luotang case Essay
As soon as Tan Min Yi received the 2011 Report of Operations for the Luotang Power Company, he called company Controller Fiona Zhu and Sales Manager Ricky Wang into his office to discuss the results.
Tan was general manager of the Luotang Power Company, a 600 Mega Watt (“MW”)1 coalfired power plant, located in Hubei Province, China. He was scheduled to make a presentation to the Board of Directors of his parent company, China Hua Tong Power (“HT Power”), the following week about the most recent results and was concerned about their reaction to the disappointing results.2 Tan knew his company had performed well during the year. Both plant availability3 and fuel economy had improved over the previous year. Additionally the plant’s primary customer, the Hubei Provincial Power Company (“HPPC”), had met its contractual electricity purchase obligations for the year.
However, there had been limited opportunity to sell energy above the contractual minimum, either to HPPC or others. Still, Tan felt that these factors were outside his control. His team had performed well—it just didn’t show up in the financial results. The scheduled presentation to the Board was important for two reasons. First, HT Power was considering a 2,000 MW expansion at Luotang. However, on a more personal note for Tan, he had been general manager of Luotang since 2002, and he hoped it would be time for a promotion.
He hoped that HT Power would consider him for the company’s Executive Vice President position. He also knew how critical fuel price management was to HT Power’s success but wasn’t completely sure how well his team had managed this aspect of the business during the year. Would HT Power pass 1 One megawatt (MW) is equivalent to 1,000 kilowatts (KW).
A one megawatt system would generate enough power to displace the electrical usage of 140 average-sized homes in the USA. (Source: http://www.eia.doe.gov/emeu/recs/recs2001/enduse2001/enduse2001.html) 2 For additional background information on Mr. Tan and his colleagues, please refer to Exhibit 1. 3 Plant availability measures the percentage of time over the year that the plant was available to dispatch electricity if requested by the power purchaser.
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913-533 | Luotang Power: Variances Explained over him and consider one of his coal supplier’s management team for the role instead? After all, there were several ambitious, young, capable executives working within their main coal supplier, the newly listed Pindingshan Coal Company (“Pingdingshan”). Tan had no doubt that the team from Pingdingshan wanted to place some of these individuals with major customers to strengthen longterm supply relationships.
Background to the Luotang Power Company In 1997, the Provincial Planning Commission, working on behalf of the Hubei Provincial Government, had solicited bids from international power developers to finance, design, construct and operate a 600 MW coal-fired power plant.
The plant was to be located in Luotang City, Hubei Province in Central China, approximately 100 kilometers south of the provincial capital, Wuhan. Additionally, the project would be contracted on a Build Operate Transfer (“BOT”) basis; the power plant would be given to the Hubei Provincial Government after 20 years of operation at no cost. Although the area around the power plant was primarily rural in nature, Luotang City’s economic development had been rapid since the plant had opened. New auto-part and electronic manufacturing businesses sprung up that added to the economic growth provided by traditional linen and fabric manufacturers already in operation.
Approximately 30 power developers were invited to bid on the project; an American independent power producer was selected as the preferred bidder. Over the next four years, the American company established a special purpose company, Luotang Power Company (“Luotang”), to run the project. It was Luotang that negotiated all the required project contracts, obtained government approvals, and arranged close to $500 million in total financing required to construct the power plant.
The highest government authorities approved the project to be wholly foreign-owned. However, these approvals were conditional on the use of Chinese-manufactured equipment with a consortium of Chinese construction companies. Although the power plant was designed to burn coal, the construction contract required emissions to meet all relevant Chinese standards as well as the more stringent World Bank Standards. Luotang was to be one of the least polluting coal power plants for its size in the country.
During the 20-year operating period, Luotang was contractually obligated to sell electricity to HPPC pursuant to a power purchase contract. HPPC, a state-owned electric power company established in 1994, was the only power transmission and distribution company in Hubei Province. It owned all the power transmission and distribution facilities and was expected to be the sole purchaser of electricity generated by independently owned power plants operating in the province.
HPPC’s power purchase contract with Luotang provided for a minimum annual purchase of electricity based on 5,000 hours generation at the 600MW plant capacity for a total of 3,000,000MWh per annum (the “Normal Take”). This amount would be reduced, however, if the plant ran below capacity, or was unable to generate and dispatch power when requested to do so.
The contract further required that Luotang sell amounts in excess of this minimum annual purchase quantity (“Excess Energy”) at approximately 65% of the regular price. Given that HPPC held the option to request Excess Energy and was the only entity legally allowed to purchase electricity generated by the plant, this meant that HPPC would typically seek to renegotiate this price annually based upon its expected needs for electricity.
Luotang had negotiated a coal supply contract with Pingdingshan. According to this contract, Pingdingshan was required to supply low sulfur bituminous coal that met certain quality specifications based on coal extracted from its mines in the neighboring Henan Province. Luotang 2
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Luotang Power: Variances Explained | 913-533
paid a fixed price per tonne4 of delivered coal, adjusted to account for inflation, changes in transportation costs, and for the energy or water content of the coal if either fell outside a specified range as shown in Exhibit 2. The challenge with the adjustment formula was that it didn’t really kick-in until the coal quality had deteriorated about 3% from the expected quality.
When buying over RMB300million of coal each year, this was potentially a large number, especially if the mining company was able to consistently provide coal close to the low end of the intended quality range. However, Luotang was somewhat protected from the effects of increases in fuel prices since the power purchase contract between HPPC and Luotang contained provisions to adjust the electricity price to reflect fuel price changes over time.
Having negotiated and executed all the major contracts—including, inter alia, the land lease, water supply, coal transportation, and electricity dispatch agreements—the US independent power company that had originally obtained the rights to build and operate the power plant sold its interest in Luotang to Hua Tong Power (“HT Power”) in the summer of 2002, which named Tan general manager of Luotang.
Formal construction began later that year with the two 300MW units beginning commercial operation well ahead of schedule in July and November 2004, respectively.
After construction was complete, Tan found that electricity demand was largely controlled by the power purchaser, HPPC. Although HPPC was only committed to purchase 3,000,000MWh of electricity annually, Tan’s team had proven to be relatively successful at bidding to sell electricity above these amounts in prior years.
Unfortunately, given that HPPC also had many of its own electricity generating units across Hubei Province, electricity that HPPC purchased from the Luotang plant effectively substituted for electricity it could have produced itself. During the last year, Tan felt that HPPC had been negotiating harder than in previous years with respect to the Excess Energy sales. He wasn’t sure why; perhaps it was to lower future expectations—or maybe it was the first round of negotiations relating to the proposed expansion at the project site.
However, as can be seen from Exhibit 3, its demand for electricity from the project had fallen dramatically over the previous 12 months. Having spoken to some of the other power plant managers in Hubei Province, Tan was confident that no other team had sold more Excess Energy this year than his; it just didn’t seem as much as in prior years.
The difficulties caused by falling revenues were accentuated by the high debt burden that the project carried, with approximately 80% of the initial construction costs being financed by debt. As Tan considered how he would present his report to the Board, he considered its membership. Individuals like Shen Li, his predecessor as general manager of Luotang, understood the nuances of Chinese power projects.
In contrast, Michael Abrahams tended to take a more rigorous financial approach. This belied his high level of understanding of the engineering, gained in part during his experience working with American engineering giant Bechtel Corporation, but strongly reflected his educational background which included an MBA from Harvard.
The logic for these adjustments is that coal with higher heat content (dchv) will burn to release more energy which, in turn, permits the power plant to generate more electricity per kilo of coal used. However, neither side of the negotiation wanted to adjust prices for small variation in coal quality. Similarly, wet coal needs to be dried before it will burn.
This takes energy which might otherwise have been used to produce electricity, meaning that a kilo of high moisture content coal is worth less than a kilo of low moisture content coal.
The amount of the adjustments was designed to ensure that the returns to power plant owner was not materially affected by changes in delivered coal quality.