Center for a New Economy: LUMA contract needs amendments

By The Star Staff

While the Puerto Rico Electric Power Authority (PREPA) needs to be transformed, Sergio Marxuach, the policy director at Center for a New Economy, said Monday that the contract with LUMA Energy to operate PREPA’s transmission and distribution (T&D) system needs to be amended, and if that can’t happen then it should be canceled.

Marxuach spoke before the island House of Representatives during a public hearing investigating the transaction.

“In general terms, we are concerned that Puerto Rico’s government may lack the required capacity to successfully manage this complex multilayered process, with several dimensions that intersect and reinforce each other,” he said. “Furthermore, it is apparent from our analysis of the O&M Agreement that it does not equitably allocate risks between the parties.

In our opinion, the government of Puerto Rico needs to develop a greater capacity to clearly establish the public policy objectives to be achieved and to successfully negotiate this type of agreement, if it wants to continue implementing public-private partnerships in the future.”

The agreement grants LUMA Energy the right to operate and manage PREPA’s T&D system for 15 years, while PREPA retains the ownership of the system. In consideration for managing the T&D system in accordance with the O&M Agreement, the operator is entitled to receive a service fee consisting of a fixed fee that starts at $70 million in the first year and increases to $105 million for each of years 4 through 15, and an incentive fee, which is payable upon LUMA Energy achieving certain performance benchmarks. The incentive fee starts at $13 million in 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. The agreement also includes a “Front-End Transition Period” and a “Back-End Transition Period” for which the fees are different from the service fees.

Among Marxuach’s concerns was that LUMA Energy in order to collect the annual incentive fee, has to achieve certain performance benchmarks as set forth in Annex IX to the O&M Agreement. Annex X, in turn sets forth the methodology for calculating the amount of the incentive fee that is due, if any. The concern here is that a significant number of the benchmarks have not been determined yet and are subject to further negotiation among the parties.

The Puerto Rico Energy Bureau (PREB) has yet to approve the benchmarks.

“This is a key issue for determining the success or failure of the transaction,” Marxuach said. “We understand that it may be necessary to set benchmarks against PREPA’s prior performance during the initial years of the contract period as the T&D system needs significant remediation in order to perform at reasonable standards. But at some point, the performance benchmarks should be set against similar utilities in the United States.”

Another concern is that the Public-Private Partnerships Authority (P3A) committee report states that the present value of the fixed fee and the incentive fee over the 15-year term of the agreement is some $1.35 billion.

“This means that entering into the O&M Agreement would be rational, from a purely financial perspective, if, and only if, the present value of the future savings to be generated by the operator exceeds $1.35 billion,” Marxuach said. “According to a P3A presentation that took place when the transaction was announced, annual savings are forecast to reach $288 million by the fifth year that the agreement is in effect, compared to an annual fee payable that year of $138 million, for net savings of $150 million,” he said.

FTI Consulting estimated savings of $177 million.

“Both analyses fall well short of the full cost/benefit analysis we would like to see, but at first glance it appears that the agreement, if executed in accordance with its terms, would pay for itself,” Marxuach added. “The problem is that PREPA is notorious for overestimating savings from various reform efforts undertaken in the past.”

He also said LUMA Energy does not have an obligation to make any capital improvements to Puerto Rico’s T&D system. However, it does have the option, pursuant to the agreement, to propose operator-owned capital improvements to the PREB. The PREB, in turn, would evaluate any such proposal on its merits and allow for LUMA Energy “to earn a reasonable rate of return thereon consistent with the returns permitted to be earned by companies operating in the United States electricity transmission and distribution business on similar investments.”

Indeed, it appears that at least one of the partners in the LUMA Energy consortium, Quanta Services Inc., believes there is significant upside in making those investments, Marxuach said, noting a press release issued by Quanta.

“While the O&M Agreement mandates the PREB to review these transactions, we believe related-party transactions are particularly vulnerable to rent-seeking and shall be subject to additional review by the P3A as administrator of the O&M Agreement,” he said.