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Energy crisis calls for a radical policy change

PAKISTAN’S energy crisis, if not tackled at both operating and strategic level in the immediate future, might become a national security threat.

It has been a major drag on the economy and a serious impediment to growth with an estimated cost of 10 per cent of the GDP over the past five years.

The present crisis started around 2006-2007 as a gradual increase in demand outstripping power generation. The installed generation capacity is 23,500MW but at any given time, the actual available capacity has remained below 14,000MW because the independent power plants (IPPs) have not been able to buy the fuel oil, and production of old plants in the public sector has dropped causing a shortfall of 4,000 to 7,000 MW.

While it is true that the IPPs are not producing enough power to meet the shortfall, it is only part

of the problem.

Total electricity generation has virtually remained flat since 2008 despite an increase of 7,827 GwH produced by the IPPs since the generation by old public sector power plants (otherwise known as Gencos) decreased by 7,647 GwH as shown in the table.

The government’s failure to upgrade and make capital investments in old facilities like Jamshoro and Guddu thermal power plants not only caused the production to fall but also contributed to higher cost of generation. Due to poor maintenance, public sector power plants lost nearly one-third of their capacity and nearly 17 per cent of their thermal efficiency due to plant degradation. In addition, hydro power plants were mismanaged causing a fall in their output in 2012.

However, the energy crisis is not about the installed generation capacity. While one can blame incompetence of the previous government for the present level of power shortages, the structural reasons go far beyond just the circular debt, bad governance and corruption. Hence, policy prescriptions that remain limited to the revision of tariffs to recover full cost of power generation, phasing out of subsidies, and the removal of the so-called circular debt may buy some time but will ultimately fail to address the fundamental causes of the crisis.

Therefore, the conventional wisdom and mantra of market-driven reforms articulated by the World Bank and some economists need a full and deeper examination by the incoming new government. It is pertinent to point out that in South Korea, 93 per cent of electricity generation is done by a vertically integrated publicly-listed corporation (Kepco) controlled by the government.

Only a massive and determined state intervention by a strong political leadership involving a) radical restructuring of the power generation sector, b) consolidation, reorganisation, and recapitalisation of the distribution networks, and c) mega investments in hydro, coal, and nuclear energy (secured through friendly foreign governments and other sources) can provide a lasting solution to the energy crisis which is too big and complex for the private sector to manage given the ground realities of the country’s political economy. A lesson learnt from the 2008 global financial crisis, when big banks were brought under the state control by the western governments, is that during extra-ordinary situations that threaten to destablise an entire system, there is no alternative to state intervention no matter how undesirable it may be in ideal conditions.

Pakistan’s energy crisis resulted primarily from the failure of a strategy which was driven by short-term considerations and misguided notions about the role of the private sector and how it should be engaged. Until the mid-1980s, the Water and Power Development Authority (Wapda) and Karachi Electric Supply Company (KESC), the two public sector organisations responsible for the generation, transmission, and distribution of electricity did a reasonably good job.

Faced with the power shortages in the early 1990s and due to delays in exploitation of hydropower potential in the country, the 1994 energy policy opened up the power generation industry to the private sector. There were two serious flaws with that policy.

The private sector was asked to participate in what was rather the easy part of the energy sector: generation. The policy attracted investments only in the thermal power as it offered a quick and almost risk-less way to make money due to the generous terms offered to the investors. The most difficult and challenging part, that is, managing the distribution was never privatised except in the case of badly executed privatisation of KESC in 2005.

Second, the 1994 policy was against the very spirit of free market economics as the private sector was guaranteed a rate of return for putting in a rather small portion of its own equity while major risks were assumed by the government and 70-75 per cent of the investments were actually financed by the bank loans. The first big step in this direction was the Hub Power Project (or Hubco), a 1,292MW, $1.6-billion thermal project that was actively supported by the World Bank. It was the beginning of a strategic blunder that was to haunt Pakistan decades later. This policy was continued by the successive governments and though adding thousands of megawatts to the electricity generation capacity also made Pakistan hugely dependent on the most costly source, that is, thermal power, especially on oil.

As long as oil accounts for a major portion of the electricity generation, Pakistan will continue to be a high-cost producer of energy, contributing to a persistently higher inflation rate, and its industry will remain relatively less competitive and hostage to the volatile international oil price.

Pakistan’s unfavourable high cost energy mix, in contrast to international and Asian norms, lies at the core of the energy crisis. While the IPPs provided much-needed new power generation capacity at the time, the country’s generation mix shifted heavily towards fuel oil/furnace oil (FO).

The policy to divert gas to other sectors of the economy, such as domestic consumers, fertiliser producers, and to encourage use of compressed natural gas (CNG) for private vehicles further limited gas supply to the power sector, forcing thermal generators to depend on more expensive fuels. The share of hydropower that accounted for 60 per cent of the power generation during the 1960s through the 1980s fell to around 30 per cent by 2005.

But even in 2005, gas-based (whose costs are lower compared to plants using oil) plants accounted for 52 per cent the power generation. Today, the plants using imported oil represent the single largest source of electricity generation as shown in the figure 1.

Since 1994, the international price of oil increased five-fold as depicted in figure 2, inflating the cost of generation. The problem of rising oil prices was compounded by the depreciating Pakistani currency. As international oil prices are denominated in dollars, the cost of imported FO increases as the rupee devalues against the dollar. From 2005 to 2011, the cost of FO increased in real terms from $236 per ton to $639 per ton. At the same time, the rupee depreciated against the dollar such that the cost of imported FO rose from Rs21,087 per ton to over Rs70,930 per ton. As a result, the cost of power generated from FO grew 236 per cent in just six years.

As shown in figure 3, the average cost of FO-based electricity delivered to the power distribution companies (Discos) was Rs15.94/kWh in 2011-12 compared to Rs4.24/kWh for electricity using gas, Rs1.13/kWh using nuclear power, and Rs0.16/kWh using hydro power.

The widening gap between the high cost of thermal power and the regulated electricity prices is the primary reason for the debt crisis.

It was in 2005 that the circular debt problem emerged as a significant issue. At the end of 2005, the circular debt (or rather the inter-enterprise and corporate debt) stood around Rs84 billion because the government kept electricity tariffs far below cost-recovery level.

General Musharraf’s government did not allow the rise in electricity prices in line with the steep rise in the international oil prices for obvious political reasons and tariffs were frozen between 2003 and 2007 at a very low level.

While the Pakistan Peoples Party government increased electricity prices by 34 to 74 per cent during 2008-2011 (based on usage), the tariff hikes were still not enough to compensate for the rise in the energy costs. The gap between the timing of increase in costs and implementing of higher tariffs compounded the crisis.

Apparently, higher prices also led to collection problems. Out of the Rs872 billion in energy-related debt, Rs197 billion (or 22 per cent) is on account of non-payment of bills by the consumers. The federal and provincial governments also ran up unpaid bills to the tune of Rs133 billion reflecting the poor state of fiscal governance.

During the period 2006-2012, the circular debt grew by a staggering Rs788 billion to Rs872 billion (nearly four per cent of GDP) at June 2012 according to recent study published by the Planning Commission of Pakistan. Notwithstanding the non-collection problems, about 62 per cent of the cumulative increase in the debt has been attributed to the pricing and subsidy issues as shown in figure 4.

The recent tariff determinations given by the National Electric Power Regulatory Authority (Nepra) indicate an increase in the financing gap to Rs550 billion per annum from Rs350 billion due to the widening gap between the applicable electricity tariff and the tariff approved by the Nepra. In other words, users would have to pay an aggregate of Rs550 billion (or about 2.5 per cent of GDP) to prevent further accumulation of circular debt or the situation will continue to deteriorate.

Even if half of this burden is transferred to the users through tariff hikes, it would still represent a substantial burden and would probably result in more unpaid bills and energy theft. The energy crisis has already slowed growth by an estimated two per cent per annum in the last five years.

Another price shock is bound to adversely affect the growth. In the next 6-12 months, government may end up increasing the electricity tariffs. It may, however, try to minimise such an increase by borrowing from external sources (e.g., Saudi Arabia) to buy some time.

But is it fair to ask the public to bear the entire cost of what is arguably the strategic blunder of the state compounded by bad governance? It must be pointed out that as a country; the most rational and optimal choice would be to import electricity till such time generation capacity of non-thermal sources is increased because the domestic cost of thermal power is prohibitively higher.

Advocates of free markets and trade should support this argument rather than make a case for financing the white elephants called the oil-based power plants. This is inherently an unsustainable proposition.

Therefore, a restructuring and rationalisation plan for the generation sector is needed. This should include the following steps:

*The government should attach the highest priority to importing electricity from the neighbouring countries to minimise the adverse impact of high cost energy mix.

* The IPPs owned by the domestic companies should be bought by the federal government to bring down average cost because under the current policy, they are not economically viable on a sustainable basis. They should be converted into coal-based plants to the extent feasible. A one-time restructuring cost would be a better option compared to throwing money into what seems to have become a bottom less pit.

* Some of the larger public sector oil-based plants should also be converted into coal-based operations to the maximum possible extent.

* The residual financing gap should be financed through tariff hikes and additional direct taxes with the target of raising an amount equivalent to at least one per cent of the GDP. For this purpose, a financial emergency should be declared in accordance with article 235 (1) of the constitution and the federal government should help the provincial governments to raise more revenues as they currently lack the capacity to do so.

The level of transmission and distribution (T&D) losses which have ranged around 22 per cent is another critical aspect. The public ultimately pays for these losses through higher prices and power outages.

In comparison to other Asian countries, these losses are extremely high. For example, T& D losses are only 3.6 per cent in South Korea, eight per cent in China, and just seven per cent in OECD countries.

Ironically, the privatised KESC has experienced much higher level of T&D losses (around little more than 30 per cent ) compared to the public sector distribution companies.

These losses are due to a host of factors including old-age generation plants, low-voltage transmission and distribution lines, weak grid infrastructure, inaccurate metering and billing, and outright theft. It is obvious that the experiment to improve distribution through setting up different regional companies also failed.

Consolidation of distribution companies at the provincial level via four companies (other than the KESC) and making the provincial governments a major stakeholder should be considered provided the companies are run by autonomous boards

consisting of professionals from the private sector.

The distribution network requires political and administrative support of provincial governments, professional management as well as huge capital investments.

Privatisation is highly unlikely to be a successful policy to meet the challenges in the electricity distribution in the medium term. Moreover, large companies backed by the provincial governments would have a better chance of attracting capital and support from foreign governments.

In the long-term, the government must not allow any more thermal based power plants and should focus on hydro (specially through smaller dams), coal, and nuclear energy because only a radical shift in the current energy mix can provide a lasting solution to Pakistan crippling energy crisis.

Yousuf Nazar is the author of a book “Balkanisation and Political Economy of Pakistan” and a former head of Citigroup’s emerging markets equity investments group.

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