Privatesector P U B L I C P O L I C Y F O R T H E The World Bank June 1996 Note No. 84 The England and Wales Electricity Model— Option or Warning for Developing Countries? John E. In the late 1980s and early 1990s, the England Important features of the E&W model that other Besant-Jones and Wales power supply industry underwent countries pioneered include the following: the most radical transformation ever experi- ▪ Unbundled supply systems, with many enced by such an industry. It went from being wholesalers and retailers serving a power a state-owned, state-controlled, integrated struc- market (Finland, the Netherlands, Norway). ture to being a privately owned, autonomously ▪ Competition in the wholesale market (Chile, regulated, unbundled structure. This change but cost-based rather than price based). happened too recently to allow unequivocal ▪ Competition through periodic bidding for judgments about the suitability of the England long-term contracts to supply distribution and Wales electricity model (the E&W model) companies and large power users through for developing countries. But experience with independent power projects developed with the model has generated some useful options limited recourse financing (the United States, and warnings for power sector reform in following passage in 1978 of the Public Util- developing countries, even though the charac- ity Regulatory Policies Act). teristics of their power markets differ sub- ▪ Formal sector regulation (the United States, stantially from those of the England and Wales but regulation of profits by multisectoral pub- power market.1 Some of the lessons arise from lic utility commissions that control prices; the innovations in the E&W model. But the dem- E&W model uses price caps set by a single onstration that such a radical model can be regulator for the sector). introduced is also setting a challenging example ▪ Private ownership of power suppliers (Fin- for other countries. land, the Netherlands, Norway, the Philip- pines, the United States, Venezuela). Innovative features and demonstration value The E&W model is important for countries con- templating power sector reform because it dem- Many of the features of the E&W model typi- onstrates that a package of radical reforms to cally viewed as innovative were first introduced stimulate competition is a plausible alternative in other countries. The misperception probably to the traditional European state-owned, inte- arose from the combined impact of the many grated structure and to the rate-of-return-based, radical changes that occurred in the reform of investor-owned utility model developed in the the England and Wales power market. United States. It is also an alternative to the Chilean model for countries that want to move The three truly innovative features of the E&W toward competition in their power markets. model are price-based competition in the bulk supply market, price-based regulation for fran- The demonstration effect of a successful model chised services through caps on average revenues, is easily underestimated. In the 1940s and and a structure giving ownership and operation 1950s, developing countries generally modeled of the transmission network to an entity that is their power sectors on that of their main part- separate from generators and distributors in or- ner among industrial countries (Britain, France, der to ensure open access to the network. the United States). In the 1980s and 1990s, the Industry and Energy Department ▪ Vice Presidency for Finance and Private Sector Development The England and Wales Electricity Model—Option or Warning for Developing Countries? Chilean model has been sweeping Latin England and Wales and including Argentina, America (Argentina, Bolivia, Colombia, Peru). Bolivia, Hungary, Peru, Poland, and Ukraine. Also in the 1990s, the independent power Thus, there is a sufficient track record to pro- projects approach to attracting private invest- vide assurance that unbundling is possible ment has been spreading across Asia (China, while still ensuring coordination among power India, Indonesia, the Lao People’s Democratic system components and maintaining security Republic, Malaysia, Nepal, Pakistan, the Phil- of supply to users. But it is also very important ippines, Thailand, and, recently, Vietnam) and that competition be introduced in the power Central America and the Caribbean (Guatemala, market by structural reforms at the start of a Honduras, Jamaica, Panama), although with less reform process, rather than by relying later on competition than in the United States. Using regulatory interventions to reduce the market models pioneered in France, Francophone power of the largest generating companies, as Africa (Côte d’Ivoire, Guinea, Senegal) has been occurred in England and Wales. experimenting with privatizing utility manage- ment under contract. Second, private financing of power investments in a competitive market is feasible in a sound Now the United Kingdom has entered this com- business environment. The key is to ensure that petition of models with one that is more radi- private developers carry the risks that they can cal than the others. The model was made manage, and that government guarantees are politically possible by the market liberalization limited as much as possible to sovereign risks. in the United Kingdom during the 1980s, and technically feasible by the explosive growth in Third, power sector reform can yield huge pro- computing power and the dramatic decline in ductivity gains, particularly through dynamic computing costs. This model offers the most efficiency gains under competitive pressures. sustainable long-term benefits because it gives These gains have therefore appeared earliest the strongest efficiency incentives to suppli- in the England and Wales wholesale power ers. But it is also risky, especially for develop- market, where competitive entry has been easi- ing countries, because the strong incentives est. But regulators have difficulty making pro- have to be regulated firmly, impartially, and ducers pass on some of their productivity gains transparently to ensure that they remain con- to franchised electricity consumers through sistent with the interests of consumers and so- lower prices without creating undue uncertainty ciety. This high-risk but high-reward option has for investors (similar issues are arising in Ar- already attracted serious interest in such coun- gentina and Chile). Those who lose from pro- tries as India (Orissa State), Pakistan, Poland, ductivity gains and other consequences of and Ukraine, though it will require some ad- reform, such as displaced workers and subsi- aptation to local situations, notably in the dis- dized power consumers and primary energy patch and pool trading arrangements. suppliers, have to be dissuaded from under- mining the reform process (for example, by Key lessons compensating workers and helping power con- sumers and energy suppliers adapt to the new Experience with implementing and operating market conditions). the E&W model yields six general lessons for power sector reform. First, it shows that radi- Fourth, an extended transition period is needed cal unbundling is feasible—that generation, after radical reforms are introduced, during transmission, and distribution can be separated which the government and the regulator must from one another even in power sectors that expect to face unanticipated challenges. In did not adopt this structure from an early stage England and Wales, the unexpectedly large of development. Several countries have recently profits made by the privatized distributors un- unbundled their power sectors, starting with der the new price cap regulation have provoked unscheduled price cap reviews by the regula- Argentina (macroeconomic financing pressures), tor and created political pressure for a tax on India and the Philippines (extreme, long-term these so-called windfall profits. power shortages), and Brazil, Colombia, and most countries attracting independent power Fifth, the sequencing of reforms is critical. The projects (long-term financing concerns). legal and regulatory apparatus should be in place before restructuring and privatization, and In view of these priorities, there are five main major restructuring should precede the creation features of the E&W model that have relevance of private ownership rights to avoid problems to developing countries: with stranded assets. The timing of reforms is ▪ The pricing of electricity supply as a com- also critical, particularly the timing of the mercial service, rather than as a public obli- privatization of electricity suppliers and any gation or a means of supporting low incomes. supporting increase in electricity tariffs rela- This policy not only gives users the correct tive to the electoral cycle. The success of a privatization program often depends on divest- ing all or most of the state’s ownership before In two important respects, establishing the government faces the next election, and this can force a compromise with long-term competition in the market—such as efficiency objectives. In England and Wales, for example, an upcoming general election led through a price-based pool—and the reformers to accept a virtual duopoly in a sup- posedly competitive wholesale power market. functioning of autonomous regulatory Finally, the government’s full and sustained com- agencies, the E&W model may have only mitment is vital to the success of its reform pro- gram. This requirement was evident for the limited or long-term relevance for many England and Wales power market reforms dur- ing the difficulties of designing, restructuring, developing countries. and privatization, and it continues after the re- forms, as the government must resist tenden- price signals to use electricity efficiently; it cies by some power entities to revert to the also relieves hard-pressed government bud- pre-reform structure. gets of the burden of subsidizing the wealthy. But some help to enable low-income house- Relevance of the E&W model holds to obtain connections to the electricity to developing countries network can substantially raise their real in- comes without blunting incentives for effi- Because the power markets of developing coun- cient supply and use of electricity. tries have development priorities that differ from ▪ The explicit separation of the state’s regula- those of the England and Wales power market, tory functions from its ownership and policy it is important to identify the features of the E&W responsibilities, to allow state-owned utilities model that are relevant to these countries. The the necessary autonomy and accountability main development priorities for power sectors and to provide fairness in regulation for all in developing countries are to meet rapidly in- suppliers, both state owned and private. creasing industrial and commercial needs and ▪ The vesting of regulatory duties in a sector- to expand the population’s access to electricity specific regulator as an alternative to the under severe public financing constraints and lengthier and costlier U.S.-style judicial with weak institutional endowments. Power re- process. form in developing countries tends to be driven ▪ The establishment of an independent trans- by failure to meet one of these priorities, as in mission company with nondiscriminatory ac- The England and Wales Electricity Model—Option or Warning for Developing Countries? cess for suppliers to prevent the incumbent vestors in most developing countries because supplier from frustrating attempts to facili- of the lack of institutional checks and bal- tate competition. ances. Protection against regulatory uncer- ▪ The market-based approach to planning ex- tainty must be offered instead through pansion of the system with due consideration licenses (to distributors) and contracts (for of investment risks—because investors, not independent power projects). ▪ taxpayers, must bear the consequences of un- ▪ The poor credit ratings of many developing certainty in construction costs and schedules, countries greatly complicate the contractual plant availability, and fuel prices. process for mobilizing the large amounts of commercial finance needed for power invest- In two important respects, establishing com- ments, and thus require extensive perfor- petition in the market—such as through a mance guarantees by governments. price-based pool—and the functioning of au- ▪ Domestic capital markets are too under- tonomous regulatory agencies, the E&W model developed to replace foreign finance or to may have only limited or long-term relevance provide a market assessment of performance for many developing countries, because of the by suppliers and regulators; thus, develop- following concerns: ing countries must avoid giving perceptions ▪ The small size of the power market in most of excessive risk to foreign investors in the developing countries would result in trans- global competition for finance to develop action costs that exceed the efficiency gains their power sectors. from vertical unbundling. 2 ▪ The power markets in many developing Conclusion countries also are too small to allow enough The Note series is an open forum intended to suppliers for effective price-based competi- There can be no doubt that the E&W model encourage dissemina- tion without serious loss of scale economies provides an ultimate target for reform programs tion of and debate on under horizontal unbundling (about 100 de- in developing countries moving toward com- ideas, innovations, and best practices for veloping countries have power markets of petition and private participation. The question expanding the private less than 1,000 megawatts). is whether a developing country should embrace sector. The views ▪ Operating a competitive pool based on spot the model entirely, or even largely, without al- published are those of the authors and should pricing is too complex for all but the most lowing a long period of adaptation. Some ad- not be attributed to the advanced developing countries. There are vanced middle-income countries could consider World Bank or any of its simpler approaches to managing the whole- this approach. For most developing countries, affiliated organizations. Nor do any of the con- sale power market structured around a however, a policy of selecting only the features clusions represent well-designed set of market rules based on that can be adapted to local conditions is advis- official policy of the production costs. By allowing competition able. The key is to find the reform path that World Bank or of its Executive Directors for market share, these approaches can give best suits a country’s circumstances. or the countries they producers incentives to reduce costs. Such represent. markets are operating in Argentina, Bolivia, 1 See Robert Bacon, “Lessons from Power Sector Reform in England Comments are welcome. Chile, Peru, and Poland. and Wales” (Note 61, October 1995). Please call the FPD ▪ For developing countries that are fast grow- 2 See Robert Bacon, “Restructuring the Power Sector—The Case of Note line to leave a Small Systems” (Note 10, June 1994). ing, financially constrained, or both, the per- message (202-458-1111) or contact Suzanne sistence of large supply shortages rules out Smith, editor, Room the possibility of competitive power pools: John E. Besant-Jones, Power-Energy Utilities G8105, The World Bank, for competition to develop, adequate sup- Team, European Bank for Reconstruction 1818 H Street, NW, ply capacity must be available to meet all and Development, London (email: besant@ Washington, D.C. 20433, or Internet address load segments (base, peak, and so on). ebrd4.ebrd.com) ssmith7@worldbank.org. ▪ The substantial discretion given to the regu- 9 Printed on recycled lator in the E&W model over such matters as paper. setting pricing rules would deter foreign in-