States going back to Old Pension Scheme will hurt India. Here’s what 8th Pay Commission can do

The first payment need not be 50 per cent of the last wage, but could potentially be linked to the proposed indexation of the pensions in payment.

20 September, 2023
The Print

Several states in India have shifted back to the Old Pension Scheme (OPS) for their employees. There have been concerns that this may prove to be very expensive for governments as they will have to spend a larger proportion of their revenues in just paying pensions. We may be underestimating the full fiscal burden as we may not be considering the impact of future increases in salaries and pensions owing to the next pay commission recommendations. A future pay commission should bring parity with the National Pension System by reigning in pension increases, or at the very least make changes to the pay structure only after considering the cost of indexation. At retirement, a government employee typically gets a defined benefit pension of about 50 per cent of last wage as per OPS.

There are two ways in which Pay Commissions impact the value of the pension a government employee enjoys.

Pay commissions and pensions

First, if the pay escalation is such that the employee gets a huge wage hike in the last few years of employment, thus making the initial pension automatically much higher. Second, escalation of the dearness relief as well as changes in the pay structure can significantly increase benefits of retirees. For example, the dearness relief for Union government employees was increased from 38 per cent to 43 per cent of the basic pension from 1 January 2023. These rates are revised every six months on the basis of All India Consumer Price Index for Industrial Workers (AICPI-IW). The 7th Pay commission also recommended parity between past retirees and current retirees for the same length of service in the pay scale at the time of retirement. Government employees effectively enjoy inflation as well as wage indexation of their pensions.

In the National Pension System (NPS), an employee has access to their accumulations in the NPS account and has to buy an annuity with at least 40 per cent of the accumulations. The NPS could possibly match 50 per cent of the last wage that the OPS provides if one invested higher amounts in equity, and if one annuitised more than 40 per cent of their final accumulations. However, pension increases because of the increases in dearness relief may be hard to match for any market-based system.

Indexation can be thought of as insurance — a payment is made when a specified event occurs (such as inflation). Insurance needs to be priced. In the case of the OPS, future tax-payers shoulder the burden. In the NPS, the subscriber will have to “purchase” the insurance from the market. If a person wants an inflation indexed annuity, the premium will be higher. This implies that the accumulations over the working life will have to be higher.

Indexing pensions

Defined benefit schemes such as the OPS are financially vulnerable. Improvements in life expectancy, for example, jeopardise the actuarial calculations that may have shaped the policy at its inception. Indexation, however, is not just about the pensions-in-payment. There are multiple aspects of a pension scheme that could be indexed to keep the contribution-benefit relationship in actuarial balance. For example, a pension system could index the retirement age to longevity increases. The first pension payment need not be 50 per cent of the last wage (or the average of the last ten months wage), but could potentially be linked to the proposed indexation of the pensions in payment. One could choose to begin with a relatively lower base if one wants a higher escalation of the nominal value of the pension, thus keeping the overall expenditure constant.

One way of designing inflation indexation is to think of “anticipated” inflation as different from insurance against inflation. The standard pension formula pays for a small escalating annuity. A payout would be made only if actual inflation was higher than a “deductible”. The cost of this insurance would be paid for by the individual. The heterogeneity in inflation across different parts of India might help further defray the cost of the insurance. A future pay commission could ask what the sum-total of the inflow of contributions would have to be if a cohort retiring in a particular year needs to be given an escalating annuity with different deductibles. This way of providing inflation indexation is cheaper than complete inflation indexation. While there are no explicit contributions in the OPS, this allows us to estimate the cost of paying for the indexation.

Early estimates of the cost of government employee pensions estimated the implicit debt to be almost 60 per cent of GDP. When one adds the pay revisions and increases to the dearness allowance, the cost of the defined benefit under Old Pension System is likely to go up. Government employees are a small part of the workforce. Inflation and wage indexation ensures that they get a large share of the revenue receipts in any year. This leaves less for welfare and capital expenditure that directly benefits all the citizens. The 8th Pay Commission, whenever it is set up, should consider removing the wage indexation, and pricing inflation indexation to evaluate the cost to the fiscal on a net present value (NPV) basis.

Let states receive global capital. They can’t achieve net zero on their own

Chhattisgarh and Jharkhand where 97% of power generated is from thermal plants will require special support in green transition.

06 September, 2023
The Print

Decarbonisation and transitioning to net zero is one of the key challenges facing India. The country has correctly taken the position that there cannot be a one-size-fits all solution to the energy transition. Within India too, the transition strategy for each state will be based on its priorities and its wherewithal. In his speech a few days ago, PM Modi alluded to the debt crisis in countries being of great concern for the world. While one can argue whether the debt of the states of India has reached “crisis levels”, there is little doubt that it is rather high, and continues to increase. The state budgets are not going to be able to meet the demands of decarbonisation. In fact, the states will have to be a recipient of capital to reform their power sectors, and push the agenda of decarbonisation. We should consider ways of enhancing the ability of state governments to access other sources of domestic and global capital for their energy transitions. This will allow for a many-solutions approach within India.

Transitioning to lower carbon

If India has to move closer toward its net zero commitments, then it has to find ways to consume less and less coal. There is tremendous progress in the renewables space in India. According to the All India Electricity Statistics 2023 report by the Central Electricity Authority, as of FY22, solar accounted for 10 per cent of electricity generation. Even today, almost 74 per cent of electricity consumed in India comes from coal plants, and needs to be slowly phased out. While the renewables sector in India has made remarkable progress in the last decade, there is still a long way to go before the share of thermal energy can be brought down. Shifting to renewables has two challenges.

First is the investment required in creating the infrastructure that can handle solar, off-shore wind, and other forms of renewable sources. For example, as more renewables hit the grid, greater investments will be required for the grid to handle this power. Deliberations at the Global Just Transition Dialogue in March this year suggested that at least $900 billion will be required for just energy transition in India over the next 30 years, only for coal mines and thermal power plants.

Second is the extent of fiscal transfers required to deal with those that are affected by this change. Take the example of the two states that rely on coal — Chhattisgarh and Jharkhand. In both these states, 97 per cent of the electricity generated is from thermal power plants. Not only is the electricity consumed from coal-based plants, but a large part of the economy is based on coal mining and related activities. For example, almost one-fourth of the total coal mines in India are in Jharkhand, with the coal mining industry supporting 3,00,000 jobs. As coal mines get decommissioned, and electricity consumption shifts to renewables, there will be significant implications on the economy of these two states. Unless the political economy problems are resolved, states will not be able to take the required steps to move away from coal. Each state has its own set of challenges as it embarks on the path to net zero.

Fiscal health of the states

Difficult transitions are often financed through state budgets. Electricity is a state subject, discoms in several states are still owned and operated by the state. The path towards decarbonisation has to pass through the reform of the power sector. This includes dealing with subsidies on electricity tariffs, especially for domestic and agri consumers, and the political economy considerations that come with this. The focal point of action, therefore, are the states. Tamil Nadu for example has proposed to increase the contribution of green energy from the current 21 per cent to 50 per cent by 2030. The trajectory of each state will be different.

The current fiscal position, however, leaves little room for the states to invest in either their discoms or the improvement of infrastructure, or provide support to those on the losing side. The debt to Gross State Domestic Product (GSDP) ratios of states such as Andhra Pradesh, Telangana, Kerala and Tamil Nadu range between 20-30 per cent of their respective GSDPs. When one adds the off-budget borrowings, these increase to as high as 44 per cent of GSDP. In Tamil Nadu, 96 per cent of the off-balance sheet borrowing is by the Tamil Nadu Generation and Distribution Corporation Limited (TANGEDCO). In Andhra Pradesh and Telangana, the state power finance corporations account for 12-18 per cent of the off-budget borrowings. It is likely that the power finance corporations further lend money to the discoms. If one looks at revenue expenditure, in several states, the growth in interest payments is higher than the growth in developmental expenditure.

The path to net zero requires the debt overhang, especially of the discoms, to be addressed and for states to devise their own strategy for the transition. The choice of technology, as well as the strategy for dealing with socio-economic consequences needs to come from the states. Reliance on multilateral agencies is not going to be enough. We must look for models for state governments to access pools of capital, both in India and overseas. Today, the states are constrained from accessing global capital directly. We should consider ways in which these avenues can be opened-up.