Middle East Economic Survey
VOL. XLVIII
No 49
5
GCC
Reforming Electricity Pricing In The Middle East
By Ahmad Faruqui, Robert Earle and Anees Azzouni
The following article was written for MEES. Ahmad Faruqui and Robert Earle are consultants with CRA International in California and Anees Azzouni is the head of A S Azzouni Management Consultants in al-Khobar, Saudi Arabia. Questions can be directed to afaruqi@crai.com.
Electricity is one of the most capital-intensive industries in the world. In addition, since it cannot be stored economically in large quantities, reserve capacity has to be built to meet peak demand conditions that occur on just a handful of days in the year. The Middle East is no exception to these trends.
Rapid load growth in the electricity sector, caused by population growth and economic development, is requiring governments in the Middle East to invest billions of dollars in enhancing the capacity for generating, transmitting and distributing electricity. Over the last decade, the region has experienced sustained growth rates in electricity consumption of over 6% per year with some economies such as Jordan, Lebanon and the UAE experiencing even higher growth rates.
Even the wealthiest of the economies, such as Saudi Arabia’s, are finding it difficult to continue making large-scale investments in their power sector. Consequently, Saudi Arabia and other countries such as Lebanon, Qatar and Yemen encountered power shortages this past summer. Not surprisingly, the less wealthy countries are finding it more difficult to manage their power shortages by expanding supply.
It is useful to see how much capacity three Gulf countries are projecting to acquire between now and the year 2010. Saudi Arabia plans to acquire 20,000mw of new capacity at a cost of $15bn, UAE to acquire 6,600mw at a cost of $5.1bn and Kuwait to acquire 3,400mw at a cost of $2.5bn. This story reverberates through the region as booming economies and growing populations continue to put pressure on national grids. According to some experts, the region may require an investment of $1 trillion over the coming two decades in the power sector.
Privatization Programs
With the exception of Iran and Yemen, governments in the region have sought to solve this problem of attracting foreign capital into the power sector by privatizing government-owned utilities. This often involves restructuring the electric utility into separate companies that generate, transmit and distribute electric power. While this approach promises improvements in the supply-side of the business, it needs to be supplemented with solutions on the demand-side of the business.
For a variety of reasons, options that just emphasize building more transmission and generation capacity cannot deal with the problem on a timely basis. For example, more international trade in electricity would help alleviate generation shortfalls in individual countries. But as of a couple of years ago, only Iran, Israel, Jordan, and Lebanon were engaged in significant international trade in power generation. Similarly, the creation of a regional power gird among GCC countries will help close the gap but cannot be expected to eliminate it, since hot weather is likely to trigger peak demands in all Gulf countries at the same time. In the near term, it may be confined to short term uses such as emergency reliability management.
One of the key elements in managing demand growth is to make sure that the price of electricity reflects the full cost of producing and delivery it. It is well known that most countries in the Middle East subsidize the price of electricity, encouraging greater rates of electricity consumption than if prices were not subsidized. The problem is especially pronounced at peak times, when the cost of providing power may be five-to-10 times higher than the cost at normal times but the price of power, under current pricing schemes, remains the same as during normal times.
Air Conditioning
Analysis of load growth in many Middle Eastern economies indicates that much load growth is being driven by rapid penetration of air conditioning systems in homes and businesses. Economic development normally leads to growth in air conditioning demand. However, subsidized electricity prices provide no incentives for consumers to purchase energy efficient equipment. Nor do they provide incentive to builders to use energy efficient designs. As a result, load factors are going down for utilities, raising the average cost of electricity.
Middle Eastern utilities need to emphasize integrated solutions in the electricity sector to improve economic efficiency that involve both demand and supply-side elements. On the demand side, the problem is twofold. The first problem is that average demand is rising in response to growth in population and higher incomes. The second problem is that peak demand is rising faster than average demand, mainly by the greater penetration of air conditioning systems. This situation results in declining load factors and requires additional power capacity to be purchased that is used for only a few hundred hours a year and is idle for all other hours. Costs are much higher for all customers than they would be otherwise.
Three-Pronged Approach
A three-pronged approach to managing the growth in power demand is recommended. This would address both the growth of average demand and the even higher growth of peak demand. It is important that all three prongs be implemented eventually, even though they do not have to be implemented at the same time.
In the first prong, the amount of the electricity price subsidy would be computed by customer class. It is not uncommon to find that electricity prices are being subsidized to the extent of 10% to 30%, with the magnitude varying by customer class. Then these price subsidies would be converted into income subsidies. Once the price subsidies are removed, customers will see the full price of electricity and optimize their consumption levels, even though they would be provided an income subsidy that would allow them to consume the previous levels. Most likely, they will use some portion of the income subsidy to buy other goods and services. The removal of the price subsidies would immediately improve the financial position of the electric utilities in the region, since several of them are in the red. The financial burden of subsidizing customers would be shifted back to the government, where it rests appropriately. Subsidization is ultimately a social responsibility that should be shouldered by the government rather than being imposed on the electric utility. Eventually, as customer incomes rise, the income subsidies would be phased out, reducing the drain on the exchequer.
In the second prong, the rate design would be changed so that higher prices are charged during peak times and lower prices during off-peak times. Such pricing designs are often referred to as time-of-use rate designs and are widespread in countries outside the Middle East. Both traditional and dynamic options should be considered. In the traditional option, the customer faces the same peak price during all summer days. In the dynamic option, the customer faces a much higher price during the top 12-15 days. He is notified the day before that tomorrow will be a “critical” price day and can plan ahead for it. Such a pricing design is called critical peak pricing. In the most advanced version of dynamic pricing, which is often used with very large customers, prices vary on a real-time hourly basis. Such a pricing design is called real time pricing. Clearly, the more dynamic the rate design, the greater the benefits that it would generate for the power system. This prong does not simply involve changing rate designs but may also require changing existing electric meters to smart digital meters capable of making such time-specific measurements. Several “operational” benefits would flow from changing out the meters such as lowered meter reading costs, faster outage detection and theft prevention. Finally, changing in billing systems would also be needed. Utilities should perform cost-benefit analysis of changing out the meters and implementing the new rate designs. On the benefits side of the ledger, they would need to account for the reduced electricity capacity investments and operational benefits. These would be weighed against the cost side of the ledger, comprising the costs of purchasing and installing the smart meters, changing the billing system and making any other changes in the customer service systems. The second prong would lower growth in peak demand and improve system load factors, thus lowering average electricity costs for everyone.
And, in the third prong, codes and standards that specify minimum energy efficiency levels for energy using equipment and buildings would be established. The experience of other countries has shown that this is the most cost-effective way to rationalize growth in energy consumption. It costs a lot less than providing expensive financial incentives to customers to purchase more energy efficient equipment. It is also a more sustainable approach, since no one can afford to pay incentives to customers indefinitely. Some work would be involved in developing minimum energy efficiency levels, to make sure that the standards cost less to implement than building generation and transmission capacity. This prong would help manage the growth in average demand.
By implementing this three-pronged approach, utilities in most countries will find that they have reduced the annual rate of growth of electric peak demand by two-to-three percentage points. Over a five-year period, this would translate into a reduction in peak demand of some 10% to 20%, lowering the need for new capital investment. As a bonus, by reforming the pricing of electricity, Middle Eastern economies would become more attractive destinations for private investors.