Electricity subsidies are getting better

by Akshay Jaitly and Ajay Shah
Business Standard, 26 May 2024

There is an increasing use, by policy makers, of explicit electricity subsidies that are transparent to the recipient and explicitly paid for by the exchequer. This strategy offers an important alternative to the traditional complexities of the electricity sector, where government ownership and distorted regulation were used as a way to deliver less transparent subsidies to favoured groups. Carried two steps further, these incipient policy initiatives can take us closer to an efficient electricity sector, that operates on market principles, coupled with political objectives being met through explicit subsidies. More generally, the best path to prosperity lies in stoking the engine of GDP growth made by the private sector, and then using tax revenues to achieve political objectives.

Electricity is one of many sectors in India where state power is used to build a tax-and-spend system where some customers are overcharged in order to subsidise others. These systems are not desirable. If all taxes and all expenditures come together in budgets, at the level of the union or state or city, then policy making will be superior. Taxation will favour good taxes (personal income tax, GST, property tax) and bad taxes will be gradually phased out (such as the burden of taxation upon C&I electricity users). Expenditure strategy will see a unified view, and choose the best uses of money, on the tradeoffs between public goods and subsidies, and on the precise groups in society that are sought to be politically targeted for subsidies.

In addition, the within-sector tax-and-subsidise schemes hinder transparency and competition in the sector. In the name of redistribution, a great deal of inefficiency is perpetuated. The electricity sector will work well under private ownership and the incentives of the price system. The reforms that would take us there have been staved off on the grounds that they interfere with the tax-and-subsidy scheme running within the electricity sector, which can only be sustained in collaboration with publicly owned firms.

It is in this context that we should see a series of electricity subsidy programs that have sprung up, e.g. those in Tamil Nadu, Karnataka, and Delhi. The new idea is that computerisation within government has now reached the maturity that the policy maker is able to define a subsidy program and precisely deliver the commensurate money to the distribution company. A typical structure is to give each household a subsidy of about Rs.1000/month in the form of 200 kWh of free energy each month.

This structure is gaining ground because it is efficient politics. The recipient is able to directly see the steps where she got a subsidy. She sees an electricity bill, where about Rs.1000 is owed for 200 kWh of energy, and then she sees the subsidy paid by the Ministry of Finance, through which her bill goes to zero. This creates a greater sense of gratitude, in the eyes of the recipients, as compared with the complex traditional tax-and-subsidy scheme running within the electricity sector where it was not clear to the recipient what she was getting. We suspect that this rationale will lead to an increasing use of this kind of electricity subsidy, all over India.

Such subsidy structures open up important possibilities for improvements in electricity reform. The present electricity system contains an array of interventions. For example, in Tamil Nadu, there are 22 different prices of electricity depending on who is the buyer, the quantity purchased etc. There is much to gain from replacing all these interventions, which are poorly understood by anyone other than civil servants working on electricity, with a system of explicit subsidies to the politically favoured recipients. Each recipient would feel greater gratitude when they see a normal electricity bill (with a clear and consistent pricing of electricity) and then a line item which is the subsidy recieved from the Ministry of Finance.

The ideal arrangement is one where the Ministry of Finance determines politically advantageous subsidies, and the electricity system is oriented towards delivering reliable and inexpensive electricity. Removing political objectives from the electricity system would take a great burden away for everyone involved in the electricity system.

Electricity regulation is supposed to be primarily about one problem: to prevent distribution companies from exploiting their monopoly power and over-charging for electricity. Instead, state electricity regulators have got enmeshed in the political economy of electricity that is driven by public sector ownership and the tax-and-subsidise scheme. These complexities have hampered the emergence of state capability at state electricity regulators. If the political problem -- of choosing target groups to which money is delivered -- is moved out to the Ministry of Finance, this can create conditions for technically sound electricity regulation to emerge.

With numerous success stories of private distribution companies, it is generally understood that private distribution companies work better. What holds back the greater shift to private distribution, in many locations in India, is the extent to which political economy is played out through non-transparent decisions made within distribution companies. Once the political economy is shifted out to the Ministry of Finance with explicit on-budget subsidies to politically favoured groups, it would be easy to obtain greater efficiency through private distribution companies in more locations.

This reasoning, within one sector, is part of a bigger idea. It is wise to separate the problem of politics and redistribution from the problem of obtaining GDP. If the coercive power of the state is used to interfere with the working of the price system for political considerations, this hinders GDP, and is sub-optimal. Guided by the price system, the private sector is good at getting cost minimisation and GDP growth. Policy makers should create a policy environment where the price system is given the space to do that. Once the GDP is made, the political decisions are about the desired level of taxation, the split between spending on public goods vs. spending on subsidies, and the favoured groups who should get subsidies.

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