This article first appeared in The Edge Malaysia Weekly on January 1, 2018 - January 7, 2018

THE Ministry of Energy, Green Technology and Water’s (Kettha) announcement last week — that electricity tariffs will be kept unchanged at 38.53 sen per kWh until 2020 — is scarce in important details.

Furthermore, it appears that the government will be footing a RM929.3 million subsidy bill for the next six months to keep the tariffs unchanged.

So far, the market seems to have taken the news positively, with Tenaga Nasional Bhd’s share price gaining 1.9% week on week to close at RM15.26 last Friday.

But what are the implications of the announcement for TNB?

First off, the announcement has two elements. The first is the average tariff rates, which have been maintained at 38.53 sen per kWh for the next three years. This is known as the second regulatory period, or RP2. RP1 ran from 2014 to 2018.

To put it simply, the government calculates and determines the average tariff rates that TNB can charge consumers each period. For RP1, the tariffs were increased by 4.99 sen per kWh.

Note that only the average tariff rates have been maintained for RP2. Fluctuations in fuel prices — which are passed on to consumers via the imbalance cost pass-through (ICPT) mechanism — have not been taken into account.

For the next six months at least, the government has agreed to subsidise the ICPT component of the tariff, or 1.8 sen per kWh. This will result in an out-of-pocket expense for the government, and will add up to an estimated RM929.3 million. This is the second element of the announcement.

Implications of keeping tariffs unchanged

Since 2014, TNB has been operating under the incentive-based regulation (IBR) framework, which determines the returns from its regulated assets as well as the additional capital expenditure that will be granted to the utility.

Regulated assets refer to TNB’s transmission and distribution assets, among others. Basically, these are businesses in which the company holds a structural monopoly. The regulators prescribe a fixed internal rate of return for these assets and also ensure that TNB meets certain key performance indicators (KPIs). Furthermore, the tariff can be adjusted to provide more funds to the utility to invest in additional regulated assets.

Investors familiar with TNB will recognise this business as the core reason it is highly sought-after by fund managers — it generates incredibly stable returns in the long run with minimal operational risks.

Thus, it is in the best interest of shareholders that the base of the regulated assets continues to grow. This means that TNB needs to invest more in capex in each regulatory period.

In RP1, 18% of the tariff hike pertained to TNB’s increased capex needs. This was simply referred to as the base tariff revision and worked out to 0.9 sen per kWh, translating into a large sum of money for TNB.

Based on the total sales of 108,858 GWh in 2016, a base tariff of 0.9 sen per kWh translates into RM979.7 million in additional revenue.

So, is TNB worse off without a tariff revision?

That depends.

First off, the announcement by Kettha was unclear. While the average tariff will remain at 38.53 sen per kWh, the ministry has been tight-lipped about the impact on TNB’s capex.

According to industry sources, however, TNB will enjoy a slight revision to its base tariff. The exact quantum is unknown, but it means that the utility will be receiving more cash to invest in regulated assets.

This is because TNB’s generation costs have actually fallen substantially since 2014 due to an increased reliance on coal and a near-complete reduction in the use of imported liquefied natural gas (LNG).

Back when RP1 was calculated, the national grid had been wrestling with the high unavailability of several coal-fired power plants due to unscheduled outages. This forced TNB to rely on its gas-fired power plants. In turn, it had to consume substantially more gas.

This meant that TNB had to import LNG, which is substantially more expensive than the regulated natural gas that Petroliam Nasional Bhd supplies to the grid. At the time, LNG had cost about RM46.02 per MMBtu, roughly triple the price of regulated natural gas of RM15.20 per MMBtu.

Since then, however, the technical issues plaguing the coal-fired power plants have been resolved. On top of that, a number of new coal-fired power plants have come on stream, while a few gas-fired power plants have been decommissioned.

As a result, TNB today uses virtually no LNG, while the percentage of coal it consumes has increased from 43% to nearly 53%.

Note that the price of both coal and regulated gas has increased by 46% in the same period. But overall, TNB’s generation costs are still slightly lower, providing it with buffer funds that may be used for additional capex.

The exact quantum, however, is not known. Its capex will also be highly constrained since the average tariff has been capped by the ministry — a cap that is unlikely to change given the impending general election.

One source with knowledge of the matter says this has resulted in deferments and the downsizing of TNB’s non-critical capex.

“TNB had originally planned to deploy three million smart meters in RP2 but this has since been reduced to 1.5 million. Some other projects that have been deemed non-critical have also been postponed to RP3. However, critical investments are still in place.”

In short, TNB will be getting more money for capex but it will be less than it had hoped for. More details are expected from the regulators in the coming weeks.

Implications of subsidising ICPT

On paper, the government’s move to subsidise the ICPT should be neutral for TNB. However, it sets an uncomfortable precedent for the utility.

The ICPT mechanism is supposed to allow TNB to reflect the changes in fuel and generation costs in consumers’ electricity tariffs every six months. But the government’s decision sets an expectation for consumers that the tariffs can be artificially depressed.

Furthermore, energy prices appear to be reaching an inflection point. LNG is less relevant to the grid today, but coal prices have gained almost 37% since June, with the Newcastle coal futures touching US$100 a tonne last week.

Keep in mind that there has been a sharp pivot towards coal, which is expected to meet 57% of Peninsular Malaysia’s energy needs.

Couple this with the government’s tight fiscal position and it puts TNB in an uncomfortable position — caught between the government’s populist agenda and tenuous fiscal position.

It brings back memories of the gas shortage of 2012 and 2013 that ended up costing RM3 billion because TNB was not allowed to increase electricity tariffs. The costs were eventually shared between TNB, Petronas and the government.

While the current tariff regime is substantially more robust, reintroducing tariff manipulation comes with a risk that is difficult to quantify — that TNB, one of the country’s most profitable corporations, may once again be called upon to bear the cost of so-called “national service”.

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