Electricity at the Right Price
This working paper by Donald Hertzmark (DMP Resources) was commissioned for the 2012 Pacific Energy Summit on “Innovation Generation: Powering a Prosperous Asia.”
The paper presents a framework for thinking about electricity pricing in countries with state-owned utility companies. The full text is also available in Vietnamese.
EXECUTIVE SUMMARY
MAIN ARGUMENT
For many years, electricity utilities around the world used largely similar approaches to both structure and pricing. Utilities were integrated operationally and tariffs were supposed to apply to the company as a whole, not to individual segments such as generation, transmission, and distribution. Unfortunately, many countries allowed electricity prices to drift below the cost of supply, with retail prices often lower than the cost of fuel in generation alone. As demand for electricity grows, fueled in part by these low prices for power, utilities are put in a financially untenable position. They cannot afford to expand to meet new demand and, in some cases, cannot even maintain existing equipment.
Without financial soundness, utilities must rely on external financing, often in the form of supplier credits, export credit financing, or loans from international development banks. If an electricity supply company is relatively large, in terms of its share of a country’s overall economic financing, its expansion can eventually impact the financial risk rating of a country. A number of potential solutions exist. They involve bringing in private generation, unbundling of lines of business, restructuring, or even outright privatization. However, if the pricing of electricity is not sound, then none of these potential remedies can work well.
POLICY IMPLICATIONS
- The most important business of the electricity tariff is to cover costs of supply, including new generation and network investments. This is the prime directive of electricity pricing. Without cost coverage, there is no amount of clever restructuring, unbundling, or packaged “models” that can work for more than a short time.
- Once cost coverage is achieved, then further complexity can be added to the pricing system, such as where and when to use or supply electricity.
- There is no one correct way to structure the electricity sector; a number of different structures have been able to work as long as the pricing of electricity is reasonably accurate. However, the structure that is adopted must be consistent with the country’s commercial and banking capabilities. The ability to regulate the monopolistic aspects of the industry must evolve as well, keeping pace with changes in structure and industry capabilities.
Donald Hertzmark is an international energy and economic consultant, with more than 30 years of experience worldwide in more than 90 countries.
