Pakistan’s electricity dynamics: Status quo & future direction

It is high time for the government to put its foot down and move away from the current 'Take or Pay' policies, which force it to pay capacity payments to IPPs, and move towards market liberalization of the electricity market, which happened in most countries of the world over 2 decades ago!

The electric power sector in Pakistan has been in focus for more than two decades now, yet, problems in the sector have increased to a point where it can bring the whole economy down if significant reforms are not undertaken.

It is Pakistan’s most significant macroeconomic issue. For years, balancing Pakistan’s supply against the electricity demand has remained a largely unresolved matter. Electricity is an indispensable good for households and an essential input for the industry in almost every economy.

Currently, Pakistan’s power market is riddled with non-payments and cash flow issues, high losses, long-term generation contracts backed by sovereign government guarantees, sky-rocketing circular debt, and excess generation. However, sadly, the majority of the solutions proposed by economists are price-focused.

This essentially means moving towards further tariff hikes, over-burdening the already highly charged good customers, shrinking the affordability net, and encouraging more theft and thus losses. Moreover, governments look for a short-term fix whenever the problem becomes untenable, happily print money, or issue bonds/bills as a bailout.

The annual billing of the power sector for the whole country is about PKR 1.5 trillion per year, and any attempt to fund a large part with subsidies is neither affordable nor sustainable (currently, 85 percent of consumers – that consume less than 300 units – in the country are subsidized).

The underlying cause of this high basket price of energy needs to be addressed. The public interest needs to be safeguarded, which unfortunately was wholly ignored in the past governments. Even if it is assumed that price correction is the only sensible solution, then too, no such measure will prove fruitful unless the policy driving the sector is corrected.

Governments unwilling to take difficult path

The current structure of Pakistan’s wholesale power market is a single buyer arrangement. Presently, CPPA-G is involved in all power procurements, maintaining a central power pool. The current market of a single buyer can only be moved to a multiple buyer in a phased manner, i.e., through a long-term transition plan.

One of the first key milestones in this transition is allowing willing IPPs under their existing PPAs to sell power directly to bulk power consumers (BPC), i.e., removing exclusivity clause and allowing bilateral sale to BPCs. Once a thriving bilateral market (direct sales between IPPs and BPCs) is established, a smooth transition towards CTBCM can be ensured.

The ultimate aim is to reduce sector inefficiencies and costs to the consumer. Hence, it is critical to focus on demand creation. For starters, the government needs to put its foot down and move away from the current ‘Take or Pay’ policy (which guarantees capacity payments to IPPs irrespective of whether government buys from them or not) and contract all future IPPs (regardless of the source) in the form of a hybrid merchant market, i.e., not providing any guaranteed return; and thus, the profitability of these IPPs to be derived from their cost of production.

All the existing generation projects set up under ‘take or pay’ contracts that have yet not achieved their financial close needs to be converted to ‘Take and Pay’ contracts (where payment is made only if electricity is bought from the IPP). Moreover, the private sector interested to put up generation in the future needs to bear the risk.

It essentially means IPPs will be responsible for securing their bilateral contracts implying that new IPPs coming online will bear the cost of their own idle time. In essence, the inherent policy driving the sector is flawed. It is a no-brainer that the private sector delivers through competition.

In an oligopolistic market, businesses compete; this process enables the value to reach the consumer. Sadly, the existing power policy does not foster such an environment. Instead, it is the other way around, i.e., inefficiency in the system is encouraged where private power has no incentive to utilize more efficient technology, optimize fuel, or scale choices.

Starting from the premise that government should not be running economic business enterprises, the inevitable solution for the power sector’s problems is to move towards market reforms and liberalization.

One of the most attractive promises of liberalization is that investment risk is shifted from consumers to the private sector (as in other consumer products). At the same time, it is an attractive goal to get to a Merchant market for electricity, where it is traded like a commodity rather than a franchised monopoly service.

Case upon case worldwide has shown that when electricity is commoditized, the cost goes down, and service quality goes up. Furthermore, this model applies to electricity and many industries over the last 50 years.

However, for this to happen, some fundamental elements are essential. These elements are missing in Pakistan, and until they are first put in place, any attempt to create a merchant market is not only futile, it will simply generate more complications to untangle later.

Real cost to Pakistan’s GDP

In Pakistan, the investments required to bolster exports are short in supply. Moreover, the investment environment also falls prey to uncertainty. To make matters worse, Pakistan’s energy tariffs do not commensurate with the income levels of the general population or with regionally prevailing tariffs.

A recent PIDE study has highlighted that energy tariffs in Pakistan are high due to operational and commercial inefficiencies, governance issues, ineffective planning, poor policies, and sub-optimal energy mix.

The unit energy price covers all the inefficiencies and is higher than the cost of service for industrial consumers. Moreover, the study finds that an electricity tariff above 7.5 cents/kWh is regionally uncompetitive, and thus, industrial demand of providing electricity at 7.5 cents/kWh is unassailable.

In essence, the government’s objectives of economic growth, a bright future, and becoming an export “powerhouse” cannot be achieved unless power tariffs are revised to a competitive and stable level.

Pakistan's electricity dynamics
Source: NTDC & NEPRA Annual Reports

Urgency of policy shift

In the past two decades, the pace of reform and change in the electricity sector worldwide has rapidly increased, and the nature of the reforms adopted has become steadily more sophisticated.

From China to small countries, such as Bolivia, many countries have enthusiastically adapted reform models most suitable to their own needs and circumstances. Both developed and developing countries have embarked on a program of liberalizing and reforming their power sectors.

The principal driving forces behind this reform movement, described by many authors, include (a) the poor performance of the state-run electricity sector in terms of high costs, inadequate expansion of access to electricity service for the population, and/or unreliable supply; (b) the inability of the state sector to finance needed expenditures on new investment and/or maintenance; (c) the need to remove subsidies to the sector to release resources for other pressing public expenditure needs; and (d) the desire to raise immediate revenue for the government.

In many countries, all these factors have been present simultaneously, and Pakistan is no exception. However, despite all these factors present in Pakistan’s power sector, a lengthy period of state ownership, without the forces of competition or the incentives of the profit motive to improve the power ministry leadership, is tackling the issue with a myopic vision.

It is hell-bent on proving that the only way to pull the power sector out from the current crisis is by saving the incumbent, i.e., CPPAG. This tunnel vision is putting the entire economy in jeopardy.

At the helm of affairs, the power ministry is eyeing anti-competitive measures, i.e., tariff hikes, restricting wheeling to bulk power consumers (BPCs), and maintaining ‘Take or Pay’ contracts to put the sector back on its feet or to resolve the sector’s issues.

To make matters worse, Ministry has also proposed a very regressive National Electricity Policy (NEP). NEP aims to achieve social development goals, promoting reforms, fostering improvement and sustainability of the power market and power sector.

However, NEP indicates that Ministry is not yet ready to learn from its own mistakes. To put it point blank, NEP lacks the essential substance to pull the ailing power sector out of the present predicament and set it on a course to financial health and vitality in the future.

The policy has expressed an urgency to address the problems that plague the power sector but has failed to prescribe any practical measures to correct them. For starters, NEP is anti-competitive by design and regressive in nature.

Instead of laying down a road map for market reforms to deregulate the sector and pave the way for market liberalization, NEP will further over-regulate an already regulated sector. Therefore, instead of blindly following NEP, the need of the hour is to have an independent holistic review of the same to see whether it would help address sector challenges or aggravate them.

Government needs to step out of the market

In light of the above discussion, it is pretty clear that to reform the power sector, the energy tariffs need to be reduced, demand creation measures need to be adopted, and most importantly, the government needs to move out of the electricity business.

Moreover, the government needs to take a step back and look at the entire issue from an economic lens rather than focusing on reviving the power sector in isolation. The current measures being enforced to revive the sector, such as tariff hikes to remove circular debt, discouraging competition, and relying on subsidies, might keep the incumbent afloat but will come at the cost of the country’s GDP growth.

The power ministry is applying force on the wrong end of the stick or carrot– where it is only thinking about the power sector exclusive of the rest of the economy – whereas what is direly needed is some out-of-the-box thinking. For this to happen, we need to adopt reforms or measures to kick start the economy and promote industrialization.

Kickstarting demand

As a first step, the export industry needs to be competitive, for which energy tariffs need to be aligned with the regional tariffs. Since grid electricity is unaffordable for industry, they end up relying on their own captive generation. To address this, the IPPs need to provide electricity directly to the industry at competitive rates (creating a market).

This will generate wheeling revenue for the DISCOs and generate additional tax revenue for the government. When the industry gets cheaper electricity, their output will increase, generating more tax revenue; as the IPPs enter the new Power Purchasing Agreements, they will create a new tax stream for the government.

Over the years, Bulk Power Consumers (BPCs) moved to captive generation due to expensive and unreliable grid electricity. The government on its own has made multiple failed attempts to encourage grid electricity utilization, and thus, the only way to revive the sector is through private sector interventions (proven internationally as well).

The heart of the problem lies in the single buyer model, limiting competition and promoting a monopoly. Therefore, to kick start the reform process, the government needs to allow BPCs to purchase electricity directly from generators.

The regulatory framework for the same is already in place, i.e., NEPRA (Wheeling of Power) Regulations 2016 were notified, allowing nationwide wheeling of power by all DISCOs/NTDC to BPCs with a connected power load of 1 MW or above.

However, the DISCOs, NTDC, and CPPA-G are still opposing the wheeling of power by tooth and nail. The DISCOs want B2B deals to be charged for cross-subsidy and stranded costs. As a rule, the cost of cross-subsidies, stranded costs, and inefficiencies cannot be exported.

If the country needs to progress on export-led growth and a sustainable economic model, then the free market must be developed in letter and spirit. Competition is the critical principle for developing and expanding the energy market, and wheeling is the first step.

It is pertinent to mention that if the wheeling charges are not maintained at the current levels, the electricity tariffs will not make economic sense. Thus the industry will not move to grid electricity.

Instead, more industry will move away from the grid, leaving higher idle capacity charges to be recovered from a smaller customer base. It is more like a vicious cycle, where the government will increase tariff burden, encouraging more industrial customers to move away from the grid and rely on captive generation.

The government needs to understand that incorporating the cross-subsidy and stranded asset cost in the wheeling charges to save the incumbent will choke the economy further. Eventually, the entire sector will collapse, taking the economy down with it.