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FINANCIAL CHRONICLE™ » DAILY CHRONICLE™ » Is the New Electricity Pricing Structure – unfair?

Is the New Electricity Pricing Structure – unfair?

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CSE.SAS

CSE.SAS
Global Moderator
by R.M.B Senanayake

Everybody is grumbling about the increase in electricity charges. According to the CEB cost estimates it will need Rs. 268 billion to provide electricity to consumers in 2013. The regulator has decided that the estimated costs can only be recovered through electricity tariffs. Critics say there is much waste and corruption but these are difficult to quantify and hence cannot be taken account of. There is also piracy of electricity. The loss due to piracy has in the past been quantified and it was large. It is no doubt necessary to reduce such piracy. But it is not possible to wait till piracy is eliminated for the CEB is running enormous losses.

The CEB is a public monopoly and its price is not market determined but fixed by the government. Economists say price should be equated to the marginal cost which is the increase in costs due to the last unit produced and sold. This marginal cost is equated to the common price charged for all buyers.

Household Tariff

One TV channel analyzed the new structure of rates and pointed out that the consumers would have to pay the rate applicable to their highest slab on all the units consumed. Previously the rate varied for different slabs and the units consumed were allocated into the respective slabs up to the slab maximum and the surplus over the slab was carried forward to the next higher slab and charged at the higher rate applicable to that slab. The total bill payable was the sum of the different rates for each block multiplied by the units falling under each block. A person who consumes 90 units will have his bill computed at the rates applicable for each slab and only the marginal increase in units over the slab limit would be charged at the price for the next higher slab etc. The final marginal increase in units consumed will be charged at the price for that slab. But under the new system the applicable rate will be the rate for the topmost slab of consumption and the rate relevant to that slab will be applied for all the units instead of the marginal increase in units from slab to slab.

People are grumbling about this and arguing that the affluent are having their bills increased by a smaller percentage than the poor. This may be so but this structure provides a stronger incentive for consumers to reduce consumption than the earlier system based on subsidizing the low end consumers. How much of the total consumption is by lower end consumers? (It is perhaps quite large which is why the regulator used the new structure. The varying marginal cost at the total amount consumed will have to be paid for by all consumers . Is it unfair? Economists would say no.

Why and wherefore

When the price of any good or service does not reflect the economic value, the demand for it will exceed the supply. Governments thought they could electrify the whole country on subsidized electricity and more people were encouraged to obtain connections when they could not afford to pay the true costs of electricity. Others went in for refrigerators, TV sets, air conditioners because electricity was cheap. This foolish policy has now come to roost. The CEB had to generate more and more power at higher and higher prices to cater to a continuous increase in demand (6-8% per annum). It meant that its marginal costs (to the CEB) would keep on increasing as it used more costly forms of energy including buying power from private producers at a fixed price agreed to earlier which engineers say was excessive.

Over 60 percent of country’s power requirement is met by fuel combustion and 80 percent of the total expenditure of CEB is for the purchase of oil. As the fuel price increased in the world market, the marginal cost to the CEB increased and the gap between the marginal cost and the marginal revenue (the price) kept on rising, increasing the loss. The electricity tariff was kept unchanged despite the marginal cost increasing with the demand increase. It gave a higher standard of living based on a false economy. So with this revision this false economy will be corrected and electricity consumers will have to reduce their consumption.

But why not a flat rate for electricity? Because it will shut out consumers who cannot afford to pay the higher price. The units generated would have to be sold to obtain revenue and so monopolists resort to price discrimination. It is not a matter of fairness but of economic necessity.

Basis for Price Discrimination

Is there a case for charging different consumers at different rates? The marginal cost (the cost of the last unit produced) should be reflected in the price and as marginal costs increase during the peak hours It would be necessary to charge more for consumption during the peak hours. The price structure for industrial and commercial establishments reflects this cost difference.

The price discrimination to the domestic households in the new structure is based on a different principle which economists call ‘consumers surplus.’ This means that while the good or service costs the same to produce, the price is set by the circumstances of the buyer. It is like a doctor charging more from a foreigner than from a local patient. He bases it on the foreigner’s capacity and willingness to pay.

Price discrimination on its surface may seem unfair, but it makes perfect economic sense. Price discrimination would allow access to more people that otherwise could not afford it. This is where the system of differential price structure can be justified.

But what about the new structure instead of the old structure. If a person can afford to consume more units at a higher price, then it can be presumed that at the earlier lower price, he enjoys a ‘consumers surplus’ where the value to him is higher than the price. If so, does he need a subsidy on the ground of welfare economics? Pricing is not taxation where higher tax rates are charged on higher incomes.

Why Price Discrimination?

The reason why a monopolist loves to practice PD according to economics theory is that if he can charge different customers the amount they are willing to pay for a certain good, then he would be able to claim the entire consumer surplus of that customer and make the maximum profit. That sounds technical but an example will illustrate what is meant. There is this old man who sells Persian carpets which cost him $100 each. When any customer comes to buy a carpet, instead of quoting the customer the price of the carpet, he sits the customer down and has a chat with him. He claims that he wants to understand the customer’s reasons and motivation for buying a Persian carpet. He discusses the plus points of the Persian carpet unlike any other carpets. At the end of the chat he quotes the customer a price much higher than the $100. The customer looks surprised, tries to bargain, but the old man refuses to negotiate. Then the customer gives in and buys the carpet at the price quoted by the old man.

The old man has in his chat ascertained what the carpet would be worth for that customer. Then he quotes a price based on its value to the customer. The price he quotes has nothing to do with his cost. So it is not a bad thing to practice price discrimination. There is however good and bad price discrimination. If a restaurant charges more from a particular ethnic group than from others it would be bad price discrimination. Merchants charging higher prices in tourist shopping places are good but if a doctor charges more from a foreigner than from a local merely because he is a foreigner, it is bad. Price discrimination will not always succeed. Coca Cola introduced the practice of charging more for a cold coke on hot days and less on cold days. It did not go down well with the consumers and the company abandoned it. So the hype about unfairness of the new price structure is empty rhetoric.

Commercial and Industrial Tariff

But the charging of higher prices from the export sector and the import substitution industries is likely to pose a problem. Exporters cannot pass on the increase in electricity charge to foreign buyers like those selling to the domestic market. If import substitution industries seek to pass the higher electricity price to domestic consumers they will not be able to compete with the corresponding import and these import substitution industries will collapse. So what should be done? The Real Exchange rate has appreciated by about 7% last year and presently the rupee is overvalued to this extent. The nominal exchange rate should be determined by market forces that reflect trade flows and not capital flows. But where there are free inflows of foreign capital the rupee appreciates and harms exports and import substitution industries. This happens to our exchange rate now. So relief can be provided by a rupee depreciation of 7% which should at least partially compensate. If the nominal exchange rate is not allowed to become over-valued in terms of the Real Effective Exchange Rate an adjustment may take place to counter the present increase and help preserve the competitiveness of our exports and import substitutes.
http://www.island.lk/index.php?page_cat=article-details&page=article-details&code_title=77744

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