Tariff Series: Understanding Electricity Tariffs 

There is a price associated with most goods and services. This price may not be borne by the consumers but may be covered either in part or in full, by other entities such as governments and charitable entities. What is important to note is the existence of a “price”. The same principle applies to electricity, it has a price that represents the cost of making electricity available to customers when for example, a light switch is flicked on. This price is called the electricity tariff, and in Nigeria, is determined by the Nigerian Electricity Regulatory Commission (NERC). In this article, we will look at the Nigerian electricity tariff methodology and electricity price cost components.

A tariff methodology is simply the procedure or steps applied in the calculation of a tariff or the calculation steps in determining tariffs. According to the Electric Power Sector Reform Act (EPSRA) 2005, NERC must abide by the following key objectives when setting end-user tariffs:

1. Make prices fair to consumers.
2. Ensure that prices allow the licensees/commercial stakeholders to finance their activities.
3. Ensure that prices allow the licensees/commercial stakeholders to make a reasonable profit for efficient operation.
4. Ensure that the licensees/commercial stakeholders with efficient operations recover the full cost of their business activities and earn a reasonable return on capital invested.
5. Ensure that stakeholders are encouraged to improve their technical and economic efficiency and the quality of services they provide.

Based on these principles, NERC has adopted an incentive-based tariff methodology for the Nigerian Electricity Supply Industry (NESI). An incentive-based approach seeks to reward performance above certain set benchmarks in a bid to encourage improved outcomes, for example, certain organisations reward their staff with bonuses for achieving sales targets. NESI’s tariff  methodology can be categorized into three (3) major building blocks, which are:

• Allowed Return on Capital – This is the interest recovered on the capital investment made by an investor. For example, the cost of buying a transformer.
• Allowed Return of Capital – This is the recovery of the capital invested in buying infrastructure or building/developing the infrastructure. For example, the depreciated cost of the purchased transformer.
• Efficient Operating Costs and Overheads – This is the actual cost the business incurred in providing services to customers. For example, the staff and maintenance costs associated with the transformer.

Operating as a licensee in the electricity sector is capital intensive requiring significant ongoing investments in power equipment and infrastructure, and operational expenses for service delivery. Therefore, to remain profitable, the income streams of a licensee business should provide a return of capital, a return on capital, and efficient operating costs and overheads to ensure it can operate efficiently.

A prudent recognition of these costs in the tariffs enables licensees to guarantee a stable and reliable electricity supply, which ensures customer satisfaction and incentivizes licensee investors to continue investing. As a result, NERC is legally responsible for protecting the interests of customers and licensees operating in NESI, ensuring that tariff components are determined fairly and efficiently and that the price paid for power is commensurate with the quality of service received.

With the three (3) building blocks, NERC sets a tariff for the end-user that consists of the entire value chain costs involved in providing electricity. These include generation, transmission, distribution, and administrative costs. Along with these costs, NERC also applies macroeconomic, grid performance, and energy supply assumptions to the tariff. Some of the assumptions include:

• Nigerian Inflation/US inflation
• Foreign exchange rate – (Naira/$)
• US consumer price index (CPI)
• Weighted Average Cost of Capital
• Gas price
• Generation capacity
• Energy generated
• Aggregate Technical Commercial & Collection losses (ATC&C) – Electricity Losses

The assumptions mentioned above will be addressed in Part 5 of our tariff series. In this article, the key focus is on the costs.

There are three main sectors in the NESI value chain: generation, transmission, and distribution. The costs attributed to each of these sectors are contained in the end-user tariff. Apart from these costs, the regulator and supporting agencies with administrative functions also have embedded cost components in the tariff.

A. Generation Cost

There are two main costs in the generation sector of the NESI value chain:

• Capacity charge
• Energy charge

Electricity generation tariff is made up of 2 components, capacity, and energy. Capacity, denominated in Megawatts (MW), is the amount of electricity a power plant was designed to produce, while energy is the amount of electricity the power plant produces within a given time denominated in Megawatt hours (MW/h).

The capacity and energy charge account for two different things.

To illustrate this difference, let’s assume I patronise a car hire service that charges a fixed fee for renting a car and an hourly service fee for using a driver. If I spend 6 of those hours at work, it means I can only be driven for 2 hours. Therefore, I will pay the fixed fee representing the car’s availability for 8 hours but will only pay for using 2 hours of the driving service. The fixed fee is similar to the capacity charge while the service fee I pay for using the driving service is the energy charge.

The capacity charge compensates the Generation Companies (GenCos) for the portion of their power plant that is made available to generate electricity at any time while the energy charge covers the actual amount of electricity that is generated and sent out of the plants.