Some developing countries see restructuring and deregulation as a way of encouraging private investment in electricity infrastructure
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The recent California electricity ‘crisis’ has raised concerns about the wisdom of electricity industry reform. If things could go so wrong in California, how can other countries hope to implement even more sweeping reforms successfully?

The California crisis does not mean deregulation and electricity markets are unworkable. Instead, it shows that deregulation and market introduction without appropriate hedging strategies is risky in the face of volatile spot market prices.

The California crisis arose from a peculiar approach to electricity markets, shaped by multiple political compromises. The California crisis was actually a combination of a financial crisis and a security of supply crisis. The two are only loosely connected.

Financial crisis

In California, incumbent utility retailers were required to supply end-use customers at fixed regulated prices. They were also required to purchase in the wholesale spot market, largely without hedging. Only low spot market prices would have kept them financially solvent.

High spot market electricity prices exposed a flawed and risky deregulation and market introduction plan, containing an enormous unhedged financial position. Low spot prices meant deregulation would work; when spot prices were high, vast sums of money were lost.

Hedge contracts signed after market start, but before spot prices were high, could have prevented the financial crisis. Even better, vesting contracts – hedge contracts assigned to generators prior to divestiture – could have supported the original rate freeze regardless of spot price levels.

The California financial crisis has destroyed the utilities’ credit, and the state will take decades to repay the costs incurred. To compensate for inadequate hedging of spot market purchases, California has imposed price caps to control losses – removing important market price signals even while the state is in great need of new generation entry.

If the Californian utilities had been deregulated prior to the 1998 market start, with the retail functions selling to customers at fixed regulated rates separated from the regulated wires business and removed from regulation, risk management would have been a very high priority.

Shifting from regulated utilities to markets brings risk. This is a hard lesson after decades of experience in the regulated US utility industry, where cost-based transactions and full recovery of costs in rates were the norm.

In New Zealand in 2001, a supply shortage caused by low rainfall into the predominantly hydro system led to high spot prices. These high spot prices, along with insufficient hedging, led to the major retailer withdrawing after significant financial losses.

Asian electricity reformers should look to Australia, Singapore and other countries in the region where vesting contracts and sensible hedging strategies have worked to prevent financial crises similar to California.

Supply shortfalls

California also has adequacy of supply problems. Regional supply shortfalls and transmission capacity constraints have caused blackouts over the past year.

Long-term failures of utility planning before the 1998 market start take most of the blame. California’s robust state load growth was met with significant imported power, despite the inadequate transmission infrastructure in the entire western region. In 2000, a combination of hot weather in the southwest, causing sustained high demand peaks, and low rainfall in the northwest, causing below normal power exports during peak periods, led to supply problems inside California.

Price caps exacerbated this problem in the short term, as power was sold outside California to take advantage of prices above the price caps inside. These supply and transmission problems must be examined and resolved on a regional basis, favouring market-driven entry rather than even more government intervention.

Reform in Asia

The lesson for Asian electricity reformers is that an inadequate system will not be quickly reinforced by market entry. Rather than looking to California, countries considering a move toward competitive markets should seek guidance from Australia, New Zealand, Pennsylvania-New Jersey-Maryland in the USA, and Singapore as alternative examples of areas with successful electricity reforms and markets.

However, no standard model has yet emerged, as each of these countries has different features. Some issues that are highly important in less developed countries, such as incentives for private investment in transmission assets, are not yet resolved even in these instances.

The most successful electricity markets have been introduced into countries (or states) with relatively well developed electricity infrastructures. Indeed, one of the important drivers of deregulation and a shift to markets in, for instance, New South Wales and Victoria in Australia, was excess electricity infrastructure investment causing high regulated rates. In contrast, some developing countries may see introducing electricity markets as a potential mechanism to incentivize private investment in electricity infrastructure, that relieves the Treasury’s financial burden, particularly given the difficulties encountered with the IPP models commonly adopted in the 1980s and 90s.

Private companies will only invest in electricity infrastructure if they can reasonably expect returns on their investment. Once it was easy to lure private capital with generous long-term contracts. However, the recent news about Dabhol and other private power projects in India and earlier private power projects in Indonesia has raised concerns among investors. It is untenable to offer private investors attractive long-term contract prices if the underlying system and its ratepayers cannot support these.

More generally, electricity reforms’ success will ultimately be evaluated against the tariff levels, public funding requirements, and the quality and scope of service resulting from the reform. In many developing countries, revenue yields are significantly below revenue requirements. Reforms may improve efficiency and generate corresponding reductions in revenue requirements, but this may not be enough to avoid tariff increases needed for financial viability. Countries in this situation must be able to convince stakeholders that tariff increases are necessary to increase electricity availability, that quality of service will improve, and the tariff increases are not caused by utility inefficiency.

In addition, there are some prerequisites for electricity industry reform that have been taken for granted in countries where reform has been successful. A robust legal system with clear property rights and legal remedies is essential when private investors are considering large, long-lived fixed investments. Impartial, transparent, and independent regulation, and associated subsidy policies, are also necessary. Adequate levels of infrastructure development are essential, to provide sufficient alternatives and hence a level of competition.

Electricity reform may distract decision-makers from addressing accountability and corporate governance issues, which are prerequisites for reform. In many developing countries, utility managers are inadequately empowered to take actions, expectations are not clearly defined, performance is not measured, and rewards or sanctions are seldom meted out for performance against targets. These problems often derive from dysfunctional relationships between governments and state-owned utilities. Failure to establish accountability denies consumers the immediate benefits of potentially lower prices and better service, and compromises readiness for reform and privatization.

Intermediate steps

Countries considering electricity reforms, but lacking these prerequisites, should consider a phased approach. For example, the government might develop an electricity infrastructure before implementing fundamental reform. Government funds expended to construct transmission and generation assets might be recouped during later privatization. Initiatives to improve accountability, and hence technical and financial performance, at all levels of the sector are no-lose propositions.

Another example is for governments to move to an intermediate step of regulation prior to full reform. This might involve separating utilities into retail, distribution/transmission, and generation companies and floating the regulated distribution/transmission company. In this model the form of regulation and the rules for recovery of regulated investments offer useful tools to drive private-sector transmission and distribution investments.

In such a phased approach, vesting contracts between sellers and buyers of power can allow control of customer rates during transition to full competition.

In a phased approach, the institutions, long-term contracts, and other features of a transitional stage should not preclude later reforms. Accordingly, long-term planning is essential. A deliberate and phased approach to electricity reform will allow countries to make progress toward fundamental reform while learning from reforms elsewhere.

Electricity markets are workable and allow market forces to shape the form of the electricity system. Less developed countries should approach the path toward electricity markets with deliberate care, ensuring first that necessary prerequisites are in place.