Tuesday, September 16, 2008

Deregulation of electricity markets. Phase 1: Privatization of the generation segment

As the concluding posting to the “Primer Series”, I wanted to discuss the state of deregulation of electricity markets around the world and the key lessons thereof. However, one thing that I’ve learned while writing this blog is that my postings are too long. This time, I will focus on the privatization of the generation segment, and I’ll return to the deregulation topic several times again in the future. Deregulation is only justified from the efficiency point of view. In the developed world, deregulation has been driven by high operating costs and retail prices, construction cost overruns, and technological innovation. In developing countries, deregulation has been associated more with the need to build more capacity. Historically, privatization of generation has been often the first phase in the creation of competitive electricity markets, although there are some exceptions, which we’ll discuss further later.

There’s a general text-book model for deregulation that has been followed successfully by many countries, and experience shows that departing significantly from the model has lead to performance problems in the electricity market, as in much of continental Europe and Japan (Joskow, 2007). The standard architecture for competitive markets involves the following components (see Sally Hunt, 2002):

1. Privatization of state-owned electricity monopolies to create high-powered incentives for performance improvements and to make the pursuing of political agendas through these entities more difficult;

2. Vertical separation of potentially competitive segments (generation and retail) from segments that continue to be regulated (distribution, transmission and system operation) to avoid cross-subsidization and discriminatory behavior that affects access to the network.

3. Horizontal restructuring of the generation segment to create adequate number of competitors to mitigate market power.

4. Horizontal integration of network operations to create regional wholesale markets, and the designation of a single independent system operator to schedule the dispatch to meet demand, to maintain the physical parameters of the network, and to guide investments, through price signals, to new infrastructure, where those investments are needed the most.

5. The creation of voluntary wholesale spot energy and operating reserve market.

6. The development of active demand-side to let consumers react to real prices of energy production.

7. The establishment and enforcement of supporting regulatory rules, e.g. to efficiently allocate scarce transmission capacity

8. The unbundling of retail tariffs from the regulated transmission and distribution charges

9. If retail competition is not introduced, alternative suppliers must be obligated to serve these customers, by purchasing power in the wholesale market.

10. The establishment of regulatory agencies that have good information and are able to regulate and monitor the competitive and regulated market (transmission and distribution) efficiently.

11. Necessary transition mechanisms from old to the new system.

There are several lessons to be learned from the past decades of electricity market reform, and one is that the text-book model really is a robust guide for reform. The most successful reforms have followed the model fairly closely, and market performance has mostly increased in terms of costs, network losses, generator availability, quality of service, and price levels and structures. This is not to say that retail prices will always fall following liberalization. In some countries, prices were too low before deregulation, which discouraged investment and encouraged wasteful consumption.

Privatization of generation segment is a key factor to creating a competitive market. England has, eventually, become one of the best examples of a successful reform program. However, it failed initially because of the decision to create only three generating companies out of the state-owned CEGB, leading to severe market power problems for years. The market has become competitive only after the entry of new generators and divestitures by incumbent producers. Unlike England, Argentina immediately put a serious effort in generating a structurally competitive generation market, and the results have been excellent. The experience shows that no market design will function well, unless there’s an adequate amount of competitors and the market power of dominant firms has been mitigated in some way.

On the other hand, Australia, the Nordic countries, Ontario and Brazil have proceeded with liberalization without fully privatizing their generating segments. This has raised some very interesting issues regarding both short run market performance and long run investment incentives. Namely, investments in new generating capacity based on non-market incentives by the public sector seriously undermines the incentives for the private sector to do investments, because it doesn’t have similar support in form of direct or indirect subsidies. Since China is trying to create appropriate incentives for new investment in generating capacity, the mixed public-private generating sector is a serious issue. In fact, it should be realized that the reason why most of continental Europe didn’t privatize the generation segment in the first place, was because most of the countries had significant excess capacity at the time of liberalization.

Policymakers may fear that private sector’s commitments to build new capacity are inadequate, but this should be dealt as more of market design issue, not as obstacle to privatize the generating segment. The regulator can impose resource adequacy or forward contracting requirements, or it can provide capacity payments to generators to restore those incentives. Above all, private investors are looking for stable market rules and longer term contractual commitments, and the more there’s redesign of the market reforms, the more costly will the transition be to the society. Therefore, a strong political commitment to the reform is necessary.

The general lesson from privatizations in other countries is that success which brings efficiency gains and other benefits requires strong institutional and regulatory capacities (Banks, 2006). Moreover, the transformation of government’s role from the caretaker and provider of electricity to a mere regulator and/or system operator is extremely challenging in a top-down, state managed economy, such as China. It requires a lot of commitment from the reformers to convince the state apparatus and the public of the benefits of privatization. This is not only due to the powerful local interests among public generators, but also due to general public concerns, such as employment, which may be quite coveted in government enterprises. These are concrete political and economic issues, and no doubt there are losers in every privatization.

The distributional effects of privatization are surely a concern to many. According to Birdsall and Nellis (2003), there doesn’t seem to be much association between the amount or speed of privatization and increase in inequality. They find method of divestiture, type of new owner, sequencing of other reforms and the institutional framework before, during and after the privatization as more plausible reasons behind increasing inequality. They conclude that the key factor for avoiding harmful distributional effects is the creation of an independent regulatory regime that designs and monitors contracts and introduces rational and enforceable rulings. Where this key factor has been emphasized, the privatization has led to increased access, especially for the poor.