Understanding the New Electricity Tariffs: What Are We Paying For? (1), By Odion Omonfoman
Prior to 2008, there was no transparent commercial electricity tariff setting framework that reflected the true price of electricity in Nigeria in terms of what it costs to generate one MW of power, to transform, transmit and distribute that same MW to customers. As we understand it, electricity tariffs were simply set by PHCN (formerly NEPA) using very simplified inputs, which didn’t reflect key variables such as inflation rate, exchange rate fluctuations, increase in the price of natural gas and capital expenditure requirements for the entire electricity sector. Once agreed, the tariffs were forwarded to the Presidency for approval. During this period, there was a huge under-investment across the entire value chain in the power sector as not enough budgetary provisions were made for capital expenditure in the power sector, and tariffs were generally too low to make the required capital investments to improve the power sector or at least, maintain the existing infrastructure.
…in 2008, NERC adopted the Multi Year Tariff Order (MYTO) tariff methodology to regulate tariffs and the tariff setting process.
One of the main thrusts of the Electric Power Sector Reform Act (EPSRA) 2005, which established the Nigerian Electricity Regulatory Commission (NERC), was for NERC to come up with a tariff methodology for the power sector. Section 76 of the EPSRA provides for NERC to adopt an appropriate tariff methodology, which, amongst other general tariff principles, should allow for the recovery of efficient cost, including a reasonable rate of return to the power sector and provide incentives to market operators to improve efficiency and quality.
To this effect, in 2008, NERC adopted the Multi Year Tariff Order (MYTO) tariff methodology to regulate tariffs and the tariff setting process.
What is MYTO?
The Multi Year Tariff Order (MYTO) was introduced in 2008 and is a unified way to determine total industry revenue requirement in line with the general tariff principles of the EPSRA. The MYTO tariff methodology was developed in consultation with industry stakeholders, labour groups and consumer groups. MYTO is supposed to provide a correct pricing of electricity, taking into consideration the key principles of cost reflectivity, affordability of electricity tariffs, and incentives for efficient operations.
MYTO, as introduced in 2008, provided for a five-year electricity tariff path over a 15-year period, with semi–annual minor reviews for inflation, exchange rates and gas prices and major reviews every five years for all other assumptions and inputs (capital expenditure, operating expenditure, revenue collection efficiencies, cost of capital, etc). For the first MYTO model introduced in 2008, tariffs for the initial five years ranged from N9 to N11.50 per Kwh with an average of N10 per Kwh.
Prior to the introduction of MYTO in 2008, electricity tariffs were last reviewed in 2002. In all of the reviews of the MYTO methodology, electricity tariffs have always gone up. The only exception to this trend is the MYTO 2.1 (amended) Order of April 2015, where NERC sought to reduce electricity tariffs by removing the collection loss component.
Since 2008 to date, there have been several reviews of the MYTO Methodology and Tariff Orders issued by NERC pursuant to the reviews of the MYTO Methodology. The first MYTO Order was christened MYTO 1.0 and was in effect from 2008 to 2012. In June 2012, following a major review of the methodology, the MYTO 2.0 Order was issued and was supposed to be in effect from 2012 to 2017. In December 2014, after a minor review, NERC issued a new MYTO Order, the MYTO 2.1 Order that would take effect from January 2015 to 2018. However, in April 2015, NERC, in its wisdom, revised and amended the MYTO 2.1 Order (MYTO 2.1 Amended) by removing the collection loss component of the electricity tariffs. Following from NERC’s actions and the resultant force majeure notice issued by Discos as well as their core investors, a review of the MYTO 2.1 Order (amended) was done. The review brought about the issuance of the MYTO 2015 Order that would take effect from 2016 to 2024. The MYTO 2015 methodology provides for a 10 year tariff pathway to ensure Investors have a tariff plan that enables them make necessary investments and recover costs over this period.
Prior to the introduction of MYTO in 2008, electricity tariffs were last reviewed in 2002. In all of the reviews of the MYTO methodology, electricity tariffs have always gone up. The only exception to this trend is the MYTO 2.1 (amended) Order of April 2015, where NERC sought to reduce electricity tariffs by removing the collection loss component. Unfortunately, NERC’s actions which was announced in March 2015, prior to the general elections of 2015, was largely seen by many as being politically motivated.
The Building Blocks of MYTO Methodology
To understand the building blocks of the MYTO methodology, it is important to first gain an understanding of the power sector value chain and the flow of cash within the power sector. Primarily, the electricity sector comprises of three main segments, namely generation, transmission and distribution/retail segments. Connected to the power sector is the natural gas industry that supplies natural gas used as fuel to generate more than 85% of power generation in Nigeria.
Fig -1: Gas-to-power value chain
While electricity is generated at the generation end of the value chain, the revenues to pay the entire power sector, and the natural gas producer, is generated at the customer metre point. Service providers in-between both ends who provide ancillary and market services, as well as the Regulator, are paid from the revenues as well.
The MYTO methodology sets tariffs for the three electricity sectors namely – Generation, Transmission and Distribution, based on certain key assumptions and inputs. The focus of this article is to highlight these key assumptions and inputs in these three sectors which gives rise to the final tariffs, which we pay as electricity consumers.
Determining Wholesale Generation Tariffs under MYTO:
Generation units are of two types – existing generation units (successor Gencos) and new generation units (IPPs). Following from this broad categorisation of generation units, the MYTO methodology employs two methods for setting generation wholesale prices for these two types of generation units:
1. For existing generation units (Successor Gencos), the wholesale generation tariff is derived using the Long Run Marginal Cost (LRMC) approach for the most economically efficient new entrant in the generation sector. The MYTO model assumes the Open Cycle Gas Turbine (OCGT) is the most economically efficient generation plant. The LRMC approach involves calculating the full (life cycle) cost of the lowest cost new entrant generator, taking into account current costs of plant and equipment, returns to capital, operation and maintenance and fuel costs.
The selection of OCGT as the lowest price new entrant is in recognition of the fact that natural gas is the most abundant fuel in Nigeria.
2. For new generators (new IPPs), the Open Book approach is used to determine wholesale generation tariffs. The Open Book approach assumes that each new IPP has an efficient generation technology and a Power Purchase Agreement (PPA) negotiated on an arm’s length basis for the contracted power.
For both approaches, there are broad general cost assumptions that feed the MYTO methodology as highlighted below:
|Capital Costs||Capital costs include the following:
· EPC Costs
· Land Acquisition
· Site specific costs (infrastructure, water, etc)
· Capital Spares
· Connection to the transmission network
· Fuel handling/storage
|Cost of Capital||The cost of capital (debt and equity) is an important component of wholesale generation tariffs and is intended to provide a return on existing assets and appropriate incentives for future investment. The cost of capital is derived using the Weighted Average Cost of Capital (WACC) methodology.
|Operations and Maintenance (O&M) Costs||These are the expenses that the generator incurs in providing service to its customers. They include the cost of labour, materials, rent, etc. O&M costs are key cost components in generation and comprise Fixed O&M costs and Variable O&M costs.
|Fuel Cost||Fuel cost is the price of natural gas as well as the cost of transporting the natural gas to the power plant. The price of gas is a pass-through cost.|
|Grid Connection||Cost of connecting to the National Grid operated by TCN|
Besides the costs inputs, there are technical assumptions and inputs that also affect the price of wholesale generation tariffs. These technical inputs are as follows:
|Technology type||Open Cycle Gas Turbines (OCGT) Combined Cycle Gas Turbines (CCGT), Coal fired, Renewables, Nuclear|
|Plant Capacity||Installed capacity of the generation plant
|Available Capacity||Actual capacity that the plant generates
|Capacity Factor||This is the ratio of the actual output of a power plant over a period of time, to its potential output if it were possible for it to operate at full nameplate capacity continuously over the same period of time
|Heat Rate||Refers to the efficiency in converting gas thermal energy into electrical energy
|Auxiliary requirements||This is the internal energy/electricity use in the power station
|Plant life||This is the life over which costs are recovered. MYTO assumes that plant life is 20 years, which is usually, linked to the tenor of the PPA.
|Plant Availability||The proportion of time in any operational year that a plant is available to generate.|
|Gross Generation Capacity Sent Out to Grid (GWh)||This is the total electrical energy that is put on the transmission grid and is the true actual measure of power generation.
This is a significant variable in electricity tariff determination. Under MYTO 1, projected generation capacity was put at 4000 MW for 2008; 6000 MW for 2009; 10,000 MW for 2010; and 16,000 MW for 2011. Same aggressive generation projections were also assumed for MYTO 2. However, none of the projections were ever achieved causing additional major disequilibrium in the market and contributing very significantly to the suboptimal performance of the MYTO methodology in properly setting tariffs.
In addition to the cost assumptions and technical assumptions and inputs, there are macro-economic assumptions and inputs that are factored into determining wholesale generation tariffs. These economic assumptions are as follows:
|Inflation Rate||The rate of inflation in Nigeria as measured by the NBS (in some cases the US – CPI for dollar denominated costs). In the MYTO, the rate of inflation is used to ensure that investors are well compensated against rising cost of doing business in Nigeria and workers in the power sector are paid living wages.|
|Exchange Rate||The MYTO model assumes the official CBN exchange rate plus a 1% premium. The Exchange rate is a key variable in wholesale electricity tariffs as lot of components and services in the power sector are procured offshore. Besides, the price of gas is denominated in dollars.|
Capacity Charges and Energy Charges
Wholesale generation tariffs are broken into two main parts: Capacity Charges and Energy charges. Capacity charges are the charges that accrue to Gencos to enable them recover the cost of the power plant as well as their return on capital over the life of the PPA. Energy charges are simply the cost of the fuel (natural gas). The cost of natural gas is a pass through cost in the electricity tariff. By Pass Through cost, it means that the cost of natural gas is borne directly by the electricity customer and not the Genco. Natural gas is sold as a dollar denominated commodity and the dollar price of gas is a direct pass through cost in the tariffs.
With the state of the economy, uncertainties in the foreign exchange market and a rising inflation rate, we may soon see wholesale generation tariffs go even higher.
The Inflation Rate and Exchange Rate escalate both the Capacity Charge and the Energy Charge during semi annual reviews of the MYTO. Any official devaluation of the naira will immediately escalate wholesale electricity tariffs in an exponential manner. So also any growth in inflation rate. With the state of the economy, uncertainties in the foreign exchange market and a rising inflation rate, we may soon see wholesale generation tariffs go even higher. (To be continued).
Odion Omonfoman is an energy consultant and the CEO of New Hampshire Capital Ltd. Please send feedback to firstname.lastname@example.org