Session 3: The South Asian Experience – Case Studies NEPRA’s 2002 KESC MYT Determination

1. Session 3:The South Asian Experience – Case StudiesNEPRA’s 2002 KESC MYT Determination Ian Alexander Wednesday, August 13th 2003 SAFIR MYT Workshop, Delhi

2. Outline • Background on KESC • The 2002 determination • Some observations • Conclusions

3. KESC • Effectively state-owned company (small %age listed on Pakistan’s three exchanges) • Vertically integrated company, including generation • Also purchases from IPPs and WAPDA • Peak-load is evening: 1,860MW • Service area: 6,000 km2 • 1999: 12,500 employees

4. Total Losses

5. Balance Sheet Restructuring of KESC Billion PkRs Share Capital vs. Debt vs. Accumulated Loss

6. Price Determination • To support the privatization plans, Government of Pakistan requested NEPRA to consider an MYT • NEPRA considered and made a proposal in September 2002 • Consider the key building blocks: • Losses • Efficiency savings • Return on assets • Other elements of the regime: • Length • Profit-sharing • Determination linked to change in ownership

7. Losses • Clearly dominate all calculations • Increasing since the 1980s • Some brief successes in reducing losses but not sustained • “Commercial” losses are important • Law and order situation not easy • Improvements here will drive success • Significant reduction mandated in years 1 and 2 (5% per annum)

8. Efficiency Savings • KESC proposed a sliding scale with the X value depending on the inflation rate • KESC asked for a 0 value for years 1 to 3 • NEPRA considered: • Potential impact on quality of service • Industry efficiency levels rather than company specific • Clear dominance of T&D losses • Incentives for investment to promote capacity expansion

9. Importance of O&M Costs

10. Forecast Efficiency Savings

11. Evolution of O&M Costs

12. Return on Assets • Two elements: • Asset base • Allowed rate of return • Asset base: historical cost of assets • WACC • No direct evidence provided • 12% figure proposed (8% risk free rate plus 4% risk premium) • Subsequent information provided by the Commission

13. Market return: 11% Risk-free rate: 8% Risk premium: 3% Equity beta: 0.66 (based on US data) Country risk: 2% Cost of equity: 12% [8% + (3% x 0.66) + 2%] Av’ge cost of debt: 12.4% Capital structure: Debt 55% Equity 45% WACC 12.2% WACC Calculation Source: Presentation on August 9th 2003 at SAFIR Core Course by A. R. Khan

14. Regime Issues: Length of Control Period • Normal control period is 3 to 5 years • KESC requested 10 years • NEPRA considered: • Extent of immediate price increase • Impact of profiling • Ability to earn a commensurate rate of return • Proposed a 7 year control

15. Regime Issues: Profit Sharing • Concern about possibility of abnormal profits • Would be driven by ability to reduce losses at faster than anticipated rates • Social and political acceptability of big profits – real concern • Introduce a profit-sharing system to accommodate this

16. %age Share to: <12% 12% - 15% 15% - 18% >18% Consumers 0 25 50 75 Company 100 75 50 25 Profit-Sharing Mechanism

17. Observations • What happens at end of period? No clear indication of whether another MYT would be considered • The 12% figure needs careful review • Possible incentive impacts of mixing a strongly profiled profit stream (early years there are losses, then profits with a very significant profit in the final year) with profit-sharing • Ability to deliver the loss reductions • Treatment of investment

18. Conclusions • First real MYT system adopted in electricity in South Asia • Has been implemented even though privatization has been delayed • Some very good features and practical solutions to problems • Some aspects could be improved on – the WAPDA successor companies are now petitioning for determinations and at least one, FESCO, has requested a MYT linked to its planned privatization…..