What is the Circular Debt?

Power sector dues have crossed $13 billion and no sustainable solution is on the horizon.

Nov 16, 2020

According to disclosures made by the National Electric Power Regulatory Authority (NEPRA), circular debt in Pakistan’s power sector crossed Rs. 2,100 billion by June 2020. The inability of distribution companies — DISCOs — to recover payments from power consumers is a significant part of the problem:

Combined recovery of all DISCOs in financial year 2019-20 stood at 88.77pc of total bills as compared to 90.25pc in FY19, a decrease of 1.48pc year-on-year (YoY).
Receivables from public and private consumers as well as delayed payment of subsidies were causing an increase in the circular debt.

But the issue is far more complex than that and I spent this past weekend reading a fantastic working paper authored by Dr. Afia Malik and published by the Pakistan Institute of Development Economics (PIDE).

The entirety of the paper is a must-read for anyone interested in understanding all that ails Pakistan’s power sector. Before jumping into what stood out to me, here is a definition of circular debt from Dr. Malik:

“Circular debt” is a shortfall of payments at the Central Power Purchasing Agency (CPPA). CPPA does not receive the outstanding payment from power distribution companies (DISCOs) due to shortfall in receivables by the state-owned distribution companies (DISCOS) and privatised K-Electric (K-El). Thus, CPPA does not make payments to other power companies in the supply chain, that is, state-owned generation companies (GENCOs), Independent Power Producers (IPPs) and National Transmission and Dispatch Company (NTDC). GENCOs fail to clear their dues to fuel suppliers. Similarly, IPPs, due to delay in payment from the government could not make payment to the fuel suppliers. The fuel suppliers, in turn, default on their payment towards refineries and international fuel suppliers.

The most shocking part of the paper?

Since 2007, Rs.5.7 trillion — ~USD 35 billion at current exchange rates — have been pumped into the sector as equity adjustments and subsidies.

The failure to reform this sector means that Pakistan is using scarce resources to prop up a power sector and losing out on the opportunity to invest in human development.

What is the impact of all of this?

In FY2020, electricity subsidies account for almost 8 percent of net revenue. In comparison, education is hardly 2.6 percent.

The state of affairs is such that Pakistan, a country lagging countries like Rwanda in terms of youth education metrics, is spending more in terms of providing power subsidies than education.

Let that sink in.

The path to reform has been a long, drawn-out one. Essentially, the process began in 1992 and continues to this day. Yes, 28 years later, Pakistan’s policymakers are still on the long journey towards reforming this sector.

The impact of this failure is not just in terms of an opportunity cost.

The growing burden of the state’s inability to reform and make everyone pay for the power they consume is borne by compliant customers, including small and medium businesses. The result is that with every IMF program and upwards revision in power tariffs, new surchages and fees are added to fleece you, the compliant consumers.

Meanwhile, the party continues for those who do not pay up.

One way to measure these losses is by looking at the distribution losses across the various DISCOs in Pakistan. Here’s what Dr. Malik has to say about DISCOs and their performance:

Except for IESCO, LESCO, GEPCO, and FESCO; the rest of them have extremely high losses. IESCO, GEPCO and FESCO have had low rates for the whole period (2006 to 2019) and closed to the target set by NEPRA. However, the rest of DISCOs, especially, PESCO, HESCO, SEPCO and QESCO have shown no significant improvement, thus adding to the circular debt (Fig. 16). The accumulated impact of these losses, after the clearance of debt in 2013, was about Rs 241billion (FY2014 to FY2019).

And what causes these losses?

Corruption and negligence by DISCO officials.

Which means that without serious reforms at the DISCO level, recoveries will not improve, leading to continued increase in the amount paid by compliant customers across Pakistan.

To resolve all of the various issues inflicting this sector, Dr. Malik recommends the following:

An integrated and long-term approach to planning for Pakistan’s power needs
Growth in renewable and hydro power generation to reduce generation costs and reduce mix of imported fuels
Renegotiation of generation contracts with power producers
Elimination of tariff differential subsidy and allowing each distribution area to have its own tariffs
Re-evaluation of subsidies and surcharges and a shift towards fair pricing
Investment in T&D infrastructure and a serious crackdown against defaulters
Improved corporate governance at the DISCO level
Investments in energy conservation and efficiency

Finally, if you have been a frequent reader of this newsletter, you have probably noticed a theme about how complex state regulations leads to rent-seeking and capture, leading to sub-optimal economic outcomes both for citizens and the broader economy.

The same is true in the power sector and eventually Pakistan needs a competitive power sector, one that is governed by economics, not a complex web of regulations, subsidies, and surchages.

But given that the status quo does not really hurt those at the top, is there any incentive to reform?