1. SUBSIDY ISSUES FOR RURAL ELECTRIFICATION

This paper follows closely the presentation on subsidies made by CORE International at the Colombo, Sri Lanka Workshop on October 29, 2003. The key issues explored in this paper are the following ones:
 · Establishing an effective and transparent system of Rural Electrification (RE) subsidies
 · Creating performance indicators to monitor programs
 · Regulating and adjusting subsidies

2. SUBSIDIES FOR RE ARE COMMONPLACE THROUGHOUT THE WORLD

Subsidies are believed to be needed for RE systems for the following reasons:
* Costs of providing electric service to rural areas is high because of low density
* Low purchasing power of rural population, makes the provision of electric service to rural areas generally not commercially viable
* Lack of industry causes demand to sparse and concentrated around peak hours
* Collections from rural consumers may be difficult

Subsidies can take many forms, both rural electricity utilities (REUs) and consumers may receive subventions. The following are a few of the most common forms of subsidy that most governments provide to promote and accelerate RE:

For the REU, subsidies take a variety of forms:
* Corporate tax holiday for a pre-defined period;
* Other tax benefits such as sales tax relief on imported equipment used for providing electric service;
* One-time grant based on the number of consumers served
* One-time grant based on equipment purchased
* One-time grant for setting up the utility
* Electricity generation tax;
For consumers, RE subsidies are usually limited to three main forms:
* Ongoing subsidy to RE consumers
* Subsidies for the capital component of either a grid connection or for the purchase of distributed generation equipment; and
* Low interest and/or moratorium on interest for some period by domestic development banks on loans to rural electricity providers under a government scheme for rural electric service companies.

Sources of funds for RE will vary a great deal by country and even program, but normally include one or more of the following:
* Subsidy by multilateral and bilateral donors in the form of grant and low interest loans;
* Suppliers credits at low or no interest for equipment and engineering;
* Taxes on generation or transmission to provide for RE fund.

3. EVALUATING SUBSIDIES

Eventually, a government that wishes to both provide RE services and remain financially solvent will need to assess its RE subsidy programs. There are three essential criteria for the financial and technical efficacy and sustainability of such programs:

* Is the subsidy affordable?
* Is the subsidy sustainable - i.e., can you keep meeting the subsidy requirements if demand rises over time?
* What type of behavior does the subsidy promote - constructive or destructive?

In assessing whether the subsidy is affordable, government and regulators usually need to look at the following issues:

* Subsidy as a proportion of value of REU sales
* Sources of funds for subsidy

Affordable in the context of a RE subsidy usually means at least two criteria are met:

* Subsidy is strictly less than annual debt service on sunk costs; and
* There are no operating cost subsidies

Important here are the trends – are demands for RE subsidies rising or falling as a proportion of total costs? Are sources for subsidies broadening or becoming more narrow? Is the Ministry of Finance concerned about RE subsidies? How about the International Monetary Fund (IMF)? Is there a path for consumers to gradually convert to a commercial tariff basis?

Closely related to affordability is sustainability. A system of RE subsidies can be sustainable only if certain traits characterize such subsidies. These traits include the following ones:

* Can the subsidy demand be met now and in the future?
* Are the funding sources, known and secure?
* Does the balance of internal and external funding for RE subsidies move away from external/donor sources over time?
* If operating costs are now subsidized, what is the plan for eliminating this over the next 5 years?

Unfortunately, most current subsidy programs have trouble with one or more of these questions. In particular, the operating cost subsidies and the sources of funds, whether they are domestic RE levies or external financing, are usually not sufficient to provide for a large scale program over a period of many years.

Governments are loath to tax electricity heavily, for fear that a program of sufficient size to truly benefit RE consumers will raise electricity prices enough to make the economy uncompetitive. This fear is well-founded, and thus, even domestic sources for RE subsidies cannot be considered reliable over the long term.

Operating cost subsidies are both pernicious in their effects on utility performance and on the customers that are supposed to benefit from the subsidized electricity. Where electricity tariffs do not cover the cost of fuel or other variable elements, the REU will have a strong incentive to minimize its supply to such customers. As demand by such customers grows, the financial position of the REU will tend to worsen. Eventually, either the subsidies will bankrupt the REU, service will be cut back or dramatic tariff increases will loom.

Foreign donor sources are even more problematic. Where funds are tied to commodity purchases, the cost of the commodities, their suitability, (or not), and their economic lifetimes may be insufficient to outweigh increases in operating costs, additional spares and maintenance and fuel savings, if any. Grant funding is at best an episodic measure, incapable of providing long-term sustainable funding for the RE sector. It is no wonder that eventually governments look to the reduction, withdrawal or modification of RE subsidies as the only viable long-term alternative

Finally, many RE subsidy schemes are initiated without significant thought to the incentive structure that they promote. If subsidies are to be eliminated or reduced, then performance by all of the parties must follow a path of increased productivity, efficiency and financial sustainability.
Designing and enforcing such behaviors will probably fall to the regulator. This subject is addressed in greater detail toward the end of this paper.

The next section shows how better program design and performance monitoring allow a greater impact form a given subsidy budget.

4. METHODS OF GRADUAL WITHDRAWAL OF SUBSIDY

The problem with government subsidies is that no one usually plans an exit strategy. Once the subsidy is put in place, it typically remains there and the governments find it, politically, very difficult to remove the subsidies. No matter how the subsidy is designed and targeted it does have an impact on the performance of the market. Governments, therefore, find themselves in a dilemma — how to design subsidies without affecting the market. The World Bank has done considerable work in this area and offers approaches for subsidy design without distorting the market. The grid or off-grid electricity providers cannot remain commercially viable if they provide
subsidized power and the electric service would deteriorate over a period. Some of the findings of the Bank’s work should be considered by SARI members in designing their RE subsidies. Indeed, many of these measures have already been adopted in one or more of the SARI/E participants. The following offer a few options for consideration:

* Initiate other rural development programs for poverty alleviation of rural population
* Train and employ rural populations in the activities of rural electricity providers
* Create an environment for rural industries that can employ rural populations and encourage rural cottage industries
* Improve educational and health facilities in rural areas
* Involve local NGOs in all aspects and activities for poverty alleviation programs Involve local rural populations in decision making in developing and implementing rural development programs
* Develop a targeted Rural Consumer Education Strategy to emphasize that (i) electricity cannot be provided to them on subsidized rates forever, (ii) the subsidy would be withdrawn over a period in a gradual manner, and (iii) they have to increase their economic condition to afford electricity after the subsidy is completely withdrawn
* Initiate a pricing policy that allows the regulator to set the tariff at a level that protects consumer interests while simultaneously protecting the utility/provider’s financial viability

REVENUE COLLECTIONS
One factor not mentioned in the overall issue of subsidies is revenue collection. Without an ongoing commitment to reducing commercial losses, any subsidy program, no matter how well thought out, will fail. The governments can initiate a number of rules and actions to affect adequate levels of revenue collection from the rural consumer. Some of the mechanisms could include the following:·
*	Develop and implement a mechanism for consumer participation, disclosure and procedures for addressing consumer complaints regarding metering and billing
*	Provide a meter reading and billing frequency that suits the consumer and the electricity provider (preferably monthly or bi-monthly)
*	Change the working route of meter reading and bill serving regularly
*	Tie the sale of technology such as solar home systems (SHSs) to a maintenance contract, which stipulates inspection of the system at a regular interval. The maintenance crew may tie up the collection of the due payments during the nspection visit
*	Tie loan collections to the income cycle of the communities (e.g. Bi-monthly, quarterly, or six-monthly)

5. TRANSPARENCY, SUBSIDIES AND REGULATION – ELEMENTS OF IMPROVED PERFORMANCE

There are many elements involved in improving the performance of REUs. As regards to the role of subsidies, the key elements include the following ones:

* The subsidy is applied in a well-understood and publicly acceptable manner, and
* The desired changes in both REU and consumer

performance can be quantified, measured over time and included in tariff and subsidy decisions. In order for these two elements to be effective, the design and implementation of subsidies should follow the general path listed below:

* The amount is known in advance and is budgeted
* The mechanism for obtaining the funds is understood
* A phase-out plan is included in the program design
* Regulators understand the subsidy and its application

A key element is transparency. Both consumers and the REUs should understand both the financial and performance issues inherent in a particular subsidy program. In particular, there should be clearly defined financial and technical indicators, along with timetables for implementation or achievement of certain targets, to trigger further subsidy and tariff program
elements. Some examples include the following ones:

* Cost targets
* Service extension
* Reliability and safety
* Investment by new participants

Approvals for new subsidy schemes should be keyed to meeting targets. Such a regulatory approach, now known as “Performance Based Regulation” has been implemented around the world. In this region, PBR has even been adopted as a part of one country’s new transmission tariff approach. That is, the tariff moves the transmission system from one with numerous implicit and explicit subsidies to one that is characterized as follows:

* Unbundled costs
* Clear performance targets
* Timetables for achieving these targets
* Incentives for good performance, penalties for missing targets or dates
* System of shared savings for system owners, users of system and customers.

Each stage of the tariff is explicitly described, along with the regulatory, technical and financial elements of meeting the approved targets. This system, which will eliminate subsidies in the transmission system within 3 years, exhibits transparency, fairness and rule of law. Similar approaches in RE will bring great benefits to the countries of the region.