Electricity price hike: Is it a necessary evil?

By Asia Wealth Management Research

The recent increase of Sri Lanka’s electricity prices for both residential and commercial consumers by a significant level stirred a great deal of public discussion regarding the necessity for such a steep price revision and the impact it would bear on the individual consumer and economic activity in general.

In this brief discussion we will be focusing on the analysis put forward by Sri Lanka’s academic community regarding the price revision and will attempt to make a comparative study on the electricity generation process of Sri Lanka with that of regional economies where generation costs as well as the supply price of electricity stand significantly below Sri Lanka.

Academic stance

Analytical accounts made by Sri Lanka’s academics regarding the issue of electricity price hike emphasise the fact that upward revision of electricity tariffs is a step in the right direction and ‘is a necessary evil’ in getting the prices to reflect generation and distribution costs, which would in turn transform loss making public enterprises into commercially viable entities.

Hence, the price hike is assumed to reduce the burden on the country’s banking system by freeing the government from having to subsidise electricity prices through a colossal volume of borrowed funds. This is believed to release the domestic savings available to more private sector investments at a lower rate of interest.

Further, it is pointed out that the high cost of electricity generation is attributable to the operational inefficiencies in the Ceylon Electricity Board (CEB) and hence privatisation of the electricity generation process would raise the efficiency level of the latter and in its turn would bring down the costs incurred in the generation and transmission processes.

Regional rates

The first point which emphasises the need to raise domestic prices to reflect supply costs could be considered reasonable if the rates on electricity of competing economies in the region are at a comparable level with the rates of Sri Lanka. In this regard comparable data on regional electricity rates indicates that the current level of Sri Lanka’s electricity tariffs are approximately three times that of regional competitor economies shown in the above table except for that of Thailand.

It should be further noted that Sri Lanka’s electricity tariffs were significantly above the regional economies even before the current price increase and remained the highest in Asia by a significant margin. However, in contrast, despite the abnormally high supply price of electricity the Ceylon Electricity Board remained a major loss making institution while regional economies, have maintained price levels significantly below that of Sri Lanka and simultaneously remained commercially viable.

This is to say that the issue with regard to the large losses incurred by the CEB to the tune of Rs. 61.2 billion in 2012 accounting for over 12% of fiscal deficit for the year does not necessarily lie with supply price of electricity as indicated, but is largely attributable to the cost structure of domestic electricity production, which is not in line with the regional level.

This indicates that the problem lies not within the realm of pricing but within the particular production structure adopted by the domestic suppliers, both private and the public in electricity production.

The whole idea of raising the domestic supply price still more to match the production costs incurred in electricity production would not necessarily address the supply side contradictions that are specific to the Sri Lankan situation; hence, what is required is to realign the domestic costs as well as the prices with that of the regional rates in electricity production.

Cost inefficiency

World Bank data on the sources used in electricity generation across the world and in regional economies in particular indicates that oil is the least utilised source of energy for the purpose of electricity generation. This is due to extremely high production costs of oil fired power generation compared to the use of resources such as coal, natural gas, hydro and nuclear power. The cost inefficiency in using oil as the main source of energy in producing electricity has made oil the least preferred resource in the world for the purpose of electricity generation.

World Bank data pertaining to the matter further indicates that over 75% of global electricity generation is carried out using hydro, coal, natural gas and nuclear energy and only 4.3% is produced from oil. Even the oil rich Middle East and North Africa produces as low as 29.7% of its electricity output using oil sources.  In contrast, Sri Lanka currently producers as much as 63.2% of her total electricity output from oil while the figure for the competing economies in the region averages below 5%, as shown in the table above. This further indicates that the issue with Sri Lanka’s electricity supply does not lie with the supply price being lower than production costs but is centred on the fact that electricity generation is carried out in large scale using cost inefficient power sources.

Hence, a step in the right direction and “getting the prices right” in the medium to long term would require a reduction of the supply price of electricity (not a further increase as a short term fix as suggested) by cutting production costs involved by way of shifting to cost effective energy sources in the power generation process.

Ownership structure

The second key point made on the issue concerned asserts that the ownership structure of country’s electricity generation contributes to its inefficiencies and in turn leads to high electricity costs in the economy. That is to say that the Government ownership and management of domestic electricity production has led to the stark inefficiencies and hence, privatisation would result in an overall increase in accountability, an increase in efficiency levels and hence ultimately a better service to the end consumers.

However, what should be noted in this regard is that 48% of the total domestic power output is already produced by private entities (CBSL Annual Report 2012) and the highest cost component of electricity generation is held by these firms that are mainly using oil as a source of energy.

The idea that private sector ownership of electricity generation would lead to an increased level of efficiency in the production structure does not take into account these obvious realities and also the technical aspects pertaining to the particular level of factor development (the level of productivity of production factors) and factor endowments (relative availability of factors) of the Sri Lankan economy.

During the initial stages of economic transformation in now advanced economies in Western Europe, North America as well as in East Asia, the state possessed the comparative advantage in supplying public utilities such as electricity, water, railways, roads, etc., due to the high capital to output ratio (the ratio measure the aggregate fixed capital formation that is required to achieve a given volume of output) that is typical of infrastructure investments.  The private sector of advanced economies made inroads into these investment spheres much later, only after the capital output ratio and hence the capital endowment in the economy as a whole increased to the level that comparative advantage in infrastructure investments too gradually shifted away from the government towards that of the private sector.  This was achieved at an advanced stage in the process of economic development of first world economies and not during the stage that characterise the state of the Sri Lankan economy which currently accompanies a low capital to output ratio. (The capital to output ratio also bears an inverse relationship with the general rate of interest in the economy, which explains the prevalence of high and low rates of interest in developing and industrialised economies respectively).

Misallocation of resources

However, the situation in Sri Lanka is such that private sector has moved into mass scale power generation projects under the facilitation of the Government even before the comparative advantage in investing in capital intensive public utilities has shifted from Government to that of the private sector, causing a misallocation of resources within the economy.

The domestic private entities ventured into large scale power projects considering the low initial setting up costs in oil fired power plants and short setting up time as opposed to their high electricity generation costs compared to coal or natural gas power plants. This in turn led to domestic electricity prices reaching the highest in Asia eroding the external competitiveness of the economy as a whole.  It is our view that the level of capital endowment in the economy which is determined by the capital to output ratio is in a stage where the comparative advantage in investing in capital intensive infrastructure projects with long gestation periods such as railways, roads, power, etc., still lies with the public sector.

The private sector is presently not in an economically beneficial position to engage in cost effective large scale power generation projects such as coal, hydro or natural gas with high setting up costs, long gestation and payback periods. It is also asserted that hydro power generation plants have not been used to their optimum potential even during the periods where volume of rainfall was favourable. This would have further increased CEB’s power purchasing from oil fired power plants raising the supply price of electricity in the economy.

Realigning domestic cost structure Therefore, the public sector should adopt immediate measures to improve the cost effectiveness of electricity generation process by shifting to cost effective sources of power generation with the aim of realigning the domestic cost structure with that of the economies in the region. This would assist the private sector to concentrate on development oriented investments that bear a tendency to improve the industrial capabilities of the system.

Hence, in conclusion we would suggest that electricity price increase is certainly not a necessary evil and that Sri Lanka should rather follow the complex path set by economies which already reached the advance status in the quest of improving not only the conditions involving power production but also general economic development.