Daily Times

Pakistan’s energy sector is facing an existential crisis rooted in the financial and legal quagmire surrounding Independent Power Producers (IPPs). The circular debt tied to IPPs has ballooned to an unsustainable PKR 2.6 trillion as of 2024, up from PKR 2.2 trillion just two years ago. This staggering increase has not only crippled the energy sector but has also strained the broader economy. The crisis, stemming from flawed contracts and compounded by currency depreciation, requires a nuanced and legally sound approach to resolution. However, resolving this crisis is no simple task; it involves renegotiating complex contracts, managing legal risks, and implementing structural reforms.

The IPP crisis traces its origins to the early 1990s when Pakistan’s government, grappling with severe power shortages, sought to rapidly increase electricity generation capacity by inviting private investment in the energy sector. To attract these investors, the government offered extremely favorable terms, including guaranteed dollar-denominated returns and long-term power purchase agreements (PPAs) with take-or-pay clauses. These clauses obligated the government to pay for the electricity generated, irrespective of whether it was used. While these agreements initially succeeded in boosting power generation, they also sowed the seeds for today’s financial turmoil.

As the Pakistani Rupee depreciated-losing more than 30% of its value against the U.S. dollar in just the past two years-the cost of servicing these dollar-denominated contracts skyrocketed. The result has been a sharp increase in electricity tariffs, further burdening an already strained economy. The circular debt, which has been growing at a rate of PKR 20 billion per month, has created a vicious cycle where the government’s inability to pay IPPs on time has led to reduced power generation. This, in turn, has resulted in frequent power outages, stifling industrial productivity and exacerbating Pakistan’s economic woes.

The uncertainty and financial instability in the energy sector have severely dented investor confidence

The economic impact of this crisis is profound. In FY 2023-24, energy subsidies and payments to IPPs accounted for over PKR 800 billion, nearly 2% of the GDP. This massive expenditure has contributed significantly to Pakistan’s fiscal deficit, limiting the government’s ability to invest in other critical areas such as infrastructure, education, and healthcare. Furthermore, the uncertainty and financial instability in the energy sector have severely dented investor confidence. Both domestic and international investors are wary of committing further capital to a sector beset by delayed payments and a growing debt burden.

Addressing the IPP crisis requires renegotiating the existing PPAs, but this is fraught with legal complexities. The original PPAs are legally binding contracts that provide IPPs with guaranteed returns and payment obligations in U.S. dollars. Any unilateral attempt by the government to alter these terms could lead to costly legal disputes, potentially resulting in international arbitration. Many of the IPPs involved are backed by foreign investors who have the option to seek redress through forums such as the International Centre for Settlement of Investment Disputes (ICSID). The ICSID, under the World Bank Group, is a common venue for resolving international investment disputes, and Pakistan has faced cases there in the past. The government must approach these negotiations with a clear, well-structured strategy that minimizes legal risks while aligning the contracts with the current economic realities.

One approach to mitigating these legal risks could be to offer incentives for voluntary renegotiation, such as extending the duration of the contracts in exchange for lower tariffs or converting the dollar-denominated returns into local currency, perhaps indexed to a basket of currencies to hedge against volatility. This strategy could help reduce the immediate fiscal pressure while maintaining investor confidence. Additionally, it’s crucial for the government to engage in these negotiations in good faith, demonstrating a commitment to honoring its contractual obligations while seeking necessary adjustments.

Another legal consideration is the impact of these renegotiations on Pakistan’s sovereign risk profile. Renegotiating contracts, particularly in a manner perceived as unfavorable to investors, could increase the perceived sovereign risk of investing in Pakistan. This could have broader implications beyond the energy sector, affecting foreign investment across the economy. To mitigate this risk, the government must ensure transparency in its approach to renegotiations, providing clear communication to both current and potential investors about the rationale for contract adjustments and the steps being taken to ensure long-term stability.

Furthermore, Pakistan must strengthen its legal framework for future energy agreements to avoid a recurrence of the current crisis. Future contracts should include more flexible terms that allow for adjustments in the event of significant economic changes. For instance, rather than locking in dollar-denominated returns, future contracts could include clauses that allow for currency adjustments based on predefined economic indicators. Additionally, establishing a clear dispute resolution mechanism within Pakistan, rather than relying on international arbitration, could help manage future disagreements more efficiently and at a lower cost.

Beyond the immediate need for renegotiation, Pakistan must address the structural issues that have exacerbated the IPP crisis. Improving the efficiency of the power distribution network is critical. Currently, transmission and distribution losses exceed 18%, a staggering figure that represents a significant drain on resources. The government should invest in infrastructure upgrades, including smart grid technology, to reduce these losses. A realistic target would be to decrease these losses by at least 5% within the next two years. This would not only improve the financial viability of the energy sector but also reduce the burden on consumers, who currently face higher tariffs due to inefficiencies in the system.

Diversifying the energy mix is another crucial step. Pakistan’s heavy reliance on imported fuels makes the country vulnerable to global price fluctuations and currency depreciation. The government should accelerate the development of renewable energy sources such as solar, wind, and hydropower. These resources are abundant in Pakistan, particularly in regions like Sindh and Balochistan. The government should aim to increase the share of renewables in the energy mix from the current 6% to 20% by 2030. This ambitious but achievable goal can be supported by offering tax incentives and reducing bureaucratic hurdles for investors in the renewable energy sector.

Moreover, revenue collection within the energy sector needs a complete overhaul. The current system, which heavily relies on subsidies, is unsustainable. A tiered tariff system, where higher-income consumers pay more, could help balance the need for revenue with the imperative to protect vulnerable populations. Additionally, the implementation of digital billing and prepayment systems could improve collection rates and reduce defaults. These systems could be rolled out nationwide, with an initial focus on urban areas where the infrastructure for digital payments is more developed.

Engaging with international financial institutions (IFIs) such as the IMF, World Bank, and Asian Development Bank will also be key to securing the necessary funds for these reforms. These institutions can provide low-interest loans targeted specifically at energy sector improvements. However, such assistance must be contingent on a clear, transparent reform plan that ensures accountability and progress. Pakistan’s history with IFIs has been mixed, with many reform programs stalling due to a lack of political will or implementation capacity. To avoid repeating these mistakes, the government must ensure that any agreements with IFIs are based on realistic targets and timelines, with clear benchmarks for measuring progress.

The IPP crisis in Pakistan is not just an energy issue-it is a national economic emergency that demands immediate and decisive action. The combination of rising circular debt, currency depreciation, and legal complexities surrounding IPP contracts has created a perfect storm that threatens to derail Pakistan’s economic progress. However, with a strategic approach focused on renegotiating contracts, restructuring debt, improving efficiency, and diversifying the energy mix, Pakistan can navigate this crisis and emerge stronger. The government’s response to this challenge will determine the country’s economic trajectory for years to come. By addressing these issues head-on, Pakistan can avoid the catastrophic economic fallout of a failing energy sector and set a course for a more stable and prosperous future.

The writer is a financial expert and can be reached at jawadsaleem.1982@gmail.com. He tweets @JawadSaleem1982.