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The woes of power: A moderate approach to the discom sector might be the answer

Abhishek Anand, Navneeraj Sharma and Arvind Subramanian write: Political economy of discom operations and intensifying populism on freebie-ism at the level of state governments will make reforms harder. A more rational, measured approach should be considered

The financial situation of the discoms has been a real concern for the government, especially the Ministry of Finance (MOF). The government has responded by offering carrots to — and wielding sticks at — state governments to incentivise reforms. (Illustration: CR Sasikumar)

In our previous article (‘Power, a reality check’, IE, August 17), we presented three new facts on the power sector. First, the problem of discoms is considerably worse than recognised because true losses of Rs 3 lakh crore exceed substantially the headline number of Rs 78,000 crore. Second, as a result, state government finances are considerably more precarious than even the recent RBI analysis suggests. True state government deficits are about 5.5 per cent of GSDP compared with the headline number of 4.7 per cent, and the true debt of state governments is 34.5 per cent of GSDP not 31.0 per cent. Third, unsustainable discom operations are increasingly financed not by public sector banks but by the Power Finance Corporation/Rural Electrification Corporation (PFC/REC).

What are the political economy implications and possible policy responses?

The financial situation of the discoms has been a real concern for the government, especially the Ministry of Finance (MOF). The government has responded by offering carrots to — and wielding sticks at — state governments to incentivise reforms. Under the latest Revamped Distribution Sector scheme (RDSS), states’ access to some central government resources is conditional on their adhering to regular revision in tariffs, smart metering and committing to a reduction in the AT&C losses. But it is possible that the objectives of different ministries –the Ministry of Power (MOP) and those of the MOF— may be diverging.

The MOP has the mandate to pursue those power sector objectives that are politically popular (access and quality) and important to showcase India’s reputation internationally (increasing renewable capacity). As a result, the MOP has to lend higher priority to infrastructure building over financial sustainability while for the MOF the latter is a strong policy objective. And PFC/REC is an instrument for the MOP to achieve its objectives.

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Now, PFC/REC is a strange institutional beast. On the one hand, it is regulated by the RBI as a non-bank financial company (NBFC) although it is not clear how effectively. On the other hand, it is also a creature of the MOP, zealously pursuing the government’s quantity targets on access, quality, and renewable capacity. It has a AAA rating despite its considerable exposure to the discoms and generating companies, which can only be due to back-stopping by the government.

Since discoms owe increasing amounts of money to PFC/REC, any default by them will jeopardise PFC/REC. Therefore, the MOP will be reluctant to impose hard budget constraints on the discoms, which creates moral hazard. The incentives for discoms and state governments to reform are blunted. In fact, the new scheme itself is testimony to this moral hazard because it reflects a failure to enforce the hard obligations envisaged under UDAY. One can see why the MOP and MOF will then diverge in their approach to and enthusiasm for discom reforms.

When the public sector banks (PSBs) were doing the bulk of the lending, the RBI was an actor that in principle was on the same side as MOF in seeking discom reforms. Of course, the RBI is meant to regulate PFC/REC as NBFCs but legally and practically, that regulatory oversight will be lighter compared to that involving the PSBs. At the same time, we see that actual and aspiring state governments are tending to greater freebie-ism in the power sector — the underlying Ponzi dynamic of cost under-recovery shows no signs of being addressed. Offering free electricity is increasingly becoming a stock promise in state elections, as the recent experience of Punjab, Tamil Nadu, Gujarat, Himachal Pradesh and Uttar Pradesh shows.

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So, the new political economy of discom sector operations and financing on the one hand, and the intensifying temptation to power sector populism on the other, together result in dimmer prospects for discom reforms.

What should be the response to this reality? One temptation would be to attempt yet another set of ambitious reforms, targeting institutional changes and financial performance. To some extent, the latest RDSS scheme along with proposed changes to the electricity law have succumbed to it. But as an excellent TERI report shows, there have been at least five attempts at support and reform since 2000, which have all failed as steadily rising discom losses over the last two decades make clear. In this light, one can admire the motivation of the latest reform effort. And unlike the UDAY scheme, it desirably frontloads the actions that discoms and state governments need to take and the proposed legal provisions under the Electricity Bill may help make the RDSS provisions more effective. Nevertheless, a modicum of scepticism about ambitious reforms is almost forced by experience.

The time has come to try something different — for example, reforms that are more modest and technical. We would suggest a few. The first relates to transparency. Discom losses including arrears must be fully reflected in state government deficits and discom debt in state government debt. Perhaps the next finance commission should require this of the state governments.

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The second relates to simplicity. As was discussed in the Economic Survey (2015-16), power tariffs in India are monstrously complex. Most states have more than a hundred tariff rates (there are categories that would confound even the wildest imagination: For example, “mushroom and rabbit farms” and “salt farming upto 15HP”. This has large costs and zero benefits. The central government and the central regulator should nudge/persuade their respective state government counterparts to have tariff schedules with no more than say 5-6 rates (one for agriculture, one for industry and commerce, and say 3-4 for households).

The third, which is featured in the recent package, would target smart metering of the entire system, including agriculture. This reform would both appeal to the MOP and have potential long-run payoffs for financial performance and reducing inefficiency and corruption.

Finally, reforms should aim to eliminate rampant cross-subsidisation. Part of accepting the reality of discom losses
is the related recognition that they will all be put on the balance sheet of state governments and perhaps eventually of the central government. Eventually, all discom losses are fiscalised. In that case, why not minimise or eliminate the micro-distortions? For example, cross-subsidisation should be eliminated: Industrial and commercial consumers should pay tariffs close to the costs of procuring power by the discoms and not the costs that make up for losses elsewhere in the system. These losses stem from below-cost pricing for agricultural consumers and households. They also stem from inefficiency and corruption in discom operations.

So, the principle to embrace would be that tariff, regardless of who is consuming power, cannot incorporate costs and losses elsewhere. If this principle of no cross-subsidisation is accepted, we estimate that industrial tariffs could be about Rs. 2-2.50 per kilowatt hour lower on average (of course, with large variations between the states). The net result of avoiding these distortions will be a larger hit to state and central government balance sheets. But that is happening in any case. Codifying it would at least have the advantage of avoiding the micro-distortions and reaping the gains in the form of lower costs and greater competitiveness for the manufacturing sector.

In sum, the political economy of discom operations and the intensifying populism on power freebee-ism at the level of state governments will make discom reforms harder. It is possible that “this time will be different” for the latest reform actions but the past suggests that we cannot abandon scepticism.

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It might be worth embracing a more modest approach to reforms, focusing on ensuring accounting transparency of discom operations so that their true losses are fully reflected in state government deficits and debt; simplifying tariff schedules so that there are no more than say 5-6 tariff rates; expeditiously implementing full smart metering, and espousing the principle of no cross-subsidisation so that no consumer pays for recouping losses elsewhere in the system whether they stem from free/subsidised power for agriculture or the inefficiency and corruption in discom operations.

Anand and Sharma are consultants in the private sector. Subramanian is with Brown University and the Center for Global Development

First published on: 18-08-2022 at 04:00:30 am
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