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1- POWER TARIFF FORMULA
2- REVENUE COLLECTION
3- UTILITY REGULATION
4-
DEMUTUALIZATION OF STOCK EXCHANGES
5- THE PRIVATIZATION OF KESC
6- SHORTAGE OF ESSENTIAL MEDICINES
7- SSGC FURTHER DIVESTMENT

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UTILITY REGULATION

 

Applying International Best Practices to Pakistan


By AFTAB RAZA
Jan 19 - 25, 2004
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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.

REGULATORY INDEPENDENCE

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 consumers.

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 regulation.

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 regulation.

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 regulation.

MAIN FEATURES OF CPI-X REGULATION

CPI-X regulation has the following two main characteristics:

1. Regulation of prices or revenues, rather than profits.
2. 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 annum.

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).

 

 

CONCLUSIONS

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 independence.

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.