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    Why Pakistan must replace electricity subsidies?


    July 1, 2022 - Monthly Energy Updates

     

      Pakistan's current economic crisis has once again brought to the fore the issue of electricity subsidies. While on one end of the policy spectrum, economists argue that our fiscal position necessitates the withdrawal of subsidies, on the other end, there are strong advocates for keeping subsidies intact to keep electricity affordable and protect the masses from inflation.

      The issue becomes even more dire once we realise that we cannot avoid raising electricity prices indefinitely. Over 65 per cent of Pakistan's electricity is generated using imported fossil fuels, which exposes us to international supply shocks and fuel price fluctuations, and there is no escape from that in the short term.

      The costly policies on the generation side - for example capacity payments - make our electricity the most expensive in the region. Add to this mix the inefficiencies on the distribution side - high transmission and distribution losses and poor bill recoveries - further raise the cost of delivering electricity, and it is no wonder that the power sector remains stuck in a high cost-poor service equilibrium.

      As economists who have been studying Pakistan's power sector for quite some time now, we present an alternative to tackle the thorny issue of electricity subsidies, which is based on keeping electricity affordable for those who truly cannot pay for it but in a fiscally prudent manner.

      We first argue that the current subsidy regime fails to meet its desired objectives and imposes an unsustainable fiscal burden and, therefore, must be reformed. It is important to communicate this message to the public in an easy and accessible manner, as broad consensus must be built around rationalising the subsidy system to help us move away from populist and simplistic rhetoric. We then propose a system of revamping electricity subsidies based on targeted in-kind transfers in the form of an electricity voucher programme.

      From an economic perspective, the objective of subsidies is to correct under-provision of a socially desirable good or service by the market. If we consider access to electricity a basic necessity and want to ensure a decent level of consumption for every household, we want to have a policy instrument that enables us to achieve this objective, with minimal unintended negative consequences. However, the current subsidy regime fails to deliver on the objective of ensuring access to electricity for multiple reasons.

      One of the most important flaws of the current subsidy regime is that it is poorly targeted and benefits richer households disproportionately. Under the current system, residential customers are billed under an incremental block tariff structure as shown in Table 1. The tariff is increasing in consumption slabs ranging from 0-100, 101-200, 201-300, 301-700 and above 700 units. There is also a lifeline slab with less than 50 units of consumption.

      The National Electric Power Regulatory Authority (Nepra) determines a tariff based on the cost of electricity generation and distribution. The Government of Pakistan (GOP) then notifies a consumer tariff which is lower than the Nepra tariff, hence subsidising the electricity price for end consumers. On each tariff slab, the subsidy rate per unit of electricity consumed declines as consumption moves up from one slab to the next.

      For example, on the first 100 units, the subsidy rate is Rs6.85 per unit, for the next 100 units the subsidy rate declines to Rs6.35 per unit, and for the next 100 units, the subsidy rate further declines to Rs5.38 per unit. For the additional units consumed above 300, the subsidy is reversed and consumers pay a higher price than the Nepra tariff.

      Using the nationally representative Pakistan Social And Living Standards Measurement household (PSLM-HIES) survey data, we find the share of households falling in each tariff slab. We then estimate the subsidy burden from each tariff slab using the average per unit subsidy, assuming an average consumption level per household within each slab. This exercise yields some important insights.

      The largest group benefitting from the subsidy is households with consumption between 301-700 units, which accounts for 56pc of the consumers or nearly 16.8 million households. Assuming the average household in this group consumes 500 units per month, the total subsidy burden translates into Rs25.8b per month - out of a total monthly subsidy of Rs37.8b for all groups.

      Under this structure, the annual subsidy burden would amount to Rs454b. This is almost twice the share of social protection programmes, which were allocated Rs255b in the 2021-22 federal budget. Thus, the current subsidy structure means that even well-off households benefit and in absolute terms, they are the recipients of the major chunk of the power subsidy.

      The electricity sector's circular debt - inter corporate debt due to outstanding receivables of firms in the energy supply chain - is presently Rs2.5 trillion or 6pc of the GDP. One of the main reasons for circular debt accumulation is not allowing electricity prices to rise in line with rising fuel prices in world markets.

      High operational losses and poor recoveries of distribution companies, which are linked to the demand side issues discussed above, also contribute to the circular debt. The electricity sector's poor financial health means that we cannot afford to pay generation companies for costly electricity.

      Plants stay idle even while we have available capacity. As a result, load shedding continues unabated. Moreover, loss-making distribution companies are unable to undertake adequate investment in maintenance and expansion of the grid network. Around 25pc of the population (nearly 50 million people) is still living without an electricity connection. Therefore, we must recognise that the current system is failing to achieve its objectives, even without accounting for the unbearable financial burden of the subsidies.

      Thinking of alternatives

      One policy option which has been advocated recently is to replace the present subsidy system with targeted cash transfers that poor households can then use for paying electricity bills.

      The National Socio-Economic Registry, which covers around 85pc of the country's households, can be used to identify those below a certain eligibility cut off in terms of income or wealth. The biggest challenge of such a system could be that since cash is fungible, people might find it difficult to commit this money to pay electricity bills especially if they are due at the end of the month.

      Instead of offering support through cash transfers, we propose a targeted voucher and rebate system. A voucher system offers a simple and non-distortive way to provide in-kind support to households for consuming electricity. Since the support will be applied directly to the electricity bill, it should be easier to build consensus around such a system as opposed to completely eliminating the current subsidy system.

      In addition to providing financial assistance to eligible households, this targeted subsidy equivalent voucher scheme can have multiple positive cascading effects.

      First, it will enhance bill payment because vouchers may only be used to pay for electricity bills, improving the utilities' revenue situation. Second, it will relieve fiscal pressure on other budgetary expenditures by reducing the government's circular debt burden. Third, it will encourage households to conserve energy according to their needs as exceeding the threshold consistently means losing the support. Fourth, richer households, who receive no subsidy, will be tempted to install solar as an additional energy source to supplement their energy consumption from the grid. Finally, given the dire state of the energy sector, a low-cost loan arrangement for installing solar systems can be proposed for middle-income households.

      In a nutshell, a simplified electricity voucher and rebate system has the potential to achieve a number of goals, including improving electricity access, incentivising electricity conservation, boosting the adoption of clean energy sources and reducing CO2 emissions, while alleviating the financial burden of circular debt.

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