The past decade has seen privatization and
restructuring of various utilities such as electricity and
telecommunication around the world. Privatization can introduce new
technological development, managerial techniques and corporate culture
into 'inefficient' utilities and can provide much needed funding for
capital maintenance and expansion to meet growing demand. However,
customers often see privatization as the sign of increase in utility
tariffs. The experience around the world suggests that privatization
alone is not sufficient to make utilities efficient in the long run to
the benefits of customers. Privatization must be accompanied with
competition to reduce customer bills and improve quality of service.
However, certain elements of each utility industry are natural
monopolies and hence cannot be subject to competition. In such
circumstances, effective regulation is required to mimic competition and
to achieve economic efficiency.
Like many other countries, Pakistan has established
regulatory authorities for various industries characterized by natural
monopolies. These regulatory authorities include National Electric Power
Regulatory Authority (NEPRA), Pakistan Telecommunication Authority (PTA)
and Oil and Gas Regulatory Authority (OGRA).
The effectiveness of regulatory authorities is often
measured by the extent to which they are able to reduce the sector costs
(and hence the customer bills) and improve the quality of service. This
in turn depends on the independence and competence of these authorities
and the approaches or tools they employ to regulate the companies. This
article discusses these aspects of utility regulation with reference to
Pakistan and highlights some of the international best practices for
application to the regulation of Pakistani utilities. It emphasizes on
regulatory independence, incentive-based regulation, extensive
consultation on tariff determinations, capacity building measures and an
end to public ownership of the utilities.
NEED FOR UTILITY REGULATION
There are two fundamental justifications for
regulation of utilities. First is the belief that the utility's outputs
are essential to the well-being of society, including households and
businesses. Secondly, the technological and economic features of the
utility sector are such that a single firm can serve the overall demand
for output at a lower total cost than any combination of firms.
Utilities often have a high ratio of fixed costs to total costs and
hence the increasing economies of scale. Consequently, as output
increases, average cost decreases. When this remains true for a broad
range of output, it is generally more efficient (less costly) for one
firm, rather than two or more, to supply the entire market. This is
called "natural monopoly", and it gives a single utility the
power to restrict output and set prices at levels higher than are
economically justified that is abuse of market power. Electricity, gas
and water utilities are the obvious examples of natural monopolies which
have "captive" customers who do not have the freedom to
choose, hence are at the mercy of their local supplier. However, not all
activities of the utility are natural monopolies.
For example, the technological elements of the power,
gas and water industries that create natural monopoly conditions are,
first and foremost, the transmission and distribution (T&D) systems.
They have very high fixed costs and low operating costs: it doesn't pay
to have two or more sets of wires or pipes running down the street.
T&D exhibits tremendous economies of scale. In contrast to this,
most economies of scale in electricity generation appear to have been
exhausted; cost no longer declines as the size of power stations
increases for the larger, industrialized nations. Electricity generation
is therefore not considered a natural monopoly business and can be
allowed to be undertaken by many companies and subject to competition.
That is why, in many countries including Pakistan, power sector has been
unbundled to separate generation from T&D so that competition can be
introduced into generation while T&D be subject to regulation.
Similar is the case of fixed-line network in
telecommunication sector, which exhibits the characteristics of a
monopoly. While competition can be relied upon for Internet, and mobile
services, fixed-line services need to be regulated.
Unless constrained by appropriate regulation,
monopolies can abuse their market power and charge the customers with
unnecessarily high prices. The economic regulation is therefore seen as
the necessary and explicit public or governmental intervention into a
market to constrain market power of monopolies. The main objective of
economic regulation is to set economically efficient and fair prices
protecting consumers' interests, while simultaneously giving the
regulated firm a reasonable opportunity to recover its legitimate costs
of providing service (including return on investment).
Though Pakistan has established regulatory
authorities for its power, gas and telecom sectors, there remains a
number of utility and infrastructure sectors, such as water and
sanitation, public transport, airports, railways, etc. which need
independent regulators to oversee their tariffs and quality of service.
The structure, scope and powers of a regulatory
authority are key to a successful restructuring of the industry. The key
characteristics of a good regulatory authority include independence from
the political process and regulated firms, a broad mandate to protect
the public interest, technical expertise in the functions and business
of the regulated enterprise, and continuing monitoring and enforcement
of rules and orders.
The single most important characteristic of a
successful regulatory authority is its independence from political and
industry influence. Capital markets or investors are typically very
concerned with the political and regulatory environment faced by any
company. This is especially the case in the utility industries, which
are highly capital intensive and essential to virtually all aspects of
public life and hence have the potential of becoming the focus of
political interest. Capital markets have higher confidence in financing
utilities where the regulator has greater independence from the
political process, both as a matter of explicit policy and through the
demonstrated track record of the regulator and government. Higher
political and regulatory risks translate directly into higher financing
costs and, ultimately, higher retail prices.
A recent study of telecom sectors in various
countries indicates that privatization, by itself, is not a driver of
improved performance but only when it is combined with an independent
regulator. A regulator is considered independent if it is a separate
agency not directly under control of a ministry. Independence of a
regulator is measured by the extent to which decision making occurs in a
manner that is transparent, non-arbitrary, free from day to day
political interference and to which the regulator is able to maintain
credible commitment. The study suggests that reformers are correct to
emphasize independent regulation along with privatization, since
privatization without attention to regulation may be costly to
While the regulatory authorities in Pakistan may be
linked to one ministry or the other for administrative purposes, they
must strive to maintain and demonstrate their statutory independence in
their decisions. To this end, NEPRA has been making efforts for some
time, particularly in its dealing with WAPDA.
Many sectors in Pakistan, such as water and
sanitation, public transport and railways are not subject to independent
regulation but to regulation by certain government departments. Further,
these sectors are predominantly owned by the government. It is therefore
not surprising to see poor performance in these sectors.
BASIC MODELS OF REGULATION
To achieve the objectives of regulation, the form or
model of regulation used by the regulatory authorities is equally
important as the independence of these authorities. The economic
regulation of monopoly prices can take a number of forms. However, there
are two main models: rate of return (ROR) regulation and price cap
ROR regulation is the standard form of utility
regulation in the US. Under pure ROR regulation, a company is guaranteed
an agreed rate of return on capital and its prices are adjusted as
required to ensure that this rate is earned.
One of the advantages of ROR regulation is that, by
allowing a certain ROR to the investor, it reduces perceived regulatory
risk, resulting in a lower cost of capital. However, the main
disadvantage of ROR regulation is the lack of adequate incentives for
companies to reduce costs so as to increase profits, since any increase
in the resulting ROR will be corrected by the regulator.
The ROR regulation often works on an annual basis (or
on more frequent basis, as in the case of power sector in Pakistan) by
requiring companies to file petition with the regulator for revised
tariff for the next year. In addition to the US electricity sector this
approach has been in use in Canada, Japan, Norway, India, etc. In
general, regulatory authorities in Pakistan also apply this form of
The pure price cap regulation involves the setting of
prices or revenues over a long period of time (3-5 years) such that a
well-run company can expect to earn a fair rate of return, but the
opportunity to earn and retain higher profits if company reduces costs
gives it a greater incentive for efficiency. The system is
forward-looking: reasonable cost levels must be forecast far into the
future with a high degree of accuracy so that reasonable prices can be
set. If this is done effectively, higher profits come from greater
efforts by the company in reducing its costs below the forecast levels.
When utility privatizations were carried out in the
UK in the mid to late 1980s, a price-cap system, known as RPI-X or CPI-X
regulation, was introduced to regulate monopoly businesses. Under this
regime, price levels are constrained to rise each year only by retail
price index (RPI) or consumer price index (CPI) based inflation rate
minus an efficiency factor, X.
This CPI-X model of regulation is used by various
regulatory authorities in Argentina, Australia, Chile, UAE (Abu Dhabi),
UK and the US (mostly in telecom sector). In South Asian energy sector,
KESC is the first and only one company which is subject to RPI-X
MAIN FEATURES OF CPI-X REGULATION
CPI-X regulation has the following two main
of prices or revenues, rather than profits.
Use of price or revenue controls extending over several years, rather
than annual reviews.
First, CPI-X model regulates prices or revenues and
not profits. Regulating profits (i.e. ROR model) provides no incentive
to the company to reduce its costs. Under CPI-X regulation, prices are
set to allow sufficient revenue for the company to cover its costs, less
an amount reflecting the efficiency gains the regulator considers
achievable. The firm has an incentive to make those gains, because
otherwise it will make a loss. This incentive for efficiency therefore
also exposes the company to risks. But the company also has an incentive
to exceed the gains, because it is free to keep any additional profits
it can earn during the control period. At the end of the control period,
the regulator adjusts the prices, passing the benefits of the efficiency
gains to consumers through lower prices.
Several studies have demonstrated that compared to
ROR regulation, price cap regulation leads to more investment and
efficient operations. For example, in the UK electricity transmission
and distribution businesses which have been subject to RPI-X regulation
since early 1990s have shown significant reduction in their cost levels.
The average annual reduction in unit operation costs (adjusted for
inflation) in the UK over the period 1992-98 is about 6.5%-6.8% per
Second feature of CPI-X model is its longer control
period than ROR model. The limit on the company's revenue is fixed for a
period of several years and automatically adjusts each year by CPI less
(occasionally plus) an adjustment called "X" factor. The
revenue limit can also, upon approval of the regulator, adjust for
several other factors, such as under or over recovery of revenue in
previous years, changes in uncontrollable costs notably input purchase
costs, windfall profits, changes in the legal obligations like tax laws,
etc. The price cap extending over a number of years determines a clear
path of future prices which provides certainty to both the regulated
company and its customers.
Potential investors have the perception that the
tariff-setting methodologies used by the regulatory agencies in Pakistan
and other countries of the region lack certainty, as they fail to
clearly define the price-path for the future that can assure the
investor of recovery, and earning a return on, its investment. The owner
of a distribution company recently privatized (and went into problems)
in Orissa (India) considered a multi-year tariff as imperative for
resolving deep-rooted problems with the government and regulator. The
World Bank has identified risky and weak regulatory framework for
infrastructure in Pakistan as one of the four key reasons for
government's failure to improve investment climate in the country. These
examples indicate the importance of CPI-X regulation, defining tariffs
over a number of years, for privatization of Pakistani utilities.
PAKISTAN'S EXPERIENCE OF CPI-X REGULATION
In 2002, NEPRA approved a framework of CPI-X based
Multi-Year Tariff (MYT) for Karachi Electricity Supply Company (KESC) in
view of its expected privatization in the near future. This framework
should provide the required certainty and assurance to the privatized
KESC to earn profits over a long term and incentives for KESC to reduce
losses and costs.
Under the MYT regime, KESC's tariffs have been fixed
for seven years alter the privatization and are subject to adjustments
from time to time for inflation, changes in fuel price and changes in
power purchase costs. The adoption of MYT for KESC is a radical shift
from a ROR regime to performance based regulation in the power sector of
Pakistan. Similar MYT schemes are expected to be introduced for other
distribution companies in Pakistan, especially Faisalabad Electricity
Supply Company which is being prepared for privatization.
As the first clear CPI-X based MYT in the energy
sector in South Asia and in any sector in Pakistan, there are clearly
lessons in NEPRA's decision that other regulators and regulated
companies should consider. Too long duration of control period, only 10%
of total tariff subject to CPI-X, relatively small efficiency factors
(2% - 3%), and too short time allowed by NEPRA's tariff rules for
determination are some of the issues that MYT for KESC poses for future
reviews. However, there are many positive aspects of KESC's MYT from
which other regulators can benefit, such as incentives for company to
reduce costs, regime to control abnormal profits and to automate
quarterly adjustment for input prices.
An international best practice in the arena of
regulation is the publication by the regulator of a number of
consultation documents on tariff reviews before the final determination.
In Pakistan, regulatory authorities usually publish in newspaper a very
brief summary of the company's request for tariff review, make available
the company's request and holds public hearing. This process does not
enable the interested parties to fully understand the implications of
the company's request. A consultation document does not only elaborate
on the company's petition but also indicate the regulator's views on the
matter and its intention for the final determination. However, this
review process requires longer period (1-2 years) for consultation than
allowed by tariff rules of the regulatory authorities in Pakistan
(usually 6 months).
Restructuring, privatization and regulation have long
way to go in Pakistan. There is now extensive experience available
around the world on utility regulation to benefit from. The regulatory
authorities in Pakistan can further improve on their regulatory
approaches and processes and demonstrate to the customers and regulated
companies that they are independent, and are effective in bringing down
the customer bills and improving the quality of service or performance
of the regulated companies.
Like other countries and regions, the utility
regulators in Pakistan may establish a formal or informal forum for
sharing their experiences and agreeing on common or consistent
approaches for their sectors. Possibly such a forum will also help the
regulatory authorities protect and preserve their statutory
As regards to the regulation model, while CPI-X
approach can provide strong; incentives for companies to reduce costs
and hence consumer tariffs, however it must be recognized that the
continuing government ownership of these companies may ultimately place
a limit on the efficiency improvements that can be achieved.