Group A2PAK ARAB REFINERY LIMITED MANAGEMENT OF CIRCULAR DEBTWhat are the key factors behind recurring circular debt?In essence, the term circular debt is understood to be the amount of cash shortfall within the CPPA, which it cannot pay to power supply companies. This short fall is the result of:1. The difference between the actual cost of providing electricity and the revenue realized by the DISCOs from sales to customers2. Insufficient payments by DISCOs to CPPA out of the revenue realized since they give priority to their own cash flow needs.Deficiencies of governance at the government, corporate, and sector level are at the heart of the circular debt issue. At the government level, these can be attributed to political interference, short- sighted and defective policies. At the corporate level, poor governance and the ineffectiveness of the DISCO BODs in guiding and monitoring company performance is a major problem. At the sector level, NEPRA performance under the NEPRA Act of 1997 leaves much to be desired[footnoteRef:1]. [1: The Causes and Impacts of Power Sector Circular Debt in Pakistan, FUNDED BY THE UNITED STATES AGENCY FOR INTERNATIONAL DEVELOPMENT (USAID).]

Primary factors of circular debtAlthough there are many contributing factors to circular debt, there are five primary drivers.1. Poor sector governance The federal government, as owner, retains the prerogative of ultimate decision-making regarding customer tariffs. Unfortunately, as a political entity, the government is influenced by both political and socio-economic considerations. These often overshadow commercial decision-making, and result in a reluctance to pass on the full cost of electricity to customers. At the provincial level, governments generally are not proactive in the resolution of issues such as the reconciliation of electricity bills, payment of tube well subsidies arrears, arrears of provincial departments, and arrears due to court orders. Governance at the company level leaves much to be desired. For the most part, the DISCOs BODs do not have sufficient authority or capacity to demand accountability of management and staff and are ineffective in managing DISCO performance. NEPRA also lacks effectiveness in enforcing accountability of the DISCOs, particularly with respect to reducing T&D loss levels, and meeting performance standards and license conditions as set out through the investments allowed through the tariff petitions filed and performance targets set.2. Delays in tariff determination by an inadequately empowered regulator compounded by interference and delay in notification by the Government of Pakistan (GOP): Delays in tariff determination and notification contributed Rs72.19 billion[footnoteRef:2] to the circular debt for FY 2012. [2: : PDP Analysis based on data from Tariff Cell -Ministry of Water & Power.]

Without new tariff values from NEPRA and the GOP, the DISCOs had no chance to receive the necessary cash required to meet their monthly wholesale power cost.3. A fuel price methodology that delays infusion of cash to the power sector: The FPA mechanism adds to circular debt during periods of rising fuel costs by delaying this adjustment value by two to six months. This creates a cash shortage for the power producers for energy already delivered.4. Poor revenue collection by the DISCOs: Non-payment of electricity dues by private consumers is one of the largest contributors to circular debt. Of the Rs197 billion[footnoteRef:3] receivables from private consumers at the end of FY 2012, 73% is attributable to PESCO (including Tribal Areas Electric Supply Company (TESCO)), HESCO (including SEPCO), and QESCO. [3: Source: PEPCO DISCOs Performance Statistics Reports 2012.]

The main factors contributing to the increase in receivables include the DISCOs lack of accountability, political interference, failure to disconnect defaulting customers, lack of modern technology for metering and revenue collection, and fear of reprisal from protesting customers upon disconnection or replacement of meters. DISCOs supply electricity to various provincial government departments, schools, hospitals, police stations, water and sewerage facilities, and offices, some of which are perpetual defaulters for example Azad Jammu and Kashmir government. Collection of billed electricity in FATA has historically been a challenge due to the extreme poverty and palatable attitude of the government towards the tribal areas. Federal government receivables on these accounts stand at Rs30.1 billion as at June 30, 2012[footnoteRef:4]. [4: PEPCO DISCOs Performance Statistics Reports 2012. (Receivables = Federal Govt + FATA + agricultural tube wells (GOP share)) ]

5. Delayed and incomplete payment by the Ministry of Finance (MOF) on Tariff Differential Subsidy (TDS) and Karachi Electric Supply Company (KESC) contract payments6. Prolonged stays on fuel price adjustments (FPAs) granted by the courts7. Transmission and distribution (T&D) losses and theft The federal government also has been lax in passing appropriate legislation to curb electricity thefts, promote energy conservation, increase commercial transparency, strengthen regulatory entities, and promote an open and competitive energy market.Secondary factors of circular debtThere also are several secondary causes to circular debt, including:1. The need to improve the thermal efficiency of the GENCOs and for NEPRA to set tariffs based on actual vs. estimated heat rates.2. Inadequate budgeting of the TDS, which delays payment and increases financing costs3. Unfavorable generation mix of the GENCOs, due largely to the GOPs fuel allocation policy that diverts natural gas to other non-economic uses4. Non-commercial/non-professional approach to load shedding; non-improvement in tariff terms and conditions; impact of court decisions that have delayed payments to the DISCOs5. Late payment surcharges (LPS) paid by CPPA to the IPPs resulting from the inability of the DISCOs to fully pay CPPA; the GOPs neglect in promoting demand-side management, energy efficiency and renewable energy resources6. The need to settle payment arrears (both disputed and undisputed) in a comprehensive manner; and the need for expanded authority of CPPA to collect payments from the DISCOs through formal and enforceable power purchase agreements (PPAs). ______________________________________________________________________________

What solutions will you propose at a policy level to the government in handling the circular debt?Following solution can be given as proposal to the Government. Reduce the electricity theft as electricity of 1 billion is being theft daily in Pakistan.

Provide full fuel supplies to power plants to reduce power outages by about 25 to 30 percent.

The government should attach the highest priority to importing electricity from the neighboring countries as a temporary measure to minimize the adverse impact of high cost energy mix.

The government should aim to convert idle capacity in the thermal sector into coal-based plants to bring down national average cost.

The level oftransmission and distribution (T&D) losseswhich have ranged around 22% is another critical aspect. These loses are due to old-age generation plants, low-voltage transmission and distribution lines, weak grid infrastructure, inaccurate metering and billing, and outright theft. So government should take measures to remove these kind of loses.

Another solution can be that Energy Sector entities should be placed under professional and competent management and should be restructured on a non-political basis, to allow for good corporate governance.

Further the energy sector companies should be provided autonomy and full government support to enable them to move to economic and commercially viable operations without political interference.

There should be revenue collection board in every sector under the government responsible for the revenue collection. This will decrease the revenue collection period and exclude the circular debt.

There should not be borrowing more than a certain limit from the banks and government should responsible for that.

Privatization should be done for only short period of time.

There should not be flexibility in the pricing formulas for oil and gas prices. In the long term, the government must not allow any more oil-based power plants and shouldfocus on hydel (especially through smaller dams), coal, and nuclear energy.

The government should avoid delay in payments, which would curtail accumulation of circular debt and enable IPPs to run on maximum capacity.

Foreign Exchange rates fluctuation also creates complications. Government should take measurements to avoid this.

Tariff and subsidy disputes between the provincial governments and CPPA and the DISCOs, need to be resolved, either by negotiation or arbitration.

Improve the fuel allocation policy in the short-term to allocate fuel to the highest value uses (e.g., assign a high priority to power sector in the allocation of natural gas), and in the long term eliminate fuel allocation so that fuel use is based on competitive market forces.

Aggressively monitor the performance of power companies to enforce compliance with their license conditions.

Introduction of empowerment and accountability, reward and reprimand at all levels. What solution/way forward will you propose to the leadership of PARCO in wake of recurring circular debt and financial volatility faced by PARCO?Pak Arab Oil Refinery Limited is facing serious concerns regarding the piling debt, volatile market conditions and huge losses. The company can use following recommendations to improve its current condition and recover from consistent losses and inefficiencies. The company should revamp itself by hiring new management personnel who have the capability of handling the current situation of the company by setting new strategic goals and aligning them with departmental goals, ways of improving financial health without taking any further debt and increasing productivity levels. Overall governance of the sector should be improved through drastic steps that will ensure sound revenue collection and a reduction in power theft. Power theft should be declared a state crime and special courts should be established for this purpose. The management of PARCO should set up committees to check up fraud and theft and the reporting procedures should be transparent and free from any political interference. As PARCO deals in other functions such as oil pipelines and storage facilities, the company should invest more in these divisions in order to cover up costs from the oil refining segment. As per the case, PARCO has receivables of Rs.25.9 billion. The management must devise stringent policies to recover the income from the debtors. The average collection period must be compared with the industry average and should be shortened in order to fulfill cash requirements. Until the problem of debt is solved, the company should stop sales on credit. Upfront cash payments must be made a part of every transaction which will help the company to generate profits. Investment in the pipeline infrastructure is another option where the company can enhance its capability of supplying more oil to four provinces and thus increase sales. Instead of relying on oil marketing companies and paying huge amounts of fees, PARCO should set up small retail outlets in major cities for the purposes of distribution. This will save immense costs and will ultimately boost profits. According to the financials given in the case, PARCOs inventory turnover is 37 days approximately. Debt turnover is 64 days and fixed asset turnover is 6 days. All of these figures are an indication of the inefficiencies of the management and work processes of PARCO. Changes in policies must be made and inventory processing period should be shortened in order to improve efficiency and productivity. The smaller the inventory turnover period, the better it is for the company. Also a high fixed asset turnover indicates that the company is not utilizing its assets effectively and is not using them to their full capacity. It can be due to old machineries or less usage than actual capacity. Clear guidelines must be laid out by the management with careful analysis that in a certain amount of days one cycle must be completed which is in synch with achieving the goals of profits and increased shareholders wealth.