(Today’s post is co-authored with Paul Gertler. Wolfram and Gertler direct the Applied Research Program on Energy and Economic Growth (EEG) in partnership with Oxford Policy Management. The program is funded by the Department for International Development in the UK.)
As we teach our students in econ 101, the prices of most goods and services reflect both demand and supply factors. So, to use a classic example, the price of snow shovels may go up during a blizzard, even if it costs no more to supply them when it’s snowing.
On the other hand, as we teach our students in regulatory economics 101, prices for regulated utilities are different. Their prices are driven almost purely by costs and, not just current costs, but costs incurred in the past that other businesses might write off as sunk.
In the textbook model, regulated utilities are what we call “natural monopolies.” They are supplying a good for which it makes the most economic sense to have a single supplier. This could be driven by the high fixed costs of building the transmission and distribution system to supply electricity, for example.
Regulated utilities are implicit signatories to what’s called the “regulatory compact.” Basically, the regulator gets to set prices for the utility, ensuring that the company won’t take advantage of its monopoly position to charge prices through the roof. And, the regulator requires that the company offer universal service to anyone who wants it at the regulated prices. In exchange, the company gets assurance that it will be allowed to collect revenues to cover reasonable costs of doing business.
According to a fascinating report recently released by the World Bank, the regulatory compact appears seriously out of whack in Sub-Saharan Africa.
The figure below highlights the problem. Each bar reflects the situation in a single country. The red diamonds reflect the cash collected per kWh by the main electricity provider (most are vertically integrated monopolies), and the purple and green bars reflect the costs. Note that for all but two of the countries, the dots are to the left of the bars. This means that the companies’ revenues are not covering their costs.
But, who is breaking the deal? Are companies’ costs too high? Perhaps “imprudent” in some sense, maybe due to corruption? Or, are the local regulators setting prices that are too low? Or, is it some combination of the two?
It’s first worth noting that only some of the countries in Sub-Saharan Africa have regulatory agencies, and only a subset of those have any real power over prices, so we’re using the “regulatory” part of the “regulatory compact” broadly.
We recently saw these issues up close in Tanzania. As part of a DFID-funded research program on Energy and Economic Growth, we organized a policy conference in Dar es Salaam, together with our partners at Oxford Policy Management.
Tanzania’s local monopoly, the Tanzania Electric Supply Company (TANESCO), only collects revenues to cover 82% of its costs (14 out of 17 cents per kWh), based on the World Bank calculations above. TANESCO is a vertically integrated utility, and the government owns 100% of its shares.
According to people close to the company, the rate-setting process is highly politicized, so rates are poorly aligned with TANESCO’s claimed costs. They point out that on the day the new Minister of Energy was appointed, he announced his intention to initiate a rate cut.
On the other hand, the regulators seem to believe that TANESCO’s costs are not “prudently incurred,” though they didn’t use that phrase explicitly. They argue that the company is inefficient, and the rates would easily cover costs if they cut fat.
It’s difficult to know who is right. Consider TANESCO’s recent experience procuring power from independent backup generators. Historically, over half of the country’s annual generation came from hydroelectric generators. In 2010, a severe drought led to persistent electricity shortages, so TANESCO signed several contracts for what’s been called “emergency” generation, including a contract with a company that owned two 50 megawatt diesel generators. Diesel prices were high in 2011 and 2012, though, and, under the contract, TANESCO had to pay the fuel costs. TANESCO’s losses during that period were reportedly more like 50% of their total costs.
Now, the company is saddled with debt from this period, but the regulator contends that the emergency generation costs were too high and is unwilling to raise rates to cover the accumulated debt. Also, the regulator increased rates by 40% in 2014, so may feel like it’s already done its part. Figuring out what the right prices for generation procured in an emergency is difficult, though. Presumably, the utility did not have much time to shop around. Then again, maybe it should have foreseen the emergency situation and planned to avoid it.
Tanzania, like many countries in the developing world, also experiences high levels of “nontechnical losses” (largely theft). So, even if rates are set to cover costs if most consumers pay, the companies will experience heavy losses. Theft appears to have a political component as well, though. This paper, by Brian Min and Miriam Golden, shows that nontechnical losses in India increase when elections are near.
The World Bank report divides each utility’s losses into four categories: underpricing (meaning the regulators are breaking the deal and setting prices lower than what would be required to cover reasonable costs), bill collection losses (meaning the utility bills for the consumption, but fails to collect), transmission and distribution losses (a combination of technical line losses above an acceptable limit and theft) and overstaffing (relative to a benchmark, suggesting the company’s costs are imprudently high). They do not attempt to identify other types of inefficiencies, such as purchase power costs that are too high.
They find no underpricing in Tanzania – suggesting the regulators are upholding their side of the compact. They attribute 80% of the losses to bill collection and nontechnical losses – suggesting the company needs to improve their billing system and distribution network. The remaining 20% is due to over-staffing. In its current situation, though, TANESCO struggles to finance its ongoing operations, let alone the investments needed to achieve fewer billing and distribution losses, so more price increases may be needed in the short run.
The new Energy and Economic Growth program will sponsor research to address some of these key questions and issues. First, we suspect there are real costs in terms of economic growth and other development outcomes due to the kind of institutional breakdown documented in the World Bank report. We need to document the extent to which economic growth is constrained by unreliable power, for example. We aim to measure costs like this by collecting new data and conducting new analyses. Second, we will work with policymakers, regulators, the utilities and other stakeholders to learn about the best ways to improve the institutions.
Catherine Wolfram is the Cora Jane Flood Professor of Business Administration at the Haas School of Business, Co-Director of the Energy Institute at Haas, and a Faculty Director of The E2e Project. Her research analyzes the impact of environmental regulation on energy markets and the effects of electricity industry privatization and restructuring around the world. She is currently implementing several randomized control trials to evaluate energy efficiency programs.