The natural gas controversy

The natural gas controversy

There is a general gas shortage in the country for the past few years. Known reserves and deposits are on the way to exhaustion, while the exploration activity has been at a low level. Most of the gas these days is being produced these days. Gone are the days when most gas used to come from Sui in Balochistan. Thanks to exploration activities in Sindh, many new deposits have been discovered in Sindh and production started from those wells. More exploration activity is expected to yield new gas resources in Sindh. Due to the political and law and order problems in Balochistan ,no new deposits are being discovered as no exploration activity could be sustained there for the past many years. This is a very unfortunate situation , in which no body is benefitting, people or province of Balochistan who are deprived of income and employment and the other parts of the country and people as they are facing gas shortages.

Shortages create many economic and political problems. A number of controversies have developed. Industries have protested and some of which closed down in protest or due to gas shortage. Earlier Sindh assembly passed a resolution demanding priority in gas allocation and a number of prominent politicians issued statements in this respect. They have complained that Sindh's gas is being taken elsewhere in the central system and that Sindh’s demands should be met first, and then the residual should go elsewhere. The issue of distribution priorities! They have argued that there is a constitutional provision in support of this stance. Now KESC has joined the debate. In a message to the public and consumers in Karachi printed in this newspaper, CEO of KESC demanded more gas allocation and implied that the gas supplies were available and adequate gas supplies are unfairly denied to his company. And in a related case, LPG distributors are going on strike because of what they think is an arbitrary increase in prices by the LPG producers’ cartel. Let us examine the merits of the issue. To top it all, some multilateral agencies are proposing to enhance gas prices to the level of line which in their view would solve many problems including the ones in gas allocation. GOP is already under severe public pressure regarding the proposed increase in electricity tariff. This last issue would require exclusive discussion and we leave it to some future opportunity. We would examine here the other issues as described earlier in the above.

There is a general shortage of gas throughout the country. Power plants in Sindh are not getting enough gas and thus load shedding of electricity. Gas and electricity are distributed to user sectors and customers who pay for the service. It is not supplied to an abstract concept or entity as a province. Then gas is distributed and allocated as per priorities. For example, fertilizer sector is a priority and supposing all of the capacity is located in Sindh, allocating and distributing gas to Fertilizer sector does not mean that gas is allocated to Sindh.

If this logic of prior right of producing province is accepted, then many problems would have been created for Sindh itself. Gas exploration and abundance in Sindh is only a recent phenomenon. Previously all gas consumed by Sindh came from Balochistan and most hydro electricity came from Sarhad/KP. Very little was consumed or allocated in the producer provinces, as there was no demand or distribution investment was not justified for widely scattered insufficient demand. Similar demands and protestations were made by some circles in Balochistan, when natural gas was brought to Karachi and Sindh first leaving Balochistan towns unsupplied.

The issue is that Production, transmission and distribution facilities have to be invested in. Often the investment comes from private and foreign entities that have to be paid back. The revenue is generated through consumers and customers and not from provincial or federal government. Principles of economic efficiency, markets, sustainability and rate of return to investors are involved. If we do not learn to respect these principles, we are going to end up in more shortages due to lack of investment in supplies sector and higher production costs of utilities and services. The capacity of people to pay has already reached or even crossed their limits.

If there is a shortfall both equity and efficiency considerations are their in allocating priorities. Where there is no efficiency or criticality issue, equity principles of equal distress are to be applied and not a province based formula based on the ownership of resource.

As to the ownership issue of the resource , except for political ownership which does not mean much in practical sense ,bulk of the resource(88%) that has been extracted belongs to the producer who has spent money, effort ,resources and know-how in bringing out the resource from the earth and processing it and making it use-worthy. So the ownership of the extracted resource belongs to the producer, save the royalty portion of say 12%, and not to the province where the resource is located. What is in ground belongs to a people and provincial or federal government as per laws and constitution of the country, but when it comes out of ground it is a different issue.

Energy sector in Pakistan has been developed as one undivided market. It is still the case even after 18^th amendment. Electricity has become a federal only subject, while it used to be a concurrent subject earlier. In the past almost all investments in energy have come from federal or foreign equity or debt sources. All WAPDA investments and the ones in Oil and Gas have come from federal kitty. And even in future all investments in nuclear and hydro resources is to come from federal resources. After all these investments, would KP politicians be in their right to make similar demands of electricity ownership. Certainly, they can demand their royalties which issue should be resolved on a permanent basis. They cannot possibly demand that Tarbela should meet their demand first and then the electricity should flow to the rest of the country. KP has been suffering severe load-shedding despite Tarbela being right there. In future also when hydro power would come from Bhasha and Bunji etc dams, there would be no fundamental right of priority allocation to KP. In fact if Sindh’s argument and demand of priority allocation based on producer provinces right is accepted and established, it would be a sufferer in the long run .Temporary advantages and ups and downs do develop in various parts of the country at different times and these should not lead us to bring in constitutional issues unnecessarily.

Constitutional provisions are often desires and ideals. These have to be creatively and constructively interpreted and understood. It is well-nigh impossible for the framers of the constitution to understand the implication of every sentence they write into the constitution. American constitution explicitly allows only currency, defence and foreign policy in federal domain. American courts have interpreted the constitution so broadly and in totality, that there are sixteen federal ministries dealing with 16 or more subjects. Constitution may have to be amended if too literal interpretation of the quoted constitutional clause is attempted.

As for KESC, its issue is a bit complicated due to the tariff issue, which may not be intelligible to the non-specialist. KESC runs on what is called a constant tariff, with periodic adjustments for the fuel price inflation and general inflation as well. Gas is more thermally efficient fuel than oil in the sense that in combined cycle plants, an efficiency of 50% or more is possible to day than the traditional efficiency of steam turbine plants run on oil. KESC is expected to earn through increase in thermal efficiency and reduce other losses and leakages. There are many other issues with KESC tariff formula as it exists today. Normally such formulae are agreed to for relatively short periods. It has no answers or solutions for the long run. It may cause much more serious problems in future, details of which cannot be explained in this space. A review of this formula is required, along with a number of reforms and pro-active actions. For the time being GOP has allowed Oil sales and supply in lieu of non-supplied gas, at the price of gas. Perhaps this solves KESC’s working capital problem. A longer run solution would require the following steps; KESC should be a part of the central pool and eligible to draw from the central pool as per an agreed formula ; KESC to be treated as an IPP, and allowed to make investments in generation outside Karachi, for example utilizing cheaper gas resources elsewhere. KESC’s generation assets and activities be separated and treated at par with other IPPs .A new tariff formula based on cost-plus approach and central whole-sale pricing is introduced as it is there in other parts of Pakistan

KESC Tariff difficulties;Shun constant Tariff formula

There seem to be difficulties again with the implementation of a rather unique tariff system given by foreign privatization consultants. I have not been closely following KESC tariff issues over the past many months.However my cursory following indicates to me that there are implementation issues involved in KESC tariff.There was earlier some kind of a divide on KESC issue at NEPRA board ,wherein two of the honorable members either wrote a note of dissent or withheld signature altogether.Now there are difficulties in awarding fuel price and O&M adjustments.NEPRA member Tariff,who reportedly presided over three member public hearing on KESC tariff,ordered physical verification of fuel expenditure invoices from the KESC. Let me give the reader some background on the tariff setting systems.

There are broadly two system:one of cost-plus,where all costs of the utilities are paid as these occur,and a fixed or variable Return on Investment(ROI) or Equity(ROE) is paid,generally related to the on-going interest rates.All IPPS are paid based on this cost-plus approach.There is a reference tariff determined through regulatory process,escalation above which is provided based on agreed formula and current fuel and other variable prices.It is relatively fair and simple.In case of distribution companies,with highly depreciated assets and often negative equity,Return on Asset(ROA) approach is used.OGRA is also doing the same with the gas distribution companies.

In case of KESC , a constant price tariff approach was adopted,however,with provision of escalations.The difficulty with KESC is that ,it is an integrated utility,with generation,transmission and distribution.Electricity is self generated by the KESC and is also supplied from WAPDA network.At the time of privatization, a certain mix of self generation,and purchase and an assumption of oil/gas mix was made.Depending on such assumption, a reference tariff was given with provision of escalation.At that reference price, there was an implicit loss to KESC, and the expectation was that the new KESC management would make the required investment and essentially earn through loss reduction.There were and still are Transmission and Distribution losses in the KESC system more than if compared with the

public owned companies like LESCO and IESCO etc.Also the thermal efficiency od most of its plants is very low,wasting a lot of expensive fuel oil.KESC has done some investments and is in the process of making more investments towards improving thermal efficiency and saving fuel cost.This saving ,however,will go towards reduction of losses,wiping out the accumulated losses and finally towards return on investment.These savings cannot be passed on to the public as some people seem to be demanding.

However the existing system of constant price with escalations has become very cumbersome and even lacking in terms of transparency due to its complexity.Traditionally,this constant price formula has been used in distribution companies only, and that also for up to three years,with no provision for escalation.

In most of the developed world, electricity generation is out of regulatory process.Whole sale electricity prices are set through demand and supply through an auction process through electricity exchanges on the lines of share bourses.Generation prices are relatively more stable in the OECD countries as most electricity generation is based on gas,coal and nuclear power,where price volatility has been lesser.Even in the neighboring India,the electricity prices are much more stable than here,due to the domestic and public controlled coal.In Pakistan,hydro and gas based electricity used to provide price and tariff stability,but due to increasing contribution of oil based generation.price volatility has increased.This oil dependence and the increasing trend on oil dependence is the single largest threat to Pakistan's economy and social stability.The earlier other sources such as hydel and coal are utilized the better.

Coming back to KESC,the very purpose of constant price system of offering simplicity and transparency seems to have been defeated due to so much variability and complexity.It is quite possible that the young men at NEPRA who do these calculations may sometime fail to appreciate the issues and commit mistakes.Even this writer often gets confused and finds himself at a loss as to how to separate permitted variabilities from the non permitted ones.The situation would get even more complex and complicated if and when KESC makes new investments in new generation capacity.Questions have already been raised by the stake-holders,casting doubt and feeling confused.

Our business community,which is not used to spending money on building institutional capacity in their representative organisation,has never managed to make a technically valid case and has relied more on delaying litigation to oppose tariff increases.If nothing else ,the KESC tariff system is becoming too cumbersome to be transparent.Recent load balancing practices and requirements ,and the consequent changes of oil and gas mix have further complicated the situation.

It would be only appropriate that the government and the regulatory bodies consider changing the KESC tariff system to a conventional simpler system of Cost-plus,which is being practiced with other IPPs ,and distribution companies.Even KESC management may feel at ease, if the stake-holder confidence in the system is improved.For this to happen,KESC tariff has to be a three part tariff, separately for generation ,transmission and distribution.In this case comparability with other similar companies would be available preventing abuse or error.This would be for regulatory body and the KESC: public would be having one tariff as usual and would not be burdened with such disaggregation.Foreign consultants as usual are to be appointed,as the requisite expertise and objectivity may not be available locally.

Targeting loss reduction and basing tariff on it is to make tariff contentious,controversial and fluid.KESC tariff system has this feature as well.It has been demonstrated now that the private sector has no special leverage in reducing T&D loss reduction.most of which is theft and pilferage.In fact private sector is susceptible to political and group pressure more than the government functionaries.As to the reduction of fuel cost and increasing thermal efficiency,it is a matter of attractiveness of investments in the sector and tariff stability.Third party investment for Karachi is being discouraged due to the existing system and KESC would itself be discouraged to make the requisite investments,if tariff issues remain fluid as these are at the moment.Lenders would also be hesitant as well.

And finally contemplating over these problems,one reaches a conclusion that after all,the idea of privatizing distribution utilities may not be a good one.Government would have to be around to take responsibility and to keep footing the bill,if there are losses,be it private or public sector.However,IPPs have been a successful innovation that must continue and in all probabilities would be sustaining into the long term future.