Real cost of cross subsidies

No other commodity in Pakistan creates more economic distortions than electricity. Normal goods, public goods, inferior goods, and Giffen goods are the few kinds of goods that exist in economics.

Such is the scale of the crisis in Pakistan’s energy market—if it can be called a market at all—electricity cannot be classified under any of these.

We are in a place where the discourses driving decisions on issues with implications for the entire economy have become so severely misinformed that the record must be set straight.

It has been recently claimed that “Pakistan’s consumer tariff is based on principle of equity: it transfers resources from the rich to the poor; from richer regions to poorer regions; and from federal pool to poor consumers in poorer regions”.

Apart from the oblivious mischaracterization of facts, such as that there is no nomenclature providing for “rich” or “poor” consumer tariffs and that there is no “federal pool”—only a growing pile of circular debt backed by large and persistent fiscal deficits—this statement runs contrary to all economic norms and public policy rationale.

Pakistan’s power sector is characterized by a state that is partially unable, partially unwilling to mobilize revenue generation capacity and is therefore bent on exploiting its unholy monopoly in the power sector for a pretend redistribution of income, no matter how damaging the consequences.

Around 68 percent of domestic consumers in Pakistan fall under the protected category and another 25 percent are lifeline consumers. Together they account for 73 percent of domestic power consumption.

The remaining 7 percent of domestic consumers—often referred to as high-end domestic—pay full tariffs and account for 27% of around 56,000 GWH of total domestic consumption.

The size of the subsidy given to protected and lifeline consumers is between Rs. 900 billion and Rs. 1 trillion rupees, both according to the Power Division and by our own estimates. All else aside, it is not mathematically possible for high-end domestic consumption — i.e., “rich” consumers—to pay for a subsidy of Rs 900 billion.

This begs the question, who is really paying for this subsidy. The answer is: it depends. Directly, it is a combination of high-end domestic, commercial, and industrial consumers with a cross-subsidy embedded in their power tariffs.

But once we consider the economic linkages that exist between all agents of the economy, everyone is paying for it—including and especially the protected and lifeline consumers whom it is meant to benefit.

Because electricity is an input across all sectors of the economy, taxes embedded in electricity prices are always passed on to the final consumers.

First, this adds to the lack of productivity and competitiveness in domestic activities, thus requiring even higher levels of protection from imports, fuelling distortions in domestic markets.

Second, and more importantly, it results in a loss of welfare for consumers across the board, but substantially more so for the poor than for the rich because the rich—by virtue of their wealth—are always willing to pay more for any given commodity than the poor.

But what is even more dangerous is when such taxes are imposed on export sectors. In the case of exports, the final consumers are international buyers with relatively elastic demand.

When the price of electricity for export sectors rises significantly above that faced by competing firms in other countries, demand disappears, and the industry inevitably collapses. This is what is happening in Pakistan.

Power tariffs for industrial consumers contain a cross-subsidy ranging from Rs 10.85/kWh, according to government sources, to Rs 16/kWh, according to our own estimates that are largely consistent with those from research institutions like the Pakistan Institute for Development Economics. This makes the power tariffs faced by Pakistani exporters almost twice the regional average (Figure 1, below).

• Tariffs in Pakistan can fluctuate between 14 to 16 cents/kWh based on prevailing exchange rates. 14 cents/kWh is based on $1 = Rs. 280.

** 80% of industry in Bangladesh is energized through competitively priced gas.

*** The bulk share of Indian textile industry is located in the state of Maharashtra.

With energy costs accounting for around 12% of total input costs during the RCET regime, our estimates suggest that a rise in power tariffs from 9 cents/kWh to the current 14 cents/kWh reduces firms’ net profitability from an average of 8 percent to only 1 percent and crowds out the export sector. To connect this with reality, one only needs to look at the abysmal state of FY23 profits reported by publicly listed textile firms, and the continued decline in textile exports (down 10% in FY24Q1, year-on-year).

Not only have exorbitant power tariffs had a direct impact on export firms and the millions of jobs they generate, but the effects have spilled over across the entire value chain.

Over 60% of production across the country is halted and Faisalabad is completely shut; mill owners are scrapping their machinery at Rs 120/kg to pay outstanding electricity bills and leaving the sector, and cotton prices are plummeting because there is no downstream demand.

There is broad consensus on a need for deep-rooted structural reforms to save our ailing economy from this destruction. However, what is poorly understood is that deep-rooted structural reforms are a precarious and continuous process, the utmost prerequisite for which is a relatively stable macroeconomy that is currently absent in Pakistan. Achieving this level of stability requires a sustained increase in exports to build up economic buffers necessary to shield the economy from exogenous and endogenous shocks during the reform process.

The only realistic avenue to achieve this over the near and medium term is to reform how electricity is provisioned to export-oriented sectors.

First, export-oriented industries must be provided with a separate power tariff category, excluding economic inefficiencies like stranded costs and cross subsidies.

This will provide competitive electricity tariffs that don’t inhibit the ability of exporters to compete in international markets. Second, the government must initiate a move towards a free-market and distortion-free power sector by allowing B2B contracts for power wheeling at a wheeling charge of 1 cent/kWh, all inclusive.

And finally, the cap on solar net-metering for industrial consumers must be increased from 1MW up to 5MW to provide 5,000MW at the point of usage and move towards net-zero emissions in exports — required by the 2030 to continue exporting to key Western markets.

Otherwise, the Power Division must explain the unjustified loss of livelihoods to the nation.

Copyright Business Recorder, 2023