Export sector: prohibitive energy costs

If the economy is to be stabilized, exports can no longer afford to pay for the energy sector’s failures and inefficiencies, and the government’s social obligations.

Power tariffs in Pakistan are amongst the highest in the world (see below), and contrary to all economic norms industry and exports subsidize non-productive sectors of the economy.

Since the withdrawal of regionally competitive energy tariffs in March 2023, over 50 percent of production capacity in the textile sector has remained idle and textile exports have declined from $19.3 billion in FY22 to $16.5 billion in FY23.

Exports for the first two months of FY24, similarly, do not seem encouraging and are down by 13 percent compared to last year while Indian textile exports have posted a 5 percent growth.

Distortions in energy pricing are largely to blame for this. Export sectors were being charged a regionally competitive energy tariff of 9 cents/kWh in FY20. This created a favourable business environment leading to significant fixed capital investments and expansion of export capacity. Between FY20 and FY22, exports increased by 54 percent from $12.5 billion to $19.3 bn.

However, the regionally competitive tariff was withdrawn in March 2023 and the power tariff for industrial consumers now sits at around 15 cents/kWh.

An analysis of this tariff shows that of the 15 cents/kWh charged to industrial consumers the actual cost of service is only around Rs 8.2 cents/kWh, while the remaining 6.8 cents/kWhare cross subsidies that the energy sector imposes on exporters to finance its own failures, inefficiencies and to support low tariffs for nonproductive sectors.

Who actually ends up paying for this subsidy to the unproductive sectors is the key to understanding why it cannot be imposed on export sectors.

In the case of industry serving domestic markets, any increase in the price of inputs—including electricity—is passed on to the final consumer and therefore it is the final consumers who pay for it.

However, demand is not very elastic because domestic sectors are largely protected by high tariffs and, among other things, an expensive dollar makes it very expensive to import. So domestic consumers have little choice but to continue consuming domestically produced products at higher prices.

The case of exports, however, exhibits one similarity and one very important difference. Like in non-traded sectors, power costs must be passed on to the consumer.

But, in this instance, the final consumers are international buyers who easily substitute Pakistan’s exports with those of competing firms in regions with considerably lower power tariffs and therefore prices. By virtue of international trade, these consumers are not liable to pay for the inefficiencies that are embedded in prices through the cross-subsidy component of power tariffs, and demand completely vanishes in response to even marginal increases in prices.

The implication of this is that trade continues to be diverted away from Pakistani firms towards their regional competitors in countries like Bangladesh, India and Vietnam.

The economy’s exporters and foreign exchange earnings fall as a result, which puts upward pressure on the exchange rate, causing power tariffs to increase further in rupee terms, giving way to a vicious cycle of increasing power tariffs and, decreasing exports, rising unemployment and inflation that our economy is now stuck in.

The only way to come out of this cycle is to provide exporters with internationally competitive power tariffs.

Ideally, this should be done through a separate consumer category for exporters, with power tariffs based on actual cost of service and excluding cross subsidies and stranded costs that penalize exports.

However, this would entail a tariff hike of around 0.6 cents/kWh (Rs 2) for other consumer categories, which represents the government’s social liability currently being borne by the exporter sector.

For the long-term, the government must provide exporters with a functional wheeling mechanism to allow B2B contracts for competitively priced electricity.

The wheeling charges should fall within 1-1.5 cents/kWh and exclude any stranded costs, reservation of power charges and cross-subsidies. This will allow the export sector to build up its own power supply without any burden on the government exchequer.

The cap on solar net-metering for industrial consumers should also be raised from 1MW up to 5MW. This will add 5,000MW of solar energy to the point of usage with no upfront investment or guarantees from the government.

Both initiatives will also support the transition towards net-zero energy emissions, which is required to be achieved by 2030 to continue exporting to key Western markets.

None of these are subsidies since they do not involve any transfer from the government to the exporters. A sustainable increase in exports is the only solution to our economic woes, and what is simply needed is that the energy sector stop extorting money from exporters to pay for its own social obligations, failures and inefficiencies.

Copyright Business Recorder, 2023