The ongoing crisis in Pakistan’s power sector, highlighting the circular debt and energy cost challenge, extends beyond mere power generation; it fundamentally revolves around the overwhelming burden of debt. While surplus power generation capacity should ideally serve as a catalyst for industrial growth and increased demand, the country struggles to leverage this potential due to a substantial debt overhang.
This situation is primarily driven by a combination of project debt, working capital debt, and, most critically, circular debt. As it stands, the circular debt and energy cost challenge has ballooned to over Rs2.26 trillion, largely resulting from inefficiencies and incessant subsidies within the sector.
This staggering figure directly influences electricity bills, with an estimated Rs3.23 per kilowatt-hour (kWh) attributed solely to markup payments related to financing this debt. When taxes are factored in, the cost rises to Rs3.81 per kWh for most non-protected consumers. While the exact figures may vary across different consumption slabs, the burden on electricity bills remains significant for all consumers.
Moreover, the financing cost associated with circular debt is embedded in electricity bills through a PHL (Power Holding Limited) Charge, inflating overall electricity costs. Consumers find themselves footing this bill due to inefficiencies and poor financial management at the macro level. This inflation of electricity tariffs, driven by extraneous costs, has contributed to a declining demand for electricity, which in turn hampers both industrial growth and broader economic development.
Electricity demand is particularly price-sensitive; estimates indicate that a mere 1% decrease in electricity prices can lead to a 0.3% increase in consumption. There is a strong correlation between rising electricity consumption and economic growth. Essentially, sustainable economic development is unattainable without affordable electricity, and achieving affordable electricity hinges on resolving the underlying debt problem. The current bloated state of circular debt serves as a significant drag on economic expansion.
Reframing the Problem
To effectively tackle this crisis, it is essential to first frame the power sector issues as fundamentally debt-related. Within the staggering circular debt of Rs2.26 trillion, approximately Rs683 billion is linked to the Special Purpose Vehicle (SPV) known as Power Holding Limited (PHL). Another Rs1.06 trillion is owed by the Central Power Purchasing Agency (CPPA) to various power producers, while Rs520 billion is categorized as non-interest-bearing. Consequently, approximately Rs1.74 trillion incurs financing costs, which ultimately fall on consumers through their monthly electricity bills.
Currently, the financing cost associated with PHL is pegged to the three-month Karachi Interbank Offered Rate (Kibor) plus 0.45%. The payable amount by CPPA to power producers begins at around 3m Kibor plus 2% for the first 60 days, escalating to 3m Kibor plus 4.5% for amounts overdue beyond that period.
Notably, it is estimated that about half of CPPA’s payables are overdue by more than 60 days, leading to an average financing cost of 3m Kibor plus 3.5%. Power producers often resort to commercial borrowing to cover these receivables, which results in their financing costs being lower than what consumers pay through electricity bills. This creates a distortion in the market that needs to be addressed through a better price discovery mechanism.
Rationalizing Costs and Improving Efficiency
All of these debts and payables are fundamentally backed by the sovereign, whether through guarantees or contractual arrangements. Despite this backing, the financing costs remain disproportionately high compared to the sovereign’s borrowing costs, which are typically below the 3m Kibor.
In today’s economic climate, characterized by declining interest rates, sovereign-backed entities like the Trading Corporation of Pakistan (TCP) and the Pakistan Agricultural Storage and Services Corporation (Passco) are able to secure loans at rates significantly lower than 3m Kibor. The fact that these financing costs are passed on to consumers, with minimal effort made to rationalize expenses, places undue strain on household electricity costs.
A solution can be modeled after the Treasury Single Account (TSA) framework advocated by the International Monetary Fund (IMF), which suggests that all government funds be consolidated into a single account.
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Similarly, managing debt in a consolidated manner would help alleviate the inefficiencies in the current borrowing structure. It makes little sense for sovereign entities to borrow at vastly different rates due to a lack of price discovery, which only serves to inflate electricity prices for consumers and curtail their ability to increase consumption.
The IMF’s latest Country Report for Pakistan has explicitly highlighted the necessity of converting PHL debt into cheaper public debt. Such a transition is not only economically feasible but also beneficial for consumers. A strategic plan must be implemented to capitalize on declining interest rates, allowing the government to exchange circular debt for far cheaper public debt, resulting in substantial savings in financing costs.
Exploring Islamic Banking Options
Additionally, Islamic banks in Pakistan currently enjoy a surplus of liquidity, enabling the government to issue debt through Islamic structures at lower costs compared to conventional borrowing. There exists a significant opportunity to convert PHL debt into longer-term Islamic instruments with maturities of 5 to 10 years. As interest rates decline, the potential to borrow at rates significantly below the existing 3m Kibor could yield net benefits for consumers.
Transitioning circular debt from PHL to more affordable sovereign debt would result in reduced PHL charges for consumers, while simultaneously lowering the mark-up for all entities involved. This shift creates a net gain for the entire system.
The CPPA’s payables, amounting to Rs1.06 trillion, should also be gradually exchanged for sovereign debt, starting with the more expensive overdue amounts that currently incur a mark-up of 3m Kibor plus 4.5%. The government can issue long-term bonds, whether conventional or Islamic, based on market appetite, facilitating a seamless exchange with power producers’ receivables.
In this scenario, power producers receive long-term sovereign bonds in place of their receivables, which can be traded in the open market, providing them with liquidity that can be utilized for competitive market strategies or shareholder dividends. These instruments could be competitively priced via the Pakistan Stock Exchange (PSX), promoting more efficient pricing and better price discovery, thereby lowering costs.
Enhancing Risk Profiles and Reducing Costs
The receivables from power producers are already financed by banks, and settling them in exchange for sovereign debt would enhance the risk profile for all stakeholders. Banks would gain access to tradable sovereign instruments, reducing their exposure to the power sector, while simultaneously fostering greater investment in energy security and efficiency. Tax incentives on such instruments could further bolster participation, provided that the net cost to the government is manageable.
By implementing this strategy, the risk profile for all parties involved improves, and financing costs diminish. As circular debt is converted into public debt, electricity consumers stand to benefit from a direct reduction of Rs3.81 per kWh in their electricity prices. This maneuver alone could save approximately Rs90 billion in annual financing costs through a contraction of lending spreads and the utilization of superior terms available through sovereign debt.
In summary, it is feasible to lower electricity bills by Rs3.81 per kWh, which, coupled with other reforms, could stimulate necessary growth in consumption and catalyze industrial expansion. A shift towards public debt is instrumental in this context, generating a consumer surplus and driving economic growth. The fundamental gains derived from this approach are efficiency-driven, aimed at eliminating existing distortions in how the sovereign borrows.
Structural reforms in the power sector require time, but achieving efficiency gains can be expedited by minimizing these distortions. The power sector remains burdened by a dysfunctional cost-plus pricing regime, resulting in excessive costs for consumers. Streamlining this system is critical for enhancing competitiveness within the power sector, thereby propelling economic growth.
It is imperative that we address the debt problem based on sound principles rather than simply imposing additional costs on consumers, who have been burdened with the consequences of poor financial management and inefficiencies in the sector.
The Power Division presented a report to the National Assembly detailing capacity payments to Independent Power Producers (IPPs) from July 2023 to July 2024. A total of Rs 979.29 billion was paid to 33 IPPs.
Including Rs 718.064 billion to eight coal-based IPPs, Rs 106.991 billion to three hydropower IPPs, and Rs 81.60 billion to eleven furnace oil-based IPPs. The report highlighted that increasing payments, driven by the rupee’s devaluation, further burden consumers and strain the energy sector.
