Sri Lanka formally entered its 17th International Monetary Fund (IMF) programme in March 2023. It began with a Staff-Level Agreement (SLA) in September 2022. A structural benchmark of the programme relates to the setting of electricity tariffs: that they should be cost-reflective. But the latest review of the programme stipulates that “cost-recovery electricity pricing is no longer maintained and needs to be restored without delay”.

This view of the IMF is based on an assessment that the tariff reduction instituted by the Public Utilities Commission of Sri Lanka (PUCSL) in January this year led to a failure in recovering the cost of supplying electricity from consumers and Government transfers.

This is odd because ensuring cost-reflective pricing is not just an expectation of the IMF, but also under the law (Sri Lanka Electricity Act No.20 of 2009) governing the PUCSL, which is the independent regulator of the electricity sector, set up by an act of Parliament. 

The task of the PUCSL is to set a cost-reflective tariff, in line with relevant Government policies, that is designed to recover from consumers and Government transfers, all justifiable costs of supplying electricity.

Two questions to be answered 

Q1: If the IMF and PUCSL are aligned on the outcomes of electricity pricing, why do they end up with different assessments with regard to prices being cost-reflective? 

Q2: In a disagreement between an independent regulator and the IMF, what options does the executive authority have within the rule of law?

This insight, drawn from forthcoming publications by Verité Research, sheds light on these two questions. 

Prior question: What led to past losses of the CEB? 

The governing law requires the regulator to set the cost-reflective tariff when the executive authority – through the Ceylon Electricity Board (CEB) – requests a price revision. In the past decade, the pricing was not cost-reflective because of executive (in)action; the CEB did not request the PUCSL for approval of tariff revisions.

In other words, the executive authority made a decision, implicitly or explicitly, to subsidise the cost of electricity supply instead of moving to revise prices, and in doing so, it accumulated losses in the CEB instead, paying for the subsidy through transfers from the Government budget.

Since the inception of the latest IMF programme, however, the Government has approached the PUCSL for price revisions on a regular basis, and the latter has asserted that the current pricing is based on cost-reflective criteria.

Q1: Why do IMF and PUCSL differ?

The analysis by Verité Research finds two reasons for the IMF and PUCSL to differ.

Reason 1: due to using a different metric to evaluate cost-reflective pricing. 

Reason 2: due to using different input data to calculate the metric.

To explain why each of these apply, we begin by understanding the challenge of setting a cost-reflective tariff in a situation where future costs and revenue are uncertain.

Principle of correcting estimation errors in cost-reflective pricing

The cost-reflective tariff is forward-looking: it is set based on expectations of future demand and supply. To set a forward-looking tariff that collects, as revenue, the cost of supply, requires significant estimations. 

For instance, estimations are needed regarding future economic activity that will influence demand, weather patterns that affect both demand and supply (e.g. hot weather increases demand, while rain increases hydro generation and lowers supply costs, etc.), and future input costs – such as the price of coal and diesel – for power generation. 

In other words, the estimation must account for a range of uncertainties and is therefore bound to be a proximate, not a precise, estimation. As a result, when all is done and dusted, it will always be the case that revenue will equal cost, plus or minus some ‘estimation error.’ 

The implication of the plus or minus estimation error is as follows: when the estimation error is a plus, it means that anticipated revenue exceeds anticipated cost (due to higher revenue or lower costs than anticipated) – resulting in an unplanned excess in retained earnings; when the estimation error is a minus, it means the converse – anticipated cost exceeds anticipated revenue (due to lower revenue or higher costs than anticipated) – resulting in an unplanned deficit in retained earnings (loss).

What should be done with the unplanned variation in retained earnings arising from estimation errors? The standard principle of any cost-recovery pricing model is to set tariffs that minimise the estimation error in the future and compensate for the estimation errors of the past, i.e. to have the cumulative estimation errors over time moving towards zero.

Therefore, the forward-looking tariff will not only attempt to recover the forward-looking cost, but will also be increased or decreased depending on the unplanned deficits or excess accumulated from the previous periods. In this way, past estimation errors are compensated for on a rolling basis through future tariffs.

Reason 1: Different metrics on the agreed principle

Both the PUCSL and IMF agree on the principle of correcting for estimation errors. But there are two differences in the metrics that are used in applying the principle. 

The first difference is that while the PUCSL uses a metric that seeks to bring the cumulative estimation error to zero, the IMF uses a metric that only seeks to make it non-negative. Since a cumulatively negative estimation error creates a loss, the test effectively requires that there be no deficit to the CEB, making excessive profit through excessive pricing acceptable. So, the IMF metric is not testing for cost-reflective pricing per se, but rather for cost-recovery pricing. 

The PUCSL is concerned about that and more: that excessive profits of the past are also reversed through reduced tariffs in the future. This only means that the PUCSL metric is more demanding; the two metrics are not in conflict.

The second difference is the time horizon over which the cumulative estimation errors are checked. The PUCSL considers the cumulative error from at least two periods of prior tariff adjustment, which can be 12 months or more, while the IMF considers the cumulative variance only from the last quarter of the previous calendar year, which is generally a shorter period. 

Another way to understand the difference is that the IMF’s focus is on a Government budget cycle of one year, while the PUCSL is focused on the CEB as an entity, smoothing out the errors over a rolling horizon that can even span a couple of years.

This difference causes a conflict. Why? When the more demanding metric of the PUCSL is applied over the longer horizon, it calls for a clawback from the excess revenue collected in the first half of 2024. 

Accordingly, the CEB reported a profit of Rs. 119.2 billion in the first half of 2024, of which the excess arising from the estimation error on the tariff was evaluated by the PUCSL to be only Rs. 51.1 billion. Therefore, in the first half of 2025, the PUCSL adjusted the tariff to set off that amount in line with the cost-reflective principle. 

However, the IMF metric only leaves space for clawback for excesses that accrued from the last quarter of 2024. Therefore, the clawback, required by the PUCSL metric, to reduce the excess accrued to the CEB from the first half of 2024, registers on the IMF metric as creating a deficit. The problem would not exist if the IMF metric took account of the longer time horizon.

Reason 2: Different accounting data to calculate the metric

The core interest of the IMF is not cost-reflective pricing; it is that the CEB should not accumulate losses that are not reflected in the national budget. Therefore, the application of the IMF metric is likely to be flexible if the accounting data were evaluated as not creating a fiscal liability ‘off-budget.’

However, there is currently also a difference between how the regulator (the PUCSL) and the regulated entity (the CEB) are presenting and evaluating the underlying data. Therefore, the second reason for the IMF and PUCSL to differ is that they seem to have different readings of the CEB accounts.

Q2: What options exist to resolve the IMF-PUCSL conflict, within the rule of law?

Within the rule of law, the Government is not free to accept the IMF metric as the basis of cost-reflective pricing (although it has done so in the past), unless it first amends relevant legislation and regulations. Without that, doing so would constitute political interference that upends the integrity of the independent regulator.

In any disagreement regarding the interpretation of the accounts of the CEB, the law places the regulator as the umpire – not the CEB, not the Executive, and not the IMF. Therefore, any coercion of the Executive to run roughshod over the independent regulator would seriously undermine governance.

To put it simply, even if we were to think that the IMF’s metric and interpretation of accounts were superior to that of the regulator, the only options available to the Government are to change the law and regulation to institute improvements, or make a judicial challenge to the regulatory decision as permitted by law. 

Neither of these would be possible in the short time available to meet the condition placed within the IMF programme. 

Way forward within the rule of law

There are two options for the Government and the IMF to move forward without undermining the rule of law. 

Option 1: IMF programme adjustment. That is for the IMF programme stance to be revised with regard to the tariff increase, to accept the authority of the regulator in setting a cost-reflective tariff, and evaluate the options available within the rule of law, as outlined above, if it can be established that the method used by the regulator needs improvement. 

Option 2: Adaptive fiscal accounting. That is for the Government to institute a temporary transfer to the CEB, that is made explicit in the budget (so not ‘off-budget’) to offset what the IMF has estimated as a deficit, with a view to transferring it back to the Government after the differences with regard to metrics and interpretation of accounts are resolved. This would be expected to be a budget-neutral transaction.

Caution on upending regulatory governance

The tariff assessment and adjustment methodology of the PUCSL, the regulator, is grounded in Sri Lanka’s laws and regulations, which have been instituted on well-honed principles of regulatory governance. While the IMF methodology focuses exclusively on protecting the Treasury from off-budget fiscal obligations, the regulator’s method of cost-reflective price adjustments does that and more: it also protects the consumer from monopolistic price exploitation, and constrains cost-escalating proposals that can arise from mismanagement and corruption.

Improving governance is a critical foundation for Sri Lanka’s economic recovery. This makes it all the more important for the country to pursue one of the two options available within the rule of law, as outlined above, instead of using executive power to upend its regulatory governance. 

Investors, including foreign investors, look for integrity of governance and regulation to assess risks and make investment decisions. If Sri Lanka is seen to be overriding its independent regulators through (authoritarian) executive action, that would constitute an undermining of governance, which, in turn, undermines the economy as well. 

Recognising the consequences of compromised governance was why the present IMF programme identified governance as ‘macro-critical.’ The programme should take care not to exacerbate the problem that it was designed to solve.

(The writer is the Executive Director of Verité Research)