Tutorial Discussion on Nepra

8/7/2019 Tutorial Discussion on Nepra

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TO BE RETURNED AT THE END OF THE EXERCISE

NATIONAL INSTITUTE OF MANAGEMENT, LAHORE

10TH MID CAREER MANAGEMENT COURSE

(MONDAY, 20TH

SEPTEMBER, 2010 TO FRIDAY, 24TH

DECEMBER, 2010)

TUTORIAL DISCUSSION

(Faculty Guide)

ON

Role Of Regulatory Bodies (Nepra & Ogra) At The Operationl

& Tactical Level.

Sponsor DS: Mr. Salman Choudhry


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DISCLAIMER:

This document contains training material designed exclusively to promote

discussion by the participants of 10th

MCMC at NIM. It is not prediction of the

future nor does it necessarily reflect the views of the institution.


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Role of Regulatory Bodies (NEPRA & OGRA) at the Operational/Tactical

LevelMethodology/Requirement:

Syndicate activity is planned in two phases, discussion and reducing its essenceinto written form. First, the Syndicate DS would open the discussion by introducing the

topic. He would then invite the syndicate members to present their considered views

cross cutting all dimensions of the topic. The discussion will follow the sequence of the

stated parameters steered by the DS. This activity will be undertaken for about one and a

quarter hour.

The first five to ten minutes of the remaining forty five minutes will be utilized for

presentation of a nominated sub-syndicate on recapitulation of important points that come

up in the discussion. At the conclusion of the discussion, any one participant, a volunteer

or as nominated by the DS will be assigned to reduce the essence of the entire meeting

into a written form containing five to six pages, also adding his own views andexplanations as deemed appropriate. It is incumbent upon all members to continually jot

down the important points and issues that emerge out of the discussion which would later

facilitate the writing part.

Aim

1. The concept of natural monopoly.2. Why regulate a natural monopoly.3. Why regulate a public utility, and Its importance in a public utility.4. To sensitize the participants to the basic paradigm of a regulatory regime for

public utilities in Pakistan.

5.

Legal framework for creating NEPRA and OGRA.6. To understand the tariff mechanism.7. Efficiency of the tariff regime.8. To discuss inefficiencies of a regulatory framework.

Discussion Parameters:

1. What is a Natural Monopoly?

A natural monopoly exists when economies of scale are so substantial that a single

firm can produce total business output at a lower unit cost, and thus more efficiently than

two or more firms (Sherer 1980). In effect, the long-run average costs are falling over

such a wide range of production rates (relative to demand) that only one firm can survive

in such an industry. A more specific criterion is the subadditivity of the cost function.

Natural monopoly gives rise to a potential conflict between cost efficiency and

competition, with an increased number of competitors leading to some loss of scale

efficiencies. The typically quoted examples of natural monopoly are utilities (electricity,

telecommunication, water, gas, and oil), transport (railways), with natural monopoly

elements being centred on networks (Yarrow 1994).

An electric company is a classic example of a natural monopoly, where

competition may lead to an inefficient market outcome. Once the huge fixed cost


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involved with power generation and power lines are paid, each additional unit of

electricity costs very little. Having two electric companies split electricity production,

each with its own power source and power lines, would lead to a near doubling of price,

because of low marginal costs, high sunk costs and declining average costs. Natural

monopoly thus poses the difficult dilemma of how to organize these industries so as to

gain the advantages of production by a single firm, while minimizing all the vicesresulting from non-competitive markets

1.

Traditionally, countries around the world, assuming the inevitability of

monopolization, either regulated private enterprises or nationalized natural monopolies in

order to deal with this dilemma. A natural monopoly situation usually arises when there

are large fixed costs and small marginal costs. The existence of a natural monopoly gives

rise to the following problem: Allowing a natural monopolist to set the monopoly price is

undesirable due to the Pareto inefficiency, and forcing the natural monopoly to sell at the

efficient price (i.e., marginal cost based price) is infeasible due to negative profits. The

solution to this problem was then to let the government operate the service, for example,

at price equal to marginal cost and to provide a lump-sum subsidy to keep the firm inoperation. This practice rests on the assumption that the imposition of public interest

prices and standards may be achieved more effectively by the flexible decision-making

inherent in the public ownership frameworkconsiderable internal discretion, subject

only to political accountabilitythan by legal controls of private firms (Ogus 1994, pp.

267-68). Otherwise, regulation of private monopolists has usually involved some form of

price regulation and/or entry and quality regulation.

2. Why to regulate a natural monopoly:

These regulatory practices were theoretically underpinned by the market failure

argument, which provided the central economic argument for state intervention in

industries with natural monopoly characteristics. Alongside other conditions such aspublic goods, positive and negative externalities, incomplete markets and imperfect or

asymmetric information, natural monopoly is an important market failure situation (under

which a market economy fails to allocate resources efficiently) that warrants regulation

and nationalization. In fact, it is argued that the most serious market failure problems are

likely to occur in network industries with natural monopoly characteristics. According to

Yarrow (1994), this is because natural monopoly is combined with high-entry barriers.

These industries are typically capital-intensive and require significant investments in

long-lived, sunk capital facilities. Most assets are specific and durable, giving rise to

high-entry barriers via extensive sunk costs. At the same time, the economies of scale in

some industries such as water distribution or electricity are so great that the largest firm

with the lowest costs could drive all other competitors out of the market.

1 These vices range from deadweight welfare loss due to allocative inefficiency, productive inefficiency (or

inefficiency)due to lack of competitive pressures, increased possibility of collusion among firms, increased

possibility of predatory pricing or pre-emptive investments and other wasteful behaviour to increased

possibility of exploitation of consumers and of input suppliers by the dominant firms (Chang 1997, pp. 707-708).


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It is important to note that regulation of natural monopolies also occurs for reasons

other than market failure (generally considered a static efficiency problem). In fact, many

real life regulations have been motivated by the concern for dynamic efficiency,

distributional considerations and other considerations, including even moral

considerationssuch as fairness.

In particular for developing countries, dynamic efficiency (or in other words,developmental) objectives such as growth are often more important than static efficiency.

The most important dynamic efficiency consideration is, as Bradburd (1992) points out,

whether an unregulated private monopoly will make the investments necessary to offer

the quality of service appropriate to the countrys changing needs over time. Natural

monopolies servicesare an important part of a nations infrastructure, and if they are sub

optimally provided, this can be an impediment to growth. Thus, the new regulatory

reform should give adequate attention to considerations of dynamic efficiency. Some

countries conduct their deregulation-based reform purely in terms of static efficiency, and

the impacts of regulatory reform on productivity and growth are not duly considered

when reforming the existing monopoly regulation policy. This is a highly inadequateapproach, as Chang (1997) points out, as higher static efficiency will not necessarily lead

to higher dynamic efficiency. In addition, removing distortions in more, but not all,

markets does not necessarily improve even the static efficiency of the economy.

Schumpeter (1987) argued that monopoly rents provide the incentive to innovate and, in

the modern age of large-scale R&D, the resources to innovate. If this is true, there may

even be trade-off between static and dynamic efficiencies. If the regulatory reform

involves reductions in market power and the associated monopoly rents (e.g., by

intensifying anti-trust regulation), the rate of innovation and productivity growth may be

adversely affected.

Regulation practice is driven not only by normative considerations of reducing andcontrolling rent-seeking behaviour. The positive theory of regulation, based on public

choice theory, treats the existence and forms of regulation as responses to the demands of

politicians and other interest groups. In summary, the traditional rationales and a wide

range of (non-static efficiency) issues that traditionally belong to the realm of natural

monopoly regulation policy may still remain valid and require adequate attention when

reforming the existing regulatory regimes. While reforms may be necessary to make

services more efficient and economical, the usual public service raison dtre of many

natural monopoly industries also remains essential. Particularly in the developing world

context, it is important to keep in mind that the ultimate objective of these industries is

sufficient and sustainable provision of their services.

3. The need for a regulatory framework for a public utility:It may be asked, what is the need to have exclusive regulatory agencies for public

utilities? What is so special about these utilities that they cannot be regulated in the

normal manner like other departments of the state? It is submitted that PublicUtilities

are indeed very different from other sectors providing services to people at large. These

utilities, be it a gas or electric company, operate in an environment of monopoly. As a

matter of fact it is almost impossible to create competition, for example having more than


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NEPRA is a quasi-judicial body and all decisions are taken by theAuthority collectively and the decisions are taken by the majority of

Authority Members present.OGRA

Oil and Gas Regulatory Authority (OGRA) was established by the Federal

Government on 28th March, 2002 in pursuance of the Oil & Gas Regulatory AuthorityOrdinance, 2002. The NGRA Ordinance, 2000 stood repealed on the commencement of

OGRA Ordinance and all properties, assets and liabilities pertaining to NGRA were

transferred to OGRA. The Chairman and Members, employees, experts, consultants and

advisors appointed pursuant to NGRA Ordinance were deemed to have been appointed

under the OGRA Ordinance. Similarly all agreements, orders, determinations, rules and

regulations made by NGRA were let to be in force under the OGRA Ordinance. OGRA is

required to meet all its expenses through fees and charges collected from the licensees in

pursuance of the OGRA Ordinance.

An amendment to the OGRA Ordinance was promulgated on 8th November 2002

with a view to clarifying that upstream petroleum activities shall not be governed byOGRA. These activities shall continue to be regulated by the Ministry of Petroleum &

Natural Resources. The petroleum producers can now lay the pipelines connecting the

petroleum field to point of delivery without obtaining a licence from the OGRA provided

that delivery of petroleum is made to a purchaser other than a retail consumer for natural

gas or retail consumer for oil. However, if a producer claims transportation or

transmission tariff then the provisions of OGRA Ordinance shall apply.

Presently OGRA has been organized into six Departments namely Gas, Oil,

Finance, Legal, Administration and Registrars Office. OGRA has been initially

organized with major thrust on natural gas since provisions relating to Oil, CNG and LPG

related activities have not yet come into force. The process of activating the relevantprovisions in respect of Oil, CNG, and LPG is underway.

Regulated Activities

Under the Ordinance a licence is required for undertaking any of the regulated

activities, namely:

a) Construction or operation of natural gas pipelines, storage facilities and otherinstallations;

b) Transmission, distribution and sale of natural gas;c) Construction or operation of oil refinery, oil pipelines, storage facilities, blending

facilities and oil related installations;

d) Marketing and storage of refined oil products;e) Construction or operation of pipelines, processing facilities, storage facilities and

installations relating to LPG; and

f) Production, filling, marketing and distribution of LPG and CNG.Key Powers And Functions

The OGRA Ordinance has entrusted the Authority with the following key powers and

functions:

a) Exclusive power to grant, amend or revoke licences for regulated activities.


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b) Promote competition and efficiency.c) Develop and enforce performance & service standards.d) Determine in consultation with Federal Government and Licensees a reasonable

rate of return for natural gas licensees.

e) Prescribe procedures and standards for investment programmes of the gas utilitiesand oversee their capital expenditure to ensure prudence.

f) Determine annually the revenue requirements of gas utilities on the basis ofprescribed rate of return taking into account the cost of gas, prudent capital

investment & O & M cost and depreciation.

g) Determine and notify wellhead gas prices in accordance with ProducersAgreements with the Government.

h) Enforce compliance of licence conditions and ensure efficient practices in theregulated oil and gas sector.

i) Resolution of complaints and disputes between a person and a licensee or betweenlicensees relating to regulated activities.

j) Enforce standards and specifications for petroleum products.Implement the policy guidelines of the Federal Government, not inconsistent with theprovisions of the Ordinance.

5. Major Issues and InefficienciesLack of generation capacity, Circular debt, and increasing constraints in

Transmission and Distribution systems are the main issues.

Availability and Efficiency of Existing Power Plants

Pakistan has not only failed to make substantial additions in the generation

capacity but it also could not use the existing power plants to their full potential. The

problem could be linked to the failure of adding new power generation capacity. In order

to avoid power cuts and load shedding, the existing power plants operate round the clockresulting in the essential maintenance schedules being overlooked, specifically for power

plants in the public sector. Such a practice which has been continuing over the years has a

telling effect on the operational performance of the existing power plants and their

capability to supply power to the grid. Their efficiency and availability have reached

alarmingly low levels; resulting in frequent breakdowns. The overall requirement of fuel

has increased to produce the same amount of energy and the plants operated at their

required design efficiencies. This issue needs the urgent attention of the concerned

Authorities.

Circular Debt

In Pakistan, the power sector has effectively become hostage to Circular Debt

which is created when the power generation companies fail to clear their dues to the fuel

suppliers. The fuel suppliers in turn default on their payment commitments towards

refineries and international fuel suppliers. Inefficiency in collection of revenues from the

private sector, non-payment of dues by the public sector including the provincial

governments and in-effective contractual arrangements between the Pakistan Electric

Power Company (PEPCO) and the Karachi Electric Supply Company (KESC) are the

major causes for inter-corporate debt. According to the Ministry of Finance the position


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of net circular debt as on June 30, 2009 was Rs. 216 billion which in April 2010 stood at

Rs.115 billion due to the support of the Federal Government in the form of subsidy. The

factors responsible for the circular debt in the power sector include:

The inability of the DISCOs to pass on the cost of electricity to consumers.The cost of providing electricity to consumers could not be fully recovered

as no real increase in tariff was notified by the Federal Government from2004-05 to 2006-07. The tariffs allowed by the GoP were inadequate to

cover the average costs of the companies, therefore the companies started to

incur losses which continued to build up to unmanageable limits.

Affordability of consumers has always remained a key consideration beforethe Federal Government in notifying any change in the consumer-end tariff.

Sociopolitical pressures prevent the government to pass-on the cost of

power to the consumers. After the year 2007 the NEPRA determined tariffs

were not passed on to the consumers, as the Federal

Government notified lower tariffs with the gap reaching Rs.3.43/kWh on

January 1, 2010. The policy affected negatively on the financial viability ofthe companies.

Externalities like global economic meltdown and extraordinary high oilprices further compounded the circular debt issue. In order to pass-on the

fuel price variation NEPRA provided adjustments on a six-monthly basis.

However the oil prices fluctuated so rapidly that the six monthly

adjustments could not support DISCOs in their day-to-day operations. As a

result DISCOs had to resort to bank borrowing which became tougher

under the liquidity position of the financial institutions who considered that

their exposure to the power sector had already reached an unsustainable

level.


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Final Word

Besides having inferior operational performance, almost all the EXWAPDA

Distribution Companies (DISCOs) are not aware about their role and the need of good

governance as a corporate entity. The DISCOs, even the loss- making ones, are not

reducing their operation and maintenance costs. Their mindset is still that of a publicsector entity without due regard to their rights and obligations. Their power purchase

contracts are not in place and defaults and delays are routine.

As a result of various problems faced by the power sector as outlined in the fore

going paras, the country has been facing acute power shortages manifested in long hours

(ranging from 4 to 12 hours) of load-shedding in both urban and rural areas. The power

shortages have resulted in power riots in various cities in the country and the civil society

and media has also been raising hue and cry because of the problems faced not only by

the common man but the adverse impact of these power shortages on the industry,

agriculture and all other sectors of the economy.

The government has taken a number of steps to face the situation. Among others,an Energy Summit chaired by the Prime Minister of Pakistan and attended by all the

Chief Ministers of the Provinces decided to immediately initiate a number of energy

conservation measures including two days weekly holidays, setting the time for closure

of markets, encouraging energy saver bulbs etc. On supplementing the generation

capacity, the Ministry for Water and Power and various other government entities have

been working to bring on board various on-going Independent Power Producers (IPPs).

Likewise, to bridge the yawning gap between power supply and demand, rental projects

have also been initiated to supplement the generation capacity in a short period. The

actual contribution of these rental power plants in terms of adding generation capacity

has not yet been felt so far as only 120 MW additional generation capacity has beenadded through the rental power plants. The provincial governments, particularly Punjab

and Khyber Pakhtunkhwa, have also issued power policies and have taken various

measures to conserve energy. They have been working hard to increase the generation

capacity. The Sindh government is also working on expediting the Thar Coal power

project which once implemented would supplement, in a major way, the power

generation capacity in the country.


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Essential Readings:

Annual Report 2009-10 National Electric Power Regulatory Authority Annual Report 2009-08 Oil & Gas Regulatory Authority NEPRA Act 1997 Oil and Gas Regulatory Authority Ordinance 2002 Regulation of Natural Monopoly Ben W.F. Depoorter, 1999.

Researcher Center for Advanced Studies in Law and Economics University

of Ghent, Faculty of Law

On The Origins Of The Concept Of Natural Monopoly Manuela Mosca,2006. University of Salento, Dipartimento di Scienze Economiche eMatematico Statistiche, Ecotekne, Via per Monteroni, 73100 Lecce (Italy).

The reading materials are available on LAN, for assistance please contact ITpersonnel.

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Tutorial Discussion on Nepra