Unbundling SEBs

The reform strategy on which the Act is based raises several questions and may, in fact, seriously undermine the intended reforms themselves. It is necessary to bear in mind that there is a strong opposition to privatisation of power sector in India. Like the words ‘family planning’, which came into disrepute after the Emergency and had been replaced by the words ‘family welfare’, the word privatisation too has negative connotation in political and social parlance in India and has been replaced by words such as divestment and disinvestment. It is necessary to underline that, with all their limitations³ , the transparent, participative and open working of the state and central electricity regulatory commissions has created public awareness of the serious problems facing the SEBs and a climate in favour of reforms in the sector. Unfortunately, several provisions of the Act discussed hereafter are likely to be counter-productive in these endeavours and may lead to increasing the resistance to reforms in general and much larger involvement of private sector in particular without adequate, effective and transparent safeguards. Entry of large industrial houses such as Reliance in the sector has strengthened these misgivings.

The act is largely based on the reform strategy advocated by the World Bank. The World Bank often claims that its lending strategy is owner-driven rather than being donor-driven. But this is hardly borne out in practice. For example, the training and visit (T and V) strategy adopted by the World Bank for lending to agriculture for a number of years was thrust on India, in spite of serious reservations in the country. The advocacy by the Bank to reduce government support to higher education and for its marketisation has led to serious social tensions. Insistence on eliminating agricultural power subsidies in India, in spite of large agricultural subsidies being given in US and a number of other developed countries, is increasingly difficult to comprehend. The flat rate tariff for agriculture propagated by the World Bank in the mid-1970s was similarly misconceived and India is paying the heavy price for it for over three decades. Same is true of the several strands of the new power policy advocated by the World Bank for (what it itself describes as) its ‘client countries’. Unfortunately, the precept of accountability which the Bank preaches so assiduously to its client countries is hardly ever considered relevant in its own work.

The most important element of the reform strategy contained in the Act is of unbundling of SEBs. A great deal can be said in favour of selective approach to unbundling rather than this being advocated as a mantra, as the Act seems to do. The experience, world over, is not uniform in this regard. In USA itself, reportedly there are about 200 vertically integrated privately owned power utilities. There are also countries in which vertically integrated PSUs are functioning successfully. Further, the Act itself says that distribution licensees would be free to undertake generation and generating companies would be free to take up distribution business. As a result, Reliance, for example, have already announced their plans to integrate their operations from gas fields to common consumer of electricity. Tatas too have announced plans to expand their generation capacity as also to take up new distribution responsibilities. How can there be separate dispensations for the private sector and SEBs? This is nothing but denying a level playing field to SEBs with a vengeance.

At this critical stage of reforms, it would be counter-productive to create a public perception that the sector is to be left at the mercy of the private sector. But this is precisely what is going to happen with the recent advocacy by the World Bank of ‘regulation by contract’ to promote larger private sector investment in electricity distribution.⁴ In brief, the discussion paper of the World Bank asserts that the key lesson of the last 10 years is that regulatory independence, by itself, creates neither regulatory commitment nor balanced decision-making. Regulatory independence must be combined with a clearly specified regulatory contract that must be negotiated by political authorities. Such a regulatory contract would substantially limit the regulator’s discretion. The idea is to limit the discretion of the regulator in areas that are known to deter investment. The key component of the regulatory contract is a performance-based, multi-year tariff-setting system. It is argued that the concept of independence does not logically require that a regulatory commission design the tariff system that it implements. The paper suggests that, insofar as India is concerned, it would be better to, inter alia, (i) transfer tariff-setting authority back to the government on a one-time basis for the initial post-privatisation period, (ii) incorporate the tariff-setting formula directly into the privatisation agreement, and (iii) establish fairly detailed tariff principles and processes that would apply to subsequent multi-year tariff (MYT) periods. According to the perceptions of the paper, without such changes, any privatisation will take place under a cloud of legal uncertainty. It is further suggested that, in this process, risks should be shared between the private party, consumers and the state government. The paper asserts that a multi-year tariff system can be put into operation even in the absence of high quality data. The paper has a touching faith that “data quality will improve through privatisation”. This is an amazing assessment in the light of shocking corporate scandals such as of Enron and a host of others due to falsification of accounts and records and collusion by accountants.

The fact that this advocacy is not just a straw in the wind is further underlined by its serious consideration by the government of Karnataka as a part of the strategy for privatisation of distribution in that state. The distribution margin (DM) approach accepted by the state government has two components: base revenue and incentive charge. It is important to note that the base revenue is the amount of revenue that the distribution company is allowed to retain to meet its cost of operating the distribution business. The strategy is based on the acknowledgement that “because the system currently has a large cash deficit and the required information is unavailable, the current regulatory arrangements need to be modified before investors can take business and regulatory risks.”⁵ The government of Karnataka has under active consideration amendment of the state regulatory commission Act for introduction of multi-year tariff. The consultants appointed by the state government have, inter alia, recommended that of the several risks facing the investor in privatisation, only the collection risk in respect of metered consumers, theft risk limited to the starting levels of theft, risk in respect of inaccurate meters, operational management risk and capital expenditure management risk should be borne by the investor. All other risks should be borne by the state government. In its comments, the Karnataka Electricity Regulatory Commission (KERC) has observed that “these amendments seem to operationalise the concept of a regulatory holiday for a period of ten years”. KERC has advised against undertaking such amendments and has further stated that if this view does not find favour, “it [the commission] be kept in a suspended animation during this period of 10 years to avoid the completely unnecessary expenditure of around Rs 2 crore per annum on its maintenance and upkeep”.

Regulatory Contracts

The above regulatory contract approach is fraught with serious consequences and should not be accepted as blindly and mindlessly as similar other prescriptions in the past. What may be acceptable in and suited to Latin American or East European countries may not either be acceptable or relevant in India. Each country must look at its own ethos, past experience, institutional and legal framework and other relevant parameters before following the advice of international aid agencies. This is the least that we can do, at least now, with the comfortable foreign exchange reserves position. But, this will call for an altogether new mindset than in the past. At the outset it must be noted that the regulatory contract will have all the characteristics of the series of highly controversial power purchase agreements (PPAs), such as in respect of Enron, entered into by the state governments for generation projects, by adoption of MOU route, after the onset of reforms in this sector. These had totally undermined the credibility of the government both at the centre and the states. It was on this background that there was wide reception of the idea of approval of all investments in the sector by regulatory commissions in an open, transparent and participatory manner. Going back on this progressive step will be grossly inadvisable. Second, it needs to be noted that approval of a contract at the political level is more prone to risks of it being disowned, cancelled or abrogated than if a contract has been approved by a statutory authority such as CERC/SERC in an open and transparent manner with a ‘speaking order’. Third, the Act provides for arbitration (section 158). Appeal over the decisions of the CERC/SERC lies to the national appellate tribunal presided over by a judge of the Supreme Court. There is also a further appeal provided to the Supreme Court. By any international and other well recognised standards, these are enough safeguards against any regulatory excesses. Fourth, the words ‘regulatory risk’ connote a contradiction in terms. In fact, there is more risk of arbitrary and unpredictable decisions on contractual matters at the political level than by statutory bodies such as regulatory commissions. Why should private investors not be prepared to face such so-called risks when they are assured of fair and open hearing and judicial process? Fifth, in all matters involving pricing of power, decisions inevitably get politicised and lead to controversies. Acceptance of such decisions becomes less painful and simpler if the consumer representatives have an opportunity to look at all relevant data and place their point of view before the regulator. They must also be convinced that strict standards will be laid down for monitoring the performance of the utility and that its inefficiencies will not be passed on to them automatically by way of increase in tariff. This is all the more important in a situation such as in India where the existing tariffs for certain politically sensitive groups are low and will need to be stepped up in practically each of the years in the near future. Sixth, the concept of automatic pass-through of certain costs such as power purchases can be open to serious question. This will be particularly true in the case of vertically integrated utilities or where there are cross-holdings in relevant companies. Seventh, MYT-setting should be an important objective but it cannot be put into practice immediately. The present data base in SEBs is so weak and unreliable that any projections based on it are bound to be way-off the mark. This is brought out in the reports of SERCs year after year. It is necessary to underline that even with much more reliable data, the projections, for a five-year period, made quinquennially by state governments and the centre for submission to the central finance commission in respect of their revenues and expenditures are found to be far from realistic. The same is true also of the projections made by the finance commissions themselves on which their recommendations for vertical and horizontal devolution of central resources to the states are based. On this background and experience, there are bound to be severe limitations to MYT-setting. With the present state of highly unreliable data, such MYT-setting may give rise to and incentivise manipulation of data and creative accounting by utilities. Eighth, currently the consumer representatives are ill-equipped to go into the complex facets of MYT-setting. As far as one can see, the approach suggested by the World Bank does not envisage consumer bodies participating in this exercise at all. But, even if they were to be given such a right, it is doubtful how far they will be able to do justice to it. It will therefore be necessary to strengthen the NGOs by training their personnel, enabling them to have their own panel of independent experts etc. before MYT-setting is taken up seriously. Ninth, much is being made of the risks which have to be faced by the private sector in taking up power distribution business. Private utilities cannot be permitted to blame others if they fail to do their homework before taking investment decisions. It is for them to take steps to satisfy themselves about the validity and authenticity of the data put out by government in the tender notices. They must also make a realistic assessment of their own capabilities in setting and achieving targets such as for reduction in aggregate technical and commercial losses, testing of meters, energy audit, recovery of arrears, etc. Assured rate of return on capital, coverage of foreign exchange and other risks by the state government and government transmission utility, and providing for distribution margin as a first charge on revenue make a mockery of the very justification underlying privatisation. Tenth, the whole purpose of privatisation is to bring in the risk capital, management expertise and business acumen. The regulatory contract approach seems to be based on the assumption that private sector lacks these attributes. If this is to be so, it can hardly be trusted to create conditions for and confidence among investors for infusion of fresh capital in the business, thereby defeating yet another objective of privatisation Eleventh, one other justification for privatisation is to reduce the burden of subsidies on the state exchequer in an open and transparent manner. This purpose too is likely to be frustrated by the regulatory contract approach as risks which are to be borne by the state government will not explicitly come up for public scrutiny, either initially or during the transition period. It may also not be clear as to how long such subsidisation by the state government may have to be continued as there will be a tendency on the part of utilities to pressurise the state government to continue the regime of sharing of risks. This is all the more so since such decisions are to be made by political authorities. Finally, a question may be asked whether such a regulatory contract can be entered into under the provisions of the new Act as it would water down the authority of the SERC substantially and may even make it superfluous. A reference may be made in this context to the provisions of Article 254 (2) of the Constitution of India. It states that, “Where a law made by the legislature of a State with respect to one of the matters enumerated in the Concurrent List contains any provision repugnant to the provisions of an earlier law made by parliament or an existing law with respect to that matter, then the law so made by the legislature of such state shall, if it has been reserved for the consideration of the president and has received his assent, prevail in the state.” Thus, all that would be required is for the government of Karnataka to obtain prior approval of the president before undertaking such a legislation. Looking to the leverage of the World Bank, it would be surprising if the centre refuses such a request. In fact, it would not be surprising if this new approach is incorporated in the central Act.

The Act is a half-way house on the road to reforms in more ways than one. It professes that its basic premise is that SEBs should not be continued in their present form. The transitional provision in section 172 (a) states that a SEB constituted under the repealed laws shall be deemed to be the state transmission utility and a licensee under the provisions of the Act for a period of one year from the appointed date or such earlier date as the state government may notify and function accordingly. However, importantly, its proviso states that the state government may, by notification, authorise the SEB to continue to function as the state transmission utility or a licensee for such further period beyond the said period of one year as may be mutually decided by the central government and the state government. The same position emerges from section 131 dealing with vesting of property of SEB in state government. It, inter alia, states that, “with effect from the date on which a transfer scheme, prepared by the state government to give effect to the objects and purposes of this Act, is published or such further date as may be stipulated by the state government …” This shows that no final date has been set for the abolition of SEBs and this decision has been left to the state governments. Looking to the likely compulsions of centre-state relations in the medium term, it is unlikely that the centre will ever be able to turn down proposals for the continuance of SEBs as the licensees under the Act.⁶ In such a scenario, though the SEBs will cease to exist, their place will be taken up by separate and several government companies formed for generation, transmission and distribution. This insistence of the Act on unbundling at any cost is difficult to understand as it is unlikely that private sector will have the capacity to take over the whole electricity business from SEBs even during the next two decades. As the recent experience of most reforming states has shown, creation of government companies alone does not lead to any noticeable improvement in their performance and, in fact, leads to increase in the tariff for the consumer by adding to overhead costs at each stage.