In developing countries, electricity generation and distribution have traditionally been controlled by centralized government-owned utilities. But in the early 1980s, generation began opening up to the private sector, and industry players saw possibilities emerging for independent power production. A decade later, forecasters predicted that worldwide demand for new capacity would rise by between 630 and 940 MW during the 1990s—an increase that exceeds the entire installed capacity of Western Europe. Developing countries were expected to account for up to 70 percent of that growth, but since their financial and technical resources were limited, it seemed that independent power producers (IPPs) might enjoy tremendous opportunities to contribute foreign capital and technology.

Despite a few early successes, however, these hopes have not been fulfilled. Many projects have been delayed or abandoned. Of 258 projects in developing countries that had received letters of intent or won competitive bids, about half had not concluded financing by March 1995, while a further quarter either had failed or were experiencing problems (Exhibit 1). These impasses arose as a result of a fundamental shift in bargaining power. IPPs no longer have the upper hand; governments do.

This shift has occurred for two main reasons. First, demand is dominated by a handful of countries, while numerous IPPs compete to supply. China, India, and Indonesia account for about 55 percent of the market, but at least 200 players are vying for projects worldwide, none with a dominant share (Exhibit 2). An absence of barriers to entry—equipment, construction skills, and financing and risk management expertise can readily be bought on the open market—has permitted a rush of players into power production. Many of these entrants have succeeded without the benefit of a background in the industry, among them Saha, a Thai group with plants in China, and YTL, a construction company that built Malaysia’s first IPP.

Second, governments are now better informed about benchmarks such as prices, project costs, and cost of capital. Widespread discussion of electricity issues in the mass media, at conferences, and in specialist publications has improved their knowledge and given them confidence in negotiating with IPPs. At the same time, they have become more discerning about the capabilities of domestic entrants.

Armed with their new bargaining power, governments are demanding projects that meet their needs. China’s government seems to have imposed a cap on project returns, halting IPP interest. State authorities in India are cancelling or renegotiating a number of projects. Many other governments are shying away from making sovereign guarantees. China and India have both demanded lower prices from IPPs; Pakistan has fixed prices in power purchase agreements (PPAs). In Indonesia, prices are on a downward slide.

Whereas projects used to be awarded on an ad hoc basis, most countries are now opting for some kind of competitive process. Thailand and Taiwan have gone straight to competitive tender. In this new environment, most projects in the IPP pipeline have fallen by the wayside or been stalled. The result has been frustration on both sides: for IPP customers—the governments of developing countries—because demand for electricity is not being met, and for IPPs because their efforts are not yielding tangible results.

The shift in bargaining power toward governments will require IPPs to change their strategy. Most are still playing a first-mover game, expecting high returns but neglecting their customers’ needs in pursuit of their own. To succeed in the new game, they must rethink the way in which they conceive and deliver projects.

The need for change

The old approach no longer works because it fails to meet customers’ needs: prices are too high, cost structures are uninnovative, and diseconomies persist.

High prices

IPPs have been asking developing countries to pay higher prices than developed countries. In the United Kingdom and Australia, the wholesale price ranges from 3 US cents to 4 cents per kWh, while developing countries pay between 5.3 US cents and 8.2 cents (Exhibit 3). Such high prices are largely attributable to the high returns that developers have come to expect. They remember a fledgling industry when proven players were few, new capacity was urgently needed, and interest rates were high. Pioneers were able to earn excep-tional returns, often as high as 16 percent (Exhibit 4).

Today’s environment is different. Long-term bond yields in US dollars have slumped, and the nominal cost of capital on full project funds can be expected to fall to about 9 percent per annum. If investment is to be encouraged, developers need to earn higher rates than this, but even so, the 18 percent return¹ that many expect seems high—certainly higher than their average cost of capital.

Antiquated cost structures

In the old game, IPPs had no incentive to keep costs low; on the contrary, their returns were often directly linked to costs via a rate-of-return regime. Not surprisingly, many projects ran up high costs. An unimaginative approach to fuel options and the inherent complexity of IPP deals only made things worse.

High capital costs. The capital costs of IPP projects in developing countries are similar to those in developed countries, even though land, labor, and materials are cheaper. Indeed, recent gas-fired projects in developing countries average about 10 percent more than in developed countries. Creative solutions to slash capital costs in capital-starved countries have thus far been lacking. The kind of massive cost reduction that propelled Korea’s growth, for example, is conspicuous by its absence.

Unimaginative fuel options. Old-game IPPs make little attempt to capture fuel cost advantages. Many use imported fuel, forcing developing countries to pay international prices they can ill afford. Those that do use local fuel often fail to exploit any underpricing that may arise because of transport barriers or when a field is below economic scale for alternative uses. Moreover, they usually miss the chance to use wasted energy such as coalbed methane and gases from industrial sources, blast furnaces, and oil refineries.

Complex deals. IPP deals are notoriously intricate.² Typically, multiple shareholders have to deal with fuel suppliers, builders, equipment suppliers, financiers, the utility, and government, all of which have their own lawyers and other external advisers. Though participants’ desire to protect their interests is understandable, the associated costs are considerable.

Diseconomies of scale

Old-game IPPs are unconcerned about diseconomies of scale. Many retain a "big country" mentality, regarding large projects as the standard answer to electricity shortages. Players that have progressed from small to large projects often lose their enthusiasm for lesser deals. Prevailing wisdom holds that the larger a project, the lower the average unit cost of electricity produced. But while IPPs like the economies that large projects can offer, their customers resent the rising costs that go with growing scale.

Diseconomies can occur in:

Additional infrastructure. Many small projects are viable with minimal extra infrastructure, whereas large ones usually require substantial new investments. A major project using imported liquefied natural gas would require extensive landing and re-gasification facilities, as well as high-tension transmission lines for sending electricity to demand centers. By contrast, a more modest project using imported coal might well find existing port facilities adequate.

In the same way, large projects using domestic fuel tend to entail considerable associated investment. Even if large-scale coalmining opened up to IPPs in India, for example, major investments would be needed in transmission lines or in rail or ship transport to move fuel from mines in the east to power plants in the west.

Poor use of heat. Only about a third of the energy contained in fuel is converted into electricity. The remainder is lost as heat. When plants are located near groups of industrial users, that heat can be used. Offering the potential to cut the net cost of electricity by more than half, such cogeneration arrangements are on the increase worldwide. Unfortunately, large power stations produce so much heat that even large industrial plants are unable to use it all.

Socio-political dislocation. The economic and political impact of large projects can be overwhelming in developing countries, where they may weaken the economy and pose threats for the government. In India, fuel already accounts for about one-quarter of all imports; further imports for big projects would be unwelcome. In Indonesia, large projects would not only be seen as jeopardizing the debt/service ratio, but also lower the country’s credit rating and increase the cost of debt. China has recognized the external costs of large projects for some time: projects above 100 MW or US$30 million must be approved by the central authorities.

Social and political dislocation increases as projects grow. With large projects, the volume of electricity supplied to subsidized customers rises steeply. Utilities then face a worsening deficit or the prospect of raising prices in the relevant sectors, neither of which may be palatable. If a quarter of Indian output continues to go to farmers, the present value of subsidies from a 1,000 MW plant over a decade will exceed US$1 billion.

A new value proposition

New industry leaders must meet all the needs of their customers and recognize that attractive returns can only be captured when superior skills are deployed to deliver superior value propositions. They will need to serve high-value niches, forge partnerships with governments, cut costs and complexity, and adopt an appropriate scale.

Serve high-value customers

High-value customers fall into two groups: less price-sensitive private customers and creditworthy utilities.

Serve private customers directly. The private sector, especially industrial end users, tends to be less price sensitive than public bodies. Throughout the developed and developing world, prices are fairly consistent (Exhibit 5). Utilities often fail to meet the need for reliable supply. Tenaga National’s nine-day blackout on Penang Island, Malaysia, in 1995 caused such an uproar that the state legislature adopted a motion calling on the utility to make ex gratia payments to compensate consumers for the losses they incurred. In a previous nationwide blackout, losses were estimated at US$30 million in the electronics industry alone.

Industrial customers can be reached individually through power plants located at or near their sites, eliminating the need to use a utility’s transmission or distribution facilities. Mission Energy, for example, is building a plant for Texaco in Manila. Alternatively, one plant can serve several customers at a single location. In Thailand, Amata Power is supplying the Bangpakong industrial estate southeast of Bangkok.

Serve creditworthy utilities. Until recently, developers focused on such countries as India, China, Indonesia, and Pakistan because they were the only open markets. But as countries including Thailand and Taiwan open up, IPPs can target the more creditworthy underperforming utilities (Exhibit 6). Elsewhere, they can concentrate their efforts on those utilities that are making strides to improve their productivity and reduce their dependence on subsidies.

Forge partnerships with governments

Even if their direct targeting of private sector customers increases, IPPs will still need to continue their relationships with governments. They must avoid the adversarial and acrimonious stances that blighted these relationships in the past, and recognize the benefit of forging partnerships characterized by a mutual commitment to joint problem solving and by clear benefits to the customer. Transparent and "clean," such partnerships demand that companies invest in building links with governments at the most senior level. The key to this process is a well-connected country manager who aligns the goals of the company with those of the government and communicates the advantages that the community will derive from this relationship.³

Examples of such partnerships can be seen in a variety of industries and countries. With their strong relationships and superior intelligence, Esso and Shell account for 89 percent of Malaysia’s proven oil reserves (and for 86 percent of gas), but have drilled only 40 percent of exploration wells. Not surprisingly, they lead their field in global shareholder value creation. Similarly, at a time when foreign investors were reluctant to supply funds, Freeport McMoran helped the Indonesian government develop its copper industry in the 1960s, establishing a business worth US$4.5 billion.

Opportunities already exist for IPPs to make breakthroughs in building country partnerships. They can be open and objective about the cost of capital and work with governments to reduce a project’s financial risk. Though they may prefer to serve financially sound utilities such as those in Thailand, Malaysia, and Taiwan, they can also exploit opportunities in countries with unprofitable utilities by using escrow accounts to minimize the risk of default. While not a long-term solution, such accounts give utilities time to improve their performance while providing developers with a bankable project. IPPs can use this new lease of life to help governments improve distributors’ efficiency and gradually reduce subsidies.

Reduce cost innovatively

Whether they serve utilities or private customers, IPPs will have to be adept at cutting costs to earn superior returns and meet the lower prices that governments are able to afford. They can accomplish this in a number of ways:

Use capital efficiently. In industries including telecommunications, mining, and metals, companies that have adopted world best practice in capital management have consistently found that the capital costs of major projects can be reduced by between 15 and 45 percent. In iron ore, for example, Western Australia’s Marandoo project was able to cut its capital cost by 40 percent, saving investors US$200 million. There is no reason why IPPs cannot achieve similar economies.

A systematic process for achieving best capital management practice is outlined in Exhibit 7. It highlights the opportunities available to companies to link marketing and engineering, challenge sacred cows and rules of thumb, and drive out waste and "gold-plating."⁴

Exploit disadvantaged energy. Successful players will utilize waste gases from blast furnaces and refineries, or disadvantaged fuel from gasfields that are not large enough for normal oil and gas developments. They will also sell energy to cut costs, as in the Sengkang project on Sulawesi, Indonesia, where gas is being sold to a major industrial user, the nickel producer Inco, and a nearby township. Energy Equity bought the Sengkang gasfield for a mere US$5 million, and plans to build a 135 MW plant. At a proven 407 billion cubic feet plus a further possible 200 bcf, reserves were too small to attract the former owners.

In Andhra Pradesh, India, the GSX Group is planning a 695 MW multi-fuel plant in conjunction with an oil refinery. Instead of being flared, refinery gas will be used to fuel the power plant, thus reducing fuel costs. In Karnataka, also in India, Tractabel and Jindal are planning to use Corex gas, a by-product of direct reduced iron, while in Australia, Energy Developments is exploiting coalseam gas from BHP Steel’s collieries in Appin, New South Wales.

Reduce complexity. Such is the nature of the industry that projects are invariably complex, and negotiating skills will always be important. All the same, smart players will find ways to cut the cost of complexity, which often derives from a tendency to shift risk to other parties rather than reduce total project risk. At this stage in the industry’s development, two opportunities stand out:

• Backward integration, which has the added advantage of lowering fuel risk. Although vertical integration is a difficult strategy, being both capital intensive and difficult to untangle, vertical market failure is a strong argument in favor of pursuing it.
• Building alliances across multiple rather than single projects eliminates the risk of working with several partners, as well as reducing complexity cost. It also cuts hunting and bidding costs, and may boost an IPP’s bargaining power vis--vis customers and suppliers. Already common in car manufacturing, airlines, and a number of other industries, multi-project alliances are becoming popular with IPPs. Duke Energy and Exxon have agreed to work together to develop opportunities in China, and Mobil has announced plans to cooperate with Texas’s Wing Group on Asian projects.

Adopt appropriate scale

Successful electricity providers will focus on smaller projects, since these are often a more economic way to meet customer needs. They will understand that a big business can be founded on a portfolio of little projects.

Prefer small-scale projects. Current technology for electricity generation can be economic at around 50 MW, creating an opportunity for IPPs to embrace small scale. In addition, small-scale projects are easier and quicker to execute.

New-game players can learn from the experience of industries that have already reduced the scale of their operations. In the steel industry, for example, minimills have increased their share of Western production from 16 percent in 1970 to 36 percent in 1994. By producing a narrow range of products at sites close to users, they have succeeded in simplifying management, reducing distribution costs, improving their responsiveness to customers, and phasing their development to match small increments in demand. Minimills can be economic below 0.5 million tonnes per year, while integrated mills require a minimum 3 to 4 million tonnes. Consequently, minimills blossomed in the 1980s, while integrated mills saw their capacity utilization plummet. Many faced financial distress or market withdrawal.

Grow skills and reputation with the business. Small scale does not mean small business. Astute players will pursue an incremental approach, taking modest steps to acquire local skills, build up their relationships and reputation, and establish a growing project portfolio. The timing and path of such an approach will vary by country and player.

In China, say, an IPP strong on fuel supply but weak at project develop-ment might consider taking on small, single-customer cogen projects using cheap fuel that it already owns. After progressing to running a few of these projects simultaneously, it might add a more complex project serving an industrial estate, perhaps using waste gases from blast furnaces. As its relationships with governments mature, and prices and utilities become more economic, it might embark on an integrated mine-mouth project where it could capitalize on its mining expertise.

The IPP industry stands at the threshold of a dawning era. To succeed in the new environment, developers must revise their concept of what their business is, who to serve, what to sell, and how to produce and deliver it. In short, they must become new-game players.