Current incentive frame work and payment structure

The cost of service regulation prevalent in the electricity industry of Pakistan along state ownership of generation, transmission and distribution businesses have not allowed any cost minimization incentives in the industry (see section 1.3.2). However, Government of Pakistan is facing

stringent financial conditions by International Monetary Fund (IMF) to reduce tariff differential subsidies for electricity industry and to mobilize more resources and lower associated costs of the electricity supply. The transmission and distribution business is owned by government30 and in addition government also owns some of thermal generation business. In settings of principal agent model, the ministry of water and power (MWP) acts as principal on behalf of government while management of transmission, distribution, and generation companies are agents to the principal.

The top management of state owned entities in the electricity industry directly face incentives as poor performance will result in the removal or transfer of the management. At retail level distribution companies (DISCOs) face incentives to lower distribution losses and eliminate revenue losses (see section 1.2), however institutional capacity and political constraints curtail these incentives. One of the institutional constraints is high exogenous system losses resulting from given state of technology, and in addition the financial health of the distribution companies does not allow for the required investment in infrastructure that will lower the system losses. The political constraints include ineffectiveness of government and non-availability of law enforcement

apparatus to lower the pilferage and recover unpaid bills particularly in politically troubled parts of the country. There is evidence that incentives faced by lower tiers of management in distribution companies are not consistent with the incentives faced by their top management due to corruption incentives at lower tiers (GOP 2013).

The distribution companies can stop supplying electricity to the areas where revenue coverage is substantially lower and system losses are unreasonably high. However the regulatory authority have shown reluctance to allow distribution firms to stop supplying electricity to a high loss feeder as the minority paying regular bills with a legal connection might suffer from the indiscriminately operated power cuts in the affected areas. The incentive based power cut policy was adopted initially by privatised utility in Karachi and lately government distribution companies have started implementing this policy in some parts of the country.

The incentives faced by the main transmission company, NTDC, are similar to distribution networks, where lowering the losses will result in lower effective wheeling cost. However institutional constraints not allow for required investment to improve system performance. The ministry of water and power (MWP) reports that required investment to revamp the national grid is around $ 6 billion, while currently regulator allows $885

million total annual investment to distribution and transmission segment of the industry31.

The thermal generation capacity is partly owned by private sector IPPs and partly owned by government owned companies GENCOs. The power plants are allowed a certain heat rate by the regulator and plant manager have incentive to economize on that heat rate by minimizing cost of electricity generation. The IPPs potentially reap any heat based incentives demonstrated by load factor and total output, while government plants have lower available capacity as plants are quite old and not well maintained ( see Chapter 2). Therefore government owned plants are restricted to increase total sales with given dependable capacity which is much lower than installed capacity.

The Ministry of Water and Power (MWP) notifies effective tariffs for the sale of electricity to final consumers in the country, these effective tariffs are lower than the tariffs determined by the regulator that results in tariff differential subsidy. The MWP faces incentive to allow regulator determined tariffs that will lower subsidy and free up more fiscal resources. However, political constraints restrict the incentives to increase the tariffs as low income household consumers are concentrated in some of inefficient

distribution companies, while government want to pursue a uniform tariff policy in the country (see section 1.2.1).

The system of payments in the electricity industry is shown in Figure 1.2. The distribution companies (DISCOs) conduct retail business and collect revenues for the sale of electricity, after deducting electricity distribution costs the DISCOs transfer payments to the transmission company NTDC that also performs the role of Central Power Purchase Agency (CPPA) based on the single buyer model. As the net revenues of distribution firms fail to cover cost of total electricity purchased, the ministry of water and power MWP transfers tariff differential subsidy to the power purchase company to settle the accounts of government owned generation companies and private IPPs. The delay in the subsidy payments and poor recovery of sales revenue by distribution/retail firms create circular debt in the supply chain and effects electricity supply in the system (GOP 2013). The lack of transparency and delay in subsidy payments to the distribution firms impact the financial performance of the distribution companies. The financial dependence of the distribution companies on Central Power Purchase Company (CPPA), which also runs transmission business NTDC, potentially create incentives for distribution companies’ management to keep coordination high with CPPA and NTDC management, that forces de facto vertical integration of the government owned electricity supply business.

Figure 1.3: Real distribution cost, GEPCO (rupees per kWh)

Source:NEPRA, Tariff Determination Reports Various Issues, 200-01 constant prices