Privatization of Karachi Electric Supply Corporation
(KESC) has been high on the government's agenda for sometime. One of the
investors' main concerns in the privatization of utilities is the
certainty about the tariff that they will be allowed to charge customers
after privatization. National Electric Power Regulatory Authority (NEPRA)
has recently approved a framework of Multi-Year Tariff (MYT) for KESC,
mainly to assure the prospective investor that it will be allowed a
reasonable period to recover the losses of the initial years of
privatization before the base tariff is adjusted through a review. The
assurance to earn reasonable returns and incentives to make investment
are based on the investor meeting the efficiency targets.
The adoption of MYT for KESC is a radical shift from
the traditional rate of return (ROR) regime to forward-looking incentive
based regulation in the power sector of Pakistan. Similar MYT schemes
are expected to be introduced for other distribution companies created
through the unbundling of the Power Wing of Water and Power Development
Authority (WAPDA). The advantages of incentive based regulation have
been recognized in many countries. However, the success of this kind of
regulation in Pakistan depends upon a number of factors.
KESC has been facing financial losses since 1996 due
to high technical losses and pilferage, and high cost of power
purchases. Transmission and distribution (T&D) losses have increased
from 17% in 1985-86 to 40% in 2001-2002 (Figure 1). In contrast, T&D
losses of WAPDA were 23.6% in 2001-2002. Such losses in other countries
such as Malaysia, Thailand and Indonesia are in the range of 10-12%.
KESC has been unable to generate any resource out of its revenues to
support capacity expansion in order to meet the growing demand and even
to cover its recurring expenditures. Recently, the government has
converted its outstanding loans into equity and reduced capital to
eliminate accumulated losses to maintain KESC's financial viability.
However, government cannot continue such financial support due to its
budgetary constraints and pressing needs of other important sectors.
Customers also cannot afford to pay unacceptably high price of
electricity (at least 25-30% higher than economic costs) to compensate
KESC for its losses and inefficiencies.
The experiments with public sector management through
non-traditional methods including the induction of army personnel in
uniform as top managers since 1999 have not shown any signs of
significant improvement. It is recognized that even substantial tariff
increases may not increase revenues of KESC due to possibility of
customer shift to self-generation and increase in pilferage.
Privatization is therefore considered by many a better or rather the
only way out.
KESC is planned to be divested as a
vertically-integrated utility through the sale of 51-74% of total equity
with management control to a strategic buyer. At least since 1997, the
target date for privatization of KESC has been extended from time to
time. As part of the recent efforts, preliminary information to
investors has been issued in March 2002 and a number of parties have
expressed interest in the privatization.
PRIVATIZATION ALONE IS NOT SUFFICIENT
Though the evidence from other sectors and other
countries supports that private ownership is more efficient than public
ownership, privatization alone is not sufficient to guarantee efficiency
and performance improvement of a utility, or simply stated to cut
customer bills. The recent experience of privatizing electricity
distribution businesses in other countries confirms this. Customers may
not see improvement in the service quality and complain about
significant increase in the bills due to high technical and
non-technical losses and reduction or elimination of subsidies or
cross-subsidies. Investors may also be unsatisfied with recovery of
The benefits of privatization are the potential
improvements in efficiency, which in the case of monopoly companies like
KESC come from an appropriate regulatory regime. The regulation of KESC
until recently has been on an adhoc basis and driven by the compulsion
to compensate KESC for its losses and inefficiencies. Such regulatory
regime also fails to assure the private investor of recovery of its
costs with reasonable returns and to incentivise him to reduce losses
and inefficiencies. Successful privatization requires both certainty
regarding tariff that the privatized KESC can charge and incentives for
NEW REGULATORY REGIME FOR KESC
In May 2002, KESC filed a petition before NEPRA
seeking an increase of 16% in the average customer tariff and approval
of a formula based MYT for the next ten years. The tariff was to be
reviewed after a period of ten years and thereafter every five years.
NEPRA's Tariff Standards and Procedure Rules allow formula based tariff
designed to be in place for more than one year.
NEPRA approved the MYT framework for KESC on 10
September 2002, while making a number of changes to the proposal.
Salient features of the approved framework are as follows:
1. The base
tariff for MYT shall be the prevailing average customer tariff with an
initial increase of 6.5%. Table 1 shows various components of the base
2. Upto the
seventh anniversary of privatization, the base tariff shall be subject
to quarterly adjustments for variations during the previous quarter in
fuel price and power purchase cost and annual adjustment to O&M cost
components based on the consumer price index (CPI) inflation rate less
an efficiency factor X. The efficiency factors shall be zero for the
first three years and 2-3% for next four years.
quarterly tariff adjustment for fuel cost variation shall be limited
upto a maximum of 2.5% and for power purchase cost variation upto 1.5%,
such that the remaining burden or relief is transferred separately to
the next quarter.
4. Under a
claw back mechanism (CBM), the profits accruing to KESC beyond a
pre-determined real ROR on asset (before tax and interest) in any year
shall be shared with consumers through tariff reduction in the next
year. Profits translating into ROR in excess of 12% shall be shared in
the ratio of 25:75 between consumers and KESC respectively, in excess of
15% in the ratio of 50:50, and in excess of 18% in the ratio of 75:25.
ASSESSING THE NEW REGULATORY FRAMEWORK
The MYT has obvious strong advantages, such as
certainty for investors and customers and incentives for KESC to reduce
losses and costs. While the principles are simple, the devil is in the
details of how the framework is designed, whether it will be implemented
as envisaged and whether it will be successful in achieving its
objectives. Under its Tariff Rules, NEPRA has to decide on tariff
petition within six months of the filing of a petition. In practice,
more time is required for a comprehensive review of tariff if it is to
be in place for a long period such as 5-7 years. Regulators in other
countries where MYT is in vogue conduct thorough consultation over 18 to
24 months and publish numerous consultation papers before they make any
decision. NEPRA needs to assess this aspect of its procedure and ensures
more transparency and objective consultation with the interested
1. TARIFF CERTAINTY
It is often argued that privatization and regulatory
strategies must work together. Regulatory uncertainty is usually
considered as the major obstacle to successful privatization. The
regulatory uncertainty is the inability of investors to predict with
confidence what tariffs they will be allowed to charge after
privatization. Investors' concern is not the levels of tariffs but their
certainty, because the levels of tariffs (whatsoever), if certain, can
be incorporated by investors in their bids at the time of privatization.
In fact, the regulatory certainty was the main reason
for the government's proposal as well as the regulator's decision to
adopt MYT for KESC. NEPRA forecasted that, with the approved MYT and
efficiency targets, KESC should be able to reduce its cumulative losses
to zero during the next three years (2003-2005) and to earn a reasonable
accumulative overall return over seven years (2003-2009). Figure 2 shows
the historical trends of unit cost and sale rate and their expected
profiles for the next three years. Table 2 shows NEPRA's forecasts of
costs and revenue for the next three years.
In the absence of any clear-cut commitment from NEPRA,
an uncertainty remains about the continuity of MYT framework at future
price reviews, though with new base tariff and X factors. In any case,
the investor is likely to seek the required commitment from the
government at the time of privatization, possibly backed by sovereign
2. INCENTIVES FOR EFFICIENCY
MYT scheme for KESC acts like a price cap by defining
the base tariff and then allowing variations only for uncontrollable
costs like fuel and power purchase costs and for CPI-X indexation of
controllable costs. NEPRA has also set targets for KESC's performance on
losses: 35% in 2002-03, 30% and 26.5% for next two years and 15% in ten
years (Figure 1). The price cap provides strong incentives for KESC to
reduce costs and losses. If KESC can reduce losses and costs beyond the
set targets, it can earn extra profits and retain them (to the extent
allowed by CBM) at least until the next tariff review, when NEPRA may
determine a new base tariff based on the efficient costs achieved by
KESC. It may be argued that KESC's present situation indicates a greater
extent of efficiency improvements than what implied by the targets and
X-factors set by NEPRA.
While the zero efficiency factor for early years
adopted for KESC has also been implemented in other countries, 2-3%
X-factor for KESC in subsequent years is on the lower end of the X
factors or price cuts adopted by other regulators (usually two-digit
figures). Further, X factors for KESC apply only to O&M cost
components (which make only 10% of total tariff) and not to the total
costs, and therefore seem to provide lower targets for efficiency.
However, the X factors for KESC are in addition to the system loss
FOR FUTURE INVESTMENT
KESC's generation plants and networks require massive
investments. However, the base tariff is presently not based on any
investment plan nor the MYT framework provides any explicit assurance
for recovery of any investment.
NEPRA has argued that the approved MYT provides an
incentive for investment in capacity expansion by allowing KESC to
increase its revenue through increase in consumer base as well as
increase in sales/consumer without any restriction. Investment in system
refurbishment will reduce losses and consequently generation costs and
hence will be rewarded as increased profits. If the reduction in losses
exceeds the targeted efficiency levels the company will earn more
profits. With a larger asset base (which would avoid triggering of CBM),
KESC will be able to retain most of the resulting profits.
However, it is not obvious that the benefits of
investment (increased sales and profits through capacity expansion and
reduction in losses and generation costs) would be enough to recover the
actual investment with reasonable returns. As far as the profit sharing
through CBM is concerned, it may incentivise KESC to manipulate its ROR
to avoid or reduce any profit sharing with the customers, rather than to
provide direct incentives for investment. It could be argued that the
investor will take into account its investment requirements while
submitting its bid at the time of privatization, rather than to make
investment in response to any indirect incentive of MYT.
4. DURATION OF CONTROL PERIOD
NEPRA has approved MYT for the period when KESC is
not privatized plus a period of seven years commencing from the date
when KESC is privatized. There are two issues relevant to the duration.
First, what will happen if privatization is delayed
considerably? If KESC is not privatized, say, for 2 to 3 years, the MYT
period will run for about 9 to 10 years which will subject a state owned
KESC to the MYT framework principally designed for a privatized KESC and
to performance targets that have not been achieved so far. KESC is
therefore likely to ask for revision of approved MYT or for additional
tariff increases in case the privatization is delayed significantly.
Second, whether the seven-year period after
privatization is appropriate? The control period for such regulatory
regime is usually 3 to 5 years. Longer the control period, lower will be
the regulatory risk for investors and higher the incentive for cost
reductions. However, long duration results in significant deviations in
prices from the costs to the disadvantage of customers. More
importantly, circumstances will undoubtedly change during a long period
requiring changes in the tariff formula or methodology.
It seems appropriate that NEPRA should have set a
target date for privatization of KESC, say two years. NEPRA could have
then set two separate MYTs: one MYT for upto two years when KESC is not
privatized and another MYT for five years after privatization. The
former MYT would have been revised if KESC is not privatized in two
years based on the circumstances and latest information. This approach
would have capped the total duration to seven years and addressed other
concerns. Presently, the total duration of the approved MYT is
5. PROFIT SHARING
While there seems to be no strong possibility that
KESC will earn profit in the early years of MYT and any significant
profits even in the later years, CBM should be regarded as a good
attempt to further reduce such possibility. However, the design of CBM
has two inherited flaws.
First, the mechanism is subject to manipulation. KESC
can increase its regulatory asset base (and thus reduce actual ROR) by
making investment though prudent at times when the threshold ROR is
expected to be exceeded.
Second, the profit sharing is subject to discrete
levels of RORs. That is, the same profit sharing percentages apply to a
wide range. For example, the profit sharing ratio of 25:75 applies to
returns in the entire range of 12-15%. Ideally, the scheme should have
been continuous or should have many small ranges, so that the customers'
share of profits would have increased more rapidly with increase in
return than allowed under the present design. This was also required to
minimize the effect of any manipulation of returns by the company.
THE NEW TARIFF FRAMEWORK SUCCEED?
The introduction of MYT for KESC is a significant
development in the power sector of Pakistan. This should provide the
required certainty and assurance to the privatized KESC to earn profits
over a long term, the incentives to reduce losses and costs, and hopes
for the customers to see improved service quality and tariff reduction
over a long term. Performance based multi-year regulation has been
successfully applied in various sectors around the world to achieve such
objectives (for example, in the UK since late 1980s).
However, the main question to answer is whether the
MYT for KESC will succeed, at least over a short-term. The success
mainly depends on whether customers will be able to afford frequent and
significant tariff rises, and whether the political government will let
such a framework to work as envisaged.
In the rare case, a maximum of 4% quarterly tariff
adjustment for fuel and power purchase costs (which translates into 17%
annual tariff increase) and 0.3-1.3% annual tariff adjustment for CPI-X
indexation (based on actual inflation of 2.7-13% p.a. during the last
ten years) may be required. This translates into an overall annual
increase in tariff by 17.3-18.3%, which is definitely not affordable by
the customers as well as the government (both politically as well as
financially if it decides to subsidize tariff).
Table 1: Components of Base Tariff
verage Sale Rate
As % of Total Rate
As % of Total Rate
Power Purchase Cost
Projections of KESC
Electricity Units available for sale
Transmission and Distribution Losses %
Average rate of sale of power
Increase over previous year %
Total Revenue Million
Total Expenditure Million
(including depreciation and interest)
Tax Expense Million
Net Profit after Tax Million
Cumulative Profit/(Loss) Million