Making sense of electricity prices (2024)

The process of determining electricity prices in Pakistan is top-down, in which a reference price is set once a year, followed by multiple adjustments instead of quarterly adjustments and fuel adjustments. This leads to confusion regarding what is the actual tariff being charged to the consumer, as multiple adjustments are done during the year.

The primary variables affecting the electricity price are the price of the source fuel used for electricity generation, interest rates, rupees-to-dollars parity, potential demand levels, and inflation, among other factors. As these market-oriented variables keep changing, so do the adjustments to electricity prices — on top of the reference price that is calculated once a year.

Such a convoluted structure is largely a function of a cost-plus and single-buyer regime, where the government is the primary buyer of electricity and sets the price according to costs incurred rather than based on demand and supply.

This leads to second-order effects, in which an increase in prices due to cost escalation results in a reduction in demand — which further exacerbates the price increase, as the same cost base now needs to be spread over a reduced number of electricity units dispatched.

For consumers using more than 200 units of electricity, the increase in month-on-month tariff is in the range of 7pc to 9pc

It is important to note here that almost three-fourths of electricity generation costs are fixed in nature. This means that as the number of electricity units dispatched reduces, the same fixed cost per unit increases. This results in a double whammy: cost-plus pricing-driven escalation results in lower demand, which further increases the cost per unit due to the higher fixed costs of the system.

The cost of generation, transmitting, and distributing electricity in the country is around Rs35.5 per unit, of which the average energy cost is Rs10.9 per unit, while the capacity cost is around Rs18.4 per unit. Adding on top of this are transmission costs of Rs1.54 per unit and distribution cost of Rs4.6 per kWh.

All costs over and above this that are reflected in the electricity bill are a mix of theft and other losses, taxes, and any potential cross-subsidies.

The amount attributed to theft and other losses is more than Rs500 billion, spread over regular paying customers. Reducing theft and other losses will reduce prices for regular paying customers across the board.

In the latest reference tariff, electricity prices have increased significantly compared to the last reference tariff. However, the reference tariff for last year has already been escalated multiple times due to quarterly and fuel adjustments.

In such a scenario, comparing the electricity tariff on a month-on-month basis makes more sense, rather than comparing the same to the tariff twelve months back. On a month-on-month basis, the tariff for protected consumers, who make up around 58 per cent of total consumers, and are in excess of 17 million, will only see a 2pc increase in tariff.

However, for consumers using more than 200 units of electricity every month, the increase in month-on-month tariff is in the range of 7pc to 9pc. This is largely due to the introduction of fixed charges in electricity bills. The increase in tariff will continue to squeeze disposable income and may lead to an even greater drop in consumption. For households with higher consumption, a case for transitioning towards solar has been strengthened further.

On the flipside, as interest rates reduce, the rupee-to-dollar parity is stabilised, and inflation starts declining, the quarterly tariff adjustments may potentially be negative in nature, resulting in an actual decline in tariff.

It is expected that quarterly adjustments that are due are put into motion and tariffs may be reduced by 2pc for consumers across the board. Although the number is nominal, flatlining costs in a high inflationary environment effectively means a reduction in prices in real terms.

A major change in the latest reference tariff is a reduction in the variable component of industrial tariffs and the introduction of a fixed charge that is linked to the maximum demand of a particular industrial consumer.

Introducing a fixed charge ought to potentially incentivise greater consumption, thereby resulting in higher production, such that industries can reduce their electricity costs on average. It is estimated that, on average, industrial units may see their electricity costs reduced by 10pc to 15pc, depending on their consumption levels over the next few months.

The same may not bode well for industries that operate at low utilisation levels, as higher fixed costs may further increase their costs. This may potentially lead to either the shutdown of low to zero utilisation units or potential mergers to attain economies of scale. The updated industrial tariff structure implicitly encourages more efficiency and economies of scale.

Electricity tariff is a labyrinth, and there is no easy way out. A centralised pricing mechanism that endorses a uniform tariff across the board has led to all sorts of unintended consequences. Decoupling the tariff across the country, as well as associated subsidies and losses, while encouraging the development of a competitive market in parallel is the only way forward.

Immediate relief in electricity prices is certainly not possible. However, reforms that move the market to a competitive regime and make electricity prices a function of demand and supply rather than a cost-plus mechanism are the only way forward. Even flatlining prices at these levels over the next few quarters or years ought to serve consumers well, as their effect in real terms will be diluted.

The writer is an assistant professor at the IBA, Karachi

Published in Dawn, The Business and Finance Weekly, July 8th, 2024

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Making sense of electricity prices (2024)
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