No. MERC/National Tariff Policy/2003/0648 April 05, Subject: Formulation of Tariff Policy under the provisions of EA, 2003.

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1 No. MERC/National Tariff Policy/2003/0648 April 05, 2005 Shri R.V. Shahi, Secretary, Ministry of Power, Government of India, Shram Shakti Bhavan, New Delhi Subject: Formulation of Tariff Policy under the provisions of EA, Sir, I am directed to refer to Ministry of Power s letter No. 23/2/2005-R&R dated 16 th March, 2005 seeking comments on the enclosed draft Tariff Policy. The comments of the Maharashtra Electricity Regulatory Commission on the draft Policy are enclosed. With regards, Yours faithfully, Sd/- (A.M. Khan) Secretary, MERC Encl: Cc: Cc: Cc: Cc: as above. Shri Alok Kumar, Director, (R&R Cell), Ministry of Power, Government of India, Shram Shakti Bhavan, Rafi Marg, New Delhi Chairman, MERC Member (Shri Velayutham) Director MERC's Comments on Draft Tariff Policy.doc 1

2 COMMENTS OF MAHARASHTRA ELECTRICITY REGULATORY COMMISSION (MERC) ON DRAFT TARIFF POLICY CIRCULATED UNDER MOP LETTER DATED General Comments: 1.1 At the outset, MERC would like to emphasize that these comments are informed by the unique participatory, consultative process through which it developed the various Regulations under the Electricity Act (EA), 2003 which cover many issues relevant to the draft Tariff Policy. The Regulations were notified after extensive interaction between consumer representatives and licensees, apart from the many comments received from other stakeholders and the general public to whom the outcome of these discussions were put in the form of draft Regulations. 1.2 Under EA, 2003, the SERCs are only to be guided by the Policy, and can depart from it if the circumstances of any given issue or case so require. Thus, the Policy can only be recommendatory and guiding in nature, and not prescriptive or binding. At many places, by the use of terms such as 'would', 'should', 'shall' and in other ways, prescriptive or mandatory dispensations have been set out which are not envisaged by the EA, The draft Policy needs general revision in this respect. 1.3 MERC and other State Commissions have already put in place certain dispensations in the form of Orders or other instruments which are not inconsistent with the provisions of EA, 2003 but which may differ in some respects from the Policy provisions now being introduced. These earlier dispensations by the various Commissions are in any case subject to judicial or quasi-judicial review. Where they are not inconsistent with the Act, a new element of regulatory uncertainty is not introduced and the process already set in motion is not disturbed. The Policy should make it clear that such dispensations are protected, leaving it to the respective Commissions to decide whether any modification is called for Unlike any other State, Maharashtra has 4 different types of distribution licensees with varying backgrounds, orientation and consumer mix, and who had also been operating under different legal dispensations, viz. two private entities, a local authority, a co-operative society, and the SEB. The draft Policy is silent as to the definition and treatment of equity in the case of such different types of entities and seems to take the meaning as given, which is not the case. This omission in the draft Policy needs to be rectified. 1.5 In the context of the diversity of existing distribution licensees in Maharashtra referred to above, MERC also notes that the Policy ignores the existence, even prior to EA, 2003 of parallel licenses and second licenses in the same area, as in Mumbai. Various issues arising out of this situation, particularly since one of the licensees has only a partial network, cannot be resolved through the mechanism of MERC's Comments on Draft Tariff Policy.doc 2

3 open access to the consumer from one licensee using the facilities of the other. Moreover, network expansion to meet the universal service obligation has implications for the optimum use of resources in terms of duplication, which cannot be ignored. 2. Specific Comments: Policy Objectives 2.1 Clause 4.0- The objectives of the Policy, particularly in view of the new legal framework and the evolving power scenario in the country, would depend on the time frame that is being considered, since the emphasis required today and the objectives that may be relevant at a future date are likely to be quite different. However, the draft Policy does not give any indication of the time horizon that has been kept in view before it is expected to be revisited. MERC also notes that the stated objectives do not mention several important aspects, viz. (a) efficiency, (b) competition and (c) transparency in utility governance. General Approach to Tariff 2.2 Clause 5.1-The draft Policy states that all power needs to be procured competitively, except where tariff-based bidding may not be cost effective from the consumers' point of view (such as in cases of project expansion or where there is an identified developer) and where norm-based tariff determination will be necessary. MERC is of the view that there are many pitfalls in this approach in the present circumstances. It is also not supported by the statutory provisions, which allow various alternative methodologies also while moving towards or simulating a more competitive situation. Thus, while competition needs to be encouraged, an appropriate regulated pricing regime may be necessary, as mandated under the Act, depending on the circumstances. Further, it is not merely a question that tariff based bidding may not be cost effective from the consumers' point of view in many situations. Indeed, the interest of direct consumers is only one among several factors that have to be taken into account by the regulators under the Act. Apart from the limited experience of competitive procurement in the country and the need for much higher levels of investment in generation as well as other segments, competitive bidding in the present circumstances may well work to the future disadvantage of consumers and of society at large, for instance, by arresting the technological development and investment in renewables. Moreover, there is a contradiction in the wording of the draft inasmuch as the competitive process can be by-passed merely on account of identifying a developer, i.e. in the MoU route. MERC's Comments on Draft Tariff Policy.doc 3

4 2.3 Clause 5.2-Similarly, the statement that "multiple players will enhance the quality of service through competition" is simplistic and misleading inasmuch as, apart from the possibility of collusion, it does not take into account the mandate to utilize resources optimally, and may also lead to unhealthy duplication of infrastructure with adverse implications for longer term economic and financial costs. 2.4 Clause 5.3(a)-The draft Policy states that the rate of return on equity for generation and transmission notified by CERC shall be followed by the SERCs also. As mentioned earlier, the Act does not mandate the use of the term 'shall' in this respect. At most, the SERCs might be asked to consider such notified RoR on equity. Moreover, it appears that the draft Policy has at the back of its mind the conventional thermal and hydro projects to the exclusion of others. As pointed out at para 1.4, what constitutes 'equity' in respect of different types of entities also has to be elucidated. Further, Clause 5.3 (a) states that the RoR notified by the CERC for transmission would be adopted by the State Commissions for distribution also. The MERC is of the view that EA, 2003 clearly segregates transmission from distribution, and to automatically apply the RoR of one to the other is therefore not warranted. Moreover, on many considerations such as losses, consumer mix, power purchase, etc., distribution generally entails a greater risk than transmission, which may have to be compensated through a higher RoR for the former. The Explanation to Clause 5.3(a) clarifies the return on equity. MERC is of the view that, in the context of this Explanation, Accounting Standards should be developed for this purpose, and that the draft Policy should incorporate a commitment to do so. 2.5 Clause 5.3(c)- Clause 5.3(c) states that the depreciation rate notified by the CERC for transmission assets would also be applicable for distribution. Apart from the earlier comment that the dispensation with regard to transmission cannot be applied mutatis mutandis to distribution, this prescription does not take into account the fact that the life of assets in these two segments is likely to be vastly different and cannot, therefore, be subject to the same depreciation rate. Moreover, considering the accounting depreciation of 5 to 7% governed by the provisions of the Companies Act for different classes of assets matching the loan repayment to this duration (14 to 20 years) does not appear practicable. It may merely be stated that, for the purposes of tariff determination, the depreciation could be linked to a suitable loan repayment period. 2.6 Clause 5.3(d)- It is highly unlikely that lenders would generally agree to provide for re-fixation of interest rates every 3 years to reduce the interest rate risk on the project developer. MERC's Comments on Draft Tariff Policy.doc 4

5 2.7 Clause 5.3(e)- MERC is of the view, that in the case of RoR on foreigndenominated equity, it is necessary to move away from the concept of dollar or other foreign-denominated returns. MERC notes that in the competitive bidding guidelines, this has been considered only in rupee terms. This needs to be made clear in the Policy. 2.8 Clause 5.3(f)- The draft Policy states that "operating norms" for distribution networks would be notified by the SERCs. This provision needs to be reworded so as to make the meaning of the term 'operating norms' clear. It implies that a Distribution Code, akin to the Grid Code, is envisaged, which does not seem to be the case and is also not practicable in the present stage of development. Perhaps what is envisaged is efficiency or performance norms. In any case, this needs clarification so that there is a clear understanding of what is expected over and above the State Grid Code, Supply Code and Standards of Performance required to be specified under the Act by the State Commissions. 2.9 Clause 5.3(g)- The Policy states that appropriate capital costs should be assessed after thorough scrutiny "including public hearing". Such assessment of capital costs, both through the tariff determination process and otherwise, and pre and post investment, is done by the Commission in accordance with the requirements of these processes. Apart from the provisions in the relevant Regulations, MERC has also issued Guidelines for pre-investment, in-principle clearance of capital projects and schemes. It is not for the Policy to prescribe the procedure by which this is to be done, which is guided by the relevant Regulations, particularly relating to its Conduct of Business, which may or may not require public hearing depending on the stage and circumstances of the process. The reference to the requirement of public hearing should, therefore, be removed Clause 5.3(h)(3)-According to the draft Policy, uncontrollable costs should preferably be recovered within the financial year itself (typically on a quarterly basis). Further, such uncontrollable costs would include fuel costs, inflation, statutory levies, variations in power purchase unit costs, etc. While MERC appreciates the rationale for this provision and, indeed, had in the past mandated a pass-through formula for the SEB that took some of these factors into account, with the coming into force of the EA, 2003, no such dispensation is possible (unless there is a contrary legal interpretation of the clear terms of Section 62(4) ). Under Section 62(4), no tariff or part of tariff can ordinarily be amended more than once a year. The exception to this general rule is only in respect of any changes permitted "under the terms of any fuel surcharge formula" that is specified. Thus, regular variations in tariff have been limited by the Act to cover only variations in the fuel cost, and cannot take into account changes in other costs. Therefore, this provision of the draft Policy violates Section 62(4) Clause 5.4-This clause mentions that user charges which are to be paid by the consumers also include duties, cess levied by the State Govt. As a matter of clarification, MERC would like to point out that not all such statutory levies by MERC's Comments on Draft Tariff Policy.doc 5

6 the State Govt. have a one to one incidence on consumers. Whereas the incidence of certain levies, such as Electricity Duty, is directly on the respective consumers, there are other levies, such as Tax on Sale of Electricity, which are to the account of the licensees, and are reflected in the consumer tariff along with other components of the ARR as and when it is determined. Generation 2.12 Clause 6.2(1) and (2)- The MERC notes that what is suggested is implementation of a UI mechanism as a balancing market modality. The MERC also notes that as per Clause 5.7.1(b) of the National Electricity Policy, State Commissions are required to introduce ABT regime at the State level. However, the detailed scope, pricing methodology, exclusion of some participants and other matters have to be left to the discretion of the respective Commissions. The intra-state ABT mechanism need not necessarily mean a UI mechanism with frequency linked pricing as is applicable at the regional level. While it is necessary to develop a mechanism for power transfer exchange pricing, balancing and settlement at the State level, its emphasis and objectives and, therefore, its modalities are likely to differ significantly from the existing inter-state ABT framework. Indeed, the National Task Force had also opined "that the principles for inter-state flows may not be readily replicable for the State networks due to peculiarities and complications involved." The MERC notes that various pricing options are available for introduction of a balancing market mechanism at the State level, including (a) regulated pricing (including frequency-linked pricing mechanism specified by CERC), (b) cost based pricing, and (c) market based pricing. The mechanism suitable for a particular State would have to be determined by the concerned Commission. The primary objective of introduction of frequency linked UI price based ABT regime at the regional level has been to encourage grid discipline amongst pool participants, which is not the primary focus intra-state. Moreover, the UI mechanism is not suitable for trading as variability of prices is the key to success of any market, and the underlying assumption of the UI mechanism is to maintain the frequency at close to 50 Hz. However, with a frequency-linked balancing mechanism, it is either possible to maintain frequency or to manage trading, and not both. Further, ABT mechanism with frequency linked UI pricing was introduced at a time when most of the State participants were structured as integrated/ bundled entities. Thus, the response of State participants at the regional level has been a reflection of their system operations (scheduling and dispatch) by managing their load as well as the generating stations at their disposal. Moreover, the system is highly vulnerable to manipulation and 'gaming'. It is also important to appreciate the implications of the change in role envisaged for various participants, including the SLDC, upon un-bundling/ restructuring of the SEBs, as mandated under the Electricity Act, MERC's Comments on Draft Tariff Policy.doc 6

7 Thus, the objectives of ABT at the State level have to be defined differently in view of the changing industry structure. Further, selection of an appropriate mechanism for introduction of ABT at the State level will have to be guided by the need to have minimal impact on sector entities and retail consumers while meeting the objectives at the State level. Therefore, State Commissions will have to identify suitable balancing market mechanisms while implementing two part tariffs for generating stations. The term 'ABT at the State level' may be relevant only as a generic term used as a matter of convenience. It should be clear that the objectives and precise mechanism of such a power transfer / exchange balancing and settlement pricing mechanism would be different from the inter-state ABT, the specifics of which would be laid down by the respective State Commissions based on their own assessments Clause 6.3-The draft Policy states that the tariff for captive generation should include variable cost of generation as well as reasonable compensation for capacity charges. It may be pointed out that there is a contradiction inasmuch as such compensation for capacity charges cannot co-exist with the earlier recommendations of an ABT mechanism which already includes a fixed charge. Further, MERC notes that the draft Policy is silent on many aspects of the EA, 2003 provisions regarding captive generation, and is not aware of whether MoP proposes to address any of these outside the Tariff Policy. They include the differing interpretation of both the extent and permissibility of 3rd party sale by captive generators, the kind of Association of Persons entities that would meet the legal test for consideration as captive generation, etc. There are also issues with regard to the extent to which cross subsidy and additional surcharge should be leviable on third party purchasers in a situation of general demand supply gap. MERC has addressed some of these issues, considering the EA, 2003 provisions, in its Order dated on fossil fuel based Captive Power Plants Clause 6.4(1) and (2)-According to the draft Policy, "(1) Pursuant to provisions of section 86 (1) (e) of the Act, the Appropriate Commission may fix a minimum percentage for purchase of energy from such sources taking into account availability of such resources in the region and its impact on retail tariffs. As it will take some time before non conventional technologies can compete with conventional sources in terms of cost of electricity, the State Regulatory Commissions would be able to fix only a modest percentage initially for procurement. Such percentage for purchase of energy should be made applicable for the tariffs to be determined by the SERCs from April 1, (2) Such procurement by Distribution Companies shall be done through competitive bidding process within suppliers offering energy from nonconventional sources. In the long-term, these technologies would need to compete with other sources in terms of costs." MERC's Comments on Draft Tariff Policy.doc 7

8 MERC notes that Section 86(1)(e) of EA, 2003 requires the State Commissions to promote co-generation and generation of electricity from renewable sources of energy by providing suitable measures for connectivity with the grid and sale of electricity to any person, and also specify, for purchase of electricity from such sources, a percentage of the total consumption of electricity in the area of a distribution licence; The draft Policy is silent on some of the important provisions of this Clause. Although the Act recognizes the special grid connectivity requirements in respect of many such generators owing to locational and other factors as a major issue, the draft Tariff Policy (as well as the National Electricity Policy and the CEA draft Regulations on Grid Connectivity) does not address it. It is advisable to do so through broad Policy guidelines. Both before and after the coming into force of the EA, 2003, MERC has considered the matter of grid connectivity in such cases through its Orders on Wind Energy, Bagasse and other non-fossil fuel based Co-generation, etc., and these could serve as one type of approach for the purpose. The Commissions are required to promote sale of electricity from co-generation and renewables, not only to distribution licensees, but also to any other person. The Tariff Policy needs to address the issues relating to such third party sales. In particular, payment of cross-subsidy surcharge to the distribution licensee is not warranted considering the separate status accorded to generation from such sources explicitly in the Act, which enjoins its promotion. Besides, among other things, at the present stage of development of such sources of energy, application of such surcharge may put their viability at risk. This is apart from the fact that, in the widely prevalent scenario of a demand-supply gap, capacity addition and sale to third parties from such sources needs also to be looked at from the angle of avoided cost of generation capacity. The accelerated development of co-generation and renewable sources of energy intended by the statute requires a Policy dispensation which takes these factors and the legal mandate into account. MERC has already put in place a mechanism for a minimum renewables purchase obligation by distribution licensees. However, the prescription in the draft Policy that such obligation be met entirely by competitive bidding does not take into account the present stage of development of renewables, and would arrest their growth to full maturity, thereby defeating the purpose of the Act and depriving both consumers and society at large of financial and other wider benefits in the future. Several uncertainties surround renewable generation, including difficulties in accurately estimating the availability and potential of renewable resources, the still nascent nature of many technologies, inadequate experience in plant operation and consequently significant variations in operating costs, etc. At present, there are relatively few players in the market. In a competitive procurement scenario, on the one hand, it would be difficult to avoid cartel like situations and, on the other hand, it would restrict further development because only those developers who are favourably placed in cost terms would set up these facilities. This is apart from the fact that the country has very limited experience in competitive procurement even with regard to conventional generation. In the present MERC's Comments on Draft Tariff Policy.doc 8

9 situation, therefore, ostensibly competitive signals will not reflect wider social and economic benefits. Unless the tariff determination process takes these into account, the critical mass required to achieve technological maturity and economies of scale and a situation enabling prices to be determined competitively, will not be attained. Therefore, the MERC is strongly of the view that requiring competitive procurement of renewables at the present stage would arrest their development and defeat the purpose of the Act, and is not warranted. (A Note is annexed explaining why the Central Electricity Authority's time-tested normative cost-based methodology for according techno-economic clearance to power projects should be adopted for determining tariffs for renewable and nonconventional energy projects in the initial years.) Thus, the MERC believes that the Tariff Policy should clearly mandate that the State Commissions determine the tariffs for different renewable energy technologies after taking into account factors such as availability of resources, suitability of technology, cost of capital equipment and other State-specific factors such as State concessions, infrastructure facilities, etc. keeping in view the considerations set out above, to make it possible to move to a more competitive regime once maturity is achieved, apart from setting a minimum purchase obligation. This would not only provide certainty and encourage immediate investment in such plants, but would also ensure the development to maturity of different renewable technologies. Finally, the Tariff Policy should recognize the regulatory developments that have already taken place in this field in some States, and ensure that the Policy provisions do not in any way undermine the much needed regulatory clarity and long term certainty offered to the renewable energy sector by earlier Orders of State Commissions (such as in Andhra Pradesh, Maharashtra, Madhya Pradesh, Karnataka., etc.). An explicit provision to that effect should be incorporated. Transmission 2.15 Clause 7.1(5)- According to the draft Policy, in order to meet the revenue requirement of transmission developers other than CTU / STU, a competitively determined annuity may be added to the revenue pool, to be recovered through transmission tariffs. In the MERC's view, the Policy cannot bind the Commission to a competitively determined annuity rather than a cost based approach when EA, 2003 mandates that different such alternatives can be considered. The provisions of the Policy cannot negate the provisions of the Act itself. Distribution 2.16 Clause 8.1(4)- The Act requires approval to tariffs, or the fixing of a ceiling under certain circumstances. When 'rebates' were being given selectively by a licensee, MERC had held them to be unauthorized and did not allow them to be recovered in the ARR, as also now proposed in the Policy. However, such charging of tariffs lower than those approved should require a dispensation from the concerned Commission which may allow it, with certain conditions if necessary. This would avoid future problems which often result from predatory pricing and MERC's Comments on Draft Tariff Policy.doc 9

10 can impact on supply, particularly in a situation where there is more than one distributor Clause 8.1(6)-Contrary to the provisions proposed in the draft Tariff Policy, in fact the licensees cannot have the option of filing for separate revenue requirements for an area where the Commission has issued multiple licenses. The revenue requirements have to be examined in respect of the license as a whole, although the Act permits a differentiation to be made in tariffs as between different geographic areas or categories of consumers depending on the circumstances. These circumstances may include the existence of other licensees in a particular area, and the Commission can consider them appropriately while determining the tariffs Clause 8.1(8)-The provision that requisite tariff changes come into effect from the start of each financial year is not warranted by the Act, and should be removed. It is best left to the Commissions to decide if and when to take up tariff revision suo moto if they feel satisfied that it is necessary on the basis of a scrutiny of revenue requirement filings. Similarly, if tariff revision proposals are made by the licensees themselves, the matter of when the finally approved tariffs will take effect is also a matter that is entirely within the Commission's jurisdiction and cannot be dictated by the Policy, and also depends on a variety of procedural as well as substantive factors Clause 8.2.1(1)-While MERC appreciates the rationale behind not restricting power purchase costs on the basis of linkage to a normative T&D loss level, the relevant provision needs to be reworded and qualified. The word 'normative' is misleading. Instead, admissible power purchase costs should be considered keeping in view reasonably assessed targets and considering the actual circumstances Clause 8.2.1(2)-The draft Policy refers, inter alia, to consumer tariffs linked to different ATC loss levels in a MYT dispensation. The MERC is of the view that, while the intention of incentivising ATC loss reduction can be understood, it is essential to clearly differentiate between commercial losses on the one hand and technical losses on the other and to focus on them separately if results are to be achieved. The concept of ATC does not clearly distinguish between technical impediments, often a result of low investment in the sector, and commercial impediments, often a result of collusive revenue leakage. Hence, technical loss reduction under MYT framework should be treated as distinct from commercial loss reduction which is a function of better governance Clause 8.2.1(3)-The draft Policy provides that if the utility could not charge the applicable tariff, and any uncovered gap on account of unpaid but due subsidy from the State Govt. remains at the end of the year, it should be added in the ARR of the following year. This provision is not mandated by the Act, and would defeat the purpose as well as the letter of Section 65. In fact, to the extent that compensation for any subsidy against tariff required by the State Govt. is not paid MERC's Comments on Draft Tariff Policy.doc 10

11 to the licensee in advance, then to that extent the subsidy cannot be reflected in any reduction in the charges as compared to the approved tariff. There is no question of meeting the gap through the ARR and in future tariff when the law does not provide for any shortfall in the first place by operation of Section 65. Indeed, the proviso to Section 65 ensures that no such direction of the State Govt. shall be operative if the compensation to the licensee is not made in accordance with its provisions. Thus, the last sentence of this Clause should be deleted Clause & The draft Policy refers to the "average cost of supply". It may be noted that Section 61(g) requires that the tariff progressively reflects the cost of supply of electricity, and does not contain any reference to the 'average' cost of supply (in contrast, for instance, to Section 29(2)(e) of the erstwhile ERC Act, 1998) Clause The proposed provisions are self-contradictory inasmuch as they require the need for sustainable use of ground water resources to be taken into account while fixing agricultural tariffs while, at the same time, stating that, State subsidy could be considered to support farmers where the water table condition is adverse. Essentially, this would imply that over-exploitation of ground water resources should be discouraged through the tariff, but can be encouraged through subsidy. Moreover, requiring the level of ground water in different areas to be an explicit determinant of agricultural tariff is also highly impracticable given the wide variations in the ground water table even within micro regions, the differences in pumpset usage between different categories or income classes of farmers, and for several other reasons. If at all, the Policy may provide that agricultural tariff setting may take into account resource implications, such as impacts on ground water exploitation Clause The need and purpose of this provision is not clear, since it presumes that at present connection charges are not considered to be a part of the charges to be determined by the Commission. In fact, all charges under Section 46 and 47 of the Act are to be specified or determined by the Commission, including connection charges. (It may be mentioned that, in a tariff determination Order passed under the erstwhile ERC Act, the MERC had held that the SEB's Commercial Circulars, which dealt with matters impinging directly or indirectly on tariffs or charges to consumers, were all within the Commission's jurisdiction and required its approval. The SEB challenged this contention in the High Court, which upheld the Commission's view) Clause and MERC is of the view that the Policy should not prescribe a detailed formula for the computation of the cross subsidy surcharge. In general, the Commission is in agreement with the earlier recommendations made by the FOIR in this regard. With regard to cross subsidy, FOIR had held that the avoided cost approach would balance the twin objectives of safeguarding the financial viability of the licensee and the promotion of competition, and has recommended it over other methods. However, in adopting the avoided cost of generation MERC's Comments on Draft Tariff Policy.doc 11

12 approach, each Commission would have to look into certain specific and peculiar characteristic of its system. As far as additional surcharge is concerned, in the present scenario of shortage of generation, no generation capacity is likely to get stranded due to migration of load. In the case of intra-state transmission lines and distribution system, assets would continue to be used by the open access consumers by paying wheeling charges even after migration. In such cases, therefore, the question of stranded capacity does not arise. As and when a situation of stranded generation of intra-state generation or transmission assets arises, it would have to be dealt by the State Commissions on a case to case basis Clause In case of prospective/ new consumers in an area supplied by two or more licensees (i.e. in cases where he is not getting supply from any of the licensees but ab-initio obtaining power from some other entity), it may be clarified that the cross-subsidy surcharge be paid to the licensee from whom open access is being availed Clause In modification of the proposed provision, the Policy may suggest that such standby arrangements should be provided on payment of not less than the tariff for the relevant consumer category, but not more than the applicable UI charges. Thus, a band may be indicated rather than a particular rate. (A.M. Khan), Secretary, MERC Encl. Annexure to MERC Comments on Draft Tariff Policy. Mumbai. 5th April, MERC's Comments on Draft Tariff Policy.doc 12

13 ANNEXURE TO MERC COMMENTS ON DRAFT TARIFF POLICY (SEE PARA 2.14) Normative Cost Based Tariff Methodology for Tariff Determination of Renewable Energy Projects in Initial Years Rationale for * Why do the Renewable Energy Technologies need special dispensation? The main problem with renewable energy technology is while a few of them are feasible, both technically and economically, they are not so commercially. Ignoring externalities and purely comparing the financial estimates of per unit life cycle costs of electricity generation from these technologies and the conventional power plants, the two are comparable. But when it comes to estimates of these costs in commercial operations, things change completely. One of the major problems is that several renewable energy units have high capital cost but low short-run costs. Besides, financing structure of these projects complicate the matter further, as principal and interest payments are high during years when debts are being repaid generally 10 years. In a dynamic situation when technology is still evolving commercially, this becomes a significant barrier, even more so when promotional policies change without providing protection to earlier investments. Global Approaches to Supporting Renewable Energy Technologies A usual approach that most governments around the world - with renewable energy programmes - have taken in dealing with these issues is to forcibly create markets for these technologies, by introducing specific laws and regulations favouring their promotion. These technologies have been backed-up with preferential tariffs, subsidies and various other fiscal incentives, in the last 30 years. In Europe, feed-in tariffs have been used very effectively to get renewable energy technologies off the ground. Several governments in Europe have made it obligatory for power utilities to connect local renewable power generating units to the grid, and pay them the feed-in tariffs. These tariffs have been fixed at different levels for different technologies. By securing income and the reducing risk for developers, various governments have successfully boosted their commercial deployment. For example, Germany s relatively high feed-in tariffs have led to its emergence as the world s largest wind turbine market. With a view to spurring investments in renewable energy development - immediately after the 1974 oil crisis - the US government provided investment tax credits and research and development funds to those engaged in renewable energy technology. However, the enactment of the Public Utility Regulatory Policies Act (PURPA) in 1978 was the single most important factor in the development of a commercial renewable energy market in that country. PURPA created a qualifying facility status for these units and co-generation technologies, mandating utilities to purchase power from them at their full-avoided cost. It also encouraged utilities to enter into long-term contracts running into years, with them. As a result, the rates paid to renewable energy units in the US were unusually high in the 1980s. * Based on the book titled ELECTRICITY REFORMS AND GREEN POWER DEVELOPMENT by Dr. Pramod Deo & Shri Shrikant Modak, published by WISE, Pune. MERC's Comments on Draft Tariff Policy.doc 13

14 In contrast, in Britain s Non Fossil Fuel Obligation (NFFO), the potential renewable project developers - after bidding successfully under each renewable energy technology category - have been awarded tariffs as stated in their bids, for a pre-determined period (15 years). Unlike the fixed feed-in tariff approach of other countries, this approach has proved advantageous, spurring cost and tariff reductions. For example, the price of wind electricity dropped in the UK from 8-9 pence to 4 pence in six years in the 1990s. It is, however, not clear whether this drop was due to developers confining their new investments only to clearly advantageous wind-sites or to deployment of more advanced technology, or both. In recent years, the electricity industry has increasingly come under regulatory and economic pressure to become more competitive. In fact, in the mid 1990s, the Federal Energy Regulatory Commission (FERC) ruled against some states in the US for using rate setting mechanisms to set renewable energy rates above the avoided costs. Competitive pressures in the power sector have since increased in that country and elsewhere, seriously affecting the future of renewable energy technologies in several ways. To begin with, as utilities are forced to compete more heavily on price in the short-term, the flexibility to experiment with renewable energy technologies would diminish. In such situations, the premium for short-run cost minimization would increase substantially, squeezing out technologies that are not cost-effective over a short period. Utilities that might otherwise have invested in technologies that are cost-effective in the long run, but carry high short-run costs, would be less likely to do so once there is competitive pressure. Nor would they want to roll out expensive generation together with the less costly, if plant based merit order dispatch is in practice. In such a scenario, they would be more inclined to consider each power source independently and determine whether it is competitive. Similarly, they would have little incentive to spend money on the development of technologies that offer common benefits to all generators. Further, increased competition could potentially have the effect of diminishing the importance of beneficial attributes (it s non-polluting and risk reducing aspects) of renewable energy technologies. For this reason, in countries that promote renewable energy technologies, distributed generation is often relatively unencumbered by the rules of central systems (scheduling, pooling, dispatch). In the UK, embedded power stations, including renewable units, with total registered capacity of up to 50 MW do not have to trade through the pool and are not dispatched through the system operator (grid). However, they have to comply with the distribution code, though not the grid code. As far as excess supply is concerned, they have to sell this to authorized suppliers or the end-users. In NFFOs case, the public electricity suppliers are obliged to buy all power output from renewable units and, in turn, are reimbursed the price difference between the market price and NFFO tariffs. In fact, Sweden, Germany and Denmark have special regulations for renewable energy generation. Under the Swedish system, concession holders are forced to buy all power from small-scale generation at tariff rates representing their avoided costs. MERC's Comments on Draft Tariff Policy.doc 14

15 Regulatory Commissions Role One issue that is unlikely to go down well with economists is the fact that MERC and APERC banked on normative cost based methodology in determining tariffs for nonconventional energy projects. Although the Central Electricity Authority has been using this method for many years for according techno-economic clearance to power projects, it has not been without criticism. The chief criticism against this approach has been that the average costs provide misleading signals to the decision makers. Since regulatory commissions, in the case of market failure or in the absence of market, must take over and perform the role as market would, adopting rules that do not conform to the operating principles of competitive markets goes against the basic function for which the regulatory commissions are set-up. But how serious is the matter as far as the renewable technologies are concerned? The answer perhaps is, not very! The fact that EA 2003, Section 86 (1) (e) spells out that the regulatory commissions must fix a certain percentage for renewable energy in the total consumption of electricity in the area of distribution licensees clearly implies that these projects are to be spared the rigours of market competition. Working backwards, it means all generation planning for supply of electricity to an area must begin by reserving a specific percentage of electricity supply from the renewable sources. Which in turn implies, to that extent the cost concepts such as the opportunity costs, avoided costs or the marginal costs need not apply to these energy sources, as they are put outside the domain of economic selection. However, it does not mean no-holds bar in pricing of power from renewable energy sources. That is where the regulatory function of SERCs acquires significance; especially, since those having information required by these bodies for setting tariffs, as MERC s as well as the experience world over indicates, are unlikely to divulge it to the fullest extent necessary. Which means SERCs would have to base their cost estimates on information other than what they can get from these sources as well as use their own judgment on the veracity of the available information. The ultimate aim of regulatory exercises for renewable energy based power technologies must be to maintain the balance between the need to encourage their growth while maintaining enough pressures on promoters and manufacturers to perform efficiently. Lastly, even when projects based on renewable technologies are commercially viable, it is not necessary that the power sector utilities, whether public or private, would queue up for setting up these units. The investment required is too small for the scale of operations to which these utilities are used to and it may not be worth the efforts as there are ample opportunities available to them for investments in large generating stations. That means the governments would have to adopt more proactive role in promoting these technologies and, in that context, SERCs too would have larger role to play in their advisory capacity to the governments. Finally, were renewable technologies competitive and so were power markets, some of the issues such as banking would not remain as issues, as spot markets would take care of undelivered energy and there would be no need for banking. Of course, these are the matters for the future. For the moment however, regulatory commissions will have to remain proactively (though not over zealously) engaged in the promotion of renewable energy sources. MERC's Comments on Draft Tariff Policy.doc 15