Wonder how is your electricity tariff calculated? Read on

This post explains how the generating companies calculate(and get approved from Electricity Regulatory Commissions) the tariff for their power. It does not cover UMPP/long term PPP based tariffs. The basis for this post is the National Tariff Policy.

Infrastructure economics have certain unique issues. They have high fixed costs(both initial and operating) relative to variable costs. Debt financing being in vogue to extent of 70%+ project cost, interest and(in case of foreign debt-forex MTM fluctuations) becomes a major chunk of recurring costs. Given that the facility once set up is a monopolist(atleast in a few areas), smart pricing is the key to profit maximization. However, as any micro economics textbook would tell you, producers may be tempted to lower the output(not in public interest) to maximize their profits.

The power sector can be broadly divided into

1. Generation. Here, regulators design incentives to encourage producers to operate the plant efficiently and to the fullest possible capacity. Competition via free markets is the eventual goal.
2. Transmission & Distribution :-This was, is, and is likely to remain a natural monopoly where prices have to be regulated.

The objectives mentioned in the tariff policy(with my comments in bold italics) are to

(a) Ensure availability of electricity to consumers at reasonable and competitive rates(no monopoly abuse)
(b) Ensure financial viability of the sector and attract investments(Since Govt cannot fund(or properly execute) the necessary power projects)
(c) Promote transparency, consistency and predictability in regulatory approaches across jurisdictions and minimize perceptions of regulatory risks(change of coalition Govt in the states etc)
(d) Promote competition(to eventually determine basis for PPP/free market rates), efficiency in operations(allow pass through only for controllable costs) and improvement in quality of supply(increase the expected Plant Load Factor(PLF) yearly).

For a five year period(say 2009-14), the utility gets its capex plans and projections approved at a public hearing where consumer and industry associations can voice objections(which they usually do). Then each year, the utility estimates the operating parameters in advance and projects its operating costs accordingly. Depending on forecasted output and consumer classes, the tariff is proposed. The aforementioned associations try to bring down the costs while the utilities inflate it. If you want to really understand the economics of this industry, try reading any of the tariff petition proceedings on the CERC site. They are quite illuminating(the behind the scenes fight for every rupee!!). Typically, the regulator fixes a mid-way value for most items.  If the utility achieves/surpasses its operating benchmarks, it can charge an incentive tariff from the customer.

It is on the basis of this forecasted cost that your bill is prepared. At the year end, the surplus/deficit is calculated and then passed on. Since there cannot be any direct bill refund(so far infeasible), consumers as a class get that bill adjustment.