MULTI-YEAR TARIFF FOR KESC

New Privatization and Regulation Strategy

By AFTAB RAZA
June
30 - July 06, 2003

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.

PRIVATIZATION IS THE ONLY WAY OUT

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 their costs.

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 efficiency improvements.

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 tariff:

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.

3. The 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 parties.

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 guarantees.

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 reduction targets.

3. INCENTIVES 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 open-ended.

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.

WILL 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 for KESC

Tariff
Component

verage Sale Rate

O&M Component

Rs/kWh

As % of Total Rate

Rs/kWh

As % of Total Rate

Generation Cost Go

2.43

51%

0.10

2%

Power Purchase Cost Po

1.48

31%

 

 

Transmission Cost To

0.30

6%

0.04

1%

Distribution Cost Do

0.53

11%

0.32

7%

Total

4.74

100%

0.46

10%

 


 

Table 2: 
NEPRA's Projections of KESC

Year

2002-03

2003-04

2004-05

Electricity Units available for sale GWh

11,908

12,150

12,259

Transmission and Distribution Losses %

35.0% 30.0%

26.5%

Average rate of sale of power   Rs/kWh

4.739

4.974

5.147

Increase over previous year %

6.5% 5.0%

3.5%

Total Revenue Million Rs

37,063

42,743

46,870

Total Expenditure Million Rs

43,253

41,322

41,468

(including depreciation and interest)

Tax Expense Million Rs

185

214

235

Net Profit after Tax Million Rs

-6,374

1,207

5,168

Cumulative Profit/(Loss) Million Rs

-6,374 -5,168

0