Nepali World of Subsidies: Understanding Subsidies in the Power Sector in Nepal

Energy sources in Nepal comprise primarily of traditional sources with commercial sources prevalent among urban population, of which LPG is the most widely used source of energy. With Nepal lacking in petroleum resources of its own, it relies solely on imports from the Indian Oil Corporation (IOC) to meet the ever increasing demand for petroleum products within the country. With alternative sources of energy such as hydropower still severely underdeveloped, import is particularly essential to meet the energy demands of the nation which thereby creates a negative impact on the trade balance of the country.

The petroleum and electricity sector in Nepal functions in such a way that the pricing system isn’t optimal for the state monopolies. The retail price for petroleum products includes the import cost (determined by IOC) with the addition of custom duties, costs of transportation, profit margins and other applicable taxes. Meanwhile with the NPR pegged to the INR the Nepali market is inevitably affected by forces affecting the Indian market. Under the current pricing system, the prices of petroleum products are heavily regulated by the Government; consequently miniscule profits are made only through petrol and kerosene, and heavy losses made on LPG and diesel.

Electricity, on the other hand, has different power purchase rates for the dry and wet seasons; with the rate almost doubling during the dry seasons. With most hydropower projects being run of the river projects, the gap between demand and supply is at its peak during the dry seasons, due to which a big share of electricity has to be imported from India to meet demand. The selling price for electricity is generally set by the Electricity Tariff Fixation Committee (ETFC), which takes into consideration various factors such as units of consumption, electricity voltage and sectors of electricity consumption. While NEA which is the sole purchaser and distributor of electricity and buys electricity at seasonal prices, the prices for the end consumers more or less remain the same.

The prevalent pricing system in Nepal has significant impacts on the state monopolies as well as the economy. Some of these impacts are listed below.

  1. Since NOC is not reimbursed by the Government for the losses incurred on petroleum products, NOC subsequently bears the subsidized amount, thereby providing an involuntary subsidy on the products on which it incurs losses.
  2. Both energy institutions have been incurring losses on account of the pricing system; while NOC has been making losses due to the regulation of prices by the GoN, NEA on the other hand has been making losses due to inefficiency in pricing, and the inability of the ETFC to fix prices that can recoup operating costs. Additionally price escalations in Power Purchase Agreements (PPAs), increase in crude oil prices in the international market, and the devaluation of the INR; and subsequently the NPR against the USD, only adds to the mounting losses of the state monopolies.
  3. Increased demand for energy means that more and more electricity and petroleum products have to be imported. This coupled with increased price negatively impacts the trade balance.

Faced with deteriorating financial health and ballooning losses, the GoN has had to substantially increase its loan provisioning as a form of indirect subsidy to these two state owned monopolies. The key issue in the energy sector arises from an increased demand for energy stemming from urbanization and population pressures, resulting in increased imports which further widen the negative gaps in trade balances. This has left both institutions in a permanent cycle of loss and inability to make profits. Subsidies therefore have to be provided by the GoN and donor agencies to ease the financial burden on these institutions and ensure regular supply.

Apart from the involuntary subsidy provided by NOC and the indirect subsidy provided by the Government, direct subsidies have been recently introduced for the renewable energy sector under the Subsidy Policy for Renewable Energy 2069 BS (2012 AD) to support the development of micro and pico hydropower projects. Other than this, no direct subsidies exist.These subsidies are generally provided to producers by the government or donor agencies to ease financial burdens in production or operational processes in the form of grants, loans and concessions. While indirect subsidies by the government have been focused on the petroleum sector, subsidies from donor agencies are more focused on the hydroelectricity generation sector.

While there are no provisions for pre-tax subsidies for the energy sector in Nepal, given the price regulation by the GoN on the sale of petroleum products, consumers are recipients to an involuntary subsidy, of which NOC generally bears the cost. The post-tax subsidy in Nepal for petroleum products however is generally lower than that in other countries. This is due to the negligible negative ramifications to the environment, as most of the petroleum products are imported and processing and refining of crude oil takes place elsewhere.

Given the increased dependence on petroleum products, scaling up of energy generating capacities through investment in the sector is essential particularly during the dry seasons which is when Nepal faces its most severe energy crisis. Currently, the key recipients of government investment have been NEA and the Alternative Energy Promotion (AEPC) for renewable energy. A total of NPR 1.09 billion was allocated for investments in the energy in the FY 2068-69.

However, a comparison of government investments and indirect subsidies indicate that subsidies are far greater than investments, with investments comprising only 2%-6% of the subsidies within the last six fiscal years. This is indicative of the precarious situation of the country’s energy sector, wherein the government is more reactive in its efforts, rather than being proactive and investing towards development of the energy sector. Meanwhile a comparison of government investments with donor contributions in the forms of loans and grants indicates that donor investments and contributions are still significantly higher than that of government investments, but still substantially lower than government subsidies.

As identified above, the current energy scenario of the country is such wherein a majority of the energy has to be imported to meet demand. While the government has made energy subsidies an important budgetary component, this has proven to be ineffective in terms of providing pro poor subsidies as the existing subsidy policies do not differentiate between income-levels of subsidy recipients. The low income households that are generally targeted by these subsidies are often not the actual recipients, with the subsidies often taken advantage of for commercial purposes.

Some recommendations are provided below focusing on shifting towards an alternative (renewable) energy sector, increased levels of community participation, and prospects of developing pro-poor subsidies in potential energy sectors.

  • Extra electricity generation: There is vast potential for extra electricity generation in Nepal. Governmental focus on investing in this area rather than using it in the form of soft loans to the NOC and NEA will be more fruitful in the long run.
  • Switch to electricity: Statistics indicate that a majority of the population either use traditional sources of energy or petroleum products as a source of energy. Switching to electricity will therefore help in reducing the country’s dependence on petroleum products, thereby facilitating the reduction in the country’s BOP deficit, of which petroleum imports is a key component. However, this is contingent on the country successfully generating extra electricity to meet this latent demand.
  • Remove barriers to switch: The barriers to switch from petroleum products to electricity is greater for producers rather than consumers, investment therefore needs to be made in scaling up electricity generation plants, and transmission and distribution lines.
  • Pro Poor subsidies: While energy subsidies impose substantial fiscal and economic costs particularly for developing countries, pro-poor subsidies are likely to be more successful if they are embedded within a broader reform agenda. For instance, a system of cash subsidies directly aimed at the poor through the distribution of cash coupons to low income households will directly benefit the poor, as in India.
  • Cross subsidization: This is another successful mechanism to provide pro-poor subsidies. For instance the recently introduced NOC system of using of color-coded LPG cylinders- red for domestic use and blue for commercial purposes is an effective example of ending subsidies towards commercial users and utilizing the profit earned towards providing subsidies to households which is the targeted group.

This is an extract from a report commissioned by the Royal Norwegian Embassy in Nepal. This document is solely the work of Nepal Economic Forum. The information documented and the views expressed by this economic periodical do not necessarily reflect the ideas of the Royal Norwegian Embassy.