Philippine Electric Power Distribution Industry: An Economic Analysis

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Philippine Electric Power Distribution Industry: An Economic Analysis

FORMAT FOR THE CASE STUDY:  

* executive summary 

* introduction  

* body 

* conclusion 

* reference

reading reference:

7:46pm TuetiDec n. Etta) I amt-tn 3of’18 1 INTRODUCTION The Philippine power industry is divided into three main divisions: generation, transmission, and distribution, Generation refers to the actual production of electricity, be it from non-renewable resources such as coal and oil, or renewable resources such as solar and wind energy. Transmission, on the other hand, refers to the transfer of electricity from power plants to electrical substations. However. the focus ofthis paper will be on power distribution, which in turn refers to the transfer of electricity from higher-voltage substations to end—users, such as establishments and residences. According to the National Association of Electricity Consumers for Refomts. there are three types of power distributors in the Philippines: Private Distribution Utilities {PDUs}, Electric Cooperatives tECs}, and Municipal Utilities (MU). Private Distribution Utilities. from the natnc itself, are owned by private companies and investors. Electric Cooperatives, on the other hand, are owned by the end—users within the scope of such cooperatives, while Municipal Utilities are owned and managed by local government units. For the purposes of this paper, we will he utilizing data from the largest private distribution Utility in the country: the Manila Electric Company [Moraleo], due to the fact that it is the only electric distribution company with sufficient data which allows this paper to draw valid conclusions regarding certain economic concepts that will be discussed. Scope of the Paper In order to provide a more in—depth discussion into the power distribution industry, this paper will focus on Meralco. This is due to the fact that it is the only private distribution utility with an extensive amount of data. Meralco is also the subject of most academic studies on the Philippine electric power industry, which means that focusing on Meralco allows readers of this paper to easily confirm and verify certain assertions which this paper will be positing. However. the discussion which we will be providing in this paper can be generally applied to the rest of the power distributors in the country since we will be making use of economic concepts in order to discuss and to explain the operations ofsuch power distribution companies. As mentioned earlier, this paper will analyze the economic aspects of the Philippine power distribution industry; therefore, it will heavily focus on the production side of the electricity market. However, this paper will also be making use of some concepts from consumer theory in order to further elucidate certain concepts {such as price discrimination, etc}. The initial part of this paper shall cover the production process of power distribution companies. and to this end, we will be focusing on two important aspects of production: costs and profit. In analyzing both concepts, we will be utilizing data obtained fi’om the ‘- aforementioned power distribution companies in order to understand the workings of these .. _ companies with respect to their operational costs and pricing strategies. We will be identifying key factors which these companies consider in determining their levels of expense, and most importantly, their prices. The second part ofthis paper will tackle the naturally monopolistic nature ofthe power distribution industry. and the various methods by which government regulation is implemented in order to curb the influence and market power of large power distribution utilities such as Meralco and VECO. To tackle the concept of a natural monopoly, we will be highlighting concepts such as economies of scale. special costs. and other related concepts. We will also discuss briefly the huge capital outlays required in order to establish a power distribution company, as well as the numerous bureaucratic processes one has to undergo before a power distribution company can be formally established, as these factors contribute to the natural monopoly which is the power distribution industry.

7:46pm TueSDec n. “EM? 0 amt-in Lastly, this paper will briefly discuss the welfare economics behind the power distribution industry. To this end, we will be utilizing the theoretical frameworks of consumer and producer surplus, as well as making use of the concept of price elasticity of demand in order to draw certain conclusions about the overall welfare obtained by the stakeholders of the electric power distribution industry. THE PRODUCTION PROCESS Costs Incurred According to Meralco Corporate Partners and a cross-reference with the Meralco website, to supply electricity for the people, companies like Meralco incur the following types of costs: “Generation Charges, Transmission Charges, Merslco Charges, System Loss Charges, Taxes and Subsidies" and these are the costs that they usually charge to cuneumers (Metalco Corporate Partners). Moreover, these charges can be found in the sample bill summary and also a pie graph to show the division of the costs or charges (see Appendix A and B). Since Meralco is a Power Distribution Company, it is able to receive supply of electricity from large power producers like “San Miguel Corporation’s Power, First Philippine Holdings Power” (owned by the Lopez family) and other private power producers {Meralco Corporate Partners}. This means that the cost they incur from these power producers are reflected on the bill. Moreover, the power generated from the power producers will be "transmitted" or delivered to the "distribution system of Meralco” provided by the services of the “National I131id Corporation of the Philippines” [Meralco]. The transmission costs would be reflected in the Transmission Charges in the bill. The System Loss Charges are the costs incurred by the company due to "technical or non-technical system losses". Examples of these non-technical system losses include the “illegal topping" or the tampering of power lines (The Philippine Star, ZOGI }. Moreover, the loss due to “additional infrastructure or upgrading [of] facilities" is an example of technical loss which is ultimately charged to the consumers (The Philippine Star, 2001). Unfortunately, why companies like Meralco charges these costs to the consumers remains a highly debatable topic within the Philippine Senate despite the fact that these costs seem to he more ofexpenses of the company rather than than that of the consumers (Rivera, 2016). However, ifwe also take into consideration the company’s explanation, they will really need a considerable amount of capital to improve their services I.” The Philippine Star, 2001]. Furthermore, since Metalco is a firm whose electricity supplies are dependent on other companies such as San Miguel Corporation, the costs they incur are charged to the consumers in order to pay for the power that was generated and transmitted from these companies. This is ‘- also true with regards to the taxes that are present in our bills like the “ValueuAdded Tax" and the “Local Franchise Tax" which goes to the national government and the local government units respectively [Metalco Corporate Partners]. Other costs that electric power distributors incur which is charged to the consumers include "Universal Charges" which are used to pay the Power Sector Assets and Liabilities Management Conaoration (Meraico Corporate Partners). Examples of these Universal Charges are the “Missionary Electrification C harge” and “Environmental Charge" which are used to provide "basic electric service to remote and unavailable-to serve areas" and rehabilitation and maintenance of "watershed reservations surrounding hydroelectric plants for sustained power generation" (Meralco Corporate Partners). The Memlco Charge consists of the “Distribution Charge, Metering Charge and Supply Charge" wherein these are the costs the Meralco incurs in "building, maintaining, operating of

7:46 pm Tue 6 Dec 81% 6 of 18 this is that these function as a form of incentive being given to those who wish to begin commercial or industrial ventures. The electrical rate felt by commercial and industrial users is found within the overall average rates for each kind of user or group. Meralco also employs what they call a "Peak/Off Peak" rates program wherein lower generating costs can be availed for during off peak hours (Meralco). These off peak hours are in the evening and early morning during the hours of 9pm to 8am from Monday to Saturday and 8pm to 6pm on Sunday (Meralco). Other electrical companies also perform this simply because they have a difficult time providing all the electricity demanded from them during the peak hours (hence the name). They then incentivize users by letting them use their appliances at a lower rate during times when they would have no trouble providing for all the electrical need of the consumers. Thus, the power usage is spread throughout the day and is not clumped during the peak hours. This makes electricity distribution throughout the day more consistent which will then take a minimal toll on their systems. Profit of the Firm Generally, firms would avoid having their profits being equal to their costs, since that would mean zero profit. Therefore, Meralco "tweaks" the price to its advantage so that it can not only earn profit but maximize profit as well. However, given the circumstance that there are no definite terms or measures (like willingness to pay due and market price coming from price discrimination) to define the consumer side of the market besides the revenue that Meralco earns from the payment of their bills. It is also safe to say that an ideal amount to show how much profit they earn; it has to be Total Revenue (TR) minus Total Cost (TC). However, from the data that we gathered we were only able to see a complex income statement but we didn’t want to delve into it because it is only concentrated on the Accounting Cost and not the Economic Cost. MARKET SHARE OF THE POWER DISTRIBUTION INDUSTRY A Natural Monopoly According to Microeconomics by Daniel Rubinfeld and Robert Pindyck, a natural monopoly is defined as a "firm that can produce the entire output of the market at a cost lower than what it would be if there were several firms." While most monopolies are usually considered on a national (or even an international) scale, the electric power distribution industry is more aptly described as a "geographical" (Oplas, 2015) or "regional" monopoly. This is because "franchise areas" for the roughly one hundred and twenty (120) electric distribution utilities are demarcated across the country. However, there are also some areas where there are possible interactions between such electric distribution utilities and their respective franchise areas: in the case of Meralco, it is the only electric distributor for Metro Manila and some of its nearby provinces. However, in provinces such as Laguna, Batangas, and Quezon, Meralco only services some parts of the area, while other electric cooperatives service the rest. This shows that the franchise areas of such electric distributors are not solely bound by pre-existing geographical boundaries (such as provinces, cities, etc.); rather, they are determined by government regulations. One reason as to why such demarcations would be necessary is the redundancy of having two or more sets of power lines owned by several companies. This is closely related to the concept of economies of scale, which is an inherent quality of a natural monopoly. This will be further discussed later on. In order to further characterize the monopolistic nature of the electric distribution market, let us analyze the concept of special costs, which specifically prohibit firms from freely 5

7:46 pm Tue 6 Dec 0 81% 5 entering and exiting a non-competitive market. According to Microeconomics by Jeffrey Perloff, a natural monopoly is an industry which entails high infrastructural costs, and other barriers to entry (2015). These in turn grant the largest (usually the first) supplier greater advantage over other potential competitors. Translated into the electric power distribution industry, such special costs would include the huge capital outlays required to set-up electrical grids and power lines, as well as the bureaucratic processes firms have to undergo before they are able to initiate operations. The process of exiting the market is also a very costly one as well: they are multiple barriers to exit which have to be considered. According to Kathryn Rudie Harrigan and Michael E. Porter (1983) of the Harvard Business Review: "If the assets, either fixed or working capital or both, are specialized to the business, company, or location in which they are being used, their diminished liquidation value creates exit barriers. A company with specialized assets such as sole-leather tanneries must either sell them to someone who intends to use them in the same business, usually in the same location, or scrap them. Naturally, few buyers wish to use the assets of a declining business" (Harrigan and Porter, 1983). Other possible exit barriers would be litigation expenses and other penalties (due to unfulfilled contracts, labor disputes, etc.), as well as the social implications of an electric distributors exit: due to the fact that such an industry is a vital public utility, the government may not allow investors to easily get away with exiting the industry without certain concessions or penalties. While we are on the topic of the government, it is also important to consider that the level of government integration within the industry also contributes to the monopolistic nature of the electric power distribution industry. According to Perloff’s Microeconomics, `many local governments own and operate public utility monopolies that provide garbage collection, electricity, water, gas, phone services, and other utilities" (2015). A prominent example of this would be municipal utilities (MUs), which are owned and operated by the government. Other ways in which the government contributes to the creation of a monopoly include regulatory processes (such as the granting of national licenses, which create additional barriers to entry), as well as government ownership/stakes in distribution utilities (such as Meralco, especially before the privatization of such utilities). Economies of Scale In order to understand the economic concept of a natural monopoly, we have to turn to the concept of economies of scale. According to Microeconomics by Rubinfeld and Pindyck, economies of scale refers to a situation wherein increasing output (increasing energy distribution) will result in lower costs per units of production. A simple graphical representation of such a phenomenon is presented towards the end of this paper (See Appendix D). The average total cost (ATC) of a single firm in a natural monopoly decreases as the firm continues to expand, and this is because of the large demographic serviced by such firms. Electric distributors incur huge fixed costs (such as taxes, maintenance expenses, wages), and therefore, they would require a significant amount of customers in order to make returns on their investments. In economic terms, as more output is created, the average total cost (which is mostly composed of fixed costs) greatly declines. Should another firm enter the geographic extent of a market ( or the franchise area) which has already been allocated to an existing electric distributor, they will have to divide the customers between themselves, rendering the market inefficient and raising incurred costs. As we have pointed out earlier, it would be impractical for two or more firms to set-up their own separate power grids and lines throughout a given 6

7:46 pm Tue 6 Dec 81% 6 area: this would only needlessly divide (and ultimately confuse) consumers, and costs would exponentially increase. GOVERNMENT REGULATIONS AND REFORMS The electric distribution industry is heavily regulated due to the many possible abuses that opportunistic firms may impose upon both the consumers and possible competitors. For example, if electric distribution utilities were not limited according to their mandated franchise areas, there is a high likelihood that larger companies with more resources could usurp the areas serviced by smaller electric cooperatives or utilities, potentially creating a national monopoly or oligopoly in the truest sense of the word. Another possible harm of a deregulated electric distribution industry would be collusion in terms of the set prices: due to the geographic monopolies brought about by the allocation of franchise areas, consumers might be hard pressed to find alternatives in the event that the existing electric distributors decide to charge exorbitant prices. Existing Rules and Regulations Due to these inherent risks, there are stringent government regulations in place in order to monitor these firms. Laws such as the Electric Power Industry Reform Act of 2001 (EPIRA), the Philippine Distribution Code, and regulatory agencies such as the Energy Regulatory Commission and the National Power Corporation set guidelines for these firms in terms of pricing, as well as anti-competitive behavior. One of the most significant reforms implemented by EPIRA would be the unbundling of electricity tariffs. This resulted into the itemization and segregation of the different costs the average consumer would have to pay in his/her monthly electricity bill, and it promotes greater transparency and accountability in the face of an otherwise potentially abusive and corrupt company. Another reform introduced by EPIRA would be the imposition of caps and limits on the volume of electricity that distribution utilities can purchase from power generating companies. Another important provision of EPIRA states that "no company or related group can own, operate or control more than thirty percent (30%) of the installed generating capacity of a grid and/or twenty-five percent (25%) of the national installed generating capacity." However, this particular provision can become problematic, as we will discuss later on. The regulations behind the awarding of franchises to electric distributors are found within the implementing rules and regulations of EPIRA, which state that the electric distribution industry shall be a common carrier business requiring a national franchise. Such franchises are the exclusive purview of the Congress of the Republic of the Philippines, which means that it would require a firm to undergo intense scrutiny (as well as incur some possible processing costs) before they would be granted a franchise. The granting of such franchises is ultimately the final protection against abusive practices by opportunistic firms: should they extensively violate the provisions set by regulations such as EPIRA and the Philippine Distribution Code, the Philippine Congress may decide to revoke or to deny the renewal of the electric distributor’s franchise. Current Issues in the Electric Power Industry Despite the reforms initiated by the government, there are still persistent issues within the entire Philippine electric power industry, Ironically, some of these issues were brought about by provisions in the EPIRA which continue to be exploited by several firms. According

7:46 pm Tue 6 Dec 81% to Professor Epictetus E. Patalinghug of the University of the Philippine’s College of Business Administration, there is a troubling provision in the EPIRA: its cross-ownership provision. According to Dr. Patalinghug: "It allows for cross-ownership between a distribution company and a generation company up to 30% of the installed generation capacity of a grid (e.g. Luzon grid) and up to 25% of the national installed generating capacity. This provision opens the possibility for a distribution company to enter into supply contracts with its generation subsidiaries and create hidden profits for the owners of the power conglomerate" (Patalinghug, 2003). An example of an exploitation of such a provision would be "Meralco’s supply contracts with the Lopez-owned First Gas Power and Quezon Power, Lid." Dr. Patalinghug further states that this is a "classic case of the disadvantageous nature of the cross-ownership provision of EPIRA. Meralco is accused of buying power from its affiliated IPPs (Independent Power Producers) at higher prices compared to the price charged by NPC" (Patalinghug, 2003). This is primarily problematic due to two reasons: the consumers ultimately bear the generation costs (as indicated in the unbundled rates of the monthly electric bill), and the cross-ownership means that the firm engaged in such a practice is unscrupulously earning higher profits at the expense of its consumers. Another issue which continues to weigh down the electric power industry are certain regulatory uncertainties brought about by controversial policies and regulations. One particular issue is the imposition of a competitive selection process (CSP) for all distribution utilities (DUs) and electric cooperatives (ECs) via a memorandum issued by then Department of Energy (DOE) Secretary Jericho Petilla. The CSP is a requirement that all DUs and ECs have to undergo before they can secure power supply agreements (PSAs), and it aims "to determine the least cost of power through demand aggregation" (Rivera, 2015). The CSP is controversial because public opinion has been largely divided on the matter. Several players in the industry, particularly Meralco, have complained that such a requirement "would lengthen the process of securing power supply deals." Meralco President Oscar Reyes stated that while "the CSP is a "nice, attractive concept," it is merely "a one-size-fits-all process will not promote the best interest of consumers." Another prominent individual, former energy secretary Francisco Viray, also criticized the imposition of a third-party requirement in the "implementation of the CSP," stating that the DOE and ERC should instead ensure that implementing rules and regulations are made clear. However, on the part of the consumers, as represented by David Celestra Tan, founder of the Philippine Independent Power Producers Association, "competitive bidding would result in fairer and more reasonable rates." He even laments that "it is only now that the government has come out with a directive that protects consumers." The confusion over this matter is made worse by an apparent disagreement between the ERC and DOE: in an ERC order at the time, no mention was made regarding third- party requirements. Such issues within the regulatory framework create unneeded confusion within the electric power industry, and could potentially discourage (or even alarm) investors. ANALYSIS OF PRODUCER/CONSUMER WELFARE Market Inefficiency Being a natural monopoly, the Philippine electric power distribution industry can be considered inefficient. According to Perloff’s Microeconomics, a profit maximizing monopoly’s inefficiency stems from the fact that it wastes potential surplus, resulting in a 8

7:46 pm Tue 6 Dec 81% 9 This paper has also identified the degrees of price discrimination which is utilized by electric power distributors: second-degree price discrimination and third-degree price discrimination. The second-degree price discrimination used in particular by the electric power distributors is called "inverted block rate" since it goes against the usual style of block pricing: in this case, higher consumption of electricity results into higher prices. The third-degree price discrimination employed by Meralco, on the other hand, segregates users into three groups: residential, commercial and industrial users. Both degrees of price discrimination are utilized by Meralco, as well as other electric power distributors, to maximize their profits. This paper also discusses the nature of the electric power distribution industry as that of a natural monopoly, wherein a single firm producing the output for an entire market would incur lower costs compared to when there are two or more firms. We discussed the factors which make the industry a natural monopoly: the high capital outlays required in order to enter the market, as well as the existence of multiple barriers to entry and exit which would disincentivize firms from entering the market. The paper also briefly discusses the role that the government plays in keeping such "geographical monopolies" (Oplas, 2015) intact. To further emphasize the idea of a single firm producing the output for an entire market, we also discussed the concept of economies of scale. This paper also delved into the issue of government regulations and reforms. We cited several landmark legislations and regulations, such as the EPIRA and the Philippine Distribution Code, as having laid the groundwork for the restructuring of the Philippine power industry in general. We also briefly discussed examples of such reforms, such as the unbundling of electricity tariffs, and the imposition of limitations on cross-ownerships. However, we also discussed two primary issues which current pervade the Philippine electric power industry: the exploitation of the 30%/20% cross-ownership provision of EPIRA, and the regulatory uncertainties which threaten to shake investor confidence in the industry. Lastly, this paper also provided an analysis of the producer/consumer welfare in the industry. We discussed the effects of a natural monopoly on the respective producer’s and consumer’s surplus in the electricity market, and we made use of the concept of elasticity to highlight the severity of the monopoly’s impact on the reduced consumer’s surplus. We also discussed the existence of a large amount of deadweight loss due to this market set-up, and the two factors bringing it about: the monopoly’s output production at a less efficient point, and the taxes incurred by the power distributor. Finally, we pointed out that despite the deadweight loss, the monopolist still stands to gain more producer surplus due to the significantly reduce consumer surplus in the market. It is clear that after an exhaustive analysis of the electric power distribution industry, there are still significant issues which continue to mar its operations. The natural monopoly inherent to the industry means that government regulators must maintain a constant and vigilant presence in order to prevent the players in the electric power industry from taking advantage of their position within the market. Through understanding the economic concepts which define such a phenomenon, as well as the regulatory rules and regulations imposed by the government on such firms and players in the market, we are able to become more circumspect with regards to our precarious situation as consumers in a market which is heavily predisposed in favor of the producers. 10

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