The Fiscal Cost of Iraq’s Electricity Sector and Potential Gains from Reform

This chapter examines the fiscal burden stemming from the challenges of Iraq’s electricity sector and discusses elements of a potential reform strategy to help the sector provide adequate supply while moving closer to cost recovery.

Abstract

This chapter examines the fiscal burden stemming from the challenges of Iraq’s electricity sector and discusses elements of a potential reform strategy to help the sector provide adequate supply while moving closer to cost recovery.

The Fiscal Cost of Iraq’s Electricity Sector and Potential Gains from Reform1

This chapter examines the fiscal burden stemming from the challenges of Iraq’s electricity sector and discusses elements of a potential reform strategy to help the sector provide adequate supply while moving closer to cost recovery.

A. Background

1. Iraq’s electricity sector imposes high social and economic costs on the country. Weak service provision has long been a source of grievance for the public as grid-supplied electricity coverage falls short of the 24 hours, prompting citizens and businesses to increasingly rely on costly, noisy and polluting private fuel-based neighborhood generators. In addition to contributing to Iraq’s socio-economic fragilities, lack of reliable access to electricity has also constrained private sector development. More than half of Iraqi firms identify electricity as a major constraint, second only to Yemen in the region, according to Enterprise Surveys conducted by the World Bank. Expenditures on electricity consume sizable amounts of public and private resources, with some accounts estimating that more than $80 billion went into the sector since 2003 (Al-Khatteeb, 2015).

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Enterprise Survey: Electricity

Citation: IMF Staff Country Reports 2023, 076; 10.5089/9798400231759.002.A002

Source: World Bank Enterprise Survey.

2. The sector has been caught in a cycle of inefficiency, loss-making and under-investment. Weak maintenance and underinvestment result in inefficient production processes and financial losses, which, in turn, crowd out the resources needed for maintenance and efficiency enhancing investments. While most of Iraq’s power generation capacity is designed to run on natural gas, the critical gas-to-power value chain remains underdeveloped, and around half of Iraq’s associated gas is being flared with adverse environmental, health, fiscal and balance-of-payments outcomes.2 As a result, many generation plants use less efficient and more polluting liquid fuels while the rest of the sector depends on imports of gas and electricity from neighbors.

3. There is an urgent need for comprehensive reforms which have been elusive in the past. Several plans for reform and commercialization were drawn over the years but were not implemented due to security challenges, political instability, and governance issues. On the supply side, prioritization of generation in resource allocation combined with significant damage to large parts of the transmission and distribution grids further compounded technical and commercial losses.3 Attempts to raise tariffs and increase private sector involvement were strongly resisted, and the authorities have been unable to stem electricity theft and improve collection. As a result, the sector remains dominated by the state and highly reliant on subsidies and budgetary support.

4. The paper focuses on the fiscal burden imposed by the sector, key elements of a reform strategy and potential fiscal gains. The rest of the paper is structured as follows: section B overviews the key trends in the sector, section C focuses on the fiscal cost of the sector, while section D looks at the potential fiscal impact of various reform strategies and makes policy recommendations to enhance the sector’s fiscal sustainability.

B. Recent Trends in the Electricity Sector

Since 2003, Iraq has added sizable generation capacity in an effort to catch up with growing demand. Nameplate capacity has more than quadrupled since 2003 reaching 35.9 GW in 2021, of which, 20 GWs representing mostly gas-fired generation plants were added since 2003 through investment projects by the Ministry of Electricity (MoE).4 More recently, in light of investment budget constraints, the authorities have enlisted independent power producers (IPPs) which contribute 5 GW. Interconnection lines with Iran and private producers in the Kurdistan region (KRI) add around 2.4 GW to available capacity. The bulk of Iraq’s electricity is produced from fossil fuels: aside from 1.8 GW in hydroelectric capacity (which was installed prior to 2003) no major sources of renewable energy have been added in the past 18 years.

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Nameplate Generation Capacity

(In GW)

Citation: IMF Staff Country Reports 2023, 076; 10.5089/9798400231759.002.A002

Sources: National Authorities and IMF staff calculations.

6. However, actual supply falls significantly short of nameplate capacity due to inefficiency.5 Generated electricity peaked at 21.1 GW in 2021, only 59 percent of nameplate capacity. The under-utilization by 14.8 GW of total capacity is mainly attributed to (i) obsolesce and weak maintenance, (ii) use of suboptimal fuel mix, as liquid fuel is often used to operate gas-generation facilities to compensate for gas shortages, and (iii) turbine overheating, in the absence of cooling facilities.6 Moreover, technical losses across the supply chain are very high—at 23 percent compared to a peer average of around 14 percent. Another 41.4 percent of production is attributed to non-metered consumption or theft, so that only 35.6 percent of produced electricity is being sold to customers

7. As demand outpaced supply, the electricity deficit widened significantly over the past two decades.7 Between 2003 and 2021, peak demand has grown by an estimated 25.1 GW compared to a 17.7 GW increase in supply. As a result, the electricity deficit has tripled from 3.3 GW 2003 to an all-time high of 10.7 GW in 2021.

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Supply-Demand Gap

(In MW)

Citation: IMF Staff Country Reports 2023, 076; 10.5089/9798400231759.002.A002

Sources: National Authorities; and IMF staff calculations.

8. Neighbourhood generators and demand suppression have helped to close the gap between demand and supply. Small-scale generators, spread across neighbourhoods and operated with subsidized or free fuel, are estimated to have supplied the equivilant of 5 GW in off-grid electricty in 2018, covering roughly half of the electricity deficit. On top of being very noisy and polluting, the electricity produced by them is extremely expensive with tariffs equivilant to around 60-120 USD/kWh compared to an average tariff of around 0.8 USD/kWh applicable to the highest consumption bracket of grid-supplied electricity. High-cost electricity provided by generators is largely unregulated and imposes a heavy financial burden on consumers. The neighbourhood generator industry has grown in scale, and its revenues in 2018 were estimated at around US$ 4 billion—roughly four times what the official electricity sector had collected during the same period (IEA, 2019). The rest of the deficit is closed through consumption rationalization.

9. Economic and population growth coupled with absence of metering and demand management policies were the main drivers of the rapid demand growth. Iraq’s per capita electricity consumption has doubled since 2003 to levels comparable with oil importers in the region, yet it remains lower than in oil-exporting regional peers, particularly countries of the Gulf Cooperation Council (GCC). Non-metered consumption has been the largest contributor to demand growth followed by residential customers. On the other hand, Government consumption has been declining on average since oil prices collapsed in 2014 reflecting government efforts to constrain spending and rationalize electricity demand.

10. To supplement public investments, the government has attracted private sector participation, although it gained traction mainly in the generation stage. Several attempts were made to involve the private sector across the value chain. A pilot for private sector management of distribution in Baghdad, for example, saw initial success before being overturned under pressure from vested interests, most importantly those connected to the neighborhood generator industry.8 Private sector participation in generation, however, found significant traction with the authorities to overcome insufficient investment allocations for new generation capacities. Between 2018 and 2021, 5 GWs in gas and fuel generation capacities were commissioned by 7 IPPs. The majority of IPPs are contracted on a take-or-pay basis and are supplied subsidized fuel by the Ministry of Oil (MoO).9

11. Imports of fuel and electricity have been rising to overcome insufficient fuel supply. The growing gas deficit amid rising demand and stagnating domestic supply prompted imports of Iranian gas starting in 2017, in addition to imports of electricity through four cross-border high voltage transmission lines. The accumulation of arrears, geopolitical tensions and climate shocks in Iran have often affected the reliability of imports resulting in occasional major power shortages. The federal government also purchases electricity from private producers in the KRI and, in recent months, announced plans to import electricity from Turkey, the GCC countries, and Jordan, as well as liquefied natural gas (LNG) from Qatar.

C. The Cost of the Electricity Sector

12. The electricity sector’s costs far exceed its revenues and the deficit has been widening. Explicit operational costs10 are often 10 times the sector’s revenues or higher, implying significant losses and financing needs to maintain service provision. In 2019, for example, the total explicit operational costs amounted to ID 11.0 trillion ($9.3 billion or 4.0 percent of GDP), while revenues were less than ID 1 trillion. Moreover, explicit costs have increased significantly in recent years along with the rise in electricity purchases and imports.

13. In addition to the explicit cost, significant resources go into subsidizing domestic fuel used in electricity generation which further raise total costs. The MoO sells domestically produced natural gas, crude and fuel oil to the electricity sector at highly subsidized prices, which are fixed in Iraqi dinar regardless of movements in international energy prices or exchange rates. Natural gas is sold at the equivalent of $1.0/MMBTU (down from $1.3 before the dinar devaluation in 2020), while crude and fuel oil are sold at the equivalent of $5.5/barrel and $19/barrel respectively (down from $6.7 and $23.5 per barrel before the devaluation). In 2019, these prices represented 16, 11 and 46 percent of their respective international prices implying an additional cost of ID 6.4 trillion in implicit subsidy. By including the implicit cost, the total cost of the electricity sector in 2019 amounted to ID17.4 trillion (6.3 percent of GDP).

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Electricity Cost: 2019

(In ID trillion)

Citation: IMF Staff Country Reports 2023, 076; 10.5089/9798400231759.002.A002

Sources: National Authorities; and IMF staff calculations.

14. Fuel and electricity purchases are the largest cost component. Fuel is the largest cost item with imported gas representing a quarter of explicit costs in 2019, followed by subsidized domestic fuel with 21 percent, even though the latter underlies 63 percent of generated electricity. Purchases and imports of electricity from IPPs, Iran and the KRG together make up a little more than another quarter of total cost. The last quarter is split between wages, which represent 11 percent, and other costs. Accounting for the implicit subsidy, domestic fuel becomes the largest cost item by 50 percent of total cost, which is more in line with its share in generated power.

15. Meanwhile, the sector has struggled to mobilize tariff revenue. While collected revenues almost doubled between 2013 and 2020, they remain far short of costs or potential. In 2020, it is estimated that the sector supplied electricity, including non-metered consumption, valued at ID 4.2 trillion at prevailing tariff rates.11 Of this amount, only about ID 1.7 trillion was billed to consumers and less than half (ID 0.8 trillion) collected. Since electricity demand has been driven by non-metered consumption, revenue has failed to benefit from the rapid expansion in supply. An attempt to increase tariffs in 2016, which was partially reversed in 2017, mostly led to increased electricity theft and non-payment with little impact on collected revenues.

uA002fig09

Electricity Sector’s Revenues

Citation: IMF Staff Country Reports 2023, 076; 10.5089/9798400231759.002.A002

Sources: National Authorities and IMF staff calculations.

16. Through implicit subsidy and internal arrears, MoO underwrites a significant portion of the electricity sector costs which are eventually passed on to the budget. While the implicit subsidy is not recorded as an expenditure on the budget, crude oil and products directed to domestic electricity generation reduce the volumes available for export and hence affect export and budget revenues. Even at the subsidized prices, the electricity sector has been unable to fully pay domestic fuel bills to MoO. Inability to recover its costs or stop supplying domestic fuel, in order not to disrupt electricity supply, have prompted MoO to reduce distribution of dividends by its state-owned enterprises (SOEs) to MoF citing liquidity shortages. Cumulative arrears to the oil sector have been consistently rising over the years reaching around ID 23 trillion in 2021(7.7 percent of GDP).

17. The rising explicit costs and financing needs of the electricity sector have been increasingly borne by the government budget. In 2019, the budget covered ID 6.7 trillion or 60 percent of the electricity sector’s explicit costs, up from only 9 percent in 2015. Spending on electricity represented 7.7 percent of the government’s current expenditure envelope in 2019, up from only 1.3 percent in 2015. The budget prioritizes funding purchases of gas and electricity which represented 82 percent of the total purchases of goods envelope in the budget. In addition to current expenditures, the electricity sector is allocated a significant portion—as much as a tenth in some years—of the non-oil public investment budget. Since 2017, an average of 5 percent of the government’s total expenditures were directed to the electricity sector. Purchases of goods for the electricity sector represented 82 percent of the total purchases of goods envelope in the budget.

18. Part of the deficit is financed through external arrears, especially when budget allocations are constrained. Since 2019, the sector started incurring arrears to Iran and IPPs which increased significantly in 2020, affecting the regularity of supply and leading to intensified power shortages in Iraq. The past stock of arrears was settled in 2022 using allocations from the Emergency Law for Food Security and Development but new arrears for the year have already been accumulated due to insufficient allocations for current import payments.

D. Strategies for Reform and Policy Recommendations

19. A continuation of past trends and policies could undermine the financial sustainability of the sector and public finances. Attempting to close the supply-demand gap, by adding fuel-based generation capacities, either through IPPs or directly by MoE, would see technical and financial losses multiply. Meeting the growing demand would require more than doubling 2021 supply by adding 19 GW over the medium term. Such an increase amid limited supply of natural gas would lower the share of gas in the fuel mix from 54 to 35 percent reducing plant productivity and fuel efficiency. Meanwhile, increased liquid fuel consumption would more than double to 0.9 mbd crowding out oil exports. Moreover, without significant upgrades, the transmission and distribution networks may not be able to handle the increased volumes; and with little ability to meter consumption and collect bills, costs will be difficult to recover. As a result, attempts to close the supply-demand gap using past strategies would lead to losses more than doubling to ID 55 trillion by 2027 (12.6 percent of GDP) from ID 19 trillion in 2021 (6.5 percent of GDP).

20. The authorities have begun to change track. Their US$31 billion reform and investment plan envisions adding 28 GW to supply to close the demand gap and build a strategic surplus buffer. The supply additions would come from efficiency enhancing investments (13 GW) and new power stations (25 GW), of which 3.5 GW would be based on solar energy. As part of the plan, domestic natural gas production will be significantly boosted through gas capture projects to enhance the fuel mix in new and current generation plants. The plan also envisages spending US$ 11.5 billion over the medium term to upgrade the transmission and distribution networks to reduce technical losses.

Table 1.

Iraq: Electricity Sector Financial Balance

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1/ The current policies scenario assumes new capacities are contracted by IPP in return for a fee that includes capital cost, given lack of sufficient budget allocations for investments, The authorities plan for 2022-2027 costs US$ 31.2 bn in investments, of which US$20 bn are effeciency enhancing and are assumed in the reform scenario.

21. Nevertheless, these measures alone would not ensure financial sustainability. On top of the sizable investment costs, the operational deficit would rise to ID 41 bn by 2027 (9.4 percent of GDP) and significant amounts of liquid fuel will continue to be required to operate the additional capacities, even with domestic natural gas production doubled. In this context, the authorities’ current plans could be further enhanced by prioritizing the following:

  • Maximizing the productivity of existing assets and fuel allocations through targeted investments and a regular maintenance schedule. Reducing the underutilization of existing generation capacity and the excess technical losses would help to significantly narrow the supply demand gap. Prioritizing allocations for a regular maintenance schedule and targeted investments (e.g. by installing coolers to prevent overheating and converting single-cycle turbines to combined cycle) would significantly improve productivity without raising demand for fuel, hence yielding the most return on investments. In parallel, upgrading the transmission and distribution network will be critical to reduce both excess technical and commercial losses, thus helping to contain demand and mobilize tariff revenues.

  • Accelerating gas capture plans to avail more gas for generation. While the ability to use alternative fuels in gas-fired stations allows operational flexibility, it reduces turbine productivity and should be minimized. While requiring significant investments, capturing the gas that is currently being flared—in addition to significant environmental benefits—can potentially add more than 4 GW in power supply, free up significant oil volumes for exports, and reduce import dependence12. An important priority toward this end is streamlining and standardizing gas capture agreements to ensure transparency and investing in the infrastructure for the capture, storage, transportation, and treatment of the natural gas to be used in power plants.

  • Leveraging private resources and renewable sources of energy. New generation capacity should primarily come from renewable energy sources which are more cost efficient and environmentally sustainable. Iraq is among the top countries in solar power potential. Rapid technological advancements in recent years have significantly brough down costs of renewable energy to levels competitive with fuel-based generation, while reducing pressure on fuel resources. Another particularly useful feature of solar energy for Iraq is that it can be deployed in different scales varying from large IPP-operated solar parks, as in regional peers, to small rooftop mounted cells, which could reduce citizen’s reliance on neighborhood generators. Formulating a clear regulatory and contractual framework would help accelerate adoption including by streamlining land allocation and offtake agreements with IPPs and developing a net metering scheme to encourage rooftop installation by residential consumers. Additionally, as in other countries, the authorities could consider fiscal and monetary incentives for the purchase and financing of solar panels and energy efficient equipment.13

  • Strengthening demand management policies to contain demand and help close the supply-demand gap through increased energy efficiency. Without measures to slow demand, the supply-demand gap will continue to be a moving goalpost. Combating non-metered consumption and electricity theft will be of paramount importance to the sustainability of any investment strategy. It will require accelerated upgrading of the distribution network and rolling-out of smart meters. Given the length of time needed to setup this infrastructure, it will be critical for the authorities to set the process in motion at the soonest. Revising the tariff structure so that vulnerable groups continue to receive low-cost lifeline service while tariffs for high consumption tiers reflect the economic cost of service will be the next step14. Time of day and day of week charges can help shift non-essential and industrial consumption to non-peak hours reducing overall peak demand. In parallel, promoting the adoption of energy efficient lighting, appliances and building materials is a no-regret measure that will help contain demand and save on consumers hefty neighborhood generator bills.

22. Staff estimates that such policies would allow a gradual reduction of the electricity sector’s annual cost by an additional 2.6 percent of GDP over the medium term. Strong demand management measures would reduce the need to expand supply15. The increase in supply would primarily come from efficiency enhancing investments which would raise the productivity of current capacities. Renewable energy would make up the difference by adding 6 GW16. Capturing and redirecting flared gas to stations would significantly enhance fuel efficiency helping to contain costs. In parallel, improved quality of service and better management of an upgraded transmission and distribution network would facilitate metering, collection and tariff adjustment helping to mobilize tariff revenue and recover costs. As a result, the sector’s deficit can be contained at ID 29 bn by 2027 (6.7 percent of GDP).

23. Strengthening of public financial management will be critical to enable electricity sector reforms. Centralized monitoring of all the sector’s costs and liabilities, including implicit costs borne by MoO, at the Ministry of Finance will be essential to have a clear view of the total burden imposed by the sector, develop adequate financing plans and consolidation policies, and to avoid build-up of hidden costs and arrears. Alongside, a clear strategy to finance the sector’s large investment needs and transparent implementation will be critical. Given the scarcity of financial and fuel resources, the strategy should look to sequence and prioritize investments and frontload those with significant efficiency enhancing gains. The strategy should also consider whether the public or the private sector is better suited to undertake each project and ensure efficient implementation within a public investment framework.

24. Intergovernmental coordination, public communication and transparency will be equally important. Close coordination between different government entities—most importantly the ministries of finance, planning, oil, and electricity—will be of particular importance in the allocation of costs and financing, the resolution of internal and external arrears as well as fuel provision and advancing on gas capture and renewable energy plans. In parallel, clear communication with the public and explicit recording of the sector’s true cost in the budget would help inform societal debate and increase public buy-in for tariff collection and restructuring efforts. Transparent contractual and regulatory frameworks for gas capture and renewable energy generation would encourage private sector investments in these areas.

References

  • Al Khafaji, Hayder, 2018. “Electricity generation in Iraq problems and solutionsAl-Bayan Center for Planning and Studies

  • Al-Khatteeb, Luay, Istepanian, Harry, 2015, “Turn a Light On: Electricity Sector Reform in IraqForeign Policy at Brookings

  • Al-Saffar, Faisal, and others, 2021, “Iraqi Electricity Sector OverviewKAPITA

  • Energy Agency (IEA), 2019, “Iraq’s Energy Sector A Roadmap to a Brighter Future

1

Prepared by Moheb Malak.

2

Iraq is the second largest source of gas flaring after Russia, according to World Bank Global Gas Flaring Reduction Partnership (GGFR).

3

Almost one fifth of Iraq’s electricity network was destroyed during the ISIS insurgency with damages amounting to US$7 billion according to the World Bank’s Damage and Needs Assessment report.

4

Nameplate capacity refers to the maximum possible generation capacity under optimum conditions including regular maintenance, ideal temperature, and fuel input according to the manufacturer.

5

Supply refers to actual electricity produced in the generation stage before technical and commercial losses in the transmission and distribution stages. Peak supply refers to the maximum rate of electricity generation, which usually takes place in the summer months, even if not sustained throughout the year.

6

Unutilized capacity refers to the gap between nameplate capacity and peak supply.

7

Estimates for actual demand are uncertain due to its suppression.

8

In 2016, pilot projects were implemented in parts of Baghdad that increased tariffs in return for guaranteeing supply. Consumption of electricity was reduced by 30% and collection rates improved. But opposition from political and business groups has halted the pilot (KAPITA, 2021).

9

Under take-or-pay provisions, the offtaker or buyer, who in this case is the Iraqi government, is required to pay the IPP for a minimum portion of the standing capacity even if it did not receive the electricity, for example in case it failed to secure sufficient fuel supply or due to losses in the transmission network.

10

Explicit operational costs, hereafter explicit costs, refer to operational costs excluding the implicit subsidy for domestic fuel used in generation as well as investment and capital costs. In contrast, total operational costs, hereafter total costs, are those including the implicit fuel subsidy but still exclude investment or capital costs. While total costs are a better measure of the sector’s true financial burden, explicit costs better proxy MoE’s operational financing needs.

11

The estimate is calculated by applying the average effective tariff rate from the sold portion of supply to the non-metered volume.

12

The investment cost needed for gas capture and elimination of gas flaring in Iraq was estimating at $29 billion in the World Bank’s 2022 Climate Change Development Report.

13

The Central Bank of Iraq has recently launched a lending support program for green investments in the amount of ID 1 trillion.

14

A World Bank commissioned report on “Cost of Service and Tariff Design/Rationalization Study for Electricity Supply in Iraq” includes more detailed recommendations for tariff design by consumer type.

15

Demand projections in this scenario assume an annual 10 percent increase in tariffs starting 2024 with a demand elasticity of -0.2.

16

Iraq’s Nationally Determined Contribution to the Paris Agreement (NDC) envisages adding 12 GW in renewable energy capacity by 2030.

Iraq: Selected Issues
Author: International Monetary Fund. Middle East and Central Asia Dept.