By Shahid Sattar | Absar Ali

On Tuesday 28th November, power regulator Nepra will hold a public hearing on the Discos’ petitions to determine a ‘Use of System Charge’ for power wheeling under B2B contracts. A seemingly routine matter, this determination will, however, define Pakistan’s economic trajectory for years to come.

For context, the National Electricity Policy allows for a Competitive Trading Bilateral Contract Market (CTBCM) where bulk power consumers can directly purchase electricity from competitive power producers and use the government’s transmission and distribution system to transport it from the point of generation to the point of usage. The Use of System Charge (UoSC) is the “price” such consumers must pay to use the transmission and distribution system.

The export sector has long advocated for this to overcome prohibitive power tariffs that render manufactured exports internationally uncompetitive and are a barrier to not just export growth but also foreign and domestic investment in export-oriented activities.

Pakistan’s power sector is characterized by a single-buyer model where the government purchases electricity from different power producers and distributes it to final consumers at self-determined prices.

The grave issue with these prices is that in addition to the actual cost of generation and service, they include various economic inefficiencies like inter- and intra-DISCO cross-subsidies that make power tariffs for industrial consumers in Pakistan almost twice the average tariff for competing firms in the region (Figure 1).

To achieve regionally competitive energy costs ideally requires a separate power tariff category for exporters based on the actual cost of service, excluding all forms of taxation and other distortions. B2B power contracts with a UoSCat 1-1.5 cents/kWh to cover the transmission and distribution costs incurred by Discos can also achieve the same objective without any subsidies from the government.

If allowed, this would rid the export sector of prohibitive distortions in power tariffs and significantly boost export competitiveness.

Estimates suggest that annual exports could increase by up to $9 billion annually by facilitating closed production units to reopen and operationalizing additional capacity already installed under export financing schemes but sitting idle due to high energy costs. It will also create a favorable business environment to stimulate fresh investment in further expansion and upgradation of production capacity to add another $20 billion to annual exports.

In this regard, Nepra has solicited petitions from the DISCOs for the determination of the UoSC. What the DISCOs have proposed, however, can be described as preposterous at best(Table 1).

Table 1. DISCOs’ proposed UoSC for hybrid consumption.

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                            LESCO     FESCO     GEPCO     HESCO     IESCO     MEPCO    PESCO
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                                    Industrial B3 Consumers
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Energy Cost                 0.00                                    0.28      0.71      1.20
Capacity Cost               8.73      8.75      10.12     13.65     5.87      6.21     11.70
Transmission Charges        0.70      0.71      0.81      1.10      0.47      0.50      0.90
Distribution Charges        1.13      1.37      2.93      4.22      1.37      1.26      2.20
Total Applicable Costs      10.56     10.83     13.87     18.97     7.99      8.67     16.00
Impact of Losses            1.27      0.92                2.68      0.32      0.83      2.70
Total Cost of Service       11.83     11.75     13.87     21.65     8.31      9.50     18.70
Cross Subsidy               5.58      6.74      6.93      10.37     7.06      15.56     5.20
Proposed UoSCRs./kWh        17.41     18.49     20.80     32.02     15.37     25.07    23.90
Proposed UoSC cent/kWh      6.11      6.49      7.30      11.24     5.39      8.79      8.39
============================================================================================
                                    Industrial B4 Consumers
============================================================================================
Energy Cost                 0.00                                    0.07      0.09      1.23
Capacity Cost               8.58      8.53      10.12     16.93     6.14      7.00     12.62
Transmission Charges        0.69      0.69      0.81      1.36      0.56      0.56      1.02
Distribution Charges        0.88      0.66      2.93      2.70      2.03      0.79      1.93
Total Applicable Costs      10.15     9.88      13.87     20.99     8.80      8.44     16.81
Impact of Losses            0.26      0.16                0.62      0.08      0.11      0.40
Total Cost of Service       10.41     10.04     13.87     21.61     8.88      8.55     17.21
Cross Subsidy               7.40      9.50      7.35      10.34     7.25      16.58     6.81
Proposed UoSCRs./kWh        17.81     19.54     21.21     31.95     16.13     25.13    24.01
Proposed UoSC cent/kWh      6.25      6.86      7.44      11.21     5.66      8.82      8.43
============================================================================================
Rs. 285 = $1 assumed for conversion to US cents. 
Source: DISCOs’ petitions for determination of UoSC as published on NEPRA website
============================================================================================

Taking B3 industrial consumers as an example, the DISCOs propose a UoSC ranging from 5 cents/kWh to 11 cents/kWh. Not only is this around as much and in some cases higher than the average cost of generation and service at 9 cents/kWh in Pakistan, but also much higher than what firms in competing economies are paying for power generation, transmission, and distribution (see Figure 1).

What is even more appalling is that no basis or justification behind the application of cross-subsidies—mathematical or otherwise—has been provided, except by LESCO, which specifies that:

“Undoubtedly, the consumer price should reflect the real cost of the generation, transmission, distribution, and supply of electric power to allow the fullest recovery of the legitimate cost for the provision of the electricity. However, where the same is not possible for any reason whatsoever then the cost for the provision of electricity is recovered in a manner that the consumers who can pay the high cost pays for the high prices which supports the other consumers.

The eligible BPCs are the consumers of 1 MW or more of the power. Generally, such BPCs are the industries who actually pass on the costs.” (LESCO petition for UoSC determination, as available on the NEPRA website) Several points require emphasis:

First, this statement concedes that cross-subsidies paid for by industrial consumers are undefined and untargeted. It acknowledges that consumer prices should reflect the real cost of generation, transmission, and distribution, but when this is not possible “for any reason whatsoever” the cost is recovered through cross-subsidies.

This implies that the cross-subsidy is not necessarily directed towards lifeline or protected consumers as it has been made to believe. Rather, it is effectively a subsidy to the DISCO when and where it fails to conduct its most basic task of recovering the amount for which it has sold electricity for “any reason whatsoever”.

Second, the cross-subsidy is paid on the principle of “who can pay the high cost pays for the high prices which support the other consumers”. Apart from the obvious issue that DISCOs have no expertise or jurisdiction in deciding who can or cannot pay for the high costs, the indiscriminate application of cross-subsidies across all industrial consumers is in contradiction to this objective.

Third, the assumption that generally consumers who can pay the high costs are “industries who actually pass on the costs” is problematic in every conceivable manner.

Broadly, industries can be categorized into non-traded and traded sectors.

Non-traded sectors are those that cater to the domestic market. Firms in these sectors pass on the impact of power sector inefficiencies and the government’s own welfare obligations to domestic consumers at the cost of consumer welfare. Because the cross-subsidy is applied indiscriminately to all industries across the country, it is paid for by all consumers of any goods manufactured in Pakistan.

Effectively, this is an extremely inefficient and unequal form of taxation, much like sales tax, that is paid for in the same manner by rich consumers and poor consumers, those buying essential commodities or non-essential commodities, no matter what.

In the case of traded sectors, it is even more problematic. Unlike non-traded firms that receive heavy protection through import duties and other restrictions and, therefore, have the ability to pass on the impact of higher energy costs to consumers, export-oriented firms must compete in international markets where competition is fierce and on price.

These firms cannot pass on the impact of higher energy prices because consumers can simply substitute their products with those of competing firms in regional economies with lower energy costs and lower prices. For traded sectors like textiles and apparel, on which the entire economy depends to generate foreign exchange earnings — the shortage of which is the fundamental issue behind every economic crisis Pakistan has faced — cross-subsidies in power tariffs take the form of a tax that cannot be exported.

But this logic seems to be completely lost on our policymakers. It was reported in a newspaper on November 21st that the power division has shown a reluctance to propose to operationalize the CTBCM model because it would mean an end to the cross-subsidies that the power sector is extracting from exporters. Furthermore, the NTDC is seeking wheeling charges at Rs 27/kWh, which is actively “meant to fail the CTBCM model.”

So, to answer those who ask why exports have not increased despite substantial investment in the textile and apparel industry, it is because they are being held hostage by a power sector unable to sustain itself and bent on passing on its own inefficiencies to the rest of the economy. But at what cost?

As power tariffs have increased following the withdrawal of the Regionally Competitive Energy Tariffs regime, textile and apparel production has been reduced by over 50 percent and exports have plummeted. Repeated warnings that deindustrialization is imminent went unheeded to the point that in October 2023, monthly power consumption of textiles and apparel firms on the LESCO network stood at only 114GWh compared to 224GWh in October 2022—a decline of 49%. If the status quo is maintained only to balance the books in the short term, this trend will continue to the point where there will be no export sector left to extract cross-subsidies from.

It must be reiterated that the trajectory of our economy over the coming years hinges on this UoSC determination. Over the next 5 years, Pakistan’s gross external financing requirements—i.e., the difference between all expected inflows and outflows of foreign exchange—are projected at an average of $27 billion annually.

This is the number by which we must increase our annual exports if we are to service our debt and finance our imports without completely drowning in a debt trap in which we are already knee-deep.

“Allowing B2B contracts at a rate of 1-1.5 cents/kWh will provide the export sector with the necessary business environment to work towards this number. It will also facilitate exports in the long run by allowing industry to directly procure electricity from clean sources and achieve net zero emissions that are required to continue exporting to key Western markets beyond 2030.”

Exports cannot be held hostage by policy inaction. Disallowing B2B contracts with wheeling at 1-1.5 cents/kWh will be tantamount to committing economic suicide.

By Shahid Sattar | Syed Absar Ali

The fundamental problem of our economy is that balance of payments crises and a perpetual risk of default have become the status quo.

This is because we import too much and export too little for the economy to be stable. Since FY04, our imports and exports have diverged so much that in FY22—during the run-up to the economic crisis—we imported 2.25 times what we exported, compared to 1.6 times in FY13 and 1.2 times in FY04 (Figure 1).

Instead of focusing on increasing exports and balancing our trade, we have relied on foreign remittances and external financing to fill the gap. Both increase the vulnerability of the economy to external shocks, and external financing comes with its own additional costs in the form of debt servicing and an implicit tradeoff on sovereignty when an economy inches closer to delinquency as Pakistan has.

Our policies continue to suppress exports while protecting unproductive domestically oriented industries to substitute imports—a strategy that has terribly failed in Pakistan and many other countries around the world.

Furthermore, uninformed rhetoric from various quarters of protected non-traded sectors and even some media outlets has not helped. For instance, a recent article in Business Recorder incorrectly claimed that “one of the members of the current interim setup who represents a specific sector tried to outsmart the system by using general non-export industries to cross-subsidize the export sector.” Even in other newspapers, claims regarding the export sector being provided with subsidies are frequent and have dangerously misguided the discourse on economic recovery and reforms. First, the authors of such misinformed propositions need to check their definitions of what a subsidy is. Second, they must present at least some evidence of where these subsidies are because our analysis indicates that there are none.

Power tariffs for exporters include a cross subsidy of around 5 cents/kWh to nonproductive sectors, making them almost twice the regional average. Similarly, gas prices following the recent reform have been increased to well above what prevails in the region, especially amongst competing economies (Figure 2).

Under the new pricing structure, the cost of captive power generation for export sectors has increased to as much as 15 cents/kWh for SNGPL and around 12 cents/kWh for SSGC consumers, which is around the same as getting electricity from the grid so that there is no real benefit in captive power generation. A statement from the IMF (International Monetary Fund) confirms that this was indeed the government’s purpose behind setting gas prices at these levels.

Ironically, captive power generation is—in the first place—incentivized by prohibitively high power tariffs that force productive sectors to pay for the government’s own social obligations and inefficiencies through cross subsidies, transmission and distribution losses, and stranded costs, etc.

The obvious balancing act was to remove the cross subsidy from power tariffs and equalize end-use prices for captive and grid electricity to shift industry away from captive generation. Instead, the government has included these unwarranted costs in gas prices to further undermine export competitiveness.

In the case of electricity—as acknowledged by the Power Division and power regulator NEPRA—a component of the cost of generation for power used by residential and agricultural consumers is extracted from industrial and commercial consumers, and this cross subsidy is clearly seen if one compares the power tariffs across different categories to the cost of generation and service (Figure 3).

But in the case of gas, it is a fuel delivered to consumers to convert and use as they prefer—i.e., as electricity in the case of industrial captive, and heat in the case of industrial process or household cooking and heating. Of the country’s total consumption, around 75 percent is indigenous gas, the cost of which, as per Ogra, is Rs 1,350/MMBtu, and 25 percent is imported LNG at approximately $13.50/MMBtu based on October 2023 rates. Accordingly, the weighted average cost of gas is around Rs 1,990/MMBtu.

Revised gas prices for export captive are Rs 3,145/MMBtu from March to November and Rs 3,830/MMBtu from December to March for SNGPL, and Rs 2,800/MMBtu throughout the year for SSGC consumers. Because prices for exporters are well above the cost, there is no subsidy to the export sector and, if anything, the export sector is again being made to subsidize the government’s debt and consumption in other sectors of the economy.

However, since we do not have enough indigenous gas to meet the entire country’s demand, the question of gas pricing is really one of resource allocation. By the law of price and demand, sectors that are subject to lower prices will consume more gas. So, do we want to allocate more gas towards productive uses, that will add value, earn foreign exchange, mobilize government revenue, stabilize the external sector, provide jobs, and create opportunities for productive investment that create future returns and benefit generations to come, or do we want to continue to burn away our precious resources in nonproductive activities?

The answer, based on prevailing policies, seems to be the latter. The energy sector provides vulnerable segments with cheap and underpriced electricity and gas but does so by systematically dismantling productive sectors that provide jobs to the same people, enabling them to purchase the same energy, efficient appliances and much more without any subsidies.

But this logic seems to completely escape the naysayers. Our policies continue to suppress exports while protecting unproductive non-traded sectors to substitute imports—a strategy that has terribly failed in Pakistan and many countries around the world.

The country’s international image and economic potential have deteriorated so severely that even strong and long-standing bilateral partners like Saudi Arabia and China have become wary of putting their money in Pakistan. For all our efforts to bring in foreign investment, nothing is materializing and how can it in a country where even domestic investors are increasingly parking their money in the safest and least productive of assets?

Pakistan’s gross external financing requirements, including current account deficits and amortization of debt, are, on average, projected at around $27 billion annually over the next 5 years. Prospects for receiving foreign investment remain bleak, and foreign investment in non-export sectors that do not generate returns in foreign currency is a liability in any case.

This is where we stand now: The foreign exchange shortage continues to persist, and exports for FY24 are likely to remain well below the FY22 peak of $32 billion. Following a brief appreciation, the exchange rate is depreciating again, which, coupled with the increase in gas prices, could very well reverse the downward trajectory of inflation, and result in a prolonged period of high interest rates. All of this will continue to cripple real economic growth and diminish the chances of recovery.

To come out of this vicious cycle of crisis after crisis and achieve sustained economic growth, a fundamental strategy of fostering competition and increasing exports must be adopted at all policy levels, across all sectors of the economy. Exports are competitive only if export sector input costs are at par with competing economies. Any form of taxation, either direct like sales tax or indirect like cross-subsidies, cannot be exported. The choice is simple: Export or perish.

By Shahid Sattar | Syed Absar Ali

Distortions caused by a distraught policy landscape — from high energy costs to an industry-wide liquidity crisis — have made it next to impossible for Pakistani exporters to compete in international markets.

To put things into perspective, Bangladesh exported more in ready-made garments ($15.7 billion) in the past four months than Pakistan’s total exports since January of this year ($13.3 billion).

While Pakistan has no shortage of rhetoric around increasing exports, policy makers remain dangerously oblivious to the fact that export sectors require a distortion-free environment to enable them to compete in international markets.

Currently, they are provided with anything but a level playing field.

Energy, on average, accounts for between 12 and 18 percent of input costs across the textile and apparel value chain. A cross subsidy of Rs 10.84-16/kWh embedded in power tariffs for industrial makes them almost twice the average for major textile exporting countries in the region (Figure 1A). Similarly, manufacturers across the country are faced with constant gas shortages with no end in sight while the impact of the gas pricing reforms, that place RLNG/gas rates well above a regionally competitive level (Figure 1B), is yet to be seen and evaluated.

The industry is also faced with a severe liquidity crisis. Due to rampant exchange rate depreciation and inflation experienced over the past year, the same dollar-denominated export order requires around 40% more rupees to process.

However, there is a severe shortage of working capital, and what little is available comes at exorbitant interest rates. Non-bank credit across the supply chain is a lifeline for Pakistani businesses, but with interest rates at over 22 percent investors are finding it more profitable to simply park money in banks. And over 70 percent of banking credit is being used to finance the government’s fiscal deficits, crowding out borrowing by the private sector.

The liquidity crisis is further propagated by around $1.3 billion (Rs. 370 billion) being stuck in the tax refund regime at any given time. FBR persistently delays issuance of sales tax refunds despite a 72-hour commitment under law and refuses to issue other refunds, including income tax refunds, non-FASTER refunds, custom duty drawbacks, etc., that have been pending for years. There is no logical reason for this except that the government needs this money to manage its own troubled cash flows, but at what cost?

Then there is the issue of close to no fixed capital investment in up-gradation and expansion of production capacity—one of the reasons for a long-term decline in manufacturing productivity. According to industry estimates, 50 percent of spindles in the textile sector will be scrapped without replacement over the coming year.

This means that Pakistan will not have enough upstream capacity to produce high-quality yarns that can be used in modern air-jet looms in downstream processes. The sizable investment that was made in up-gradation and expansion under TERF and other export financing schemes was either left incomplete due to restrictions on L/Cs on import of machinery or is sitting idle due to high energy and other operating costs.

If fixed capital investments remain abysmal, we will see an increase in imported intermediate products and a decline in domestic value added in exports over the coming months and years, further adding to the economy’s balance of trade deficit and external sector vulnerabilities.

Another issue is that of polyester staple fiber (PSF) prices. Domestic PSF suppliers—the basic raw material for man-made filaments and synthetic fibers—are exhibiting a ‘monopolistic’ behavior, keeping PSF prices artificially high.

This is made possible by heavy protection in the form of prohibitive import and anti-dumping duties on imports of cheaper and higher quality PSF.

This has created a “cotton-bias” in the industry, rendering it vulnerable to exogenous cotton supply and price shocks, and is a major challenge to export diversification within the textile sector export basket.

Add to this the plethora of bureaucratic red tape and regulatory sludge that exporters must regularly put up, Pakistan’s textile sector prices and turnaround times are simply too high to be able to compete with firms from regional textile and apparel hubs.

However, it is still not too late: given how the international policy landscape is shifting, the textile sector is still well-positioned to take advantage of these shifts, given a conducive policy environment at home, but further inaction could very well result in continued deterioration. Two important examples are discussed below.

First, the Carbon Border Adjustment Mechanism (CBAM) in Europe is expected to become fully functional at the end of this decade. Accordingly, by 2030, imports to the EU will be taxed for the energy emissions generated in their production outside the EU, effectively imposing an import tariff on any exports to the EU depending on their energy emissions.

To overcome CBAM-related taxes requires net-zero energy emissions across the export sector value chain. Bangladesh has already started to incentivize this: a recent policy requires new buildings with a rooftop area of over 92.2 square meters to have net-metered solar power to be eligible for a grid connection.

But in Pakistan, industrial consumers are subject to a cap of 1MW on solar net-metering. Furthermore, the textile sector has pledged to generate its own electricity using clean geothermal energy, but this requires B2B contracts with a wheeling charge of no more than 1 cents/kWh, all inclusive. The government refuses to increase the cap from 1MW up to 5MW or allow B2B contracts, only to protect its own distorted revenue streams.

Second is the Western movement to decouple from China. According to the USFIA’s annual textiles and apparel industry benchmarking exercise, 80 percent of the largest apparel and clothing firms in the United States are planning to reduce sourcing from China over the next two years, and shift from a “China plus Vietnam plus Rest of the World” sourcing model to an “Asia plus Rest of the World” model.

Once again, Bangladesh and Vietnam have already taken advantage of this, and their shares in international textile and apparel markets have gradually increased since around 2014, while those of China have declined (Figure 2).

Both countries are also offering very attractive incentives to further expand their textile and apparel manufacturing capacities. In Bangladesh new ready-made garment factories pay income tax at preferential rates of 10-12%, with many firms being eligible for further exemptions of up to10 years.

In Vietnam, new projects are offered preferential income tax rates of 10 percent for 15 years, including a 2-year tax holiday and a 50 percent reduction for the subsequent 9 years. In both countries, these are in addition to other incentives such as duty-free import of raw materials and reduced tax rates on export earnings.

India, to counter the growing importance of Bangladesh and Vietnam, is setting up seven mega textile and apparel manufacturing parks with full vertical integration. These include ‘plug and play’ facilities, all sorts of ancillary infrastructure, common processing houses, design centers, testing facilities, workers’ hostels and housing, and training and skill development facilities. Additionally, $36 million has been allocated to each textile park to provide a rebate of up to 3 percent of annual turnovers to newly established factories.

This begs a very simple question: Why would any investor anywhere in the world choose to invest in Pakistan when this is what they are being offered right next door, in a much more stable and export-oriented economic environment? The answer is they would not, which is why our entire economy is functioning on a hand-to-mouth, loan-to-loan basis with abysmal investment — foreign direct or domestic — in any sort of productive activities.

The way forward is simple:

The government must ensure a distortion-free supply of inputs to export sectors, whether energy or raw materials. It must remove the cross-subsidy embedded in power tariffs for exporters, allow B2B power contracts with a wheeling change of 1 cents/kWh all inclusive, raise the cap on solar net metering for all industrial consumers from 1MW up to 5MW to support the move towards net-zero, and ensure adequate supply of gas/RLNG at regionally competitive prices.

On PSF, import duties must be rationalized and irrational anti-dumping duties removed entirely. All imported inputs for the textile sector must be duty-free at the point of entry because duty rebates are economically inefficient and cause a loss of purchasing power to the exporters when they are inevitably and indefinitely delayed.

FBR must get its house in order, issue all pending tax refunds at once, and honor the commitment of issuing all FASTER refunds within the stipulated timeframe of 72 hours. Customs procedures for exports and export-sector imports must also be simplified and processing times reduced to enable faster turnaround times for export orders.

“Furthermore, there is an overall need to cut down on regulatory sludge, reduce the government’s economic footprint, and rationalize fiscal expenditures and revenues within a growth-oriented framework. This will reduce government borrowing, bring down inflation, allow for a reduction in the policy rate, and free up credit for private sector investment.”

To take full advantage of emerging opportunities, incentives offered by competing economies must also be matched or exceeded to stimulate investment in up-gradation and expansion of manufacturing and export capacity, both for domestic and foreign investors alike.

These may be bitter pills for policy makers to swallow but the only alternative is another crisis on the horizon—one we really cannot afford.