ZESCO and Why You Should Pay More for Electricity

Why You Should Pay More for Electricity - 21 May, 2009

By Alexander Chileshe

Zambia has virtually the lowest electricity tariffs in sub-Saharan Africa. Despite this ZESCO is arguably the most unpopular organisation in the country, particularly since regular load shedding started early this year. The price of anything determines how much is bought and consumed (demand) and how much is produced (supply). If the price is too high producers will be unable to sell all their production. If the price is too low consumers will demand more than producers are willing to supply (because the price does not cover the cost of production) and there will be shortages. The ‘right’ price is the one that at which all production is sold and every consumer can buy as much as s/he is prepared to pay for.

Most prices are determined by the forces of supply and demand in competitive markets. However, where markets are uncompetitive government regulation may be needed. Since ZESCO is virtually a monopoly supplier of electricity to the Zambian market, the Government established the Energy Regulation Board to ensure that the monopoly is not abused.

What principles should a regulator follow when fixing electricity tariffs? The most obvious and important principle is that tariffs must at a minimum cover the costs of (efficiently) generating, transmitting and distributing electricity. If costs are not covered the utility will lose money and, unless it is subsidised, sooner or later it will go out of business. There are two broad cost categories – operating costs and capital costs. The main costs of operating on a daily basis to generate, transmit and distribute power, are fuel, labour, maintenance and revenue collection. Since Zambia is one of Africa’s richest countries in terms of rivers and hydro-electric potential, virtually all ZESCO power is generated in hydro-electric power stations. Since the ‘fuel’ for a hydro station is water, ZESCO operating costs are much lower than in, say, South Africa, where most electricity is generated using coal.

What about ZESCO capital costs? While hydro-electric power stations have lower operating costs than thermal power stations of the same capacity, their capital costs are much higher because of the need to construct dams, tunnels, etc. But no new hydro stations have been built in Zambia since the mid 1970s. Some people argue that since the capital costs must have been ‘paid off’ by now this justifies low electricity tariffs in Zambia.

While this might seem reasonable to an accountant, it is bad economics for two reasons. First, while ZESCO’s power stations may be fully ‘depreciated’ this is a purely paper exercise. The economic reality is that the power stations are still extremely valuable assets because (with proper maintenance) they can continue generating power – and raising revenue for ZESCO - for decades to come. When they were built is irrelevant. Economic efficiency requires that ZESCO earn a return on its capital assets which is equivalent to what it could earn investing money elsewhere; otherwise capital costs are not ‘covered’. The resulting profits should then be paid to the owners as dividends or reinvested in expanding capacity, or both. If tariffs are set too low to enable ZESCO to earn an economic return on its assets this means that its customers are effectively being subsidised by ZESCO’s owners.

But ZESCO is a parastatal. It is owned by the Government and therefore by the people of Zambia. So does it matter if tariffs are subsidised, since the owners and customers are the same people? If all Zambians consumed equal amounts of electricity there might be some substance to this argument. However, this is not the case. Only 27% of Zambians have access to electricity, almost all of whom live in towns. Subsidising electricity tariffs, therefore, effectively means the rural population subsidising urban dwellers and the mines - or the poor subsidising the rich.

The second, and more important, reason why tariffs need to provide a proper return on capital is that without this no new power stations will be built. Hydroelectric plants in particular require substantial investment over several years before any electricity is generated. The Zambian Government does not have nearly enough funds to finance major new power plants on its own - and, in any case, it should give priority to services such as health, education and water. It has no choice, therefore, but to rely on funding from either the private sector or multilateral lending agencies, or both.

No investor will invest in a project unless it expects to earn at least as high a return on its funds as it could obtain from alternative investments. Similarly, banks will not lend money for projects unless they are confident that revenues will be high enough to cover loan repayment and interest. The minimum tariff needed to justify building new hydro power stations in Zambia is probably of the order of US 6 - 9 cents per kilowatt hour. Yet ZESCO tariffs currently range between 2.5 and 3.5 cents. The main reason why no new power stations have been built in Zambia since the 1970s is that tariffs have been too low to provide a reasonable return on the capital needed to build them. Investors and banks could get better returns elsewhere.

Zambia’s rapid economic growth in recent years has meant increased demand for electricity. While ZESCO is increasing the generation capacity of the Kariba North and Kafue Gorge power stations, this is not sufficient to meet the increasing demand. As a result, ZESCO no longer has sufficient capacity to satisfy the demand for power during peak hours - at current tariff levels. The inevitable result is load shedding. In other words, the power cuts currently being experienced are a direct consequence of Zambia’s exceptionally low electricity tariffs, because they have discouraged new investment in generation capacity.

Even without new investment ZESCO can cover part of the shortfall by importing power from DRC, which currently has spare capacity. However, DRC can also sell its surplus power to South Africa and elsewhere. It will only sell to ZESCO at international market prices, therefore. It was reported recently that DRC proposes increasing the price at which it supplies ZESCO to 4 US cents per kilowatt hour. At current Zambian tariff levels ZESCO would lose money importing from DRC at this price – even before counting the costs of transmission and distribution to customers.

The Energy Regulation Board is aware of the above reasons for increasing tariffs. Why then are they still so low? The fundamental reason appears to be that the legislation establishing ERB requires it to consult electricity consumers before revising tariffs. Since no one ever responds positively to the question ‘do you want to pay more?’ there is a built in bias against increasing tariffs. The newspapers are full of letters from consumers objecting to increased tariffs. Yet the authors have a conflict of interest - they want to continue being subsidised. The people who are effectively subsidising tariffs – the rural population who do not have access to electricity – are not aware of this and, not being consumers, are not consulted; so only one side of the story gets told.

To sum up, the main reason for power cuts in Zambia is the reluctance of electricity consumers to pay tariffs which cover the costs (particularly capital costs) of supplying continuous, reliable power. There is an old expression ‘you get what you pay for’. Until Zambians are prepared to pay a proper price for electricity they can expect power cuts to continue indefinitely.

Yes, but…

1) ‘ZESCO is overstaffed, overpaid and inefficient. Why should customers pay for their inefficiency?’

If ZESCO is inefficiently managed it is the responsibility of ZESCO’s Board and ERB to address the causes, if necessary by replacing the management. This applies regardless of the tariff level. Managerial inefficiency does not represent a valid reason for charging tariffs that are so much lower than elsewhere in the region. Several utilities in the region are alleged to be inefficient, not just ZESCO. Excessively low tariffs themselves contribute to inefficiency if they discourage new investment and starve the utility of funds for maintenance. Two wrongs do not make a right.

2) ‘Increasing tariffs will hurt the poor’

Only 27% of the population have access to electricity, so anyone who can both access and afford to pay for it is much better off than most Zambians. Most of the poor live in rural areas and will never have electricity in their homes. Among those fortunate enough to have electricity, the poor consume less than the rich. Many countries protect low income urban groups by subsidising the first 50 or 100 kwh per month of consumption – called a ‘lifeline block’. Above this level normal rates apply. Currently all electricity is subsidised in Zambia, because the tariffs do not cover capital costs. Most of the subsidy goes to the rich and to the mines. ERB should consider introducing a lifeline block to soften the impact of increased tariffs on the poor.

Paradoxically, excessively low tariffs actually increase the costs of many businesses – because of the disruption caused by load shedding and the need to run (expensive) generators. This increases costs throughout the Zambian economy and discourages investment. This, in turn, reduces employment and growth - and hurts everyone.

3) ‘It is better to conserve electricity than to increase its price’

Energy conservation is obviously important – whatever the tariff. However, economics tells us that the most effective way of conserving anything is to increase its price. The main reason electricity gets wasted in Zambia is that its price is too low so there is less incentive for consumers to conserve. Increasing the tariff would reduce both the consumption of electricity and the need for power cuts.

4) ‘Zambia has lots of rivers, so electricity should cost less here’

Total generation costs of efficient hydro plants should be below those of thermal plants, especially if the environmental costs of coal fired generation are taken into account. So if it exploited its hydro potential efficiently, Zambia could both have (sustainable) lower costs and lower tariffs than most of its neighbours and be a major exporter of power.

However, ZESCO tariffs are currently so far below normal international levels that they are not sustainable, because they do not reflect costs - particularly capital costs. While hydro power stations are cheaper to operate than thermal ones, they cost much more to construct. Tariffs must cover both operating and capital costs. Current tariffs are so low that they do not even cover all operating costs. They are preventing Zambia from exploiting its hydro potential. Until tariffs are fully cost reflective, no more power stations will be constructed and Zambia will not be able to meet the domestic demand for power - let alone be an exporter. Having more potential to generate hydroelectricity than its neighbours is of little value to Zambia if tariffs are too low to attract the investment needed to exploit the potential.

5) ‘Why can’t Government use mining taxes and increasing fiscal space to build more power stations?’

While the Government’s fiscal position has improved in recent years, it does not have nearly enough resources to finance all the priorities in the Fifth National Development Plan. Hydroelectric plants are extremely expensive to build and do not begin to generate electricity or revenue for at least five years. Despite this, private investors and multilateral lending agencies are prepared to finance hydro schemes – as long as tariffs are realistic. It is more sensible, therefore, for Government to spend its scarce resources on improving essential services to the poor, such as health, education, water and roads – since these will not be financed by the private sector. In addition, even if the Government used all the additional revenue from mining taxes for power generation, it would not have sufficient to finance the investment requirements without private and multilateral investment.

6) ‘The mining industry consumes 50% of Zambia’s electricity, AND they are the main reason for the large increase in power demand. Why don’t they pay?’

They certainly should, and we understand that ZESCO is negotiating higher tariffs with the Copperbelt Energy Corporation and the mining industry. In addition, some mining companies have expressed interest in developing Kafue Lower, the largest new project in the power investment programme. But if electricity tariffs are increased ONLY for the mining industry, it will eventually become profitable to supply ONLY the mining industry. So charging the mining companies more than the rest of us is only a temporary solution.

7) ‘It takes months for ZESCO to connect new customers. They do not deserve higher tariffs.’

At current tariffs it costs ZESCO more to provide power to new customers (in peak hours) than it receives in revenue. Also, during load shedding, supplying power to new customers simply takes it away from existing ones. So there is no incentive to connect new customers.

8) ‘You are applying western, neo-liberal economics to this problem. But we can get the power investment we need from China, which will not require these conditions’

If China is prepared to finance power investment in Zambia without requiring tariff increases, it is obviously in Zambia’s interest to seek Chinese assistance. But look out for hidden costs. Some investors, (not only from China), look for guaranteed supplies of copper at discounted prices. And if Chinese companies invest in Zambian power generation, don’t expect their motives to be any different from anyone else’s. They also have alternative uses for their funds.

*This article originally appeared in the January 2009 issue of Zambia Analysis.