Download Jasleen Kaur

CRISIL YOUNG THOUGHT LEADER 2006
“Should the government or market forces determine prices in
the Indian energy sector?”
Jasleen Kaur
Room no: 59, RMH Hostel
Xavier’s Institute of Management Bhubaneshwar
Email id: [email protected]
[email protected]
Phone No: 9937412412
Contents
Executive Summary: .......................................................................................................3
Introduction:....................................................................................................................4
Market, Government or Independent Regulation: ............................................................4
Types of regulations: .......................................................................................................5
Cost plus method (Rate of Return):..............................................................................6
Performance Based Regulation (PBR): ........................................................................8
Utility reforms in other countries:..................................................................................10
Chilean electricity sector: ..........................................................................................10
The market model is critical to all other decisions:.....................................................10
Present situation of Indian Energy Sector and scope for improvement: ..........................11
Oil and gas: ...............................................................................................................11
Current situation ...................................................................................................11
Way ahead:............................................................................................................11
Power sector:.............................................................................................................13
Current situation ...................................................................................................13
Way ahead.............................................................................................................14
Conclusion: ...................................................................................................................15
Bibliography: ................................................................................................................16
Executive Summary:
To attain higher growth rates than those feasible now India must ensure reliable
availability of energy at internationally competitive prices. However our present pricing
structure fails to support growth of our energy sector. In such a case we try ask which one
is more desirable; continuation of government interference in price determination,
independent regulation or market forces. We reach the conclusion that the nature of the
sector is such that to prevent exploitation of consumers we cannot leave pricing entirely
to market as monopolists will then push up the prices. Regulation can lead to creation of
pseudo competitive market conditions.
But for price discovery various factors need to be kept in mind. We cannot directly hope
to have all correct policies in place at all the time but we can learn from experience of
other countries and from reforms of different sectors within the country.
Critical evaluation of Cost Plus Method and Performance Based Regulation for price
determination is carried out and it has been recommended to move towards the latter.
After having a look at the current financial situation and efficiency of Power and Oil
sector certain steps to move towards better pricing to ensure long term sustainability have
been recommended.
Introduction:
Rising oil prices have not only led to nations looking for alternative sources of energy but
also raised concerns about role of governments in setting of prices for energy sector.
Proponents of market efficiency have often raised voices against interference of
government in markets as it leads to inefficiency.
It is well understood fact that in order to meet India’s growing demand for energy,
significant new investment is needed and the necessary legal and regulatory framework
must be in place to attract the needed capital. Supply of energy at a reasonable price
could be a major bottleneck in the efforts to maintain high rate of growth of Indian
economy. Undoubtedly, there is a huge untapped potential for our energy sector. But with
the present price regime, it is next to impossible to tap the potential.
The focus of the paper is on Power sector with some discussion on Oil sector. The
conclusions drawn can be extended to any regulated utilities.
Market, Government or Independent Regulation:
The current scenario clearly demands the role of the government to fade away with time
in determining prices in any market, whether it is oil, foodgrains, gas, electricity etc.
Regulation is often seen as replacement of government orders as the principal
institutional device for assuring good performance. However regulation in context of the
paper would be seen as independent regulation (Competitive regulation which prevents
abuse of market power rather than non-competitive which aims at controlling prices and
supply).
Public utilities are subject to regulation because of the important role they play in any
economy. In a market scenario unlike a regulated one there is no assurance of return on
investment. Unless until the long run marginal costs equals average tariff the investment
will not be forthcoming. In such a case to attract investments into the sector regulation
becomes a must. Attracting investments in not an end in itself. To sustain profitability we
need price reforms. Another problem is ability of natural monopolies to raise prices to
elbow out competition and if not regulated may lead to exploitation of consumer and also
dampen the growth of economy. After recognizing the importance of independent
regulator in markets to create synthetic competition in otherwise natural monopolies we
see that the key to success however lies in successive evolution of regulation to be able to
provide business incentives to serve customers, lead to price discovery, attract
investment, improve efficiency, and expand capacity. Policy makers should be able to
provide an environment in which managers can earn profits and investors get returns for
the risks taken.
Types of regulations:
We’ll see in the course of the paper why energy cannot be completely left to the market
and in the hands of government. Energy sectors all around the world are regulated in
some form of other. We’ll now look at various methods of regulation, their impact on
profitability of utilities, implications for efficient use of resources and ability to sustain
development of the sector.
Cost plus method (Rate of Return):
It involves determination of allowable expenses, a rate base and the rate of return to be
allowed on the rate base. The rate base also known as capital base, represents the written
down value of assets less approved loan.
The formula adopted for calculation of Annual Revenue Requirement (ARR) is as
follows:
RR= CoP + EC+ MC+ AC +D +I + T +[RB x RoR]
Where,
ü RR = the total annual revenue requirement of the utility (after taking credit for
any subvention from State Government)
ü CoP = Cost of power purchased
ü EC = Employee Cost
ü MC= Material Cost
ü AC= Administration and General Cost
ü D = annual depreciation expense
ü I = Interest on various loans
ü RB = the rate base (required investment) of the utility = Capital base in case of a
licensee and Fixed assets in case of the Board
ü T = annual taxes paid by the utility
ü RoR = the allowed rate of return on investment (debt and equity) = Reasonable
return in case of a licensee and not less 3% surplus for the Board
Presently Power sector and hydrocarbons in India are regulated by the RoR method.
Some drawbacks:
Information asymmetry due to concealment of information or providing
wrong information
Lack of incentive for utility to perform since both improvement in
efficiency and increase in efficiency can be passed to final consumer
Tendency to over invest. Since the above method requires calculation of
return on capital base the more you invest more will be your profits.
.
Table 1: Financial performance of state power sector( in Rs. Crore)
Performance Based Regulation (PBR):
Performance based systems gives direction to the regulated firms .The firms can then
chose the way in which they want to meet these targets .The regulatory commission sets
targets for the key performance parameters of the utility and calculates the tariff
assuming that the targets are met. If the utility exceeds the target, it would make profit,
and if it falls short there is profit reduction or even loss. PBR makes use of the firm’s
information advantage. The regulator thus controls less behavior and rewards outcomes.
There are number of different approaches to PBR viz. price cap, revenue cap, profit
sharing methods etc. Under this method, maximum prices or revenue are established for a
period of say 5 years. The maximum price or revenue is fixed on the basis of projection.
The popular method is the using RPI –X +Y. Where, RPI is the index, X is the expected
improvement, and Y is uncontrollable costs. The regulated firm can retain profits within
the cap. Some of he advantages of this method over ROR are:
Once the tariff is determined, it remains in place for some time. Thus the PBR
brings in the feature of stability to the tariff structure
PBR is less susceptible to the risk of over-investment by the firm.
Mechanism of retaining profits provides the necessary incentive to the regulated
firm to reduce cost and improve efficiency
Cost plus method for value chain of power sector can be understood as below. Though it
seems that such pricing provides no incentive for cost cutting it usually ends up in under
recoveries at every level because of stringent nature of evaluating the ARR’s. There is a
need for system to be self sustainable rather than regulator looking at each and every cost
of the licensee.
Generation
Proposed–1.75P/U
Passed -1.5 P/U
Transmission
Proposed-3.5P/U
Passed-2.75 P/U
Distribution
Proposed -7 P/U
Passed-4.5 P/U
Final consumer
4.5 P/U
(Usually in such cases the cap on the P/U (Price per Unit) for consumer user is decided
and the accordingly costs that can be recovered from consumers are allowed)
Table 2
Annual Revenue Requirement Application for the FY 2004-05 filed by
CESCO
14%
30%
8%
§
§
§
Depreciation
Interest
Reasonable Return
12%
36%
Investment Related
EC
RM
BadDebts
dep
Looking at Table 2 we see that there is a need to look further into costs that utilities are
incurring. For example reasons for high employee cost, is depreciation high because of
overinvestment, is the utility picking high cost loans leading to higher interest payments
etc. Performance based system on the other hand will ensure that companies themselves
are efficient for the profits they make by way of efficiency can be kept by them.
Now we’ll look at utility reforms in countries across the world and keeping them in mind
evaluate Indian pricing and regulation scenario and suggest areas for improvement.
Utility reforms in other countries:
Chilean electricity sector:
Chile’s power market (though relatively small in size) has successfully delivered low
prices and reasonable rates of return for investors. This has been due to a combination of
free entry into the generation sector and the price restraint posed by the marginal cost
based bidding system in the power pool which has limited the short run exercising of
market power by the three incumbent generators. The result of free entry has been that
their market share of capacity has fallen from 79.7% in 1993 to 59.1% in 2003 with the
share of the largest company, Endesa, falling from 47.7% to 27.6%.37 This situation has
come about in part due to the lack of restrictions on new building and the fact that the
linear nature of the transmission system has made upgrading the transmission links
reasonably straightforward. The Chilean system illustrates the success of private
ownership of generation combined with free entry in the presence of cost based bidding.
The market model is critical to all other decisions:
Market seems panacea for all problems however governments should consider how much
competition will occur and where it will occur before settling issues such as privatization,
interconnection, incentive regulation, and universal service.
The UK started with pure price cap regulation for BT, but had to shift to something
closely resembling rate of return regulation because competition did not develop as
quickly has had been hoped.
Present situation of Indian Energy Sector and scope for improvement:
Oil and gas:
Current situation:
State controlled refiners and retailers in the fiscal year ending on March 2006,
lost a combined $8.6 billion. And Merrill Lynch estimates they will lose another
$12 billion to $20 billion this year.
Under-recoveries in petroleum products which was Rs 45,400 crore during 200506 is estimated to be Rs 72,000 crore during 2006-07
Cost of production with returns methodology is least suitable for fixing price of a
commodity like gas, as producer prices worked under this method were based on
historical costs as per books of accounts and thus do not incorporate the impact
of additional investments planned in offshore and onshore producing fields
The current dispensation is sending wrong signals to the oil companies since
There is no pressure on them to innovate and improve efficiencies and to reduce
their cost of operations. They know that the under-recoveries would get covered
by bonds and government-directed discounts from upstream companies.
Way ahead:
The trade parity principle for pricing petrol and diesel recommended in Integrated
Energy Policy report envisages price as a weighted average of the import parity
and export parity prices in the ratio of 80:20. This will reflect true opportunity
costs. The price so determined would act as a ceiling with the government not
interfering in price. The marketing companies should be allowed flexibility to fix
the actual retail price subject to the indicative ceiling. This will introduce an
element of competition that will be in consumer interest.
Regulator in downstream and upstream sector on lines of regulation in power
sector. Had there been an oil sector regulator in place today, it would have had no
option but to ensure the government compensated firms like Reliance for such
under-pricing. In the electricity sector, where the Delhi government wanted to
keep tariffs low, to cite a similar case, it actually gave a subsidy to the new private
players (BSES and NDPL) to ensure this.
Table 3
The anomalies present in table 3 and 4 highlight the fact that lower prices are not
universally the goal of liberalization. Where prices have been subsidized to be well below
cost, liberalization may be intended to bring prices into line with costs and lay the
grounds for future investment.
Table 4
Power sector:
Current situation
High transmission and distribution (T and D) losses and inaccurate estimates of
the same act as a barrier to private sector
T and D losses in the northern region still range between 27 and 44 per cent( 17th
Electric Power Survey Report)
Mounting subsidies in which suggests transparency and routing the same through
State budgets.
Unbundling of Utilities as part of SEB reforms.
Way ahead
Introduce limited competition where bulk consumers are given option of buying
power from generating source of their choice.
Restructuring the Accelerated Power Development and Reform Programme
(APDRP) by tackling issues of lack of baseline data to assign accountability and
assess outcomes; poor preparation of projects; and lack of incentives for the staff
to reduce the aggregate technical and commercial (AT&C) losses.
A process of “Tariff Rationalization” to cover the gap between expenditure and
revenue, reduce distortions arising from cross subsidies and reduce Government
subsidy is inevitable, which may cause tariffs to initially rise but reduce later as
efficiency gains are achieved.
Long term tariff Principles: (LTTP)
·
Tariff principles will be quantified and fixed for a control period of 3 to 5
years.( Multi Year Tariff )
·
Profitability of licensees is neither guaranteed nor capped, but entirely
dependent on their performance. Further, profit in excess of normative
returns achieved by means of higher efficiency, growth in business, etc.,
would be shared with consumers through rebates.
·
Standards of quality for supply and customer service will be monitored
closely and penalties for falling short will be introduced in a phased
manner.
·
Adequate investments in the business for asset creation and working
capital must be ensured, and licensees will be fully compensated for it.
Conclusion:
Letting markets determine prices is not the panacea of problems of Indian energy sector.
The ultimate aim of any utility reform is to bring efficiency and attract investment. Our
current pricing system is far from achieving these goals but at the same time we need to
understand that move towards deregulation is progressive one. Historically all utilities
were regulated. Regulations are in place to serve a purpose but at the same time there is a
need to continuously evolve with time. Majority of regulated sector pricing started off as
cost plus and gradually countries moved towards performance based. As seen above
Market liberalization does requires market regulation for its sustenance. At the same time
effective pricing will require that many obstructions such as government interference,
distortionary tax structure etc. also need to be looked in tandem. However any regulation
should be independent from the influence of the government to have sustainability in the
tariff principles which otherwise would become a tool for serving political purposes.
Bibliography:
·
A citizen’s primer on the electricity sector, Prayas Energy Group , Pune
·
Consultative paper on Long Term Tariff Principles , Andhra Pradesh Electricity
Regulatory Commission,2002
·
www.oeirc.com
·
http://www.infraline.com/iplus/iplus.asp?Id=61
·
http://bear.cba.ufl.edu/centers/purc/publications/documents/World_Lessons.PDF
·
www.thehindubusinessline.com
·
Integrated Energy Policy-Report of the Expert Committee, Planning Commission,
Government of India ,August 2006
·
Jamison M.A. “Lessons from the World's Utility Regulators” 27 March 2000.
·
Pollitt M.
“Electricity Reform in Chile Lessons for Developing Countries”,
CEEPR, September 2004
·
Report of the Committee on Pricing and Taxation of Petroleum Products
,February 2006