Dealing with the energy mess

I have been saying for long that the energy sector mess alone can drag the economy down to abyss. The IMF in its latest review is giving a similar picture. The circular debt in the energy chain increased from Rs450 billion in 2013 to Rs1.7 trillion.

The Fund's recipe to reduce the circular debt by increasing tariffs is tricky. The IMF is effectively saying if the government cannot reduce the inefficiencies, pass it on to the consumers - increase the tariffs. The electricity cost in Pakistan is already higher than what it is in regional competitors. With more increase, the industrial competiveness will be further eroded. It is an antidote to manufacturing exports growth. It is an antidote to industrialize the economy.

The increase in tariffs will sway consumers (mainly industrial) from the grid. One of the reasons for tariff hike is growing fixed capacity payment to existing and new power plants. To dilute the impact of fixed capacity charge per unit, the load on the grid is to increase (number of units consumed to grow). But with higher tariffs, consumers have incentive to opt for alternate power sources.

In case of industries, it makes sense for running generators (captive power plants) on Furnace Oil (FO). Many industries in Punjab have these plants installed at sites (erected in yesteryears when electricity shortages were high). With FO prices nose-diving, (perhaps permanently due to IMO-2020) generating own power is becoming cheaper than buying electricity from the grid. For industrial consumers in Sindh (not any industry as such in KP and Balochistan), domestic natural gas is supplied at steep discount. They are better off using captive power generation on gas.

In case of commercial (where use is higher in day time) and domestic consumers, the day time energy need is to become relatively cheaper on solar (adjusting to initial cost which can be recovered by supplier in monthly installments). Solar is viable without storage. The commercial solar solutions are ought to grow.

When the government increases prices every quarter, marginal consumer will sway away from the grid. This will require further increase in grid electricity prices. Another set of marginal consumer to move away from grid. This method to end the circular debt is circular.

There are two problems. One is the leakages in electricity distribution companies (DISCOs) and other is increasing fixed capacity payments of existing and new plants. The consequential problems of these two are the finance costs associated with growing circular debt and untargeted subsidies to certain sets of consumers. If the government can solve the first two, the rest will come in order automatically.

The biggest contributor to circular debt of Rs465 billion last year was electricity distribution companies (DISCOs) inefficiencies (Rs171bn). The DISCOs get electricity from the grid (National transmission and distribution company - NTDC), sell to end consumers, and pay the proceeds back (adjusting for own margins) to Central Power Purchasing Authority (CPPA). DISCOs have permissible transmission and distribution (T&D) losses limit of 15.5 percent with 100 percent recovery. Some are doing fine, but others have high losses. The brunt has to be borne by all consumers eventually through tariff hike.

There are political economy challenges in poor DISCOs (Hyderabad, Sukkur, Peshawar and Quetta). Successive government failed to improve the recovery. Consumers in Sindh say that they provide natural gas at cheap rates to power producers (IPPs and government GENCOs) and in return get electricity at high rates. Hence, some simply refuse to pay electricity bills. Those in KP have similar argument on hydel power supply. Balochistan's are invariably deprived people. The argument is why to pay for Punjab consumers which has to rely (in other provinces absence) on expensive imported fuel. The solution is not hidden merely in curbing theft. The need is to develop an economic consensus through Council of Common Interest (CCI) - a body for coordination between provinces and federal government.

The second biggest contributor to Rs 465 billion circular debt in FY19 was delayed tariff adjustments (Rs119bn). Here the issue of capacity payments to independent power plants (IPPs) haunts. Capacity fixed charge is to cover generation companies including Independent Power Plants (IPPs) fixed cost related to design and construction of plants, generators' guaranteed return on equity, and debt financing charges. These are indexed to exchange rate and domestic interest rates.

With new plants coming in FY18 onwards, the fixed capacity charge is increasing. The plants with financial close will keep on coming online for next 2-3 years. The currency depreciation and higher interest rates are inflating the existing payments. The growth in circular debt is increasing financial charges. The government is bound to pay KIBOR +4 on delayed payments. These IPPs can get working capital loan from banks against receivables at K+1 -2. The IPPs are enjoying the arbitrage.

The other issue is growing financial charges on settled circular debt parked in Power Holding Private Company (PHPL) at K+2. With higher interest rates, the financial charges are growing. The incremental circular debt is to pass on from CPPA to PHPL. This will increase the financial charges further. The tariff will increase further as these financial chargers are distributed over all the consumers. The government aims to provide subsidy to agriculture, exporting industries and life line consumers. Not all the subsidies are targeted. Untargeted subsidies will add to circular debt further.

The solution is two-fold. Renegotiate the contracts with IPPs by transferring the debt repayment towards the end of contracts. To renegotiate on interest rates (from K+4 to K+1-2) on delayed payments. To renegotiate on inflated cost of design and construction (hard call). Still the gaps will persist. Interestingly, within country, K-Electric (KE) is another grid where demand is higher than supply. The case is for IPPs in south from NTDC (where supply is higher than demand) to KE to lower the capacity fixed charge load on NTDC.

The second leg is of DISCOs. These companies need capex for lowering T&D losses. This cannot happen in current shape of poor governance. These have to be given in private hands or disintegrated into more companies. The problem does not end with above mentioned measures. The overall country demand is less than supply. To spur demand, prices must come down. But the immediate need is to increase the prices (tariffs). Let's hope with IMF increased focus on energy mess, the government finally starts take corrective actions in real sense.

Copyright Business Recorder, 2019