Problem

Pakistan is a nation with burgeoning energy needs. With a population exceeding 220 million, the demand for energy is escalating. Gas is the linchpin of Pakistan's energy matrix, accounting for nearly 40% of its energy consumption. However, gas consumption has grown so rapidly in recent decades that the country is currently simply unable to fulfill demand and regular loadshedding has become the norm, especially during winter months when demand is at its highest. As Pakistani policymakers grapple with the challenge of meeting the country’s energy needs, there is an additional dimension to consider – climate change. As the 7th most vulnerable country to climate change (add source), Pakistan must also ensure its future energy solutions are environment friendly.

The inability of the gas sector to meet demand stems from multiple factors. Most significantly, Pakistan’s known indigenous natural gas reserves are rapidly depleting. By 2030, official projections indicate that the supply-demand gap will widen to a staggering 4,190 MMCFD, unless significant local reserves are discovered, or importation is ramped up.

Exploration for new reserves is slowed down by policy issues. The widening gap between supply and demand is partially bridged by importing LNG, which is four times more costly and sourced from a fluctuating international market. The situation is worsened by the inadequate transmission and distribution infrastructure that can't keep up with demand and is prone to leakages or theft. Additionally, the two state-owned gas transmission and distribution companies face huge annual losses mainly because of government subsidies to various sectors.

With respect to exploration, an unfortunate mix of government and policy uncertainty combined with a lack of incentives has seen most private sector multinational companies exit the Pakistani market. To fulfill unmet demand, at least partially, the nation has witnessed a marked increase in its dependence on imported LNG. While almost two-thirds of Pakistan’s LNG importation capacity (currently limited to ~1,200 MMCFD) is booked through long-term, fixed-price, government-to-government contracts, the remainder is utilized through spot contracts on the open market.  Alarmingly, LNG available in the spot market can be four times costlier than the gas produced domestically. Moreover, the price of LNG in the international market is subject to volatility, adding another layer of complexity, shown in Exhibit C.

These hurdles, significant in both dimensions and time-scales, call for a nuanced, multi-tiered strategy for both immediate redressal and sustainable long-term solutions.

Immediate-term Solutions

At the forefront is the need to overhaul inefficient pricing and allocation structures that currently plague the system. Transmission and distribution companies, particularly state-owned entities like Sui Northern Gas Pipelines Limited (SNGPL) and Sui Southern Gas Company (SSGC), have been suffering substantial losses annually. These companies, fundamental to the country's gas supply, incurred losses of PKR 18.9 billion and PKR 17.7 billion respectively in 2020, a situation exacerbated by the COVID-19 pandemic's economic repercussions¹

The foremost issue to be addressed with regard to gas pricing in Pakistan, is a comprehensive calculation of cost of gas supply which subsequently determines the prices imposed on various consumers. While this may seem immediately obvious, a major issue that has plagued that gas sector is that the cost of LNG procurement is not accounted for in the overall cost of providing gas to all sectors except for power.  LNG was initially imported in Pakistan in 2015 to specifically help address electricity shortages in the country. Diversion of these imports into the country’s transmission and distribution system to supplement indigenous gas supply was an unplanned measure to address the shortfalls that began to emerge.

The aforementioned SOEs continued to calculate cost of gas supply solely with reference to indigenous extraction, even though expensive LNG was increasingly being added to the mix. The state has recently introduced a Weighted Average Cost of Gas (WACOG) mechanism to enable inclusion of LNG costs. This is a step in the right direction, whereby the actual cost of gas provision is charged from consumers, which should enable significant reduction of losses for transmission and distribution SOEs.

On the other end, the government's fiscal limitations make the current subsidy regime for various sectors untenable, necessitating an immediate revision. Streamlining these subsidies and pricing structures would not only minimize the supply-demand gap but also bolster the financial health of these pivotal entities. Enhanced financial viability could, in turn, spur much-needed investment in gas supply infrastructure, improving its capacity to handle larger volumes efficiently and with fewer losses.

With the limited supply of gas currently available in the country, we must examine the distribution of consumption, as well as understand the state’s rationales for providing increasingly unsustainable subsidies to various sectors which price gas well below the production cost.

The majority of gas supplies in Pakistan are consumed by the power, domestic, fertilizer, and industrial sectors (which we shall examine in greater detail below) and the latter three are subsidized by the state for reasons ranging from inflation control to food and national security.

Gas-powered electricity generating power plants run exclusively on LNG, and do not consume any indigenous gas. These power producing entities pay full price in terms of cost of importation to SOEs such as Pakistan LNG Limited (PLL) and pass on the increased cost to electricity consumers.

Besides concerns regarding electricity prices imposed on consumers (which are in turn subsidized by the state), the power sector does not in fact receive any direct subsidies and does not contribute to the gas sector financial losses. Moreover, there is little room for intervention given the shortfalls in electricity in Pakistan.

In comparison, the domestic sector comprises of ~11,000,000 household connections, belonging to a variety of socio-economic strata with significant variation in their consumption volumes. Domestic consumption is priced in terms of volume consumption slabs, with all household subsidized through progressive slab pricing as consumption increases, along with previous slab benefit, i.e. a household’s volume consumed up to the previous slab’s upper volume limit is charged the previous slab’s price (which tends to be lower), while any consumption above that is charged the actual price of the slab the household lies in. While the decision to subsidize the domestic sector is understandable as a political necessity and from an inflation control perspective but maintaining these subsidies is increasingly difficult. Moreover, such subsidies disincentivize efficient consumption, since the cost of wastage is not significant enough.

A close examination of domestic consumption patterns shows that there is significant disparity in terms of households’ gas consumption, and there is perhaps room for increasing prices for high consumption households. ~78% of all households consume up to 1hm3 (which should be sufficient to fuel a 2-burner stove and 1 space heater) but only account for 48% of total domestic consumption whilst higher consumption households account for the rest. A possible approach to compel higher consumption households to reduce consumption and wastage is to significantly increase prices beyond a threshold such as 1hm3 slab. Ultimately this would also allow the transmission and distribution SOEs to reduce losses from the domestic sector whilst maintaining subsidies for lower consumption households and also reducing overall demand.

The fertilizer industry enjoys perhaps the greatest subsidization by the state after the domestic sector on account of its key contribution to the agricultural sector and the country’s food security. In some instances, certain companies pay less for gas than even the most heavily subsidized domestic consumers. Moreover, several fertilizer production units have dedicated and direct pipelines from indigenous gas reservoirs, which provide them with a fixed supply volume regardless of actual consumption. Gas is not only required as a key production input by the fertilizer sector but is also used as a fuel. Given the unobstructed access to extremely cheap fuel available to fertilizer companies, unsurprisingly all the major players earn substantial profits as evidenced by their publicly available annual profit-loss statements. Whilst controlling fertilizer prices is undeniably important to national interests, there is a need to move subsidies away from fertilizer producers to consumers. This would not only enable the gas sector to recover costs from fertilizer companies but also enable more equitable outcomes by providing relief to individual farmers rather than large corporations.  The state may achieve the same goal of fertilizer price control through direct subsidies to farmers under a coupon scheme, whereby the buyer of fertilizer can receive reimbursement from the state against a coupon code included with each unit sold.

In the industrial sector, gas consumption is subdivided in terms of process (used in production) and captive (used as fuel to power production). Moreover, there is a separate category within the sector for zero-rated export industries which are given price concessions to enable an improved trade balance. With regard to type of use in industry, while process gas is a necessity for these industries to continue, captive use is the private sector’s response to frequent loadshedding that disrupt production. Captive use by industrial concerns generally tends to be inefficient, since these smaller power generation units are unable to attain returns to scale achieved by larger power production units which supply electricity to the relevant transmission and distribution system.

Assurances and guarantees to industry regarding reduced loadshedding and preference in electricity allocation would be essential to curbing the practice of captive power production. This would enable larger amounts of electricity to be produced with the same amount of gas that is currently being used across the power sector itself along with captive power production in industry.

On the issue of special concessions to the export sector, two things need to be addressed

• First, such subsidization means that losses on the balance of payments ledger are merely being transferred to the government’s budgetary deficit, because the government is essentially absorbing part of the cost of production to enable these industries to be internationally competitive. Industries from comparable countries competing in the same export markets as Pakistan pay a much higher price for gas, indicating greater production efficiency is possible without government support.
• Second, this supposed increase in exports is being enabled at the cost of non-export industries which potentially do not enjoy opportunities for easy profits and end up not achieving similar growth, further necessitating increased imports to meet domestic demand. Therefore, the overall impact on the balance of payments is not as significant as it might appear to be. The state ought to remove this designation for export industries and compel the industry  to compete on an even playing field -  only this would ensure Pakistan’s industries meaningfully strive towards and invest in efficiency-driving measures.

While allocation and pricing intervention may not be the silver bullet for solving all issues in the gas sector, some of the ideas proposed above would enable some relief and create room for further necessary changes to be made.

Short-term Solutions

Addressing line losses, which include unaccounted-for gas primarily due to theft and leakages, is crucial in the short term. Pakistan's line losses stand alarmingly high, with estimates indicating that the country lost around 138 billion PKR to gas theft in 20191. Curtailing these losses necessitates substantial investment in existing infrastructure and robust anti-theft measures.

Simultaneously, enhancing the LNG supply is imperative. As indigenous reserves deplete, Pakistan has turned to more expensive LNG imports, costing the country around $16 billion from 2015 to 20201. Augmenting LNG supply involves deregulating imports to encourage private sector engagement, incentivizing investment in infrastructure like LNG terminals and regasification plants and expanding the gas transmission network through pipelines for efficient nationwide distribution.

Medium-term Solutions (~3 – 5 years)

The medium-term strategy should focus on pivoting energy sector SOEs towards green energy initiatives. Pakistan's renewable energy sector, particularly solar and wind, holds immense potential yet remains largely untapped due to limited investment and focus. By transforming key players like SNGPL and SSGC into green energy companies, Pakistan can significantly reduce its reliance on natural gas, mitigate environmental impacts, and foster a sustainable energy market.

Long-term Solutions (~10 years)

Finally, the long-term approach should aim at boosting exploration activities to counter the depletion of known indigenous reserves. Despite having substantial potential gas reserves, exploration activities in Pakistan have been sluggish. From 2012 to 2017, there was a 40% decline in the number of exploratory wells drilled in Pakistan1. Revitalizing this sector requires incentivizing private investment through conducive policy reforms and regulatory facilitation.

In conclusion, Pakistan’s natural gas sector, while currently fraught with challenges, holds the promise of sustainability and efficiency if navigated through a strategic, multi-pronged approach. This comprehensive plan, ranging from immediate fiscal measures to long-term environmental considerations, stands as Pakistan's beacon in ensuring energy security, economic growth, and sustainable development in the forthcoming decades.