Are Nigerian electricity tariffs really cost reflective?

The last time the grid collapsed was because electricity workers in Nigeria went on strike.

According to news reports, the Transmission Company of Nigeria (TCN) was conducting interviews to promote acting principal managers while still owing ex-TCN staff. In protest and solidarity with their ex-colleagues, still union members, the union of electricity workers shut down the grid in phases. By evening, they had shut down the entire grid.

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Their action was very interesting for two reasons. The first was how amazing it is (in a bad way), that everyone in Nigeria could lose electricity access for hours just like that. Grid collapses are pretty regular here, so it wasn’t surprising that electricity workers and the TCN would allow the grid to be shut down before agreeing to negotiate. Most countries would do anything to prevent electricity blackouts because the costs to sectors like manufacturing would be too high.

For instance, Europe is battling an electricity crisis that cities are doing everything to prevent. In July, London dodged a total blackout by importing electricity from Belgium even though the price was 5,000% higher at £9,725 per megawatt-hour (MWh). I should explain that electricity markets in developed countries are more like stock markets where prices change based on demand and supply.

However, the second reason is what we’ll be breaking down today. Today, the TCN gets nearly 100% of its invoice from distribution companies (discos). You see, the Nigerian Electricity Supply Industry runs a waterfall payment structure which determines who gets paid first after the discos collect payments from customers. The CBN’s ₦120 billion Nigerian Electricity Market Stabilisation Fund (NEMSF), which serves as a loan to the power sector, gets serviced first. After that, the Gencos get paid a percentage of their invoice as set by the regulator, the Nigerian Electricity Regulatory Commission (NERC). Then, the TCN gets paid 100% of its invoice, and the discos make do with whatever is left.

So, at the end of the day, all these costs that keep the sector running are based on the tariff. If the electricity tariff is ₦30/kWh, the Gencos could get ₦10/kWh, TCN could get ₦4/kWh, and the discos could get ₦16/kWh. The tariff is the power sector's primary source of revenue and liquidity. So, the success and liquidity of the sector depend on the tariff and people paying bills.

Today, TCN gets nearly 100% of its invoices and charges discos ₦6/KWh, a rate that should fully cover TCN’s costs, also known as cost-reflective rates. We could cite issues like poor management for why TCN isn’t paying its staff. Still, Nigeria’s so-called cost-reflective tariffs aren’t actually cost-reflective when you look beneath the surface.

This article will explore why but first, how do we determine tariffs in Nigeria?

How tariffs are determined in Nigeria

Cost-reflective tariffs reflect the full costs of the companies in the power sector from generation to distribution based on the electricity they supply to customers. The alternative is a non-cost reflective tariff, which, in Nigeria, means that the costs not covered by the tariffs should be paid to the companies as a subsidy from the government.

On the surface, electricity tariffs are a simple concept. The tariff is the electricity sector’s costs in naira per kilowatt of electricity supplied. But, here’s what it really is.

Tariffs in Nigeria are determined by a macro-filled excel model called the Multi-year tariff order (MYTO), based on assumptions and adjusted to reality retrospectively. It’s called a Multi-year tariff because it determines tariffs for five years at least. On the surface, the tariff is the sum of the disco costs, TCN costs, Genco costs, regulatory charges and loans divided by the energy to be supplied that year. By costs, we mean operating expenditure, depreciation for capital expenditure, and debt servicing for the period. This gives us the average tariff for the disco, which is then weighted and allocated to different customer groups. For instance, Ikeja Disco’s average tariff is ₦49/kWh, but some customers pay as much as ₦60/KWh while others pay ₦31/kWh.

However, the assumptions affect the costs. The major assumptions are inflation, exchange rate and loss target for the disco. Inflation is important here as it affects the companies’ operating expenses (OPEX). The higher the inflation rate in Nigeria, the higher the real OPEX for TCN, Gencos and discos in the MYTO model. The second, the exchange rate, really affects capital expenditure (CAPEX) and, to an extent, OPEX. You should know by now that we don’t produce much in Nigeria. Electricity equipment used by the sector, like transformers, cables, and rods, are imported, so the higher the exchange rate, the higher the CAPEX required.

Finally, we have the loss targets, known as Aggregate Technical Commercial & Collection (ATC&C) losses. To understand how this works, imagine that the MYTO model says generation companies and TCN will supply 5,000 MWh to the discos this year because they supplied 4,800 MWh the year before. However, discos only bill their customers for 4,000 MWh after getting 5,000MWh of electricity, maybe because of metering issues, and only get paid for 3,500 MWh. This means the discos have lost 30% of the 5,000 MWh. So, 30% is the ATC&C loss. This loss has a target set by the MYTO model, which reduces over time to ensure the discos are more efficient yearly. So, ATC&C losses affect the energy supplied and the recovery rate of the sector.

In summary, we have inflation, exchange rate and ATC&C loss rates as the major assumptions that affect the inputs, which are costs and energy, for determining tariffs in Nigeria. What’s the problem with these inputs? We’ll start with the costs.
 

There’s nothing reflective about these tariffs

The first issue is that the power sector’s costs are super-regulated to protect consumers while allowing companies to earn a reasonable return on investment. You see, as much as we complain that tariffs in Nigeria are high at ₦60/KWh, the companies in the electricity sector barely cover their costs.

The tariff model sets caps on CAPEX and OPEX that companies, especially discos and the TCN, cannot exceed. For discos and the TCN, an example of CAPEX would be purchasing a new transformer, while OPEX includes salaries and buying parts to fix faulty transformers (maintenance costs).

Now, on the one hand, capped spending sounds like a good idea because it means the companies (discos and TCN) can save their money. However, the discos and TCN have ATC&C loss targets that require CAPEX and OPEX to keep the networks in tip-top shape.  If the expenditure cap were reasonable, it wouldn’t be a problem, but the caps limit how much these companies can spend on reducing losses. We’ll explain later, but at this point, it’s important to remember that higher loss levels affect discos’ revenues.

According to the French development bank, AFD, if the spending limits are too low and the discos and TCN can’t attract funding, how are they supposed to improve their performances? The World Bank also notes that MYTO terms do not reflect reality. For instance, Ikeja Disco can’t spend more than ₦31 billion on operating expenditure this year, assuming inflation is 17.76%, and the exchange rate is ₦420 to $1. The disco will not recover any kobo spent above this amount. Essentially, the costs that make up the tariff guide the sector’s expenditure in the period.

If a disco wants to buy a part to fix a transformer, they’ll need to get it at the black market rate of ₦689 to the dollar, which they can’t recover from the tariff. As a result, because the discos’ equipment maintenance (an operating cost) is priced in dollars, even the capped OPEX is far less than required. Luckily inflation is updated according to the Nigerian Bureau of Statistics figures, so the OPEX accounts for that.

CAPEX is also capped, but the problem is that the CAPEX is way too high for the discos and TCN. Interestingly, the discos came up with the CAPEX amounts from their approved performance improvement plans. They set out projects they would need to do to reduce losses and improve electricity access in five years. However, discos don’t recover all their costs to fund CAPEX due to high losses. Also, the electricity sector’s illiquidity makes it impossible to attract enough funding for CAPEX. This means that the discos and the TCN can never meet their CAPEX caps in a period. So, at the end of the period, the regulator deducts whatever they didn’t spend. This doesn’t affect the tariff much, and I’ll explain why later, but it means that the loss-reduction projects never get done, and performances don’t improve.

It might seem a little technical, but this all means that the discos’ and TCN’s costs are not reflective of reality. The OPEX in the tariffs are less than required, and there’s no funding available to meet CAPEX. Furthermore, even though these costs are adjusted for inflation, most equipment is imported, meaning exchange rate issues erode the values of the costs in the tariff.

But, another input is energy. Earlier I mentioned that the model could state that a disco should supply 5,000 MWh because it supplied 4,800 MWh the year before. The idea is that there should be marginal realistic improvements yearly, as the energy also affects the tariff. For instance, Eko disco can supply 2,000 MWh in 2022, and when you divide its costs by 2,000 MWh, you get a tariff of ₦80/kWh. But that’s too high for Nigerians, and people will protest. So, as a regulator, what do you do? You increase the energy denominator to 5,000 MWh to fix the tariff at ₦50/kWh, a rate you think Nigerians won’t be too angry with. Why do they do this? To keep the tariff artificially low while claiming to have delivered cost-reflective tariffs. It’s almost a win-win for the government and the regulators—the customers are protected from the real cost-reflective tariff while the government no longer has to pay subsidies to the power sector.

As of July 2022, Ikeja disco started charging cost-reflective tariffs, which essentially means no more electricity subsidies for Ikeja disco customers. However, the average tariff, which is also the cost-reflective tariff, for July to December 2022 is just ₦49/kWh, while from January to June, the cost-reflective tariff was ₦52.7/kWh. Still, the disco was only allowed to charge ₦47.5/kWh. How come the cost-reflective tariff went down even when business costs in the country increased with inflation and exchange rates? For one, the disco supplied 1,919 GWh (1,919,000 MWh) between January and June, but the model expects Ikeja to supply 3,021 GWh between July and December, a 57% increase. Everyone knows this is impossible, but using a realistic value will produce a higher tariff.

So, what happens in December when Ikeja supplies 2,000 GWh? NERC will adjust the energy value to what was supplied and Ikeja’s costs. Remember I mentioned that discos couldn’t spend 100% of the CAPEX? Well, this gets adjusted at the end of the period and balances out the tariff retrospectively.

Another assumption that affects the tariff is ATC&C loss. If Ikeja disco’s real ATC&C is 20%, it means that if TCN sends 2,200 GWh to Ikeja Disco, the disco only gets paid for 1,760 GWh. But the tariff model doesn’t recognise 20%. It recognises 12%, the aspirational loss level Ikeja should have achieved by 2022. So, even with cost-reflective tariffs, Ikeja can never recover 100% of its costs because the model doesn’t recognise that Ikeja’s losses are higher than 12%.

Now, opinions on this vary depending on the side of the fence you’re on. Ikeja disco would argue that it’s impossible to achieve 12% when it doesn’t have access to financing to improve its network. On the flip side, the regulator will say that it’s up to Ikeja to find funding as a privately owned company. But neither argument is 100% sound. On the one hand, the discos should be more efficient, and losses shouldn’t be as high as they are now. Still, on the other hand, the electricity sector is highly regulated to protect customers, which is sometimes detrimental to the discos.

Where does this leave us?
 

Cost-reflective tariffs that aren’t really cost-reflective

The general sentiment has always been that the power sector can’t be liquid without cost-reflective tariffs, which makes sense. How can you run a business where you don’t charge customers correctly? It works as a customer acquisition strategy for startups but is unsustainable in the long run.

The deal was for the government to cover the electricity subsidy. Still, they haven’t held up their end of the bargain with trillions of naira owed to the sector as electricity subsidies and electricity consumption charges from ministries, departments and agencies.

But can Nigerians cope with cost-reflective tariffs? This is the same question that keeps us with subsidised petrol in Nigeria. First, who are the Nigerians we’re even talking about? 90 million don’t have grid access, and most live in rural areas. But, if the power sector can’t cover its costs, it can’t expand access to rural areas. People in urban areas who benefit from the non-cost-reflective electricity rates also face the erosion of their purchasing power as prices of other commodities rise.

The problem here is a Nigerian economy problem where people’s earnings are too low, and prices are high. So, the government sets up price caps on petrol and electricity that don’t even get to the poorest in society because they can’t afford these services even with the subsidies. Instead, we end up in a situation where the government tries to eat its cake and have it by sneakily increasing the caps on petrol and electricity prices while still protecting middle-class citizens from high prices. Ultimately, the sectors suffer because nothing changes for the companies with no way of recovering their mounting costs.