Energy reform must be created, not copied

One of the benefits of working in multiple countries is seeing how different people take different approaches to solving problems. In energy reform, this can be especially intriguing.

As markets reform, governments and their advisers face hundreds of decisions, both big and small, that must all be carefully weighed up, assessed and executed if reform is to succeed. In such an environment, it’s perhaps not surprising that sometimes the approach to these decisions can be to add excess complexity in a futile quest for perfection or to simply copy and paste aspects of other reform models rather than create one that best suits this market.

Restructuring an electricity market presents governments with some of the toughest issues they will ever have to solve. These issues pose questions of fairness ” how much should people have to pay? They grapple with history and long-held entitlement ” what is the future role of the state-owned utility? Understanding, prioritizing and solving these often competing issues can see policy makers fall into two common traps.

Finding nirvana in reform?

The first is the belief that perfection can be achieved when creating new energy markets. One of the most influential economists of our time, Harold Demsetz, described this mindset as the nirvana fallacy ” a misguided belief in the existence of a perfect solution. It sees policy makers reject imperfect proposals merely because of their imperfection, comparing the solution or idea to some notion of perfection, which, in most cases, can never be achieved, even if by any other criterion it is the best imperfect solution available.à‚ 

This fear of imperfect solutions is what leads governments to add layer upon layer of red tape and bureaucratic complexity. The drive for perfection encourages over-regulation amid fears of creating environments where prices will not reflect perfect marginal cost. It sees market designs made unnecessarily complex as governments strive for the latest and most up-to-date settlement systemsà‚  when in reality, simpler bi-lateral contracting could be just as effective when all costs are considered.à‚  The desire to stamp out undesirable behaviour ” before it’s even been hinted at ” leads to heavy-handed, non-economic compliance regimes that may not even be needed.

The reality is that electricity systems are the imperfect products of a hundred years or more of myriad laws, rights, responsibilities and expectations. Any government embarking upon reforming such a system must first adopt a rational, realistic idea of what can be achieved.

The “copy and paste” mentality

The second misconception is that the issues of a particular reforming energy market are not unique.à‚  But each market ” with its own specific regional history, legislation and company structures ” can bring individual issues and needs.

When faced with complex problems, it is people’s nature to seek solace in existing solutions rather than take on the task of creating a new one. It is not surprising then that, when seeking the right solution to new energy market design, governments can be quick to take examples from other markets. This ‘cookie-cutter’ approach to energy reform in diverse settings has a strong appeal to International Financial Institutions and investors alike for its potential to provide well understood investment opportunities.

Keynes once said we are all the slaves of some defunct economist. Those in the business of prescribing energy market models are often the slaves of the markets where we have the most experience, whether this is the US’s PJM, the bi-lateral trading model of the UK or the Australian NEM model.à‚  It can be all too easy for government policy makers to take an aspect of a market they know well and try to apply it to a particular issue, such as ring-fencing, cost allocation, metering ownership, revenue controls, distribution performance standards or linear versus triangular licensing regimes.Keynes

But local circumstances do matter and can be seen to impact outcomes. India represents a good example of this in practice. Variations in regulatory systems and in degrees of commitment to energy reform have led to significant differences in the success of IPP projects between different Indian states.

Around the world we’ve seen examples of where copying and pasting aspects of energy reform has simply not worked. In Romania, policy makers adopted a day-ahead electricity market, based on the UK model, but since only low volumes were traded, the market did not provide an effective price signal. The Canadian province of Alberta also installed a UK-style pool system in 1996, but within four years had decided to move to a system of direct contracting between counter-parties, coupled with access to optional power exchanges. One of the reasons given for this change at the time was poor alignment with other markets in the Pacific North-west. Lack of price certainty, market power and asymmetrical price volatility were other factors behind the move.

This is not to disregard the benefit of experience ” indeed it is the knowledge of these systems and the ability to apply selective adaptations to new markets which can save governments considerable time.à‚  It is important, however, that policy makers are aware of the risk of introducing designs seen elsewhere without adequate consideration of the impact on the specific characteristics of a market during implementation and over the longer term.

Create, don’t compile

As with most things, perfect solutions are rarely found in energy reform and the quest for nirvana will invariably end in failure. Instead of searching for perfection, decision makers must carefully consider, amend and apply certain attributes of appropriate energy market solutions while using the insight that only on-the ground experience can provide. While, in my opinion, this requirement for deep thought is one of the reasons energy reform is such an interesting area in which to work, it also presents its greatest challenge.à‚ 

The temptation to “compile” existing solutions, rather than muster the courage and commitment to create a better answer based on new and fact-based analysis, is the greatest challenge facing reforming governments and their policy makers. It can also mean the difference between good government and great government.

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