Practices in Power Sector. R. Krishnamoorthy Member CERC

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1 TOTAL COST MANAGEMENT Practices in Power Sector R. Krishnamoorthy Member CERC

2 Total Cost Management Systematic and structured approach to understand the costs of an organization, with the aim of providing a holistic framework to control and reduce costs. Alternatively, It is the process of managing the financial outcome of activities, internal and external to the organization.

3 Total Cost Management - Cost include any investment of resources in the enterprise's assets including time, monetary, human, and physical resources. - Total refers to TCM's comprehensive approach to managing the total resource investment during the life cycle of the enterprise's strategic assets.

4 Total Cost Management TCM is comprised of business processes that transcend all areas of an organization, including procurement, finance, engineering, sales and marketing to proactively manage all the fixed and variable costs of doing business.

5 TCM in Power Sector Power Sector is Regulated by the Independent Regulators All the Business process of the utilities are regulated either by CERC or by SERC Tariff Determination Process is nothing but ascertaining the prudence and reasonableness of the cost incurred at various point of operations right from generation to supply of Electricity. Utilities have to keep proper cost records to satisfy the regulators for a better tariff. Contd.

6 Power Sector has traditionally been following cost plus (ROR) Regulation. In generation and transmission the project cost as approved by the competent authority (earlier the appropriate Government and now the appropriate Commission) forms the basis for Tariff. Return is allowed on the equity portion of the capital cost. In distribution business, traditionally, it was the capital base on which return was allowed (6 th schedule of E(S) Act, 1948). Contd.

7 Tariff to reflect cost Cost of each activity/process has been properly ascertained Capital cost of the Projects has been discovered through a transparent process of bidding Capital has been procured at a competitive cost from the market O&M expenses are reasonable Adequate working capital have been provided to take care of liquidity requirement Optimum consumption of fuel/oil Minimum auxiliary consumption Incentive for better performance

8 TCM in electricity sector aims at effective management of capex as well as opex. Assets are created only through a transparent system, against a firm expression of demand on a demonstrated and verifiable least cost basis. Return is allowed on Rate base. Typically the rate base represents the historic cost of the assets employed, less the accumulated depreciation of the asset. Contd.

9 Tariff Principles Cost plus method of tariff determination the approach of allowing Standard rate of return on Capital Base was continued even in ERC Act, Under ERC Act, 1998 regulators were required to follow the cost plus tariff fixation principles of 1948 Act. They could deviate by recording reasons in writing. The Electricity Act, 2003 marks the departure from this trend and does not mandate any specific method of tariff determination. Contd.

10 The determination of Terms and Conditions of tariff has been left to the domain of the Regulatory Commissions. Only guiding principles have been provided for in the Act. The mandate for the Regulatory Commissions is to ensure that tariff reflects the cost of supply of electricity and also progressively reduces cross-subsidies within the specified period. Contd.

11 CERC has fixed Multi-year tariff principles for generation and transmission under the Electricity Act, SERCs have also fixed tariff principles for distribution licensees. These principles however continue to reflect cost plus approach Contd.

12 Cost plus approach has inherent draw back of not being able to induce utilities to manage their cost efficiently. CERC does prudence check of the capital cost of a project. However, there are limitations in terms of wherewithal (- manpower, database etc.) in CERC for proper prudence check. Capital cost being starting point for tariff regulation, there is a need for a proper regulatory framework which sends signals to utilities to be cost efficient. CERC has initiated study on Benchmarking of Capital Costs for Thermal Generation and Transmission. Contd.

13 At the State level also at present we have the same problem of lack of wherewithal (in terms of manpower, database etc.) for proper scrutiny of capital base of utilities. Forum of Regulators (FOR) has also initiated proposal of a study on Capital Cost Benchmarking for Distribution Business Contd.

14 To induce efficiency improvement in operation, Regulatory Commissions specify various norms of operation. There are also incentives for improvement over and above the specified norms. These inducements have incentivized utilities to achieve significant improvement in their operations. Examples: Improvement in performance of CPSUs like NTPC, NHPC, PGCIL over the last two tariff periods. Performance improvement of distribution utilities in Delhi and some other States. Contd.

15 Regulators Dilemma Regulatory intervention so far has been able to induce operational efficiency but Introspection is required for inducing Cost efficiency especially of Government owned utilities. Capital Cost Benchmarks, if they could be evolved, could help induce cost efficiency but Contd.

16 The present form of cost plus Regulation (even with capital cost benchmarking) will continue to have limitations in providing the desired signals for efficient cost management as utilities would have a tendency to over project capital expenditure for earning higher returns. The solution to one extent lies in performance based Regulations like price cap regulation, revenue cap regulation etc. The question is whether we are ready for such regulation?

17 Cost Management Tariff Policy in para provides that competition will bring significant benefits to consumers, in which case it is competition which will determine the price rather than any cost plus exercise on the basis of operating norms and parameters.. All efforts will need to be made to bring the power industry to this situation as early as possible, in the overall interest of consumers...

18 The Way Forward Competition The Electricity Act, 2003 gives enough bandwidth for encouraging competition. Section 61 requires the commission to be guided by factors including the factors which would encourage competition, efficiency, economical use of the resources, good performance and optimum investments. Section 63 provides for discovery of tariff through competitive bidding process. This provision has the potential of inducing efficient cost management for utilities and has been tried successfully in three projects. Contd.

19 The Way Forward The Tariff Policy stipulates the requirements of future procurement power through competitive bidding route. It is encouraging to find that more such projects (under competitive bidding route) are in the offing. The CERC has significantly contributed to evolution of the competitive bidding guidelines under section 63 of the Act. State Commissions have also been inducing their utilities to procure power through competitive bidding (under both case 1 and case 2).

20 The Way Forward Use of Information Technology Tariff Policy provides in para that effective utilization of all available resources for generation, transmission and distribution of electricity using efficient and cost-effective technologies is a paramount importance. Effective control of power system at State, regional and National level can be achieved only through use of Information Technology.. Application of IT has great potential in reducing technical and commercial losses of distribution and providing consumer friendly services.

21 The Way Forward Use of Efficient Technologies Further in para 5.6.2, the Tariff Policy provides that efficient technology like super critical technology, IGCC etc. and large size units would be gradually introduced for generation of electricity as their cost- effectiveness is established. Tariff Policy also emphasizes on promoting R&D Power sector.

22 The Way Forward Structural changes At the State level, cost management of SEBs has been highly inefficient because of various factors like: Monolithic structure, lack of requirement of and framework for cost management on commercial lines etc. The Electricity Act, 2003 therefore provides for reorganization of SEBs on functional lines The objective is to create smaller and clearly identifiable functional structures (on lines of SBUs) for better and efficient cost management.

23 Thank You