Subir Gokarn: Power-ing ahead?

Mumbai may well be the symbolic power equivalent of the country's gold reserves being shipped to London in 1991.

The Union Budget for 2006-07 came and went. In sharp contrast to last year, when the fringe benefits tax and the cash withdrawal tax provided fodder for criticism for many days after the event, this one barely created a ripple. My own assessment, which was obviously shared by many people, was that, at the very least, it did nothing to hurt the current growth momentum, which was enough to judge it as a good Budget. In fact, it may have done things to reinforce and sustain it. In this regard, though, judgment will obviously have to wait until the promises are delivered on and the benefits become visible.

The most significant of these initiatives is in the power sector. It involves the setting up of an empowered committee of state power ministers to carry forward the process of state-level reforms. In a recent column ("Power points", February 13, 2006), I had described the four critical requirements for enabling a genuine national market for power, which is a key objective of the reform process. These were open access at all levels of the transmission grid, the absence of entry barriers (import duties at the state level), the absence of exit barriers (export taxes at the state level) and the conversion of cross-subsidies to direct subsidies, financed out of the state budget.

While the current central legislation facilitates these, it does not mandate them. In effect, the only way the Centre can get the states to put them into place, other than the rather week-kneed "moral suasion", is by making certain transfers conditional on appropriate measures being implemented. This approach is already being followed in the Accelerated Power Development and Reforms Programme (APDRP), but the objectives and milestones of that programme, while consistent with the more fundamental reform agenda described above, do not go as far as is necessary to achieve it. Besides, even strictly enforced conditionality does not guarantee that enough states will comply at the same time, which is essential to realising the full benefits of the strategy.

State governments have to come to terms with two facts about the power sector. One, the principle of comparative advantage works just as well here as with any other commodity. States that do not have a comparative advantage in generating it will be better served by importing it. Two, economies of scale in generation imply that large, optimally located plants serving a widespread consuming population will reduce the costs of power for all consumers. Both these motivate the need to create as large a market as possible (even across national borders where possible) and concentrate generating capacity as close to fuel sources as possible.

What comes in the way of this ideal state is the basic distrust that state governments show towards one another. This is manifest in a variety of areas, from foodgrains to water. It may be well-founded on historical experience, but it need not be so. In the particular case of power, this sits well with the fragmented, state-specific model of generation and distribution; inefficient self-reliance is preferred to efficient interdependence.

States need to collectively recognise that, with the creation of a national market as visualised by the reform blueprint, every one of them will gain. Some may gain more than others, but this will not be at the cost of anyone else. For an individual state, the most immediate priority is whether its power availability situation will improve in response to a specific course of action; if the answer is an unambiguous "yes", that is all the justification it needs to make the decision.

In fact, some states will realise benefits even if they act alone, with other states not co-operating. This is because of the relatively large pool of captive power sources that will be able to access the market, thus becoming available to all consumers. However, this will be a sub-optimal outcome from a long-term investment perspective. Generating plants of the right scale at the right locations will simply not be viable unless, as argued above, they have access to the widest possible geographical spread of consumers. From the macroeconomic point of view, collective action by all states is by far the superior outcome.

We know the process can work; it eventually did with the value-added tax (VAT). Of course, the VAT model, whose logic is also driven by the objective of a seamless national market for goods and services, is still to reach that goal. It took about seven years for the first concerted step to be taken, in April 2005. But we still have some way to go before the full impact of the system, in terms of tax credits becoming transferable across states, is felt. We simply cannot afford to wait that long for power sector reforms to be implemented. With gestation periods of perhaps four years for efficiently constructed plants, we already run the risk of an "operation successful, but patient dead" outcome. The growth rate will fall victim to power shortages, sooner rather than later.

Interestingly, the two other significant references to the power sector in the Budget, relating to the facilitation of ultra mega power projects (4,000 Mw and above) and enhanced resources for rural electrification, are both dependent for their success on states implementing the reforms. Private sector finance would not consider such an investment, even with all the fiscal benefits, unless it had unrestricted access to a widespread market. Similarly, rural electrification is money down the drain if there isn't any power to flow through the lines that have been set up.

How does the central government get the process going and speed it up? There are at least three things it needs to do right off the bat. One, identify the states with the most to gain on either side of the equation""easing of the supply constraint and flow of investment funds""and persuade them to be the "champions" of reform. Two, as it did with VAT, offer some credible compensation to states to deal with several costs that will inevitably arise. Such an offer could have been made, in general terms, in the Budget speech itself. Three, allocate its own resources over segments and regions in a way that ensures that the immediate benefits will be realised in a relatively equitable fashion.

Mumbai, being subject to power outages, may well be the symbolic equivalent of the country's gold reserves being shipped to London in 1991. Will the summer of 2006 be for the power ministry what the summer of 1991 was for the finance ministry?

The author is chief economist, Crisil. The views here are personal