Detailed report on SBA: IMF accuses energy sector of causing fiscal haemorrhage

ISLAMABAD: The International Monetary Fund (IMF) has portrayed the energy (power and gas) sector as the major cause of fiscal haemorrhaging in Pakistan.

The Fund in its detailed report on $3 billion Stand-By Arrangement (SBA) said, multiple efforts to reform the energy sector have failed due to their direct and huge perceived social costs.

In February 2023, during the 9th review discussions, the Cabinet adopted the Revised Circular Debt Management Plan (CDMP) for the power sector, which entailed measures worth at 0.2 percent of the GDP in FY23 alone.

The measures taken by the authorities under this plan helped catch up with the deferred tariff adjustments and permanently expanded the base and level of debt service surcharge by removing all new unbudgeted subsidies.

Similarly, the gas sector has seen a sharp increase in circular debt in the last few years. While agreeing to the advice of staff in February 2023, and to avoid burdening the budget with additional subsidies, the authorities introduced an increase of 75 percent in gas prices, on average, as determined by the regulator, along with an updated tariff slab system.

The IMF is of the view that the energy sector’s long precarious situation has become acute, with severe liquidity pressures now adding to the continued over-accumulation of unsustainable payment arrears (circular debt, CD).

This situation has built up over the past decade on the back of slow reform to address deep-seated deficiencies that create operational losses and hike generation costs, aggravated by political reluctance to pass-through international commodity prices, currency depreciation, and financial and other costs to tariffs, and repeatedly granting new unbudgeted, untargeted subsidies.

This was demonstrated again by the further deterioration in the power sector in FY23, with substantial unexpected additional budgetary subsidy needs amid a higher-than-expected arrears accumulation, binding liquidity constraints, and increased recourse to supply shortages with regular widespread power outages (load shedding).

The Cabinet is expected to adopt an updated FY24 CDMP in July 2023 with measures to help contain the budgeted FY24 power subsidy to Rs976 billion (0.9 percent of GDP).

The FY24 power subsidy will also allow CD stock payments of Rs392 billion (0.4 percent of GDP) to compensate for the projected FY24 CD flow of Rs392 billion and stabilise the FY24 CD stock at its expected end-FY23 level of Rs2,374 billion (2.2 percent of GDP).

Key measures agreed with the IMF include (i) notification in full (and, if needed, retrospectively with effect from July 1, 2023) of the FY24 annual rebasing (AR) as per the National Electric Power Regulatory Authority (Nepra)’s imminent determination (end-July 2023 SB); (ii) some modest relief from near-term measures aimed at improving distribution efficiency (primarily on the collection side); and (iii) steadfast acceleration of crucial medium-term cost-reducing reforms.

Fund maintains that timely alignment of power tariffs with cost recovery levels along the established tariff structure that protects the poor through lifeline and protected tariffs. Staff stressed that regular tariff adjustments—in line with established formulas for the one AR, four quarterly tariff adjustments (QTAs), and twelve monthly fuel price adjustments (FPAs) per FY— are critical to implement the CDMP, halt CD accumulation, limit fiscal pressures, lend credibility to the Nepra, lower load shedding, and restore the viability of generators and ensure their ability to operate.

The authorities concur that subsidy reform needs to continue to effectively protect the vulnerable, introduce more fairness, and reduce fiscal costs.

Staff commended the authorities for committing to: (i) entering the third stage of their multi-year subsidy reform plan, supported by the World Bank, and submitting to cabinet a subsidy rationalization reform plan for tube-wells for large agricultural users by end-2023; and (ii) persevering with regular tariff adjustments while sparing the lifeline and protected slabs, which will increase the progressivity of the tariff structure for residential consumers and improve fairness.

Pursuit of other medium-term reforms to reduce costs and CD, the authorities’ efforts remain geared toward reducing commercial losses, technical losses, and generation costs; improving governance and PPA terms; increasing competition; and greening the energy mix.

Staff; therefore, called on the authorities to speed up work, mainly supported by the World Bank and ADB, to: (i) improve price signals for inputs (including gas, to help channel the most expensive inputs to the most efficient power generators in line with the merit order principle); (ii) renegotiate remaining purchasing power agreements (PPAs) in return for clearing un-guaranteed CPPA arrears; (iii) convert publicly-guaranteed PHPL debt into cheaper public debt (along the 10-year repayment plan); (iv) expand renewable energy capacity; and (v) improve distribution efficiencies.

The IMF has further stated that restoring the power and gas sectors’ financial viability remains critical to reducing unsustainable spillovers onto the budget, the financial sector, and the real economy.

The recently-adopted energy measures, especially the full surcharge hike and strict limitation of energy subsidies to the vulnerable, must be maintained as a first step to limiting these spillovers.

In addition, it will be critical to ensure timely alignment of energy tariffs with cost structures as per the Nepra’s and the OGRA’s formulas (while protecting the vulnerable), and to implement reforms to reduce operational, generation, and CD-related financial costs in line with the current power and emerging gas CDMP to put tariffs on a downward trajectory.

Limiting energy subsidies—as also to be reflected in the cabinet-approved update of CDMP for FY24 by end-July 2023—primarily through the notification of the annual rebasing of the power tariff for FY24 in full and with effect from July 1, 2023, as determined by the Nepra in July 2023, continuation of regular tariff adjustments in line with established formulas in a timely manner, and acceleration of structural cost-reducing reforms. To guard against the materialisation of fiscal risks in an adequate manner, we also included contingency spending for emergencies of PRs 250 billion.

Underperformance continued until end-March 2023 sending the CD stock to a new historical high of Rs2.5 trillion (three percent of the GDP), mainly on account of CD flow overruns of Rs387 billion (0.5 percent of GDP) relative to the Circular Debt Management Plan (CDMP) from early-FY23.

Key drivers were policy slippages (mostly from new unbudgeted, untargeted energy subsidies for exporters and agriculture, and some deferred tariff adjustments for certain residential consumers) and slow progress with structural cost-side reforms.

Amid mounting liquidity pressures for fuel inputs, debt payments, and capacity charges to Independent Power Producers (IPPs), the authorities took a set of corrective socially-balanced measures from March 2023 to contain both the FY23 budget subsidy (to 1.1 percent of GDP) and CD flow (to 0.4 percent of GDP).

Also enshrined in their cabinet-adopted FY23 CDMP update in February 2023, these measures (worth 0.2 percent of GDP in FY23 alone) not only helped catch up with the deferred tariff adjustments but also permanently (i) expand the base and level of the debt service surcharge; and (ii) remove all new unbudgeted subsidies. Each month of delaying an adjustment of PRs 1 per kWh adds about PRs 8½ billion to the stock of arrears.

The energy (Power and Gas) sector has been a major cause of fiscal haemorrhaging in Pakistan. Multiple efforts to reform the energy sector have failed due to their direct and huge perceived social costs.

In February 2023, during the 9threview discussions, the cabinet adopted the Revised Circular Debt Management Plan (CDMP) for the power sector, which entailed measures worth at 0.2 percent of the GDP in FY23 alone.

The measures taken by the authorities under this plan helped catch up with the deferred tariff adjustments and permanently expanded the base and level of debt service surcharge by removing all new unbudgeted subsidies.

Similarly, the gas sector has seen a sharp increase in circular debt in the last few years. While agreeing to the advice of staff in February 2023, and to avoid burdening the budget with additional subsidies, the authorities introduced an increase of 75 percent in gas prices, on average, as determined by the regulator, along with an updated tariff slab system

Pakistani authorities have recognized that conditions in the power sector have grown acute in FY23, with power subsidy pressures growing in the face of binding cash constraints, higher-than-expected arrears accumulation, and increased load shedding.

At end-March 2023, the stock of power payment arrears (called circular debt, CD) reached a new historical high of PRs 2,542 billion (three percent of GDP), reflecting an increase of PRs 289 billion since end-FY22 (with PRs 417 billion from the CD flow and Rs 128 billion from gradual CD stock clearance from the budget).

Together with distribution companies’ (Discos) continued large under-collection, policy slippages fuelled the sector’s financial losses: mainly new unbudgeted subsidies and delays in regular tariff adjustments.

On the brink of a liquidity crisis and amid tight fiscal space, we had to take measures worth PRs 196 billion to contain the overrun in both: (i) budget subsidies to PRs 335 billion; and (ii) CD flow to PRs 336 billion (as also reflected in our updated FY23 CDMP approved by our cabinet on February 13, 2023).

From Mach 2023, we: (i) recouped the deferred June and July 2022 FPAs (PRs 31 billion in FY23) by collecting instalments over eight months from the originally sheltered households (but the flood affected); (ii) reformed the debt service surcharge (DSS, about PRs 80 billion in FY23 and PRs 302 billion p.a. from FY24) by permanently expanding the base (from only ex-Water and Power Development Authority (Wapda) Disco consumers to, additionally, K-Electric (KE) consumers) and hiking the level, fully sparing protected consumers10 (from PRs 0.43/kwh to, on average for the FY and across consumer slabs, PRs 3.82/kwh until end-FY23 PRs 2.63/kwh from FY24; (iii) phased out new and unbudgeted subsidies (PRs 65 billion in FY23) by letting the zero-rated industry and agriculture subsidy packages permanently expire; and amended the GST regime (PRs 14 billion in F23 alone) by (a) levying GST on notified (rather than the determined) power tariffs in FY23 and reimbursing Discos a remaining PRs 5 billion in monthly tranches until end-June 2023 that FBR continued to collect during a transition period; and (b) making Discos pay GST on a collection basis (rather than on a billing/accrual basis).

The Authorities have projected the sector’s financial gap (after revenue collection) to amount to Rs976 billion (0.9 percent of GDP), a slight decrease from the projected FY23 financial gap thanks to permanent relief from the crucial FY23 measures on the revenue side (see above) and our steadfast reform commitment.

A budget subsidy of PRs 976 billion (0.9 percent of GDP) will address urgent liquidity needs in FY24 by covering: (i) outlays for the projected power tariff differential (for Discos and KE, PRs 319 billion) and other—in large parts one-off or instalment—payments to provinces, tribal areas, and KE (PRs 265 billion); and (ii) CD stock payments of PRs 392 billion through PHPL principal settlements (PRs 82 billion) and payments to GPPs and CPEC IPPs (PRs 310 billion).

Copyright Business Recorder, 2023