Explainer: What is cost reflective electricity pricing and how does everyone benefit? (1)

Explainer: What is cost reflective electricity pricing and how does everyone benefit? (1)

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In the last six years, Nigerians have embarked on a quest to make electricity consumption and supply more efficient through privatisation, based on the belief that private sector actors working with market forces of demand and supply would help rectify the ailments in the sector.

However, the privatisation process has been slow to produce the desired outcomes in terms of attracting fresh investments across the sector’s value chain of generation, transmission and distribution of electricity.

Lack of fresh investments into the sector have brought some electricity distribution companies (Discos) to the edge of bankruptcy and caused investment shortfalls of close to N1.4 trillion. These investment gaps account for the fact that Nigerians do not enjoy the benefits of steady electricity supply.

A major function of the Nigerian Electricity Regulatory Commission (NERC) as contained in section 32(d) of the Electricity Power Sector Reform (EPSR) Act, 2005 is to ensure that the prices charged by licensees are fair to customers and sufficient to allow the licensees to finance their activities and to allow for reasonable earnings for efficient operation.

To make the sector self-sustaining without bailouts from the government, cost-reflective electricity pricing has been called for. But what is cost reflective electricity pricing and how will it benefit everyone?

Cost reflective electricity pricing requires Discos to introduce tariffs that more strongly reflect their underlying costs. Good tariffs should be efficient, equitable, provide stable bills for consumers and revenue for businesses, and be acceptable to customers. There are several types of cost-reflective tariffs, and each fulfills these criteria to a greater or lesser extent.

An average retail electricity price today is N32 per kilowatt hour, for a product that has an average retail price of N80 per kilowatt hour on a cost reflective basis. This includes the debates around gas pricing too, which has been described as uncompetitive.

The power generator gives invoices to the bulk trader at an exchange rate of N360/$, the distribution companies are made to charge the customer using an exchange rate of N199/$ because the Multi-Year Tariff Order (MYTO) designed to review tariffs (in light inflation, exchange rate, interest rates, and generation capacity) has missed six reviews.

Power generation companies bear the biggest pain in this warped pricing system. Egbin Power, Nigeria’s biggest generation company is owed over N160 billion. Other electricity generation companies (Gencos) complain of large debts because invoices are not fully settled by the Nigerian Bulk Electricity Trading Company which can only pay about 30 percent of invoice.

The Transmission Company of Nigeria recently said it gets paid only 25 percent of its market invoice. The whole electricity value chain is caught in a web of consequences flowing from the absence of a cost reflective pricing of electricity.

Nigeria is not alone in wanting to make its electricity supply industry more compliant with market forces of demand and supply and the use of pricing mechanism to efficiently allocate resources in the sector.

In 2014 the Council of Australian Governments’ Energy Council saw tariff reform as the essential next step in the process of providing better price signals to consumers. The Australian Energy Market Commission (AEMC) Approach Paper on the Electricity Network Regulatory Framework Review noted that cost-reflective network tariffs can result in significant savings for consumers and creates an essential foundation for future reforms.

Electricity networks cost a lot to build but little to use. Erecting power poles and stringing wires is expensive, and a network needs a control centre and field crews to operate and maintain it in safe working condition. Sending electrons (electricity) along the wires doesn’t produce much wear or tear, and so is comparatively cheap; once a network has been built, whether it’s used to 10 percent capacity or 90 percent capacity does not greatly change its costs.

Prices significantly below marginal cost of production encourage excessive or “wasteful” consumption, and cost society more than the benefit for which people are prepared to pay.

Conversely prices significantly above marginal cost reduce overall value within the economy by causing consumers to forego the enjoyment or benefit that additional consumption would have provided, at the same time only reducing costs (of production) by a smaller amount. In either case, poor tariffs can result in poor investment decisions and significant misallocation of resources.



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