AUDIT NOTE ON POWER PURCHASE AGREEMENT BETWEEN MAHARASHTRA STAT

ANNEXURE __

AUDIT NOTE ON THE PPA FROM THE OFFICE OF THE ACCOUNTANT GENERAL DATED 19/6/95

AUDIT NOTE ON POWER PURCHASE AGREEMENT BETWEEN MAHARASHTRA STATE ELECTRICITY BOARD (MSEB) AND

DABHOL POWER COMPANY (DPC-ENRON)

The following are the observations as a result of scrutiny of Power Purchase Agreement (PPA) between Maharashtra State Electricity Board (MSEB) and Dabhol Power Company (DPC).

1. The PPA was entered into without calling for any global tender. There is no mention in the PPA of the estimated cost of the project. According to the agreement the DPC will recover every single amount that it will spend in the form of Capacity Charges and Energy Charges but the MSEB will not have any say on the cost of plant and machinery and the fuel that will be imported by DPC through Enron Development Corporation appointed by it as Fuel Manager. In absence of any specific mention of the estimated cost of the project, it will not be possible for MSEB to know at what cost it will have to buy power from the DPC by the time project is ready for generation of power.

2. As per agreement, MSEB will have to pay separately for Capacity Charges and Energy Charges. Unit cost of electricity will be calculated taking into account both Capacity Payment and Energy Payment. As per Schedule 9 of the Agreement, the Capacity Payment will include capital recovery, return on equity, debt servicing (principal and interest), fixed operation and maintenance cost and annual insurance premium. As per Schedule 10 of the Agreement, the Energy Payment will include delivered energy payments in terms of BTU, “take or pay” fuel adjustment, various fees, such as, testing fees, fuel management fees, commissioning fees and variable operating and maintenance charges. The Capacity Payment appears to be fixed, which actually is not, as the payment is price indexed link for which necessary adjustment will have to be made depending on the price escalation and exchange fluctuation. Secondly, Capacity Payment will be on the created generation capacity of the power plant and not on actual generation of power. This means the MSEB will have to pay idle charges in the event of under-utilisation of the plant capacity (i.e. in case of lower load factor). The Energy Payment will vary depending on price of the fuel i.e. distillate or LNG as the case may be. In effect, there will be least control by the MSEB on the payment to be made on these two accounts.

3) The capital recovery will be made from the MSEB in the form of depreciation to be charged on the plant and machinery. The contract does not mention anything about the life of the plant and machinery, the rate and method of charging depreciation. In case the DPC decides to recover the whole cost of plant and machinery in a shorter period the unit cost of the electricity is bound to be higher than what is being projected now.

4) Even though the annual insurance premium will be recovered from the MSEB, as per clause 15 of the PPA, the DPC will select insurance company, which company will necessarily be a foreign company. The overriding clause [15.2(h)] takes away the right of the MSEB to select an insurance company. Schedule 9, Part IV of the PPA indicates the total insurance premium at 1997 base price as $23,989,000. In Rupee term, the amount will be around Rs. 74/- crores per year. This is subject to fluctuation of rate from time to time. In absence of definite mention of cost of the plant & machinery and any competitive tender, it is not clear how this amount is worked out. This aspect is required to be examined.

5) According to the Clause 6.4 of the Agreement, Enron Developing Corporation is appointed as Fuel Manager for importing distillate or LNG by entering into contract with the global parties. The MSEB will virtually have no say in respect of finalisation of such contract. This will affect the interest of the MSEB in the absence of any specific clause in the Agreement as regards finalisation of contract of the fuel on competitive basis.

6) Before agreeing to the use of imported fuel, possibility of the availability of indigenous distillate or LNG and its utilisation for generation has not been considered by the MSEB. Thus, the country will have to pay more for imported fuel. This aspect needs to be examined by the MSEB/Government.

7) According to the Agreement, the Phase I involves construction of a block with a Nominal Baseload Capacity of 625 MW plus a black start facility. This Phase will initially be fueled by No. 2 Distillate Fuel oil and the Phase II involves construction of the two more blocks and conversion of the whole Power plant into natural gas firing one (to be fueled by Liquefied Natural Gas). According to clause 2.5 (b) of the Agreement, either party by giving a notice of 21 days may terminate the contract regarding Phase II due to non fulfillment of condition precedent to Phase II. In case such termination occurs the Power plant will remain unconverted and hence continued to be run be distillate fuel oil which is a costlier fuel. As a result the country will inherit costlier fuel run power plant. This will be prejudicial to the interest of the country.

8) The generation of power does not have any meaning unless it is transmitted through the transmission line. The DPC shall be transmitting power through the transmission lines of MSEB and to receive power from the power plant the MSEB will have to build infrastructure by spending an amount of about Rs. 323 crores. The DPC will avail of the infrastructure built by the MSEB and also avail of the existing transmission line to sale the power generated by it but will not make any payment or any adjustment either in the fuel cost or in the capacity charge. Neither will it bear any transmission loss though the power generated by it would be transmitted through MSEB’s transmission lines.

9) Though DPC is neither bearing any cost for construction of transmission line nor paying any service charges for using MSEB’s transmission line, MSEB will have to pay liquidated damages for delay in entry into commercial service into Phase I or either block of Phase II because of MSEB’s delay in construction of transmission lines (vide clause 4.8 of the Agreement). This aspect needs to be examined by MSEB/Government.

10) According to clause 3.4 of the Agreement, the MSEB is only a purchaser of power from DPC. Though a purchaser, under its obligation at development stage the MSEB has accepted the responsibility of carrying out the work necessary to achieve each Development Mile Stone relating to each phase at its own cost on behalf of the DPC. The DPC though a seller of the power does not have any responsibility to build up any infrastructure other than the power plant. This aspect may be looked into by the MSEB/Government.

11) The agreement does not incorporate any clause as regards checking of cost details by MSEB for facilities created by DPC to generate power as well as the cost incurred to deliver energy in MSEB system though MSEB will reimburse the cost in the form of capacity charges and energy charges.

12) As per Schedule 12 of the Agreement, the DPC is exempted from the payment of the Sales Tax and Electricity Duty. The exemption from payment of Sales Tax and Duties on sale of bulk electricity will be a perpetual revenue loss to the State.

13) As already mentioned, capital recovery is one of the elements of Capacity Charges; hence capitalisation of assets plays a very important role in determining the capacity charges. The policy to be followed in case of capitalisation is not spelt out in the agreement. The following points requires close attention and consideration in this connection :-

i) It is not clear from the Agreement whether the elements included in the Capacity Charge payable for commercial period would be the same as that of Capacity Charges payable for non-commercial periods, i.e. Capacity Charges payable in case of delay in entry of Phase I or either block of Phase II for reasons attributed to MSEB. It will be against the interest of the MSEB if the interest on Working Capital for Commercial and non commercial period is uniformly charged. Interest on working capital would arise only when a particular phase will start commercial production ; hence it should not be included in the capacity charges recoverable in non-commercial period.

ii) The interest on debts is one of the elements of Capacity Charges. It is not clear from the Agreement whether this will be capitalised. If this is capitalised, it will stand included in the depreciation which is also one of the elements of the capacity charges and will tantamount to double payment.

iii) It is not spelt out in the Agreement whether the interest on debts would be regulated with reference to schedule of repayment of debts. In case this is not so regulated, any additional burden of interest, because of deferment of repayment of debts, due to reasons, not attributable to MSEB, would have to be paid to DPC in the form of Capacity Charges which will be against the interest of MSEB. Further the impact of foreign exchange fluctuation in discharging debts at variance with the repayment schedule agreed upon, if any, should neither be capitalised nor be recovered in the form of Capacity charges from MSEB. The Agreement does not spell out clearly of this aspect.

iv) Expenditure incurred during performance test prior to entry into commercial service (commissioning expenditure) should be capitalised, only after deducting revenue on sale of active energy generated during performance test. This aspect needs to be clearly spelt out in the Agreement.

v) As per Part IX of Schedule 9 of the Agreement, if the Rated Baseload Capacity of the power plant is reduced by an event of Industry Force Majeure occurring after entry into commercial service of the first block in Phase II and reduction is continuing in whole or part, after a period of twelve months following the claim for relief to the event in question under clause 16.3 (a) MSEB shall make additional payment (Advance capacity payment) to DPC though the factors contributing such events or circumstances are not within the control of MSEB or cannot be stated to have been caused by MSEB. This aspect needs to be examined by the MSEB/Government.

vi) As per Clause 16 (d) read with Clause 16.3 (c)(ii), in the event of Political Force Majeure if the construction or operation of any part of the power plant of the fuel facility or the estimate aggregate cost get affected materially and adversely, the fund reasonably regarded by DPC as sufficient (including interest payable under Financing Agreement) to restore its ability to perform its obligation under the element will be arranged by the DPC. MSEB cannot question the fund arrangement though the same will be recovered.

14) The Liquidated damage clause in the contract is one sided as stated below :-

i) As per Clause 4.3 of the Agreement, the DPC will pay liquidated damages for delay in entry into commercial services of Phase I or either block of Phase II for reasons attributed to DPC at a fixed rate as mentioned in Clause 4.3 (b) (i) & (b) (ii) of the Agreement; whereas as per Clause 4.8, if MSEB fails to comply with its obligation with respect to transmission line or GOM fails to comply with its obligation with respect fresh water pipe line by which the date of entry into Commercial Service of Phase I or either Block of Phase II is delayed, MSEB shall pay to DPC liquidated damages an amount equal to the Capacity Payments, which would have been payable if Phase I or either Block of Phase II had Entered into Commercial Service as per schedule date of completion in the agreement but for such delay. In case of Phase II besides such Capacity Payment, an incremental cost as a result of such delay (i.e. difference between Capacity Payment which would have been payable if the Phase II would have been completed in time and Capacity Payment arrived at due to rise in cost for delay) would have to be paid by the MSEB. In short, due to delay, whereas DPC will pay liquidated damages at fixed rate the MSEB will have to pay a disproportionately huge amount of liquidated damages equal to Capacity Charges. This needs examination by the MSEB/Government. In addition, as per Clause 4.8(a) of the Agreement, MSEB will indemnify DPC any loss or expenses incurred in connection with failure or inability of DPC to take delivery of any distillate or LNG as a result of such delay. It is not understood when Enron Development Corporation is the Fuel Manager why MSEB will have to indemnify anything in connection with the procurement of fuel.

ii) As per Clause 5.2 (a) of the Agreement, entry of Phase I or either block of Phase II into commercial service will depend upon solely on written declaration made by DPC. It, however, appears from the existing agreement that such delay will also be counted for charging liquidated damages on MSEB in case of delay otherwise occurs for any phase entering into commercial service. This aspect is required to be examined.

iii) As per Clause 5.2 (d) and (e) of the Agreement, the DPC will not pay any liquidated damages if the Tested Baseload Capacity or Tested Peaking Capacity during performance test fails short of Nominal Baseload Capacity or Nominal Peaking Capacity within a period of 365 days of entry into commercial service. Upon expiry of such 365 days period. DPC will pay MSEB liquidated damages in respect of difference between Nominal Baseload Capacity and highest Baseload Capacity achieved during such 365 days period at the rate of US $100 per KW. This means the DPC is allowed a grace period of 365 days before liquidated damages are charged. But no such grace period is allowed to MSEB in case the MSEB fails to adhere to fulfill its obligation in the Agreement. Similarly it is provided in the Agreement that in case the DPC is unable to attain Nominal Peaking Capacity, it will pay liquidated damage for the difference between Nominal Peaking Capacity and highest Rated Peaking Capacity after a grace period of 365 days. Consideration of highest rated Baseload Capacity or Average Peaking Capacity for the purpose of computation of liquidated damages payable by DPC. This aspect needs to be examined by the MSEB/Government.

iv) There is not provision in the agreement for liquidated damages payable by DPC in case the Rated Baseload Capacity and Rated Peaking Capacity is found less in any capacity test followed by subsequent re-test than the earlier established Rated Baseload Capacity or Rated Peaking Capacity. (vide Clause 8.1(d) and 8.2).

15) As per Clause 10.4(d) of the Agreement, if DPC enters into a distillate supply contract with minimum “take or pay” provisions and energy payment made by MSEB to DPC in respect of any month for Active Energy delivered to MSEB system falls short of minimum “take or pay” distillate payment, the difference amount will be recovered from MSEB. Similar conditions are laid down in the Agreement in case of LNG supply contract. It is not understood why there would be payment obligation on the part of MSEB for reasons not attributable to MSEB.

16) As per Clause 6.4 of the Agreement, if, at the request of the MSEB prior to the estimated date or start of the regular delivery, DPC enters into a distillate supply contract for a term expiring prior to the start of regular delivery, DPC would not be liable to pay for (or would be reimbursed by MSEB in full) distillate supplied under the contract but not burnt as a result of any event or circumstance of Force Majeure. It is not clear why MSEB will have to pay for in such circumstances when they are not responsible for such action.

17) As per Clause 10.4 (d) and 10.4 (e) of the Agreement, if DPC procures distillate for Phase I on a spot basis and the level of dispatch by MSEB is less than that notified under clause 6.4 (g), MSEB shall indemnify DPC in respect of any loss or any reasonable additional expenses fairly attributable to such lack of dispatch if DPC does not require the use of such supply ordered. MSEB is liable to indemnify under this clause even if level of dispatch fails short of that notified for reasons not attributable to MSEB. If the situation becomes reverse i.e. level of dispatch required by MSEB is greater than that notified pursuant to clause 6.4 (g) DPC will not indemnify MSEB despite its inability to comply with the dispatch instructions resulting solely from insufficiency of distillate or DPC’s inability to procure adequate fuel oil.

18) The asset (i.e. the Power Plant) is owned by the DPC and will be insured by the DPC by a foreign Insurance Company but the annual insurance premium will have to paid by the MSEB and this premium is included in the Capacity Charges to be paid by the MSEB. The following further observation is made in this connection :

i) According to Clause 15.4 of the Agreement all insurance claims shall be paid to the DPC, who may apply the proceeds of such claims as it sees fit. There is no safeguard in the Agreement that the DPC shall apply (the word used is `may’) the proceeds of such claim. Secondly, it is also not clear why such proceeds should go to the a/c of the DPC when the annual insurance premium will ultimately be paid by the MSEB. The claim amount (or `proceeds’ as mentioned in the Agreement) settled by insurance company in respect of any assets, the cost of which is already capitalised and being recovered from MSEB through depreciation as one of the elements of Capacity Charges, should either be passed on to MSEB or be credited to capital account to eliminate the possibility of double recovery from the MSEB by way of depreciation.

ii) In addition to the cost of the assets of the project to be recovered from the MSEB by way of depreciation, insurance premium for any goods insured by DPC during the construction period and the commercial period will be recovered as an element of Capacity Charges from MSEB during the commercial period. It therefore flows that the DPC should replace any damaged assets out of proceeds received by it from the insurance company will be in the account of DPC. Hence depreciation on assets to the extent financed by the fund received from the insurance company should not be recovered from MSEB as Capacity Charges for the reason that MSEB had already paid insurance premium through capacity charges to DPC for the assets to be insured.

CONCLUSION

The Power Purchase Agreement (PPA) is basically a cost plus contract in true sense, though specifically not spelt out the Agreement, with ensured rate of return on equity (stated to be about 16%) in the initial period of the project, after recovery of cost from MSEB. The Agreement would not protect MSEB from payment of the idle capacity is well as cost of inefficiency etc. on the part of the DPC, if any. The DPC will be conducting business of selling power without any risk on any single amount it will spend on this project. In the absence of any specific mention of the estimated cost of the project and keeping every aspect of the cost flexible and variable, the unit cost of power remains to be uncertain due to various variable elements of cost. Further if the argument is that the DPC is a seller of the power and the MSEB is a buyer and hence MSEB need not know at what cost DPC will buy plant and machinery and fuel etc., in that case the seller (i.e. DPC) should clearly spell out at what cost they will be selling power instead of keeping it flexible and price index link of the foreign market. The unit cost of the power stated to be at Rs. 2.40 at 1997 base price by the DPC has hardly had any credibility as it could be noticed from the working sheet that while calculating Capacity Charges the DPC did not take into account Equity Return, Debt Servicing, fixed O&M charges and Tax incremental as envisaged in the PPA and while calculating Energy Charges it did not take into account Testing and Special Operation Fees, Commissioning Fees, Fuel Fees and Fuel “Take or Pay” Adjustment as envisaged in the PPA. Moreover, in absence of any specific information regarding cost of the plant and machinery and fuel cost etc. how the unit cost is arrived at is not clear. Taken into consideration all the costs and variable thereof, the unit cost is bound to much higher than Rs. 2.40 as shown in the present calculation.

Compliance of the Board to the aforesaid observations may please be furnished to Audit.

Signed/19/6/95

Audit Officer / Report

Office of the Accountant General

(Commercial Audit)

101, M.K. Road, Bombay- 400 020.