Service quality, technical efficiency and total factor productivity growth in Pakistan's post-reform electricity distribution companies

Highlights

• We estimate technical efficiency of electricity distribution companies for post-reforms period.

• Impact of quality of service parameters has been estimated on technical efficiency using SFA.

• Malmquist Productivity Index is implemented to decompose TFP into scale change, technical change and efficiency change.

• Technical efficiency score declines from 98 percent to 36 percent with the inclusion of service quality parameters.

• We propose greater autonomy of regulatory body and adoption of incentives regulations instead of rate of returns regulations.

Abstract

Pakistan's energy sector has undergone substantial reforms during the last three decades with the aim to improve its operational performance and to cater to the growing energy needs of the economy. In the wake of these reforms, the WAPDA Act was passed in 1998 to achieve operational and financial efficiencies. Pakistan's electricity market is still hampered by issues like extended blackouts, electricity thefts, high circular debt and poor service quality. The electricity distribution sector is thus an interesting case to investigate its efficiency in the post-reform period by examining the impact of service-quality parameters (SQPs), which have generally been neglected in the literature. Stochastic frontier analysis has been used to estimate technical efficiency, while the Malmquist Productivity Index is implemented to decompose total factor productivity (TFP) into scale change, technical change and efficiency change from 2006 to 2016. We conclude that the technical efficiency score declines from 98 percent to 36 percent with the inclusion of SQPs in the models. The results also indicate a negative trend in scale change, implying that distribution companies are not operating at the technically optimal scale. We propose that the regulatory body should change its governance regime and focus on incentive-based regulation instead of rate-of-return regulation.

Introduction

Pakistan's energy sector has passed substantial reforms during the last three decades with the aim to improve its operational performance, technical efficiency and to cater to the growing energy needs of the economy. Pakistan passed WAPDA Act, 1998 and the vertically integrated natural monopoly, Water and Power Development Authority (WAPDA) was unbundled into generation, transmission and distribution segments (Khalid & Iftikhar-ul-Husnain, 2016). The purpose of this compartmentalization was to improve technical efficiency of each segment for better provision of electricity to support domestic, commercial and industrial activities with minimum transmission and distribution losses and ensure that prices reflect the marginal cost to reduce the fiscal burden on the government exchequer (Malik, 2012). Electricity distribution sector was separated into one transmission company and eight publicly owned distribution companies (DISCOs) (Khan, 2014). An independent regulatory body, the National Electric Power Regulatory Authority (NEPRA) was established in 1998 to regulate the overall electricity market (Saleem, 2007). ‘

Despite all these reforms in place, the electricity market in Pakistan still faces many problems including electricity theft, transmission and distribution losses, low collection of bills, inadequate investment in generation, transmission and distribution sectors, frequent interruptions, overloaded transformers, retail prices away from the marginal cost of production, poor governance, incomplete payment by the ministry of finance to the power sector and prolonged judicial stays on fuel price adjustments resulting into the accumulation of circular debt¹ (Aziz and Ahmad, 2015).

The quality of service has a significant impact on the operational and financial position of any firm (Duncan and Elliot, 2002) and “has a great impact on client contentment”. Quality of service and efficiency are closely related to each other as the former reduces the cost of rework (Rust et al., 1994). The objective of service-quality parameters (SQPs) is to shift the paradigm from price regulation to incentive regulation by promoting competition among the distribution utilities (Jamasb and Pollitt, 2000). It is also argued that in the presence of price regulations, profit-earning efforts by the distribution utilities may result in poor service quality, and the lower service quality has socio-economic impacts. It is also argued that in the absence of SQPs, price cap regulation may distort the incentives for future development (Holt, 2005).

Therefore, the nature of electricity distribution companies has remained a widely examined issue in theoretical and empirical research, which supports the evidence of a natural monopoly in a distribution network (Filippini, 1998; Salvanes and Tjøtta, 1998; Yatchew, 2000; Growitsch et al., 2009a, 2009b). However, the relationship between technical efficiency and quality of service has not been given considerable attention in previous studies.

The distribution companies in Pakistan are subject to rate-of-return regulation for tariff determination as prescribed by NEPRA Rules, 1998 (Ashraf and Khan, 2016). After filing of tariff petition by distribution companies, NEPRA invites public comments and conducts a hearing on petition to ensure transparency and accountability. NEPRA determines the tariffs for generation, transmission and distribution companies separately, and the cost is recovered from consumers through tariffs set for distribution companies. Thus, the revenue requirement for distribution companies (RRD) is determined as;

RRD = PPP_D + DM_D + PYA_D

Where PPP_D is power purchased price (cost) for an eligible distribution company, DM_D is the distribution margin of the distribution company, and PYA_D represents the prior year adjustment for a distribution company.

The power purchase price (cost) is determined as;

PPP_D = PP_(EC) × Q(p) + PP_(CC)+ TC

Where PPP is the power purchase price, PP_(EC) is the energy charge part of PPP, Q(p) is quantity purchased by the company, PP_(CC) reflects the capacity charge on the part of PPP and TC corresponds to the transmission cost.

Based on these parameters, NEPRA determines the distribution margin for each distribution company using Equation (3)

DM_(D) = RB_(D) × RORB_(D) + D_(D) + E_(D) + t_(D) ± ORC_(D)

Where DM_(D) presents the distribution margin of the distribution company, RB_(D) reflects the eligible distribution company's rate base, RORB_(D)is the eligible distribution company's cost of capital, D_(D) corresponds to the depreciation expense of distribution company, E_(D) expresses the expenses of distribution company but not limited to maintenance, operation and human resources, t_D relates to the provincial and federal taxes and ORC_(D)stands for other regulatory costs, including other income.

The above-mentioned methodology of tariff determination indicates that tariff rate depends on the company's petition and revenue requirements based on a base year, and provides evidence that the cost of inefficiency associated with the distribution companies is transferred to end-users without penalizing the distribution companies. This situation suggests that the existing regulatory mechanism in Pakistan's electricity market provides limited or no incentives for the distribution companies to improve their technical and operational performance. Furthermore, before the final announcement of electricity tariff, the government decides to provide subsidy to the consumers and thus partially or fully finances the inefficiency cost of the distribution companies. Moreover, the quality of service offered by these distribution companies does not become part of the tariff determination criteria.

In 2005, NEPRA introduced new performance standards relating to reliability, quality of supply, and customer services for the distribution companies. Reliability, according to the new performance standards, is measured by SAIFI² and SAIDI.³ The quality of supply to the consumers is measured through the provision of electricity at recommended volts, i.e., nominal voltage and frequency, whereas the customer services reflect how successfully customer problems are solved. If the power sector can ensure reliable power supply to its consumers, economic growth and welfare will improve (Berry et al., 1998).

There is limited evidence available on the dynamics of efficiency and productivity of distribution companies in the South Asian region. Only three studies are available to the best of our knowledge that discuss the dynamics of technical efficiency for the electricity distribution companies for the case of Pakistan. However, none of these studies has explicitly discussed the role of service-quality regulations in determining the technical efficiency of distribution companies for the case of Pakistan. Saleem (2007) estimated technical efficiency of distribution companies in post reforms period by using data envelopment analysis (DEA) and found that reforms in Pakistan have remained ineffective in increasing the technical efficiency of distribution companies. Total factor productivity growth was only three percent.

Zakaria and Noureen (2016) estimated technical efficiency of eight distributional companies of Pakistan for the period 2003 to 2013. The study only estimated the static behavior of the distribution companies but ignored the dynamic behavior of distribution companies. Secondly, this study did not calculate the total factor productivity growth in the electricity distribution sector to have complete insight regarding scale change, technical change and technical efficiency change.

Mirza et al. (2017) employed fixed effect stochastic frontier analysis to estimate technical efficiency of eight distribution companies of Pakistan for 2006 to 2013. The study attempted to fill gaps in the literature by considering dynamic aspects of the distribution companies by calculating total factor productivity index and its component in the post reforms periods. However, the impact of SQPs on technical efficiency of distribution companies was not estimated, and there is a wide gap in the literature that we intend to fill in this analysis.

Apropos, the above discussion reveals that the impact of service quality on the technical efficiency of distribution companies in Pakistan has not been adequately discussed. We attempt to fill this gap in empirical literature by studying the impact of quality-of-service variables on technical efficiency and total factor productivity and the sources of technical change for electricity distribution companies of Pakistan.

The remainder of the paper proceeds as follows. We present a conceptual framework in Section 2. Section 3 illustrates data and methodology, and Section 4 elaborates the findings from empirical models. Section 5 concludes the paper with suitable recommendations.