MARCH 19, 2014

POLICY RECOMMENDATION PAPER

ELECTRICITY MARKETS (U6057)

HARSH VIJAYSINGH
MPA – 1ST YEAR
UNI – hs2713
To: Hon. Minister of Power, Government of India
Subject: Power Sector Reforms in India – Progress, Challenges and Strategies
Date: 19th March 2014

POLICY ISSUE IN BRIEF

Power sector in India faces many challenges, mostly arising out of the surge in demand following increase
in industrial activity and rapid urbanization. Power generation, distribution and transmission in India was
concentrated in the hands of Public Sector Undertakings, operating as vertically integrated monopolies
within states. Since the introduction of power sector reforms in 1991, and successive waves of reforms to
create institutional capacity for regulation and introduction of competition, the power sector has seen
significant improvement in generation capacity and growth in transmission networks.

However, the rationale behind the reforms, i.e. to usher privatization is still a far-fetched goal. Most of the
incremental capacity in generation and transmission has been done through the unbundled public sector
companies. Wholesale markets have not been introduced yet, with single buyer models operating in most
states. The reforms are currently in their initial phases, and the next few years will be very important in
determining the long term efficiency of the reforms.

Lessons from restructuring process in other countries (US, Australia, Argentina) have proven the need for
wholesale power market and introduction of competition and efficiency in the electricity market, which are
still missing from India’s reforms. This memo studies the progress of the restructuring process, identifies
additional elements that might be needed to tweak the reforms, and recommends better implementation
strategies for improved results.
 BACKGROUND INFORMATION AND MOTIVATION FOR REFORMS

The power market in India has been evolving significantly over the past century, with successive steps of
reforms aimed at improving the reliability and efficiency of the power sector. The Indian Electricity Act 1910
provided the original framework for the electricity industry. It was the first legislative directive detailing the
rules of functioning for private sector licensees, who were mostly active in the power generation activity.
The act detailed process for distributing licenses for generation, the framework for laying down distribution
lines, and the rules governing the relationship between licensee and the consumers. There was significant
emphasis on promoting private sector activity.

After India’s independence in 1947, the Electricity Supply Act (1948) attempted to reverse the ownership
and operation of power sector from private companies into the hands of the public sector. Electricity was
rightly deemed as one of the most important factors that would determine the economic prospects of a
newly independent nation, but the attention led to increased interference by the government in the power
sector. Smaller fragmented utilities were consolidated to form 19 vertically integrated monopolies in the
form of State Electricity Boards
(SEB’s) were created in each state
to oversee the generation,
transmission and distribution
within the boundaries of their
states, and central government
owned generation and
transmission companies were also
established simultaneously. While
private sector participation was
permitted in generation sector to
begin with, the structure that
emerged led to a single buyer
model, with SEB’s purchasing the
generated electricity from the Figure 1- Indian Power Sector pre-reform (Source: Singh, 2004)
private entities.

In the decades that followed, the power sector in India was characterized by lack of generation capacity,
poor transmission network, frequent blackouts and lack of adequate funds to modernize the grid or to
increase generation capacity. The politically sensitive environment was not attractive for private
investment either, and the complex maze of permits and licenses further exacerbated the problem. The
sluggish growth in the economy came to be characterized as the “Hindu Growth rate”, and the effects were
very much evident in the electricity sector as well.

By 1990’s all of the SEB’s were a sink for the tax payer’s money. Decades of inefficiency, mismanagement
and political pressure to subsidize tariffs for agricultural consumers had rendered all the SEB’s as loss
making entities. Inefficiencies in SEB’s and resulting financial difficulties can also be partly attributed to the
lack of accountability and adequate incentives for the employees. Such inefficiencies were responsible for
large scale theft of electricity, high T&D losses, low volumes of revenue collections from customers, and
time and cost overruns in completion of investment projects caused by procedural delays and contractual
failures1.

Consequently, the SEB’s were unable to pay dues to the generating companies owned by the central
government or to private entities, and being cash strapped and under burden of subsidies, they could not
invest to increase generation capacity either2. The electricity sector faced peak power shortage of 20% in
the late eighties, and about 12% in terms of overall electricity requirement of the currently connected
consumers3. The led to deterioration of quality of power supply, and increased the effective cost of power
to the consumers who had to resort to other sources of power like private diesel generators or kerosene
lamps.

In the wake of near insolvency of the SEB’s, and the overall economic liberalization in India following the
balance of payments crisis in 1991, the power sector saw some initial few steps towards reform. Private
participation and foreign equity was allowed in electricity generation, with guaranteed post-tax return of
16%, additional returns for enhanced Plant Load Factor (PLF), five year tax holidays, free repatriation of
dividends and interests, accelerated depreciation and reduction in custom duties. However, even after
attractive terms such as these, private participation in electricity generation was way below target. Despite
the huge demand for power, private sector companies were unable to operate. The main reason for this
was the financial non-viability of SEB’s, who were supposed to be the bulk purchasers of electricity. They
could not enter into reliable long term contracts with the private generators with guarantee of purchase of
electricity.

Power sector reforms and introduction of a regulatory structure was seen as a possible mechanism to
improve the condition of SEB’s, which were like a bottleneck for success of any comprehensive electricity
policy4. Following the success of electricity industry restructuring in some Latin American Countries, the
World Bank put forth power sector reforms as a condition for future assistance to power sector in India in
1996. The restructuring process was piloted in the state of Orissa5, which has very low component of
agricultural subsidies. The process began with functional unbundling and corporatization of the SEB into
separate entities for generation, transmission and distribution. A regulatory authority was set up in the
state which administered licensing for undertaking business in the Orissa and set tariffs for T&D businesses
using cost of service regulation6. The presence of a regulatory framework is important in industries with
natural monopolies, and which can be influenced by private interests. Additionally, Power Trading
Corporation (PTC) acted as an intermediary between the generators (public and private) and the buyers
(unbundled SEB).

Following the pilot project in Orissa, more and more states followed the unbundling process. Currently,
most of the states have unbundled their SEB into separate entities for generation, transmission and
distribution and have an independent state level regulator.

1
Shantakumar V., 2003: Impact of the Distribution of the Cost of Reform on Social Support for Reforms
2
The dues of SEB’s to Central Public Sector Undertakings was estimated at INR 414.73 Billion in 2001-02
3
Shantakumar, V., 2003: Impact of the Distribution of the Cost of Reform on Social Support for Reforms
4
Carstairs J., Ehrhardt, D., 1995: Financial Structure in Indian Power Sector
5
Rajan, A. T., 2000: Power Sector Reform in Orissa: an ex-post Analysis of the Causal Factors
6
Shankar, T. L., Ramachandra U., 2000: Regulation of the Indian Power Sector ASCI Journal of Management
The strategy for electricity reform in India drew from experiences of reforms in other countries, but were
shaped by local political and economic context. While vertically integrated generation capacity was
unbundled and sold to private investors in US and Chile, SEB’s in India were not privatized, but corporatized
instead7.

At the central level, reforms were initiated to resolve issues governing generation and transmission issues
involving more than one state through enactment of Regulatory Commissions Act in 1998, which led to the
formation of Central Electricity Regulatory Commission (CERC). CERC is responsible to regulate tariff for
generating companies owned by the central government or any other generation company catering to
more than one state. Additionally, in order to introduce transparency and efficiency, CERC has presided
over landmark changes in tariff determination by imposing Availability Based Tariff (ABT) to bring reliability
in the grid by providing frequency linked incentives and disincentives.

Furthermore, piecemeal approaches to reform were seen in the introduction of Accelerated Power
Development and Reform Program (APDRP) for reforms in distribution through provision of transitional
finance to SEB’s for measures such as 100% metering, improving HT/LT ratio, energy audits, replacement
of distribution transformers, etc8. Additionally, since most of the SEB’s were on the verge of financial
collapse, a one-time settlement of SEB debts was initiated in 2002 as a tripartite agreement between the
state government, Ministry of Finance and Reserve Bank of India.

While such measures helped the electricity sector, they were not long term solutions by any means. In
order to remove systemic flaws, the parliament passed Electricity Act 2003, which overrides all pre-existing
legislations (Indian Electricity Act 1910, Electricity Supply Act 1948 and Electricity Regulatory Commissions
Act 1998).

Electricity Act 2003:

The act aims to bring qualitative transformation in the electricity sector by creating a framework that
distances government from regulation. It consolidates the laws relating to generation, transmission,
distribution, trading and use of electricity by taking measures conducive to the electricity sector.

The act provides less constrained environment for potential investors by removing administrative hurdles
wherever appropriate, and has created an environment to introduce competitiveness in the market by
rationalizing electricity tariff structure. In addition to allowing for private investment in all the sectors of
the power industry, the act also includes9, among others:

 De-licensed generation
 Freedom of captive generation
 Recognition of power trading as an independent activity
 Open access to all generators in transmission and distribution networks

7
Cropper, M. L., Limonov, A., Malik, K., Singh, A., 2012: Estimating Impact of Restructuring on Electricity
Generation Efficiency – Case Study of Indian Thermal Power Sector
8
APDRP has since been re-structured in 2012
(http://www.powermin.nic.in/distribution/apdrp/projects/pdf/Re_Structured_APDRP_during_XI_Plan.pdf)
9
Garg, A., Gaba, V., Bajaj, A. L., 2008: Regulation in Practice: Impact of Tariff Orders in Indian Electricity Sector
  Multiple distribution licensee in a supply area
 Mandatory unbundling of all SEB’s and setting up state power regulators
 Independent operation by load dispatch centers at state, regional and national level

Essentially, the
Electricity Act
2003 has
provided the
process map
for a market
based
transparent
regime through
progressive
introduction of
competition. A
very important
shift in this act
was from a
Figure 2 - Indian Power Sector after Electricity Act 2003(Source: Singh, 2004) single buyer
model to a
multiple buyer model, where the monopoly of SEB’s in buying and selling would cease, leading to a market
determined rate structure.

However, a decade after introduction of the reforms, the effects have so far been mixed. There is
considerable lack of evaluation of the efficacy of the reforms. Remaining parts of this paper attempt to
outline some of the continuing discrepancies in the power sector that were either overlooked by the
reform, or did not bear the intended impact, and the possible strategies to accomplish the same.

CURRENT SITUATION OF INDIAN POWER SECTOR

In the prime of its economic resurgence, India’s prospects have been stymied for the want of reliable and
affordable electricity. The existence and development of adequate power infrastructure is essential for
sustained growth of the economy. Following successive waves of reforms, the installed electricity
generation capacity has grown significantly since independence, from 1,362 MW in 1947 to 234 GW 10
(Figure 3) as of December 2013. Currently, India has the fourth largest power generation capacity in the
world.

10
CEA : Executive Summary of Power Sector – December 2013 – See Figure 3
 Figure 3- All India Installed Capacity (MW) as on 31-12-2013

Despite this significant growth in generation capacity, the shortage of power continues to persist, as growth
in capacity has not been able to keep pace with the growth in demand. The T&D network has also seen
commensurate expansion, enabling the expansion of network across the country’s geographic space.
Officially, as per Ministry of Power, 94% of the villages have been connected to the grid11. However, only
55%12 of the villages have access to electricity due to systemic inefficiencies. The annual per capita
electricity consumption in India is 819 kWh13 (Figure 4), which is significantly below those in developed
economies as well as the average per capita electricity consumption in the world. Many parts of the country
continue to be under chronic power shortage.

Figure 4- Per Capita Electricity Consumption in Various Countries during the year 2009

The power system has high peak demand shortages (Figure 5), which is a serious deterrent to sustained
industrial and commercial activity. Furthermore, T&D losses of approximately 25% undermine efficient
utilization of resources, representing a wasted economic opportunity.

11
CEA : Executive Summary of Power Sector – December 2013
12
Anoop Singh, 2004: Power Sector Reform in India: Current Issues and Prospects
13
CEA : Growth of Electricity Sector in India (1947-2012) – See Figure 4
 Figure 5: Peak Demand / Peak Met in December 2013 (Source - CEA Annual Report, December 2013

EMERGING ISSUES AND RECOMMENDATIONS

Over the course of the decade, the achievements of the power sector reforms are truly remarkable. The
institutional arrangements have helped to improve the operation of the electricity system. Additionally, the
transparent and inclusive approach taken by regulators in enacting their orders has provided a space to
incorporate issues of various stakeholders in public domain14. It has often been quoted about India’s
economic growth that it happens not because of, but despite the government. The same is true for the
power sector as well.

It might take more time to undo the damages done by the decades spent in pursuing adverse policies.
However, the purpose of the reform is not to introduce competition or reduce tariffs, but to make the
power sector more efficient in all its activities - technical, operational, economic and regulatory. The
economic and commercial gains are essentially derivatives of the improvement in efficiency of the sector.

1. Information Asymmetry in Tariff Determination:

Tariff is a mechanism through which the financial viability of the utilities and the prospects of future
investment will be determined. It is very important that the tariff send the appropriate price signals,
promote healthy competition and lead to higher efficiency in the system. The current approach to
tariff determination in Indian power sector is based on a cost – plus (or cost of service) mechanism,
wherein the regulators set benchmarks for parameters determining both fixed charge and energy
charge components of tariffs15.

The operational benchmarks for determination of fixed and variable components of the tariff are
set by the regulators ex-post, on the basis of information provided by the regulated entities. In an
ideal case scenario, these benchmarks are supposed to serve as a normative point of reference if
regulators have perfect information about operational data to set the performance benchmarks.
Power plants that perform better (more efficiently) than the norm earn a profit, as their revenues
are set on a fixed benchmarked scale, rather than actual expenditure incurred.

14
Prayas, 2003: A Good Beginning but Challenges Galore
15
Chikakur et. al, 2007: Tariff Based Incentives for Improving Coal Power Plant Efficiencies in India
 However, regulated firms control the flow of information to the regulators, which can lead to the
problems of adverse selection and moral hazard16. In both scenarios, asymmetry of information
about endogenous inputs leads to higher tariffs and lower efficiency of the generation system.

One of the primary variables to determine the operational norms is the heat rate, which attempts
to normalize the power generation across different fuels and technologies. The first benchmark
was set in 1992, with scope of further revision and tightening of benchmarks on the basis of actual
operational data. However, successive attempts to revise the benchmark have failed, and been
even contested in the courts17. The absence of updated information on heat rates handicaps the
regulator on the process of revision of tariff norms.

Promoting competition and developing market in electricity sector cannot be an excuse for
inefficient operation, which has further serious implications. In addition to sending the wrong price
signal and promoting rent seeking practices, it exacerbates the pollution problem and leads to
inefficient utilization of scarce fossil fuel resources. Chikakur et. al. (2007) mention the following
strategies to improve efficiency of power sector in India through an alternative mechanism of tariff
determination:

 Median Heat Rates - Calculation of the basic tariff on the basis of median of actual gross
heat rates or peer groups of power plants, rather than normative benchmarks set by CERC
 Relative Performance Incentive – Positive incentives to power plants that perform better
than the median, that escalate with increasing deviation from the median efficiency to
motivate high efficiency plants to further improve their performance and to incentivize
plants around median efficiency to reduce their heat rates
 Self-improvement Incentive –Financial benefit to plants to improve efficiency relative to
their own past performance

Such performance based ratemaking schemes being determined on the basis of industry wide
norms rather than the costs and performance standards of an individual utility, the potential for
realizing rent due to information asymmetry is reduced. This eliminates the onus on regulators to
make frequent revisions to the tariff structure, and focus more on the other tasks like improving
quality of power supply, strengthen the regulatory structure, enforcing tighter customer service
norms etc. Also, since the duration of performance based ratemaking practices are long term, the
utility has an opportunity to take advantage from its investments in improving efficiency18.

2. Open Access and Independent System Operator:

Open access implies that a number of licensees can reach the consumer through the network being
operated by the distribution company. A non-discriminatory open access is a vital pre-requisite for

16
Joskow, P. L., 2006: Incentive Regulation in Theory and Practice- Electricity Distribution and Transmission
Networks
17
CERC, 2000b. Section 5.3.2
18
Ahluwlia, S., Baithani, G., 2000: Tariff Setting in Electric Power Sector – Base Paper on Indian Case Study
 competition. The open access provision calls for increased spending on additional distribution
infrastructure, as any incremental capacity will need provision for timely and sufficient dispatch as
soon as it goes under operation. Presently, there is little surplus in distribution infrastructure, as
the entire capacity is being consumed by the existing generators. The incremental installation of
distribution should precede, rather than follow, the incremental capacity installation.

As number of players in the generation sector increases, this might put additional pressure on the
grid due to compromise in quality of power supply, thereby affecting the grid discipline. This
necessitates the presence of an efficient Independent System Operator (ISO) ensure proper
compliance of the supplied power with grid codes. There is a stray possibility that independent
power producers may pump in power into the grid even when the system does not desire it. In
order to prevent such situations, definite protocols for power transmission and dispatch scheduling
need to be conveyed uniformly to each power generator.

3. Promotion of Independent Power Producers (IPP’s):

Increased participation of IPP’s in power generation has been a consistent theme in each of India’s
electricity related legislations, with the exception of Electricity Supply Act 1948. Since 1991, the
government has offered attractive returns and incentives in order to promote private investment
in power generation. However, as of 2002, though IPP’s expressed interest for adding generation
capacity for about 95000 MW, only 6500 MW could be realized19. Despite series of reform
measures, the power generation continues to be heavily dominated by public sector utilities 20.

Even today, more than two decades after liberalization process began, private sector participation
in generation has failed to pick up in the intended manner. Majority of the private generation
capacity is in the form of captive power generation plants, which are owned by large consumers of
electricity for their own consumption. The primary reason for this trend could be, that the multi-
buyer objective of Electricity Act 2003 has still not been realized. Most of the power is still
purchased by single buyers, which are inevitably SEB’s in their jurisdiction functioning as monopoly
transmission agencies. Financial instability of SEB’s and political influence over their decisions do
not make an attractive proposition for a private generator to invest heavily in power generation.
Following unbundling of SEB’s, the situation is improved over the past years, but not to the level
that they might be seen as reliable purchasers of electricity. In order to overcome this bottleneck,
the central government should make provision of a separate fund to compensate a private
generator for loss or delay in revenue realization from a SEB.

The Electricity Act 2003 seeks to remove the weak link of SEB’s from the supply chain. It further
provides for many attractive terms to promote IPP’s. However, there is no time line for
implementation of some key measures of the reforms, such as phasing out cross subsidies,
disintegration of state utility boards, and introduction of wholesale and retail competition.

19
World Energy Council 2002: India Energy Market Reforms
20
NTPC accounts for almost a third of power generated in India, and is currently sixth largest in the world
 Furthermore, T&D networks account for approximately 25% of power loss in India. In order to
promote further private investment in power generation, the T&D losses need to be controlled by
extensive process of grid modernization, 100% metering, etc.

4. Political Interference in Reform Process

Agriculture consumes more than one third of India’s power, yet provides less than 5% of the
revenues. Most agricultural supply is for water pump sets, which goes unmetered, denting a severe
loss on the balance sheets of the SEB’s. The central and state governments have instituted
measures to compensate for the loss of revenues to SEB’s through subsidy payments. Alternatively,
industries and other large consumers of electricity pay more than the marginal cost of electricity
in order to cross-subsidize the low tariffs for agricultural and rural consumers. The issue of subsidies
to agricultural consumers, and to some extent to residential consumers as well, is politically
sensitive. These demographics represent vote banks for any power aspirant, and removal of
subsidies will require considerable political will.

The tariffs for industries in India are higher than most developed nations, precisely because of the
cross-subsidy quotient. Such practices have led the industries to drop out of the state power
generation and distribution network and install captive power plants for their electricity needs. The
economics of captive plants are far cheaper than the tariffs charged by the SEB’s to the industries.
However, increased prevalence of captive power plants can put further pressure on the
constrained fossil fuel resources.

The subsidy regime has perhaps been the bane of India’s power sector, and there is urgent need
for gradual elimination of the subsidies. The experience from the power sector reforms over the
past two decades has shown that consumers are not against paying higher prices for electricity if
there is significant improvement in reliability. The prices of electricity have risen consistently by
higher than the annual inflation rate since 1991, yet number of consumers has risen consistently,
signifying the importance of quality and reliability of power supply.

5. Metering and Energy Audits

Distribution sector provides the last mile connectivity to the consumer, yet it is the weakest link in
the country power sector value chain. At present, Aggregate Transmission and Commercial (AT&C)
losses account for more than 25% of the power generated in India21. Proper metering of consumers
will help to identify the exact nature and quantum of power loss through non payments or through
leakages in the system. Over the years, there has been a practice among DISCOMS to attribute loss
of revenue to agriculture, thereby masking the true reason for the power and revenue loss.

Agricultural and rural feeders should be separated, in order to minimize the losses accounting from
wasteful consumption of subsidized electricity. Separation of agricultural and rural feeders will also
give a more accurate picture of losses, and will help in proper scheduling so as to make minimum

21
Garg, S., 2012: Indian Power Sector – Challenges and Opportunities
 impact on peak hour functioning of the grid. It will also enable to make more reliable estimates of
the volume of subsidy payments to states which have substantial agricultural power consumption.

Much of the commercial losses are due to non-payment by many residential consumers.
Installation of smart meters for residential consumers / groups of consumers will facilitate the
recovery of dues from the consumers. Smart meters also help in improving consumer service by
relaying real time power performance data to the DISCOM, and are an essential component for
many ancillary services as well.

6. Time of Use (ToU) Tariff

ToU tariff structure sets prices in advance that vary at small intervals of time (less than a day). ToU
tariffs are often imposed by electricity companies on the consumers to improve economic
efficiency of power supply. Typically, the base load power supply at off-peak hours has lower tariff
than peak power tariffs. Such difference in tariff structure can motivate consumers to shift power
consumption to off-peak hours, thereby smoothening the power supply curve and ensuring a more
efficient utilization of the base load power generation capacity. ToU structure has not been
introduced yet in India, though it can be initiated in urban centers, where high population density
puts extra pressure on the generation company through high peak power demands, occasionally
leading to blackouts.

7. Environmental and Welfare Perspective

It is also very important to observe that impact of power sector reform in India, or any developing
country for that matter, would be different from those in developed countries. There is enormous
heterogeneity among the consumers in developing countries, and it is virtually impossible to
impose a uniform tariff structure across the consumer base even within a jurisdiction without
sacrificing the welfare objectives of the reforms. It may not be possible or practical to embark on a
strategy to phase out subsidies in power at the earliest, which needs to be done gradually over a
longer period of time through repeated assessment of economic and income indicators. Hence,
there is need for progressive government intervention22 to shift the reform process towards a more
responsible development path that takes into account social and environmental issues endemic to
India.

22
Wamukoya, N., 2003: Power Sector Reform in Developing Countries: Mismatched Agendas