Why does Pakistan fail to overcome the vicious cycle of circular debt?

The story of Pakistan’s power sector has been a tale of institutional weaknesses, weak governance and a lack of financial sustainability. The result has been decades of power outages and expensive electricity thanks to the incompetent corporate governance and implausible financial management in country’s power companies. This has led to a chronic shortfall between inflows and outflows, which are commonly known as circular debt. 

Basically, 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 (KE). Because of this, the CPPA does not make payments to other power companies in the supply chain. These include state-owned generation companies (GENCOs), Independent Power Producers (IPPs), and the National Transmission and Dispatch Company (NTDC). 

This leads to GENCOs failing to clear their dues to fuel suppliers, and similarly IPPs are also unable to make payments to their fuel suppliers because of the government delaying their payments. This is followed by the fuel suppliers defaulting on their payment towards refineries and international fuel suppliers. As a consequence, most of the thermal plants are forced to operate at a very low ‘capacity factor’.

For the last many years, Pakistan’s circular debt has been on the rise. It is a vicious cycle of unpaid bills in the power sector, starting from the power generation end of the process, and going all the way to the distribution process to recovery and electricity theft. Eventually, however, the bulk of the burden cuts around the fuel supply companies and ultimately ends up at the doorsteps of consumers in the form of expensive electricity. Since energy prices are not stable, neither is circular debt, and the cost of power generation and of doing business is erratic, despite government efforts to curtail losses by checking power theft as well as recovering unpaid bills.

 Rising circular debt 

The Federal government on January 7 confirmed that the power sector’s circular debt went past Rs2.306 trillion as of Nov 30, 2020, up by Rs156 billion over the first five months of the current fiscal year, at a rate of Rs31.2bn per month. During a meeting of the Cabinet Committee on Energy (CCoE) presided over by Planning and Development Minister, Asad Umar, one solution tabled to this problem was a new, meterless, smart metering system that has been successfully tested and proven on the ground but was not adopted by power distribution companies.

The meeting was also told that a bulk share of the increase in circular debt was poor governance in the public sector itself. During the meeting, it was also revealed that the Rs156bn increase in circular debt included the non-payment of budgeted and unbudgeted subsidy, delayed payments on account of interest to independent power producers (IPPs), other mark-ups, pending price adjustment on account of quarterly and monthly adjustments and non-payments by K-Electric.

The information technology ministry also complained in the meeting about the fact that it had been repeatedly asking the Power Division since November 2018 to adopt Electrocure, the meterless smart metering system developed by a government company called Ignite that was mentioned earlier. Ignite claims that the new meters will help in reducing chronic issue of line losses, power supply, and identifying electricity theft.

Speaking to Profit, former Federal Minister for Finance during the PML-N’s tenure, Miftah Ismail, said that what is even more alarming than this unprecedented level of circular debt, now equal to 6% of GDP, is the monthly increase in circular debt. “We are now adding about Rs 70 billion to this every month. This is devastating not just for the energy sector, but for the fiscal sector as well,” he said. “The PTI has increased Transmission and Distribution losses, reduced bill collection and violated NEPRA’s merit order. If you run power plants on diesel and not on gas, this is bound to happen.” 

Opinions from other stakeholders and economists are not particularly hopeful either. Sakib Sherani, a former member of the prime minister’s economic advisory council, tells Profit that the sharp increase in circular debt since 2018 can be explained by a few main factors. “There has been a 35% increase in installed capacity since the beginning of 2018, coupled with a nearly 10% decline in capacity utilisation, a suspension of electricity tariff adjustments since January 2020 and a deterioration of nearly 4% in recoveries.”  

Economist Dr Aima Mehdi says the power sector’s circular debt has plagued Pakistan’s economy since 2007. “This vicious cycle is fuelled by delays in cash inflows and outflows by the Central Power Purchasing Agency along with a series of other causes. Prime Minister Khan promised that he would set the country free of its Rs 1.148 trillion (June 30, 2018) debt by the end of 2020 however this figure had surged to Rs 2.306 trillion by November 2020,” she tells us. 

“The reasons why Khan could not fulfil his promises are evident in the flawed system running the energy sector of the country, yet a reflective view shows the absence of corrective measures as well. It is failure to comprehend these causes which has helped the figures to surge by approximately Rs 1 trillion. The first and the foremost issue is the delay in tariff determination to match the time periods.” 

Dr Mehdi rightly points out that since this delay in tariff settlement causes revenue issues to the suppliers, the end result will always be further addition to the debt status. The most sophisticated way to charge for electricity prices in order to keep the system is called half hourly settlement, which allows prices to be settled 48 times every day to keep prices in balance. This allows timely circulation of payments and maintains balance in payments.

Further, there are several administrative issues that need to be addressed. These issues include inefficiencies posed by DISCOs because DISCOs are not offered any incentives on a performance basis. DISCOs are given subsidies equally which poses no interest for them to improve and enhance their distribution networks. There is a chunk of consumers that remain unbilled. The metering issue has remained unsolved over the decades.

For Dr Mehdi, there is confusion between the roles of NEPRA and the Ministry of Power. NEPRA is meant to be a regulator and nothing more, but has its hands tied to the power of the Ministry. In order to get the regulator to work efficiently, it needs to be given the due authority. After doing so the regulator can be held responsible for its actions. “This is why the government should have taken the required actions to restructure NEPRA with bright minds,” she says. “Furthermore, NEPRA should be held accountable on several fronts, such as setting competitive bids for the distributors to take up networks. These distributors should submit their business plans and cost/revenue structures to NEPRA. As a regulator, NEPRA should develop a competitive environment where the consumers are safeguarded and benefitted alongside development and maintenance of the infrastructure of transmission systems.” 

Another major problem, of course, is a demand and supply mismatch. The problem is not shortage in supply but the problem is with DISCOs who hold supply due to payment issues. Therefore, by making accurate forecasts and allocating payments on time a lot of undue inefficiencies can be easily resolved. On a macro level, circular debt has sequentially multiplied due to dollar indexation. External pressures from the IMF have exacerbated our debt position. Another major challenge is to fight the  political forces that have done much harm to the development of the power sector.

How did we get here? 

The question at this point is, how exactly did Pakistan get here? What was the point where the circular debt problem came to life? According to Professor Dr Qais Aslam, who teaches economics at University of Central Punjab (UCP) in Lahore, the issue is one of bad deals with IPPs that have not been made any better, and can be traced back to the second government of the late Benazir Bhutto, which made a deal with the IPPs that was very expensive per unit for consumers. 

“The Musharraf regime then made it worse by not allowing the public sector to produce cost effective hydro electricity, therefore creating a demand and supply gap that further made electricity expensive and scarce,” Dr Qais added. “After that, the Zardari government allowed electricity to be produced in the private sector with second hand machines that had completed their economic life and depended on foreign oil and gas. Whereas, the PML-N government of Nawaz Sharif in order to solve the energy crisis also depended on IPPs, producing from oil, gas and coal with inefficient and old technology.”

After all of these mistakes piling up, the PTI government has only added on to them in their own fashion. “The line losses from electricity proliferation and stealing are great. 70 percent of electricity is stolen by the government itself and 25 percent by businesses of parliamentarians,” he alleged. “Unless the government adopts new state of the art technologies which are cost effective and eco friendly to reduce the per-unit tariffs, the problem of circular debt cannot be solved.” 

Meanwhile, Special Assistant to Prime Minister (SAPM) on Petroleum, Nadeem Babar, during a webinar in August last year observed that historically, the power sector has operated as a controlled monopoly by the state. Private power generators were only introduced 20 years ago. Tariffs are determined entirely by the state without allowing open market competitiveness. The basis of tariff is cost plus, because of which efficiency in generation takes a back seat. The government provides subsidies in order to meet the gap between revenue and cost. It is a blanket subsidy without having a focused target.

“About 43% of Pakistan’s power generation relies upon imported fuels. As the exchange rate fluctuates, the cost of imports rises further contributing to increasing the costs of power generation. There are substantial losses due to leakage, non-recovery and theft,” he told the webinar. “Energy production has not risen in the last several years, despite growing demand. Furthermore, gas production is declining at a rate of 9.5% annually. The supply side needs to grow to meet the rising demands of an increasing population.” 

The special assistant recommended that the power sector should be opened up, and the government monopoly should be broken. Regulatory reforms should be instituted to create an open trading environment for electricity. Market forces of demand and supply should be allowed to regulate the prices, and instill competitiveness and efficiency within the sector. “The government plans to bring about changes to the fuel mix. Domestic sources of energy will be developed, using Thar coal and hydroelectric power plants. By 2025 the government plans to use 60-75% of domestic inputs to generate power,” he said. 

He also recommended that old defunct plants be shut down, and the existing oil refineries be upgraded. To address the growing problem of air pollution, the government will be improving the quality of fuel being imported. Pakistan has been importing high sulphur fuels up until now. From September 1st 2020, all petrol imports will have to comply with Euro Standard 5, which is a low-sulphur fuel that reduces emissions.

Government agreements with IPPs

The Committee for negotiations with IPPs, notified by the Government of Pakistan in June 2020 and the IPPs representing the 2002 Power Policy projects, had several rounds of discussions and they have agreed to alter their existing contractual arrangements and signed MoU’s in August 2020 with the government. Following this, solar based IPPs had signed MoU’s in August 2020 and had reached an agreement with the government negotiating team for signing amended agreement to slash power tariffs. On January 10, 2021, the solar energy-based independent power producers (IPPs), bagasse-based IPPs also agreed to sign amended power purchase agreements with the government.

The signing of the amended purchase agreements will slash the existing tariffs to a considerable extent. According to details, eight bagasse-based IPPs will sign an amended deal of power tariff with the government, whereas both sides will sign the amended agreement after endorsement from the federal cabinet. “The new power agreement will also require approval from the governing boards of the bagasse-based IPPs,” sources had earlier told Profit.

Presently, the government’s negotiating team is in talks with IPPs over their dues payment mechanism and signing the amended PPAs.   Prime Minister Imran Khan in a tweet on August 14, 2020 had stated that the government is fixing the damaging structure in the Power sector that his PTI government inherited. “After long negotiations we have signed new agreements with Independent Private Power Producers (IPPs) which will bring down the cost of power generation and reduce circular debt. Next reform target is the power distribution system,” the PM tweeted.

Federal Minister for Power, Omar Ayub Khan, during a press conference on August 17, 2020 stated that the federal government is leaving no stone unturned through its new agreement with the IPPs, and was working towards mitigating the cost of electricity in the country. He had said that the reforms pertaining to the power sector would be initiated within the next three weeks.  

The power minister put the blame of the energy crisis on the previous governments. He added the previous governments during their tenures had not done the sufficient level of work to boost the energy sector. While commenting on the new agreement with the Independent Power Producers (IPPs), Khan stated that the agreement will help in mitigating the burden of circular debt and will also promote the industries. “The new agreement with IPPs will help the federal government in providing cheaper electricity to the end consumers. The government is interested in providing cheap electricity to the agriculture sector and small businesses,” he said.

The narrative that the mess is solely because of previous governments is one that is the official government line and can be found coming out of the mouths of almost all government ministers. During a press conference on August 15, 2020, Minister for information and Broadcasting, Shibli Faraz, said that the new agreement with IPPs would help the government in purchasing cheap electricity from the private power producers and providing it to end consumers at lower rates.Faraz had said that the initial or basic agreement has been signed with independent power producers which is the major step towards providing cheap electricity to the masses (consumers).

“The previous governments had failed to negotiate properly with the IPPs that led to expensive power contracts being signed and it was not possible to get rid of such contracts unilaterally,” he said. “The prime minister wanted to take up the issue of expensive electricity on war footings due to which a team was constituted which negotiated with the IPPs to revisit the former contracts. As per the new agreement signed with the IPPs, payments will only be made against the electricity acquired and consumed instead of the total installed capacity of a particular power plant. From now onwards, the return on equity will be paid in Pakistani rupee rather than the US dollar.” 

During the same press conference, SAPM on Power Division Shahzad Qasim had said that one of the key milestones achieved in the newly signed MoU with the IPPs is fuel efficiency, and that all of the plants will be duly tested.  “The IPPs would not only have to follow the prescribed limit of the National Electric Power Regulatory Authority (NEPRA) but the savings would also have to be shared with the government that would help in reducing the cost of electricity,” Qasim had said.

Can agreements with IPPs mitigate circular debt? 

To a lot of experts, however, the agreement between the government and the IPPs is not much more than a wish list that is unlikely to bring about any material change in terms of reducing circular debt and power tariffs. One of these is Shahid Shafi Sial, an expert on the Power Sector and IPPs, and Honorary Secretary of The Institution of Electrical & Electronics Engineers Pakistan (IEEEP). Sial claims that the only good thing about the MoU is that it may put a cap to a certain extent on any further exploitation of consumers in Pakistan, and may put an end to the periodic grandstanding that every incumbent regime deems appropriate to undertake in order to hide persistent policy failures.

“The 660kV Lahore-Matiari DC transmission line, a flagship CPEC project, is expected to be operationalized by March 2021, which may prove to be another permanent source for jacking up circular debt. Since many power generation projects in the south of the country seem to have been inordinately delayed because of Covid-19, the government’s failure to evacuate power and the consequent payment of capacity charges may further aggravate the current situation.”

Although, this arrangement has to be time-bound, yet there are many a mile between the cup and the lips. Savings in terms of fuel and O&M as envisaged in the MoU are insignificant and may not alter current tariff structure. However, willingness on the part of IPPs to undertake Heat Rate tests is a significant development, and if implemented in true spirit, may bring some benefit to consumers. Clearance of all outstanding IPPs payments by the government of Pakistan prior to signing of revised contracts is a big question mark, however. 

“The turnaround of the power sector and consequent reduction in circular debt and electricity prices is directly linked with the creation of more electricity demand for industrial and commercial usages. Unfortunately, we failed on this count,” said Sial. “One more problem is that the engineers, who are the main stakeholders in this conversation, have been excluded altogether from the decision making process, which in turn precipitated this downfall of the sector.”

On the other hand, former managing director Pakistan Electric Power Company (PEPCO), Tahir Basharat Cheema, told Profit that the agreement between the IPPs and the federal government is a welcome move which would definitely decrease the cost of service for the end consumers and they would get the electricity at the cheaper rates. “But this will only be effective if different institutes of the power sector improve their efficiency and implement the agreements in true letter and spirit, otherwise it won’t work.”

Earlier, when the MoU were signed between the government and power producers, Sunny Kumar, a research analyst at Topline Securities Limited, had said the government of Pakistan and Pakistan IPPs, as per the media reports, under the 1994 and 2002 policies have reportedly reached agreements, whereby IPPs have agreed to lower their returns along with mark up on late payments for the first two months. The IPPs should also be content with these MoUs as there is unlikely to be any stern action given the accusations made in the IPPs commission report.

“The most crucial part of this agreement, in our view, is the release of outstanding receivables. This amount is estimated at Rs800-900bn, which is likely to be cleared after consultation with IPPs. Any deduction on account of previously received excess profits (from savings generated through O&M and Fuel) cannot be ruled out. As for the future the government has also decided to receive sharing from IPPs under the same head,” he wrote. 

Kumar added that their initial impression suggested that it is a good win for the government after the IPPs commission report, where the MoU shows material progress to handle the matter. The current agreements, in our view, will not lead to substantial decline in the country’s power tariff, where the key will be the negotiations on CPEC projects, where the government intends to elongate the debt tenure to make a substantial impact on tariff.

After the MoU’s signed between the government and IPPs in August 2020, Ailia Naeem, a Senior Research Analyst at AKD Securities Limited had said MoUs between the government of Pakistan and power plants operating under 1994 and 2002 power policies (PP), Pakistan power sector seems to be headed towards a more sustainable environment over the long term, a feat unachievable previously, where stand-alone short-sighted policy of cash injections remained futile in containing circular debt accumulation.

“The capacity additions of 8,600MW (60% of pre-expansion capacity) over FY17-19, compounded by steep currency devaluation, have led to inflated capacity payments to Rs900bn, and were expected to surpass Rs1bn in FY20,” she said. “However, with the recently signed MoUs, the capacity payments are likely to freeze at these levels, while accompanying Energy Sukuks may finally bring down the circular debt levels. These MoUs are valid for 6 months and shall stand terminated at the signing of the detailed agreements, the senior research analyst stated.”

The government’s plan to payback IPPs

The Imran Khan led federal government is considering to settle the outstanding dues of IPPs which stands at Rs450bn in three equal installments which seems to be the only first step headed to liquidation of the power sector’s circular debt. 

As per reports, the independent power producers will get 30pc of their total outstanding amount in this month and the remaining amount in two equal installments in June and December. According to the plan, one-third of the arrears will be paid to the power producers in cash and the remaining amount will be given in the form of Pakistan Investment Bonds at the floating rate. 

The PTI government’s plan also enjoys the backing of IMF after it agreed to increase the base electricity tariff as demanded by the international lending body. The payment of the first installment will materialise the MoUs signed between the government and IPPs in August last year into agreements that will reduce the size of the guaranteed capacity payment or the fixed costs paid to the IPPs which is a major source of accumulation of the country’s circular debt. According to estimates the government is expecting to save Rs850bn over a period of 10 years following the modifications in power purchasing agreements (PPAs). 

The MoUs provide for changes in the terms of the existing power purchase agreements that will reduce the size of the guaranteed capacity payments or fixed costs paid to the IPPs, a major source of accumulation of the circular debt. The government is expecting savings of Rs850bn over a period of 10 years, following the modifications in PPAs.

The federal government’s settlement scheme caters to 50-odd IPPs which were initiated in the 1990s and 2000s and had consented to the alterations proposed in their power purchase deals with the government. As per details, the majority of these plants have completed their life cycles or paid off their debts. So, as per experts Pakistan should not expect an immediate solution to the vicious circular debt problem even after the materialization of the revised deals with independent power producers. 

In recent years, the major contributor towards the country’s rising circular debt is capacity payments to large power projects established since 2015, primarily being part of the multi-billion dollar CPEC initiative, with Chinese money. Although we are being told that contacts have been made with Beijing at the highest level but on paper so far no progress has been made to get the terms of PPAs with those companies renegotiated and unless and until these contacts pay off, the issue of mounting power sector debt is unlikely to be solved.

IPPs unhappy from government’s offer 

The Independent power producers (IPPs) have reportedly rejected payment plans offered by the federal government and demanded at least 50pc upfront cash payments before signing the formal agreements for tariff discounts. 

According to the details, an implementation committee headed by Finance Minister Dr Abdul Hafeez Shaikh had recently offered payment of about Rs450bn to the independent power producers in three equal installments through a combination of cash and trade able bonds next month, June and December 2021 and each installment would comprise of one third (Rs50 bn) cash and two-thirds (about Rs100 bn) bonds.