Weekly Review – Special Edition – August 27, 2020

Published on August 27, 2020 / Leer en español

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Dear Readers:

We recently published a policy brief in which we analyze important aspects of the agreement between the Puerto Rico Electric Power Authority (“PREPA”) and LUMA Energy for the operation and management of PREPA’s transmission and distribution system; highlight some risks associated with the performance of that agreement; identify some serious concerns we have with the transaction; and offer some recommendations for its improvement.

This week’s issue of the CNE Weekly Review is a Special Edition dedicated to providing a little bit of the background of our analysis of that agreement, which is a key part of the process to transform Puerto Rico’s power system. We hope it entices you to read our full analysis of this important transaction.

Sergio M. Marxuach, Editor-in-Chief

Insights + Analysis from CNE

Background to CNE’s Analysis of the Agreement Between PREPA and LUMA Energy

By Sergio M. Marxuach, Policy Director

For at least two decades now business owners, community leaders, NGOs, trade organizations, and consumers have been advocating for a thorough transformation of the Puerto Rico Electric Power Authority (“PREPA”). The service provided by Puerto Rico’s state-owned utility is unreliable, highly polluting, and expensive. Its generation fleet is old and disproportionately dependent on fossil fuels, mostly bunker fuel and diesel. The transmission and distribution grid, for its part, has been neglected for years and suffered widespread damage as a result of hurricanes Irma and Maria in 2017.

Furthermore, PREPA traditionally has been a source of private and public corruption in the island. Appointment to senior management positions depended more on partisan politics than on personal merit. Technical and managerial decisions, in turn, were subordinated to short-term political interests for years. PREPA survived largely by postponing capital expenditures, delaying payment to suppliers, using accounting gimmicks that muddled its true financial condition, and by borrowing billions at relatively low, tax-exempt rates in the U.S. municipal bond markets, even when it was on the brink of insolvency. That all these shenanigans eventually ended in a bankruptcy filing should not be surprising. Nonetheless, it is still difficult to think of other monopolies that have managed to bankrupt themselves, with the exception, perhaps, of the state-owned enterprises in the former Soviet Union.

Given all of the above, the inescapable conclusion is that PREPA simply cannot continue operating the way it has up until now. We concur with the government of Puerto Rico, as well as several other organizations, that the time has come to take drastic action with respect to PREPA, as it has proven incapable of reforming itself and been immune to the efforts of several administrations to modernize and improve its operations.

That said, however, we believe it is imperative to meticulously analyze the political and economic context in which PREPA has operated and carefully study the options proposed for transforming the Puerto Rico electric system.

It is important to understand that no one at PREPA exercises the legal powers that shareholders—in this case all the residents of Puerto Rico—would exercise in a private company. This situation has allowed diverse interest groups, such as suppliers, political parties, beneficiaries of subsidies, unions, bondholders, bankers and consultants, and the politically connected, to organize in order to extract undeserved benefits from PREPA at the expense of the rest of the population of Puerto Rico.

These rent-seeking groups created obstacles that hindered previous efforts to transform PREPA, since each of the groups that benefited from the status quo was well organized and had a strong interest in protecting its benefits, while consumers were disorganized and the costs of acting collectively exceeded the individual benefit each consumer would receive.

The logical implication of this analysis is that PREPA went bankrupt due to the slow but steady extraction of rents by these well-organized groups, which gradually sucked the lifeblood out of the government-owned corporation. This is why we find it difficult to understand how organizations and individuals who stand outside the cercle sacré of the beneficiaries of this legally-sanctioned, but nonetheless morally corrupt scheme, can possibly advocate against the thorough transformation of PREPA.

Rent-seeking also explains why PREPA went bankrupt in the way most other businesses do: “gradually, then suddenly”. For PREPA that moment arrived in July 2017 when the Financial Oversight and Management Board for Puerto Rico (“FOMB”), acting as agent for the government of Puerto Rico, “in the interest of ensuring PREPA’s future financial sustainability…filed a voluntary petition on behalf of PREPA for protection under Title III of PROMESA in the US District Court.”

However, PREPA’s fundamental problem is not merely technological or financial, but as we have shown, it is also a problem of Puerto Rico’s political economy, and specifically of reducing the economic and political power of those special interests who unduly benefit from the existing system and increasing the power those who are adversely affected by it.

Any effort to transform Puerto Rico’s electric system needs to take into account the predatory behavior of PREPA’s internal and external interest groups that benefit from the current situation and provide mechanisms for limiting or eliminating that behavior. If the currently-favored privatization process is limited simply to transferring the assets or operation of a corrupt company in the public sector to a group of investors in the private sector, without disrupting or dismantling the rent-seeking network we have described above, then we will have achieved absolutely nothing. In other words, privatization, in and by itself, will not solve Puerto Rico’s electricity problems, if all it does is substitute a group of rent-seekers for another.

On June 22, 2020, PREPA and the Puerto Rico Public-Private Partnerships Authority (the “P3A” or “Administrator”) entered into an agreement for the Operation and Maintenance (“O&M” Agreement”) of PREPA’s Transmission and Distribution System (“T&D System”) with LUMA Energy, LLC, (“ManagementCo”) and LUMA Energy Servco, LLC (“ServCo”, and together with ManagementCo, the “Operator”). The Operator, in turn, is a consortium formed by (1) ATCO Ltd., a Canadian operator of electric systems and (2) Quanta Services, Inc., a Texas-based provider of “infrastructure solutions” for the electric power industry.

The O&M Agreement grants the Operator the right to operate and manage PREPA’s T&D System for fifteen years, while PREPA retains the ownership of the T&D System. In consideration for managing the T&D System in accordance with O&M Agreement, the Operator is entitled to receive a Service Fee consisting of (1) an annual Fixed Fee and (2) an Incentive Fee:

  • The Fixed Fee starts at $70 million on year 1 and increases to $105 million for each of years 4 through 15.
  • The Incentive Fee, which is payable upon the Operator achieving certain performance benchmarks set forth in Annex IX to the O&M Agreement and is calculated in accordance with the methodology set forth in Annex X to the O&M Agreement, starts at $13 million on year 1 and increases up to $20 million for each of years 4 through 15.

In both cases, the amounts payable on account of the Fixed Fee and the Incentive Fee, if any, will be adjusted for inflation (Annex VIII to the O&M Agreement). In addition, the Operator is entitled to recover, “at cost”, certain T&D Pass-Through Expenditures, Capital Costs, and Outage Event Costs.