Privatesector P U B L I C P O L I C Y F O R T H E The World Bank September 1995 Note No. 54 A Template for Power Reform David M. In the electricity supply industry, high-tension to justify their investment. Experience, however, Newbery transmission and low-tension distribution sys- shows that the politics of pricing are often tems are natural monopolies, but generation is heated. For social reasons, many governments potentially competitive. Because competition have set unremunerative prices, and many have is more effective than regulation in promoting failed to index public utility prices adequately efficiency, separating the potentially competi- to offset the effects of inflation. tive parts of the electricity supply industry from the natural monopoly parts that must inevita- Therefore, to give investors the confidence to bly remain regulated is good public policy. But tie up money in an investment that might not the potential for this kind of industry reform pay off for years, governments must reassure will vary by country—depending on whether them that the rule of law—specifically prop- the system is government owned, investor erty law—is sufficiently strong to ensure prop- owned, or under mixed ownership. If a coun- erty rights. And to reassure consumers and try can de-integrate its electricity supply indus- investors, a regulatory system must set rates try in this way, however, it should do so, or at satisfactory to both. Investors, in turn, must co- least keep the possibility open through contin- ordinate investment in transmission and gen- ued public ownership of the transmission sys- eration to find least-cost ways to expand the tem. And to create effective competition, system and to prevent system failures, fuel governments should privatize generation—and shortages, and price shocks. And because elec- possibly distribution—to pave the way for a tricity is vital to production, they need to reas- market in bulk power. This Note provides a sure governments that supplies will be available template for such industry reform. at all times. How to satisfy this set of objec- tives constitutes the regulatory problem. The regulatory problem What industrial countries have done A natural monopoly arises when a single firm can provide a range of goods or services at lower The history of the electricity supply industry in cost than a set of firms. Electricity networks are different countries illustrates the variety of so- natural monopolies in this sense. Moreover, their lutions that have been found to the regulatory monopoly is in the supply of a necessity, and problem. The solutions are of three main types. they have a direct connection to consumers. This The industry may be entirely publicly owned, combination of necessity and direct connection and thus subject to direct political control; it implies large potential exploitative power and may be entirely private, but regulated explic- ensures that regulation or public ownership is itly or implicitly; or it may be a mixed system politically inevitable. Investors in the electricity in which the private sector is implicitly con- industry must therefore expect limits on the trolled by the potential of the remaining pub- prices they can charge and sometimes onerous licly owned system to take over its function. obligations relating to safety, supply, and stabil- ity. In exchange, though, investors need reas- The simplest structure is a publicly owned na- surance that future prices will be set high enough tional monopoly such as exists in Belgium, Private Sector Development Department ▪ Vice Presidency for Finance and Private Sector Development A Template for Power Reform A GLOBAL FINANCING PROBLEM The performance of the state-run power sectors was frequently unimpressive—particularly when high inflation followed the oil Industrial countries’ demand for electricity increased sharply shocks of the 1970s. Despite excess demand, prices hovered after World War II. Improvements in reliability and high but below long-run marginal costs, and the rate of return fell so that falling electricity prices financed the huge investment profits could not finance needed investments. In 1991, with only 60 programs needed to meet demand and to modernize genera- percent of power sector costs covered by revenues, self- tion and transmission. Until the oil shocks of the 1970s and financing ratios fell to only 12 percent of investment requirements. growing fears over nuclear power, therefore, public criticism In fact, by the late 1980s, continuing in this vein was no longer of the power sector was muted. financially feasible for utilities or for governments, especially in In developing countries, the electricity supply industry was Latin America. Fundamental sector reform (including privatiza- almost invariably state-controlled, with international orga- tion) was proposed as the solution. In 1978, Chile had begun nizations such as the World Bank helping to meet investment radically restructuring its electric industry as a prelude to requirements. In 1984–91, nearly 9 percent of official develop- privatization. Deregulation was on the agenda in the United ment finance went to the power sector, and power accounted States, with modest beginnings in the power sector under the for about 15 percent of total World Bank lending until 1991. In Public Utilities Regulatory Policies Act of 1978. But the pace the 1980s, infrastructure accounted for more than 55 percent of quickened with the simultaneous restructuring and privatization total public investment in middle-income countries, and roughly of the electricity supply industry in the United Kingdom in 1990–91. 40 percent of that share—or a quarter of total public invest- This reform demonstrated the importance and feasibility of ment—went to power. Official aid financed about 10 percent of restructuring the industry and changing the system of regulation, the annual power sector investment—roughly US$80 billion— usually as preconditions for privatization (though, as Norway and the World Bank financed about 3 percent. shows, this last step is not logically implied by the first two). France, Italy, and Portugal and used to exist in Structural choices and the design England before 1990. Austria, the Netherlands, of regulation and Spain have de-integrated their industries to varying degrees and formed cooperative Reforming the electricity supply industry in coun- power pools that dispatch in order of cost. In tries with nationalized industries (owned and the Netherlands, four regional generation com- controlled by the central rather than the local panies own the grid and the dispatch company, government) raises different problems than in and the industry draws up plans subject to those with private (investor-owned) industries government approval. In Spain, the grid is un- or mixed systems. Governments without direct der public control, and the government deter- control over assets will be constrained in regu- mines the investment plan. And in Austria, the latory reform by the rights of the existing own- national power company owns the grid and ers. Radical restructuring is far easier under also has ultimate responsibility for ensuring public ownership, although in countries with supply, but coordination of power sector in- unclear or overlapping property rights (of work- vestment is decentralized. ers, local municipalities, and ministries), it may require clarifying the state’s control over indus- Unlike most other European electricity supply tries. For countries undertaking reform, advis- industries, those in Germany and Switzerland ers will need to answer the following questions: are complex and fragmented. This reflects the How should the industry be structured? Which federal structures of these countries and the fact parts should be public and which private? And that, because their power sectors were not na- which parts should be regulated and how? tionalized, they have not been restructured. The Scandinavian electricity supply industries are un- Industry structure der mixed public and private ownership and are largely self-regulating, coordinating electricity Since generation is potentially competitive and supply through cooperation and negotiation. transmission is a natural monopoly, separating the ownership of the two systems might allow to be most difficult, because it requires overrid- competition to effectively take the place of regu- ing private property rights or expensive compen- lation in generation. But for competition to be sation. If generation is to be transferred to private effective, there must be enough independent ownership, transmission should be kept sepa- generators actively competing in setting the price. rate, perhaps initially in public ownership, or as This active competition may be difficult to achieve a separate company with restrictions on control if new power stations are large relative to the by generators or by large users or distributors. total capacity of the country or if the transmis- sion system is unable to ensure adequate com- Public or private ownership? petition in each region. If competition fails to keep prices low, regulation may be necessary. Most studies comparing the performance of pri- vate electric utilities with that of publicly owned When generation and transmission are inte- utilities conclude that there is little difference grated, only the delivered power price needs in technical or cost efficiency, though very re- regulation. But if transmission is separate, cent studies indicate better performance un- charges for access to and use of the transmis- der private ownership. sion system will need to be regulated to en- sure efficient generation in the short run and efficient choices in plant type and location in . . . experience suggests that efficiency the long run—a challenging task. depends more on the form of regulation Some of the considerable benefits of competi- tion in generation can be achieved by inviting than on the form of ownership. competitive tenders for the construction of new plant, built and operated under long-term con- In the United Kingdom, privatizing the genera- tracts with the transmission company. But verti- tors and forcing them to compete in the bulk cal de-integration offers potentially greater electricity market doubled labor productivity in benefits. It creates competitive pressure at stages three years and improved control over invest- where entry is feasible, and it may result in over- ment costs. But the publicly owned Nuclear Elec- all improvements in efficiency sufficient to offset tric and British Coal, both forced to sell in the inefficiencies of transactions through the net- markets where there was competition from pri- work. Vertical de-integration also hinders cross- vate firms or imports, also improved their pro- subsidization and makes pricing more transparent. ductivity dramatically. In Argentina, generation availability improved within a short period after Given these considerations, what course should privatization, with Central Costanera increasing be taken by a government contemplating a po- availability from 20 percent to 50 percent and tentially radical restructuring of the industry? Such doubling its output. Norway introduced com- opportunities are rare and should not be wasted. petition in the bulk electricity market and in The guiding principle should be whether the pro- 1993 created Statnett Marked (as a subsidiary of posed reform forecloses options or keeps them the state-owned owner of the transmission sys- open. If de-integration is possible, a government tem, Statnett) to operate the power pool, with- should choose that course—or at least keep that out altering the ownership structure of the option open through continued public owner- industry. The result has been substantial trade ship of the transmission system. Continued, cen- across former franchise boundaries and de- tralized public ownership keeps most options creased dispersion of prices. In due course, the open, but municipal ownership appears to cre- Norwegian reform should provide a good test ate obstacles to further reform, at least in some of whether, in creating contestable power mar- political systems. Reforming a privately owned, kets, it is more important to restructure the in- vertically integrated generation system appears dustry or to privatize it. Note, however, that the A Template for Power Reform Norwegian system allows private generators to and new investment in transmission and gen- compete with state and municipally owned sys- eration is required, prices will need to be ad- tems. In the United Kingdom, as in Argentina equate to reward private investors. and Chile, distribution companies remain natu- ral monopolies, and the rate of improvement in The major challenge in designing regulation their performance has not changed markedly for a de-integrated industry is to provide ad- since privatization—although neither has it de- equate assurances of investor protection, so that teriorated. Altogether, this experience suggests the necessary expansion will take place, while that efficiency depends more on the form of preserving the benefits of market competition. regulation than on the form of ownership. Policymakers must ensure that the bulk elec- tricity market is adequately competitive to avoid Criteria for regulation a need for the burdensome regulation that un- dermines investor confidence. A good system of regulation does two things. It enables a utility to raise finance for invest- Priorities in developing and transition ment at an acceptable cost. It provides incen- countries tives for efficiency in operation, pricing (and thus use), investment (in the choice of type, In developing countries, the main problem is location, size, and cost), and innovation. These to improve the financial and economic perfor- requirements may conflict, however. Rate-of- mance of the industry—by rebalancing tariffs, return regulation guarantees an adequate re- eliminating costly interruptions in supply, re- turn on capital and thus enables a utility to ducing construction and operating costs, and finance investment cheaply, but it gives little avoiding construction delays. Private invest- incentive to increase efficiency. Price cap regu- ment in generation—and possibly in transmis- lation does provide good incentives to reduce sion and distribution as well—looks attractive costs. But by increasing profits, it ends up cre- on all scores, as long as entry is competitive This series is published ating pressure to tighten price regulation, which and the regulatory environment keeps risks and to share ideas and invite increases regulatory risk and raises the cost of costs low. The evidence from Chile in particu- discussion. It covers financial and private investment. Regulatory reviews must be care- lar—where regulatory reform and the restruc- sector development as fully designed to ensure investor confidence turing of state enterprises occurred first and well as industry and and continued political support. The U.K. so- privatization proceeded quite slowly—shows energy. The views expressed are those of lution is to grant licenses to the utilities that the importance of creating a sound, indepen- the authors and are not clearly specify their rights and obligations and dent system of regulation, commercialization, intended to represent can be defended or enforced in the courts. and competition, even for state-owned utili- an official statement of Bank policy or strategy. ties, and the relative unimportance of rushing Creating competition into privatization. In Eastern Europe, efforts to Comments are welcome. privatize utilities to reduce public debt have Please call the FPD Note line to leave a Creating effective competition requires separat- been hampered by low tariffs and unsatisfac- message (202-458-1111) ing transmission from generation and privatiz- tory regulation. Solving these problems would or contact Suzanne ing generation (and possibly also distribution) remove the financial urgency of privatization. Smith, editor, Room G8105, The World Bank, in order to create a market for bulk electricity. 1818 H Street, NW, This restructuring has far-reaching effects on the This Note is based on a chapter by the author in Claudio Frischtak, Washington, D.C. 20433, relative price structure, reducing the ability to ed., Regulatory Policies and Reform: A Comparative Perspective (World or Internet address ssmith7@worldbank.org. cross-subsidize and putting competitive pressure Bank, Private Sector Development Department, Washington, D.C., forthcoming). To order, contact Cindy Wong at (202) 473-3606 or by on fuel supply industries, making subsidies e-mail (cwong@worldbank.org). 9 Printed on recycled harder to justify. Paradoxically, when costs fall paper. as efficiency increases, labor is shed, and costly David M. Newbery, Department of Applied fuels such as coal and nuclear are replaced by Economics, Cambridge University, Cambridge, gas, prices may rise as subsidies to capital and England fuel are removed. If demand growth resumes