The Law and Economics of Electricity and Petroleum Prices Increase
This article by Dr Sam Amadi thoroughly examines the recent increase in electricity tariffs by the Federal Government, and the removal of the fuel subsidy which has also resulted in an increase in the price of petrol, during the Covid-19 pandemic which has had an adverse impact on the national economy and Nigerians as a whole, while discussing the roles of major players like the DISCOs, and correcting certain misconceptions about the effectiveness and profitability of privatisation
“THE PROBLEM IS THAT, THE QUALITY OF SERVICE IS EXTREMELY POOR WITH MORE THAN 45% OF CUSTOMERS NOT METERED, AND THEREFORE, SUBJECTED TO MASSIVE PRICE GORGING. ALSO, THERE ARE FREQUENT AND LONG OUTAGES IN POWER SUPPLY, SUCH THAT THE SITUATION IS BEST DESCRIBED AS PAYING MORE FOR LESS. IN THESE CONTEXTS, ASKING CUSTOMERS TO PAY MORE SEEMS LIKE GRAVE INJUSTICE .... ”
Recent weeks have been dominated by stories of protests by various civil society and professional groups against the recent increases in prices of electricity and petrol across Nigeria. The Nigerian government announced a general increase of electricity tariff, for most electricity consumers. This review has been much delayed and postponed, because of fear of opposition from civil society groups and labour organisations, and concerns about the ravages of the Covid-19 pandemic. Before the news of the general tariff increase could sink in, the government announced removal of petroleum subsidy and increase pump price for petrol. These are major policy shifts, which have tremendous implications for the economy and social and economic wellbeing of Nigerian citizens and residents.
These policy shifts are greeted by contentions amongst proponents of so-called free market, and their antagonists. As expected, there is a lot exaggeration and misstatements on both sides. The critical question, is whether the government was right in increasing the prices of these essential commodities at this time of the pandemic, and its adverse impact on national economy and household income and welfare.
MYTO and Access to Affordable, Adequate and Reliable Electricity Services
The justification for the increase in the electricity tariff, is that it is the only way to save the sector from collapse and ensure access to reliable, adequate, and affordable electricity. The economic argument is that electricity tariffs in Nigeria are prohibitively low, such that there is no real chance of significant investment either from the operators or external investors, and no realistic chance of improvement in quality and quantity of service. The case for a tariff system that will encourage investment and improvement in the quality of electrical services, is centred around the mythical ‘cost-reflective tariff’. This phrase is bandied about, in a manner that suggests it is a magical bullet that solves all the problems in the sector. The truth is that a ‘cost-reflective’ tariff, is just one of the important pieces of a possible multifaceted solution to the near collapse of the sector.
The reform started with the standard toolkits of neoliberal reforms: an ‘independent’ regulator, unbundling of generation from transmission and distribution; unbundling of policymaking and regulation, and enactment of a law incorporating these strategic changes. That law- the Electric Power Sector Reform Act (EPSR) Act, 2005, provided for a ‘cost-reflective’ tariff. It mandates the regulator-Nigerian Electricity Regulatory Commission (NERC)- to allow an efficient operator to recover all
prudent costs. Section 32(1)d mandates NERC to “ensure that prices charged by Licensees are fair to consumers, and are sufficient to allow the Licensees to finance their activities and to allow for reasonable earnings for efficient operation”.
Part of NERC’s responsibility is to ensure such recovery of costs and establish a regulatory framework that prices of electricity services in Nigeria are ‘just and fair’ and ‘just and reasonable’. This statutory duty calls for a methodology, for pricing of electricity services. In 2009, NERC developed a methodology for the pricing of electrical services in Nigeria whose hallmark is the Multiyear Tariff Order- MYTO. As its name suggests, it lay out the tariffs that operators will collect from consumers over a period of years. The order is a subsidiary legislation that has the force of law.
The logic of the MYTO is that even as electricity services are public goods (some would say, ‘impure public good’), they remain products whose costs would need to be recovered. The producer needs to cover its costs, and approved return on invested capital. The logic of MYTO is also that the sustainability of production, means that cost recovery needs to be guaranteed by law over a long period that aligns with the tenure of borrowed funds and depreciation of assets. MYTO sets tariffs for the three electricity sectors based on certain principles and assumptions, namely: Cost recovery/financial viability-licensees recover efficient costs, including a reasonable return on capital; Signals
for investment- tariffs should encourage an efficient level and nature of investment (e.g., location); Certainty and stability of the tariff framework enables private sector investment; Efficient
use of the network- tariffs should reflect the marginal costs that users impose on the system, influence efficient use and reduce cross-subsidies; Allocation of risk- the tariff framework should allocate risks efficiently to those best placed to manage them. Risks such as Operational Risks, Financial Risks (interest, currency, Payment Risks, Business Risks etc). In implementing the MYTO, the regulator has to protect consumers interest by ensuring availability of affordable supply of electricity; reliable and safe supply of electricity; protection from exploitation by operators; participation, consultation and transparency in all activities of the regulator and operators; prompt response to customers issues and complaints; above all, value for money.
In achieving balance between operators and customers interests, the regulator operationalises MYTO through key principles like
Simplicity and cost-effectiveness – the framework should be simple and not costly to implement; Incentives for improving
performance – it should incentivise cost reduction and quality of service; Transparency/fairness – it should be transparent and ensure open access to monopoly networks; Flexibility/ robustness – it should cater to unforeseen changes in the market;
Social and political objectives – it should provide for the achievement of social goals such as, affordability, universal access and demand-side management.
These principles, models and framework reveal that MYTO is a scientific formula, to the extent it is based on predictable inputs that are not discretional. When prices change, there are justifiable reasons for the change. The MYTO makes provision for annual minor reviews to index changes in inflation, foreign exchange, cost of gas and available generation. If these variables cumulatively are + or – 5% then, the prices would be re-indexed. The major review takes place when the entire cost structure of the tariff needs drastic review, either due to major changes in cost efficiency frontiers or when new investments had been or are about to be made. The major advantage of MYTO is that it provides a framework for bringing together all industry costs together, in a manner that assures that tariff represents the true costs of production.
Price regulation in the electricity sector, is not just about science. It is also an art. This requires strategic decision-making, that considers the political economy of the country. First, is that the EPSR allows recovery of cost to an operator only on the basis that it is an efficient operator, and the costs are prudently incurred. The regulator should not allow recovery for inefficiently incurred costs. That will not be incentive regulation. The problem is that, incentive regulation assumes that the regulator has the capacity to see through the cost structure of the operators. Typically, regulators suffer from information asymmetry, and relay on costs supplied by operators. The problem with the MYTO and the cost reflective tariff, is that their probative value is based on the assumption that the costs that regulators pass to consumers are costs that are prudently incurred, and not costs that are either irrelevant and over bloated. It is because of this problem that, in 2014, as Chairman of NERC, I refused to pass what is labelled as ‘collection losses’ to consumers, unless the distribution companies justified such costs. This was politicised. But, that is the problem. The equation of ‘just and fair’ tariff cannot balance, until the regulator develops the capacity to subject the costs structure of the industry to effective prudence check. So far, we are not yet there.
Another strategic consideration for tariff-making in the context of the MYTO, is that the regulator may not allow the operator to recover all the costs, even if they are prudent, because of their larger socio-economic impact. What is required is the credibility of the methodology, and regulatory assurance that the deferred revenue will be recovered in a specified period when conditions improve. But, this presumes that the operators can finance operational and maintenance costs and capital investment with borrowing, while awaiting recovery. But, with the financial insolvency of the investors in the Nigerian electricity market, such deferred recovery means deferred improvement in electricity supply. So, the regulator is minded to ensure near immediate recovery of costs. This worsens as Aggregate Technical, Commercial and Collection (ATCC) losses increase, and thereby, make production and supply of electricity expensive.
Also, the regulator has the obligation to ensure availability and affordability of electricity supply. This requires first balancing of tariff between various classes of customers, based on costs of serving each customer class and ability to pay. In some countries, strategic consideration tilts the balance in favour of industry consumers. In Nigeria, the balance tilts toward residential consumers. But, more important, the regulator uses tariff as an incentive for enhanced performance. Tariff increases should be benchmarked, to verifiable improvements in power supply. This partly explains why the NERC has themed the recent tariff increase, as ‘Service-Level Tariff’. But, the question is whether this is not just an appellation. Can the regulator guarantee that all those whose tariffs have increased (more than 60% in most service jurisdictions), receive more than 12 hours daily power supply? Doubtful.
Economics and the Science of Reform Failure
The problem with the tariff increase, is not that the prices are not justified by increases in cost of production. Clearly, the tariff structure in Nigeria’s electricity market does not align with the cost structure. There is a massive under-recovery arising from a depressed tariff structure, and massive collection losses. These debts go back to the public sector, and further damage the prospect of more investment to improve the electricity supply. Poor electricity supply aggravates revenue shortfall, which further discourages smart investment in the sector. This is a vicious circle. The tariff increase is targeted as breaking an important chain in this vicious circle. The problem is that, the quality of service is extremely poor with more than 45% of customers not metered, and therefore, subjected to massive price gorging. Also, there are frequent and long outages in power supply, such that the situation is best described as paying more for less. In these contexts, asking customers to pay more seems like grave injustice and a violation of the ‘operator-consumer-regulator’ compact in the EPSR.
The beginning of understanding the hysteria over tariff increase, begins with understanding the structure of Nigeria’s electricity industry. Since 2013, the Nigerian electricity industry has become largely a private electricity market, on account of the privatisation of the 11 distribution companies and the 6 generation companies. This continued with the reform that ushered the liberalisation of generation and commercialisation of the entire sector. Reform is headlined, by unbundling and privatisation of the previously vertically integrated industry. This reform is part of the neoliberal economic orthodoxy that swept through the world, especially developing countries in the 1980s and 1990. This orthodoxy is premised on the ideology
that the State ought not to be involved in economic activities, except as merely a regulator. In its World Development
Report (1991), the World Bank articulated the classical view about neoliberal economic model in these terms: “Intervene reluctantly: let market s work, unless it is demonstrably better to step in… (it) is usually a mistake for the State to carry our physical production, to protect the domestics production of a good that can be imported more cheaply and whose local production offers few spillovers benefits. Apply checks and balances: put interventions continually to the discipline of international and domestic markets. intervene openly: Make interventions simply, transparent and subject to rules rather than official discretion”.
This orthodoxy influenced the diagnosis of the collapse of the electricity industry in the National Electric Power Policy (NEPP) as mostly the result of public monopoly, and the solution largely about divestment of public ownership of electricity assets. Privatisation became the magic bullet. Although the NEPP provided for commercialisation and corporatisation as preludes to complete privatisation, the Presidential Roadmap on Power in 2010 premised the recovery of the sector on privatisation. In its ideological commitment on privatisation, the Roadmap gave short shrift to corporate reform and enhancement of regulatory and business environment before privatisation.
Of course, this was a misdiagnosis. Its ideological simplicity misdirected efforts at reforming the electricity sector and culminated in a hasty privatisation that results in a distressed sector post-privatisation. Of course, privatisation was oversold. As Chairman of the regulator commission, I fell out with Minister of Power and the DG of BPE for expressing the need for caution, arguing that privatisation is a tricky proposition, especially when it is combined with acute scarcity of the product and underdeveloped policy and regulatory institutional capacity. There was nothing original in this insight. Nobel laureate in Economics, Joseph Stiglitz famously argued that, privatisation is rarely done well. This is not just about the methodology of privatisation. But, also, about the gains of privatisation. The assumption of efficiency post-privatisation, may end as just assumptions. This is because, mere change of ownership does not lead to improvement in efficiency.
Adam Przeworski and his colleague argue thus: “the hopes attached to privatisation are based on four mistaken assumptions: (1) that private ownership will itself solve the principal-agent problems, forcing manager to maximise profit; (2) that the market is a source of incentives for employees, rather than information to managers; (3) that enough capital would be forthcoming to infuse investment into newly privatised firms, and (4) that privatisation will automatically bring forth managerial skills to run large firms, in a market environment” (Adam
Przeworski et al, “Privatisation and Its Alternatives” in Sustainable Democracy (1995) Cambridge University Press, page 94). This best describes the mistaken diagnosis of the Nigerian power sector reform, and its poor results. Change of ownership has not resulted in significant change management strategies; we are not witnessing massive infusion of capital to finance needed maintenance and expansion investments; and we are not seeing dynamic efficiency gains. The result is stasis or even regression, in critical benchmarks of quality supply.
The problem with failed privatisation as in the Nigerian case, is that it will lead to increase in prices without increase in access and improvement in electricity supply. This would be a double tragedy. Consumers will pay more and usually for less. This is not unique to Nigeria. Analysing the effects of privatisation in Britain, Massimo Florio notes that “Before privatisation, in 1985, the average (unweighted) tariff for a typical domestic user of the 12 RECs and the two Scottish companies was 6.17 pence per kWh. The minimum tariff was 5.59 (Scotland), and the maximum was 6.47 (South Wales). Three years after privatisation, in 1993, the average tariff was 8.76 pence per kWh., with a minimum of 8.35 (Scottish Power) and a maximum of 9.95 pence (South Western)”. Although privatisation led to increase, Florio argues that “The main conclusion of my study is that privatisation had more modest effects on efficiency, than the theories of property rights and other orthodox privatisation theories may have expected. On the other hand, privatisation did have substantial regressive effect on the distribution of incomes and wealth in the United Kingdom”.
Privatisation pressures tariffs to go up. The problem is that, it does not in the short to medium terms lead to significant improvement in social welfare for citizens, whether in terms of affordability, availability, and reliability of electrical services. It may actually have the effect of increasing welfare losses and income inequality, and cascade negatively on sustainable economic growth. Underconsumption of electricity by small and medium enterprises will retard economic recovery postCOVID-19, and high tariff, if not properly regulated, could lead to higher inflation and trade deficit as Nigerian manufacturers become less competitive.
Tariff Increase and the Rule of Law:
The major argument for tariff review, is that operators need to be made whole. When the cost profiles of the industry change because of exogenous and endogenous factors, the tariff structure should move accordingly. This applies to both electricity and petroleum products. These are impure public good. This means that unlike perfect public good, their consumption is rivalrous and excludable. But, unlike private goods, they are largely price inelastic, meaning that increase in their prices does not necessarily lead to less consumption, as in other private goods. Adequate consumption of electricity for all categories of citizens, is a public good that government should ensure. Access to petrol, has implications for economic development and social stability. So, the resort to market forces to determine their pricing may make economic sense. But, in some circumstances, it may not make much social sense. The impact of constrained consumption arising from lack of affordability, could be economically and social ruinous from a public sector point of view.
For the deregulation of the downstream petroleum sector, the conditions precedent for such policy are not in place. We do not have local refining capability, such that costs will be reasonable. The foreign exchange market is not transparent, and there is no infrastructure to lower costs of transportation in the fluidity of market prices. How would government achieve its constitutional responsibilities, if it migrates to full market pricing without these precedential infrastructures? Obviously, the subsidy administration in the electricity and oil and gas sectors are inefficient, and not impacting positively on poverty reduction and inequality. Many rich persons are capturing these subsidies, and imposing costs on government. These costs arguably restrict the ability of government to make investment, in human and physical infrastructure. This is a theoretic justification of the removal of subsidy in these sectors and consequent price increases in electric power and petrol.
The problem is the failure of governance makes such resort to market pricing problematic. They could undermine the social and economic welfare, of the millions of poor Nigerians. By the Nation Bureau of Statistics (NBS) conservative estimation, more than 40% of Nigerians are extremely poor. The World Poverty Clocks suggests that, about 100 million Nigerians are extremely poor. This number is increasing daily with the near collapse of livelihood support system in the context of COVID-19 pandemic and severe insecurity, especially in the north of Nigeria.
How will the government achieve the constitutional obligation of good governance, in these circumstances? What social justice imperatives should guide policymaking regarding pricing of these essential products? We can source the answer from Section 16 of the Constitution, which is part of what we is commonly referred to as ‘Fundamental Objectives and Directive Principles of State Policy’ in Chapter 2. Section 16 states as follows:
“The State shall, within the context of the ideals and objectives for which provisions are made in this Constitution – (a) harness the resources of the nation and promote national prosperity and an efficient, a dynamic and self-reliant economy (sic); (b) control the national economy in such a manner as to secure the maximum welfare, freedom and happiness of every citizen on the basis of social justice and equality of status and opportunity; (c) without prejudice to its right to operate or participate in areas of the economy, other than the major sectors of the economy, manage and operate the major sectors of the economy”.
Buried in this section are four social justice imperatives, for managing the national economy. The first is the ‘growth imperative’. The constitution commits the managers of the economy (policymakers and regulators) to manage the economy, in such a manner to promote efficiency, dynamism, and self-reliance. This sums up in the idea of economic growth. Efficiency -dynamic and productive efficiency is the driver. The next imperative for managing the economy is ‘the social justice’ imperative. As I have argued elsewhere, “The second aspect of Section 16 relates to a commitment to ensure that the management of the national economy leads to social justice and equity. The Constitution proclaims the equality of status and opportunity to access the basic structure of justice – what in the language of modern liberalism is called “basic social goods” or “basic structure of justice”. This second commitment, is called “the social justice imperative” of the national economy. What I call “the social justice imperative”, is based on the concept of equality or equal regard. The sort of equality envisaged in the directive principle of state policy, is one that provides equal opportunity for all citizens to “maximise welfare, freedom and
happiness” (see Sam Amadi, “Doing it Right: A Rule of Law Critique of Privatisation Methodology in Nigeria” AFE BABALOLA UNIVERSITY: J. OF SUST. DEV. LAW & POLICY VOL. 10: 1: 2019).
The third, fourth and fifth imperatives are the ‘state regulatory’ imperative, which requires that notwithstanding the economic model adopted by the government, the economy must be regulated in a manner that ensures orderly development and equality before the law, the equality imperatives which prescribed near equalitarian outcomes and the ‘planned economy’ imperative which requires that the national economy be planned through institutional framework. All these imperatives are part of the constitutional definition of the framework, for managing the national economy. So, the choice of models and selection of policies, should consider these implications for realising these imperatives in chapter 2 of the constitution.
Another important consideration for price increase in the regulated electricity market, is that the prices must be ‘fair and just’ or ‘just and reasonable’. What is a ‘just and reasonable’ tariff increase? What should the regulator or the court consider in determining a tariff increase is ‘just and fair’ and ‘just and reasonable’? If a regulator does not have credible control and information on how a utility incurs costs, and cannot be certain that the cost structure and profile of the utility are prudent and efficient, does it have justification to pass those on to customers as ‘just and reasonable’ costs? Alfred Kahn, the doyen of utility regulation argues that, the regulator must insist on scrutinising utilities’ costs, even to the point of controlling “company expenditure in advance, supervising and passing on their budgets” (Alfred Kahn, The Economics of Regulation: Principles and Institutions, MIT Press 1988). This is necessary because, according to him, companies have incentives to increase their cost and suppress their profit. The behaviour of the regulated company is to deceive the regulators on its costs, in order to recover more than it deserves. So, prices cannot be reasonable if there are no fraud-proof methodology for the regulator, to review and verify these costs.
Those who provide services need to be compensated for costs, and rewarded for business risks. As along as those rewarded are approved by a regulator that applies a credible methodology that scrutinises costs and detects unreasonable and inefficient costs, then the courts will allow it. So says the US Supreme Court, as far back as 1944 in Federal Power Commission v Hope Natural Gas Co. 920. U.S. 591 (1944).
Conclusion
There is no doubt that we need a competitive electricity market to ensure adequate, reliable, and affordable electricity. The Nigerian electricity market is far from competitive. But, effective regulation will help a lot towards transitioning to a competitive electricity market. Privatisation is not competition. Regulation tries to stimulate the benefits of competition. So far so bad, or not too good. It will take a great effort consistently over some period, to achieve the goal of the reform. But, privatisation so far, has not helped much. The failure of privatisation in the short to medium term, is making it difficult to make a convincing case for the needed tariff review, because quality of service is not improving. Nevertheless, allowing for commercial tariff will be helpful, as long as we are effectively reforming the sector, such that operators are becoming more efficient, and poverty is not aggravating due to underconsumption of essential services. The resort to market pricing should be more strategic, so it ties to a more efficient public sector intervention in the whole of the economy. Market pricing is not the solution to a trapped economy, like Nigeria’s. It is just one, perhaps, insignificant piece of getting institutions right for economic and social development in Nigeria. Dr Sam Amadi Ph.D & LLM (Harvard), former Chairman, Nigerian Electricity Regulatory Commission (NERC)
“..... ABOUT THE GAINS OF PRIVATISATION. THE ASSUMPTION OF EFFICIENCY POSTPRIVATISATION, MAY END AS JUST ASSUMPTIONS. THIS IS BECAUSE, MERE CHANGE OF OWNERSHIP DOES NOT LEAD TO IMPROVEMENT IN EFFICIENCY”