Thursday, December 3, 2020

Think tank: ‘Critical flaws’ in LUMA-Prepa deal could worsen situation for customers

By on August 27, 2020

CNE policy director: Loose ends in agreement could undermine goals of cheaper, reliable electricity 

CNE Policy Director Sergio M. Marxuach (Courtesy)

SAN JUAN – While the public-private partnership (P3) deal between LUMA Energy LLC and the Puerto Rico Electric Power Authority (Prepa) is a “first step” in the transformation of the troubled public utility, the contract granted to the private consortium has “critical flaws” that could perpetuate many of the problems the 15-year agreement seeks to address, including the persistence of high electricity costs, according to a policy brief issued by the Center for a New Economy (CNE), a San Juan-based think tank. 

CNE Policy Director Sergio M. Marxuach—who authored the analysis of the contract finalized between the Public-Private Partnerships Authority (P3A), Prepa and Luma—expressed “serious concerns” regarding the $1.4 billion transaction announced in June, and which would transfer to LUMA, a U.S.-Canadian consortium, the management and operation of the public utility’s power transmission and distribution (T&D) system as well as its customer service and billing components.  

Marxuach noted that the deal has many loose ends that could undermine the government’s goals of modernizing the 79-year-old utility, explaining that in addition to what was signed, there are other contracts and related documents that have not yet been finalized. His analysis flagged conflict-of-interest issues in the complex contract regarding the granting of authority to LUMA to manage fuel and power generation contracts, among other potential flaws that could negatively affect utility customers. 

While stressing the importance to Puerto Rico’s economic development of turning around the bankrupt state-owned utility, the CNE policy analyst said that “executing a bad deal is worse than having no agreement at all.” 

“We cannot advocate in favor of keeping Prepa, an utterly corrupt, environmentally harmful, and economically unsustainable entity, in charge of our power system. Yet, while we strongly favor the thorough transformation of Prepa, the proposed Agreement is critically deficient in several key areas,” Marxuach says in the policy brief. “If that Agreement cannot be corrected in a timely manner, then we can only recommend the parties return to the negotiating table. And try again.” 

Uncertain federal funding for Prepa turnaround

The deal relies heavily on an expected influx of federal funding for permanent repairs and reconstruction of the island’s power, which was devastated by hurricanes Irma and Maria nearly three years ago. P3A Executive Director Fermín Fontanés Gómez acknowledged in an interview with Caribbean Business in July that in the absence of such federal funding, there would have to be a “substantial” increase in electricity rates to pay for grid modernization and meet the goals of the Puerto Rico Energy Public Policy Act of 2019, or Act 17, to shift the utility’s power generation to fully renewable energy by 2050. 

“The financing for the modernization of the T&D System depends entirely on federal funds and there is no plan in the event that these do not materialize, the amount received is lower than expected, or they take a long time to be disbursed,” the CNE policy director said, stressing that alternate plans should be made in case the assumptions on which the agreement is based are not met. “[LUMA], Prepa, and the [Puerto Rico Energy Bureau] should develop a ‘Plan B’ setting forth capital spending priorities for Puerto Rico’s T&D System in case federal funds to finance the Grid Modernization Plan are insufficient or unavailable.” 

Marxuach said that the Grid Modernization Plan prepared by Prepa and submitted to the Central Office of Recovery, Reconstruction and Resiliency (COR3) estimates that approximately $21 billion in capital expenditures are needed to bring Puerto Rico’s power system to “industry standard levels.” Of that total, he noted, some $12.2 billion are required to rebuild the transmission, substation and distribution system to harden the power grid and improve its ability to withstand hurricane conditions. 

However, the LUMA deal does not require it to make any capital expenditures using its own funding. Congress has only appropriated about $1.9 billion specifically to modernize the island’s power system, Marxuach said, noting that the rest of the funding would presumably be allocated by the Federal Emergency Management Agency (FEMA) or would come from a future congressional appropriation of funds from the Community Development Block Grant – Disaster Relief Program (CDBG-DR). 

He pointed out that one of the conditions of the LUMA contract is that Prepa will have “adequate funding” for “capital costs” within the first three years after the private consortium takes over the utility’s T&D and services in May 2021. 

“This situation begs the question: given the known hostility of the Trump administration towards Puerto Rico, what happens if those future allocations [and] appropriations are delayed or fail to materialize in the expected amounts?” the CNE policy director questioned. 

Marxuach said that the use of funding for capital improvement projects by LUMA should be “strictly scrutinized” by the P3A as well as the Puerto Rico Energy Bureau (PREB) — established to regulate Prepa and the energy industry on the island, and which approved the LUMA deal. He said that PREB should develop a “special administrative process” to monitor these projects, which should be “subject to review and approval” by the P3A, as administrator of the LUMA agreement.  

The contract establishes that LUMA will be paid a service fee consisting of an annual fixed fee and an incentive fee. The fixed fee starts at $70 million the first year and increases to $105 million for years four through 15, while the incentive fee, which is payable upon LUMA achieving certain performance milestones, starts at $13 million on year one and increases to $20 million for years four through 15. In both cases, the amounts payable will be adjusted to inflation. 

Marxuach said that the parameters proposed to measure LUMA’s performance would mostly use Prepa’s previous performance in Puerto Rico as a benchmark, which he noted is “well below the private sector standard.” He suggested that PREB and the P3A “should develop performance parameters using standards and the best practices of similar companies in other jurisdictions as a reference.” 

The CNE policy director also questioned a supplemental agreement in the LUMA contract that would be activated if a Prepa debt restructuring support agreement (RSA) with the utility’s bondholders has not been approved by the time the transition period ends. In this case, LUMA would be entitled to an annual fixed fee of $115 million until Prepa exits the bankruptcy process under Title III of the federal Puerto Rico Oversight, Management and Economic Stability Act (Promesa). 

“The Supplemental Agreement could be used to force the government of Puerto Rico to accept both an unsustainable RSA and [debt Plan of Adjustment] that produces rent-like returns for some bondholders and induces a significant increase in electricity rates. The government… should not have accepted this condition in the first place,” said Marxuach, noting this goes against official policy stating that electricity should be made available at the lowest rates possible. 

Deal promotes ‘flawed’ energy market 

The LUMA deal requires that Prepa be split into two operating companies: GridCo, which retains ownership of the T&D system and GenCo, which retains ownership of the utility’s ageing power plants. Both are required to enter into a power purchase and operating agreement (PPOA)—the “GridCo-GenCo PPOA”—with LUMA acting as agent of GridCo, providing for expense reimbursement, power delivery and other services related to the generation, sale and purchase of power and electricity from Prepa’s generation assets. 

Marxuach said that this arrangement “raises serious concerns,” given that the contract stipulates that GenCo will be responsible for purchasing fuel for its generation units, but GridCo will pay for all fuel purchases after GenCo certifies receipt and quality and authorizes payment. Yet, according to Section 2.5 of Schedule H of the contract, GridCo will not have the obligation to verify any invoice submitted by GenCo, the CNE analyst noted. 

“The failure to require even a minimal amount of due diligence from GridCo before paying any bills, including fuel bills, is puzzling given Prepa’s nefarious track record of fuel procurement practices,” he said. “The GridCo-GenCo PPOA must require GridCo such diligence, even if it is minimal.” 

While the terms and conditions of the PPOA will govern sales of GenCo generated power, the costs that will be used to determine the price at which the energy will be sold are not defined, Marxuach said.  

“It is important that the GridCo-GenCo PPOA include a detailed definition of the ‘costs’ attributable to electricity generation to minimize consumer rates and avoid cross-subsidization of GenCo’s inefficient generating units by GridCo,” he said. 

Having the LUMA consortium in charge of power supply dispatch and management while also allowing it to make deals with GenCo and independent power producers constitutes a conflict of interest, Marxuach said, noting that this “could provide opportunities for rent-seeking or outright malfeasance by LUMA or Prepa.” 

“To the extent the amount of services provided by GridCo, and hence the fee charged, increases proportionately to the amount of electricity generated by GenCo, then GridCo may have an incentive to favor the interconnection of GenCo’s generation assets to the T&D system over more efficient providers,” the CNE policy analyst said, noting that this would create a “potentially flawed market structure where a limited number of power producers would sell to a single buyer.” 

Marxuach recommended that PREB should remove any day-to-day system operation functions from LUMA when negotiating the agreement between GridCo and GenCo, leaving the private consortium in charge of the maintenance of the T&D system and providing services to “Prepa and/or GenCo only”. He suggested the creation of an Independent System Operator (ISO), which would be exclusively charged with dispatching energy and “maintaining system reliability and stability,” adding that PREB should be the new ISO’s only supervisor.  

In fact, the CNE policy analyst, who said that the government is managing Prepa’s transformation in a “haphazard way,” called for the strengthening of PREB’s function as regulator of the island’s energy market, recommending that the next administration restore “its legal standing and powers as a truly independent regulator,” including providing the entity with enough funding to carry out its mission. 

Moreover, PREB should clarify, by regulation if necessary, the meaning of “economic dispatch” in the Puerto Rico power market, he said, adding that the regulator should also develop a process to investigate allegations of price fixing or market collusion. 

“The creation of a new market for the production and sale of electricity in Puerto Rico is really the core objective of Prepa’s transformation. Contrary to popular belief, however, the break-up of a vertically integrated utility and the liberalization of the electricity market will not, necessarily, result in lower rates for customers,” Marxuach said. “A lot depends on how the market is structured and on good, assertive regulation.” 

While “at first glance” the $1.4 billion LUMA deal, if executed in accordance with its terms, would pay for itself, the forecast of cost reductions to be generated by LUMA could be “significantly overestimated,” given that Prepa is “notorious” for overestimating savings from several reform efforts undertaken at the utility in the past, Marxuach said. He recommended that the P3A hire an independent auditing firm to perform annual audits and keep track of cost reductions allegedly generated by LUMA, adding that PREB should also be allowed to review and analyze those findings. 

LUMA: CNE concerns addressed in contract 

In a statement issued on Friday, LUMA Energy said that many of CNE’s concerns are already addressed in its operation and maintenance agreement (OMA) with Prepa, stressing that the transformation process “requires some flexibility.” 

LUMA said the agreement was the result of an 18-month competitive process designed to address “a transformation of the electric system of considerable scale, maximize the eligibility for federal disaster aid and municipal debt, and consider the continued transformation of Prepa’s generation assets and the impact of emerging technologies.”  

“The issues outlined by CNE are what created the need for a private operator — an operator that can bring world-class expertise and deliver electricity without special interest and political interference,” the private consortium said in the statement, citing a portion of Marxuach’s policy brief stating that special interests have “extracted undeserved benefits” from the public utility at the expense of its customers. 

“Ultimately the transformation requires some flexibility in order to ensure LUMA can deliver a safer, modern grid at an affordable price in an evolving world,” LUMA said. 

LUMAs statement addressed several concerns raised by Marxuach: 

  • “First, with regard to performance metrics, we wholly agree with the issues raised by CNE and its references to the analysis of Rocky Mountain Institute — the prior performance of PREPA is what led to the need for a private operator, and there are issues with data and consistency. As suggested by CNE’s recommendations, we are in close dialog with PREB and P3A to develop the performance metrics and will require PREB’s approval (in accordance with Act 17 and the relevant PREB dockets (e.g., NEPR-MI-2019-0014).” 
  • “Second, with respect to financing options, we fully agree on the criticality of the federal funds to the overall transformation and reconstruction of the electrical grid. We believe a significant part of our success will be restoring the credibility of PREPA in order to better enable those funds to flow faster and more effectively. To address this critical need, we brought IEM, a world class federal funds manager, onto our team. We are working on this area as a top priority.”  
  • “Third, with respect to estimated savings, we believe in transparency and accountability. The oversight process in the contract allows for the P3A and the PREB to independently review and audit actual savings and performance, as suggested by CNE. The performance metrics — not just on cost, but also on safety, quality of service, and the system — create both the transparency and incentive for us to perform.”  

LUMA said that it would it will “always act prudently and efficiently” to deliver the “electric system Puerto Rico deserves.” 

“As the transformation of PREPA continues (through the conclusion of the generation restructuring, Title III process, and ultimate federal funding disbursements), we believe the OMA for the electric grid is the right starting point for the PREPA transformation,” the consortium said. “We look forward to continuing the dialog and working hand-in-hand with all stakeholders on the transformation.” 

LUMA, which was incorporated locally in January, is the first private venture to directly manage and operate Prepa infrastructure since the public utility was established 79 years ago. The company is a joint venture between ATCO Ltd., a Canadian operator of electric systems; Texas-based Quanta Services, a provider of “infrastructure solutions” for the electric power industry; and Innovative Emergency Management Inc. (IEM), a U.S. firm dedicated to securing disaster relief funding. 

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