Books and MonographsPublished on May 17, 2024 PDF Download
ballistic missiles,Defense,Doctrine,North Korea,Nuclear,PLA,SLBM,Submarines

Delicensing Electricity Distribution in India: Prospects, Challenges, and Implications for Green Power Adoption

Attribution:

Promit Mookherjee, Lydia Powell, and Mihir Sharma, Delicensing Electricity Distribution in India: Prospects, Challenges, and Implications for Green Power Adoption, May 2024, Observer Research Foundation.

Executive Summary

Context

India’s development strategy hinges on creating adequate generation capacity and ensuring affordable, reliable power for its growing population. India presently boasts an installed electricity capacity of approximately 425 GW and has made significant strides in extending electricity access to nearly all its populace.

This growth has been driven by substantial reforms to its electricity sector. The Electricity Act (EA) 2003 was instrumental in unbundling the generation, transmission, and distribution segments and laid the groundwork for improving the efficiency of the sector, particularly through greater private-sector participation.

However, given that the electricity sector is part of the concurrent list, the enactment of reforms proposed by the Electricity Act has seen varied levels of adoption across different states. In particular, the distribution sector remains a significant bottleneck. Despite the Central Government’s efforts over the past 30 years through the introduction of various initiatives, including performance-based incentive programs and bailout packages, the financial health of this sector remains precarious. In 2022, distribution companies reported substantial financial deficits amounting to INR 78,000 crore. This critical financial condition not only hinders the sector’s prospective development but also poses a barrier to India’s aspirations for renewable energy advancement.

In an attempt to improve the performance of the distribution segment, the Central Government introduced the Electricity (Amendment) Bill in 2022. This proposed legislation seeks to delicense the distribution segment. It proposes a radical shift allowing multiple DISCOMs to operate within the same area using a shared network, thereby separating content and carriage and allowing for competition in the retail segment. While the Bill is currently under parliamentary review, its potential impact on the distribution sector’s efficiency necessitates careful examination, considering mixed global experiences with similar reforms.

In this context, this study aims to assess the ramifications of this transformative change. The objective is to determine whether this shift can effectively address longstanding issues that have hindered DISCOM operations, leveraging insights from international experiences and past Indian reform endeavours.

India’s Electricity Sector Reform Trajectory

The Electricity Act (EA) 2003 altered India’s power sector by introducing a governance structure aimed at improving technical performance and fostering competition. It unbundled the electricity sector, with most states transitioning from a vertically integrated framework to a segmented structure managed by distinct entities and supervised by State Electricity Regulatory Commissions, enhancing nationwide electricity generation and delivery.

In terms of private sector participation, while the generation segment has seen notable success, the distribution segment’s privatisation efforts have yielded mixed outcomes. Only nine states have some sort of private sector participation in distribution, with widely varying experiences. In some cases, such as Odisha, the implementation of a distribution licensee model has actually led to the worsening financial position of DISCOMs, leading to the eventual cancellation of the contract and various litigations. In other cases, such as Nagpur and Aurangabad, the franchisee contracts had to be cancelled due to issues with payments.

Encouragingly, substantial gains have been visible when private sector participation has been implemented successfully. Private distribution companies have reduced their average AT&C losses to below 10 percent, which is much lower than their public counterparts. Since the implementation of the EA, 2003, AT&C losses across the country have declined, reducing from 38 percent to 16 percent in 2023. Although the private sector has played a role, the primary reason for this reduction is the improved performance of the public sector, which still manages the majority of India’s distribution system. These improvements driven by the Electricity Act of 2003, were enhanced by various government schemes incentivising DISCOMs to boost their technical efficiency.

However, the distribution sector’s transformation is being stymied by persistent challenges. These include the lack of cost-reflective tariffs, which prevents DISCOMs from setting prices that accurately reflect supply costs, leading to financial strain. Additionally, the practice of cross-subsidisation, where higher tariffs on commercial and industrial consumers subsidise lower rates for agricultural and household users, further complicates DISCOMs’ financial sustainability. Lastly, irregular tariff revisions due to political sensitivities and the regulatory commissions’ reluctance to adjust prices in a timely manner exacerbate the financial woes of the distribution segment.

Despite the EA’s intentions and some successes, operational and financial performances of DISCOMs in India lag behind developed economies, with key reforms still needed to address the deep-rooted challenges within the sector.

The Electricity (Amendment) Bill, 2022

The key amendment in the Bill concerns allowing multiple DISCOMs in one area. The EA of 2003 permits State Electricity Regulatory Commissions (SERC) to license multiple entities for electricity distribution if each has its own network. The Electricity (Amendment) Bill of 2022 proposes the removal of the licensing requirement, enabling multiple DISCOMs in a single area. The Bill will additionally facilitate the sharing of distribution networks between companies, with the network owner required to grant non-discriminatory access to all competitors in the same area upon payment of wheeling charges. Thus, while the new Bill will not legally separate content and carriage like in other countries such as the UK, it will allow for greater competition at the retail or content stage of the distribution system.

Globally, the primary motivation for delicensing has been to dismantle monopolies, enhance competition, and enable market-driven pricing to reduce costs and improve social welfare. In India, the anticipated reform aims to increase private sector involvement to mitigate inefficiencies in state-run DISCOMs to improve service quality, innovation, and financial outcomes, alongside fostering green power adoption.

Implementation Challenges

The core principle guiding the governance of India’s electricity sector centres on safeguarding low-income consumers from sudden price increases, coupled with a political drive to broaden electricity access. Over time, the strategies developed to uphold these goals, from cross-subsidisation to postponing tariff updates, have inadvertently led to the very issue that the amendments to the Electricity Act aim to address. These measures have resulted in heavily indebted DISCOMs that are struggling to fund the transition to green energy shifting towards more profitable power purchase agreements (PPAs) or delivering satisfactory services to consumers with higher expectations.

From the Union Government’s perspective, the objectives of power sector reform are therefore manifold. These include ending the cycle of periodic financial rescues, thus diminishing the need for direct bailouts from the federal treasury. Additionally, the reforms aim to reduce the obscured risk and potential liabilities shouldered by state governments. By enhancing the purchasing power of DISCOMs, the reforms strive to secure investments in the energy transition and ensure a reliable electricity supply. Ultimately, these efforts seek to eliminate a significant macro-prudential risk with the potential to destabilise India’s entire financial system.

However, whether the current amendment, aimed at improving retail competition, can resolve any of these issues is still up for debate, particularly because, as highlighted earlier, they have their genesis in regulations and practices beyond the distribution sector. Thus, a critical analysis of the potential challenges and opportunities arising from this new legislation is imperative. Some of the specific challenges that may arise if this legislation is implemented follow:

  • Cherry-picking of customers: In India, electricity consumers are categorised into subsidised, who pay lower tariffs, and higher-paying consumers, who subsidise the former group. Deregulation could lead to new private companies targeting profitable, higher-paying consumers, potentially placing a financial strain on state-run DISCOMs by leaving them with subsidised, lower-paying consumers. This scenario raises further concerns for the Union Government, such as the slower expansion of energy access and windfall gains for private entities who are not reinvested in access expansion.
  • Limited benefits for small consumers: Global experience indicates that increased competition does not necessarily result in lower tariffs for small consumers. With greater involvement of the private sector, there is a tendency towards more innovative tariff models, such as dynamic pricing. Observations from more developed European countries reveal that small residential consumers gain only marginal benefits from these improved options, primarily due to better access to information and lower transaction costs among larger consumers. This disparity is expected to be more pronounced in India, where the information gap between larger and smaller consumers is even wider.
  • Sharing of legacy PPAs: Allowing new entrants to use existing the distribution network of incumbent DISCOMs raises complex issues regarding the allocation of existing PPAs. Given that most DISCOMs are bound by long-term contracts, accounting for about 90 percent of power procurement in India, devising an equitable method for PPA distribution presents a major challenge. This complexity is amplified by the dynamic and varied nature of consumer demand. Simplistic allocation based on consumer load could prevent DISCOMs from optimising power procurement. Moreover, incorporating existing PPA conditions into new entrants’ operations could limit tariff-setting innovation and deter private sector participation due to reduced flexibility and increased entry barriers. Additionally, the necessity for ongoing PPA adjustments with each new entrant complicates regulatory oversight and increases financial risks for generators.
  • Impact on overall appetite of private sector: The proposed amendments should be viewed alongside existing measures for private sector involvement in electricity distribution. The distribution licensee model has already enhanced efficiency, reduced transmission losses, and improved billing processes. However, the amendments might not significantly boost private sector interest in distribution due to increased risks, including heightened competition and earlier mentioned complications.
  • Entry barriers for new entrants: For new entrants in the distribution segment, determining entry costs, establishing a customer base, and addressing potential unfair competition with state-run entities are pivotal considerations. To minimise initial entry expenses, the issue of Power Purchase Agreement (PPA) allocation must be addressed. It will also be crucial to distinguish between the costs for private sector participants who develop new infrastructure, such as in rural areas, and those utilising existing networks, due to the stark differences in entry costs. Additionally, the strategy for expanding networks hinges on maintaining low consumer-switching costs, where misaligned incentives present challenges. In various jurisdictions, a significant hurdle is the policy on new connections for consumers with outstanding dues to previous suppliers. The swift resolution of this dilemma is imperative to prevent previous suppliers from unfairly blocking switches due to unpaid bills, which would unfairly disadvantage new market entrants. Simultaneously, measures must ensure that consumers do not exploit the ability to switch providers frequently without settling outstanding dues, maintaining a balanced and fair marketplace.

Impact on Green Power Adoption

Improving the performance of the distribution sector and the successful deployment of renewables are closely linked. The instabilities in the electricity distribution sector severely impede the execution of necessary structural reforms for integrating renewable energy into the grid. Additionally, the precarious financial condition of DISCOMs undermines their capacity to promptly compensate renewable energy generators, thereby obstructing long-term investments in these technologies.

With the delicensing of distribution, there is an expectation that innovative green pricing models deployed by new private sector entrants could act as a means for the greater adoption of renewable energy by consumers. This program may be initiated by new entrants to differentiate their service offering for a commodity such as electricity. Green tariff is expected to remain the most straightforward method for electricity consumers to access renewable energy (RE) power without the need for significant upfront investment in rooftop solar systems, which can be prohibitively expensive, or the complexities of purchasing unbundled RE power through Open Access (OA) provisions, which entail high transaction costs.

However, the deployment of green tariffs may be conditional on the ability of new entrants to source green electricity. For certain private sector entities which have their own generation capabilities, this may be easier since they will be able to purchase electricity for their own facilities. In other cases, the provision of green pricing programs will depend upon the ability to manage green power procurement with long-term PPA commitments. In particular, the creation of real-time wholesale markets will be important for new entrants to be able to manage the demand and supply of green energy in a cost-effective manner.

Even when green pricing programs are implemented, whether consumers will actually be able to adopt these models will depend upon their ability to switch to new entrants offering these services. As mentioned earlier, switching rates among consumers will depend on a number of factors related to the implementation of the delicensing regime. In particular, it is likely that smaller consumers will find it hardest to switch due to high transaction costs and therefore may not be able to benefit from green pricing programs. Moreover, the willingness to pay for green electricity may also be low in India. Studies in other countries have shown that willingness to pay is usually higher for households with higher incomes and education levels, these consumers constitute a small percentage of the total consumer base in India. The experience with green tariffs in the parallel licensing system in Mumbai also suggests that the introduction of green tariffs alone is unlikely to provide a large market for RE.

The EA 2003 established a regulatory framework to support the adoption of RE by mandating state regulatory commissions to set quotas for RE consumption within distribution licence areas. It also facilitated grid connectivity from generation points to consumers and allowed open access for all generators, enhancing competition among retail electricity suppliers. Analysing the factors driving RE adoption among various DISCOMs, both state-owned and private, can provide insights into the impact of competitive retail electricity markets on RE expansion. Although competition may influence these drivers positively or negatively, the absence of a direct comparison (counterfactual) makes it challenging to be conclusive.

  • Resource endowment: Resource endowment (water, sun, wind) is strongly correlated with RE generation. With the potential introduction of competition in the retail electricity sector, it is anticipated that private Distribution Licensees (DLs) and Distribution Franchises (DFs) will capitalise on available RE resources within a state to enhance them RE asset base. Nonetheless, the mere presence of these resources does not automatically ensure the generation and consumption of RE-based power. As previously noted, the cost associated with green energy is expected to be higher, and without consumer subsidies (creating demand) combined with set targets and mandates for DLs and DFs (stimulating supply), significant uptake of RE is unlikely to be achieved.
  • Renewable purchase obligations (RPO): Poor RPO compliance and enforcement remain key challenges for RE adoption by DISCOMs. The introduction of retail competition could possibly lead to improved RPO compliance, particularly by the private DISCOMs. However, the RPO targets need to be flexible to allow DISCOMs to choose RE sources that best suit their own particular load profile in the most cost-effective manner. Furthermore, considering the challenges associated with Renewable Energy Certificates (RECs), which stem from significant market and regulatory uncertainties at both the state and central levels, recent advancements in RE procurement strategies have emerged as effective alternatives. These include competitive bidding processes and innovative market instruments such as the Green Term Ahead Market (GTAM) and the Integrated Day-Ahead Market (GDAM), alongside the use of the Inter-State Transmission System (ISTS) with waived charges. These alternatives are likely to provide more robust options for achieving compliance with Renewable Purchase Obligations (RPO) for private DISCOMs that may enter the retail distribution segment.
  • Payment security: The establishment of payment security mechanisms for power generators is expected to encourage the production and sale of green power, with private DLs and DFs likely benefiting from more favourable terms due to their efficient financial management compared to state-owned DISCOMs. Foreign investors encounter off-taker risks as a significant barrier to investing in India’s RE sector. The government’s payment security mechanism aims to mitigate this risk, thereby attracting investment and increasing RE adoption. However, financial sustainability and economic efficiency issues persist among DISCOMs, as evidenced by the poor ratings of Rajasthan and Tamil Nadu’s DISCOMs despite being among the top three RE generators. Enhancing payment security mechanisms will be crucial for fostering a conducive environment for RE generation and adoption, particularly as competition in electricity retail emerges.
  • Resource adequacy planning: Major challenges of decarbonising the electricity grid include increasing grid flexibility and keeping grids reliable. The introduction of competition in the retail sector is likely to prompt private DISCOMs to invest in advanced technologies and skilled workforce for resource adequacy (RA) planning. This strategic approach will facilitate optimised investment in generation assets and the procurement of power on both long-term and short-term bases. Improved forecasting and planning by DFs and DLs in a deregulated retail market will enable the use of zero marginal cost generating sources, such as solar energy, to minimise costs. This, in turn, is expected to reduce electricity tariffs for consumers, thereby encouraging the adoption of RE.

In 2023, the Ministry of Power (MoP) issued guidelines for RA planning, underscoring the responsibility of DISCOMs, and eventually DLs and DFs, to ensure 24/7 reliable power supply, explicitly stating that load shedding is not an acceptable practice. Looking ahead, there is a need to develop a cost-effective strategy to meet forecasted demand consistently, including a mechanism for resource sharing among states to maximise utilisation. This approach requires a framework centred on reliable grid operations, highlighting the balance between innovation in power distribution and the imperatives of grid reliability and efficiency.

The Way Forward

To address potential challenges from delicensing and retail competition, we outline certain measures to optimise benefits for the distribution segment from the new legislation.

Ensuring pricing flexibility

  • Introducing retail competition can incentivise pricing flexibility and encourage new entrants in the distribution segment. However, introducing competition at the retail level when competition is absent in the rest of the value chain may result in sub-optimal outcomes not only in RE adoption but also in economic and technical efficiency. Considering that, in India, 70-80 percent of the electricity cost paid by consumers is at the generation stage, there is a need to accelerate the reform of wholesale electricity markets and fuel markets to realise the full benefits of retail competition.
  • The SERCs will need to be more ambitious in devising price and floors and ceilings. A key criterion in the price-setting formulation should be the consideration of the actual cost of supply. Delicensing provides an opportunity for piloting a new method for calculating the average cost of supply that accounts for the divergence across users in a particular region. There is also scope to implement a graded pricing structure, with different floors and ceilings for consumers with differing power loads. The Central Electricity Regulatory Commission will have to take the lead in devising a new pricing formula which can be piloted in the initial phase of the delicensing exercise.

Preventing cherry-picking and ensuring energy access

  • It is essential to establish precise criteria for both deposits to and withdrawals from the Universal Service Obligation (USO) fund. These guidelines must strike a balance between encouraging profitability for new market entrants and minimising the risk of selective consumer targeting. Drawing on the telecommunications sector’s approach, one strategy could involve imposing a specific levy on new entrants as a contribution to the USO fund. This will make it easier for new entrants to assess their future profitability while entering a particular area. Nevertheless, the levy’s size needs careful calibration to effectively counteract any potential selective targeting of consumers, potentially necessitating variable levies across different areas based on the actual composition of consumers.
  • The SERCs will need to set up a system to observe pricing mechanisms being deployed by new private entrants to ensure that discriminatory pricing models are not applied to selective consumers.

Ensuring that benefits reach small consumers

  • To protect small consumers from abrupt price increases, targeted subsidies should be offered to those unable to afford higher costs or unwilling to pay higher prices for better products. Previously, subsidies were distributed through DISCOMs, but there is now a need for direct benefit transfers to ensure that subsidies reach those who need it the most. Furthermore, the advent of unique pricing models by new entrants presents an opportunity to refine the allocation of targeted subsidies. Consumers with a greater willingness to pay for enhanced services can opt for new plans offered by private entities, while subsidies can be more accurately directed towards those in need.
  • Once delicensing is implemented and a new company enters a particular area, there is a need for targeted awareness campaigns to inform all consumers of the new entrant. This responsibility can be assigned to local governments through funding support from the centres. There is also a need for a centralised online platform that allows consumers to compare all offerings across different DISCOMs in their area. These awareness programmes should be mandated in the new legislation and carried out periodically to ensure that up-to-date information is available to all consumers.
  • SERCs will also need to build capabilities to monitor targeted advertisement from new entrants which are only focused on specific consumer groups. While the legislation currently includes provisions that ensure that new entrants must extend services to all consumers, it must also include specific conditions to prevent the usage of targeted and exclusionary advertisement campaigns.

Creating a level playing field for new entrants

  • The state DISCOM cannot both be the unaccountable manager of wires and compete with a private entity that uses those wires. That is a recipe for constant conflict and one that will strongly disincentivise private sector investment. In other jurisdictions, former state distribution companies have been completely converted to managers of the infrastructure. At the very least, separating these roles between two different entities may be required. A precedent for this exists within the public sector in India. The deregulation of aviation in the 1990s proceeded with different state-owned entities (i.e., Indian Airlines and Air India) being responsible for airports and participating in the civil aviation market.
  • There needs to be a centrally mandated method for PPA allocation that allows for the creation of a level playing field. If it is left up to the state regulators, there is a perverse incentive for picking methods which will shift a large part of the burden to the new entrant and not the incumbent DISCOM, which is likely to be government owned in most cases.
  • An effective contract enforcement mechanism will be essential to ensure that delicensing does not lead to endless litigation that disadvantages new entrants. Currently, disputes between the regulatory authority and private sector players cannot easily be recommended to arbitration, and it is well-known that the normal court system is capable of delaying dispute settlement considerably. Ensuring swifter dispute settlement will be important to keep private sector sentiment positive.
  • Based on the experience of other countries, a significant limitation involves the ability of a new provider to furnish a connection to a consumer who maintains an existing account and outstanding payments with the original distributor. Prompt resolution of this matter is critical. On one hand, the incumbent supplier should not possess the unilateral power to block a consumer’s switch by citing unpaid dues, as this would create adverse incentives that undermine new market entrants. Conversely, there should be no incentive for consumers to frequently change providers while neglecting their financial obligations. Therefore, accurate meter readings at the time of switching, coupled with an independent assessment regarding the handling of outstanding dues, are imperative.

Enabling green power adoption

  • Renewable Purchase Obligation (RPO) targets ought to be technology-neutral, enabling DISCOMs to select renewable energy sources that align optimally with their load profiles. This approach would particularly benefit private DISCOMs, focusing more on cost efficiency and facilitating more strategic planning to enhance RE adoption as a strategy for bolstering their financial performance.
  • REC Regulations 2022, which came into effect in December 2022, aimed to restructure the renewable energy certificate mechanism. The new regulations introduced the concept of REC multipliers by technology, increased the validity of RECs to perpetuity until sold, and, vitally, removed the floor and the ceiling prices for REC trading. The new rules may add to the uncertainty and risk associated with the REC mechanism in terms of technologies and policies at the state and central level.
  • The flexibility of Renewable Energy Certificates (RECs) must be enhanced to keep pace with changing market dynamics. In this context, International Renewable Energy Certificates (I-RECs) provide a valuable model. The advantages of I-RECs over traditional RECs include the allowance for bilateral trading of I-RECs and the cross-border flexibility provided to market participants. By enabling international stakeholders to engage in the REC market, India can leverage the benefits of bilateral REC trading, a mechanism that became operational in 2024.
  • New RE procurement strategies, such as the Green Term-Ahead Market (GTAM) and the Integrated Day Ahead Market (GDAM), along with the use of the inter-state transmission system (ISTS) that now offers waived charges, are now in competition with RECs for meeting RPO compliance. Should competition within the retail electricity sector be introduced, private DISCOMs in a deregulated market are likely to favour these emerging procurement methods. These alternatives are seen as offering greater transparency and predictability compared to the traditional REC mechanism.

Conclusion

Overall, the impact of retail competition on green power adoption will depend on several factors. In particular, the implementation of broader reform agenda for the distribution sector will substantially impact the ability of delicensing to improve efficiency in the distribution sector and encourage green power adoption. Moreover, studies indicate that, while privatisation, competition, and regulation are beneficial, implementing them all at once may not lead to positive outcomes. Recent empirical research on reform in developing countries has concluded in favour of gradualism, which emphasised the importance of first establishing institutional infrastructures that are conducive to market forces, including setting up competitive industrial structures and appropriate regulatory systems. In the Indian case, primary fuel markets are regulated and wholesale electricity markets are not dominant. Introducing competition at the retail level when competition is absent in the rest of the value chain may result in sub-optimal outcomes not only in RE adoption but also in economic and technical efficiency. However, if delicensing is to be implemented, there is a need for strong regulatory oversight and support to ensure that implementation leads to actual benefits for both consumers and DISCOMs.

(Certain parts of this report have been previously published in ORF’s Energy News Monitor, Vol. XX, Issue 26, February 12, 2024.[1])

Read the entire report here


[1] ORF Energy News Monitor, Volume XX, Issue 26, February 12, 2024, Observer Research Foundation.

The views expressed above belong to the author(s). ORF research and analyses now available on Telegram! Click here to access our curated content — blogs, longforms and interviews.

Authors

Promit Mookherjee

Promit Mookherjee

Promit Mookherjee is an Associate Fellow at the Centre for Economy and Growth in Delhi. His primary research interests include sustainable mobility, techno-economics of low ...

Read More +
Lydia Powell

Lydia Powell

Ms Powell has been with the ORF Centre for Resources Management for over eight years working on policy issues in Energy and Climate Change. Her ...

Read More +
Mihir Swarup Sharma

Mihir Swarup Sharma

Mihir Swarup Sharma is the Director Centre for Economy and Growth Programme at the Observer Research Foundation. He was trained as an economist and political scientist ...

Read More +