Pakistan’s power predicament

Summary

Pakistan lacks both money and energy, and is caught in a bind between servicing debt and paying for imported fuels

Severe currency devaluation means Pakistan will pay 7% more for gas-fired power in 2024 even if global oil and gas prices fall by 13%

Renewables struggle to displace fossil fuel imports due to policy paralysis, high cost of capital and lack of domestic financing

Better access to concessionary lending at 6% could cut energy storage costs by $57/MWh and bring Pakistani PV-plus-storage plants in line with the global average

Unblocking delayed auctions offers a simple first step towards reducing renewables costs and ramping up deployment

Deep and prolonged blackouts are becoming an allegory for Pakistan’s energy predicament. A technical fault led to a major grid outage on 23rd January that paralysed the entire system and resulted in a nationwide rolling blackout. The failure to prevent an isolated incident from cascading throughout the grid speaks to the outdated state of Pakistan’s centralised electricity infrastructure and the myriad economic impediments to reversing the country’s deteriorating fortunes.

Pakistan lacks both energy and money, and is caught in a vicious cycle between the two. The national blackout hit just as Pakistan’s foreign reserves and currency crisis entered a worrying new phase, raising fears of a debt default and IMF bailout. Reliance on expensive fuel imports, rampant inflation, fiscal fragility and currency devaluation are all part of the same positive feedback loop that is hampering economic development and eroding prosperity.

The selloff in the rupee inflated Pakistan’s fuel import bill, driving inflation ever higher and hurting consumers. This also undermines investment in indigenous energy resources and leaves the country reliant on spiralling dollar-denominated fossil fuel imports.

Crisis of affordability

This dynamic is evident in how electricity prices are formulated in Pakistan. New analysis by TransitionZero reveals that both conventional and clean power sources are less affordable in Pakistan when compared to regional neighbours and global reference markets.

On the face of it, the levelised cost of energy (LCOE) for coal and gas-fired power generation in Pakistan is actually below LCOEs benchmarked in China, India, V1 and Indonesia. But when adjusted according to per-capita GDP, all power sources are less affordable in Pakistan than other countries analysed. (The only exception is India, where the GDP-weighted LCOEs for solar, wind and coal score as slightly more affordable in Pakistan.)

The affordability question is acute for Pakistan due to its exposure to global commodity risk. Coal and gas power prices are formulated overwhelmingly based on import costs, since domestic production of these fuels represents only a small portion of the mix.

Moreover, supplies of liquefied natural gas (LNG) have proven unreliable in recent months due to global gas market tightness and diversion of whatever was available towards Europe, as it reduced its dependence on Russian gas. Coal prices skyrocketed as well, leading to low inventories for imported coal-based power plants, causing them to shut down temporarily. As many as 18 power plants totalling 3,535 MW (10% of the country’s installed capacity) were inoperative as of April 2022, due primarily to fuel shortages.

LNG supply (un)reliability

Pakistan’s difficulties procuring LNG help explain why fuel shortages are a recurrent problem for the country. Global gas market volatility in the months leading up to Russia’s invasion of Ukraine forced Pakistan to buy cargoes at extremely inflated prices. Europe’s response to the invasion – to pay huge premiums to stock up on LNG in the spot market – exacerbated the pain for price-sensitive LNG importers such as Pakistan.

Pakistan also discovered that contracted LNG supplies are only as robust as the contractual penalty for non-delivery. When spot prices rallied in late 2021 and early 2022, Swiss trader Gunvor and Italian oil major Eni both cancelled deliveries under separate contracts that stipulate a ~30% non-delivery fee. Pakistan responded by suing for damages, claiming that their failure to honour obligations forced it to buy even more expensive fuel oil to keep the lights on.

The threat of legal action did not deter Eni from cancelling another cargo as recently as January 2023. Both Eni and Gunvor cited force majeure but this has been questioned by some market participants. There is widespread speculation that both companies diverted cargoes destined for Pakistan and resold them to premium European markets, where they would have attracted much larger profits.

Pricing LNG in rupees

The LCOE of gas-fired power has tripled since Pakistan began importing LNG in 2015. Global LNG pricing quickly became the dominant element in gas-fired power prices as imports ramped up and domestic production waned. The global gas crisis of 2021-22 caused the average gas power price in Pakistan to peak at $14/MMBtu in May 2022, a new record.

Gas markets have softened since then, and this is reflected in lower forecast gas power prices throughout 2023 and 2024. But anticipated weakening of the rupee will eclipse any gains from lower global gas prices, meaning Pakistani consumers will pay more for gas-fired electricity even as LNG fuel costs come down.

The forward curve looks very different depending on the currency. When priced in dollars, the price of gas for power in Pakistan will fall nominally from $9.69/MMBtu in January 2023 to $8.46/MMBtu in December 2024 – a reduction of 13% over 24 months. But with forex markets anticipating further rupee devaluation, the local price of gas for power will rise from PKR 2,540/MMBtu to PKR 2,709/MMBtu over the same period – a real-terms increase of 7%.

Not all LNG is priced equal. Pakistan imports most of its LNG from Qatar and Italy’s Eni under long-term contracts indexed to Brent crude. These contracts account for more than 85% of the cost of imported gas in Pakistan, with (more expensive) discretionary spot purchases accounting for the rest. So while Pakistan might have decided to turn its back on expensive gas in favour of coal, the country will remain on the hook for LNG for many years to come.

Imported coal black hole

Scarcity pricing and supply disruptions offer a strong motivation to re-emphasise domestic resources in electricity planning. Domestic Thar (lignite) production undercuts imports, which fuel most of Pakistan’s coal fleet. Thar coal is regulated at ~$50/ton, which is reflected in very low LCOEs of plants using it (between $41 and $82/MWh). This compares favourably with Chinese-built coal plants, which run on imports from South Africa and Indonesia. The LCOEs of these plants are up to four times higher (between $103 and $179/MWh).

Pakistan expanded its coal fleet using Chinese capital, technology, and labour, under the aegis of the China-Pakistan Economic Corridor (CPEC). These independent power producers (IPPs) have some of the highest running costs and rank at the bottom of the merit order – so they are the first to stop generating when demand drops or commodity markets tighten.

A wartime spike in coal to $419/ton undermined Pakistan’s ability to pay Chinese IPPs, leading to a growing debt burden for the government. The debt pile swelled to PKR 340 billion ($1 billion) in May 2022, prompting scores of Chinese IPPs to warn they would be forced to shut down unless payments were forthcoming.

IPP costs cannot be passed through fully to consumers because many homes and businesses cannot afford to pay more for electricity. Nor can industry absorb higher energy costs. Pakistan’s main export – textiles – competes with exports from India and Bangladesh in global markets. Energy price rises erode exporter margins and can result in factory shutdowns and job losses.

China could come to rue its decision to finance Pakistan’s coal expansion. Lending under the Belt and Road Initiative has made China the world’s biggest official creditor, placing Beijing under international pressure to restructure bad debt. Meanwhile, domestic politics demand a return on China’s overseas investments. If Pakistan cannot honour its IPP obligations and Beijing refuses to restructure this debt as part of a multilateral bailout, Chinese political leaders will come under fire both at home and on the global stage.

No tipping point in sight

Against this troubled backdrop, the switch to cleaner power sources might seem to make economic sense for Pakistan. Costs have come down in recent years but dispatchable renewable energy paired with storage is still more expensive than thermal generation.

New data from TransitionZero’s Coal-to-Clean Price Index (CCPI), which has now been expanded to include Pakistan, show that existing gas and coal power plants briefly became more expensive to operate than solar and wind power (combined with four hours of storage capacity) briefly when fuel prices spiked in 2022. But the calculus flipped back in favour of fossil fuels when prices fell.

This illustrates both the risk of further volatility to coal and gas power competitiveness, and the need for renewable and storage costs to fall further for wind and solar to cement their place in the economic merit order.

The economics of renewables reflect Pakistan’s high cost base: materials, labour and (in particular) capital all cost more than in many neighbouring countries. The benchmark lending rate in Pakistan was recently hiked to 20%, which puts it way above India (8%), V1 (7.5%), the Philippines (6.5%) and China (5.5%). The State Bank of Pakistan introduced a concessionary financing scheme for renewables with a 6% interest rate, but uptake has been muted due to red tape and administrative barriers. The scheme is also limited, with storage projects excluded and only PKR 6 billion (~$21 million) available for projects up to 50 MW.

Since energy storage is capital-intensive, cost of capital is a major factor determining the competitiveness of dispatchable renewables. If projects were to access capital at the 6% concessionary rate, this would shave up to $57/MWh off the LCOE of storage in the county compared to a project borrowing at the central bank’s 20% benchmark lending rate. It would also reduce the LCOE of the solar PV installation, thus eliminating the difference between Pakistani PV-plus-storage costs and the global average.

Forex risk, localisation opportunity

Foreign exchange volatility is a complicating factor for energy investments in Pakistan, and dispatchable renewables are no exception. While the US dollar-denominated lifetime costs of wind, solar and storage installations have fallen in recent years, severe deterioration of the Pakistani rupee is eroding – and at times outpacing – those cost reductions. This means clean power projects with dollar-indexed feed-in tariffs are becoming more expensive to local consumers even though costs are static or falling.

The 56 MW Zorlu Enerji wind farm in Sindh province is a case in point. A halving in the value of the rupee against the dollar since 2013 has impacted almost all of the plant’s tariff components. The only exception is the local fixed operations and maintenance (FOM) cost, which is indexed to the local CPI (consumer price index).

Local FOM makes up only a tiny fraction of the overall wind tariff, with the biggest elements being debt repayments (cost of capital) and return on equity (ROE). Rupee devaluation has inflated the wind tariff required to service debt and equity, causing Zorlu’s overall tariff to more than double since 2013.

Host governments must strike a balance between attracting foreign investment and keeping consumer prices in check. Pakistan’s experience with the rising cost of wind demonstrates that the government’s approach is lopsided towards keeping the renewables space attractive to foreign investors and passing risks through to consumers.

This approach is understandable. Since there is a lack of domestic finance available in Pakistan, the government courted foreign investment by structuring power purchase agreements (PPAs) with exchange rate indexation to shield investors from forex volatility. But consumers need protection too.

Some countries have pursued a risk-sharing approach allowing some tariff elements to be indexed to a foreign currency, and the rest being fixed in domestic currency. This helps to balance the two opposing interests.

Investors have more tools at their disposal to manage forex risk, such as hedged exchange-traded funds (ETFs) and other hedging instruments. These instruments slightly increase a project’s overall cost base, but these costs are more predictable than dramatic forex movements. Lifecycle savings will more than pay for the cost of a well-designed hedging strategy.

Investors can also request for engineering, procurement and construction (EPC) contracts to be denominated in local currency to pass the hedging burden onto contractors, who in turn can pass forex risk up the supply chain. This approach can lead to equipment suppliers and EPC contractors establishing a strong foothold in local markets, which spreads forex risk more widely and leads to greater inward investment and job creation.

Renewables in purgatory

Renewables deployment rates are abysmally low in Pakistan. Forex volatility and challenging project economics are hindrances, but are not the main factors hampering progress. Administrative delays are preventing auctions from being held that would unlock several gigawatts of new capacity.

Pakistan introduced a new regulatory regime in 2019 requiring so-called ‘Category 3’ projects to compete in reverse price auctions. This would issue winning projects with tariffs and allow them to progress towards financial close.

Under the previous regime, all projects would have been granted a ‘cost-plus’ tariff structure. Shifting to auctions rewards the most competitive projects with revenue certainty and (in theory) drives down the cost of renewables for consumers. But no auctions have yet been held, even though this policy was passed in 2019.

The backlog is substantial. Pakistan has a mere 530 MW of solar PV in operation compared to a 4,193 MW pipeline of Category 3 PV projects. In wind power, Pakistan has 1,845 MW in operation and a further 2,139 MW in Category 3 purgatory.

Regulatory support is vital for enabling renewables projects to advance because there is very little domestic capital available to finance them. Attracting foreign capital is a tall order for Pakistan, which is deemed a high-risk country for foreign direct investment (FDI). De-risking investments by providing revenue certainty is a key enabler for inward capital flows.

Root-and-branch reform

Unblocking Category 3 projects by holding long-overdue auctions presents a clearly beneficial first step in Pakistan’s efforts to reform and modernise its power sector. This would enable price discovery for renewables projects and generate institutional confidence in the ability of variable renewable energy sources to achieve cost-parity with coal and gas.

But this alone will not solve Pakistan’s power predicament. For electricity sector reform to contribute meaningfully to improving grid stability and energy affordability, policymakers must embrace a wider selection of supply and demand side technologies.

For example, Pakistan’s baseload hydroelectric generation capacity could play a key role in grid balancing if retrofitted with pumped storage capability. A supportive policy framework for rooftop solar, accompanied by innovative financial products to amortise the upfront capital outlay for households and small businesses, could unleash significant distribution-level PV capacity. This would reduce transmission loads and improve grid stability during demand spikes.

For Pakistan to pivot at pace from coal and gas to clean power sources, a more supportive and holistic regulatory environment is required. And it must be coordinated with transmission network expansions to link resource-rich regions with demand centres.

The good news is that the policy framework to do so is starting to be assembled. The Indicative Generation Capacity Expansion Plan (IGCEP) 2022-31, published by the National Power Regulatory Authority (NEPRA) in September 2022, lays the groundwork for a more ambitious pivot towards wind and solar power than previous iterations.

The IGCEP is a step in the right direction but it has its shortcomings: it is non-binding, it excludes battery energy storage systems from its scenario modelling, and it makes no mention of carbon pricing. TransitionZero’s CCPI reveals that a CO2 price of $60 per tonne would tip the economic scales in favour of switching from coal to clean power, bypassing gas.

Pakistan is not in a position to impose carbon pricing at this level. But a more modest $20/t introduced gradually would go some way towards bridging the gap between coal and clean power costs. Combined with targeted policy support, preferential lending rates for clean power investments and a balanced programme of auctions to drive down wind and solar tariffs, Pakistan could start to build a more resilient, clean and affordable power sector – and reduce consumers’ exposure to global commodity price volatility.

Haneea Isaad is an energy finance analyst at the Institute for Energy Economics & Financial Analysis (IEEFA). Based in Pakistan, she covers Asian energy markets with a focus on Southeast Asia and Pakistan.