Undistributed risks

The Karnataka government is pushing through a proposal for the privatisation of electricity distribution, one that is widely seen as hurriedly conceived and too risky for the government.

If privatisation is conducted in ways that are widely viewed as illegitimate and in an environment which lacks necessary institutional infrastructure, the longer-run prospects of a market economy may actually be undermined. Worse still, the private property interests that are created contribute to the weakening of the state and the undermining of the social order, through corruption and regulatory capture.

- from the keynote address "Whither Reform? Ten Years of the Transition", by Joseph E. Stiglitz, former senior vice-president and chief economist of the World Bank and winner of the Nobel Prize for Economics, 2002, at the annual World Bank conference on Development Economics.

STARTING the last week of January, the Cauvery Bhavan headquarters of the Karnataka Power Transmission Corporation Ltd (KPTCL) in Bangalore has been under virtual siege by angry farmers. Organised under the banner of the Karnataka Rajya Raitha Sangha (KRRS), they articulate a demand - that KPTCL should restore power supply in an uninterrupted manner and for longer hours for agricultural operations - that has the State's energy administrators wincing. Karnataka's power sector is set on the path of aggressive reform. Subsidies are to be phased out and a privatisation programme has been set in motion that the government hopes will meet its objectives of an efficient, commercially viable and competitive industry which will provide quality power at affordable costs to the consumer.

The demands made by the KRSS can hardly be accommodated in this scheme. On the other hand, the farmers represent a constituency that the State government can ill-afford to displease, particularly when a crucial Lok Sabha byelection in the State is just around the corner - at Kanakapura. For the government, which is engaged in a difficult balancing act, the order recently issued by the Karnataka Regulatory Commission (KERC) turning down the tariff proposals of KPTCL could only have come as a blessing in disguise. On the one hand it must adhere to an exacting World Bank schedule of reform if it is to qualify for the Bank's next tranche of a $150 million loan. On the other, it can ill-afford to alienate popular constituencies when a high-stakes byelection is being fought.

World Bank loan disbursements are contingent on the State achieving certain milestones in respect of reform. Power reform is central to the conditionalities laid down by the Bank, which has time and again indicated the direction that reform in the sector must take. "The ultimate objective of power sector reforms is for the government to withdraw from the power sector as an operator and regulator of utilities" (Report No. P7453, May 25, 2001). The government believes that the crisis it is facing is a systemic one that can only be resolved by its withdrawal from the power sector and its place being taken by the private sector.

Today the financial crisis in the power sector is at its worst. KPTCL faces financial bankruptcy. The gap between its revenue and expenditure has been increasing sharply over the years, necessitating huge government subsidies. Its revenue gap in 2001-2002 is estimated at Rs.2,389.49 crores, while the government subsidy for the same year is estimated at Rs.1,779 crores, leaving a net gap of Rs.610.49 crores. Adding to its problems are delayed disbursements from the government, resulting in a continuous cash crunch. The Tanir Bavi Power Project (Frontline, January 4, 2002) will continue to be a major drain on its resources. According to KPTCL sources, the cost of purchasing power from Tanir Bavi Power Company Private Ltd. will account for over 10 per cent of its revenue outflow, and KPTCL has not been able to clear that company's bills fully for the last three months.

It is in this context that the State government is pushing through what is viewed in energy circles as a hurriedly conceived and unprecedented proposal for the privatisation of electricity distribution, a proposal that even World Bank representatives have sounded a cautionary note on. Proposed by a consortium of consultants led by CMS Cameron McKenna, an international law firm, the investment banking firm of N.M. Rothschild and Sons, and Deloitte Touche Tohmatsu, one of the 'Big Five' auditing and consulting firms, the plan departs radically from conventional proposals for privatisation. It should ordinarily have been debated extensively and evaluated with greater care. The consultants' proposals were circulated by the KERC to a group of distinguished Indian energy experts, a majority of whom expressed strong reservations on the proposal and its workability. The consultants responded to the criticisms at a workshop held by the Department of Energy on January 22 where some of the experts were present. Despite the overwhelming lack of support for the proposal, it was sent the same afternoon to the State Cabinet with a recommendatory note by the steering committee headed by the Chief Secretary.

ACCORDING to the consortium's proposals, the State's electricity distribution system is to be divided into four distribution zones, each to be corporatised as a separate distribution company. Through a bidding process, 51 per cent or more of the equity of each of these four companies is to be offered for sale to investors. Central to the proposal is the concept of the distribution margin (DM), which seeks to guarantee an assured income to the distribution company while insulating it from the normal risks associated with such businesses. The consultants argue that unless special measures in the form of risk-insulation are offered to investors in the distribution business, there will be no takers in this high risk arena. Their Draft Privatisation Strategy Paper states this as follows:

"The Government of Karnataka must bear many of the risks of the distribution business until such time as the electricity industry has achieved a stable and sustainable financial condition."The idea of a "transition phase", a period of handholding by the government for the private investor, is central to the distribution margin concept.

"We propose that at the time of the privatisation transaction the new private sector owners should be protected from some of the major financial risks facing the industry. These risks should transfer to the privatised businesses once the industry has reached financial sustainability."

The risks to be borne by the government as envisaged in the plan are: tariff risks (the risk that the regulator will not move tariff levels to full recovery costs); collection risks (the risk that collections from agriculture and government entities will not be increased); and commercial losses risk (the risk that commercial losses owing primarily to theft cannot be reduced).

According to the DM model, the distribution business has a first claim on the revenue it collects to meet its distribution margin (a specified sum that is meant to cover the operating cost and capital recovery cost of running the electricity distribution business). But the point of departure in this model is that the permitted revenue to the distributor is not reduced by the occurrence of risk, which is allotted to the State government. In other words, the government has to bear all the losses in the game.

Orissa's disastrous experience in privatising distribution underlines the need for a more innovative approach to make privatisation successful. The consultants believe that the DM model will help overcome the faults inherent in Orissa type privatisation. Orissa's failure lay in the private distribution companies defaulting heavily on their power purchase costs to the State transmission utility. "Shorn of its technicalities, the DM model is a 'Heads I win, tails you lose' proposition," an energy expert told Frontline. "Unlike in Orissa, in this model the distribution companies are not paying KPTCL a power purchase price at all. They are merely acting as monopoly agents in a given distribution region for KPTCL without taking on risks associated with power purchase. This puts no pressure on the distributor to improve the efficiency or procure power in a more cost-effective manner. It merely assures him a profit irrespective of what happens to the business."

The criticisms of the DM proposal by the energy experts consulted relate to its risk allocation argument, transition phase issues, and the role it envisages for the regulator and tariff fixing mechanisms. "A single buyer selling power to the distributors, who in turn bear no risks but merely collect their margins, does not seem to be a convincing marketisation of electricity supply industry in the country," argues M. Govinda Rao, Director of the Institute for Social and Economic Change, in written comments to the KERC.

E.A.S. Sarma, former Energy Secretary, Government of India, and Principal of the Administrative Staff College of India, also points to the disproportionate share of risks that the government must bear: "In effect, while handing over valuable distribution assets to the private investors, the Government of Karnataka will have to assume responsibility for almost all risks including many that are predominantly within the managerial domain of the private investor!" Sarma also points to the large and ever uncertain financial burden that the State will have to bear under this model. In addition to the extra subsidy burden on the State during the transition phase, it will have to underwrite the distribution margin and risks of the private distributor without any certainty that the company will assume the risks at the end of the transition phase. In other words, what happens if the distribution company, having made its profits from the distribution margin, decides to pack its bags at the end of the transition period?

T.L. Sankar, former Chairman of the Andhra Pradesh State Electricity Board, argues that the risks outlined in the DM proposal are exaggerated. The proposals, he says, "are totally unacceptable and are based on an exaggerated view about the risks, and the solution suggested would make a mockery of the power reform process and would be vehemently opposed by consumers."

S.L Rao, former Chairman of the Central Electricity Regulatory Commission, has questions with regard to the core of the model. If the distributor is to be protected from major financial risks till the industry has reached "financial sustainability", who is to determine financial sustainability, and by what method, he asks. Furthermore, freeing the investor from the obligation to meet the full amount of generation and transmission costs, as the model proposes, amounts to "a blank cheque to allow padding and cheating", he notes.

Former Karnataka Chief Secretary T.S. Satish Chandran, who is "inclined to support the distribution margin approach suggested by the consultants", underlines that it should only be seen as a transition period scheme. "This arrangement," he notes, "transfers commercial risks to the State government which, in the normal course, must be borne by the investor. It has the flavour of a one-sided contract; therefore, it cannot be a permanent arrangement."

AN area of concern to several energy experts relates to the statutory role of the KERC as envisaged in the DM proposal. According to E.A.S. Sarma, there are several areas where the KERC's authority is likely to become limited as a consequence of the DM scheme. The arrangement leaves the KERC constrained in the matter of tariff fixation and in setting performance standards. While the KERC can set the pace of cost recovery in tariff fixation, it will be "graduated to suit the interests of privatisation," according to Sarma.

Secondly, the licence contract entered into between the licensee, the single buyer and the Government of Karnataka will in effect become the agreement that will govern the functioning of the sector, thus marginalising the role of the KERC.

In its formal response to the DM proposal, the KERC has considered critically a series of assumptions made by the consultants including risk allocation and the role set out for the regulator. It ends with a call for transparency in the licence issuing process and during the finalisation of contractual terms.

The proposal for distribution privatisation is now before the State Cabinet for its approval. If accepted in its present form, changes in the KERC Act will also be necessitated. One lesson from the collapse of Enron is that regulatory processes should have teeth in a deregulated and free market. Stunting the role of the regulator in a private power market would erode some of the stated principles of reform such as transparency and monitoring. It would also close the only channel where public and consumer voices can be heard.

This, however, is only one of the possible consequences of the DM proposal under consideration. The more immediate question is whether the proposal will solve or further intensify the acute financial crisis that threatens the State's energy sector.