Electricity Cost and Firm Performance: Evidence from India

Investigator: CDEP Fellow Ama Baafra Abeberese

The widely acknowledged importance of infrastructure for economic growth has motivated a growing literature in development on how infrastructure influences various aspects of development. There are, however, two areas that have been relatively under-researched in this literature.  First, there has been little work on how infrastructure affects firms’ decisions and performance. Secondly, there hasn't been much work on electricity, which is important to study since it is a near-universal input in production processes.

In this project, the author studies the effect of electricity constraints, specifically high electricity prices, on firms’ decisions and performance. The author studies this question in the context of India where, as a result of a system of cross-subsidization, households and farmers pay low, below-cost prices for electricity at the expense of firms.

A challenge in trying to understand how electricity prices affect firms is that these prices are potentially endogenous. To address the potential endogeneity of electricity prices, the author makes use of two features of the electricity sector in India. First, most of the electricity generated in India is from thermal plants that use coal as the source of fuel. Secondly, each state in India is responsible for the provision and pricing of electricity for its residents. The author, therefore, constructs an instrument for the electricity price faced by firms in a state as the interaction between the price of coal paid by power utilities and the share of thermal generation in a state’s total electricity generation capacity.

Using this instrument and data on manufacturing firms in India, the author finds that, in response to an increase in electricity prices, firms switch to less electricity-intensive industries and become less machine-intensive and less productive. Since most technological innovations are reliant on electricity, these results suggest that electricity constraints may limit a country’s growth by leading firms to operate in industries with fewer productivity-enhancing opportunities.

This project is a part of CDEP's Firms and Innovation Initiative. The main research paper from this project is forthcoming in the Review of Economics and Statistics.