PAKISTAN



Circular debt — the hidden force behind rising electricity costs

The power sector’s real crisis isn’t energy, it’s debt, and until we untangle this financial knot, affordable electricity and sustainable growth will remain out of reach.

Ammar H Khan 

Published October 19, 2024
DAWN

The real crisis in the power sector is not about power generation; rather about debt. Surplus power generation capacity isn’t a bad thing — it’s an opportunity to drive industrial growth and stimulate demand. However, the inability to capitalise on this is largely due to a debt overhang, stemming from a combination of project debt, working capital debt, and circular debt.

The circular debt in the power sector is largely a function of inefficiency, and incessant subsidies, eventually resulting in the same ballooning to more than Rs2.26 trillion. The impact of such a debt has a direct impact on electricity bills, with roughly Rs3.23 per kilowatt-hour (kWh) being attributed to just mark-up payments, or the financing costs of such debt. Adjusting for taxes, the same increases to Rs3.81 per kWh, for most non-protected consumers. The numbers may vary for different slabs, but the impact on electricity bills remains significant.

The financing cost of circular debt is embedded in the electricity bills as a PHL Charge, which overall inflates electricity bills. Consumers must pay for this cost, solely due to the inefficiency, and bad financial management at a macro level. Bloating the electricity tariff with such extraneous costs has resulted in a scenario where demand for electricity continues to drop, restricting industrial and economic growth in the process.

The demand for electricity is price sensitive — it is estimated that a 1 per cent drop in electricity prices leads a to a 0.3pc growth in electricity consumption. Similarly, growth in electricity consumption has a direct, and strong correlation with economic growth. In a nutshell, it is not possible to generate sustainable economic growth, without access to affordable electricity and it is not possible to make electricity affordable, without solving the debt problem. In effect, the bloated nature of debt acts as a drag to broader economic growth.

Framing it right

Framing the problem is the first step in solving a problem. The power problem needs to be partially framed as a debt problem first. Within the circular debt of Rs2.26 trillion, roughly Rs683 billion can be attributed to a Special Purpose Vehicle (SPV) called Power Holding Limited (PHL). Another Rs1.060 trillion can be attributed to the amount that is payable by the Central Power Purchasing Agency (CPPA) to various power producers. Finally, an amount of Rs520 billion is non-interest bearing. Effectively, an amount of Rs1.74 trillion attracts a financing cost, or mark-up, which is paid by electricity consumers across the board through their monthly electricity bills.

It is estimated that the cost of financing for PHL is in the range of three-month Kibor (Karachi Inter Bank Offered Rate) plus 0.45pc. Similarly, the amount that is payable by CPPA to power producers is around 3m Kibor plus 2pc for the first 60 days, followed by the same increasing to 3m Kibor plus 4.5pc for any amount that is overdue by more than 60 days. It is estimated that roughly half of the payables of CPPA are overdue 60 days, resulting in an average financing cost of 3m Kibor plus 3.5pc.

It is important to note here that power producers cover for these receivables through borrowing commercially on their balance sheets. The average cost of borrowing for any power plant remains less than the average financing cost that the consumer is paying through the electricity bills. Effectively, it is more financially feasible for the power producer to delay realisation of receivables (after adjusting for energy payments), as the same starts attracting a financial cost of 3m Kibor plus 4.5pc. This is a distortionary practice, and needs to end through a better price discovery mechanism.
Rationalising the costs

All of this debt, and payables are effectively backed by the sovereign, either through a sovereign guarantee, or other contractual arrangements. Despite the same, the financing cost remains much higher than the financing cost of the sovereign, which remains lower than 3m Kibor. In the current context, when interest rates are on a declining trend, certain sovereign-backed entities, such as Trading Corporation of Pakistan (TCP), or Pakistan Agricultural Storage and Services Corporation (Passco), have been able to borrow at significantly lower interest rates than even 3m Kibor. Due to the financing cost being passed on to the consumer in the case of electricity, little or no effort is made to actually rationalise the cost, and improve household economics for the electricity consumer in the process.

Similar to the structure of Treasury Single Account (TSA) espoused by the International Monetary Fund (IMF), wherein all government funds are deposited in a single account — debt should also be treated in the same manner. It makes little sense for the sovereign, or sovereign-guaranteed entities to be borrowing at wildly different rates from the market, due to the absence of a price discovery mechanism. Such a structure increases electricity prices for the consumer, constraining their ability to increase consumption of electricity, while restricting growth in the process.

The IMF, in its latest Country Report for Pakistan, has explicitly noted that PHL debt needs to be converted into cheaper public debt. This is not just economically feasible, but also beneficial for the consumer. A plan needs to be in place to benefit from declining interest rates, and swap out circular debt with much cheaper public debt — thereby saving significant financial costs in the process.

Moving to Islamic banking

There has been a surplus of liquidity with Islamic Banks in the country, with the sovereign being able to raise debt through an Islamic structure at a lower cost than conventional debt.

There is a possibility to swap out, or convert, PHL debt of PKR with longer term Islamic instruments, with a maturity of 5 years, or 10 years. As interest rates continue to decline, it is possible to borrow at much lower interest rates than existing 3m KIBOR, resulting in a net benefit for the consumer.

Moreover, as the debt moves out from PHL to cheaper sovereign debt, there is a net gain for all stakeholders. The PHL charges that are paid by consumers reduce, while mark-up paid by all entities also reduce. This results in a net benefit to the system at large.

Similarly, the payables of Rs1.060 trillion by CPPA also need to be swapped out by sovereign debt. The same can be done in a staggered manner. The more expensive payables that are overdue and being charged at a mark-up of 3m KIBOR plus 4.5pc can be swapped out first, to significantly reduce mark-up expense on the same. The government can effectively issue long-term bonds, whether conventional or Islamic, depending on the appetite of participants, and swap out the same with receivables of power producers.

Effectively, the power producers get a long-term sovereign bond in lieu of their receivables — which they can trade in the open market, and either convert into cash, or just accrue income on the same till its maturity.

This opens up liquidity for power producers, who can then use the cash to repurpose themselves for a competitive market regime, or just pay dividends to shareholders. The same instruments can be priced through a competitive auction via the Pakistan Stock Exchange (PSX) thereby resulting in more efficient, and competitive pricing, as the PSX is able to attract a wider range of investors potentially resulting in better price discovery, and lower costs.

Improving the risk profile

It is important to consider here that the receivables of power producers are already being financed by banks — settling the same in lieu of sovereign debt improves risk profile for all stakeholders. The banks get access to a tradable sovereign instrument, reducing their exposure to the power sector, while also opening up an appetite for more financing in the area to enhance energy security, or efficiency. There is even an option to provide tax incentives on such instruments, subject to the net cost to the government being able to compensate for any forgone tax revenue.

Through such a maneuver, the risk profile improves for all stakeholders, while the financing cost also reduces. As the circular debt is swapped out, it becomes public debt, while electricity consumers see a straight reduction of Rs3.81 per kWh in their electricity prices. It is estimated that through the swapping manoeuvre alone, it is possible to save Rs90 billion in financing costs annually, just through contraction of lending spread, and utilisation of better terms available with the sovereign. This results in a consumer surplus, while the only ones losing are shareholders of financial institutions, who were benefiting from a distorted pricing regime for similar levels of risk.

It is possible to reduce electricity bills by Rs3.81 per kWh, which in addition to other reform measures can stimulate necessary growth in consumption, thereby catalysing industrial expansion. A move towards public debt actually stimulates growth in this context, while generating a consumer surplus at the same time. The primary gain that is being extracted here is an efficiency gain — by eliminating the distortion that exists at which the sovereign borrows directly, or indirectly through different entities.

Structural reforms require time, but efficiency gains can be achieved by minimising distortions. The power sector remains a basket case of a dysfunctional cost-plus pricing regime that has overloaded the consumer with excess costs. Streamlining the same remains critical in making the power sector more competitive, thereby boosting economic growth in the process.

We need to solve the debt problem grounded in principles rather than loading on costs onto the consumer, and deluding oneself into expecting an efficient outcome from the same.

Header image: This is an AI image generated via Shutterstock.

The author is an assistant professor of practice at the School of Business Studies, IBA, Karachi. He has previously worked at several financial institutions in Pakistan, both in commercial banking and capital markets.