Circular debt’s curse

Published February 26, 2024

Circular debt of the energy segment in Pakistan has been acting as a drag on growth for more than a decade at this point. The inability of successive governments to execute deep reforms in the energy value chain has led to a situation with the power and gas circular deficit exceeding Rs5 trillion.

If the same continues unabated, it will continue to increase at a more than 20 per cent growth rate while squeezing liquidity available across the energy value chain.

The roots of circular debt can be linked to the omnipresence of the government across the energy value chain, where the government and its majority-controlled entities are the sole buyers of electricity and gas in the country while also setting electricity and gas prices. Electricity prices are set on a cost-plus basis, which is a methodology that is divorced from economic realities. Similarly, the inability of the government to price gas according to its economic use or its marginal cost has led to a scenario where we continue to sell gas to domestic users and many other users at a fraction of the marginal cost of gas.

The marginal cost of gas is the international price of imported Liquefied Natural Gas (LNG). The inability to create a market for electricity and gas has led to a scenario where the government continues to bridge the deficit between the price charged by the ultimate consumer and the cost of production and transmission through various subsidies and debt.

The government and its entities are the sole buyers of electricity and gas in the country while also setting its prices

As the practice of kicking the can down the road continued, circular debt exceeded Rs5tr in nominal terms. This is effectively the amount that various entities in the energy value chain owe to one another — largely because the government has not been able to settle its payments.

To a certain extent, the existing circular debt is effectively supported through bank borrowings, as entities within the energy value chain borrow through short-term debt to plug their liquidity requirements. This has led to a scenario where the ability of entities in the energy value chain to access bank financing is also compromised, due to which the ability to raise debt to fund investments in longer-term capital-intensive projects remains compromised.

For example, the inability of exploration and production companies (E&P) that focus on oil and gas extraction to get cash from the government has compromised their ability to invest in expanding their production abilities — effectively reducing the availability of indigenous oil and gas and pushing the country to import more.

The unintended consequences of circular debt range from depressed equity valuations to strained availability of external debt to fund working capital or long-term investment requirements.

The caretaker government came up with a plan to settle circular debt, through which it will inject Rs710 billion into the energy value chain by settling power producers first, eventually leading to the settlement of gas distribution companies (Sui Northern Gas Pipelines and Sui Southern Gas Company), and then finally E&P entities, such as Oil & Gas Development Company and Pakistan Petroleum Limited.

Once these entities’ receivables were settled, they were expected to pay a dividend to their shareholders — the majority of which was the government itself. Effectively, the government will be clearing the circular debt to inadvertently get back a slightly higher payout as dividend income and as a tax on dividend income. The plan may work well great in theory — but considering the multiple layers of transactions and the number of entities involved, there are numerous risks.

The initial injection of cash in the energy value chain would be through a Supplement Technical Grant, which is effectively a reallocation of the available budget. However, the International Monetary Fund (IMF) does not like the utilisation of such grants, considering the already strained fiscal position.

Considering the presence of multiple entities and multiple transactions involved, the risks associated with the envisaged transaction not going through are too high. This is largely due to the presence of multiple boards and the declaration of dividends during the process.

Moreover, the absence of any plan to undertake deep reforms across the energy value chain clearly demonstrated that this was just another attempt to make circular debt someone else’s problem.

It is to be noted that the same plan has been proposed multiple times during the last three years, only to fail at various stages because of the risks involved. The inability to address those risks and being persistent about a bad plan only makes such a plan worse. In view of all these factors, the consent of the IMF was hard to come by for such an ambitious and circuitous plan.

An elected government will start operating soon, and resolving the circular debt crisis should be among its top priorities. Any plan to resolve circular debt, whether through monetisation of debt or swapping receivables with tradable government debt, must be executed on a priority basis.

It must also be accompanied by an aggressive plan to undertake reforms across the energy value chain — particularly on the transmission and distribution side. Electricity distribution companies cumulatively cost more than Rs300bn to the national exchequer — privatising them or adopting some other governance model remains critical in reducing these losses.

Electricity prices have reached a level where demand will remain stagnant or fall — which would be a leading indicator for economic slowdown or contraction. The ability to attain economic growth largely rests on growth in the consumption of electricity, which is dependent on affordable tariffs.

The habit of kicking the can down the road has led to a situation where instead of reforms, government functionaries simply pass on all inefficiencies and deadweight costs to consumers — who simply cannot afford electricity anymore.

The writer is an independent macro economist and energy analyst

Published in Dawn, The Business and Finance Weekly, February 26th, 2024

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