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CEPSI 2008 Conference Paper: Investment and Risk Management in the Power Sector in Asia Pacific

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Title: CEPSI 2008 Conference Paper: Investment and Risk Management in the Power Sector in Asia Pacific


1
CEPSI 2008 Conference Paper Investment and Risk
Management in the Power Sector in Asia Pacific
  • 31 October 2008

Jackson KamAssociate Partner, Oliver Wyman
2
The Asia Pacific electricity supply sector has
grown fastDemand growth will remain strong. USD
3.7 trillion of investment is expected in
electricity generation and TD between 2008 and
2030
Projected electricity generation capacity in
APAC (in thousand MW)
Total energy investment requirement (2008-2030)
CAGR(05-30)
4192
3
5.1
Coal production transportation
3808
8.2
2.9
1.6
3462
-0.5
Oil Gas production processing
Electricity generation transmission
3115
2846
1.8
2550
2.7
Oil Gas international trade
2.5
Oil Gas domestic pipelines
USD 3.7 trillion
Oil base
Wind, solar and others
Nuclear
Natural gas
Geothermal
Hydro
Biomass
Source Asia Pacific Energy Research Centre
(2006), Oliver Wyman analysis
3
Such growth represents substantial opportunities
for investment There have been strong interests
from investors. Currently this is mainly in the
form of domestic or government investment.
Electricity deals in Asia Pacific
Gas deals in Asia Pacific
In 2007, 75 of the deals (by value) were
domestic investment
In 2007, 98 of the deals (by value) were
domestic investment
Source PricewaterhouseCoopers Power Deals Annual
Review (2006, 2007)
4
Opportunities for investmentLiberalization
across different markets also offer varying
degrees of opportunities for private investment
Source ADB Institute Discussion Paper No. 64 by
Anoop Singh (2007), Policy Environment and
Regulatory Reforms for Private and Foreign
Investment in Developing Countries A Case of the
Indian Power Sector
5
But not everyone is a winnerSome investments led
to unpleasant results
Cancelled and distressed power sector projects
and investment (19902004)
of projects
Investment (USD billion)
Major causes of power project under stress
China
6
2.9
  • Difficulties due to price-setting and other
    regulatory issues
  • Socio-political changes and disruptions
  • Issues related to the macroeconomic environment
  • Project structural problems
  • Poor investors performance

India
3
2.8
Brazil
2
3.6
Argentina
21
9.3
Risks abound. For such investments to succeed
there are considerations from both the regulator
side and the investor side
Source ADB Institute Discussion Paper No. 64 by
Anoop Singh (2007), Policy Environment and
Regulatory Reforms for Private and Foreign
Investment in Developing Countries A Case of the
Indian Power Sector
6
What is needed from the regulator?The regulator
should strive to create a stable and attractive
investment environment and avoid
over-fragmentation of the market
Appropriate roles for an energy sector regulator
Desirable regulatory environment
  • Making rules governing utility operations
  • Hearing and arbitraging complaints, issuing
    written orders
  • Encourage measures to protect the environment
  • Regulating charges and rates of public utilities
  • Ensuring public safety and help the public deal
    with regulated companies
  • Monitoring reserve margin and setting generation
    reliability standards
  • Establishing and enforcing regulatory standards
  • Encouraging maximum efficiency in utility company
    operations and management
  • Regulatory framework should be long-term, stable,
    predictable and fair
  • Protection of private sector participants from
    political and other major risks (e.g. oil price
    hike) outside of their control
  • Effective incentives to encourage
  • optimal development and utilization of
    infrastructure
  • Improvement in reliability, service levels and
    efficiency
  • migration to become more environmental friendly
    (and to meet other policy objectives)
  • Prudence in the introduction of new entrants to
    avoid over-fragmentation of the market
    (especially for smaller markets)
  • Transparency in all mechanisms and decisions
    (including selection of key players / partners)
  • Allowing the investors to have a reasonable rate
    of return

Source ADB Institute Discussion Paper, PPPs
What does it take for Energy/Power Projects? by
Kenji Nakazawa, ERBD (2008) Council of European
Energy Regulators (2002) Hong Kong Governments
electricity market review (2006) Oliver Wyman
7
Risks facing the investorsThere are plenty of
them both before and after the investment
Strategic
Financial
Externally Driven
PR / public support
Power prices / Supplier of Last Resort
Arrival of new competitors
New Legislation Regulations
Foreign Currency Exposure
Oil price hike
Enron Fall-Out
RTO Evolution
Value Creation from MA
Regulated Rate Decreases
Industry margin squeeze
Internally Driven
Evolving Technology / Alternatives (e.g. micro
generation)
Working Capital Mgt.
New Ventures
Credit Rating
Interest Rate Fluctuation
CAPEX Over / Under Investment
Increasing customer expectation
Political risks
Liquidity / Cash Mgt.
Trading Risks
Impact of newly de-regulated markets
Post Merger Integration
Load / Demand Forecasting
Safety
Property Damage / Medical Liability
Information Systems
System Reliability
Environmental Damage
Labor Contracts
Aging System
Crew Productivity
Infrastructure economics
Cost control
Vehicular Liability / Loss
Workers Comp
Commercial and Operational
Hazard Related
Supply base risk
Major Facility Damage (fire, earthquake)
Weather / Storms
Terrorism
3rd Party System Damage
8
Investor considerationsThe investor should
consider the major risk elements and make
sufficient preparation
Some selected risk elements for discussion
Strategic
PublicSupport (e.g. for nuclear)
RegulatoryRisks
Technology shift
Infrastructure Economics
Industry Margin Squeeze
Supply BaseRisks
Commercial and Operational
Safety Security
Hazard Risks
Hazard Related
Financial Risks
Financial
9
Regulatory Risks
Key risk elements
Mitigation options
  • Market deregulation (unexpected introduction of
    new competitors)
  • Unexpected changes in regulations / political
    environments
  • Fluctuation in allowed electricity tariffs
  • New environmental emission requirements
  • New technology requirements imposed by the
    regulator
  • Detailed market regulatory due diligence prior
    to major investment
  • Long-term strategic planning that anticipates
    regulatory uncertainties
  • Development of alternative regulatory scenarios
    and contingency plans
  • Adopt flexible business design to accommodate
    possible changes in the regulatory regime
  • For price volatility, influence regulation to
    further align wholesale and retail prices
  • Proactively manage regulatory relations and pay
    attention to government/stakeholder changes

10
Public Support (e.g. nuclear)
Technology Shift
Key risk elements
Key risk elements
  • Safety record
  • Operating record
  • Development risks
  • Siting risks
  • Global issue (e.g. global warming)
  • Political uncertainties
  • Emergence of disruptive technologies
  • The rise of alternate / renewable energies
  • The change of technology in energy production and
    distribution processes

Mitigation options
Mitigation options
  • Achieve superior cost efficiency and convince the
    public with a compelling economic case
  • Heavy emphasis on public relations
  • Acquire credible capabilities in safety and
    operations maintain good safety and operating
    records
  • Anticipate mega trends, and plan for alternatives
    (exit, mitigate or transfer risks)
  • Develop a future vision and a technology
    evolution path early
  • To hedge against technology risk by double
    betting i.e. invest in two or more versions of
    technology simultaneously
  • E.g. Datong Power has invested in coal-fired,
    hydropower and wind turbine projects

11
InfrastructureEconomics
Key risk elements
Mitigation options
  • High capital cost of designs and components
  • Hefty extra costs due to delays or changes
  • Misalignment between capacity plan and actual
    demand (in either timing or volume or both)
  • Fluctuations in fuel supply market and prices
  • Be minimalistic upfront (while reaching the
    critical mass) and ramp up gradually (with
    intermediate islands of change)
  • Invest in best practice project management
    processes focused on large project risks
  • Engage in smart sequencing
  • Develop excess options when planning a project
  • Employ the stepping-stone method
  • Hedge via financial instruments to address price
    volatility of resources

12
Supply-Base Risks
Key risk elements
Mitigation options
  • Insufficient physical capacity
  • Aging workforce and decreasing labor productivity
  • Rising prices of resources and commodities
  • Learning and scale curves
  • Quality, reliability and financial health of
    suppliers
  • Global competition leading to shortages and high
    prices of certain components
  • Identification and proactive management of the
    top critical components/resources (e.g. bearings
    for wind turbines)
  • Form alliance with supplier / integrated supply
    chain management, possibly via equity / JV
    relationships
  • Establishing a business design that integrate
    supplier base
  • Extend yourself along the value chain to cover
    critical resources
  • Optimize control levers
  • Supplier selection criteria
  • Supplier relationships / information exchange
  • Number of suppliers used
  • Pricing contracts, futures contracts

13
Industry Margin Squeeze
Hazard Risks
Key risk elements
Key risk elements
  • Stagnate market growth
  • Increasing fuel prices
  • Increasing green requirements
  • Costly new technologies / RD
  • Swings in cost structure in a very short period
    of time, depending on regulatory actions or even
    customer sentiment
  • Property damage
  • General liability/legal risks
  • Workers compensation
  • Natural disasters
  • Business interruption

Mitigation options
Mitigation options
  • Shift the compete/collaborate ratio
  • Embark on aggressive cost reduction programs
    (e.g. outsource non-core operation, streamline
    operation / BPR)
  • Risk finance traditionally through insurance, but
    recently through captives and capital markets
    products as well
  • Well developed risk management practices and
    supporting industry

14
Safety andSecurity
Financial Risks
Key risk elements
Key risk elements
  • Accident risks / Medical liability
  • Regulatory safety requirements
  • Construction safety
  • Security risks (e.g. terrorists actions)
  • Capital structure
  • Credit default
  • Financial market risks
  • Interest rate changes
  • Currency/foreign exchange fluctuations
  • Liquidity, cash flow issues

Mitigation options
Mitigation options
  • Improve safety culture through communication,
    education / training, positive reinforcement
  • Adopt advanced operation process systems
    optimize business design for cost efficiency
  • Risk financing through derivatives
  • Construction of financial tools (i.e. capital
    model)
  • Well developed risk management practices

15
Adopt Enterprise Risk Management (ERM) early and
throughout the processThe investor needs to
managed these risk elements both before and after
investment
Risk identification mapping
Risk quantification
Link into strategic decision-making
Instilling in corporate culture
Key ERM aspects
  • Identify relevant risks across all the business
    activities for inclusion in a risk register
  • Assess and quantify the risk drivers
  • Aggregate quantified risks through organization
    levels
  • Results linked into the organizations strategic
    decision-making process
  • A risk-return culture that instills a
    risk-ownership mentality throughout the
    organization

Relevant risk elements
Strategic, regulatory and public policy risks
Technical and operation risks
Market risks
CloseFinancing / Commence Build
Project Conception
Project Development
Sign Contract and Notice to Proceed
CompleteConstruction
Complete Acceptance Testing


ProjectSpending Curve (s)

Construction
Operation
40 Years
16
Detailed steps to implement ERM process
Risk identification mapping
Risk quantification
Link into strategic decision-making
Instilling in corporate culture
1
2
3
4
Scenarios and sensitivity analyses
Policy setting and documentation
Data gathering and industry analyses
Conceptual risk model for new build
Mobilization
  • Economic impacts
  • Industry Associations
  • Other studies / benchmarks
  • Lessons learned
  • What-if / iterative financial analyses
  • Risk mitigation strategy alternatives
  • Risk mgmt roles for industry, OEMs, utility
  • Risk implementation choice board
  • Financing structure
  • Cost per KW installed
  • Model major value at risk
  • Build base case
  • Risk framework
  • ERM manual
  • Mitigating actions
  • Execution
  • Mobilize and formulate ERM team
  • Confirm objectives

Investor industry interviews on risk
  • Investors
  • Utilities (global)
  • Risk conclave / roundtable

17
Reasons and objectives behind ERM adoptionMany
electricity / utility companies believe that ERM
can help them to understand risks more, safeguard
against earnings-related surprises and achieve
better capital allocation
Financial services
Retail/Consumer products
Manufacturing
Chemicals/ Pharmaceuticals
Utilities/Natural resources
ERM objectives by industry responding
important or highly important
1-33
34-64
65-100
Ability to respond effectively to
critical/catastrophic risks
56
50
38
67
45
Safeguard against earnings-related surprises
54
46
67
73
65
Ability to avoid low-probability
critical/catastrophic risks
60
39
47
21
55
Common understanding of risk across functions and
units
58
67
71
67
70
Cost savings through reductions in hedging and
insurance costs
42
38
53
33
20
Better understanding of risk for competitive
advantage
54
67
73
73
75
Improvement in companys P/E ratio
44
35
42
33
25
Better regulatory compliance
44
39
53
29
40
More efficient capital allocation
65
35
54
40
65
Cost savings through better management of
internal resources
58
46
63
60
35
Ability to identify aggregating and/or offsetting
risk patterns
46
50
38
40
40
Ability to compensate management based on
risk-adjusted returns
21
31
21
10
13
Source Survey conducted by Economist
Intelligence Unit and MMC Enterprise Risk, Inc.
18
Value of Enterprise Risk Management in
infrastructure investmentsThe ability to
anticipate and mitigate risk well can protect
25 of a companys value
100
25
  • Value of risk management
  • Our research indicates that in a 5 year span, 20
    of companies will suffer a company value decrease
    of 25 or more within a single month
  • 70 of these value decreases could have been
    avoided with enterprise risk management

75
Company Value
Typical impact of poor risk management
Company value after non-mitigated risk event
19
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