By Shahid Sattar | Absar Ali

The turnover tax regime in Pakistan poses significant challenges for small and medium enterprises (SMEs), placing them at a disadvantage compared to vertically integrated firms.

Despite contributing around 40% of GDP, 25% of export earnings, and employing 78% of the non-agriculture labour force, according to the SBP, small and medium enterprises (SMEs) face numerous challenges that hinder their growth and development.

These include limited access to finance, as SMEs often struggle to secure financing due to stringent collateral requirements and high interest rates which limit their ability to invest in growth and innovation. Poor infrastructure, such as unreliable electricity supply and poor transportation networks, increase operational costs and reduce efficiency, especially in rural areas.

Many SMEs also suffer from inadequate management skills, leading to poor decision-making and inefficient operations. Complex and cumbersome regulatory requirements, often difficult to navigate for SMEs, further inhibit their growth. (Khan, Hussain & Afraz, 2013; Khan, 2022; Zeshan, 2023)

SMEs being large firms of the future, this is also one of the reasons Pakistan has very few large firms, and even these are relatively small by global standards. For instance, according to the Pakistan Export Directory, the largest exporter in 2021 exported goods worth Rs. 52 billion, the 10th largest Rs. 29 billion, and the 100th largest only Rs. 5 billion.

“Among these barriers, the turnover tax stands out as a significant impediment that disadvantages SMEs as compared to vertically integrated firms. The turnover tax in Pakistan mandates that all businesses, regardless of profitability, pay a minimum tax of 1.25% on their turnover.”

While this policy aims to create a uniform tax environment, it inadvertently imposes a heavier burden on SMEs due to the cumulative nature of the tax across multiple production stages.

When a single, vertically integrated firm manages the entire production process, the turnover tax is applied once on the final product. However, SMEs, which typically rely on multiple independent businesses for various production stages, face a different reality.

Each stage—from raw material processing to manufacturing, distribution, and retail—involves separate entities, each subject to the turnover tax on its revenue. This results in the tax being applied multiple times across the production chain, significantly increasing the overall tax burden on SMEs.

For example, in the textile industry, an SME might source yarn from one company, fabric from another, and finally sell the finished product. Each transaction between these businesses incurs the turnover tax, creating a compounding effect that does not affect a vertically integrated firm in the same way. This cumulative tax burden increases costs for SMEs, making their products more expensive and less competitive compared to those produced by integrated firms.

This compounded tax significantly hampers the competitiveness of SMEs. Vertically integrated firms, by consolidating all production stages, incur the turnover tax only once, resulting in a lower overall tax liability. SMEs, unable to vertically integrate due to financial and operational constraints, end up paying much higher cumulative taxes. This creates a market environment where SMEs struggle to compete on price and profitability, stifling their growth and innovation.

The financial strain imposed by the turnover tax also limits the ability of SMEs to reinvest in their businesses. With higher taxes eating into their margins, SMEs find it challenging to fund expansions, adopt new technologies, or enhance their workforce, further hindering their competitive edge.

To support the growth of SMEs and create a more equitable tax environment, several policy reforms can be considered. Implementing lower turnover tax rates specifically for SMEs can alleviate the compounded tax burden they face, helping them to price their products more competitively. Providing tax rebates or credits for SMEs that engage in multiple stages of production could further offset the cumulative effect of the turnover tax and encourage SMEs to expand their operations without facing prohibitive tax penalties.

Facilitating access to finance and resources for SMEs to achieve greater vertical integration can reduce the number of taxable events in the production process, while also fostering firm growth. Government programmes that support mergers and collaborations among SMEs are essential to achieve this goal. Introducing a graduated tax structure that imposes lower rates on the initial stages of production or for lower turnovers can also help reduce the overall tax burden on SMEs, making the tax system more progressive and fairer.

In conclusion, reforming the turnover tax policy is crucial to ensure that SMEs have a fair chance to compete with vertically integrated firms. Addressing the inherent disadvantages posed by the current tax system will not only support the growth of SMEs but also drive economic diversification, innovation, and employment. By creating a more equitable tax environment, Pakistan can unlock the full potential of its SME sector, fostering a more dynamic and robust economy.

By Kamran Arshad

As Pakistan prepares for a significant increase in electricity prices next year, driven by further rupee devaluation and capacity payments of over Rs 2.1 trillion, addressing these issues that have bogged down the entire economy has become a question of survival. One of the biggest contributors to prohibitive power tariffs is the heavy burden of capacity payments of over Rs 2.1 trillion per annum, which necessitates an urgent action.

Pakistan’s energy sector has long been entangled in flawed contractual arrangements with Independent Power Producers (IPPs). These contracts, dating back to the Power Policy of 1994, were intended to resolve the energy crisis by attracting private investment. However, the terms of these agreements have led to a spiralling circular debt, reaching Rs2.64 trillion as of February 2024.

The incentive structures offered to IPPs, including guarantees indexed to the US dollar, mean any depreciation of the Pakistani rupee increases returns for IPPs and places a heavier financial burden on the government. Initially, the return on equity for IPPs was set at 18%, later reduced to 12% in the Power Policy of 2002, but it remains high compared to global norms.

Additionally, cost comparisons with similar projects in other countries suggest that many IPPs were funded through over-invoicing on capital goods, resulting in no “real” underlying equity. Consequently, Pakistan is burdened with perpetual returns on ghost equity. An analysis of various published accounts and balance sheets further reveals that actual dollar-based returns to many IPPs exceed 70%.

Additionally, the government’s decision to incorporate residual fuel oil (RFO) plants, known as Peaker plants, to boost base capacity has proven problematic. These plants are inefficient, costly to operate, and environmentally unfriendly.

While the inclusion of Peaker plants is not inherently problematic, their disproportionate share in Pakistan’s energy mix, currently at 14%, is concerning. Globally, these plants typically operate during peak demand periods and constitute a maximum of 4-6% of total consumer bills.

Pakistan has an installed capacity of approximately 44,943 MW, with a huge disparity between a base-load of around 12,500 MW and summer peak load of around 30,000 MW due to shifting of winter heating loads to gas.

However, due to contractual obligations, the government must pay for the entire installed capacity year-round, regardless of utilization. In contrast, global grid planners operate some plants solely during peak demand periods, paying only when the capacity is actively utilized, while Pakistan’s generation mix is heavily skewed towards take-or-pay base-load plants.

There are two main types of energy contracts: take-or-pay and take-and-pay. Pakistan operates under a take-or-pay contract system with IPPs, where a fixed percentage of their capacity must be purchased regardless of actual demand.

This setup can be unfavorable for buyers, as they must pay for electricity up to the contracted capacity, leading to increased unit costs. In contrast, take-and-pay contracts involve buyers paying solely for their electricity consumption, though this can lead to higher prices due to negotiation or competitive buying.

The tariff structure in IPP contracts also raises issues. Consumer tariffs include various components like Energy Purchase Price (EPP), Capacity Purchase Price (CPP), T&D losses, Distribution and Supplier Margin, and prior year adjustments.

Besides IPP charges, consumer tariffs also include add-ons from Distribution Companies (Discos), such as technical losses (typically 5-10%) and factors like theft and uncollected receivables, which inflate these add-ons to over 20%.

In FY 2022, EPP comprised roughly 60% of the tariff, with CPP at 40%. By FY23, both EPP and CPP were around 50%, marking a shift from historical trends. Projections for FY24 suggest a further deviation, with CPP expected to rise to 67% and EPP decreasing to 33%. This increasing emphasis on fixed charges significantly inflates tariffs, posing challenges for consumers.

Moreover, there is significant alleged misreporting and overbilling done by IPPs as the tariffs enshrined under the take-or-pay contracts are guaranteed under international law. For instance, the actual oil consumption of several oil-based plants is allegedly less than what is billed by the IPPs; there have been alleged attempts to audit these occurrences, but any such efforts are thwarted by IPPs through, among other means, stay orders, etc.

Similarly, the O&M margins are also overstated, where the expense is Rs 500 million it is being billed at Rs 1.5 billion per annum. All other heads are similarly overstated but because the sanctity of these contracts is protected under international law and the government of Pakistan has surrendered its sovereign rights there is little that can be done to reevaluate these contracts.

Currently, electricity tariffs in Pakistan are prohibitively high. Over the past 24 years, tariffs have surged from Rs 1.37/unit in 1990 to Rs 34.31/unit in 2024, a 25-fold increase. This rise is not solely due to variables like PKR-USD parity but also due to factors like the introduction of private generation and the government’s tendency to pass on its own socio-economic obligations to certain power consumers like industrial and high-end domestic through cross-subsidies.

This scenario has contributed to premature deindustrialization, causing a decline in electricity consumption and elevated electricity costs. Immediate action is required to lower power tariffs for industries to 9 cents/kWh, stimulating demand for electricity and effectively utilizing idle capacity. Furthermore, the addition of new capacity to the system should be halted for the next 3-4 years.

Removing cross-subsidies, which act as indirect taxation on exports, is essential. Increasing tax collection to directly subsidize energy for economically disadvantaged segments and transitioning to other direct support mechanisms like unconditional cash transfers, as advised by IMF and World Bank consultants, is more economically efficient compared to cross subsidies in power tariffs.

Moreover, to reduce the undue burden of capacity payments within current contractual agreements across all consumers, there must be a significant increase in power consumption. Typically, industries drive electricity demand globally.

However, in Pakistan, inefficient allocation leads to unproductive sectors consuming a significant portion of electricity (around 47%) while industries consume only 28%. This results in industries bearing the burden of inefficiencies through cross-subsidies and additional transaction costs.

Competition plays a pivotal role in the effectiveness of take-or-pay contracts. Competitive bidding often results in favourable arrangements, especially in cases involving multiple investors and suppliers in large countries. However, problems may arise in government-to-government contracts without competitive bids, highlighting the importance of clear contract pricing through market mechanisms.

“In advanced countries with competitive electricity markets, take-or-pay contracts are prevalent. Here, electricity prices are influenced by supply and demand in spot markets, offering a mix of options for both buyers and sellers to mitigate risks effectively. Even in Pakistan, the ADB-funded Jamshoro coal power plant has demonstrated cost-effectiveness through competitive bidding.”

However, while these points must be kept in mind while negotiating future contracts, ultimately, the resolution to Pakistan’s existing capacity payment woes lies in stimulating industrial growth, which will significantly increase power consumption and reduce the per-unit burden across consumers.

By Shahid Sattar | Amna Urooj

The recent upsurge in circular debt (CD) accumulation coincided with the signing of “take-or-pay” contracts for imported coal and RLNG-based plants. These contracts, intended to address energy shortages, came with volatility and a hefty price tag.

This escalation in electricity generation costs has severely impacted Pakistan’s transition to renewable energy by diverting financial resources away from potential investments in renewables and locking the country into long-term dependencies on fossil fuels.

The persistent rise in circular debt (CD) within the power sector, currently amounting to PKR 2.6 trillion, is fueled by a multitude of factors, including high transmission and distribution (T&D) losses, inefficiencies within power distribution companies (Discos), and unbudgeted energy subsidies.

Frequent hikes in electricity tariffs aggravate Pakistan’s CD by increasing non-payment rates and T&D losses, as these losses are calculated as a percentage of the tariff. Instead of temporary fixes, policies must address the root causes of this debt.

For instance, transmission and distribution losses stood at 16.45% in FY 2022-23, while the inefficiencies and low collection rates of DISCOs have led to significant commercial losses, with outstanding debt from defaulters exceeding PKR 900 billion.

According to World Bank, Pakistan’s high energy subsidies to the domestic sector, currently estimated at PKR 976 billion (0.9 percent of GDP) for FY 2024, further strain the financial system. This explains the increasing financial burden on the power sector, highlighting the urgent need for a shift towards lower cost energy sources.

By reducing dependence on imported fossil fuels, where long-term forex-based prices are currently rising and unpredictable, Pakistan can alleviate some of these financial pressures, stabilize power prices, and pave the way for a more sustainable and economically viable energy future through indigenization and the induction of a local supply chain and renewables.

However, the current fossil fuel-based power plants should be retired, potentially through public debt financing, to address overcapacity issues and reduce the CD crisis. Advancing the planned retirement of outdated and inefficient power plants while ensuring that new additions focus exclusively on renewable energy is need of the hour.

Investing in renewable energy not only offers a sustainable solution to the circular debt crisis but also brings numerous economic and environmental benefits. Renewable technologies, such as solar and wind, have near-zero marginal costs of production, which can significantly lower overall electricity generation costs. This makes renewables highly competitive in the long term.

For example, the International Energy Agency (IEA) reports that new solar projects are now the cheapest source of power on a levelized cost of energy (LCOE) basis, with solar energy costing around $60 per MWh, while gas is $20 more expensive at $80 per MWh. Redirecting funds from LNG and coal infrastructure to renewable energy projects aligns with global trends favoring climate-friendly investments and will ensure a resilient energy future for Pakistan.

But where do we stand in terms of renewable energy in the country? Pakistan’s energy production and consumption landscape is predominantly fueled by fossil fuels. As of recent data, thermal sources—comprising natural gas, oil, and coal—contribute to nearly 60% of the country’s total installed capacity. Specifically, natural gas accounts for approximately 33%, oil for 15%, and coal for about 12% of the energy mix.

In contrast, renewable energy sources such as hydropower, wind, solar, and biomass make up a smaller fraction of Pakistan’s energy portfolio. Hydropower constitutes around 30% of the installed capacity, while wind and solar energy contribute approximately 4% and 2%, respectively.

Despite the declining costs of renewable technologies and the substantial potential for clean energy, the pace of renewable energy development has been insufficient to offset the use of fossil fuels to any significant extent. As of 2023, the total installed capacity of renewable energy sources, including hydropower, wind, solar, and bagasse/biomass, exceeds 13,000 MW out of 45,885 MW.

The truth is Pakistan’s current energy mix has significant environmental impacts. The extensive use of natural gas, oil, and coal contributes to high levels of carbon emissions and air pollution has adverse effects on public health and the environment.

While Pakistan emits less than 1% of the world’s planet-warming gases, its emissions are insignificant on a global scale, yet Pakistan suffers disproportionately from the outcomes. For instance, power plants burning fossil fuels are major sources of sulfur dioxide (SO?), nitrogen oxides (NO?), and particulate matter, leading to respiratory illnesses and other health problems among the population.

Lahore is already bearing the brunt of it, ranked 5th in the 2023 IQAir World Air Quality Report. The city frequently experiences severe air pollution, directly linked to emissions from these power plants, resulting in increased cases of asthma, bronchitis, and other respiratory conditions. Fossil fuel extraction and combustion contribute to soil and water pollution, further degrading the country’s natural resources.

Economically, the high costs associated with fossil fuel imports place a substantial burden on Pakistan’s financial resources. The country spends a significant portion of its foreign exchange reserves on importing oil and gas (roughly one-quarter of Pakistan’s imports are oil and gas), which makes its economy vulnerable to global price fluctuations.

In fiscal year 2022-23, energy imports accounted for a large share of the total import bill, intensifying the country’s trade deficit. Socially, the energy crisis in Pakistan leads to widespread energy access issues, with many rural and remote areas lacking reliable electricity supply. This energy insecurity affects education, healthcare, and overall quality of life, hindering social and economic development.

Switching to renewable energy in Pakistan offers numerous benefits across environmental, economic, and social dimensions. Environmentally, renewable energy significantly reduces greenhouse gas emissions and mitigates climate change impacts. For instance, projections indicate a potential 50% reduction in projected emissions by 2030, with a 35% reduction contingent on international grant finance and a 15% reduction from the country’s own resources.

Economically, the transition creates jobs within the renewable energy sector and provides long-term cost savings compared to fossil fuels, enhancing energy independence and security. Socially, renewable energy improves public health by reducing pollution, enhances energy access in remote areas, and empowers local communities through decentralized energy systems. These combined benefits underscore the urgent need for Pakistan to accelerate its shift towards sustainable energy solutions.

Moreover, the implementation of distributed energy solutions and localized energy grids with renewables can further strengthen these benefits. By enabling DISCOs to purchase power from the grid while supplementing it through solar rooftops, particularly in areas with limited energy access, and allowing direct purchases from dedicated plants, Pakistan can ensure a more sustainable and resilient energy use that rooftop solutions alone cannot achieve.

Wind energy also presents substantial opportunities, especially in the wind corridors of Sindh and Balochistan. The Gharo-Jhimpir wind corridor alone has an estimated potential of 50,000 MW, with several successful projects already operational.

For instance, the Jhimpir Wind Power Plant, with an installed capacity of 50 MW, has been effectively harnessing wind energy and contributing to the national grid. These projects not only support energy diversification but also promote energy security and reduce carbon emissions. To further enhance resource utilisation and cost efficiency, the government should mandate that wind installations also incorporate solar power. This hybrid approach would ensure optimal use of available land and infrastructure, resulting in greater energy output and more sustainable energy solutions.

A key development in Pakistan’s renewable energy sector is the expansion of net metering. As of June 30, 2023, net metering consumers reached approximately 56,000, a nearly 50% increase from the previous year. In FY22-23, net metering generated 482 gigawatt-hours, a remarkable 220% year-on-year growth.

Despite this impressive growth, 482 gigawatt-hours represent less than 0.4% of the total energy sold/generated, highlighting its relatively small impact on the overall energy market. Rather than penalizing net metering through gross metering, which would discourage consumer participation, it is crucial to continue and support net metering policies.

The proposal for gross metering raises serious concerns. Gross metering, which requires consumers to sell all the electricity generated by their solar panels to the grid at a fixed Feed-in-Tariff (FiT) and then buy back the electricity they consume at retail rates, is a travesty of justice.

The significant rate disparity—selling electricity at 11 rupees per unit while buying it back at up to 62 rupees per unit—makes solar investments financially unsustainable. This policy shift would compel consumers to seek mechanisms to go completely off-grid, undermining the growth of renewable energy. Instead, the government should focus on revising unsound tariff structures to support renewable energy growth, consumer benefits, and grid stability.

In addition to net metering, hydropower remains a critical component of Pakistan’s renewable energy strategy, leveraging the country’s abundant water resources. The total hydropower capacity, including WAPDA and IPPs, stands at 10,635 MW as of June 30, 2023. Major projects like the Tarbela and Mangla dams continue to play pivotal roles.

Wapda plans to add up to 10 GW of hydropower capacity by 2030 through the phased completion of its under-construction projects. Future projects, including the Diamer-Bhasha Dam, are expected to add significant capacity. However, managing seasonal variability is crucial for optimizing hydropower generation. Effective water management and storage solutions are essential to balance supply during dry periods and maximize generation during peak flow seasons.

Technological innovations play a pivotal role in overcoming challenges and advancing the renewable energy sector in Pakistan. Recent advancements in solar and wind technology have significantly lowered costs, making renewable energy more competitive with traditional fossil fuels.

The average cost of solar power generation has dropped to PKR 3.67 per kWh, making it cheaper than many conventional energy sources. In addition, the development of battery storage systems and smart grid technologies is crucial for stabilizing the power supply and managing the intermittency of renewable energy sources.

Supporting the integration of renewable energy and enhancing grid flexibility is essential. The National Transmission and Dispatch Company (NTDC) is modernizing the grid infrastructure to better accommodate the distributed and variable nature of renewable energy. This includes implementing advanced forecasting tools, real-time monitoring systems, and automated control mechanisms to quickly respond to changes in power generation and demand.

Strategies such as demand response programmes, which adjust consumer power usage during peak times, and the development of microgrids, capable of operating independently or alongside the main grid, are also being adopted. These measures not only improve the resilience and reliability of the power system but also facilitate the seamless integration of renewable energy, supporting Pakistan’s ambitious goal of achieving 30% renewable energy by 2030.

Building on Denmark’s remarkable achievements in renewable energy, Pakistan can draw valuable lessons. In 2022, Denmark announced an ambitious target to achieve net-zero emissions by 2045, aiming for 110% emissions reductions by 2050.

The Danish government has strategically focused on offshore wind, biomethane, district heating, carbon capture and storage (CCUS), and hydrogen. This comprehensive approach is guided by robust energy and climate governance under the Danish Ministry of Climate, Energy and Utilities, ensuring annual policy actions and funding through the ‘year wheel’ of the Climate Act of 2020.

This strategic focus on renewable energy sources, coupled with Denmark’s technology leadership, showcases how a well-coordinated policy framework and technological innovation can drive a successful energy transition. By adopting similar best practices, Pakistan can enhance its renewable energy adoption, ensuring a sustainable and economically viable energy future.

“The future of Pakistan lies in harnessing the power of the sun, wind, and water to create a sustainable and prosperous nation. By embracing renewable energy, Pakistan can address its energy challenges, improve public health, and build a resilient economy. As the famous quote goes, “The best time to plant a tree was 20 years ago. The second-best time is now.” It is time for Pakistan to plant the seeds of a renewable energy revolution.”