Cross-subsidies in Electricity Sector

Electricity is a development indicator and critical for India’s economic growth. The electricity is shared responsibility between the central and state governments, with states having considerable freedom to set electricity prices, the average subsidy level and the beneficiaries of the cross-subsidisation. Cross-subsidy surcharges and non-price regulatory measures are key tools for balancing distribution companies’ equity and access considerations. These only become addressable after the terms of the bargains and the flows of the funding are made explicit. Cross-subsidisation is an important arena for transformation and enabling greater social efficiency. Consumers end up paying the socially efficient price.

What is cross-subsidy?

Views on the meaning of cross-subsidisation have varied, but they have generally involved the idea that one set of customers receives favorable prices at the expense of other customers. Specifically, a product is receiving a cross-subsidy if it is priced below its average incremental cost, and a product is generating a cross-subsidy if it is priced above it’s per unit stand-alone costs. The fairness standard for determining cross-subsidy has allowed for the development of numerous cost allocation techniques; generally in the form of fully distributed cost. In context of electricity, it is the difference between the applicable average tariff of a consumer category and the cost of supply to that consumer category. The cost of supplying electricity to all categories of consumers is same. However, the tariff charged from them is different. Say, if the average cost of service is Rs 3/unit, the domestic consumer may be charged at Rs 2.5/unit while an industrial consumer may be charged at Rs 3.5/unit. It is said that the domestic consumers are cross-subsidised by industrial consumers. The cross-subsidy for a consumer category is the difference between the cost to serve that category of consumers and average tariff realisation of that category of consumers. Cross-subsidies are to be calculated with reference to the category-wise cost of supply and not average cost of supply. The tariff for different categories of a consumer may progressively reflect the cost of electricity to the consumer category but may not be a mirror image of cost to supply to the respective consumer categories.

Cross-subsidies involve a group of consumers paying more than the general cost of supply and the surplus is used to subsidize the provision to the other group at a price that is lower than the cost of supply to the subsidised group.

Cross-subsidies in electricity tariff, therefore, can be defined as a mechanism whereby some consumer groups are charged a higher tariff as compared to the cost of supplying power to them. The additional revenue generated from them is used to tide over the revenue shortfall from other consumer groups, who are charged lesser tariff as compared to the cost of supplying power to them.

In India, cross-subsidies are pervasive where commercial and industrial consumers of electricity pay higher rates of supply to cover the shortfall in revenue of domestic and agriculture electricity consumers. Most of the distribution utilities have a lower tariff for consumers residing in rural or hilly areas in comparison to consumers residing in urban areas without factoring in the cost of supply. In some cases, consumption at higher tariff slabs generates cross-subsidies for the consumer whose consumption falls in lower slabs.

Desirability of cross-subsidy

The Electricity Act, 2003 (EA03) inscribes to ensure transparent policies regarding subsidies. Section 62(3), EA03 though speaks that Appropriate Commission while determining the tariff under this Act, shall not show undue preference to any consumer of electricity still it does refer to cross-subsidisation by allowing the Appropriate Commission to differentiate tariff, according to the consumer’s load factor, power factor, voltage, total consumption of electricity during any specified period or the time at which the supply is required or the geographical position of any area, the nature of supply and the purpose for which the supply is required. Section 42 aims the distribution licensee levying the surcharge to use it for cross-subsidy within the area of sup-ply of the distribution licensee. Section 61(g) EA03 endorses that while ascertaining the terms and conditions for the determination of tariff, the Appropriate Commission must be guided with the fact that the tariff progressively reflects the cost of supply of electricity and also, reduces cross-subsidies in the manner specified by the Appropriate Commission. Sections 38, 39, 40, 42, 178 (2) (k), (m) & (r) 181 (2) (j), (m), (p) & (zc) of EA03 refer to cross-subsidies which shall be progressively reduced in the manner as may be specified by the Central Commission or State Commission.

National Electricity Policy (NEP) notified on 12-2-2005 proffers that a minimum level of support may be required to make the electricity affordable for consumers of a very poor category. Consumers below the poverty line who consume below a specified level, say 30 units per month, may receive special support in terms of the tariff which are cross-subsidised. Tariffs for such designated group of consumers will be at least 50 % of the average (overall) cost of supply. The amount of cross-subsidy surcharge and the additional surcharge to be levied from consumers who are permitted open access should not be so onerous that it eliminates competition which is intended to be fostered in generation and supply of power directly to the consumers through open access. Policy feels concerned with the increase of cross-subsidies to unsustainable levels and hiding inefficiencies and losses in operations. It craves for the urgent need to correct imbalance without giving tariff shock to consumers. It aims the cross-subsidies for other categories of that consumers should be reduced progressively and gradually.

Tariff policy (TP) notified on 6-1-2006, stated that subsidy is a better way to support the indigent categories of consumers than the mechanism of cross-subsidizing the tariff. It suggests that as a substitute of cross-subsidies, the State Government has the option of raising resources through the mechanism of electricity duty and giving direct subsidies to only needy consumers which can be the better way of targeting subsidies effectively. For achieving the objective that the tariff progressively reflects the cost of supply of electricity, the SERC would notify roadmap within six months with a specified target and those tariffs are within ± 20 % of the average cost of supply. The road map would also have intermediate milestones, based on the approach of a gradual reduction in cross-subsidy. Tariff for agricultural use may be set at different levels for different parts of a state depending on the condition of the ground water table to prevent excessive depletion of ground water. The cross-subsidy surcharge should be brought down progressively and, as far as possible, at a linear rate to a maximum of 20% of its opening level.

In fact, reduction of cross-subsidy or tariff rationalisation has been the major factor of tariff reforms and it is for this reason that the independent regulatory commissions were envisaged through Electricity Regulatory Commissions Act, 1998. The aim of electricity reform begun with EA03. Further NEP and TP marked with periodic revisions, particularised the framework to reduce cross subsidies in retail tariffs.

Detrimental impact of high cross-subsidies

Electricity tariffs in India are fixed at the predetermined level, keeping in mind socio-economic considerations to meet consumer’s capacity-to-pay. Cross subsidies are widely used to support rural electrification schemes but their effectiveness depends on the existence of a relatively large number of better-off consumers that can afford to pay more than the cost of supply. Cross subsidisation is distortionary, in that neither group is paying the correct price for power but in all cases, the loss of revenue on electricity sent out is carried by the utility or by other users through a cross-subsidy, therefore, utilities are reluctant to provide connections and regular supply to agricultural and residential consumers. Dysfunctional ties and distortions of cross subsidisation result in increasing theft and leakages, loss of accountability of revenue and misreporting.

The farmers are ostensibly the beneficiaries of subsidised electricity; they suffer from a de facto “de-electrification”. Farmers experience power rationing and poor supply quality. Low voltage, frequent interruptions, and phase imbalances hit rural areas with substantial economic costs. Poor quality of power supply imposes significant coping costs on farmers which lowers the quality of life in rural areas and hampers the growth of local industries and commercial enterprises. Delivering subsidised electricity to farmers actually imposes substantial economic costs on the farm-sector.

Cross-subsidised electricity sector encourages consumption of electricity. Cheap electricity supplied to farmer’s effects groundwater level due to indiscriminate extraction.

A free-market is the fastest and most efficient way to correct the market distortions. Cross-subsidies ob-struct competition in the retail supply of electricity. Utilities incur losses on every unit of electricity sold; Subsidization leads to economic distortions which affect the balance between supply and demand, thereby impacting quality and accessibility of electricity.

In order to finance the cross?subsidy, industry and businesses, generally are asked to pay tariffs above costs. The Higher cost of electricity increases the cost of manufacturing and feeds into higher product costs which adversely impact the competitiveness of businesses. In fact, cross-subsidy regimes prove counter-productive. Cross-subsidies lead to wastage of resources, and rising price elasticity of electricity demand in industry, force the industry to seek energy alternatives. Industries switch to “captive power generation” resulting the decline in revenue to state utilities.

Many power generation projects are in distress due to the weak financial health of distribution companies. Power distributors are not able to fully realize the cost of power supply to consumers due to tight tariff regulation. The lack of clarity on the treatment of cross subsides; the model did little to help potential investors understand the future of the sector. As a consequence, federal policy think-tank, “Niti Aayog” has pitched for letting power utilities realize full market price from all consumers by doing away with cross-subsidy provided to poor consumers.

Upshot

The principal difficulty in finding “true cost” of supply is a very subjective notion, particularly in the light of cross-subsidies. It is nearly infeasible for regulators to establish subsidy-free prices. It seems reasonable that regulators should narrow their interest to some definable social importance. The cross-subsidy surcharge needs to be lowered so that the end consumers may find it economical. Cross-subsidies should be limited to reducing the tariff for a lifeline quantity of electricity for the lowest income consumers and financed in a way that imposes the least degree of distortion on the tariffs of other customer categories. On the policy front, there are adequate guidelines that emphasise the need for winding down cross-subsidies.

 

*Harsha Rajwanshi is the Assistant Professor of Law, Gujarat National Law University & Faculty Advisor to GUVNL-GNLU Research Fellowship on Energy Law and Policy.

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