will the lenders ever assent to that is another question that is yet to be answered.

Engaging IPPs in constructive dialogue to revise PPAs and privatise the sector is essential to avoid disputes, ensure fair outcomes for all stakeholders, and ensure that the PPAs are entered into with the IPPs at arm’s length.

In conclusion, Pakistan’s circular debt crisis is a multifaceted challenge requiring urgent action. While IPPs have been crucial to meeting the country’s energy needs, their role must evolve to align with the sector’s financial realities. Renegotiating agreements and privatising the power market can address circular debt while fostering a sustainable energy future. Delays will only deepen the crisis, jeopardising economic growth and the well-being of Pakistan’s 240 million people.

The writer is an associate at the law firm Cornelius, Lane & Mufti

Published in Dawn, The Business and Finance Weekly, December 23rd, 2024