E N E R G Y A N D M I N I N G S E C T O R B O A R D D I S C U S S I O N P A P E R P A P E R N O . 1 9 S E P T E M B E R 2 0 0 6 38017 Reforming Power Markets in Developing Countries: What Have We Learned? John E. Besant-Jones THE WORLD BANK GROUP Energy and Mining Sector Board AUTHOR DISCLAIMERS John E. Besant-Jones (jbesantjones@worldbank.org) is a The findings, interpretations, and conclusions expressed in consultant to the World Bank, where he was previously Lead this paper are entirely those of the author and should not be Energy Economist in the Energy and Water Department. attributed in any manner to the World Bank, to its affiliated He also worked at the European Bank for Reconstruction organizations, or to members of its Board of Executive and Development. Directors or the countries they represent. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility whatsoever for any consequence of their use. 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All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, World Bank, 1818 H Street N.W., Washington, D.C., 20433, fax 202-522-2422, e-mail: pubrights@worldbank.org E N E R G Y A N D M I N I N G S E C T O R B O A R D D I S C U S S I O N P A P E R P A P E R N O . 1 9 S E P T E M B E R 2 0 0 6 Reforming Power Markets in Developing Countries: What Have We Learned? 1 John E. Besant-Jones The World Bank, Washington, D.C. THE WORLD BANK GROUP Energy and Mining Sector Board Copyright © 2006 The International Bank for Reconstruction and Development/The World Bank Group. All rights reserved. 2 CONTENTS ACKNOWLEDGMENTS ............................iv Private Sector Roles ........................................44 ACRONYMS AND ABBREVIATIONS ..........i v Conditions for Sustainable Private Investment ..46 FOREWORD............................................v 4.4 Improving the Feasibility of Privatizing .............. 1 . OVERVIEW........................................1 Distribution ........................................................48 1.1 Context of the Paper ......................................1 What Is Being Privatized ................................49 1.2 Strategic Elements of Power Market Reform ....1 The Prospective Private Participants ................50 Element 1: Power Market Reform Has Many ........ When Privatization Should Take Place..............51 Dimensions ......................................................2 How Privatization Should Be Conducted ..........52 Element 2: Power Market Reform Must Risk Mitigation Options ..................................52 Be Adapted to Starting Conditions ....................3 5 . MARKET STRUCTURE AND Element 3: Power Market Reform Is a GOVERNANCE ................................5 9 Process--Not an Event......................................4 5.1 Importance of the Market Structure Element 4: Power Market Reform Is an for Market Governance ......................................59 Opportunity to Help the Poor............................6 5.2 Restructuring Power Supply............................60 2 . CONTEXT OF POWER MARKET REFORM Purchasing Agency­Single Buyer ....................62 IN DEVELOPING COUNTRIES..............9 Restructuring Small Power Systems ..................64 i 2.1 The Techno-Economic Basis for 5.3 Experience with Independent Power Market Reform in Developing Countries ....10 Power Producers ................................................66 The General Case for Reform..........................10 Impact of Independent Power Producers..........67 The Case of Developing Countries ..................12 Sustainable Conditions for Independent 2.2 The Importance of Political Factors for Power Producers ............................................69 Power Market Reform..........................................14 5.4 The Role of Competition in Power Markets ....71 The Political Nature of Power Characteristics of Competition in the Market Reform................................................14 Power Market ................................................71 The Political Incentives to Reform ....................16 Wholesale Power Trade ..................................73 Political Issues for Reforming Power Markets....18 Competition in the Power Markets of 3 . CURRENT EXTENT AND OUTCOMES OF Developing Countries......................................76 POWER MARKET REFORM IN 6 . REGULATION OF POWER MARKETS . .7 9 DEVELOPING COUNTRIES ................2 1 6.1 The Need for Public Regulation 3.1 The Extent of Power Market Reform ..............21 of Power Markets................................................79 3.2 Classification of Developing Countries by 6.2 Institutional Approaches to Power Power Market Reform..........................................27 Market Regulation ..............................................80 3.3 The Rise and Fall of Private Investment ..........29 6.3 Regulatory Credibility for Private Investment ..83 3.4 Outcomes of Power Market Reform................31 6.4 Regulation by Contract to Support a Better Service Quality for New Regulatory Regime ......................................86 Electricity Consumers ......................................33 6.5 Incentive Regulation to Promote Efficiency......88 Improvement in Government's 7 . ACCESS AND AFFORDABILITY TO Fiscal Position ................................................33 ELECTRICITY SERVICES ....................9 1 Affordable Access to Electricity for the Poor ....35 7.1 Context and Background ..............................91 4 . ENTERPRISE RESTRUCTURING AND 7.2 Reform Policies for Improving Access and CORPORATE GOVERNANCE ..............3 7 Affordability ......................................................93 4.1 Corporate Governance and 7.3 Removing Regulatory and Institutional Commercialization ..............................................38 Constraints on Electricity Services ........................94 4.2 Conditions for Justifiable Public Regulation of Electricity Markets Serving Investment ..........................................................42 Low-Income Users ..........................................95 4.3 Private Sector Participation ............................43 Institutional Reforms for Supporting Access TABLE 15. Private Power Investments in and Affordability ............................................96 Latin America and Asia 1990­2002 ..................113 7.3 Financial Viability and Affordability ..............98 TABLE 16. Types of Power Market Reforms with Reducing Service Costs ..................................98 Different Starting Conditions ............................116 Designing Appropriate Tariffs..........................99 Subsidizing Electricity Services to FIGURES Low-Income Households ..............................101 FIGURE 1. System Size and National Income of 8 . IMPLEMENTING POWER MARKET Unbundled Power Systems ..................................26 REFORM ......................................107 FIGURE 2. Private Investments in Electricity in 8.1 Challenges for Implementing Power Developing Countries, 1990­2002......................30 Market Reform..................................................107 FIGURE 3. Geographic Imbalance in Private 8.2 Government Roles and Responsibilities ........109 Investment in Electricity, 1990­2002....................30 8.3 Sequencing of Power Market Reform............111 FIGURE 4. Distribution of Private Investment by 8.4 The Transition Stage for Power Market Power Market Segment, 1990­2002 ..................30 Reform ............................................................115 FIGURE 5. Power Market Governance The Importance of Starting Conditions ..........115 Framework ........................................................38 Quick versus Gradual Approaches to FIGURE 6. Private Participation Roles in Reforming Power Markets ............................115 Power Markets of Developing Countries ..............46 ii Reform Road Map ........................................119 FIGURE 7. Correlation of Power Supply APPENDIX: REFORM OF POWER Structures with Power Market Structures ..............60 MARKETS IN OECD COUNTRIES............121 FIGURE 8. Decision Tree for Source of GLOSSARY ........................................127 Subsidy Funding................................................105 REFERENCES ......................................137 FIGURE 9. The Challenging Global FURTHER READING ............................161 Environment for Developing Countries ..............108 TABLES BOXES TABLE 1. Types of Power Market Reforms BOX 1. Elements of Full-Scale Power with Different Starting Conditions..........................5 Market Reform....................................................11 TABLE 2. Distributions of Power Supply BOX 2. Fiscal Burden of the Indian Structures in Developing Countries ......................23 Power Sector ......................................................13 TABLE 3. Differences in Power System BOX 3. The Impact of Economic Turmoil on FSU Characteristics by Threshold Group ....................28 Power Sectors during the 1990s ..........................16 TABLE 4. Improvement of Privatized South BOX 4. Political and Institutional Concepts American Distribution Companies........................34 Applied to Reform of Power Markets....................17 TABLE 5. Main Features of Public-Private BOX 5. Developing Country Groups by Current Partnerships........................................................45 Power Supply Structure........................................22 TABLE 6. Power Market Risk Matrix and BOX 6. Evolution of Power Market Reform in Coverage ..........................................................54 Latin America ....................................................25 TABLE 7. Types of Vertical Unbundling ................66 BOX 7. Reforms Undertaken in Eastern Europe TABLE 8. Risk Exposure to the Impact of and Central Asia ................................................26 IPP Costs in Four Southeast Asian Countries ........68 BOX 8. Classification of Developing Countries by TABLE 9. Market Concentration in Selected Income and Size Group ......................................27 Latin American Power Markets, 1998 ..................75 BOX 9. Successful Outcomes of Power Sector TABLE 10. Impacts on Access and Affordability of Privatization in Chile and Argentina ....................32 Different Types of Utility Reform ..........................94 BOX 10. Impact of Power Market Reform on TABLE 11. Policy Instruments for Promoting Georgia's Urban Households ..............................36 Access to Electricity Services..............................100 BOX 11. Governance Requirements for Power TABLE 12. Policy Instruments for Promoting Distributors ........................................................41 Affordability of Electricity Services ....................101 BOX 12. Improving State-Owned Power TABLE 13. Subsidy Instruments for Helping Suppliers in Andhra Pradesh ..............................41 Low-Income Electricity Consumers ....................103 BOX 13. Privatization Lessons from Eastern TABLE 14. Sequence of Power Market Reform Europe................................................................52 Measures in 20 Developing Countries................111 BOX 14. Post-Privatization Lessons from Orissa ..53 BOX 15. The Distribution Margin Approach........56 BOX 16. Cash Flow Problems in Ukraine's Wholesale Electricity Market................................62 BOX 17. The Roles of the Single Buyer Model in Eastern European Power Markets ....................63 BOX 18. Example of a Small Competitive Wholesale Power Market in Guatemala ..............65 BOX 19. The Importance of Political Institutions: The Southeast Asian Experience ........69 BOX 20. China's Experiment with Competition in the Wholesale Power Market ..........................72 BOX 21. Partial Risk Guarantees for Privatizing Distribution in Romania and Uganda ..................82 BOX 22. Regulatory Principles for Promoting Off-Grid Electrification........................................96 BOX 23. Three Models for Attracting New Electricity Service Providers..................................98 BOX 24. Output-Based Aid ..............................104 BOX 25. India's Experience with a Gradual iii Approach to Power Market Reform....................118 BOX 26. Road Map for Power Market Reform ..119 BOX 27. New Electricity Trading Arrangements for England and Wales ....................................122 BOX 28. Lessons from California with Competition in the Power Market ......................124 ACKNOWLEDGMENTS A compilation and sourcebook of lessons of experience, such as this paper, naturally relies extensively on the work of others in the same field. This paper could not have been written without the benefit of drawing on the 240 or so referenced documents on experience with reforming power markets in developing countries. This paper also benefited from advice, suggestions, and corrections about the numerous technical issues involved in power market reform that was given by colleagues. I therefore express my gratitude for this help to Douglas Barnes, Philippe Benoit, the late Mathew Burresch, Charles Feinstein, Vivien Foster, Jonathan Halpern, David Kennedy, Kari Nyman, Ignacio Rodríguez, Richard Spencer, Tjaarda Storm Van Leeuwen, Bernard Tenenbaum, and Alan Townsend. I also want to thank John Prakash for his help with the references. Nevertheless, as the author, I am responsible for any errors and omissions. ACRONYMS AND ABBREVIATIONS BL build and transfer MW megawatt--equivalent to 1,000 kilowatts iv BLT build-lease-transfer NGO nongovernmental organization BOO build-own-operate OBA output-based aid BOOT build-own-operate-transfer OECD Organisation for Economic Co-operation BOT build-operate-transfer and Development BTO build-transfer-operate OGN Operational Guidance Note for Public and disco distribution company Private Roles in the Supply of Electricity Services EGAT Electricity Generating Authority of Thailand PPI private participation in infrastructure FSU former Soviet Union PV photovoltaic GDP gross domestic product PRG Partial Risk Guarantee genco generation company ROM rehabilitate-operate-maintain GW gigawatt--equivalent to 1 million kilowatts ROT rehabilitate-operate-transfer GWh gigawatt-hour--equivalent to SEB State Electricity Board (India) 1 million kilowatt-hours SME small and medium enterprises IDA International Development Association SOT supply-operate-transfer IEA International Energy Agency TI Transparency International IFC International Finance Corporation TOOR transfer of operating rights IPP independent power producer TPA third party access ISO independent system operator transco transmission company kW kilowatt kWh kilowatt-hour LAC Latin America and the Caribbean MDB Multilateral Development Bank MIGA Multilateral Guarantee Agency FOREWORD The global movement to reform electric power markets This paper complements the World Bank's Operational has advanced considerably since it started during the Guidance Note by compiling lessons of this experience 1980s. Developing countries and transition economies that help in applying the Note's guidance. These lessons have participated widely in this movement, despite huge are taken from the rapidly growing literature on power challenges for implementing such complex changes in market reform in developing countries. They cover the their economic condition. To date, about 70 developing range of issues that are involved in reforming power countries and transition economies have embarked on markets comprehensively, but cover them concisely to reforming their power markets--some to a considerable maintain its broad perspective. Details of the various extent, others more tentatively. Together their reform aspects covered in the paper can be found in published programs show variety and innovation in accommodating references, for which the paper also acts as a sourcebook the wide range of physical and economic characteristics of about 240 documented references to this reform found in these countries. All of these countries, and other experience. The paper includes Web links for most of these developing countries contemplating reform of their power documents to make them easily accessible to readers. markets, face considerable challenges to both complete and sustain their reform programs. A considerable amount Although the paper is intended for use by Bank staff, of experience in reforming power markets in developing I am happy to offer it to other participants in reforming countries and transition economies has now been power markets of developing countries, and in particular v accumulated and publicly documented. to our clients' representatives working in this field and to our colleagues in other donor agencies, as well as to The World Bank Group has substantially supported these everybody else with an interest in this subject. reforms and contributed extensively to documenting them. In 2004 following a review of the effectiveness of this support, the World Bank issued an Operational Guidance Note for Public and Private Roles in the Jamal Saghir Supply of Electricity Services for the use of its staff Director, Energy and Water working in this field. This Note provides guidance to Chairman, Energy and Mining Sector Board World Bank Group staff on assessing the suitability of June 2006 available options for public-private roles in the financing and provision of electricity in developing countries. The guidance is based on experience to date and recognizes the variety of conditions among the Bank's client countries. 1. OVERVIEW About 70 of the 150 developing countries and transition markets and--subsequently--at the social issues economies have embarked on reforming their power associated with power market reform for access and markets since the early 1990s. The drivers of this affordability to electricity services for the poor. Finally, reform movement are disenchantment with the poor the paper examines issues for implementing a reform performance of state-owned power utilities, the need program, including government's roles and for new investments and modernization to meet rapid responsibilities, sequencing of reform steps, and growth in demand, and fiscal pressure, along with the transition issues for reform programs. desire to protect and help the poor. The reforms have generally been tentative and incomplete, however, 1.2 Strategic Elements of Power Market Reform particularly in relation to market structure, degree of private participation, and development of the regulatory Power market reform in developing countries should be framework. The countries that have embarked on power assessed against three outcomes that reflect the drivers market reform cover a broad range in physical, for reform. These outcomes are better service quality for economic, and institutional terms. The most advanced electricity consumers to support economic growth and countries in reform are located in Latin America and in welfare, improvement in government's fiscal position, Eastern Europe, where they also have relatively larger and more affordable access to electricity for the poor. power systems and higher levels of per capita national They reflect the main drivers of reform. The main 1 income compared with other developing countries and elements of reform--restructuring power utilities and transition economies ("developing countries"). markets, regulation, competition, and the roles of public and private participants--are the means for achieving 1.1 Context of the Paper these outcomes. This paper compiles the lessons of experience from the The most important lesson from reforming power reforming power markets of developing countries and markets in developing countries is that "cookbook" transition economies. It focuses on reforms that address solutions for reforming their power markets are ruled out the generally poor performance of power markets in by the extensive range of economic and institutional developing countries. It also covers reforms in those endowments of these countries. This lesson emphasizes developing countries with power markets that are the importance of country and power market starting performing reasonably well. These lessons are taken conditions for reform, since these conditions determine from the rapidly growing literature on power market the initial--and often subsequent--scope and composition reform in these countries. The paper also acts a of reform. Countries with better endowments should be sourcebook of about 240 references to this able to achieve more ambitious outcomes from power documented experience. market reform than countries with lesser endowments. Reforms based on substantial market restructuring for The paper complements the World Bank's Operational large middle-income countries, for example, would be Guidance Note for Public and Private Roles in the infeasible for small low-income countries. Conversely, Supply of Electricity Services (OGN; World Bank modest reforms designed for the limited economic and 2004b). It follows the sequence of reform components institutional capacities of small low-income countries adopted in this Note in order to ease cross-referencing would have unacceptably low outcomes in large middle- between these documents. First, the paper covers the income countries. The paper shows how power market context and background of power market reform in reform can be designed to suit the specific conditions of developing countries. It then covers the strategic these two groups of countries. components of reform to power markets, starting with enterprise restructuring and corporate governance, The experience gained from implementing power market including the respective roles of state-owned enterprises reform is as important as the considerable experience and private enterprises in the provision of electricity gained about designing power market reform. In order services. It next deals with market structure and to show how implementation affects design, this chapter restructuring power systems, the experience with brings together the design lessons summarized in the independent power producers (IPPs), and competition in paper under the following four strategic elements for the power market. It then looks at regulation of power implementing power market reform: 1. Power market reform has many dimensions. restructuring and private sector participation involves complex social and political issues for market investors, 2. Power market reform must be adapted to starting utility employees, and electricity consumers. Even the conditions. basic initial reform step of separating the generation, transmission, and distribution businesses of a power 3. Power market reform is a process--not an event. utility can provoke huge social and political problems with utility employees and their political supporters. 4. Power market reform is an opportunity to help the The complexity of these issues can sometimes match the poor. complexity of the technical issues involved in reforming power markets. Element 1: Power Market Reform Has Many Dimensions Distributional issues are often at the heart of designing power reform programs. Reforms must not only offer Many dimensions of power market reform are important benefits that substantially outweigh the costs of reform, in developing countries. Under mounting experience, but also provide the means for compensating losers or power market reform in developing countries has mitigating the impact of reform on them to overcome increasingly emphasized the social, legal, and political their opposition or redress inequities against them. dimensions of reform in defining the techno-economic Although reforms to power markets have delivered 2 dimension. This reflects the reality that reform has to substantial benefits to society overall through efficiency confront underdevelopment of energy and financial gains, most of these benefits have been shared by markets, weakness in legal and governance systems, power producers, service providers, higher-income bouts of macroeconomic instability, and major concerns consumers, and commercial businesses, but have not about access and affordability of electricity services at reached other segments of society, including the poor. the prevailing low income levels. Few developing countries can contemplate the technically sophisticated The impact of power market reform on the poor is a power market reforms, such as radical market restructuring critical distributional issue. The poor have obtained a and private risk investment with competition in both the low share of the benefits of power market reform in wholesale and the retail markets for electricity, that are developing countries, and some have even suffered feasible under the much higher economic and institutional welfare losses. Some of the poor have gained from endowments of Organisation for Economic Co-operation reform by receiving otherwise unavailable connections and Development (OECD) countries.1 to electricity supply. Some of the poor who have lost from reform were obtaining some electricity service Change to commercially oriented governance is before reform--albeit illegally and of poor quality-- fundamental to achieving sustainable reform of power but were disconnected or now have to pay for their markets. Power market reform in a broad sense can be consumption. Other groups of the poor continued to viewed as a means to improve governance of the power receive legal service, but at higher tariffs as subsidies market and its participants. The traditional model of and cross-subsidies were removed under the commercial governance under state ownership is not sustainable in pressure on service providers introduced by reform. most developing countries. Commercially oriented governance irreversibly removes the management and Governments must sustain their political commitment in development of power supply from political and the face of considerable political risks for reforming their bureaucratic control to achieve commercial standards in power markets. Maintaining momentum for reform involves management practices, financial performance, and the political costs and thus requires political commitment pricing of products and services. Changing these deeply through successive phases of the reform process over ingrained attitudes is a major challenge for power one or more electoral cycles. Reform yields uncertain market reform in developing countries. benefits in the long term because unanticipated events can derail reform programs, yet reform can also incur Social and political factors are important for all power substantial unavoidable costs in the short term. market reform programs. Government must generate Governments often have to deal with opposition from public acceptance and stakeholder consensus for these the losers under reform (subsidized consumers, utility programs. Power market reform based on market employees, or the beneficiaries of corrupt procurement) Differences in physical endowments are not a factor, since many developing countries have much greater primary energy resources than most 1 OECD countries. and by society at large to privatizing this essential public institutionally. The case for unbundling is weakest in service, especially when the new service providers are small systems in countries with undeveloped institutional foreign parties. Increases in electricity prices that are capacity and weak economic conditions. perceived as entirely a consequence of reform are vulnerable to a public backlash. Yet reform proponents The numerous countries whose power systems are too have often underestimated the importance of these risks small for a competitive power market have intermediate when considering techno-economic issues. reform options. Unbundling the generation and distribution segments of the power supply chain into tiny entities Element 2: Power Market Reform Must Be Adapted would not make sense in these systems, because to Starting Conditions economies of scale and scope would be lost without gaining the benefits of competition. Forming power trade Starting conditions in the power market are important for areas with neighboring countries can be facilitated by designing power reform programs. These conditions separating the generation, transmission, and distribution include the size of the country and its power system and components of supply chains even in relatively small market, the country's location relative to other power systems. This trend is noticeable in some regions of the markets, its income level and macroeconomic condition, developing world. Even in small power systems, however, its political situation, and the capacity of its domestic separation of these components helps regulation of financial markets and institutions. They reflect the many power service providers by revealing information about dimensions of power market reform and critically their costs, increasing the transparency of price setting, 3 influence the feasibility of reform programs and hence and helping benchmark costs and service standards. the outcomes that can be achieved from them in the These systems can adopt a purchasing agency or single short to medium term. The variety of starting conditions buyer until they can reap the benefits from greater among developing countries partly explains the diversity separation of the supply chain. of their power market reform programs and the development of innovative power market and industry The variety of ways for the private sector to participate in structures and regulatory arrangements. the supply and delivery of electricity services is another indicator of the range of reforms. The role of private The variety of market structures is one indicator of the participants should match their capacity to take on range of reforms to power markets. From the prereform investment risks under specific country conditions. structure of a monopoly, market structures can be Their roles can range from virtually no at-risk investment categorized according to the increasing degree of under management contracts through some investment competition, starting from a purchasing agency-- risk under long-term concessions to accepting all also known as a single buyer--through whom passes all investment risks under divestiture of ownership to the or most trade in wholesale and who therefore manages private sector. Problems--even failures--as well successes, competition for market share among generators and have been associated with these forms of private independent power producers. In developing countries participation in power markets. As more risk and the competitive structures are based on trading responsibility are passed to the private participants, arrangements in the wholesale power market that the incentives become more powerful for these allow distribution companies and large users of electricity participants to improve services, which would lead to to purchase electricity directly from generators either in greater benefits for the country and its power consumers a power exchange or bilaterally. in the absence of severe economic disruptions. The economic case for breaking up a vertically integrated The case for bringing the private sector into power supply power utility rests on various factors. The gains from functions rests on how well this would achieve the desired breaking up (or "unbundling") the utility by separating reform outcomes under the prevailing operating conditions. the generation component from the distribution component Latin American experience shows that privatization of are worthwhile when they exceed the costs of transactions power market assets can improve services at reduced among the separated segments introduced by unbundling. costs and with fiscal benefits, provided that stable The relevant factors are power system size and country macroeconomic conditions prevail. However, many institutional capacity to manage complex trading developing countries do not offer the necessary conditions mechanisms. The case for unbundling is strongest for attracting substantial amounts of private investment in large power systems in countries well endowed in this way to their power markets. Many of them have attracted substantial investments by independent power autonomy and capacity. In many Latin American countries, producers, but only by giving contractual protection the means by which regulatory discretion is limited yet against most noncommercial risks to these producers. regulatory commitment is provided is by embedding Public-private partnerships have brought private specific rules and procedures in concession agreements management and technical expertise into countries with and licenses provided to operators or in legislation poor investment climates. ("regulation by contract"). The public sector will remain an important source, Empirical analysis presented in the paper indicates that and often for the medium term the main source, of a clear threshold exists among developing countries in investment for a power market where country and market relation to size and income for the composition of power risks deter private investors. The public sector will also market reform. This threshold is formed by a combination remain the main source of investment for network of system size larger than 1,000 MW and national per segments of the power system and certain types of capita income above US$900. A large middle-income generation assets--such as hydropower--that are kept group of countries is formed by a combination of size under public ownership as a matter of policy. In many and income above these threshold values, and a small countries, some public investment will be needed to low-income group is formed by a combination of size rehabilitate nonviable generation and distribution and income below these threshold values. About two- businesses as a prerequisite for attracting private thirds of developing countries fall into these two groups. 4 investment in them or during the early years of concessions Although these two variables influence all components for distribution businesses. The public sector can play a of power market reform, they have relatively stronger financing or risk-bearing role by means of investment influences on different components. Country income financing and the provision of subsidies and guarantees level has a relatively stronger influence than power under public-private partnerships through management system size on the roles of the public and private sectors contracts, leases, and concessions. Finally, public financing and on access and affordability to electricity services. It will also be required to restructure power sector debt also has a stronger influence on the regulation of power arrears before privatizing many power supply entities. markets on the basis that institutional capacity increases with income level. Power system size has a relatively The range of approaches to establishing the credibility of stronger influence on market structure. Table 1 shows power market regulation is a third indicator of the range how this feature of developing countries influences the of reforms to power markets. Credibility of regulation is design of coherent power reform programs for country needed to attract long-term private at-risk investment in and power market conditions typically found in these electricity services. It covers autonomy to carry out two groups. duties, transparency in procedures and processes, and accountability to government and consumers. Element 3: Power Market Reform Is a Process--Not The principal means for developing credibility is a an Event designated regulatory agency that discharges its duties in a neutral and depoliticized manner. A regulatory Pressures for rapid results should not obscure the point agency needs the legal status that gives it substantial that reforming power markets is a long-term process that autonomy from political and market influences, the requires patience to achieve the desired outcomes. authority to set parameters for contracts and monitor This is because such outcomes as improving service their implementation, and the discretion to respond to quality for electricity consumers, strengthening the rapidly changing market conditions, but with restraint on government's fiscal position, and providing affordable arbitrary actions. access to electricity for the poor take time to accomplish. This situation applies especially to countries starting with Specific contractual arrangements may be needed to weak governance structures for power utilities and poor provide stability and credibility for private investors investment climates. under a new regulatory regime. Private investors place importance on the stability and enforceability of laws Power market reforms in developing countries are and contracts, and they contend that a credible regulatory generally tentative and incomplete, and are still works in system requires more than a newly formed regulatory progress. To date, most reform programs have reached entity. This is because many regulatory agencies begin interim positions--such as the single buyer model of performing their functions with the disadvantage of limited power trade--and still need to find ways to attract TABLE 1. Types of Power Market Reforms with Different Starting Conditions DEVELOPING COUNTRY GROUP LARGE MIDDLE-INCOME SMALL LOW-INCOME COUNTRIES COUNTRIES COUNTRY STARTING CONDITIONS Power system size Very small Small to large Access to electricity Low High Investment climate Too poor to rate Low to medium Institutional capacity Very weak Low to good Governance rating Poor Poor to good INITIAL REFORM CHARACTERISTICS Market structure Limited vertical unbundling. Single Substantial vertical and horizontal buyer with some simple bilateral unbundling. Bilateral trading or a trading for wholesale power. central exchange for wholesale power. 5 Regulation Semi-autonomous regulatory agency Autonomous regulatory agency with mainly responsible for oversight of power to issue licenses and approve concessions. retail tariffs and trading arrangements. Role of private sector Mainly independent power producers Privatized generators and IPPs. (IPPs); concessions in distribution Privately owned and financed under public-private partnerships. distributors under long-term licenses. Role of public sector Continued ownership of most power State ownership in sensitive supply facilities. Primary responsibility generation sectors (hydro, nuclear), for financing sector development. transmission, and nonviable distribution service areas. Role of competition Limited to bidding for long term Competitive bidding for wholesale agreements by IPPs and by private power contracts under bilateral operators for distribution trading or bidding into a power concessions. exchange. private investment sustainably and develop their regulatory mitigation mechanisms, such as by setting limits on the capacity. These achievements are unlikely to be sustainable amount of financial risk initially faced by private operators over the long term without deeper reforms because the of power distribution and generation facilities. Transition interim positions do not change the traditional model of arrangements to provide stability and credibility for a governance under state ownership. new regulatory regime revolve around regulation by contract under which regulatory rules and procedures The initial transition stage is critical to the success of are incorporated into concession agreements. power market reform and the most vulnerable period for derailment of the reform process by many developing Sequencing of power market reform should follow a countries. For market structure, transition concerns sound strategy: the separation of the industry structure into its main components and the adoption of a single buyer trader · The legal and regulatory framework necessary for wholesale power. For private sector participation, for creating the new market structure and trading transition focuses on private sector roles that fall short arrangements is put in place before privatizing power of full risk taking, such as management contracts and supply entities and setting up new market trading other forms of private participation, with temporary risk arrangements. · Restructuring of power markets progresses from an · Whether to give investments in new generating integrated structure to partially unbundled structures capacity lower priority than investments in distribution, and eventually for some countries to a fully unbundled especially in a situation of bulk power shortages. structure. Reform benefits take longer than expected. Consumers · Restructuring of wholesale power trading arrangements usually expect better services from private companies progresses from only internal transactions within an than from state-owned enterprises. Consumers integrated power utility to the entry of IPPs selling their understandably lose patience and blame the regulators output to a single buyer, then to opening access to if tariffs go up immediately but service improvements lag power networks by large users of power, and eventually behind. Therefore, it is not surprising that most regulators, to bilateral trading between generators and distributors when faced with this situation, will try to find ways not to or to a central power pool under competitive trading. raise tariffs. The preservation of protective features, such as "life-line" rates, may be necessary, even if they mean · Major organizational and financial restructuring continuing subsidies within income classes, as well as precede the creation of private ownership rights to from industry to residential consumers. avoid problems with stranded costs. Element 4: Power Market Reform Is an Opportunity Some countries have skipped the early stages of to Help the Poor 6 these sequences, and others may do so in the future. A sequenced process, however, is less risky and more Developing countries face major challenges to improve sustainable than a single-staged ("big bang") process access and affordability to electricity services for poor for reforming power markets in the conditions of households. These countries have responded to the developing countries. Reform sequencing should not, challenges differently according to their income levels. however, follow an overly cautious approach that runs Some developing countries have met these challenges the risk of delaying reform benefits and losing political with some success since the 1990s partly by attracting momentum for reform. some private investment. These countries have an extensive energy infrastructure and basic coverage service of Sequencing of power market reform also raises tactical electricity services. The least-developed countries, such issues. A general approach would not be applicable in as those in Sub-Saharan Africa, have yet to meet the case of tactical sequencing issues, given the wide challenges that are particularly daunting where typically variety in starting conditions for power market reform less than 10 percent of their population is connected to found among developing countries. Tactics should be electricity networks. specifically designed for each set of local conditions to address problematical issues, such as the following. Extending access to affordable modern energy services--including electricity services--for poor · Whether to increase tariffs before or after investments households is one of the most practicable ways of to improve the quality of service to power users. improving their welfare. This is because expanding access to these services from the low levels found in · Whether to try improving the commercial performance numerous developing countries helps to increase of loss-making utilities and distribution entities before household incomes and meet basic needs, such as bringing in private participation or with private improved health and primary education, as well as participation. support social empowerment and environmental sustainability. The cost of these services to users is often · How to base the reform of distribution entities on a considerably lower than the corresponding traditional feasible allocation of viable urban and nonviable rural energy alternatives used by poor households without areas among the entities, as well as the sequencing of access to these services. privatization in one or more rounds of transactions. The causes of poor electricity access and service for low- · Whether to start the privatization sequence for poorly income households originate in policy and regulatory performing power markets with distribution entities constraints. Policies that grant a legal monopoly to a before privatizing generation entities. power utility in low-income service areas may impede the flow of private finance to the power sector and costs, and increase supply options. Extending electricity discourage innovation in service delivery methods. service to urban low-income households requires Regulatory frameworks often raise the biggest barriers to improvement to the existing power system. Extending decentralized options for electricity supply, including access to electricity for rural households often involves barriers to alternative power technologies for locations creating the entire energy infrastructure network and not served by electricity and fuel distribution networks. developing viable new electricity service providers. Poorly formulated taxes and subsidies often undermine Instruments that promote affordability protect low- electricity service markets by favoring one fuel over income households from general increases in tariffs and another, giving consumers distorted price signals and costs of service and facilitate payment of bills. They creating disincentives for entrepreneurial solutions to stimulate services through nonstandard service delivery electricity supply. Finally, power market reforms designed mechanisms, service types, and tariff and payment and implemented by technical groups at the national mechanisms appropriate to low-income households. level that allow users little say in the design and delivery of electricity services can end up hurting--rather than Even under successful power market reform, poor benefiting--the poor. households need help with financing the costs of connecting their premises to the network and installing Reform provides an opportunity to rectify the policy and meters at the points of consumption. Well-designed regulatory constraints on electricity access and service subsidies provide good incentives to service providers-- for low-income households. Reform can overcome both specifically for serving low-income areas, as well 7 entrenched attitudes to providing electricity services and as generally--to attract private sector participation introduce different kinds of electricity services better through concessions and asset sales. The substantial suited to the poor. Opening up the main power market empirical evidence, however, questions the effectiveness to new entrants can stimulate incentives specifically of many existing subsidy schemes as a means of helping designed to attract new entrants into markets serving low-income electricity consumers. A number of poor areas. The establishment of a new regulatory approaches have been developed to improve the system for the main power market provides an opportunity targeting and cost-effectiveness of subsidy delivery for to introduce regulations that help the poor. Reforms that extending access to electricity services by low-income place the power market on a sound commercial footing, households. They include output-based aid (OBA) however, will not automatically improve access and approaches and other competitive approaches, as well affordability of electricity services to low-income as more traditional input-based approaches. households. They may make little difference to this Competitive approaches offer the advantage of allowing situation, or even worsen it. It is important to ensure that private innovation for finding solutions to extending reform does not adversely impact access and affordability. electricity services. Access and affordable consumption of electricity by poor households can be promoted by various policy instruments. Instruments that promote access require service providers to extend access, reduce connection 8 2. CONTEXT OF POWER MARKET REFORM IN DEVELOPING COUNTRIES This paper compiles the lessons of experience from The paper broadly follows the structure of the OGN: reforming power markets of developing countries and transition economies.2 It is intended to complement the · The rest of this chapter sets out the techno-economic World Bank's OGN on Public and Private Roles in the basis and the importance of political and institutional Supply of Electricity Services (World Bank 2004b). factors for reforming power markets in developing The paper also provides a sourcebook of references to countries. documented experience for reforming power markets in these countries and for a deeper treatment of the · Chapter 3 covers the current extent and outcomes of technical issues for designing reform components, power market reform in developing countries. such as corporate restructuring, power exchanges, regulatory rules, and privatization transactions. The next four chapters cover the strategic components of reform to power markets: The paper focuses on reforms to the generally poorly performing power markets in developing countries. · Chapter 4 covers enterprise restructuring and corporate It also covers reforms in those developing countries with governance, including the respective roles of state-owned reasonably performing power markets, for which it draws enterprises and private enterprises in the provision of selectively on the experience with the sophisticated power electricity services. markets that have been established in some OECD countries. The paper does not cover the technicalities · Chapter 5 covers market structure, including restructuring of these OECD power markets because they are too power systems, the experience with independent power 9 complex for conditions in most developing countries. producers, and competition in the power market. The paper serves as a sourcebook by providing a · Chapter 6 covers regulation of power markets. comprehensive listing of about 240 published reference documents about experience with power market reform · Chapter 7 covers ways that power market reform can in developing countries, including case studies about support access and affordability to electricity services power market reform in nearly 30 developing countries.3 for the poor. These documents reflect the rapidly growing literature on experience with power market reform. They are The final chapter of the paper--chapter 8--covers reform supplemented with references to power market reform implementation, which complements the subjects covered in OECD countries that clarify technical issues for power by the OGN. The chapter covers three main aspects: market reform.4 This literature covers empirical evidence (a) the challenges for implementing power market reform, from a variety of sources that include cross-country including governments' roles and responsibilities in this econometric analysis of power market reform, efficiency endeavor; (b) the sequencing of power market reform; and productivity analysis of power companies and sectors, and (c) managing reform transition, especially the as well as single-country case studies of power market importance of starting conditions. reform. The paper also uses published reviews of experience with electricity reform generally and of The appendix to the paper examines the relevance of specific aspects of reform by international agencies experience with power market reform in OECD countries and in technical journals. for reform in developing countries. The term developing countries is used in this paper to encompass both developing countries and the transition economies of Eastern Europe 2 and the former Soviet Union. Internet addresses are included for these documents. Most of these documents can also be found through the Google search engine 3 (www.google.com). Internet addresses for articles in journals that allow online access only to subscribers are specifically for access on the World Bank's internal Intranet through the Joint World Bank­International Monetary Fund Library (Jolis). The numerous documents in Spanish about power sector reform in Latin American countries are not included, but are also invaluable sources of information. The supplementary list of references to experience in OECD countries is a relatively small sample of the copious documentation on power 4 sector reform in these countries. Each chapter opens with a summary of the OGN's countries. Notwithstanding the alleged advantages of guidance on the particular aspect of power market the prereform structures, from the early 1990s these reform covered in the chapter. Sourcebook references countries have been experiencing power shortages and for each chapter are given at the back of the paper. frequent interruptions. Their power generating plants emit toxic pollutants, their power utilities are bankrupt, 2.1 The Techno-Economic Basis for Power their power tariffs do not cover costs (particularly for Market Reform in Developing Countries residential users), electricity is widely stolen by customers (frequently with the active support of existing employees), Reform of the power markets in developing countries many citizens--especially those in rural areas--lack generally starts from a market structure that is dominated access to electricity supply, and the power sector drains by a state-owned national power utility or utilities. the government's fiscal resources. This structure is typically backed by a legally endowed or de facto monopoly and a vertically integrated supply Worldwide, government policy, public attitude, and the chain in which all the main supply functions--power intellectual environment have changed substantially for generation, transmission, distribution, and customer power markets since the 1980s. Both OECD and services--are the responsibility of a power utility, developing countries became aware during the 1980s that especially in Africa, Asia, and the Middle East. The a lengthy period of state ownership without the forces of prereform industry structure in some countries, notably competition or the incentives of the profit motive to improve 10 in South America, placed distribution and customer performance, is liable to result in the excessive costs, low services with local companies, separate from national service quality, poor investment decisions, and lack of companies that provided power generation and innovation in supplying customers in these markets. The transmission. This structure emerged during the 1940s little synergy that power generation has with transmission and 1950s from a global wave of consolidation and and distribution weakened the case for vertical integration.5 nationalization of previously fragmented power markets The current movement toward breaking up these composed of privately and municipally owned local monopolies and reintroducing the private sector goes back power monopolies. partly to preconsolidation and prenationalization structures, but with the important difference that it also now The General Case for Reform encompasses arm's length regulation and competition. The justification for adopting the prereform industry In principle, three separate sources of improvement in and market structures rested on four grounds. First, this economic performance are postulated from power structure minimized the costs of coordination between market reform: the functions in the supply chain and the costs of financing the development of power systems. Second, · First, with regard to overall allocation of resources, state financing was favored by the large-scale investments making consumers pay at the margin what it costs to in production and network assets with high fixed costs produce and supply them is expected to achieve a that were needed to capture economies of scale, better economywide use of resources. Issues of income but which had little market value in alternative uses to distribution and support for the poor are increasingly mitigate investment risks. Third, state financing was also regarded as being supportable by targeted subsidies favored by the view that the substantial degree of natural to needy groups, rather than by across-the-board monopoly in the market should be kept under state subsidies that have the effect of generally distorting stewardship to enhance consumer welfare from these patterns of the consumption of energy. The extraordinary services. Finally, governments also considered the power levels of subsidies seen in some countries (IEA 1999) market to be critical to national economic security, have produced major welfare losses in relation to as well as a means for pursuing economic and social overall economic welfare. distributional objectives. · Second, the profit motive gives a stronger incentive for Under the prereform structures, however, power supply efficient use of inputs--both lower-cost combinations has deteriorated to critically low levels and has been of inputs and reductions in inputs--required to produce failing to meet national needs in most developing a given output, than any incentives offered by an The two business activities differ fundamentally. Power generation produces a tradable commodity--where cost discipline and risk management 5 are essential for competitive success, whereas the transmission and distribution of power is a regulated service business based on network management. enterprise controlled and managed by a bureaucracy from the day-to-day control of the politicians and (World Bank 1995). bureaucrats in government, and transforming it into independent legal business units (corporatization and · Third, competition, where it is possible, provides the commercialization) under a transparent system of most likely means to reduce supply costs and pass economic regulation, often leading to the sale of assets benefits on to consumers. If the power sector can be to private investors (privatization). The subsequent elements made to cover its costs and be profitable, firms will consist of creating a market in which to trade power by have an incentive to invest, and they will also have an requiring these newly independent units to compete and incentive to seek out new markets that can be profitable. by allowing new firms to enter the market. These elements New entrants, also attracted by profit opportunities, are designed to create accountability and efficiency can seek out specialty market niches--particularly in through competition for capital and customers. Such rural areas--that may not appeal to firms supplying reforms depend on complementary reforms that liberalize mainstream market segments. access to capital markets and create institutions, particularly an independent regulator that can regulate The conventional wisdom of electricity restructuring prices and access to transmission and distribution usually envisions six main elements of reform (box 1). networks, since the services provided by these facilities Reform starts with moving the state-owned enterprise are natural monopolies. 11 BOX 1. Elements of Full-Scale Power Market Reform Following are the elements of full-scale market reform: 1.Obliging electricity enterprises to operate according to commercial principles. These principles require that enterprises pay taxes and market-based interest rates, earn commercially competitive returns on equity capital, and have the autonomy to manage their own budgets, borrowing, procurement, and labor employment. 2.Restructuring of the electric power supply chain to enable the introduction of competition. This involves breaking up ("unbundling") the incumbent power utility into multiple generators and distributors of power that trade with each other in a competitive wholesale power market. 3.Development of economic regulation of the power market that is applied transparently by an agency that operates autonomously. In the wholesale market, the focus of regulation is to prevent anticompetitive abuses of market power and to ensure appropriate investment in new supply capacity. In the retail market, the focus of regulation should be on balancing the interests of suppliers with the interests of their captive customers. 4.Privatization of the unbundled electricity generators and distributors under dispersed ownership, generally in developing countries to bring in financial resources and technical and managerial expertise that will rectify the prevailing low standard of electricity supply by state-owned power utilities. Privatization is also necessary in those countries that intend to develop competitive power markets, because competition is unlikely to develop properly between entities that are under common ownership--whether state or private. 5.Development of competition in the generation and supply segments by development of power exchanges. Competition in the network segments (transmission, distribution, and system control) is not feasible because these functions are natural monopolies. 6.Focusing government's role on policy formation and execution. This role is performed with least conflict of interest when government also ceases to be the major owner, investor and controller of the entities that constitute the power supply chain, particularly in wholesale generation and retail supply of electricity. Although much attention has been given to the endemic corruption, rampant theft of power, political construction of a standard model based on these interference, and an inability by stakeholders to work elements, such a model has rarely been applied fully toward long-term solutions. In the middle-income in practice. The divergence between theory and practice developing countries, power supply has been scaled stems from three factors. First, the special technical aspects up to the extent that the financing and management of electricity markets--in particular, the need for real time needs of the sector have generally outgrown the balancing of supply and demand because of the high capacity of state institutions. cost of electricity storage--have complicated market design in ways not fully anticipated. Second, the proper operation c. The need to remove or reduce the fiscal stress from of electricity markets requires many complementary state involvement in power supply in order to release institutions--such as independent regulators--that have state financial resources for other pressing public proved difficult for many countries to satisfy, especially needs. Electricity tariffs often do not come close to where the "rule of law" is largely absent. Third, many of covering the current costs of service provision, but low the prescriptions for the standard model for reform, tariffs do not benefit most of the poor, who largely such as leaving electricity tariffs to market forces, are lack access to electricity. By the end of the 1990s in particularly difficult for democratic societies to implement Eastern Europe, for example, the combination of high (Heller, Tjong, and Victor 2003). technical losses, nonpayment of bills to the power utilities, and electricity tariff levels well below cost 12 Reforming the electricity sector involves far more recovery levels imposed a fiscal cost that averaged than changing technical and institutional models. 7.5 percent of gross domestic product (GDP) (Estache Power market reform is taking place in the context of and Gassner 2004b). Severe fiscal problems from larger processes of globalization--notably the opening power sector deficits have also existed in India (box 2). up of markets, the growing role of private capital, and efforts to weave national power markets into the d.The desire to raise immediate revenue for governments fabric of international economic integration (World through the sale of power sector assets. In some cases, Resources Institute 2002).6 The reforms are influenced this driver was the need to reduce the high debt load by an emergent global ideology that the state should of the sector under state ownership, which drove refrain from controlling resources that markets could the design of the privatization process in some Latin allocate more efficiently, and instead focus its resources American countries, notably in Argentina and Brazil. on a limited category of social spending--mainly health and education, and that this retreat by the state is a e.Eastern European countries have the additional precondition for investor confidence (World Bank 1995). incentive of complying with the requirements of the European Union's Electricity Directive of 1996 in The Case of Developing Countries preparation for accession to the European Union (European Union 2003).7 The following forces have stimulated reform of the power markets of developing countries: Pressure for power market reform has often arisen in the context of a major economic crisis for the country. a.The poor performance of state-run power sectors that These crises have driven changes in public policy toward has resulted in high costs, much of the population power markets within a broader drive for economic reform, remaining unconnected to the public power system, which have made restructuring and private sector and those who are connected often receiving participation politically feasible. This was particularly unreliable service. the case in Latin America during the 1990s, where the opening up of power markets to competition reflected b.The inability of state sectors to finance needed the replacement of the import substitution model led expenditures on new investment and maintenance. by public investment to a market-oriented model of Many power utilities are financially distressed because economic development. of their poor governance environment comprising These views stemmed from two important advances in economics that took place in the 1980s: namely, research on the impact of the structure 6 of property rights on the decisions and behavior of firms, and the theory of incentive-based mechanism design. Ideally, privatization would bring an end to political control over firms, yielding reductions in costs and efficient prices. The EU Directive focuses on breaking up vertically integrated supply chains to allow competition in the power market, regulated or free third 7 party access to the grid, coexistence of regulated and competitive markets side by side, and freedom for large ("eligible") consumers to choose their suppliers. BOX 2. Fiscal Burden of the Indian Power Sector In India, the combined dues of all the Indian state electricity power utilities to central power suppliers and fuel suppliers amounted to about US$5.5 billion equivalent in 2001. (Figures relating to financial losses and so forth are drawn from Government of India Planning Commission 2001 and Ahluwalia 2001.) To put this magnitude into perspective, this amount was about half of what all the state governments in India combined were spending on all levels of education every year. It was double what they were all spending on health, and three times what they were spending on water supply. If power sector financial losses were reduced by only one-third, the savings from a single year would have been sufficient to fill every teacher vacancy in the country and provide every school with running water and toilet facilities. State governments face huge accrued liabilities for guarantees for bonds issued by the state electricity boards (SEBs) to central power and fuel suppliers, for the pension funds of SEBs, and for contingent liabilities under their guarantees to independent power producers that sell output to SEBs. Moreover, the Indian financial sector faces huge risk exposure to the power sector. The subventions provided by Indian state governments to their SEBs undermine state budgets, even though these subventions are rarely paid in cash, but usually take the form of offsets against payables from government agencies to the SEBs and debt-servicing payments on behalf of the SEBs. State governments help the SEBs meet their debt serving obligations to avoid defaults that would provoke calls on the guarantees provided by state governments for these debts. Otherwise, a call on these guarantees would threaten the credit ratings on state governments' own borrowings. 13 Central power and fuel suppliers, equipment suppliers to the power industry, and financial institutions have borrowed heavily via bonds from Indian financial institutions to finance their operations because of their high receivables from SEBs. SEBs have securitized large amounts of their dues to central power and fuel suppliers through bonds issued in favor of the respective suppliers. Power market reform has faced substantial difficulties and in demand for electricity, expanding access to public departed from the conventional economic model electricity supply by the population, and relieving fiscal for reform, especially in developing countries.8 This is pressure from supporting the power sector. because fundamental reform of a power sector is an extraordinarily complex undertaking, even for reforms that Although the techniques and instruments of power fall short of attempting to introduce a fully unbundled, reform are generic, conclusions reached from empirical competitive market. Yet many governments have been analysis about reform outcomes in OECD countries attracted by complex, "state-of-the-art" market models and should be applied with caution to developing countries. regulatory regimes that were designed and, to some This need for caution arises from the key differences degree, implemented in countries much better situated for in the main reform objectives between OECD and this approach. In most cases, the funding agency staffs, developing countries, as well as the huge differences politicians, regulators, and the host government had a poor in their starting conditions in relation to economic conception of the difficulties involved--the scale and scope development (the appendix). Hence, reform in many of needed changes and the realities of the physical, social, developing countries may have the opposite outcome legal, commercial, and political constraints. In other words, to reform in OECD countries. For example, the general the selected reforms were too ambitious for the country direction of retail prices as efficiency improves following conditions (Rosenzweig, Voll, and Pabon-Agudelo 2004). market reform is downward in OECD countries because prices already generally cover supply costs, whereas The objectives for reforming power markets differ retail prices usually move upward in developing countries significantly between OECD and developing countries. that are under pressure to remove subsidies and cross- In general, reform in OECD countries is discussed in the subsidies. In addition, developing countries do not have context of raising the level of existing commercial standards the substantial amounts of economic and institutional of performance by means of competition. In developing resources available to OECD countries that are needed countries, however, reform is generally concerned with to support complex reforms to their power markets. investing in sufficient power supply capacity to meet growth Chapter 3 reviews the record of reforming power markets in developing countries to date. 8 2.2 The Importance of Political Factors for countries, as well as the former Soviet Union (FSU), Power Market Reform electricity represented the good life--well-illuminated homes and workplaces, modern factories and Power market reform based on private sector participation transportation, escape from the drudgery of manual and competitive markets involves complex issues for labor--that had been denied most people. In propaganda stakeholders--and in particular for governments, and popular consciousness alike, images of a society investors, employees, and consumers. Yet reform with universal and affordable electricity became an proponents have underestimated the importance of important expression of state-led development.9 The managing this process relative to techno-economic design promise of an electrified future served governments as a and implementation issues. If reform were only a matter justification for present sacrifices. For some countries, of economics, power systems would not have been electrification projects involving massive public investment experiencing the problems experienced in so many and labor mobilization (such as the construction of large countries. Political factors cover both the importance of dams) became nation-building exercises and, upon politics and many vested interests, and they include the completion, symbols of fulfilled development promises. willingness or opposition of politicians to support a political consensus in favor of power market reform. Far from a dry techno-economic calculation, electricity This consensus is needed because reform entails a reform is often an arena of conflict between competing redistribution of property rights (to remove politics interests that are of fundamental importance to society. 14 from the management of public service providers) A broader context is needed to examine and design and formulation of new ground rules (introduction of sustainable reforms to power markets in developing competition and market-oriented incentives) through countries. The implicit social compact mentioned above changes in laws and regulations. Governments must was double-edged, because the definition of electricity generate public acceptance and stakeholder consensus as a public good represented a long-term claim by for these programs. citizens on the state for provision of electricity, which would be a potential source of discontent if this The Political Nature of Power Market Reform aspiration should go unrealized. This ideological discourse left out economic concerns, such as Power market reform is an inherently political process. competition and profitability; environmental and The political actors that support or oppose it--in social constraints; and governance issues, such as government, industry, finance, labor unions, and civil transparency, accountability, and public participation.10 society--are motivated to do so for reasons that may be irrelevant to economic theory, but are often quite Experience with reforming power market suggests that relevant to the shaping of the actual policies created. political forces are difficult to align for reform. This is Policies are implemented within institutional contexts-- shown by the tendency for reforms--especially in utilities, markets, courts, and regulatory bodies--that developing countries--to start with independent power are profoundly influenced by political concerns. Finally, producers and marginal reforms in the generation sector, the impacts of reform are not confined to improvements and to defer the task of reforming tariffs and the retail in economic efficiency within the electricity sector itself. end of the market generally. Reforms that fail to address Rather, they can affect matters of broad public concern, social and political concerns--for example, by attempting such as employment, dependence on foreign energy to raise tariffs on the poor without a compensating plan supplies, and environmental pollution. for protecting access to vital electric services--create their own political opposition and usually fail. In developing The important role of electricity in the national ideology countries especially, the preservation of the "social of many developing countries forms part of the political contract" has occurred in large part through the deferral dimension of power market reform. This is because of difficult decisions, such as restructuring of tariffs, electricity is a symbol of the social compact between even where such decisions are essential because low state and citizen, as well as being a practical necessity tariffs create perpetually loss-making enterprises of industrialization. For newly independent developing (Heller, Tjong, and Victor 2003). The case of China exemplifies this point (Zhang 2003; Yeh and Lewis 2004). 9 This paragraph and the two before it are largely taken from Williams and Dubash 2004. 10 The gap between the apparent appreciation of the need The scheduling of some power market reforms to fit for reform and actual implementation of reform measures perceived political windows of opportunity has often not is an important feature of power sector reform to date. been sustainable. These opportunities are usually linked These measures apply particularly to privatization, to a compliant or interested incumbent politician who antitheft measures, and tariff rationalization. With few faced an impending reelection against politicians that exceptions, mainly in Latin America, such as in Argentina opposed power market reform. This threat of a cutoff in and Chile, the currently reformed power systems among government support led to short deadlines for reform developing countries only partly resemble the theoretical tasks that were totally unrelated to the scale, scope, and market-oriented model, since market forces operate difficulty of the tasks involved. This rush to introduce an only at the margins of these power systems that remain "irreversible" step that would lock in future governments dominated by the state. The explanation for this difference has proved to be counterproductive. In practice, no step is often attributed to the influence of politics, poor rule is so irreversible that it forces a reluctant government to of law, and generally weak institutions that obstruct continue the reform. Some Latin American countries, for the operation of markets, and hence the ability of the example, are under pressure to reverse their power governments to implement reform plans (Heller and market reforms because of the lack of public support for Victor 2004). Governments with weak institutions have privatization and the succession of recent crises and performed poorly even when they had ambitious reform events, such as macroeconomic crises and droughts in plans. Conversely, governments with strong institutions power systems dependent on hydropower. and sustained commitment to reform have fared 15 much better, even when pursuing modest reforms Carrying out structural reform and attracting and (Tongia 2003).11 sustaining private investors are extremely difficult during conditions of economic and associated political turmoil. Consolidation of power market reforms is not automatic, This lesson is shown by the experience in Latin America, since it depends on management of the links between Eastern Europe, and the FSU (box 3). Power market reform performance and the political process for the reform involving restructuring and privatization of the simultaneous creation of traditions of respect for the unbundled entities was most difficult in countries that rights of investors and consumers. Consolidation hinges experienced prolonged turmoil (Georgia, Moldova, less on formal changes than on the existence of an the Russian Federation, and Ukraine). Reform was less effective system of social checks and balances and on difficult in countries that achieved economic stabilization mobilizing those interests that favor reform. The interests more quickly (Hungary, Lithuania, and Poland). of investors and consumers are balanced by good Although private operators of distributors improved regulation in the short term, and in theory they should cash collections during such turmoil, they could not converge in the long term. reach the levels needed for viability. The timing of reform relative to the electoral cycle can In developing countries, contrary to OECD countries, be critical for the privatization of electricity entities and environmental issues (including renewables and energy for unpopular increases in electricity tariffs. The success efficiency) generally have not figured prominently in the of a privatization program often depends on divesting process of reforming power markets. This difference may most of the state's ownership before the government reflect different political priorities. It may indicate that faces the next election, which can force a compromise developing countries will face a growing problem if such with long-term efficiency objectives for the sector (as environmental concerns are not addressed at the time that happened in England and Wales). A crucial window of private firms are encouraged to invest in long-lived capital opportunity may be created by a change of government stock that "locks in" particular environmental regimes. because the incoming group may have the mandate, strength, and time to carry out the program. In many countries, although the problem and possible solutions became evident early in the 1990s, action was not possible for several years because of the political priorities facing the incumbent governments around that time. Evidence for this latter point is provided by the experience of the Indian state of Andhra Pradesh in the period around 2000 (see chapter 4). 11 BOX 3. The Impact of Economic Turmoil on FSU Power Sectors during the 1990s One of the priorities for governments during periods of intense economic turmoil is to combat severe nonpayment of electricity bills induced by macroeconomic factors, according to the experience of countries in Eastern Europe and the FSU. The required measures are macroeconomic stabilization, removal of constraints--legal, political, and attitudinal-- denial of service to defaulters, promotion of budget discipline to eliminate payment defaults by government agencies, and improvement of procedures for the recovery of arrears and debts by utilities (Krishnaswamy and Stuggins 2003). During the 1990s these countries experienced a collapse of industrial production, continuous GDP contraction, hyperinflation, massive devaluation of their local currencies, severe fiscal and current account deficits, high levels of unemployment, and hence low and falling household incomes. Consequently, electricity demand dropped, and the ability of people and industries to pay for their consumption of energy was seriously eroded. Underpricing of energy-- including electricity--and nonpayment to energy suppliers were a major source of fiscal subsidies in many of these countries (Freinkman, Gyulumyan, and Kyurumyan 2003). Tight monetary policies under the need to contain fiscal deficits to bring down the massive inflation left government agencies and state-owned enterprises with no funds to pay their utility bills. Both during periods of economic turmoil and some years thereafter, the utility sectors in many of these countries faced acute nonpayments. In the worst cases, collections from electricity users dropped to 60­70 percent of billings, and cash collections fell to only 20­30 percent of the billings until late in the 1990s under the rapid increases in electricity and 16 gas prices as the costs of imported fuels rose toward international levels. Thus, industrial and residential consumers and government agencies defaulted on payments to utilities, which in turn defaulted in its payments to domestic and foreign fuel and energy suppliers, payment of wages to staff, and payment of taxes to the government (Krishnaswamy 1999). Ukraine's economy, for example, was barter-based at the time that it attempted major restructuring of its power market. Salaries and pensions were in arrears, and consumers could not be made to pay for electricity with cash because the government condoned the culture of nonpayment. In such an environment, the introduction of an advanced model of a competitive power market was bound to fail. Market reform objectives should have been more modest and targeted to improving technical, institutional, and financial problems. Source: World Bank 2003b. The Political Incentives to Reform Experience with power reform in many countries supports the view that "interest groups" constitute a Politicians may be willing to give up the benefits from major impediment to reform. These groups include rent- existing arrangements for power supply by supporting seeking interests, such as protected domestic industries, reform only if they have an incentive to do so.12 To provide unionized labor forces, politicians with short time horizons, this incentive, the reform must fulfill at least one of the and electricity consumers that benefit from subsidies. following conditions for politicians: it must (a) enhance Those aspects of the reform that are being blocked by their political support; (b) not meet with overwhelming vested interests or simple inertia can be distinguished opposition; and (c) provide benefits and avoid heavy from those that are publicly resisted because of legitimate losses for their supporters (Tongia 2003). Reform will concerns or different viewpoints. The latter arise when happen only if a dedicated cadre of bureaucrats and most power consumers are unconvinced that power politicians can withstand opposition from groups that market reform is designed to help them, and when stand to lose from reform, since the likely losers are few among them believe the promises that reform typically better organized than the eventual winners will eventually improve power supply and services. are. New conceptual frameworks from economic theory This indicates that reform is less likely in areas where its have been developed for explaining this type of behavior costs are concentrated on a small number of powerful (box 4). actors while the benefits are dispersed among a wide These benefits often include patronage opportunities through commissions on contracts for construction, plant and equipment for power supply 12 capacity. It also includes indirect fiscal support to governments through nonpayment for electricity by government agencies. Even if the power sector is not commercially viable, it can be a source of jobs and other favors. BOX 4. Political and Institutional Concepts Applied to Reform of Power Markets The institutional issues for reforming power markets can be analyzed in relation to three approaches developed for microeconomic reforms: the transaction-cost politics approach, the new institutional economics, and the new political economy. The transaction-cost politics approach. This approach proposes that an instantaneous switch to a first-best world is a chimera. A tradeoff between the political feasibility of the reform and the elimination of economic rents is likely to exist. Multiple interests will put the new order under conflicting pressures, thus reducing the scope of the original goals or altering their intended direction. The changes that are feasible may therefore be modest. Regulation of public services takes place under asymmetric information and limited possibilities of commitment, because the rules of the game can be skewed, skipped, or modified. Under the informational limitations of policy designers, regulation is posed as the solution to a problem of incentives between agents (the firms regulated) and a principal (the regulator). This approach contrasts with the normative approach that predominated up until the 1980s, and which contended that markets and government were equally efficient, the role of government was to remedy market failures (in regulatory terms, this meant preventing the exercise of monopoly market power), to produce public goods, and to redistribute income. The implicit assumption was that the government in question was perfect and would maximize welfare. The new institutional economics. This approach characterizes institutions as crystallized beliefs. It stresses the support of customers and the role of complementary institutions (such as the judiciary and the antitrust bodies) as the two 17 ultimate pillars of reform sustainability. In the case of regulation, the population should perceive that the increased cost of a service is offset by tangible benefits (for example, freeing up fiscal resources and using them to provide social services). It should be anticipated that changing beliefs about the benefits of a regulatory reform could operate under loss aversion conditions documented in experimental studies on decision making under uncertainty (the population may be risk-loving over regulatory losses and risk-averse over regulatory gains at the same time). This would explain, in part, the unfavorable perceptions of reform documented in opinion surveys like those of Latinobarómetro, even in situations where there are positive gains. The new political economy. This approach stresses the need of permanently assessing the net balance of political support at each instant of time so as to calibrate the depth of reform changes and its sequence. It can be used in examining the issue of the order and speed of the measures that are introduced under a reform. The two extremes are shock therapy ("big bang"), which involves all the required changes taking place at the same time, and a gradual approach, which involves the measures being taken separately and over time ("gradualism"). Gradual progress would be preferable where there is uncertainty about the results of reform, about the higher costs of getting it wrong under the big bang approach, and where the suggested measures reinforce each other at each step. Source: Benavides 2003. number of prospective beneficiaries (who may not even Pragmatism can be their guiding principle when, be aware of their beneficiary status). A stakeholder for example, fiscal distress compels a country to give analysis is needed to identify the range of interests for priority to power reform because this sector is a serious and against reform.13 drain on the state's financial resources. However, the risk with this approach is that reform is publicly perceived as In many countries, politicians have not had an just a bankruptcy workout without social objectives for ideological bias for or against reform, but have approached the power sector, under which power consumers bear the issue pragmatically. They have neither opposed it the cost of this reform with little noticeable benefit in wholeheartedly nor advocated it coherently. In power improved service. In this situation, reform does not markets where politicians have had incentives to pursue receive the required public support and hence only reform, they have done so; otherwise, they have not. lukewarm political commitment.14 Examples of comprehensive stakeholder analysis can be found for Guatemala (Fundación Solar 2002), Colombia (Ayala and Millán 2002), and 13 Honduras (Walker and Benavides 2002). This section draws on an unpublished paper by Sumir Lal entitled "Political Factors Affecting Power Sector Reform in India." 14 Political Issues for Reforming Power Markets In El Salvador, electricity prices to final consumers increased slightly after reforms were implemented, creating a public The fundamental issue for public acceptance of a power backlash against the reform. In Bolivia, electricity prices reform plan is credibility. In many countries, the power rose as a result of an increase in the price of natural utilities are publicly viewed as corrupt, mismanaged, gas used for generating electricity (World Energy Council and in a financial plight of their own making.15 The 2001). The elimination of cross-subsidies between ingredients of credibility include full government ownership consumer categories led to tariff increases for consumers of the reform, managing expectations, building in from whom the subsidies were removed. compensatory mechanisms with believable assurances of carrying them through, and committing to stability of Private investments in generation are vulnerable to financial the new policy. These, in turn, depend on the government's problems in the distribution end of the industry and to local reputation with its constituents, the prevalence of political vested interests that are defending the status quo. The checks and balances, and binding the new policy to sustainability of private investment in generation depends wide ownership and statutory commitments. Without this crucially on collecting payments in full from electricity credibility, the public may sense that a reform plan is consumers. Introducing competition among generators being forced on them "from above," and that they without reforming distribution and retail consumer are expected to pay for the utilities' inefficiencies and services to achieve commercial standards can impair the corruption. If politicians fail to recognize and address effectiveness of the overall reform program. Yet power 18 this perception, they will struggle to make power consumers utilities in most developing countries--generally in South believe that the reform effort is intended to benefit Asia and Sub-Saharan Africa, but also in many countries the wider public, and they will be unable to create elsewhere--are financially insolvent. pro-reform constituencies. Political will to support necessary increases of prices for Certain aspects of reform are endorsed when the need electricity is usually one of the most critical factors in a for reform is widely accepted in principle, but other aspects viable reform process. Any reform of power markets is often remain unaccepted. The publicly acceptable aspects seriously handicapped without such commitment. usually include making state-owned power utilities The design of these reforms in the past, however, autonomous of government, corporatizing these utilities, has generally taken for granted the existence of the establishing an autonomous regulator, and introducing necessary political support to convince customers and transparent accounting mechanisms for power suppliers. voters to accept higher power prices and to curtail By contrast, key areas of public concern are usually the inconsistent or corrupt behavior by customers and removal of subsidies and cross-subsidies, unbundling of employees (Rosenzweig, Voll, and Pabon-Agudelo 2004). a vertically integrated power utility, and privatization of components of power supply. The first set that is The treatment of utility employees affected by privatization little disputed deals with institutional issues related to raises important issues. Sorting out employment issues governance of the power market, whereas the second before privatization through formal agreements with describes a particular reform model that is questioned labor unions helps attract investors to power sectors. as an ideological choice. A public consensus generally Power market reform usually leads to lower employment emerges that the market must be better governed and levels under commercialization of supply functions, and made more efficient, but it often fails to cover what reforms that result in heavy job losses elicit tremendous would be the appropriate way of doing so. political resistance. This was the case in Hungary where some of the privatization receipts were used to secure Competition and private ownership in the power market employee cooperation. These receipts can also be used is vulnerable to a public backlash if consumers perceive to fund severance compensation. The possibility of that increases in electricity prices are a consequence of allocating to staff some shares in privatized entities was this reform. Generally, private management and ownership an important element in some of the private participation has brought about significant improvements in performance deals in Latin America, including the Chilean practice at the enterprise level, but much of this improvement has of vesting shares into pension funds on behalf of the not been translated into corresponding improvements at employees. Elsewhere, as in Ukraine, employees merely the economic and social levels. Electricity prices did not sold their shares quickly to investors to supplement their fall in all countries that liberalized their power markets. low wages. In some countries, public perception of corruption and mismanagement has extended to contracts by power utilities with independent power 15 producers, especially those concluded without public scrutiny. Power consumers need to understand and accept the terms by about 200 percent to cover costs, and they proposed reforms. Since reforming electricity tariffs in became a significant component of household developing countries is complicated by the legacy of expenditure (Krishnaswamy and Stuggins 2003). highly subsidized prices for the population, reformers should explain the rationale for tariff increases and Foreign ownership of power supply entities is often an demonstrate that in return, consumers will experience issue for the political feasibility of power market reform. tangible benefits, such as improved service. Tariff increases In countries that have a relatively small, internal, formal for low-income households should be tempered to keep financial structure (compared with the size of the sector) electricity affordable for them. Public expectations about and possibly no stock market, privatization inevitably power tariffs inherited from the prereform era can be a means foreign ownership in part or in total. Control of major obstacle to reform. Reforming electricity tariffs in such a key domestic sector by foreign companies must the FSU countries, for example, has been complicated be clearly linked to the underperformance of the power by the legacy of highly subsidized prices for the entire sector, and the government must have the support for population, the public sense of entitlement for such implementing this policy of those groups that are likely continued service, and the vital importance of reliable to determine its future. This issue has arisen in countries, energy services during the long and cold winters. such as El Salvador and Bolivia (chapter 3). Electricity tariffs rose during the 1990s in local currency 19 20 3. CURRENT EXTENT AND OUTCOMES OF POWER MARKET REFORM IN DEVELOPING COUNTRIES OGN's Guidance on the Current Extent and Outcomes of Power Market Reform Infrastructure services are critical to economic growth, poverty reduction, and the achievement of the Millennium Development Goals. However, the investment volumes required to provide the capacity to deliver these services are enormous. Reform of the power market will be needed to foster the financial viability of electricity service providers, and hence attract on a sustainable basis the public and private financing needed over time to expand services. At the heart of most power market reform efforts are a set of interrelated challenges: changing the manner in which new investments are financed, increasing the efficiency and development effectiveness of those investments, and increasing operational efficiency, while addressing equity concerns as the market expands. It is now broadly recognized that pure public financing and provision have failed to adequately support economic and social development under the poor governance standards found in most of the Bank's clients, and that they have imposed high opportunity costs on society. 21 The private sector has shown that it can deliver efficient investments and improved services to customers of the power market provided that the right business incentives are in place to attract investment--but that putting this framework in place can be challenging in many countries. The substantial investment needs of the power sector mean that increased investment from the private sector will be needed. Sector-specific measures to address this will be important. This chapter outlines the context and background to The countries that have embarked on reform have power market reform in developing countries and then progressed to date to various stages, which can be summarizes the current extent and outcomes of power categorized in ascending extent of reform as follows: market reform in developing countries since the start of the reform movement in the early 1990s (World Bank · A vertically integrated monopolist with independent 1993a and World Bank 1993b). power producers (IPPs) that sell power to it. 3.1 The Extent of Power Market Reform · A national generation, transmission or distribution entity, a combined national generation and transmission About 70 of the 150 developing countries have entity or a combined transmission and distribution entity embarked on reforming their power markets since the acting as the only wholesale power trader (single buyer) early 1990s in response to poor technical and financial with IPPs that sell power to it and regional distribution performance and lack of public financing needed to entities unbundled from the monopolist that buy power expand power supply. Reforms of these markets, however, from it. are generally tentative and incomplete, and are still works in progress (Bacon and Besant-Jones 2002). · Many distribution entities and generation entities and The remaining countries have retained the traditional a transmission entity formed from unbundling the structure of a vertically integrated monopoly, in some monopolist, in which the transmission entity acts as a cases because they felt it impossible or undesirable to single buyer of power from the generators and IPPs embark on any reform strategy that entails opening and sells power to the distribution entities and large electricity production or sales to private participants. users of power. BOX 5. Developing Country Groups by Current Power Supply Structure Developing countries fall into the following groups according to their current structure of power supply: Vertically integrated monopolist (79 countries) Angola, Antigua and Barbuda, Azerbaijan, Barbados, Belarus, Benin, Bhutan, Botswana, Burundi, Cape Verde, Central African Republic, Chad, Comoros, the Democratic Republic of Congo, the Republic of Congo, Djibouti, Dominica, Equatorial Guinea, Eritrea, Ethiopia, Fiji, Gabon, the Gambia, Grenada, Guinea, Guinea-Bissau, Guyana, Haiti, Islamic Republic of Iran, Iraq, Kiribati, Democratic People's Republic of Korea, the Kyrgyz Republic, Lebanon, Lesotho, Liberia, Libya, Madagascar, Malawi, Maldives, Mali, Marshall Islands, Mauritania, Micronesia Fed. Sts., Mongolia, Mozambique, Myanmar, Namibia, Nicaragua, Niger, Paraguay, Rwanda, Samoa, São Tomé and Principe, Saudi Arabia, Seychelles, Sierra Leone, Solomon Islands, Somalia, South Africa, St. Kitts and Nevis, St. Lucia, St. Vincent and Grenada, Sudan, Suriname, Swaziland, Syrian Arab Republic, Tajikistan, Timor-Leste, Togo, Tonga, Turkmenistan, Uruguay, Uzbekistan, Vanuatu, Venezuela, the Republic of Yemen, Zambia, Zimbabwe Vertically integrated monopolist + IPPs (36 countries) Bangladesh, Belize, Burkina Faso, Cambodia, Cameroon, China (most provinces), Costa Rica, Côte d'Ivoire, Croatia, Cuba, the Czech Republic, the Dominican Republic, the Arab Republic of Egypt, Ghana, Honduras, India (most states), Indonesia, Jamaica, Lao People's Democratic Republic, Malaysia, Mauritius, Mexico, Morocco, Nepal, Nigeria, Oman, Pakistan, Papua New Guinea, Senegal, Sri Lanka, Tanzania, Thailand, Trinidad and Tobago, Tunisia, Vietnam, West 22 Bank and Gaza Single buyer as a national genco, transco or disco, or a combined national genco­transco or transco­disco+ IPPs (16 countries) Albania, Algeria, Armenia, Bosnia and Herzegovina, Estonia, Georgia, India (Andhra Pradesh, Karnataka, New Delhi, Orissa, Rajasthan, Uttar Pradesh), Jordan, Kenya, Latvia, Lithuania, the former Yugoslav Republic of Macedonia, the Philippines, Serbia and Montenegro, the Slovak Republic, Uganda Many discos and gencos, including IPPs, transco as single buyer with third party access (6 countries) Bulgaria, Ecuador, Hungary, Moldova, Poland, Russian Federation Power market of gencos, discos and large users, transco and ISO (13 countries) Argentina, Bolivia, Brazil, Chile, Colombia, El Salvador, Guatemala, Kazakhstan, Panama, Peru, Romania, Turkey, Ukraine · An organized market of generation entities, regions (table 2A). Countries in Latin America and the distribution entities and large users in which power Caribbean and in Europe and Central Asia account for is traded competitively, supported by a transmission all the countries that have progressed to the two most entity, a power system operator and a power market advanced stages described above. In Africa, Asia and administrator. the Middle East, progress to date is generally limited to the first two stages with long-term contracts by IPPs The stages outlined above can be viewed as progressive to supply incumbent utilities (ESMAP 1999). Some stages through which countries pass on a graduated countries in East Asia, for example, have made tentative reform path. Power market reform programs in developing steps to further their reforms, as in the cases of China countries currently exhibit this variety of progress, (Yoeh and Rajaraman 2004; Zhang and Heller 2004) particularly in market structure, degree of private and the Philippines (Sharma, Madamba, and Chanc participation, and development of the regulatory 2004). Many of these countries have announced framework. This variety is shown by the lists of countries plans to take their reforms to more advanced stages, in box 5 that have reached each reform stage. and many others have announced plans or intentions to start the reform process. The countries that have embarked on power market reform cover a broad range in physical, economic and institutional terms. Reform is unevenly spread among TABLE 2. Distributions of Power Supply Structures in Developing Countries TABLE 2A. Distribution of Power Supply Structures in Developing Countries by Region POWER SUPPLY STRUCTURE GROUP REGION AND TOTAL VERTICALLY REGIONAL DISCOS, MANY DISCOS, POWER MARKET NUMBER OF VERTICALLY INTEGRATED IPPS, A GENCO- GENCOS, IPPS, GENCOS, DISCOS COUNTRIES IN INTEGRATED MONOPOLIST TRANSCO AS TRANSCO AS AND LARGE USERS, REGION MONOPOLIST +IPPS SINGLE BUYER SINGLE BUYER TRANSCO-SO Africa 49 39 8 2 0 0 EAP 17 10 6 1 0 0 ECA 28 7 2 10 5 4 LAC 32 14 8 0 1 9 MENA 13 6 5 2 0 0 SAR 11 3 7 1 0 0 Total 150 79 36 16 6 13 23 TABLE 2B. Distribution of Power Supply Structures in Developing Countries by Installed Power Supply Capacity POWER SUPPLY STRUCTURE GROUP VERTICALLY REGIONAL DISCOS, MANY DISCOS, POWER MARKET INSTALLED POWER VERTICALLY INTEGRATED IPPS, A GENCO- GENCOS, IPPS, GENCOS, DISCOS CAPACITY GROUP INTEGRATED MONOPOLIST TRANSCO AS TRANSCO AS AND LARGE USERS, (MW) MONOPOLIST +IPPS SINGLE BUYER SINGLE BUYER TRANSCO-SO <300 44 5 0 0 0 301­1,000 13 8 1 0 0 1,001­5,000 11 13 10 2 3 >5,000 12 11 5 4 8 TABLE 2C. Distribution of Power Supply Structures in Developing Countries by National Income POWER SUPPLY STRUCTURE GROUP VERTICALLY REGIONAL DISCOS, MANY DISCOS, POWER MARKET INCOME GROUP VERTICALLY INTEGRATED IPPS, A GENCO- GENCOS, IPPS, GENCOS, DISCOS (PER CAPITA IN INTEGRATED MONOPOLIST TRANSCO AS TRANSCO AS AND LARGE USERS, 2003) MONOPOLIST +IPPS SINGLE BUYER SINGLE BUYER TRANSCO-SO Low 43 15 3 1 0 Lower middle 22 13 9 3 8 Upper middle 15 9 4 2 3 Note: EAP--East Asia and the Pacific; ECA--Europe and Central Asia; LAC--Latin America and the Caribbean; MENA--Middle East and North Africa; SAR--South Asia. Sources: World Bank 2005 for country income levels; Energy Information Administration 2002 for country installed power capacities; various documents for country power supply structures. Some Latin American countries have advanced power Reform has also progressed among developing countries market reform with private participation and competition with relatively higher levels of per capita national income. in the power market. Their experience provides invaluable This feature is shown in the relationship between the lessons for later reformers (Covarrubias and Maia 1994; stage of power reform in a country and the national Fisher and Serra 2000; Inter-American Development income classification used by the World Bank (table Bank 1999; Millán and von der Fehr 2003; Moscote, 2C).16 Only four of the 62 countries in the low-income Maia, and Vietti 1995; Mota 2003; Rudnick and Zolezzi group of countries have undertaken any unbundling of 2001; World Energy Council 2001). These countries their power supply chain, whereas 20 of the 55 lower- learned from the experience of earlier reforming countries, middle-income countries and 9 of the 33 upper-middle- and in particular from the Chilean experience during income countries have undertaken some or extensive the 1980s. The evolution of reforms under this process unbundling.17 has led to less regulation of segments that are or can be made competitive (generation and energy supply The tendency for countries of similar economic, services), and regulation of the noncompetitive markets legal and political backgrounds to adopt similar power (transmission and distribution network services) market reforms indicates the importance of these basic combined with the unbundling of competitive and characteristics for designing market reforms. It shows noncompetitive segments of the industry. Even in these clear regional groupings, with Latin America the countries, however, reform is still incomplete and in most advanced in restructuring, Asia (APEC 2000; 24 some cases may not be sustainable, especially since a Fairhead and others 2002) and Africa (Estache and backlash against these reforms that has emerged in Gassner 2004a) the least restructured, and the level some of these countries (Lora and Panizza 2002; of restructuring in Eastern Europe falling in between Millán, Lora, and Micco 2001). (Bacon and Besant-Jones 2002; EBRD 2001). Reform has progressed mostly among developing Many Latin American countries have adopted competition countries with relatively larger power systems. in the wholesale power market (box 6). They adopted a Restructuring of power supply arrangements through mixture of two variants of this structure (the power pool unbundling of an integrated structure is a sure indicator design of the Chilean model, the independent transmission of whether a country has started to reform its power and system operator of the England and Wales model) and market radically. Unbundling is a feature of the larger divested most of their state-owned assets in combination power systems to date, however, and has not occurred with structural reform and greenfield investment by the in the smaller power systems (table 2B). Thirteen of the private sector (Argentina, Bolivia, Brazil, Chile, Colombia, 71 countries with power systems smaller than 1,000 and Peru).18 This model led to increased sector investment MW have opted so far to contract for power supplies and improved sector performance in these countries. This from IPPs without any unbundling. On the other hand, model also spread the impact of shocks throughout sector 15 of the 39 countries with power systems that lie between stakeholders, thereby improving its robustness (but even this 1,000 MW and 5,000 MW have been unbundled, model could not withstand the huge macroeconomic and 28 of these systems have IPPs. Moreover, power shocks of 2001 in Argentina). Eastern European and supply has been extensively unbundled in 17 of the 40 Central Asia countries have also implemented variations on countries with more than 5,000 MW of power supply. this model, particularly for the use of bilateral contracts Most countries that have unbundled their power supply between power generators and distributors (box 7). chain (generation from distribution, in particular, with transmission in a separate entity or combined with Many countries in East Asia and South Asia opted for one of the others--"vertical unbundling") have further attracting private investment in generating capacity with unbundled their generation and distribution sectors into greenfield power plants developed and operated by numerous entities ("horizontal" unbundling). IPPs. These countries include Bangladesh, China, India, Developing countries are classified by the following per capita income groups: low--US$765 or less; lower-middle-income--US$766 to 16 US$3,035; and upper-middle-income--US$3,036 to US$9,385. Per capita incomes are computed according to the World Bank Atlas method (http://www.worldbank.org/data/aboutdata/working-meth.html#World_Bank_Atlas_method). The correlation between power system size and national per capita income in developing countries is not sufficiently strong to allow only one or 17 the other to be used. On the other hand, national income should not be used instead of per capita income because it is strongly correlated with power system size. "Greenfield investment" refers to investment in new facilities on undeveloped sites--typically for power generation. A related concept is "brownfield 18 investment" which refers to investment in existing facilities. Greenfield investment has been the dominant mode for IPPs in Asia, brownfield investment has been the dominant mode for IPPs in Eastern Europe, and both forms are widely used in Latin America and the Caribbean. BOX 6. Evolution of Power Market Reform in Latin America Power market reform in Latin America proceeded in three distinct rounds. The first round started in Chile in the late 1970s with the development of new legislation that was introduced in 1982, and ended with the privatization of the major electricity firms between 1986 and 1989. Chile's neighbors carried out the second round of reforms in the first half of the 1990s, an example of the demonstration effect of reform. The third round took place during the second half of the 1990s, and it included most of the remaining Latin American countries. Reform designers attempted to extend the scope and depth of competition in each round. Moreover, reforms were accomplished faster. The changes made in Argentina from 1990 to 1992 took a whole decade to achieve in Chile. The Chilean reform contained three major innovations. First, competition was introduced to the wholesale market, in which power generation companies and large customers and distribution companies established long-term supply contracts, and transmission services were provided by a separate entity to introduce open access to the transmission network. Second, investment in generation capacity was left to market forces, specifically the profitability of developing new capacity as rising demand leads to higher wholesale power prices. Third, incentive regulation was used to compute the value added of network services provided by the distributor. Reform introduced more pro-competition regulation and restructuring of the market. Vertical integration of generation and distribution was either prohibited outright or limited. Horizontal unbundling of the generation segment helped promote competition in wholesale power pools. Restructuring of the wholesale energy market allows generators to submit price and quantity bids into a power pool, which the pool operator uses to build a system wide supply curve for 25 energy.* This curve is used to determine the order of dispatch of generating plants, replacing the merit-order system based on operating costs used by earlier reform countries. Transmission fees, as well as the charge for local distribution services provided to large customers, were set by either the regulator or the power market operator. The minimum demand threshold for eligibility by large customers to buy power from the wholesale market was reduced. Governance of the power market was strengthened by allowing distributors, some eligible customers and the transmission company to join generators as members of the wholesale market operator. Moreover, instead of regulating the price at which distributors purchased electricity, some countries obliged distributors to tender their energy requirements among all generators. Some countries employed yardstick competition (see section 6.5) to regulate their unbundled distribution segment. Regulations became more flexible, bestowing more discretion on regulators. Regulations also began to incorporate quality issues and increase fines for bad service. The process of setting regulated prices became more transparent. In Chile regulators were not allowed to publish the information used in rate-setting, except to the regulated firms, which prevents the demand side of the market from counteracting the lobbying pressure of regulated distributors. In Argentina, in contrast, public hearings became an important tool of the regulatory process. These changes made the power market in Argentina considerably more competitive than the one in Chile. * The supply curve is based on prices at nodal points in the power system. These prices reflect the anticipated weighted average values of marginal costs across the system load duration curve of meeting the projected demand on the power system over the next 48 months under an operating program for the generation capacity on the power system that minimizes these costs. The values of marginal costs take account of technical losses in the power network. The prices are adjusted monthly by indexation formulae. Source: Fischer and Serra 2000. Indonesia, Malaysia, Nepal, Pakistan, the Philippines, increased sector investment, but it did not improve Thailand, and Vietnam. Most countries proceeded overall sector performance. It also concentrated the without structural reform, although some plan to move impact of macroeconomic shocks from the 1997 Asian to some market restructuring (China in some provinces, financial crisis on the single buyer (see section 5.3). India in some states, the Philippines). This model also BOX 7. Reforms Undertaken in Eastern Europe and Central Asia Countries in Eastern Europe and Central Asia have followed a variety of reform paths for their power markets: · Kazakhstan privatized quickly most of its generation and some of its distribution at "throwaway" prices, and now it operates a bilateral contract driven wholesale market. Some of the investors have disinvested and walked out. · Tajikistan and the Kyrgyz Republic have either unbundled or are considering unbundling their sector and have not undertaken any privatization yet. The concession for Pamir Power Company to operate as a vertically integrated utility in Tajikistan is the first case of private investment. · Turkey and Lithuania have substantially commercialized and unbundled the sector and are poised to introduce competitive wholesale markets. · Poland and Hungary have unbundled the sector, introduced a single buyer model wholesale market and have substantially privatized generation and distribution. Poland and Hungary have completed privatization substantially. · Ukraine has unbundled and adopted a sophisticated competitive pool (which could not work as envisaged because of extensive nonpayment problem) and has privatized more than 50 percent of its distribution. It is still searching for a workable model. 26 · Georgia has unbundled and privatized distribution in its capital region and some generation. It has given management contracts to manage nonprivatized generation, transmission, and the Wholesale Market Operation and operates a single buyer model pool. · Moldova, the smallest among the countries reviewed, has unbundled its sector, has privatized three of its five distribution companies, and operates a wholesale market based on bilateral contracts between distributors and domestic and foreign generators. · Hungary, Poland and Turkey started with BOT-BOO-TOOR type of private sector involvement and are devising methods to accommodate them in a competitive structure and to manage the resulting stranded costs and contracts. · Romania and Bulgaria have unbundled their sectors and have privatized some distribution entities. Source: Krishnaswamy and Stuggins 2003; World Bank 1999. FIGURE 1. System Size and National Income of Unbundled Power Systems 10,000 2003) 1,000 in Income capita per 100 National (US$ 10 100 1,000 10,000 100,000 Installed Power Capacity in 2002 (MW) Sources: Based on income data from World Bank 2005 and on capacity data from Energy Information Administration 2002. 3.2 Classification of Developing Countries by These two variables have relatively stronger influences on Power Market Reform different components of power market reform. Country income level has a relatively stronger influence on the Most developing countries can be broadly classified into roles of the public and private sectors and on access and two groups in assessing their experience with power affordability to electricity services. It can also have a market reform. One of these groups ("the large middle- stronger influence on the regulation of power markets on income group") is formed by a combination of system the basis that institutional capacity increases with income size larger than 1,000 MW and national per capita level. Power system size has a relatively stronger influence income above US$900, and the other group ("the small on market structure. low-income group") is formed by a combination of size and income below these threshold values. This The threshold values of 1,000 MW and US$900 are approach is indicated by figure 1 for the developing indicative because the two groups defined by them do not countries that have unbundled their power supply hold all developing countries. Some countries have lower arrangements to date.19 It accommodates the huge power capacities but higher income levels than the range of country and sector characteristics found among threshold values. Other countries have higher power developing countries. The existence of empirical capacities but lower income levels than the threshold threshold values between these groups shows the values. Table 3A shows that about one third of all influence of scale economies on market reform. developing countries fall below both threshold values 27 BOX 8. Classification of Developing Countries by Income and Size Group Developing countries fall into the following groups according to their per capita income and size of power system: Countries with per capita income of less than US$900 and a power system smaller than 1,000 MW (44): Angola, Benin, Bhutan, Burkina Faso, Burundi, Cambodia, Cameroon, Central African Republic, Chad, Comoros, the Democratic Republic of Congo, Côte d'Ivoire, Equatorial Guinea, Eritrea, Ethiopia, the Gambia, Guinea, Guinea- Bissau, Haiti, Kiribati, Lao PDR, Lesotho, Liberia, Madagascar, Malawi, Mali, Mauritania, Mongolia, Nepal, Nicaragua, Niger, Papua New Guinea, Rwanda, São Tomé and Principe, Senegal, Sierra Leone, Solomon Islands, Somalia, Sudan, Tanzania, Timor-Leste, Togo, Uganda, the Republic of Yemen Countries with per capita income of more than US$900 and a power system smaller than 1,000 MW (27): Antigua and Barbuda, Barbados, Belize, Botswana, Cape Verde, Djibouti, Dominica, Fiji, Gabon, Grenada, Guyana, Honduras, Maldives, Marshall Islands, Mauritius, Micronesia, Fed. Sts., Namibia, Samoa, Seychelles, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, Suriname, Swaziland, Tonga, Vanuatu, West Bank and Gaza Countries with per capita income of less than US$900 and a power system larger than 1,000 MW (20): Azerbaijan, Bangladesh, the Republic of Congo, Georgia, Ghana, India, Indonesia, Kenya, Democratic People's Republic of Korea, the Kyrgyz Republic, Moldova, Mozambique, Myanmar, Nigeria, Pakistan, Tajikistan, Uzbekistan, Vietnam, Zambia, Zimbabwe Countries with per capita income of more than US$900 and a power system larger than 1,000 MW (59): Albania, Algeria, Argentina, Armenia, Belarus, Bolivia, Bosnia and Herzegovina, Brazil, Bulgaria, Chile, China, Colombia, Costa Rica, Croatia, Cuba, the Czech Republic, the Dominican Republic, Ecuador, Egypt Arab Rep., El Salvador, Estonia, Guatemala, Hungary, Islamic Republic of Iran, Iraq, Jamaica, Jordan, Kazakhstan, Latvia, Lebanon, Libya, Lithuania, FYR Macedonia, Malaysia, Mexico, Morocco, Oman, Panama, Paraguay, Peru, the Philippines, Poland, Romania, Russian Federation, Saudi Arabia, Serbia and Montenegro, Slovak Republic, South Africa, Sri Lanka, Syrian Arab Republic, Thailand, Trinidad and Tobago, Tunisia, Turkey, Turkmenistan, Ukraine, Uruguay, Venezuela Uganda is an exception among the countries in this group to this finding, since it has an installed capacity of much less than 1,000 MW and a 19 per capita income of well below US$900. TABLE 3. Differences in Power System Characteristics by Threshold Group TABLE 3A. Developing Countries Classified According to Threshold Values for System Size and National Income INSTALLED POWER CAPACITY IN 2002 NATIONAL PER CAPITA INCOME IN 2003 BELOW 1,000 MW ABOVE 1,000 MW TOTAL Below US$900 44 20 64 Above US$900 27 59 86 Total 72 79 150 TABLE 3B. Average Proportion of Population without Access to Electricity by Threshold Group of Countries, 2002 28 INSTALLED POWER CAPACITY IN 2002 NATIONAL PER CAPITA INCOME IN 2003 BELOW 1,000 MW ABOVE 1,000 MW AVERAGE Below US$900 83% 53% 73% Above US$900 49% 9% 14% Average 77% 20% 41% TABLE 3C. Average Values of TI Corruption Perceptions Index by Threshold Group of Countries, 2004 INSTALLED POWER CAPACITY IN 2002 NATIONAL PER CAPITA INCOME IN 2003 BELOW 1,000 MW ABOVE 1,000 MW AVERAGE Below US$900 2.5 2.3 2.4 Above US$900 4.2 3.6 3.7 Average 3.0 3.3 3.2 Note to tables 3B and 3C: The data needed for these tables were available for virtually all the countries with installed power capacity above 1,000 MW, whereas the data were not available for many countries with installed power capacity below 1,000 MW. Conversely, data availability did not differ significantly between the lower-income group and the higher-income group of countries, with similar proportions of countries lacking this data. Note to table 3C: The Transparency International (TI) Corruption Perceptions Index rates countries in relation to the degree to which corruption is perceived by business people and analysts to exist among public officials and politicians. It defines corruption as the abuse of public office for private gain. The index values are relative to a clean rating of 10. A rating below 5 indicates considerable corruption, and a rating below 3 indicates rampant corruption. Sources: World Bank 2005 for country income levels and for proportion of country population without access to electricity; Energy Information Administration 2002 for country installed power capacities; Transparency International 2004. into the lower income group, another third fall above 3.3 The Rise and Fall of Private Investment both threshold values into the middle-income group, but the remaining third fall outside these groups.20 Box 8 A direct result of the global movement to reform power lists the countries that fall into each group. The threshold was the rapid growth from the early 1990s in private values may change over time for future groups of reforming investment in the power sectors of developing countries. countries--either upwards or downwards. The rate of this investment peaked at US$43 million in 1997, but it dropped sharply after the Asian financial The basis for this classification is strengthened by the crisis of 1997 to around a quarter of that level from observed divergence in social and institutional characteristics 2001 onwards, as shown in figure 2 (Izaguirre 2004; that corroborate the divergence in physical and economic World Bank 2003a).21 Public investment declined, characteristics of these groups, for example: including donor financing for such investments, in the expectation that private investment would be an adequate · The proportion of the population without access to replacement. For example, annual financing for power electricity indicates a social dimension of the power sector investments from multilateral organizations fell from sector that is particularly relevant to the priorities for around US$8 billion during 1980s to around US$3 power market reform. Table 3B shows that this proportion billion from 1998 and thereafter (World Bank 2004a). is extremely high--averaging 83 percent--for countries that fall below both threshold values, whereas it is very Most private investment went to a relatively few countries low--averaging 9 percent--for countries that fall above (figure 3). Two regions--East Asia and Latin America and 29 threshold values. The average proportions for the other the Caribbean--received 75 percent of this investment, two groups lie between these values at around 50 while about 50 percent went to only five countries-- percent. These are highly significant differences for Argentina, Brazil, China, India, and the Philippines. specifying the conditions for reforming a country's About 70 percent went to the power generation segment, power sector. and the rest was mainly in the distribution segment; little went into transmission (figure 4). · A country's rating for corruption--as measured by Transparency International Corruption Perceptions Foreign private investment in the power markets of Index--shows an institutional dimension that is relevant developing countries has been vulnerable to economic to attracting investment and improving governance of the conditions in these countries. This is shown by the decline in power sector. Table 3C shows that national per capita private investment in developing countries after the East income is the critical factor for distinguishing country Asian and Russian financial crises in 1997 and 1998, groups by this rating, since countries in the lower income respectively. These crises dealt a double blow to the groups have markedly lower (worse) ratings than prospects for attracting private investment to developing countries in higher income groups. The difference in countries in general, and to countries in Eastern Europe rating based on size of power system is not significant. and the FSU in particular just as they were embarking on reforms to their power markets (Besant-Jones 1999). This This analysis provides insights into power market reform in decline is mainly attributable to three factors: investors' bad developing countries. For example, in nine countries with experiences in some countries, the unattractive investment competitive power trading arrangements, three have climates of many countries, and the difficulty for many nonaccess rates of 20 percent or more and eight have countries in sustaining the reforms to power market and corruption ratings of below five. Such conditions indicate corporate governance needed to place the power market difficulties for sustaining these arrangements. on a commercial footing. This surge in foreign investment was stimulated by low interest rates and high supplies of private funds in international capital markets, allied to 21 growing global interest in market oriented reforms to infrastructure sectors. See also Izaguirre 2000 for information about private participation in energy. A classification based on these two factors allocates many more countries into the two target groups (one higher than both threshold values, 20 the other lower than both threshold values) than a classification based on one or other factors alone, as shown in Table 3A. A single factor classification allocates countries in nearly equal numbers above and below each threshold value (73 and 78 below and above 1,000 MW, respectively; and 66 and 85 below and above US$900 per capita income, respectively), which shows little discrimination. FIGURE 2. Private Investments in Electricity in Developing Countries, 1990-2002 (billions of U.S. dollars) 50 43.0 40 30 27.2 24.7 21.7 18.0 20 14.0 12.7 13.4 9.0 10 7.1 6.7 .93 .99 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 30 FIGURE 3. Geographic Imbalance in Private Investment in Electricity, 1990-2002 Middle East & India North Africa 6% South Asia 5% 10% Phillippines 7% Sub-Saharan Latin America & Africa Caribbean China 2% 44% 10% Argentina 9% Brazil Others Europe & East Asia & 19% 49% Central Asia Pacific 10% 30% FIGURE 4. Distribution of Private Investment by Power Market Segment, 1990­2002 Integrated Utilities Distribution & 8% Generation Generation 3% 72% Distribution 16% Transmission 1% Source for figures 2, 3, and 4: World Bank 2003a. The World Bank PPI database, which is the source for this data, tracks total financial flows to projects in emerging markets that have a private component, including both investment in power generation capacity that supplies the public power system, and investments in capacity by industrial and commercial users to provide electricity for their own needs. · Investors' bad experiences in some developing country service quality and an increase in unserved power demand. power markets, which outweigh some good experiences. Industrial and commercial enterprises in many countries This situation arises from a general reduction in interest have resorted to installing their own generator sets to serve of international power investors in developing countries. their power needs, but at substantial cost that is For example, about a dozen foreign power producers undermining their businesses in competitive markets. have withdrawn from Indian power projects over pricing issues. Many foreign investors are carrying losses from 3.4 Outcomes of Power Market Reform their investments in Argentina and Brazil because of large currency devaluations, and some have sold their Power market reform in developing countries should be holdings at substantial losses. assessed against three outcomes that reflect their drivers for reform. These outcomes are better service quality for · The unattractive investment climates of many countries. electricity consumers, improvement in government's fiscal Investors are being deterred by a combination of position, and more affordable access to electricity for the continued regulatory uncertainty and general concerns poor. Outcomes are distinguished from outputs or elements about risk and reward tradeoffs in countries where it is of reform and are--or at least should be--closely related politically difficult to raise power tariffs, competition to the drivers of reform. The main elements of reform-- and financial difficulties in home markets for leading restructuring power supply chains and markets, regulation, firms in the power business, turmoil in some markets, competition and the roles of public and private such as in Argentina, and lack of access to debt participants--are considered as the means for achieving 31 financing for investment in developing countries. these outcomes. Empirical analysis to date about reform outcomes has been carried out largely for OECD countries, · The difficulty for many developing countries in sustaining Latin America and Eastern Europe where outcomes have reforms to power market and corporate governance been systematically monitored. needed to place the power sector on a commercial footing. Several developing countries are pulling back Overall, implementation of reforms has been constrained from private sector participation in power supply. by lack of country commitment, macroeconomic and For example, the economic crisis in Latin America led to political crises, and lack of experience among reform the postponement of privatizations of power entities in practitioners, particularly with political economy factors Peru, Ecuador and Brazil. This pullback stemmed from (World Bank 2003b). These reforms have not been in place many sources, including unmet expectations and popular for sufficient time to take full effect. Power market reforms criticism of poorly designed concessions, greater that restructured and privatized power entities and sensitivity about increases in power prices, and concerns liberalized power markets beyond just bringing in IPPs over contingent public liabilities under private provision started only in the mid-1990s, and most countries that of electricity services. embarked on this course are still at the early stages of reform. The empirical evidence for reform is thus limited · A recovery in the interest of foreign investors in and not in a form suitable for econometric analysis. developing country electric power sectors is uncertain Country case studies are therefore the most important both in timing and extent. Yet more than 40 developing means for examining reform outcomes. countries have announced their intention to privatize some or most of their electric power assets, which The sustainability of reform is threatened in some cases indicates a high demand for private investment in these by various political, economic and technical factors. markets. Political manipulation of tariffs is a major threat. Problems arising from market design or regulation As a result of these developments, overall investment in create technical and economic problems. Some Latin developing country electric power sectors has generally American countries, such as Colombia, have yet to not kept pace with the estimated needs during the resolve the particular problems of managing a 1990s. The current level is a fraction of total investment wholesale competitive power market in a system requirements of over US$100 billion annually in dominated by hydropower under variable hydrology developing country electric power sectors (IEA 2003). (Ayala and Millán 2002; Larsen and others 2004). Many developing countries face a huge backlog of The public image of power market reform has been maintenance and capacity expansion in their electric power damaged by some notorious cases in OECD countries, sectors, and have experienced a marked deterioration in such as in California (Besant-Jones and Tenenbaum BOX 9. Successful Outcomes of Power Sector Privatization in Chile and Argentina In Chile, power suppliers increased their capacity substantially by more than doubling annual generation from 1990 to 1998. Privatization also increased the productivity of utilities by cutting energy losses by more than half to 8.3 percent in 1997, by doubling labor productivity in distribution, and by tripling energy generation by worker in the largest generating company. Although privatized companies became substantially more efficient, however, these gains were only transferred to customers in areas under competition. In the main market, the regulated wholesale price of electrical energy fell by 37 percent, and technological change rendered uneconomical a large fraction of existing thermoelectric plants. In contrast, the final price to customers did not fall to reflect the huge productivity gains that were achieved after privatization, since between 1987 and 1998 the regulated price to consumers fell by only 17 percent. This situation led to spectacular increases in the profit rates of distribution companies: the rate of return of the largest distributor rose from 10.4 percent to 35 percent in this period, which is striking considering the low market risks carried by distribution monopolies (Fischer and Serra 2000). In the case of Argentina, wholesale power prices and unserved demand dropped substantially following market reform, as shown in the figure below. (This figure shows only the years immediately following privatization to illustrate the gains that were actually realized then. Recent events in the country have undermined the sustainability of this reform.) The average energy spot price dropped steadily from around US$45 per MWh in 1992--the first year of operation--to US$25 per MWh by 1998 under intense competition among the privatized generators. Retail power prices did not decline as much, however, because of contracts between distributors and generators concluded before 32 the parties were privatized. Electricity prices for industrial users declined more than prices for residential users. Similar price trends occurred in other South American countries (Bolivia, Colombia, Peru) that followed the same reform model as Argentina, with wholesale prices dropping by more than retail prices. Benefits from the New Wholesale Electricity Market in Argentina Fall in Average Energy Spot Price from Start of Market in 1992 Edesur--Reduced Unserved Demand from 1990 after Reform 700 45 600 40 500 35 400 $/MWh 30 300 25 200 20 1992 1993 1994 1995 1996 1997 1998 1999 100 0 -88n -89n -90n -91n -92n -93n -94n -95n -96n Ja Jul-88 Ja Jul-89 Ja Jul-90 Ja Jul-91 Ja Jul-92 Ja Jul-93 Ja Jul-94 Ja Jul-95 Ja Source: Adapted from Deloitte Touche Tohmatsu 2004; World Bank 2003c. 2001; Wolak 2003), as well as highly publicized The main policy conclusions from one econometric controversies with IPPs in some Asian countries and assessment (Zhang, Parker, and Kirkpatrick 2002) are politically inspired public opposition to the removal of that (a) neither privatization on its own nor regulation general subsidies in power tariffs.22 on its own leads to obvious gains in economic Even serious power shortages in recent years caused by abnormally low rainfall in countries dependent on hydropower (Brazil, Colombia, 22 Ghana, New Zealand, Norway, and Tanzania) have been spuriously linked to actual or nascent power sector reform in these countries. performance,since the effect of privatization and having Improvement in Government's Fiscal Position an autonomous regulator separately is statistically insignificant; (b) the coexistence of privatization and an Government's fiscal position can improve in three ways autonomous regulator reforms together is correlated with from reforms to the power sector. First, by removing or greater electricity availability, more generation capacity, reducing support for power suppliers' debts. Second, and higher labor productivity; (c) hence, an effective by removing or reducing direct subsidies for specific groups regulatory framework should be emphasized when of power consumers. Third, by receipts of proceeds from privatizing electricity supply under monopolistic conditions; divestiture of some or all of the state's shareholdings in and (d) introducing competition is effective in improving power suppliers. The first two benefits recur continually over performance, irrespective of changes in ownership or time, whereas the third constitutes a single boost to the regulation, since competition appears to bring about public exchequer. Investments by IPPs under long-term favorable results for service penetration, capacity contracts with state-owned off-takers, however, do not expansion, labor efficiency, and prices to industrial users.23 relieve the fiscal burden entirely because they substitute government backing for borrowing by government backing Better Service Quality for Electricity Consumers for off-take commitments by state-owned entities, especially if the latter involves payment guarantees that rank as Better supply quality at reduced cost should be the contingent liabilities. main outcome of investments in supply capacity. Among developing countries, these outcomes have been Latin American experience shows that privatization of 33 achieved successfully so far in a few South American power sector assets can yield substantial fiscal benefits countries, such as Chile (Pollitt 2004a) and Argentina under stable macroeconomic conditions. The high costs (Bastos and Abdala 1996; Pollitt 2004b) where privatized of restructuring the sector reduced the immediate power entities increased their efficiency and coverage benefits for government budgets. Divestitures of public substantially (box 9). Additions to generation capacity power assets yielded around US$60 billion between through IPPs from the mid-1990s onwards helped many 1990 and 2002 for the most successful nine countries developing countries that were experiencing severe in the region during a period when such infusions of supply shortages in the midst of global financial crises, funds were needed for economic stability and social although temporary surpluses occurred under programs in Chile in the 1980s, Argentina and Bolivia constrained demand (section 5.3). under the Brady Plan, and then Brazil, Colombia, and Peru in the mid-1990s.25 In comparison, divestitures of Efficiency gains have not been shared equitably between public power assets yielded around US$10 billion power suppliers and consumers, or among consumers. between 1990 and 2002 for the most successful eight Generators initially kept a high proportion of their countries in Asia. Substantial additional fiscal benefits productivity gains, and were obliged to pass some of flowed from payment of income and other taxes and these gains to purchasers of their output only in dividends to governments for their remaining shareholdings competitive wholesale power markets. Distributors were in divested entities, as well as reductions in subsidies to the obliged to pass some of these gains to consumers only power sector, as shown by the following cases from Latin under regulatory price reviews, for example in the case of America (World Bank 2003b). Brazil (Mota 2003). Likewise, real prices have generally decreased for industrial and commercial consumers, but not for residential consumers.24 The main policy lesson from this experience with privatized electricity sectors is that countries should aim to establish conditions that lead to the broadest possible scope for competition This assessment of the effects of privatization, competition and regulation on the performance of the electricity generating industry uses panel 23 data for 51 developing countries. It identifies the impact of these reforms on generating capacity, electricity generated, labor productivity in the generating sector, capacity utilization, and industrial and residential user prices. The conclusions are subject to tradeoffs between methodology and data availability (Jamasb and others 2004). A comparison of electricity prices in the power market after reform with those before reform should be interpreted cautiously, however, because 24 this type of comparison can be distorted by specific regulatory actions over prices, as when electricity prices for residential users start well below cost at the start of reform. The comparison becomes more reliable when post-reform prices are largely determined under market forces, as in the case of some Latin American countries. Table 15 in chapter 7 provides a breakdown of this amount by country. 25 · Bolivia: Fiscal revenues from the power sector (sales · Peru: The sector shifted from draining the public treasury and profit taxes) increased by 247 percent in three of US$300 million in 1990 to being a source of fiscal years (from US$17 million in 1994 to approximately income from US$300 million in profits in 1998. US$42 million in 1997). In addition, debt service of approximately US$61 million for the main power Private power operators saved governments from providing entity preprivatization, which was guaranteed by the heavy operating subsidies. Where private operators took government, was transferred to the private companies. over retail supply, they also drastically reduced payment delays, theft, and unpaid bills (from 30 percent to 12 · El Salvador: The sale of 75 percent shareholdings in percent in Buenos Aires, and about the same in Côte the distribution companies totaling US$575 million d'Ivoire, where assets were not sold but just leased). had a substantial financial impact equivalent to 5.5 A lot of the gains that eliminated or reduced the need percent of the 1996 national GDP. for subsidies stemmed from better asset management. Typically in the reformed Latin American power sectors, · Panama: In FY 2000, the privatized power sector over a five-year period plant availability increased by 10 companies contributed US$70.8 million to the percent to 40 percent, the number of customers per treasury, of which US$34.5 million was in income employee also increased by 50 percent, and power taxes and US$36.3 million in dividends for the shares outage indicators decreased by more than half. still in government hands. 34 TABLE 4. Improvement of Privatized South American Distribution Companies PERU ARGENTINA ARGENTINA CHILE ITEM LUZ DEL SUR EDESUR EDENOR CHILECTRA Year privatized 1994 1992 1992 1987 Change in energy sales (%) +19 +79 +82 +26 Change in energy losses (%) -50 -68 -63 -70 Change in number of employees (%) -43 -60 -63 -9 Change in customers per employee (%) +135 +180 +215 +37 Change in net receivables (days) -27 -38 -- -68 Change in provisions for bad debts -65 -35 -- -88 (percent of sales) -- Not available. Note: Performance improvement is measured from the date of privatization until 1998 in relation to performance relative to the year of privatization. Source: Bacon and Besant-Jones 2002. Latin American distribution companies substantially reform to 70 percent in 1997, and in Peru from 53 percent improved their performance following privatization in 1993 to 70 percent in 1998. South Africa substantially through long-term concessions. These improvements extended access to electricity during the last 10 or so years, show the benefit of focusing private management on however, using innovative measures, such as prepaid commercial performance, which has been a major metering to control customer service costs (Tewari and Shah weakness of state-owned utilities. The improvement in 2003). efficiency after privatization of four South American distribution companies is summarized in table 4. Where reforms involved adjusting tariffs to cover costs, poor These improvements are measured in the change in households supplied from the public power system were performance between the date of privatization and 1998. adversely affected, at least in the short term. In Poland, energy subsidies have tended to help the rich more than Affordable Access to Electricity for the Poor the poor (Freund and Wallich 1995). In Hungary, energy price reforms did not have a regressive impact, suggesting The poor have obtained a low share of the benefits of that subsidies prior to reforms were not effectively targeted power market reform in developing countries, and some at the poor (Newbery 1995). In Guatemala, the social tariff have even suffered welfare losses. Although reforms to introduced following privatization of the power distribution power markets have delivered substantial benefits to society companies largely fails to reach poor households, and overall through efficiency gains, most of these benefits have access to modern utility services remains highly inequitable been shared between power suppliers, nonpoor power (the richest 20 percent are twice as likely to have electricity 35 consumers and governments (through fiscal gains). Most of connections as the poorest 20 percent). Electricity coverage the poorest people, especially those in rural areas, lie is close to universal in urban areas, but reaches little more outside the ambit of power market reform. In many than half of rural households (Foster and Araujo 2004). developing countries, improving electricity access for the poor was overshadowed in the 1990s by the pressing need Existing customers, including low-income consumers and to add generation capacity. Lagging reforms in transmission industries that provide employment to the poor, clearly and distribution constrained power delivery and expansion benefited from the relatively quick elimination or reduction of access for the poor. of supply shortages. Based on research findings that growth is good for the poor (Dollar and Kraay 2001), reducing Some of the poor have gained from power market reform, generation supply constraints should have benefited the and some of the poor have lost from power market reform. poor through growth in GDP. While this may be The poor who gained received otherwise unavailable demonstrable in a macroeconomic context of trade connections to electricity supply. The poor who lost were liberalization and transition into market economies, the obtaining some electricity service before reform--albeit argument is less tenable in the sectoral context of private illegally and of poor quality--but have been disconnected capital flows into developing country electric power sectors or now have to pay for their consumption. Other groups of suffering from transmission and distribution constraints on the poor continued to receive legal service but at higher reaching the poor. tariffs as subsidies and cross-subsidies were removed under the commercial pressure on service providers introduced by Reforms to urban power markets can spur support for reform. Some of the poor may have benefited indirectly improving access and affordability to the poorest urban through economic growth and job creation. The poor are areas. This is shown by experience in Tbilisi in Georgia and often the last to benefit from increased access because of in Buenos Aires in Argentina after electricity distribution was reform (Chisari, Estache, and Waddams Price 2001). privatized through long term concessions. Under the inefficient state-run power systems, theft of electricity was Reforms have led to improved access to electricity supply by widespread as consumers tapped into electricity networks low-income households in some countries, with substantial without facing pressure to pay or be disconnected. benefits for these households. Even where electricity tariffs The solution in Georgia for the general population was a were raised under reforms toward cost-recovery levels, the combination of activities aimed at increasing revenue energy services met by household electrification still cost the collections (box 10). households less than beforehand. For example, new connections and the percentage of households having The solution adopted in Buenos Aires was the Acuerdo electricity access grew in Chile from 64 percent to 95 Marco, which was a four-year framework agreement percent in 1990­94, in Bolivia from 56 percent before the between public authorities and new distribution BOX 10. Impact of Power Market Reform on Georgia's Urban Households At the end of 1998, Government of Georgia sold the electricity distribution company serving Tbilisi to AES Telasi, a subsidiary of AES Corporation. AES Telasi greatly improved revenues and cash flow from the beginning of 2000, accompanied by substantial improvements in the quality of power supply and customer service. Revenue from the residential sector increased 91 percent from 2000 to 2001 and another 41 percent from 2001 to 2002. While tariff increases of 8 percent in 2000 accounted for some of the increase, better collections from customers--as well as increases in the amount of targeted and nontargeted subsidies--was the main source. AES Telasi was particularly successful at reducing household payment arrears. They steadily improved collection rates, rising from 44 percent in 2000 to 86 percent in 2002. The consequence of this reform on the welfare of Tbilisi's households was found to be mixed. A major concern was how reform to access and prices for energy services would lead to changes in energy consumption and expenditure patterns. Government provided energy subsidies for households through various schemes, such as subsidizing the extension of natural gas supply for heating and cooking, which helped households with affordability for other goods and services including electricity. A major finding was that an aggressive approach to reducing nonpayment did not have a disproportionate adverse impact on low-income households--particularly when suitable subsidy and transfer mechanisms were in place. Under the increased price for electricity and policy of reducing nonpayments, households in Tbilisi paid a larger share of their 36 electricity bills. The mean household consumption of electricity remained constant at around 125 kWh per month, which is sufficient for lighting and some small appliances but not for heating or air conditioning. Demand for electricity in Tbilisi remained constant despite the increase in electricity prices. This finding indicates that demand at this level of consumption was quite inelastic, and that the increase in price for serving this demand therefore caused welfare losses for these households. These losses appeared to more than offset, however, by welfare gains from access to natural gas supply. Analysis of changes to household electricity consumption patterns indicates that enforcement explains much of the improvement in collections. Metering and subsidies had a much larger impact on collection rates and revenue increases than service quality and retail prices. Collection rates were systematically higher for remetered households. The threat of disconnection seemed almost as effective in reducing nonpayment as an actual cutoff. Remetering was found to be as important a determinant of utility receipts as prices, followed by service quality and subsidies. Remetering in conjunction with tariff increases should therefore be given high priority, particularly at the early stages of reform. Improving collections did not have a disproportionate impact on low-income households, since collection rates increased uniformly across the top and bottom quintiles of household incomes. This challenges the conventional wisdom that nonpayment is closely related to affordability, since collections would be lower for the bottom quintile if affordability were important. Source: Lampietti and others 2004. concessionaires to subsidize the cost of network extension investment in supply capacity. Yet new investment by itself and regularize electricity services to the inhabitants of the has been insufficient to sustain reform in many countries, city's shantytowns. The national government waived taxes especially when it has resulted in negative social outcomes, to cover unpaid bills from users in these areas, and local such as large increases in power tariffs and pressure on authorities waived taxes to contribute funding to capital government budgets (chapter 5). Experience shows that works on the power system in these areas. The local social and environmental policies are seldom incorporated authorities also provided support to the distributors in many into reform processes for power markets. Experience other essential ways. The agreement has yielded substantial also shows that public benefits are seldom given due benefits for these local communities (Chisari and Estache consideration once the urgent financial problems are fixed, 1999; Haselip, Dyner, and Cherni 2005). partly because the technical and institutional solutions adopted for the financial situation constrain the options The impact of power market reform on the poor forms part available for addressing public benefits. Consequently, of the broader consequences of this reform for public a political commitment to promote public benefits is benefits--both social and environmental. Public benefits needed as part of the reform process (World Resources have tended to be overshadowed in many country reform Institute 2002). programs, however, by the pressing need for new 4. ENTERPRISE RESTRUCTURING AND CORPORATE GOVERNANCE OGN's Guidance on Enterprise Restructuring and Corporate Governance In the current environment, even very ambitious restructuring programs are likely to include a continuing ownership and operational role for the state. As part of a comprehensive reform strategy, institutional strengthening of companies left in the public sector will usually be required to improve management and corporate governance. Actions to attract private investors in the power sector have to take into account the overall investment climate in a country. These actions must also be realistic given the global and regional context, especially with regard to the current and future levels of investor interest. Difficulties in sustaining reforms to place the power sector on a commercial footing in some countries, a wider reduction in investment flows to emerging markets, and the withdrawal of investors have produced a more difficult climate for attracting private investment in developing country power sectors. Practical solutions for these countries may be public-private partnerships that lie between these options that do not require private investment capital, such as management contracts and leases. The public sector can have a financing and/or a risk bearing role in all of these arrangements. 37 The possibilities for different levels of private participation depend on political economy factors (including public acceptance, and pricing), the country and sector investment climate, and the legal framework that may in particular limit choices on the mode of private participation. Responsibilities, risks and rewards need to be carefully allocated in public-private partnerships, including actual and contingent government liabilities, so that the real costs and benefits of different private participation options are clear to the government and its development partners. Even where revenues are close to or cover costs and the overall investment and regulatory climate is adequate, additional measures to attract private investment may be required under which governments share certain risks with the private operators until certain pre-conditions for viability are met, and also provide well-designed subsidies. This chapter covers enterprise restructuring and the tends to be weak at all levels, private roles are usually roles of public and private electricity service providers in confined to those with modest risk exposure under improving corporate governance.26 The requirements for carefully designed contractual conditions. The conditions corporate governance and commercialization of service that apply to private participation in power distribution providers apply equally to all countries--whatever their are covered in this chapter and in power generation in size and income status. A wide range of public and the next chapter. Conversely, the role for the public private sector roles are available for these service sector in financing investments in the power sector is providers. For countries in the large middle-income unavoidably substantial--and even predominant--in group, private service providers can find conditions small low-income countries, whereas it should be targeted suited to all roles up to and including at-risk to specific areas according to policy grounds in large investments. For countries in the small low-income middle-income countries. group, where governance and institutional capacity Although these subjects are covered in separate sections in the OGN, they are covered together in this chapter because of their close links. 26 4.1 Corporate Governance and FIGURE 5. Power Market Governance Framework Commercialization Corporate governance encompasses institutions and The State processes that influence the relationship between power companies and their owners.27 Corporate governance forms part of the framework for the governance of the Legal and Regulatory Political power market and its participants that includes Framework Regulator Accountability regulation, competition and privatization.28 This view is Compact Voice based on the presumption that power markets should be organized to deliver modern energy services efficiently to produce desired outcomes, such as those covered in section 3.4. Initiatives to improve Power Service Client Power Customers governance must therefore address both corporate Providers governance and market governance. Structure of Power and Capital Markets The main governance relationships in the power market Source: Adapted from Delloite Touche Tohmatsu 2004; are fundamental to understanding the nature of power World Bank 2003c. 38 market reform. The analytical framework for these relationships is depicted in figure 5.29 It shows the two chains of accountability from customers to service processes. Some governments have even caused their providers--the one a direct route via the market under utilities to involuntarily support their fiscal budgets when competition for market share and for capital whereby their departments and agencies do not pay their customers exercise choice of provider, and the other a electricity bills. This has usually led to operational longer route via government whereby its regulator inefficiency, limited access to electricity, financial loss intercedes between customers and providers in the and the need for public subsidy by these utilities, often interests of both parties as well as the public interest. in an environment of widespread corruption. High levels The ability of customers (apart from some vested of nontechnical power losses (such as theft) from state- interests), however, to influence governance is generally owned power utilities in many developing countries also weak or nonexistent in developing countries, because of reflect a failure of governance. weak political voice and lack of choice of power service provider. The regulatory route is thus critical to the Poor consumers in particular are vulnerable to poor governance framework. The roles of the three parties in incentives and governance of state-owned power utilities. these relationships are examined in this chapter and in This situation tends to be most acute when access to chapters 5 and 6. electricity supply and payment for electricity consumption is controlled by a monopolistic utility and its employees The typical institutional environment has not provided (Lovei and McKechnie 2000). A survey of corruption the correct incentives and governance for providers of carried out in South Asian countries found that power power services to meet consumer demands efficiently. consumers faced endemic petty corruption (Transparency Most state-owned power utilities in developing countries International 2002). The survey found that more than have operated under highly distorted economic 60 percent of the electricity users surveyed reported incentives and governance for utility managers, irregular connection processes, and that direct payment employees, and customers, which have undermined to office staff was the dominant irregular practice. Bribes service provision and revenue control. Governments paid to get a proper supply and overbilling were the have controlled their utilities closely through key most common forms of corruption, with meter readers appointments, tariff setting, investment approvals and and linesmen identified as the key facilitators by means financing, employment conditions and bureaucratic of direct extortion. Users considered the power suppliers The World Bank identifies four components to corporate governance: efficient management, accountability, a supportive legal framework, 27 and transparent information flows (World Bank 1995). See also World Bank 1994a. Constitutional governance is a higher level of governance that applies checks and balances on governments through supreme courts, 28 government auditing bodies, separation of powers and independent media. A lack of this governance makes governments vulnerable to interest groups and patronage. This figure is an adaptation of the conceptual presentation of the key relationships of power discussed in World Bank 2003c, which was 29 applied to the electric power sector in Deloitte Touche Tohmatsu 2004. lack of accountability and monopoly of service provision The premise of commercialization of power supply is that to be the major contributors this corruption. These users power utilities ought to achieve commercial standards in lacked the recourse of having a choice of service provider. management practices, financial performance and in the pricing of their products and services. Obliging electricity The lack of labor reforms has restricted reform of power enterprises to operate according to these commercial markets. In most countries labor forces in the power principles requires that enterprises pay taxes and market- supply industry are highly regulated based on old based interest rates, earn competitive risk-adjusted returns legislation for protecting workers' interests. An example on their investments at prices for their services that are of a restriction is the requirement that all but the smallest affordable for consumers, and have the autonomy to companies must obtain government permission prior to manage their own budgets, borrowing, procurement, laying off employees or closing plants. Over decades and labor employment. This requirement should extend to the state-owned power utilities built up extremely large state-owned entities that undertake one or more of the work forces who view their jobs as permanent government basic functions in the supply of electricity.30 entitlements. Labor productivity is several times below Commercialization of electricity service providers is a international norms, and it is hardly offset by low wages. benchmark of good governance at the corporate level. The underemployed, underpaid, and undermotivated employees of the power utilities themselves participate Full commercialization also requires that power suppliers in providing illegal connections to the power supply raise financing for expansion of their supply capacity network and facilitating nonpayment of bills by electricity from capital markets without recourse to government 39 consumers. In addition to theft, the rampant culture of fiscal resources. Capital markets can impose financial dishonesty and side-dealing often leads to collusion in accountability provided that power suppliers do not bidding for contracts and parts. receive the protection of government guarantees. Heavy borrowings with government backing on the international In many countries, organized labor has responded to capital markets were used to finance large investment reforms with strikes and severe opposition. Invariably, programs in power plants in some developing countries labor's discontent has forced compromises in which that turned out to be economically burdensome. newly corporatized (or even privatized) entities are Such periods occurred in the late 1970s and the early required to guarantee job security for a certain period. 1980s when power utilities in Latin America embarked In some countries the government has undertaken the on major hydropower construction programs, and during politically sensitive task of laying off workers before the 1990s when some power utilities in East Asia entered privatization in order to extract higher prices from private into long term power purchase agreements (PPAs) with bidders. Where governments have avoided this task, independent power producers. this legacy has imposed costs on new managers and has hampered the ability of the new firms to innovate with The appointment of an independent and competent new technology and work culture (Tongia 2003). Board of Directors is critical for combating political and bureaucratic interference in the management of a power Change from the traditional form of governance to utility. The board should consist of outside professionals commercially oriented corporate governance is fundamental of high standing and other knowledgeable eminent to achieving sustainable reform of power markets. persons, rather than the typical practice of limiting This change includes irreversibly removing the management board membership to a few civil servants and utility and development of power supply from political and executives. Experience in Lithuania shows the healthy bureaucratic control. Efforts to improve incentives and impact this policy has on the corporate governance of governance for power service providers are not sustainable the utility. If improving performance with the existing under political pressures and noncommercial business set of managers or the Board proves to be difficult, processes. Power service providers can only function the alternatives of using management contracts or commercially on the basis of respect for property rights cooperation with or franchising from western utility and a legal framework that enables them to collect their groups could be considered as an interim measure. revenues and that penalizes theft and nonpayment. The supply services function encompasses the sale of electricity procured on the wholesale electricity market to electricity users and the 30 associated customer services of billing, collection and maintenance. Corporate governance also involves the question of Private sector participation changes the governance human capital in top management. Power supply entities arrangements for a power utility. This is because the that run on commercial principles need commercially profit maximizing interests of private owners differ from oriented management. Governments of many state- the vote winning and rent seeking interests of politicians owned power utilities, however, appoint civil servants and bureaucrats. Since a privatized utility is legally and who are trained as generalists to senior management functionally independent of the government, its owners positions, instead of appointing career power can be expected to resist government pressure to pursue professionals. The result is resentment in the ranks of noncommercial goals in nontransparent ways, as well as utility employees since good performance on the job is to push for commercial arrangements, such as tariffs not a prerequisite for advancement to the highest that fully cover costs. positions within these enterprises. Moreover, top civil servants tend to operate within their own rules and Commercialization of power suppliers cannot be cultures that might impede the development of a achieved even under private ownership when politicians business culture in the power enterprises. Where the continue to interfere in their business. Such interference state retains a large shareholding in partly privatized includes exerting patronage over jobs and failure to enterprises--as has happened in the distribution entities support measures, such as prosecution of theft of power of many countries--the presence of government and power utility property. Private owners can only appointees among top management obstructs achieve commercialization by being able to control the 40 commercialization by keeping these enterprises exposed board of directors and the labor force. The Indian state to government directives and politicians' whims. of Orissa's experience with private participation in power distribution shows that changing sector State-owned utilities can operate at high standards of governance involves more than a change of corporate efficiency and management performance when they are ownership (Government of Orissa 2001). Box 11 governed by effective commercial principles. Examples summarizes the main governance requirements for are the power utilities in the Republic of Korea, power distributors--whether publicly or privately owned Singapore, and Taiwan (China). A commercialized state- and managed. owned power enterprise meets the following general standards for corporate governance of state-owned Legislative action alone is not enough to reform enterprises:31 governance, even when supported by institutional and market restructuring under market reform. Improvement a.It does not operate as a government department. in governance is an outcome that is often mistakenly assessed in relation to reform outputs, such as enactment b.It adopts best commercial practices for management of laws, appointment of boards, the incorporation of and operations. companies, and so on. While these actions are objectively verifiable, they often give little indication of outcomes in c. It retains a corporate status. the quality of governance when political interference continues via informal mechanisms. d.It develops a corporate style of management with corporate objectives and goals. Where privatization is not feasible because of daunting risks for investors or local opposition, governments have e.It has autonomy for its board and management. options for improving the governance arrangements for their state-owned power utilities (Irwin and Yamamoto f. It adopts accrual accounting and international 2004, PA Consulting Group 2005). One way is by accounting standards. negotiating performance contracts with their managers, but this approach has generally not worked because g.It competes with the private sector on equal terms well-designed and enforced contracts can be politically without receiving anti-competitive subsidies. costly (Shirley 1998). These options still require political commitment to achievement of commercial goals by the h.It adopts commercial salaries and employment utilities, without which the performance of power utilities conditions. and their public services would continually decline. Hence the sustainability of this approach is a major i. It takes full responsibility for staffing and procurement. concern, especially under the possibility of a change See also OECD 2005 for general guidelines on corporate governance of state-owned enterprises. 31 BOX 11. Governance Requirements for Power Distributors The main financial governance requirements are (a) revenues from electricity sales, including subsidy receipts from the government, fully cover the costs of supply and distribution and generate a competitive return on capital employed; (b) large cross-subsidies among consumption categories are eliminated under a series of regulatory orders; (c) tariffs are set by a reasonably autonomous electricity regulatory commission on a multiyear basis--preferably under a legally credible statute supported by a legally and technically knowledgeable appellate tribunal for dealing with disputes between the licensee and the regulator; (d) consumers receive good quality power supply that moderates their resistance to tariff increases; (e) utilities face the financial discipline of a hard budget constraint; (f) government subsidies are efficiently targeted and transparently delivered; (g) most consumption is metered accurately by distribution companies; and (h) system technical and commercial losses are reliably estimated by distribution companies. The main legislative governance requirements legislative are (a) the legislative framework should specify that the supply of electricity is a commercial service available only to those who pay the bills for electricity supplied to them; (b) utilities have the right in accordance with regulatory procedures to deny service to any consumer who fails to pay for service provided; (c) procedures for the recovery of payment arrears are simple, fast and cost effective; (d) theft of electricity is made a cognizable criminal offence that can be prosecuted quickly and punished accordingly; and (e) politicians and their officials cannot interfere in these procedures and in court cases. The main corporate governance requirements are (a) utilities are able to combat fraud perpetrated by consumers 41 and utility employees under the perception, sometimes fostered by politicians, that the utilities have weak property rights under common public ownership; (b) politicians refrain from using power utilities as a source of patronage for employment which undermines management's control over the labor force; and (c) utility managements exert full authority over their employees notwithstanding public service employment rules and the activities of politically influential unions. The main operating governance requirements are (a) utilities are not subject to political pressure to delay or modify tariff filings and sometimes also on investment and procurement decisions; (b) utility managements possess the full range of critical skills (finance, economics, human resources management as well as engineering); and (c) utilities have reliable information about their operating data from efficient management information systems. BOX 12. Improving State-Owned Power Suppliers in Andhra Pradesh In 1999, the state government of Andhra Pradesh unbundled the generation, transmission and distribution functions of the state electricity utility with the transmission company acting as a holding company for the distribution companies. Each entity thus formed was given responsibility for managing its operations as a corporate entity. The government also established a state electricity regulatory commission that established transparent procedures for its activities, such as periodic tariff reviews. The transmission company acted a single buyer by purchasing bulk power from all sources-- both in-state and out-of-state generators--for sale to distribution companies and large users of power under regulated bulk supply agreements. The state government also launched a campaign in January 2000 to control theft of electricity from the state-owned power companies and to improve their revenue collection. The campaign focused on four measures: enacting a new law to address electricity theft, strengthening enforcement mechanisms, reorganizing the anticorruption function in the utilities, and reengineering businesses processes to improve management control and customer service. The distribution companies installed modern bulk metering and data logging equipment and millions of digital meters at consumers, and they automated meter reading and reduced billing cycles. They also consulted extensively with their customers and communicated with the general public about their reforms--a major change from previous practice. Under this campaign, the distribution companies regularized large numbers of consumers and prosecuted extreme cases of theft of electricity with the support of the legal system. As a result, they reduced losses from 38 percent in 1999 to 26 percent in 2003, and increased the collection rate to 98 percent. Source: Bhatia and Gulati 2004 from a committed government to a populist one that cannot afford to pay cost recovery tariffs needed to attracted votes by promises of subsidized electricity and ensure commercial viability, well-designed transparent reduced antitheft efforts. The scope for a committed subsidy arrangements will be critical to building private government to substantially improve governance sector interest in these businesses (chapter 7). arrangements and operating performance under state ownership is shown by the achievements of the Indian Public investment may also be needed for immediately state of Andhra Pradesh (box 12). required new supply capacity in segments of the power market that are suited to competitive pressures, but 4.2 Conditions for Justifiable Public Investment where conditions are currently unattractive to private risk capital. This situation may apply in developing countries Public financing for some investments and for covering that are faced with imminent shortages of generation restructuring costs is vital for power market reforms in capacity relative to growing demand for electricity, but most developing countries, yet it carries risks. The main lack a credible reform program for the power sector and types of investments and restructuring costs are summarized where the sector generates insufficient revenues to cover in this section. One risk is a weakening of pressure to costs and pay for incremental generation capacity. improve sector finances for countries able to mobilize Before committing public financing to a thermal power substantial financing from external sources for public generation plant, for example, government should investments. Another risk is that of increasing the drain undertake a market test to assess whether private 42 on fiscal resources to the power market before the onset investment in this plant will be forthcoming and, if not, of improvements from reform for those countries under the reasons for this state of affairs.33 fiscal stress. The fiscal risk arises in the many countries where the need to reduce fiscal stress is an important Public investment in generation capacity is not justified driver of power market reform, and hence the demand on the grounds that it reduces financial costs to the for public financing threatens to aggravate, rather than sector. This reduction simply reflects the subsidies ameliorate, fiscal stress in the short to medium term. present in public financing. In these situations, other Governments should therefore check the impact on the types of government interventions may be preferable public sector deficit of any investments in the power than supporting public financing of new generation sector to be financed with fiscal support. capacity. One example is to reduce losses and revenue leakages by supporting public-private partnerships in The public sector will remain the main source of distribution. Another example is to address affordability investment for segments of the power market kept under and equity concerns or environmental externalities by state ownership as a matter of policy.32 Even ambitious directly targeted subsidies for toward specific access or restructuring programs include a continuing ownership environmental goals, instead of using public financing role for the state. Reform strategies commonly retain for new generation capacity.34 public ownership of transmission assets and public operation of the power system, even if private investors Public financial resources should be limited to build and maintain new transmission lines. Hydroelectric preprivatization investments and organizational and nuclear power plants may also remain state-owned development for entities that governments have on public policy grounds. programmed for privatization in the short to medium term. Efforts should be focused on immediate performance The public sector will also remain an important source, improvements and on facilitating privatization. In the case and often for the medium term the main source, of of distribution entities, a typical priority is to improve their investment for a power sector where country and sector cash collections by measures, such as ensuring strict risks deter private investors. In many countries, for adherence to payment discipline and ensuring that example, some public investment will be needed to subsidy mechanisms are explicit and transparent, improve the performance of nonviable generation and for which interim management contracts should be distribution businesses as a prerequisite for attracting considered. For entities that remain in the public private investment in them. Where many customers sector, the government should place a high priority Nevertheless, the private financial sector in countries with high domestic savings rates is likely to provide substantial debt funding for public 32 sector investments in the power sector. This market test should incorporate available multilateral instruments in the bidding documents. 33 For example subsidies in competitive procurement for environmentally friendly generation, or targeted subsidies for electricity distribution 34 services, such as new connections to low-income households. on establishing satisfactory corporate oversight, Power market reforms should be financed in ways that for example, by putting an independent and qualified do not impede the reforms. The priorities for using the board in place with a clear mandate. proceeds from selling utility assets may be the dues to employees of the utility (pension fund, labor retrenchment) Public funding often has to be available for rehabilitating and payment of the utility's debts or other liabilities. power distribution networks during the early years of Preprivatization expenditures for the distribution function concessions for distribution businesses. This funding is could be financed from the sale of generating assets needed to maintain and improve supply quality when before reforming the distributors, but the proceeds private concessionaires are not willing to commit a would probably fall far short of the underlying value of sufficient amount of capital to maintain and improve the businesses because of the poor creditworthiness of service quality in the anticipation of future tariff the distributors in their current condition. Selling increases.35 Improvements to supply quality also help shareholdings in generation companies after privatizing make tariff increases needed to cover the costs of this distributors could greatly increase the sale proceeds. work more palatable to power consumers.36 Hence a This means that government should look for other reform strategy should set out in advance the tariff path sources of finance for preprivatization expenditures in needed to repay loans for these investments and the distribution. regulatory arrangements needed to adhere to this path. 4.3 Private Sector Participation Actual and contingent government liabilities should be 43 assessed where government financial support is an The case for bringing the private sector into power integral part of private participation transactions in the supply functions should rest on economic grounds. power sector. This support can be provided as subsidies These grounds require that this would yield net welfare for low-income or disadvantaged consumers, benefits to power consumers in particular and society in contributions to investments under the terms of a general, while private service providers would be able to concession, or guarantees that support power utilities to earn a competitive financial return for their investment access capital markets and to enter into PPAs with IPPs. risks. In fact, many of the benefits that are attributed to The assessment should also cover the rationale, costs private sector participation have arisen from the wider and delivery means of any subsidy as well as the risks set of reforms and the interactions of many policies that involved to the government's overall budget situation, foster private sector participation and the associated so that the real costs and benefits of different private regulatory reform (Estache, Gómez-Lobo, and Leipziger participation options are clear to the government and 2001). This finding reflects the requirement that private its development partners (Irwin 2003). sector participation needs to be supported with significant legal, regulatory and institutional changes in most Public financing will also be required to restructure developing countries, and that ownership change alone power sector debt arrears before privatizing distributors.37 is insufficient for achieving the benefits sought from The alternative of leaving a single buyer of wholesale power market reform. power to carry the sector's accumulated debt servicing obligations, as happened in Orissa, is seldom sustainable. Private service providers are expected to earn competitive Some governments face huge accrued liabilities for returns by improving sector performance in ways that guarantees for utility bonds and contingent liabilities benefit consumers. This condition requires that a system under their guarantees to IPPs. The treatment of for power sector regulation can be designed and restructuring costs by the regulator should also be implemented which provides good business incentives for clarified to take account of the tradeoff between the delivery of services of the right quality while reassuring government's wish to limit its exposure to these costs investors of the profitability of economically justified and power consumers' reluctance to pay higher tariffs investments. In practice, the amount of private investment for covering these costs. in the electricity supply industry has been shown to be This situation has occurred in low-income countries, such as Uganda. 35 Measures that increase quality of service without, however, simultaneously addressing metering deficiencies or unauthorized connections only 36 increase demand without increasing revenue. Options include conversion of existing loans to equity, debt write-offs, sale or transfer of specific state-owned assets with their associated 37 liabilities, sale of shares in power entities formed from the unbundling of utilities, securitization of utility dues, and other market-based financial instruments. A combination of these options will often be required to deal with this task. positively correlated with institutional factors that support · Lease and concession. Under this arrangement, the the business environment, such as the protection of state retains ownership of the power utility's assets and property rights, judicial and regulatory autonomy, and concedes to an outside party the use of these assets.40 country political risk (Bergara, Henisz, and Spiller 1997; The lessee or concessionaire is responsible for Zelner and Henisz 2000; Newbery 2004). providing electricity service, operating and maintaining the utility's plant and equipment, and financing the Most developing countries need to attract resources from required investments under the terms of a contract the private sector for meeting their electric power needs. signed with the authority that oversees the utility. The These countries are not able to provide from their own contract stipulates minimum levels of service and sets resources the huge amounts of necessary financial, standards for the quality of power produced and institutional and technical capacity.38 Few of them, however, delivered. The lessee or concessionaire reimburses the are willing to pass all their power sector assets into private state for use of the assets, and often the state provides ownership for the foreseeable future because of their some form of guarantee for the concessionaire's concerns that a combination of private profit motives and investments. Again, compensation is tied to results.41 regulated retail prices would not bring about sufficient investment to achieve socially desirable levels of services.39 · Divestiture. Government transfers both ownership of In addition, groups that gain from patronage and rents the electric utility assets and operating rights to a under the current arrangements in the power sector are private party or a new semipublic organization or a 44 likely to oppose the privatization of sector assets. joint venture of both types. The new owners take over plant operations and become responsible for Private Sector Roles financing all future investments at their risk. Performance is controlled through competition or The roles of private participants in the power sector should general regulation, rather than wholly or partially match their capacity to take on investment risks under through contract terms (as under concessions). specific country conditions. Their roles range from virtually no at-risk investment under management contracts through The limitations of relying on private investment for meeting some investment risk under long term concessions to the power sector needs of developing countries needs to be accepting all investment risks under divestiture of recognized. Furthermore, the view that public and private ownership to the private sector. The more that risk and infrastructure provision is a dichotomy--a case of either-or, responsibility are passed to the private sector, the more one or the other--should be replaced by an appreciation powerful are the incentives for the contractor to improve of the extent to which the performance of each is services, and hence the greater the potential benefits. dependent on the competence of the other. In other words, for the private sector to perform well, public sector capacity · Management contract. Under this arrangement, must be enhanced (Nellis 2005). This realization has the local utility delegates part or all of its operations advanced the development of public-private partnerships to an outside party. The contractor's staff fills key through management contracts, leases, and concessions management positions and ensures the quality of for countries with distressed power markets and poor customer service. The electric utility still owns the investment climates. As described above, under public- power facilities, controls investment decisions, and private partnerships the public sector can play a financing remains accountable for financial results. The contract or a risk-bearing role by means of investment financing and stipulates the improvement objectives to be achieved. provision of subsidies.42 Table 5 summarizes the main The compensation of the outside management features and prerequisites for these forms, distinguished by contractor is tied to the performance obtained. how they allocate responsibility for such functions as asset IEA estimated that developing countries face combined investment requirements in their power sectors of US$1.2 billion for 2001­2010, US$1.7 38 billion for 2011­2020, and US$2.2 billion for 2021­2030, where these requirements are expressed in real dollars using year 2000 prices and market exchange rates (International Energy Agency 2003). Exceptions to this situation include very small power systems, including those on some island states, such as Barbados. 39 The French model of affermage concessions lies between management contracts and concessions in the risk-reward spectrum for private 40 contractors. This arrangement transfers limited risks and responsibilities to the private sector, including that for working capital. See World Bank 1998 for a full description of the issues and options related to the design, award, implementation, monitoring, and modification 41 of concessions, drawing on the experience of both industrial and developing countries. See World Bank 2006 for a companion toolkit for design and award of concessions. Private contractors appear to be keener than private investors on such public-private partnerships. A recent survey of 52 international private 42 investors in developing country power sectors found that 50 of these investors did not rate public-private partnerships as being important for them, and they ranked this arrangement lowest among the factors that lead to successful outcomes for their investments (Lamech and Saeed 2003). TABLE 5. Main Features of Public-Private Partnerships FORM OF PARTNERSHIP MANAGEMENT CONTRACT LEASE CONCESSION DIVESTITURE ALLOCATION OF RESPONSIBILITIES Asset ownership Public Public Public Private Operation and maintenance Private Private Private Private Capital investment Public Public and Private Private private Commercial risk Public Private Private Private Duration 3­5 years 8­15 years 25­30 years Indefinite PREREQUISITES FOR 45 SUCCESSFUL IMPLEMENTATION Political support Low to moderate Moderate High level High level Cost-covering tariffs Preferable but not Necessary Necessary Necessary necessary Good system information Sufficient to set Required Required Required incentives Well-developed regulatory Moderate Good monitoring Good monitoring Strong capacity for framework monitoring capacity capacity regulation and capacity monitoring Good country risk rating Not necessary Good rating High rating High rating to to attract investors to attract investors attract investors ownership and capital investment between the public and risk. They offer commensurately small possible gains private sectors. Figure 6 shows how these forms fit the (as in the case of Orissa in India during the mid-1990s range of country and power market development and risk before distribution was privatized under divestiture). levels found among developing countries. They are often recommended as a transitional arrangement to bring in private sector managerial Management contracts transfer only limited risk and expertise in cases where the private sector views responsibility to the private sector. The anticipated investment risks as unacceptably high. In other words, benefit is to turn round a poorly performing utility in they can be viewed as interim arrangements in conditions that are unlikely to attract private investors preparation for deeper reforms. because of their perceptions of high country and sector FIGURE 6. Private Participation Roles in Power Markets must be committed to the success of the management of Developing Countries contract. However, designing these contracts to provide the appropriate balance between risks and rewards for the Low contractor remains difficult, and evidence also suggests Asset that the effectiveness of these contracts diminishes over Risk Divestiture time after the initial gains. While some management contractors have been able to improve performance to Market the point where the utility's cash flow is sufficient to attract IPPs under some local commercial debt, in most cases access to and Project Financing Medium commercial debt remains out of reach. Country The economics of long-term (25- to 30-year) concessions of differ little from those of divestitures with licenses. For Lease or Concession example, issues about remuneration of investment in Level Management new assets become similar. However, government has Contract the right to determine disposal of assets under High concessions, whereas the private owners have this right Low Intermediate High under divestitures. In addition, the degree of perceived 46 Level of Development (per capita GNP) protection offered to investors differs, since contract- Source: Deloitte Touche Tohmatsu 2004. based private sector participation may be seen as less risky for investors than license-based participation because of the legal context of each type of approach.43 The major difficulty with management contracts has been demarcation of responsibilities between owner and manager, One option under joint ventures is the capitalization-type and the need for the full support of owners and employees approach used in some parts of Latin America, such as for the arrangement (World Bank 2003b). Experience during Bolivia.44 This approach allows the revenues from a sale the 1990s in the power sectors of developing countries with of assets to be used for modernizing the enterprise, management contracts and affermage concessions was instead of being transferred to the national exchequer. generally disappointing. Much of this experience was It also allows the concession to be granted to the obtained in Sub-Saharan Africa (in Benin, the Democratic investor willing to invest most in the enterprise.45 Republic of Congo, Ghana, Mali, Rwanda, Senegal, Sierra The value of the business is based on this market- Leone and Zimbabwe). The contracted service providers determined value, rather than on a net book value. invested little risk capital because they faced little incentive to Additional benefits from this approach are the short-term do so under the small performance-related components in financing for both new investment and working capital their contracts. Similar experience was obtained elsewhere provided from incoming cash, and the support to balance (Bolivia, Lao PDR). Côte d'Ivoire was a notable success with sheet restructuring of the enterprise (Ewing and Goldmark a 15-year operating concession starting in 1990 that resulted 1994; Moen 2000). This approach works only when in substantially improved technical and financial performance private investors are willing to pay a substantial amount and service quality which attracted the first IPPs to the region. for the concession, that is, the business is viable and These improvements could not be sustained, however, once private sector participation is politically sustainable. the political and economic conditions in Côte d'Ivoire deteriorated substantially after 2000. Conditions for Sustainable Private Investment More recent experience indicates that well-structured Many developing countries do not offer the necessary management contracts can soon lead to improvements in conditions for attracting substantial amounts of private operating and financial performance (Tanzania, Botswana investment to their power markets.46 This is because they and Togo). This experience shows that operators must be have had reversals in reforms or have been unable to able to manage the utility autonomously and governments generate sufficient momentum to embark on the reform Long-term concessions are discussed in the subsection on regulation by contract in section 6.4. 43 Romania is using a mix of transfers to Government and capitalization for privatization of its power sector assets. 44 The investor may own up to 50 percent of the stock of the enterprise through its investment, thereby taking control of management. The 45 remaining shares are managed by pension funds on behalf of the Bolivian populace. See Asian Development Bank 2000 for an overview of promoting private sector investment in the power sector. 46 path, including difficulties in moving to and sustaining The macroeconomic and business environments alone, cost-covering tariffs, and so are in a situation of incomplete however, cannot be a sure predictor of the amount or reform. These countries therefore have to seek private viability of investment in the power market. The countries sector resources as complements to the resources of the that best attract investment offer a set of appropriate, public sectors in their power markets. clear, transparent, and enforced rules governing general and specific investment activities: Developing countries should avoid giving perceptions of excessive risk in their power markets to foreign investors · Power generators look for no serious distortions in the in the global competition for finance. Most of these market prices of wholesale electricity, viable purchasers countries will have to compete for international capital of the output, and the ability to manage uncertainty in since their domestic capital markets are too undeveloped market prices for their outputs. to replace foreign finance. Actions to attract private investors in the power market should be realistic in the · Power distributors look for predictably regulated global and regional context (World Bank 2004b). For electricity tariffs, pass through to retail tariffs of example, offers of extremely high rates of return on purchased power costs beyond the distributor's equity (25 percent and higher) under long-term PPAs to control, freedom to disconnect nonpayers, and compensate for poor investment environments create the regulated open access to the transmission network. risk of contract breakdown because these rates require unaffordable payments by the purchasers under these Investment rules require clear definitions, credibility, 47 contracts, and they generate resentment among power predictability, enforceability and clearly delineated decision- consumers and other parties in the host country. making roles. Whether rules should be formally codified by law or contract, and the role of regulatory frameworks with The importance of a stable macroeconomic environment their respective enforcing agencies, depends on country for attracting private investment extends far beyond the circumstances. The following considerations are important power market. Low inflation, sound taxation policies, for investors (Lamech and Saeed 2003). access to foreign exchange and fiscal prudence form the overall justification for the range of current reform · The rules that best answer the main concerns of and development efforts. They should be viewed as foreign investors may not require a complex regulatory complements to current reforms of power markets, framework in the host country. If the principal such as legal protection of property rights of investors, requirements of investors are clarity of rules and arm's length regulation of the power market by government predictability of results with government commitment with no serious distortions to market prices, prevention and assured payback, they may be satisfied with the of anti-competitive practices by dominant power establishment of clear contracts, rather than complex suppliers, legislated rights to entry and exit from the regulations. power market by private suppliers, and freedom to import goods, fuel, and services. · Local market characteristics, in particular rapid pace of market growth, may attract investors without the need Private investment in power markets depends on the for much regulation. China attracted huge amounts of prospective risks and returns of investments. These risks foreign investment in power generation without a and returns depend not only on the investors' perspective developed regulatory framework, largely because of the specific terms attached to each investment proposal, investors felt protected by the country's need for their but also on the specific political, macroeconomic and investment. Such examples are exceptional, however. In regulatory environment of the country. Overarching political slower growing markets, a clear regulatory framework is considerations include public acceptance of private likely to help attract the investment capital for which ownership and service provision under commercially developing country power sectors compete. set prices, and how this attitude is reflected in the legal framework by limiting the mode of private participation · An unduly heavy regulatory framework may actually (for example, by precluding full asset sales). deter new investment, even though it clarifies the rules and the system for enforcing them. Working within Private investors seek predictability and control of risks such a system may generate excessive costs of to avoid threats to their investment returns. A poor responding to regulatory requirements--both direct country risk profile is a major deterrent to investors. costs and indirect costs--for investors. · The regulator should make proper allowance for Privatization of generating plant calls for a clear factors beyond the reasonable control of power enunciation of the structure and rules of the market. entities. These entities have difficulty obtaining Privatization of generation plant has been feasible in insurance, for example, against natural disasters, countries with a single buyer model with government such as floods and cyclones (as in the case of Orissa guaranteed contracts similar to those concluded with in 1999 and 2001), and they lack the funds needed IPPs. Privatization could be feasible in countries where to restore supply, particularly to rural areas. the generation entities enter directly into supply contracts with the distribution utilities and large consumers and Private investors should be apportioned those risk where system dispatch supports such bilateral contracts. components that they can reasonably manage. In countries that plan to move to competitive power They should carry obligations to meet commercial and pools, clear market rules and enforceable payment technical performance criteria, such as construction discipline are paramount to enable investors raise deadlines and plant operating efficiency and availability finance, because the generating units will be taking the levels. In turn, they must be able to exert full corporate demand risk, dispatch risk and price risk. The absence control, and their managers must be able to change the of clear market rules and payment discipline undermined business practices of their company. The private private investments in generating assets in Georgia and shareholders in Orissa's distribution companies were Kazakhstan (Krishnaswamy and Stuggins 2003). unable to make linemen cut off delinquent payers, and 48 senior managers were prevented from moving linemen Investors in generation plant prefer to use fuels of their and other staff from long-held positions by interference choice, especially in competitive power markets.47 by politicians. Experience in Poland, Hungary, and Ukraine indicates that investor interest is reduced by saddling the The government should support the new owners' efforts generation units with the ownership of associated coal to change business practices. Orissa's experience shows or lignite mines or saddling them with the obligation to that governments should instruct local police to support use allocated fuel supplies (bowing to the pressures of the distributors' efforts to prosecute customers who steal the coal mining lobby). power and distribution employees who defraud the companies and their customers. Government support is 4.4 Improving the Feasibility of Privatizing needed for dealing with political interference in the field Distribution that frustrates the operator's efforts to improve billing and collection. An intense joint communication campaign Following the post-1997 downturn in private investment, by the operator and the government is needed to reforming countries have experienced particular difficulty persuade local politicians and administrators that in attracting and retaining private investors to their financially viable distributors are in the public interest. distribution businesses. Investors are wary of taking on the substantial level of regulatory and commercial risks Specific support from the government is needed where a that investors assumed in the first wave of privatization lack of credibility about the regulatory system threatens in Latin America. In addition to the causes cited in the viability of reforms that rely on finance and substantial chapter 3 for the general downturn in investor interest, risk-bearing from the private sector. This situation applies investors faced the prospect of low or negative investment particularly in countries that have seen reversals in reforms returns in these businesses because governments failed or have been unable to generate sufficient momentum to support the measures needed to improve sector to embark on the reform path. The issue may be performance and because regulators added to the uncertainty about an unproven legal and regulatory uncertainty about future revenues, in some cases environment, or a lack of confidence that the government leading to the withdrawal of investors (for example, in will maintain an agreed regulatory framework because the Dominican Republic, Georgia, and Orissa--India). of a poor reputation. The additional measures needed In particular, many countries have had difficulties in to attract private investment may include sharing of moving to and sustaining cost-covering tariffs. This certain risks by government with the private operators experience indicates that unsustainable compromises until the preconditions for viability are met, as well as that led to poor outcomes may have been made under strong commitments by government to agreed the pressure to complete the initial transactions. contractual and regulatory frameworks (Crow 2001). The need to liberalize fuel markets for competition in the wholesale power market is covered in chapter 5. 47 Investor interest appeared to have recovered a little in needed to attract private investors is debatable and the past few years. A partial recovery is shown by the needs to be assessed as part of the work on designing a successful closing of long-term concessions for distribution privatization strategy for the distribution sector. businesses in India (New Delhi) and Uganda, and the sale of majority ownership of distribution entities in Romania. The way that urban and rural markets are combined or These ventures offer lessons about how the private sector separated is important for configuring the distribution can be persuaded to enter power markets in countries entities formed by unbundling a power utility. This is considered to offer high risks for private investment.48 because these markets have substantially different The main lessons from the New Delhi privatizations to two economic profiles, with urban areas having much more local groups are that the transaction should be structured industry and commerce, as well as higher-income to appeal to a range of investors, investors need certainty, residences. Because the geographical areas served by a and political will is important (Agarwal, Alexander, distribution entity should consist of contiguous components and Tenenbaum 2003). The means for achieving such of the power network, a distribution entity that is classified successes are the focus of this section. as urban will also generally contain periurban and rural customers.49 A rural distribution entity may have a few This experience shows that governments need to devise medium-sized and small urban areas, but by definition strategies for attracting and retaining private investors to no large urban areas. power distribution in developing countries. Such strategies should cover the following considerations: The choice of configuration for the distribution entities 49 often lies between the following two options: · What is being privatized--in terms of viable and unviable distribution businesses. · Divide the distribution of power throughout the country or state into a few contiguous mixed urban- · Who is expected to be the private participants and rural entities to be privatized in their entirety. what form of participation will be adopted. · Separate the commercially stronger main urban centers · When the sale takes place within the broader reform (with some surrounding rural areas) from most of the program for the power market, which would be linked weaker rural areas and privatize them first, leaving the to when the necessary preconditions for attracting remainder under state ownership until other ways are private participants are met. developed through public-private partnerships. · How the privatization is conducted--namely the The first option is preferable, if feasible, because it transaction design--particularly what stakes in the avoids letting investors serve only viable urban areas, businesses are offered and the sequencing of sales in leaving the less profitable and unviable rural areas in shares of joint ventures. state hands. Investors picked only the urban segments in Georgia, Kazakhstan, and Moldova, and similar · What terms are offered to manage the risks that preferences are evident in India (Dossani 2004) and investors are expected to bear, whether these terms Pakistan. It may substantially delay privatization while change during and after a transition period, and the trying to meet preconditions (section 4.3), which risks means of mitigating these risks, such as guarantees. derailment of the reform program. In this situation, the latter option would lead to quicker privatization--albeit These considerations are examined in turn in this section. only for the better-performing businesses. Both reform strategies also face the need to foster the entry of new What Is Being Privatized service providers, such as small-scale private providers and cooperatives to expand power supply to unserved What to privatize in the case of power distribution rural areas and urban communities not connected to the concerns primarily the configuration of the businesses to main power supply network. be offered to private participants. In particular, this issue concerns the size of the businesses and the number of Distribution systems should not be fragmented into small them--which are really the same issue--and the customer and unviable entities in the hope of enabling competition, mix of each business. The minimum size of business because such entities do not attract serious investors. The benefits of providing a third party risk guarantee is illustrated in the Romanian and Ugandan cases in chapter 6. 48 A distribution entity that covers only a significant urban conurbation and its immediate surroundings is a special case of this category. 49 Some countries in Eastern Europe and Central Asia other parts of the world) with proven resources, as well fragmented their distribution systems into tiny entities, as on technical collaboration and joint venture agreements presumably to make the franchise areas coincident with with international investors. This is already happening in the boundaries of local administrations. Albania, some markets in East Asia, Eastern Europe, and Latin Georgia, and Lithuania had to regroup their entities into America (Izaguirre 2005). much fewer larger entities subsequently, but they still failed to create entities sufficiently large to attract private Foreign investors are needed because the power sector investors. This experience shows that investors in this requires intensive use of capital and skills. The concept region tended to be interested in distributors with at of strategic investors (mostly from Western Europe or least 1 million consumer connections and 2,000 GWh North America) being selected on the basis of competitive of annual sales (Krishnaswamy and Stuggins 2003). bidding worked well initially. However, bids issued for privatization have not elicited good, or even in some Policy makers should anticipate that investors are interested cases any, responses recently (such as in Armenia, the in acquiring stakes in more than one distributor in a Czech Republic, Georgia, and several other countries). country as a means of spreading their overhead costs, In many countries, the narrowness of the local private as happened in India, Moldova, and Ukraine. In the first sector prevents domestic entrepreneurs from taking the major privatization of distribution in India, namely in the lead in power sector projects. The domestic financial state of Orissa in the mid-1990s, an Indian investor sector is important for the long-term development of a 50 took three of the four distribution entities into which the power system, however, to avoid excessive risk exposure state had been divided. In Moldova, a private investor on the international currency markets that could result acquired three contiguous entities out of five distribution from over-reliance on foreign investment. entities, and the other two have not attracted investors. A similar pattern emerged from the first round of Domestic and regional investors are becoming active as distribution privatization in Ukraine. they grow and replace foreign investors. Some of these investors are large industrial conglomerates (in China, The Prospective Private Participants India, and Russia, for example), while others are large regional power utilities (from the Czech Republic, Few major international power companies ("strategic Malaysia, South Africa, and Thailand, for example). investors") are presently interested in power distribution The domestic capital markets and banking sectors in emerging markets, and fewer have business strategies are also participating--especially in Latin America, that cover low-income countries. Work on strategies for but also in some Asian countries. Regional investment privatizing distribution in these countries, however, has funds are sources of capital for privately led investments. tended to focus on attracting these companies by Creditworthy power entities can also access substantial offering large distribution businesses and by adopting amounts of capital through bond issues on regional prequalification criteria for bidders that match the capital markets (such as Singapore Power and the characteristics of the international investors in power Electricity Generating Authority of Thailand (EGAT) of assets. This approach reflects the interest of major Thailand). Numerous power generation projects that are international investors in businesses that are large too small and risky to attract the attention of international enough to carry the costs of expatriate managers and investors have been developed by local IPPs with local generate sufficient profits to make material contributions financing in Asian and Latin American countries.51 to their corporate performance.50 Additional interested investors could be attracted by Strategies for privatizing distribution should aim to offering medium-sized distribution businesses suitable for diversify the pool of investors and develop new ways to consortia of foreign power utilities and domestic or manage their financial risks. A variety of private partners regional investors, for example, the following: are available, both domestically and internationally, to help meet the needs of developing country power · Medium-sized foreign power utilities may be interested in sectors. These strategies should focus on local and a modest financial exposure, but be willing to contribute regional entrepreneurs (and financial investors from substantial management and technical expertise. This discussion also applies generally to the generation and transmission segments. 50 See Deloitte Touche Tohmatsu 2004 for experience with domestic financing of power sector investments, and Izaguirre 2005 about the 51 emergence of new investors across infrastructure sectors. · Local investors, such as large business houses, may be Governments face a number of preconditions for attracting well placed to take financial risk exposure investments and sustaining private sector involvement in distribution: in power distributors, but lack the required managerial and financial skills to run these businesses. · A clear statement of reform policy about market structure, regulation, corporate governance, protection · Foreign investors may help mobilize local investors of consumers--particularly low-income households-- who require the presence of a large neutral investor to subsidies, captive power units, third-party access, bulk act as leader and arbitrator among a group of local supply tariff, allowable returns to investors, and reform partners who are rivals in their home market. transition arrangements, backed up by enabling legislation. · A local ownership base could be developed from many small units that could eventually be consolidated · A clear demonstration of commitment to improved into larger units that attract foreign investors. governance in the sector and introduce commercial business practices, notably through support for law The sale of minority shareholdings to nonstrategic and order, antitheft and bill collection measures, as investors by governments can produce short-term gains, well as restraint from interference in regulatory but pose long-term problems. Many countries (such as processes.52 Egypt, Russia, Ukraine, and Vietnam) have sold minority shareholdings to local investors and granted or sold on · Restructuring of the sector completed with independent 51 preferential terms shares to power company employees boards and financial management and control over and through local stock exchange. These sales can raise operations and labor forces for the successor entities, funds for government budgets--although usually not access to networks on fair terms assured for market large sums--as well as raise employee morale and help traders, and a clear indication of the evolution of nascent the stock markets. When combined with minority trading arrangements for bulk power. share privatization, however, they might give control of the company in unintended ways (employees often quickly · A sustainable financial recovery plan for the sector sell their shares to investors seeking controlling interests under which past liabilities, such as unrecoverable in power companies). They tend to be unattractive to debt that is sufficiently large to undermine the viability serious investors, since groups with minority blocking of the sector, should not be added to the balance rights can always hinder whatever the strategic investor sheets of sector entities (as happened to the state grid wants to carry out (as happened in Ukraine). company in Orissa). Asset and customer bases should not be artificially inflated to project the higher tariffs When Privatization Should Take Place needed to show the viability of the entities under cost- of-service regulation. Improving the performance of distribution businesses is the priority in poorly performing power sectors. This is · Creation of a credible regulatory regime that is because inevitably one of the main problems is the conducive to private management and ownership in inadequacy and poor management of the cash flow the sector, an agency with clear functional autonomy, from billings and collections. Reform must therefore regulatory rules that deliver a degree of certainty in focus from the start on the customer end of the power relation to tariff adjustments, and processes perceived supply business, and not focus exclusively on the as fair and transparent. relatively easier steps of contracting new generating capacity from IPPs. The difficulty in attracting private · Distributors have at least positive cash flows (after involvement in poorly performing power distribution subsidy payments from governments). A subsidized businesses highlights the need to fulfill a number of bulk supply tariff from state-owned generators may be preconditions that should be met before attempting to needed until retail tariffs and operational performance reform these businesses, whatever form of private improve, provided that these generators cover their participation is envisaged. cash operating costs. Measures that support this commitment include aerial bundled conductors to reduce illegal connections, small single or three phase 52 transformers more uniformly distributed throughout service areas to improve supply quality, and tamper-proof meters located in secure, sealed boxes or sockets located outside residences with properly protected service conductors to reduce billing and metering losses. · The establishment of a credible transition path to parts of the distribution system to put forward for private commercial performance that encompasses the participation, what form of private participation to pursue, privatization process, power trading arrangements, and how to expand the range of targeted investors. regulatory processes, and subsidies and financing of Where the time that is needed to meet these preconditions initial investments to improve service quality and in full exceeds the available timescale for reform, access. In the case of poorly performing distributors, governments must resort to risk-mitigation measures at for example, transition issues for regulation include least during a transition period in order to attract the restatement of losses, working capital, service private participants at a suitable time. Numerous valuable standards, and targets for efficiency improvements as lessons can be drawn from the experience with privatization reliable information is obtained about technical and of power sector entities in Eastern European countries commercial performance. (box 13) and privatization of the distribution sector in the Indian State of Orissa (box 14). When the preconditions for privatization are largely fulfilled, the participation of the private sector will be Risk Mitigation Options more sustainable. Even when a government has made serious efforts to How Privatization Should Be Conducted put the preconditions described in the previous section in place, the possibility remains that adverse market 52 Careful attention to the strategy for transacting the sentiment may dampen investors' interest in the privatization process is critical to how the privatization is businesses being privatized. To enhance the likelihood conducted. The critical elements of a strategy are which of investor interest, governments can use mechanisms to BOX 13. Privatization Lessons from Eastern Europe The following lessons for transaction strategy emerge from privatization in the power sectors of Eastern Europe: · Privatization through transparent international competitive bidding among prequalified investors results in the most sustainable privatization deals. Negotiated privatization does not even save time (for example, Estonia) and often leads to unsatisfactory terms to the sellers. · Offer majority shares to attract strategic investors in a manner that enables them to implement prudent investment and operating decisions. In any case, the strategic investor must have management control. · Retaining only a golden share (or some similar device, such as a special shareholder agreement) for a specified period may be prudent when selling all the shares to the strategic investor. It will also help the government to prevent acquisitions and mergers that erode competition. · The privatization agreement may also contain a prohibition for the resale of assets to anyone with qualifications inferior to those of the original investor. Otherwise the elaborate prequalification exercise would become meaningless. · Sort out labor agreements (in regard to employment levels, severance compensation, and funds for assisting separated labor). · Sort out fuel supply arrangements in order to promote a genuine market in fuels used for power generation. This involves, for example, discontinuation of fuel "allocation" practices and liberalization of fuel imports before privatization. · Sort out issues relating to the "right of way" for facilities located in state or municipal lands while privatizing distribution utilities. Issues relating to the removal of any legal rights the municipalities may have in relation to distribution business and related power facilities should be sorted out in the preprivatization phase, if necessary, through special legislation. · Be wary of dishonest and collusive equity for debt swaps and asset stripping as was practiced in Ukraine. Source: Krishnaswamy and Stuggins 2003. BOX 14. Post-Privatization Lessons from Orissa Privatization in the power sectors of Orissa has yielded the following lessons: · A sustainable financial recovery plan for the sector is essential. Past liabilities, such as unrecoverable debts that are sufficiently large to undermine the viability of the sector, should not be added to the balance sheets of sector entities. Asset and customer bases should not be artificially inflated to project the higher tariffs needed to show the viability of the entities under cost-of-service regulation. · Good appraisal of current assets is important, to avoid heavy discounting of their true value by potential purchasers. Without a meaningful asset quality appraisal, a large provision has to be made for bad and doubtful receivables for the distribution companies. · Bidding documentation should be realistic about the quality of information and forecasts. Privatization documentation should not seriously understate the level of system losses and overstate forecasts of sales to profitable customer groups. · Business, political, and regulatory risks should be allocated among distributors, customers, and government with regard to capacity to carry risk exposure. This applies particularly to the period following privatization until losses have been substantially reduced and tariffs increased to cover costs. Distributors' risks are set by the method for determining allowable costs for setting tariffs. 53 · Private shareholders must be able to exert full corporate control, and their managers must be able to change the business practices of their company. For example, the new private owners must be able to make linemen cut off delinquent payers, and senior managers must not be prevented from moving linemen and other staff through interference from politicians who benefited from this patronage. · Government should support the new owners' efforts to change business practices. The local police should support the distributors' efforts to prosecute customers who steal power and distribution employees who defraud the companies and their customers. Government must prevent political interference in the field that would frustrate the operator's efforts to improve billing and collection. · Government should provide financial support for subsidies it requires. Government should provide subventions to cover the subsidies to favored groups of power consumers to avoid creating pressure to increase cross-subsidies from other consumers. · The regulator must be impartial in its actions, as well as independent of stakeholders in the power sector. It should avoid perceptions of following a populist policy. It should allow full cost pass-through in tariff orders, rather than only the costs needed to substantiate a tariff increase acceptable to government. · The regulator should make proper allowance for factors beyond the reasonable control of power entities. Orissa is prone to natural disasters, and utilities would have difficulty in obtaining insurance against them. Distribution networks were badly hit by cyclone and floods, and the distributors lacked funds needed to restore supply--particularly to politically sensitive rural areas. · The single buyer model for transacting bulk power aggravates problems when sectoral revenues do not cover costs fully. In Orissa, the single buyer--the transmission company--was in deep financial difficulty partly because it lacked revenues to service payments on debt created to cover preprivatization liabilities. Sources: Government of Orissa 2001, Rajan 2000, and other reviews. TABLE 6. Power Market Risk Matrix and Coverage BEST PARTY TO COVER COMMON SOURCE OF RISK CATEGORY RISK COVERAGE POLITICAL RISKS Expropriation/nationalization, Government, MDB/ECA MDB/ECA insurance convertibility/transferability, war and civil disobedience, terrorism LEGAL, REGULATORY, AND CONTRACTUAL RISKS Changes in law, breach of contract, Government, MDB/ECA MDB/ECA guarantees and regulatory noncompliance, obstruction of insurance arbitration, nonpayment of a termination amount ECONOMIC RISKS Inflation risk, foreign exchange risk Government Only covered as credit risk 54 CREDIT RISKS Political risk, commercial risk MDB/ECA MDB/ECA limited to public sector COMMERCIAL RISKS Construction risk, operation risk, Private investor Private sector technology risk Note: MDB--Multilateral Development Bank; ECA--Export Credit Agency. Source: Adapted from Deloitte Touche Tohmatsu 2004. mitigate perceived policy risk--including measures to preconditions when generally difficult market conditions increase the predictability of regulatory regimes, and deter investor interest in the businesses to be privatized. political risk guarantees. On the principle that risks The difference they make to the success of a should be allocated to the parties best able to manage privatization strategy depends on the extent to which the them, political risks should be allocated to government, preconditions are met and on the general state of while commercial risks should be borne by private investor interest in such markets. investors. Legal, regulatory, and contractual risks related to factors that are under the control of government The following options are available for temporarily should also be allocated to government, but third party reducing the risks investors face during a transition guarantees for government performance from period: multilateral and bilateral agencies are usually needed to support private investment in the power sectors of · Limiting ("ring-fencing") of regulatory discretion over developing countries (Deloitte Touche Tohmatsu 2004). tariff setting through a multiyear tariff-setting Table 6 summarizes this allocation of risks. arrangement, possibly further reinforced by being established in the transaction outside the remit of the These mechanisms do not substitute for meeting the regulator. Under a multiyear tariff setting, tariffs are essential preconditions for privatization, notably for tariffs determined on a multiyear basis instead of a year-to- and subsidies, and for sector and corporate governance. year basis. Tariff predictability for investors is one of Rather, they supplement the policies needed to meet the the main requirements for the privatization of distribution (unless this risk is passed to another party), years, where the mandatory multiyear tariff-setting especially during the years following privatization. regime is almost always written into either the law or a This approach has been used widely in both OECD concession agreement between the government and the and developing countries. new private investor. · Protecting ("ring-fencing" again) a portion of the Latin American experience shows that concession distributor's revenues to cover the distributor's "wires" agreements are often renegotiated within a few years costs--with supply risks carried by other parties-- because of disputes between the regulator and under such approaches as the distribution margin distributors that occur over the application of tariff-setting approach. This approach is also relatively new with formulas embedded in the concession agreement. only limited international experience. Although multiyear tariff setting is an important and necessary reform, it does not replace the need for · Vesting contracts for the short to medium term revenues to cover costs, because it requires commitment between distribution companies and generators to from governments to raise tariffs and eliminate serious reduce uncertainty about the availability and cost of arrears of payments by state-owned power utilities. bulk power supply for the new distribution companies. This approach has been used widely in Latin America The distribution margin approach is used for allocating and Eastern Europe. risks between investors and the government until the sector can be "conventionally" regulated. The 55 · Political risk guarantees to give investors the assurance distribution margin approach resembles a short-term that governments will avoid changing the policy concession that transfers payment risks upstream from framework unilaterally. Such guarantees specifically the investors in the distribution company and protects cover changes in laws and judicial decisions, them from uncertainty about regulatory performance commitments about regulatory performance, prompt (box 15). This is achieved by allowing the distributor to payment of subsidies or other transfers, and payments retain sufficient funds from collected revenues to cover for power consumption by government entities. its costs and equity returns before passing the balance Political risk guarantees can be used in the medium to the transmission and generation companies. The term to allow governments the time needed to build a distribution margin approach gives rise to concerns credible track record. In the medium to long term, about the heavy financial risks to which the government governments can best mitigate investors' perceptions would be exposed under this approach. This concern about political risk by developing a good track record could be addressed by allocating a proportion of each of implementing sound policies. risk to the distributor, with this proportion increasing on a sliding scale over time. The feasibility of these approaches has to be confirmed in the specific country context. Vesting contracts between distribution companies and generators remove trading price uncertainty for Ring-fencing does not remove the need to resolve the investment in the early years of reform. Removing this underlying problems of tariffs and governance. Ring- uncertainty provides a significant advantage for fencing part of the business risk or regulatory risk can be financing the renovation of dilapidated and viewed as a temporary--albeit multiyear--arrangement undersupplied power distribution systems, as well as for to be removed once the power supply has been dilapidated generation plant, and therefore helps sell commercialized. these businesses provided that the contracts are in place at the time of sale. Vesting contracts fix the price of The multiyear tariff-setting approach is one way to power traded between the generators and distributors counter unpredictability about the regulatory process for a set period (up to five years in some cases) before under inexperienced or politically influenced regulators, an open bulk power market goes into operation. Hence, especially in arriving at their tariff orders. It allows an these contracts are a transition mechanism that should initial period in which the regulatory institution can eventually be replaced by trading arrangements that develop the capacity and processes needed when give stronger incentives for distributors to be efficient private operators are involved. Multiyear tariff setting is buyers of power. the regulatory norm in virtually every country that has successfully privatized power distribution over the last 15 BOX 15. The Distribution Margin Approach The distribution margin approach protects the revenues needed by an operator's "wires" part of the distributor's business, in which the transitional risks for the supply part of the business are passed to other parties until these risks are removed. It is conceived as an arrangement with two important characteristics: · The revenue of a distribution business (the "permitted revenue") in a period is defined by either a fixed prespecified amount or cost-plus and incentive margin linked to improvement in specific performance variables. This permitted revenue is the distribution margin. This methodology does not depend on total revenue collected from consumers, nor on the level of other costs (generation and transmission) in the system. · The distribution business has a first claim on the amount of revenue collected, which it applies first to meet its permitted revenue--with the balance of revenue collected being remitted to the rest of the industry. The distributor becomes, in effect, a temporary collection agent for other parties involved in supplying power. This approach is designed to cover the distribution company's costs and equity returns. It incorporates incentives and penalties into the margin to achieve service and operational targets set on a multiyear basis. Government makes up the deficit between revenues and total system costs. This approach is sustainable if government can, and does, keep up its payments. It won't work if government is faced with payments beyond the capacity of its budget. The formulation of the distribution margin should provide incentives and penalties for the distributor to improve collections and thus reduce the 56 level of subsidies payable by government over time. This approach is workable when the proportion of total revenues retained by the distributor is relatively low. The distribution margin approach allocates many of the risks normally carried by distribution companies to other parties and, in particular, government based on the contention that such risks are beyond the control of the investors during the period of greatest uncertainty immediately following privatization. For a poorly performing sector, these risks would probably cover retail tariffs, demand level, bill collections, commercial losses from theft, pass-through of generation and transmission costs to consumers, adequacy of bulk supply to meet demand, and guarantees to third party financiers of capital expenditure. The distribution companies would take the risks from commercial losses caused by inaccurate metering, distribution operating costs, and cost overruns on capital expenditures. Government would have to support the distributors in such ways as prosecution of thieves and control of employees to allow the distributors to improve their commercial and financial performance. The distribution companies would be switched to "normal" regulation once certain conditions are clearly met, under which the investors will accept the various normal utility risks that are not allocated to them under the distribution margin model. The main conditions are likely to include tariffs that cover costs (possibly with continuation of some subsidies), high collection levels, definition of key regulatory rules and procedures, and the availability of sufficient information for cost-based or incentive-based regulation (in section 6.5). In essence, the period required to meet the conditions for switching to "normal" regulation can be considered a transition period that requires a different approach to allocating risks from that under "normal" regulation. The incentives and penalties under the distribution margin should create realistic prospects of achieving sector viability and thus an end to the transition period. Successful reduction of risk requires that vesting contracts Political risk guarantees allow investors to raise funds must be combined with a credible commitment by the needed for efficiency improvements from the capital regulator to pass through purchased power costs in the market. Such improvements may not be available vesting contracts. They allow regulators to focus on factors without political risk mitigation. In this way investors under the control of the new distribution companies, control the funds and are fully responsible for the especially distribution costs and supply quality. They have commercial risks, including the collection risk, with the been used to cover 80­90 percent of total power trade in government agencies assuming responsibility only for most countries that have set up short-term power markets. their own performance and the regulator's performance undertakings under the privatization agreement or commitments on risk-sharing and regulation. This is license. This approach relieves the government from because political risk guarantees offered by many having to find the funds from its own resources, and governments would not substantially assuage investors' also achieves a more beneficial risk-sharing framework concerns, because these governments have poor from the government's perspective. From the private records in honoring their contractual undertakings or investors' viewpoint, this approach would also be more supporting private investors in the power sector. Such a beneficial, because they would benefit from the political guarantee (see section 6.2) should only be provided for risk mitigation through the guarantee against a government that demonstrates its commitment to government noncompliance and interference (one of establishing a track record for sound policies (Gupta their main concerns). and others 2002).53 A third-party political risk guarantee may be required, for example, from a multilateral institution to mitigate investor's risks by backstopping a government's 57 Two recent examples of a third party risk guarantee for private investment in power distribution entities are the World Bank's Partial Risk 53 Guarantees for a long-term lease in Uganda and for asset divestiture in Romania (box 21 in section 6.2). See World Bank 2002 for a description of its guarantees and application to power projects. 58 5. MARKET STRUCTURE AND GOVERNANCE OGN's Guidance on Power Market Structure The extent of restructuring power markets should be assessed on a case by case basis. Full unbundling is generally preferred in medium to large power markets to facilitate the introduction of competition at least in the market for wholesale trade in power. For small markets with little or no opportunity for cross-border trading, regulation of a vertically integrated monopoly may be the most cost-effective choice until the power market has grown substantially. However, both market growth and regional power markets can be facilitated by the unbundling of even relatively small systems. Unbundling of accounts, staff and management should be the first step in this to increase the transparency of price setting and facilitate benchmarking of costs and service standards, but full unbundling will be required to make these changes effective. The potential benefits of moving to more competitive trading arrangements are well known and, in addition to governance and regulatory motivations, usually underpin the extensive vertical and horizontal unbundling of monopolistic service providers. The difficulties in implementing competition in power markets are also by now well known. 59 Full competition should be approached cautiously in developing countries because many existing markets are too small, there are significant risks of market power abuse, distributors may not be sufficiently creditworthy for trading on commercial terms, and policy makers have limited tolerance for the substantial price volatility that occurs with competition in the market. Governments should consider for the near- to medium-term, gradual market opening and limited competition for the market. This can be facilitated by allowing open access to networks by third parties besides the main generators and distributors, and trading on a bilateral basis between generators and distributors and other suppliers. This chapter shows how market structure and the form of willingness to invest in them. The experience of private trading within the power market are linked to market size investors has been particularly bad in countries where and income level. This relationship is clearly evident in market governance was especially weak, for example, the extent to which a power supply chain should be in some of the transition economies of Eastern Europe. unbundled into separate entities. Unbundling of The structure of the power market strongly influences the generation from distribution can be worthwhile even in governance of the power market, regardless of whether small power systems, but forming numerous generation electricity service providers are publicly or privately owned. entities or distribution entities is only suited to introducing competition in large power markets that are Governments can create the environment for attracting at least in the middle-income level. Competition for the investors and operators only by reforming market right to supply an incumbent supplier under long-term governance. In this environment, investors face reasonable agreements by independent power producers, by commercial risks without fear of expropriation and contrast, can work in power markets of any size and at corruption, while consumers, regulators, and other any income level, whatever unbundling is undertaken. stakeholders honor the contractual rights of utilities to These producers, however, are expected to carry more recover their revenues. Robust reform strategies, investment risk in the large middle-income countries regardless of the roles of the public and private sectors, than in the small low-income countries. must confront serious issues about market governance, often in a situation where prices are well below full-cost 5.1 Importance of the Market Structure for recovery (World Bank 1994b). Reform strategies are Market Governance unlikely to succeed in improving sector performance and contributing to economic growth and poverty reduction The importance of market governance has emerged in without credible steps to improve suppliers' commercial a situation of large needs for investment in the power and operational performance, and to align revenues sectors of developing countries, yet low private sector with costs (World Bank 2004b). 5.2 Restructuring Power Supply monopoly for supplying distribution companies that serve customers under regulated terms and also, in Integrated power suppliers are restructured to obtain some cases, large power users under regulated terms. benefits from competitive trading arrangements, as well The functions of this agency are carried out by many as to strengthen governance and regulation of the markets types of entities in different countries, including a in which they operate. The main issue concerns the extent national vertically integrated utility, a national of vertical and horizontal unbundling of the generation, generation entity, a national transmission entity, a transmission, and distribution-supply segments of the national distribution entity, a combined national market, taking into account the size of the power system.54 generation and transmission entity, and a combined national transmission and distribution entity. The variety of market structures emerging from reforms to power sectors can be categorized according to increasing · Competition in the wholesale power market ("wholesale degree of competition, as follows (Hunt and Shuttleworth competition")--allows distributors and large users of 1996). electricity to purchase electricity directly from generators they choose either in a power exchange or bilaterally · Monopoly--involves no restructuring and no competition (see section 5.4), and to transmit this electricity under at all, since it consists of a vertically integrated monopoly open access arrangements over the power networks to at all levels of the supply chain within a country (typically) the points of electricity consumption. Independent power 60 or a region in parallel to other vertically integrated suppliers (firms that specialize in energy trading, but do regional monopolies (as in Japan and in parts of not own or operate distribution networks) are allowed to Canada and the United States). compete with distributors for the custom of large users.55 · Purchasing agency, also known as a single buyer-- · Competition for retail customers ("retail competition")-- manages competition for long-term market share allows end users of electricity to choose their power among generators and IPPs. It generally has a supplier, with open access for suppliers to the FIGURE 7. Correlation of Power Supply Structures with Power Market Structures Retail power competition Complete with supply unbundled from distribution in addition to wholesale competition Wholesale power competition in a national power market of gencos, discos, and large users with an ISO and transco Purchasing agency as the national transco, with many Unbundling gencos and regional discos Purchasing agency as erticalV the national genco, transco, disco, genco/transco, or transco/disco Vertically integrated monopoly as a national utility or monopolies as regional utilities Complete Horizontal Unbundling/Competition The significance of power system size for restructuring to date is illustrated in chapter 3. 54 This could be delayed in those countries where distribution and supply systems are so dilapidated that they need a period of assured revenues 55 to remedy the worst deficiencies before having to compete for the business of their largest customers. transmission and distribution systems to procure their The case for unbundling gets weaker the smaller the supplies competitively at the wholesale level from system, the more undeveloped the institutional capacity, generators and suppliers. and/or the weaker the general country conditions. The correlation between power supply structures The vertical unbundling of a state-owned power utility is analyzed in chapter 3 with these market structures is seldom straightforward. This is because many of these shown in figure 7. utilities supply a wide array of social services that blend goals like employment of idle workers, protection of the Within these market structures, competition for a long- environment, and provision of energy services to poor term right to a share of the power market supplied by a areas into their daily production decisions. The deep purchasing agency or single buyer is clearly less radical links between one of these utilities and the state hinder than competition in the power market for a share of the unbundling of a large state-dominated power utility that market. Competition for a share of the market and reassembling it in a different, more market-based is a single event that relies on the effectiveness of the form. Recasting the utility's methods of financing or procurement arrangements for its benefits. Competition labor-hiring decisions, for example, is difficult without in the market is much more dynamic and therefore broader reforms in capital and labor markets. The basic potentially beneficial, since it involves repeated rounds organization of a power utility can be durable and of bidding in a market. It does, however, require much resistant to change, even once the utility has been greater institutional capacity and market development unbundled in name. In the contest for control, the losers 61 to work properly, otherwise the results could be costly. from unbundling--mainly the beneficiaries of the social As discussed later in this chapter, competition for the services provided by the utility--are already organized market can be viewed as an interim arrangement in a within the utility and the state and have direct access to long-term reform process, and competition in the market decision makers (Heller and Victor 2004). should be considered only when the main necessary conditions are in place. In a wholesale power market where power is traded under competitive arrangements, the transmission and Reform programs can progress through these structures. system control functions should be kept under separate This progression starts from a vertically integrated monopoly ownership from distribution and generation. Restrictions or monopolies and progresses to a purchasing agency are necessary on ownership or on control (through or wholesale competition, and possibly proceeds governance arrangements) of the licensees for these eventually to retail competition. It reflects the basic functions by generators and distributors, in order to sequence of a reform program, whereby restructuring prevent the acquisition of anticompetitive amounts of the supply industry and power market, as well as setting market power by any generators or distributors. This up the legal and regulatory framework, precedes the separation of ownership and control also ensures that transfer of ownership of power generation and distribution private operators and developers are not deterred from from the state to the private sector.56 A vertically integrated trading in this market by concerns about discriminatory monopoly is almost universally under state ownership in control of these monopoly services by their competitors. developing countries (for reasons given in chapter 3). Private sector participation in the transmission system The economic case for unbundling a vertically integrated should be handled carefully to avoid subsequent abuse power utility rests on whether the gains from unbundling of market power by the new owners. The primary concern exceed the costs of arm's length transactions among for the transmission operator is that payment will be the separated segments. This matter depends on such made by the users of the system, namely, the generation factors as power system size and country institutional and distribution entities. As a result, effective private capacity to manage complex trading mechanisms. sector participation in the main transmission system will In the weakest countries with little prospect of cross- depend on clear improvements in the financial viability border power trading, a key issue is whether arm's of these entities. If transmission capacity bottlenecks length transactions among sector participants can be impede private sector participation in generation, sustained. The case for unbundling is strongest in large early private sector participation may be in order. power systems in countries well endowed institutionally. These bottlenecks may be best addressed by alternative Sequencing of reform stages is discussed in chapter 8. 56 BOX 16. Cash Flow Problems in Ukraine's Wholesale Electricity Market In Ukraine during the late 1990s, the collapse of funds administration in the wholesale electricity market was the main indicator of distress in the market. These funds were supposed to be allocated to generators and service providers in proportion to their revenues due from the selling price and volume of units of electricity sold. In practice, these providers were not paid in full--and in fact they often received a very low proportion of their due amounts, because the revenues collected from users fell far short of their bills. An algorithm was therefore developed for allocating the available cash in proportion to relative sales by providers. In practice, however, the Ministry of Fuel and Energy (Minenergo) intervened by directing scarce funds to particular providers according to short-term expediency in substantially different ways than the algorithm. It claimed a number of technical reasons for its actions, such as emergencies and the need to pay coal miners, which led to numerous changes to the algorithm. The operating companies could rely on receiving funds predictably under this transit account system. According to the market rules, distributors that have not fully paid for the electricity purchased from the wholesale market should have been cut off from future electricity deliveries. But Minenergo insisted that delinquent distributors continue to receive wholesale power, and it tried to address the problem by reaching agreements with central and local governments on customers that could be disconnected without political repercussions. Consequently, some of the distributors took advantage of the nonenforcement of payment obligations and withheld from the market the cash 62 collected from their customers. The proliferation of barter and other noncash payment modes (mutual cancellation of payment obligations, promissory notes, and tax write-offs) further compromised the application of the market rules. Noncash transactions offered significant tax advantages because cash received in an enterprise's bank account was often confiscated by the tax service. Because noncash payments had limited fungibility, the market operator could only allocate cash payments. Total collections soon fell to below 80 percent, of which the share of noncash transactions in the power industry surpassed 80 percent (the economywide average was about 40 percent) and cash payments dropped to below 10 percent (nonpayments accounted for the balance). In essence, only the general population paid cash for electricity. Generators and their fuel suppliers received little cash, and even the cash allocated to the distributors under the algorithm and Minenergo's interventions did not cover the costs of their distribution networks and customer services. forms of private sector participation to divestiture of The key decision for many developing countries is shares in the transmission entity, such as transmission whether to choose a purchasing agency­single buyer or lines constructed and operated under build-operate- competition in the wholesale power market for bringing transfer (BOT) arrangements.57 private investment to the power sector. This choice depends largely on whether the power system meets the Sector unbundling should be undertaken under necessary conditions for one of the forms of competition conditions that preserve the integrity of power system in the wholesale power market. If not, a purchasing operation and power market trading. It should be agency­single buyer can be adopted because this deferred, however, if it would worsen an ongoing crisis option does not require unbundling of the existing of serious and prolonged nonpayment that reduces the integrated supply structure. These two structures are thus cash flow up the supply chain to generation and examined further in this chapter. transmission entities. This happens when the unbundled distribution entities act in their own interests by holding Purchasing Agency­Single Buyer on to most of the cash collected from customers. Under such severe financial indiscipline, competitive pools or The pure single buyer model is one among many forms even other modified forms of the wholesale market for of centralized purchasing arrangements. There are electricity could not work as intended, as happened in several ways to implement what is broadly referred to as Georgia, Kazakhstan, and Ukraine (box 16). a single buyer model. All ways have a central entity BOT arrangements work for a natural monopoly, such as transmission services, because competitive supply of these services is not 57 economically efficient. aggregating the load, playing some role in the excessive risk exposure under long-term power purchase procuring of energy to serve that load, and allocating commitments with IPPs (section 5.3). It is also vulnerable this energy among different consumers or distribution to a government's reluctance to support increases of retail companies. Given those characteristics, the expression tariffs needed for the financial viability of the single buyer "centralized purchasing arrangement" more properly when generators receive guaranteed contract prices captures the multitude of commercial arrangements that and distributors receive guaranteed margins. Hungary can be in place (Arizu, Gencer, and Maurer 2006). represents a prominent example of this situation (box 17).58 Although a purchasing agency­single buyer structure is A purchasing agency­single buyer can be used as an easier to implement than other market structures, it carries interim stage for moving toward a competitive market substantial risks for reform outcomes. Government can model for wholesale power trade. Under this strategy, still impose noncommercial practices on the market by this model is designed to provide the time required manipulating the single buyer's terms of trade. It can use for the generation and distribution sectors to develop a single buyer to commission excess generating capacity sufficiently for the operation of a competitive wholesale to actual demand and to choose costly generation electricity market. It requires that stranded costs are technologies. Its commitment to full reform may weaken manageable when the market moves to a competitive to avoid the politically controversial consequences of model from the rigidities associated with long-term PPAs introducing more private sector participation and with guaranteed "take or pay" provisions. These costs competition (Lovei 2000). This structure is open to pose a substantial challenge to regulators (Arizu, Maurer, 63 BOX 17. The Roles of the Single Buyer Model in Eastern European Power Markets A market structure based on a single buyer model had been adopted in Hungary, Poland, and other countries as an interim measure before moving to a fully competitive pool. Under this model, the state-owned transmission and dispatch company buys power from generating companies on the basis of PPAs negotiated with each producer, and sells electricity at a single pooled average wholesale price to all distribution utilities and the large consumers eligible to buy directly from the wholesale market. The retail price for end consumers is regulated by adding a distribution charge to the wholesale price. Long term PPAs (generally 10 years or more) and short term PPAs (one year or less) are covered by "take or pay" provisions guaranteed by the state. The market risk is thus fully transferred from the generators to the single buyer, who is obliged to pay generators for the power not purchased if the demand declines, as well as for increased fuel prices, exchange rate variations, and so forth, for which the prices in PPAs are usually indexed. The single buyer carries the risk of not being compensated for the resulting increase in the average wholesale price per kilowatt- hour when government does not allow the necessary increase in retail tariffs. The Hungarian government, for example, did not allow retail prices to rise to the full extent, but instead compelled the single buyer to reduce wholesale prices and compensated the single buyer through direct budget subsidies. Russia and Ukraine have operated their wholesale electricity markets on a modified single buyer basis. Under this basis, no direct contractual link exists between the generators and distributors. Generators sell electricity at regulated prices, and the wholesale market entity supplies distribution utilities at the pooled average wholesale market prices. This kind of arrangement lends itself to abuses. When supply is less than demand in the market, the wholesale market entity can be pressured by government to allocate power to favored large users and distributors, instead of following the agreed algorithm. Likewise, when the demand is below available supply, the wholesale market entity can be pressured to allocate demand to favored generators, such as the coal-fired plants (to appease the strong mining lobby). It can also be pressured to allocate demand among all generators to ensure that every plant is kept working and employment in the plants is sustained, so that uncompetitive plants are not faced with bankruptcy. These practices distort least-cost dispatch by partial loading of the thermal plants that reduces efficiency and increases fuel consumption. Further, in an environment of extensive nonpayment, where the wholesale market is unable to collect dues from the distribution utilities and settle the dues of the generating companies, it has linked distributors to generators arbitrarily for purposes of payment. Such arbitrariness can lead to corrupt practices. Instead, direct bilateral contracting and settlement should be allowed between the distribution utilities and the generators. Source: Krishnaswamy and Stuggins 2003. See Bakos 2001 for an account of power sector reform in Hungary. 58 and Tenenbaum 2004), and they are unpalatable to mobilize the support of their embassy, and they can play consumers when they are recovered from them as a small countries off against other countries. In contrast, surcharge to the regular tariff. many small countries seek private funds in situations of looming or actual electricity shortages. They have few A purchasing agency­single buyer should not be experienced negotiators and experts in these types of given a legal monopoly on trade in wholesale power. transactions, and they have high country risks that deter This is to avoid obstacles to introducing different trading foreign investors because of weak economies and unstable arrangements--bilateral or a central power exchange-- policies.59 Altogether these factors can give foreign when government decides to introduce stronger competitive developers a strong bargaining position. As a result, many pressures in the power market. The main obstacle is PPAs with these developers have entailed high prices and usually the difficulty in rescinding the legislation that shifted many project-related risks to the power purchaser. grants this monopoly. A purchasing agency does not This creates a perception of unfairness in the host country need to have a legislated monopoly to transact a large that politically undermines the sustainability of the PPAs and proportion of energy in a power system when generation more general reforms over the long term (Rufin 2002). and distribution companies find this arrangement the least risky under the poor business conditions found in The numerous countries whose power systems are too many developing countries. The proportion of energy small for a competitive power market have intermediate transacted by this agency should be allowed to decline if reform options (Bacon 1994).60 Horizontal unbundling 64 some of the generators and distributors in the market into tiny entities would generally not make sense, because prefer to start trading bilaterally, which would signal that this would causes losses in economies of scale and scope these market participants are ready to move away from without gaining the benefits of competition. However, the single buyer arrangement. both market growth and regional power markets can be facilitated by some unbundling of even relatively small Restructuring Small Power Systems systems under one of the following options: Small countries face similar problems to larger countries · Privatizing the vertically integrated utility as a whole in reforming their power markets, but with greater intensity. and regulating it until the market has grown For example, all wholesale electricity markets must substantially. This course, of action, runs the risk of grapple with issues of market power, although such having a private monopoly with weak regulation. problems are likely to be more severe in the markets of small countries because collusion is easier among few · Splitting the vertically integrated utility into two or suppliers. These countries therefore need stronger three vertically integrated regional utilities, privatizing, regulatory capacity to monitor and control their power and subjecting them to regulation. markets and thus sustain competition in these markets. Although regulatory capture and incompetence can afflict · Unbundling the existing utility into one generating a power market of any size, small countries will more entity, one distribution entity, and one transmission likely have ineffective regulation because of their smaller and dispatch entity; privatizing generation and human resources and generally lower income levels. distribution; and retaining transmission and dispatch in the public sector, as in Uganda. All three entities Small countries are also sensitive to the impact of large-- would be subject to regulation. mostly foreign--investors and developers in power generation and distribution. These investors can easily stifle The smallest countries that presently have sophisticated competition and overwhelm regulators in small countries, competitive trading arrangements in their wholesale because they have access to much greater resources-- power markets are El Salvador, Guatemala (box 18), financial, technical, and legal--than the public sectors of and Panama. All three countries, however, have a per these countries. Their proposed investments may represent capita income level and power system size above the a large proportion of total investment in the country and threshold levels that define small power systems in this total power system capacity. Foreign developers bring context (US$900 per capita and 1,000 MW--chapter 3). expertise from their projects in other countries. They can Not all small countries are weak, for example Costa Rica and Singapore. 59 About 100 countries have power markets of under 1,000 MW (see chapter 3 for details). 60 In small power systems, some degree of vertical the first step in this case, because it would provide better unbundling is likely to improve services and lower costs. information about costs, increase the transparency of price This is because vertical unbundling helps the regulation setting, and help benchmark costs and service standards. of power service providers and even the introduction of competitive pressures in the generation and supply markets Forming power trade areas with neighboring countries (table 7). Unbundling of accounts, staff, and management and unbundling to the extent that makes sense in the among the main functions in the supply chain should be larger regional power market is an option for small BOX 18. Example of a Small Competitive Wholesale Power Market in Guatemala The Guatemalan wholesale electricity market is formed by a spot market and a contract market in which energy and capacity are traded as distinct products in both markets. In the spot market, hourly energy prices are determined by the least-cost ranking of available resources, as established from incremental cost information submitted by thermal plant operators, from the value of water bids submitted by hydro plant operators, and from demand-side schedules allowing disconnection of load at certain spot market prices. Spot capacity prices are likewise determined by matching supply- side offers and demand requirements. There are more than 100 participants in the wholesale market, which has exhibited considerable dynamism since its inception. Total installed generating capacity in the market totaled 1,875 MW in 2002. Although the market is concentrated in absolute terms, barriers to entry of new operators do not appear to be high with the possible--and 65 important--exception of hydro producers. All distribution companies must supply their regulated customers through long-term contracts with generators. Rates are regulated under a price cap system, whereby the noncompetitive cost elements, such as the use of wires and transmission equipment, are set every five years in accordance with efficiency standards and adjusted periodically for inflation and other factors. Energy and capacity prices are passed through to the final consumers and adjusted every three months in accordance with the terms of the contracts. Unregulated large consumers are not required to have a capacity contract, and can contract directly from generators or marketers or buy from the spot market. The contract market offers a variety of standard contract types that accommodate bundling of energy and capacity, price certainty, and other characteristics. Four types of supply contracts are offered: (a) differences in load curve contracts, (b) capacity contracts without associated energy, (c) capacity contracts with associated energy, and (d) demand shortfall difference contracts. Capacity reserve contracts between generators are also possible. Take-or-pay contracts are not permitted. In the spot market, each buyer can buy from the pool of sellers with surpluses of their term contracts or from merchant plants. The spot price is fixed every hour and is the maximum variable cost of the generating units that generate at that corresponding hour, taking into account the power system loss factor. For each spot price there is a price for each node in the transmission grid. Each generator sells its energy to the market operator at the node in which it is connected to the grid and at the price corresponding to that node. Consumers pay the spot price for all the energy they consume in excess of their term contracts, including related losses. The difference between the spot market price for energy and the actual variable operating cost for each generating unit provides a premium for all units that are dispatched except for the marginal units. This premium contributes to meeting the fixed costs of these units, and is higher for units with relatively low variable costs. This payment system thus provides an incentive for investment in technologies with low variable costs and correspondingly high fixed costs, which favors units designed for base load operation. A capacity adjustment market supports the other markets by enabling buyers and sellers to trade surpluses and shortfalls in their contractual commitments in a pool. Prices for ancillary services are also determined by market rules. Source: Fundación Solar 2002. TABLE 7. Types of Vertical Unbundling EFFECT ON INCENTIVES EFFECT ON ABILITY TYPE OF SEPARATION DESCRIPTION TO DISCRIMINATE TO DISCRIMINATE Accounting The preparation of separate None Very little without effective accounts on a defined basis for regulatory oversight specific functions or services. Functional Separation of different services None Very little without effective into different divisions of the regulatory oversight same firm, possibly with different management and information systems, and with prohibitions on the flow of business-sensitive information between them. Corporate The separation of different None Very little without effective services into different regulatory oversight 66 corporations, although owned by the same company. Joint ownership Each competitive firm owns a None for newcomers; Some, but requires share in the noncompetitive eliminates for incumbents regulatory oversight agency. Operational Putting the operation--but not None Some, but requires the ownership--of the regulatory oversight noncompetitive component under the control of an independent entity. Ownership Separate owners of the Eliminates Some competitive and noncompetitive components. Source: Van Sicklen 2000. power systems. This trend is noticeable around the 5.3 Experience with Independent Power world with the Southern Africa Power Pool (O'Leary, Producers Charpentier, and Minogue 1998) and in Central America (Tomiak and Millán 2002), and the nascent Independent power producers (IPPs) can help launch regional power markets being developed in the reform process by showing the benefits of private southeastern Europe (Kennedy and Besant-Jones 2004), investment and management. They are often the first private East Africa, West Africa, and the Mekong region investors in a power market dominated by state-owned (Yu 2003). Similar groupings are emerging among power utilities, and they can enter the wholesale power Indian states and Chinese provinces (Berrah, Lamech, market under any of the market structures discussed above. and Zhao 2001). Regional trade can only develop In many developing countries IPPs have generally sold their successfully under liberalized arrangements when the output to the state-owned utility acting as a purchasing domestic power sectors of the trading partners are agency­single buyer on the basis of a long-term PPA subject to sound governance. with a state-backed guarantee for the off-taking utility's performance. IPPs have spread across the developing world (World Bank 2003a) and are operating in more than 60 Prices for power from the first IPPs in countries countries (chapter 3). Reviews of experience with IPPs have have tended to be higher than from subsequent IPPs. been published for many of these countries.61 These reviews High prices from the first IPPs reflected the high risk complement general reviews of experience with IPPs in associated with pioneering investments in sectors new to developing countries (International Finance Corporation private capital where the business climate and regulatory 1999; Lefevre and Todoc 2000; Woodhouse 2005a). environments were highly uncertain. Subsequently, prices fell as developers and equipment suppliers competed for Impact of Independent Power Producers business following the initial success of the early entrants. IPPs have provided timely and cost-effective solutions Successful investments for IPPs cannot ensure, and may to chronic supply shortages in some countries under even impede, attempts to produce good sector-level appropriately structured contracts. They have mobilized outcomes. In some countries (Pakistan and the Philippines, financing and added supply capacity where governments for example) the success of IPPs in reducing power had little alternative. Where IPPs signed long-term PPAs, shortages also relieved pressure on leadership and they generally accepted construction and operating risks. In policy makers for needed reforms. Some countries that many cases, they shared fuel availability risk with fuel opened their power sector to IPPs in response to capacity suppliers, either by signing an agreement with a fuel shortages were slow or weak in reforming the transmission supplier who acts as a third party to the project, or by and distribution subsectors, resulting in downstream transferring equity in the project company to the fuel bottlenecks to fully utilizing the new generation capacity. 67 supplier. IPPs are generally insulated under the terms of In Pakistan, the failure to address downstream reform their PPAs against demand risk through take-or-pay and capacity provision, coupled with weak system provisions, dispatch risk, price risk, and exchange rate risk planning, resulted in under-utilization of the IPP capacity (Roseman and Malhotra 1996). even as demand remained unmet (World Bank 2003b). The cost of power produced by IPPs can be competitive with High PPA prices (in local currency terms) under IPP the cost of power from new plants constructed and contracts with "take or pay" provisions impede moves operated by state-owned power utilities. This finding applies toward competitive power markets. Many of the early to IPPs that have freedom over plant specification, PPAs in developing countries were structured as full procurement, construction, and operation under "take-or-pay" agreements under which the purchaser is competitive bidding. The comparison allows for differences obliged to pay for a contracted minimum output even if in generating technologies used by IPPs and incumbent the amount that is actually used is less than this minimum power utilities.62 It also allows for differences in cost of level. The prices that emerge from a liberalized wholesale capital, with IPPs at a disadvantage to state-owned utilities power market are likely to undercut these PPA prices, backed by their governments in this respect. and the difference between these prices become stranded costs that are have to be absorbed under IPPs expect to offset their higher cost of capital by the restructuring of a power utility (Woolf and Halpern better control of construction and operating costs. Their cost 2001). One way to avoid stranded costs would be to of capital is heavily influenced by country and technical renegotiate more flexible off-take terms to PPAs, such as risks faced by their investments under the project financing providing in the PPA for the possibility of revising the arrangements used by IPPs to develop their projects. power purchase terms once the project debt is paid off. International rating agencies have developed If stranded costs are unavoidable, a state-backed special comprehensive methodologies for assessing these risks as purpose financial entity could take over the off-take guidance to the financiers of the high proportion of debt commitments with IPPs and then recover at least a part capital that is usually used in these projects (Rigby 1999). of the stranded costs through a retail tariff surcharge. Reviews of experience with IPPs have been published for the following countries: Argentina (Núñez-Luna and Woodhouse 2005), China (Woo 61 2005a), Egypt (Eberhard and Gratwick 2005a), India (Lamb 2005), Kenya (Eberhard and Gratwick 2005b), Malaysia (Rector 2005), Mexico (Núñez-Luna 2005), Pakistan (Fraser 2005), the Philippines (Woodhouse 2005b), Poland (House 2004), Thailand (Woo 2005b), and Turkey (Cakarel and House 2004). IPPs have generally built gas-fired combined cycle gas turbines under commercial incentives to manage their investment risks, whereas power 62 utilities have adhered to older but familiar generation technologies, such as coal-fired steam turbines or hydropower. Combined cycle plants have lower capital costs, shorter construction periods and generally higher fuel costs than the older generation technologies. Policy makers and regulators should anticipate this denominated largely in U.S. dollar terms, as occurred eventuality by insisting that PPAs contain provisions for in Argentina and Brazil (Gray and Irwin 2003). assignment of obligations. The risk exposure of utilities that are off-takers for The cumulative obligations to purchase power from many contracts with IPPs depends on how these risks IPPs exposed power utilities in many countries to serious are structured. In some cases, the utilities have taken financial risks. These obligations strained the already on substantial risks, whereas in other cases, the utilities precarious financial condition of some Asian power are much less exposed to risks beyond their control. utilities as a result of the 1997 Asian financial crisis, This difference is illustrated in table 8 for four Asian as happened in Indonesia, Pakistan, and Philippines. countries (Indonesia, Malaysia, the Philippines, The utilities were obliged to continue payments to IPPs and Thailand) that have followed the IPP route to reform. under the PPAs for energy that they did not need when The results show a wide difference in risk exposure just retail sales fell below forecast levels, and their governments among these four countries. The Philippines has the prevented them from raising their retail power tariffs to greatest overall exposure, with a high rating for all five cover increases in power purchase costs in local currency exposure indicators, which is creating enormous problems. terms under PPAs following currency devaluations Indonesia also has a high overall exposure, with a high (Gray and Schuster 1998). When some Asian and Latin rating for four indicators, whereas Thailand has a American countries experienced substantial currency moderately low overall exposure, with a high rating 68 devaluations, the cost of power from IPPs in local currency for two indicators, and Malaysia has a low overall terms rose to unaffordable levels under PPA prices exposure, with a high rating for only one indicator. TABLE 8. Risk Exposure to the Impact of IPP Costs in Four Southeast Asian Countries SOURCE OF RISK EXPOSURE INDONESIA MALAYSIA PHILIPPINES THAILAND IPP capacity in operation in mid-2000 (MW) 2,329 7,121 3,676 2,419 (high if the fuel is imported) Exchange rate exposure through origin of fuel Low Low High High supply (high if the currency is denominated in U.S. dollars or another hard currency) Exposure to exchange rate through currency High Low High Low of wholesale tariff (high if the currency is denominated in U.S. dollars or other hard currency) Exposure to exchange rate through foreign High Low High Low debt for project financing (high if the foreign debt made up more than 50% of project financing) Exposure to market risk through proportion of High High High Low domestic power needs supplied by IPPs (high if this proportion is over 50%) Exposure to off-taker payment problems High Low High Low through margin of retail tariffs over wholesale prices (high if this margin is less than US$0.03 per kWh for covering the costs of transmission, distribution, customer services, and system losses) Source: Bacon and Besant-Jones 2002, adapted from Gray and Schuster 1998. BOX 19. The Importance of Political Institutions: The Southeast Asian Experience The importance of political and regulatory institutions in shaping privatization outcomes is shown from empirical analysis of the experience of with private power provision during the 1990s in four countries in Southeast Asia. These countries--Indonesia, Malaysia, the Philippines, and Thailand--provide a natural experiment for this assessment, since all four countries undertook electricity privatization at roughly the same time and for roughly the same reason. Additionally, although the details of individual country reform programs differed, all shared the common feature of using long-term PPAs with guaranteed off-take provisions to induce entry by private investors. Subsequently, the four countries experienced the same macroeconomic shock in the form of the 1997 East Asian financial crisis. Foreign investors in the Philippines and Thailand chose to rely on contractual safeguards whose efficacy depended more heavily on credible ex post enforcement of private property rights by the government. Since 1996, Thailand has operated under a new constitution that separates the branches of government and supports relatively rigorous democratic debate among multiple parties. At the time of the financial crisis, the dispersion of party affiliations in the lower house of the legislature meant that any new policy proposal or change in the status quo policy required the approval of multiple parties with their own competing interests. Further, Thailand had begun to develop an independent judiciary over the past decade, providing an additional institutional safeguard against abrogation or unilateral renegotiation of the contracts. In the Philippines, the government faced a razor-thin majority that relied upon the support of independents and other allies in both legislative chambers. The judiciary had also begun to play a more independent role. 69 Investors in Malaysia and Indonesia chose to rely more heavily on noncontractual safeguards whose efficacy was less dependent on the institutional environment. This was because the level of institutional support for private property rights provided lower levels of credibility and safeguards for investors were considerably weaker in Indonesia and Malaysia than in the Philippines and Thailand. In Malaysia, despite the multiplicity of parties in parliament and the de jure independence of the courts, the ruling party controlled both the legislature and the judiciary. In Indonesia, the president controlled the legislature, and the judiciary was unable to exert any checks on the executive and legislative branches of government. Investors in these countries thus relied more heavily on local partnering and external enforcement by international financiers and multilateral agencies. Source: Henisz and Zelner 2001. Institutions are important for supporting the credibility institutional environment, given the extent to which the of government commitments to investment in power relevant institutions support credible commitments to generation and infrastructure. Differences in the level of private property rights. Regardless of the strategies policy credibility affect investors' choices of strategic chosen, investors in the two countries--the Philippines safeguards. The level of policy credibility affects the and Thailand--with the stronger institutions of these efficacy of safeguards in the presence of a shock that countries, received considerably better treatment strengthens political officials' incentives to behave following the crisis than did investors in Malaysia and opportunistically. This perspective complements the Indonesia, despite the fact that the governments of all perspectives of power utilities and governments four countries faced strong incentives to engage in concerning the risk exposure that is faced by IPPs. opportunistic behavior toward investors (Henisz and The importance of political and regulatory institutions in Zelner 2001). shaping privatization outcomes is shown from empirical analysis of the experience with private power provision Sustainable Conditions for Independent Power during the 1990s in Indonesia, Malaysia, the Philippines, Producers and Thailand. These countries provide the conditions for this assessment, since all four countries followed the IPP The process for selecting IPPs is critical to obtaining route at roughly the same time and for roughly the same benefits from them. In many countries, the initial reason (box 19). contracts with IPPs were concluded under nontransparent processes that attracted allegations of Sophisticated political and regulatory risk mitigation corruption and exposed these contracts to pressure for strategies are important for investors. Investors should renegotiation that substantially reduced the investment choose the types of strategies that they think would be returns for IPPs. A loss-sharing solution of lowering PPA most effective in aligning governance with the rates in exchange for an extension of the PPA term has been the most common approach and successfully used proportions of debt financing. A two-part price structure in Guatemala, Pakistan, and Thailand. In a few cases, meets these criteria, under which one part is a periodic PPAs were cancelled or remained in dispute for years availability charge that covers all the costs covered by (India, Indonesia, and Tanzania), particularly where the the PPA, except for fuel and variable O&M costs, which off-take prices were extremely high by international provides bankability. The second part covers fuel and standards for generation costs in U.S. dollar terms. variable O&M costs based on a rate that is applied to the actual amount of energy that is provided under the Much of this risk of renegotiation can be avoided by PPA, which provides the system operator with the correct obliging IPPs to earn the right to enter into PPAs under a price signals for dispatching IPP plants efficiently.63 competitive bidding process. The use of internationally acceptable bidding documents provides transparency to Access to the transmission network on transparent and the process and thus sustainability to the agreement (K equitable terms is a prerequisite for the sustainability of & M Engineering and Consulting Corporation 1994). investments by IPPs and the efficient use of their Countries that engaged in transparent and competitive generation capacity. This can be achieved credibly by bidding processes for contracting with IPPs on the whole forming an independent transmission entity that is have got lower prices, especially in countries able to regulated in accordance with these terms and is legally provide low-cost natural gas to IPPs (Bangladesh and barred from cross-ownership with generators. Chile did Egypt), and more sustainable contracts than countries this over concerns about abuse of market power after 70 that adopted noncompetitive processes. initially keeping transmission bundled with generation. The failure of off-takers to honor their payments Power utilities should not risk overextending their financial commitments to IPPs is an endemic risk in countries with capacity through long-term commitments under PPAs. generally poor governance and contract protection To avoid creating stranded costs for these utilities if the under the law. This usually arises when off-takers do not power market is subsequently opened to competition, have sufficient revenues to meet these commitments these utilities should sign only a few PPAs before they are because their retail tariffs are kept below supply costs by restructured. Hungary and Poland faced stranded cost political pressure and a large proportion of their bills issues with their single-buyer approach to contracting with are not paid by consumers (the Dominican Republic), or IPPs, and so do such countries as India, Pakistan, and the because of a macroeconomic shock that resulted in a Philippines. In Poland, the transmission company took on major devaluation of the local currency. long-term PPAs with all the generating companies formed from restructuring the sector, but at prices that were later The incorporation of IPPs into a power market introduces undercut by prices realized in the new competitive some specific issues for system planning and operation. wholesale power market. In the other countries, the These issues include (a) how to ensure that power problem stemmed from arrears in payments by the state- utilities and private producers have the incentive to trade owned utility to the IPPs caused by low retail tariffs and power economically; (b) how to price a utility's bulk low collection of payments from power users. power purchases from private producers efficiently and in a way that gives these producers an incentive to A short- to medium-term PPA with an IPP to supply power develop capacity that can supply power at a lower from barge-mounted or skid-mounted generating units is resource cost than the utility's own cost of meeting the an option to avert a costly shortage of power supply demand on its system; and (c) how to manage an capacity. This capacity can be installed in fewer than six orderly process for developing system capacity (APEC months from financial closure, and it requires far less Secretariat 1997; Roxas 2001). investment than needed for a plant installed under long- term PPAs (Bacon 1995). The price of power under this Long-term PPAs should be structured in a manner that is alternative tends to be higher, however, than under a bankable by the IPPs, yet allows efficient use of plant long-term PPA, because the generating units consume output by the power system operator. This is a key issue more fuel and the capital expenditures on these units for ensuring economic power trade with IPPs and have to be recovered over the short terms of their PPAs. enabling IPPs to finance the investment with large The benefit of quick additions to supply, however, can The economically efficient amount of output taken from an IPP's plant is that which enables the demand on the power system to be met at least 63 cost from all the power plants on the power system. A take-or-pay structure distorts this incentive by effectively imposing zero short-term marginal cost on the system for the amount of power covered by the take-or-pay provision, even if the variable cost of this power is higher than that of other plants on the system. be an advantageous tradeoff for the host country. As competition develops, the focus of regulation evolves This approach has been taken in Bangladesh, the from controlling prices and ensuring efficient provision of Dominican Republic, Guatemala, Jamaica, Nigeria, services to monitoring for abuse of market power and and the Philippines. ensuring free and fair access to the transmission system. Achieving this type of access regime requires regulatory 5.4 The Role of Competition in Power Markets intervention, as well as market structure interventions that maintain a strict separation between transmission, Competition is introduced to power markets to achieve generation, and distribution activities. The quality of price reductions and improvements in electricity services. services provided by retail power suppliers (such as Competitive power markets provide the dynamic pressure prices, service standards, and access) are regulated to on service providers and power suppliers that is essential to help consumers benefit from competition among suppliers. achieving these benefits for power consumers and the country's economy. This dynamism is founded on the ease Power supply to large electricity users is an intrinsically of entry to the power market by sufficient generators and competitive segment because the cost of competing for independent power suppliers to control abuse of market their business is small compared with the potential power and to discourage collusion by incumbents. profits. Power supply to all but large electricity users is Experience indicates that competitive arrangements can less likely to attract competition because the profits per work in the mature power markets of OECD countries customer are too small, unless the market has been (the appendix). Competition in the power market and the become highly contestable and suppliers have to defend 71 reforms needed to introduce it, such as unbundling an market shares.64 This element of supply service has integrated supply chain, private ownership, and generally been carried out by the entity that distributes mechanisms for power exchange, are not ends in electricity to these users because both these functions themselves, but rather ways to achieve the broad serve the same market segments. Separate licenses are reform goals. issued for the distribution ("wires") business--which has natural monopoly features--and power supply to The lessons of experience from countries that have facilitate regulation of the former and competition in the successfully introduced competition to their power latter.65 Hence the term supplier usually applies to a markets can be relevant to some developing countries distributor that has a supply license, unless it applies to in two respects (Besant-Jones 1996; Millán 1999; an independent power supplier. Wolfram 1999). First, competition offers a vision of a successful ultimate outcome, even when the conditions The contestable form of competition is seldom sufficiently for attaining this state cannot be met from immediate strong to force dominant wholesale power suppliers to reform efforts. Second, these lessons serve as warnings pass on their efficiency gains by reducing their prices to against attempting overly ambitious reforms in the consumers. Under weak competitive pressure, regulators unsuitable conditions for them found in most developing are responsible for pressuring suppliers to do so countries. Both viewpoints are examined in this section. (Newbery 2004). Contestability in this type of market is limited by the substantial sunk costs in generating plant Characteristics of Competition in the Power Market involved in entering the market, and by the absence of second-hand markets for generating plant for exiting the The concept of managed, or regulated, competition applies market. The incumbent must be broken up to enable to the power market, rather than the economic ideal of real competition in the market. atomistic competition without regulation. Competition can be developed in the power generation and supply service The social costs of private ownership could exceed segments, but generally it is not feasible in the network the benefits under weak competitive conditions. segments (transmission, distribution, and system control) This situation could happen, for example, if competition that are natural monopolies. Competition is more difficult were too weak to force producers to pass on cost to introduce in network industries than in other industries, reductions to consumers, as could happen under rapidly and more difficult in electricity than in other networks. rising demand for power. This could also happen if Consumers should be able to switch between suppliers at low cost, otherwise their original suppliers retain market power, even when these 64 suppliers have only modest market shares. The threshold level of customer demand at which the supply to meet it becomes competitive has been coming down, however, and full 65 competition in the retail market has been introduced in England and Wales, the Nordic countries, and some parts of the United States (Texas, Pennsylvania/New Jersey/Maryland). BOX 20. China's Experiment with Competition in the Wholesale Power Market Beginning with the economic reform which started in 1978, market and competition were slowly introduced into the national economy. The transition from a centrally planned economy to a market economy was a long process because China adopted a gradual approach to reforming. Competition in the electricity industry was particularly late because it was deemed a vital sector that needed to be controlled by the state. It was also because of prevalent capacity shortage to meet surging demand. Competition in the electricity industry first started in 1999 on a limited experimental basis. The direct cause was a sudden turnaround of the power market from chronic shortage to widespread surplus. Six Chinese provinces were chosen for this experiment. The experimental competitive market followed the old England and Wales power pool model. Each province selected its 12 largest independent power producers to compete for a part of the provincial demand. The bulk of the power demand continued to be met by allocated dispatch according to central plans. These producers were free to decide each day whether to compete or not. Simulation of the competition began in July 2000, with no actual financial settlement. The experiment was short-lived in all six provinces for two main reasons. The first reason was the absorption of surplus- generating supply when power demand picked up in 2001 because of unanticipated economic growth. The second reason was the central government's influence on who could compete in favor of incumbent integrated power utilities. 72 Source: Zhang 2003. consumer inertia blunts competitive forces by allowing the other for the reform strategy because there is a producers and suppliers to earn excessively high profit tradeoff between ease of privatization and of margins that are paid in dividends, or dissipate introducing competition. efficiency gains in higher marketing costs, wages, and directors' remuneration (Newbery 2004). If competition is the priority, privatization can become more difficult. Constant post-privatization vigilance is State-owned enterprises will weaken competition in a needed to prevent the privatized entities from anti- power market by forcing out more efficient private competitive behavior through acquisition of holdings competitors where both are present. This is because and mergers. Cross-ownership between generating state-owned enterprises can borrow at the much lower and distributing companies (especially when the wires rates than private investors can--and even as low as business and supply business are bundled together) must risk-free government bond rates.66 Protection from the be severely limited from the beginning and guarded threat of takeover or bankruptcy bestowed by state against after privatization, so that these generators cannot ownership, however, reduces their incentives for efficiency prevent other generators from accessing power users and so may dissipate their lower apparent capital costs. through the distribution networks. When distribution is In this situation, competition among state-owned service unbundled into supply and wires business, some cross- providers becomes weak or nonexistent (Newbery 2004). ownership between generation and the supply business China's experiment with competition in the wholesale may be tolerable. In a competitive model of this kind, power market illustrates this tendency (box 20). the generating plants have to take full market risk, and distributing utilities have to face uncertainty over Private ownership works best when subject to competitive the terms of power supply. Under such conditions, pressures (Zhang, Parker, and Kirkpatrick 2002). Private the investors have more difficulty accessing long-term ownership provides the diversity of ownership needed for debt at reasonable costs, which causes privatization to real competition--including investment in new capacity-- become somewhat more difficult. because private owners respond better than public sector managers to the commercial incentives that drive Since ease of privatization is the priority in many competitive behavior. Privatization and competition developing countries, restructuring of the power supply are therefore related elements of power market reform. should focus on managing investment risks for private One of these elements is usually given priority over investors. Competition in the power market is not This position also reflects the philosophy underpinning centrally planned economies that the interests of state-owned enterprises are identical to 66 the public interest, and so competition among them is wasteful. feasible under country and power sector conditions in · When unexpectedly large profits by the new private these countries. The single buyer model with little or producers and suppliers arouse public hostility to the no restructuring has been widely used to attract private reforms, they may provoke the regulator into making investment into power generation, since it removes most unscheduled price reviews or the government into market risk for the investors. Experience shows, however, considering a windfall tax on these profits (as happened that its substantial regulatory and political risks have in England and Wales). also deterred investors (the subsection on Purchasing Agency­Single Buyer in this chapter). A country that · Strong pressure to increase retail tariffs caused by wants to attract private investment under limited unanticipated large currency devaluations can lead to competition in the power market can unbundle its power demands from the utility for reductions in the off-take supply structure, but allow limited cross-ownership prices under PPAs with IPPs, as in the case of some between generators and suppliers to help investors Asian countries following their financial crisis in 1998, manage risks. Lack of clarity for this kind of choice and also in Argentina and Brazil. resulted in difficulties in Georgia and Kazakhstan where, despite announced interest in competition, some investors Wholesale Power Trade have been allowed to acquire generation and distribution facilities in the same areas. Bilateral trading and organized power exchanges are the main market designs that have emerged for competitive Once most of the power supply industry has passed into trade in wholesale power. In a gross power pool, 73 private ownership and is exposed to competitive forces, generators have to sell all their electrical energy into an oversight of the market becomes critical to the sustainability organized exchange.67 In a net power pool most--typically of the reform. However, when conditions that make over 90 percent--of the trade is conducted under bilateral competition possible cease to exist, or prove to be arrangements, under which generators sell power to power inadequate, market interventions are clearly legitimate retailers (including distribution companies) that sell power within the spirit of the new regulatory framework. This has to end users, power marketers (traders that deal with other been the rule, rather than the exception, in competitive traders and retailers), and large end users of electricity. power markets worldwide (Ayala and Millán 2002). A net power pool also has an organized power exchange to eliminate imbalances between supply and demand at · Private participation will not automatically induce the margin on the system. In a simpler form the system competitive behavior in a network industry, such as operator appoints a generator to increase or reduce its electricity supply that requires substantial coordination power production, as necessary, to keep supply in balance of producers, which inclines participants toward with demand on the system.68 cooperation and collusion. Good regulation and antitrust enforcement are therefore required to support Bilateral trading is the most common successor to this form of competition. a single buyer once the basic requirements for competition in the market are met. Electricity distributors, independent · The private owners may carry out further restructuring power suppliers, and large consumers buy from generators to reduce market risks with moves to recombine some based on a set of market rules according to production generation capacity with some distribution capacity, costs, subject to the approval of contract terms by the as in some OECD countries, or they may sell their stakes market regulator.69 It should start once merit-order dispatch to other private parties under realignment of their of generators is established, metering to measure the investment strategies, as in Brazil. These tendencies energy traded under these contracts is in place, and require careful antimonopoly regulation to maintain settlement arrangements are in force, as well as any competitive pressures on power producers and suppliers. stranded cost issues associated with PPAs are resolved. Some national power markets (Belgium, France, Ireland) include trade in power capacity as well as energy, while regional trade in power is 67 conducted via auctions for interconnector capacity between power markets where demand for this capacity exceeds the available amount (increasingly in Europe, such as the undersea connector between England and France). Such a balancing arrangement is needed because a group of bilateral contracts will not match total supply precisely with the constantly 68 changing total demand for electricity in the market, especially in the presence of transmission constraints on power flows from power generation plants to load centers. A form of this model is used in the current England and Wales power market, which uses a sophisticated arrangement for balancing supply with 69 demand by which producers, suppliers and buyers trade at spot prices to balance their needs (the appendix). Traders are exposed to different risks under bilateral Fehr 2002). Regulatory interventions include capacity trading in net power pools from trading in gross power payments and can be supported by structural measures pools. Under bilateral trading, settlement for the contracted that reduce investment risks, such as bilateral trading power is also carried out bilaterally, and each distributor and forward hedging, as well as limited cross-ownership is financially responsible for its own contracts. Only the between the generation and distribution segments of the value of the power sold for the balancing pool passes power market that can be monitored for abuse of market through wholesale market settlement procedures. power. Regulators have to contend with the difficulty This means that under bilateral contracts, generators of setting a level for capacity payments that leads to are individually exposed to the risk of nonpayment by economically efficient investment in generating capacity distributors, and so generators are concerned about the (Oren 2003; Turvey 2003).70 creditworthiness of the distributors that purchase their output. Gross power pools, on the other hand, relieve The power supply industry is highly susceptible to the generators of this specific exposure by centralizing this exercise of unilateral market power because it possesses risk, although this increases the incentive for payment product characteristics that enhance the ability of delinquency by distributors ("free riding"). suppliers to exercise this power.71 The main characteristic is the difficulty of balancing supply with demand for A power pool based on price bidding with risk-hedging electricity at every instant in time and at every location mechanisms in short- and long-term forward markets is of the network because of many factors. One of these 74 the nearest design to pure competition in a power market. factors is the inability to store electricity. Another is the Most pools use an auction system to form prices based technical constraints on generation capacity for on bids from buyers and sellers in the market, and they temporarily increasing production. An additional work with the system operator to ensure the reliability of technical constraint is imposed by congestion in the physical delivery of power. Power pools that offer a transmission network. A further factor is the inelasticity wider range of services, such as clearing services to of power demand to wholesale electricity prices because provide financial security for transactions and ancillary of the way that power consumption is metered and services required to manage the power system, allow charged. Moreover, power suppliers often possess local progressively more competition in the market (Barker, market power regardless of the congestion management Tenenbaum, and Woolf 1997). Power pools based on protocols used in the power market as a whole when price bidding are found in Australia, Scandinavia, Spain, they are shielded by transmission constraints from sufficient and some states in the United States. The California competition to discipline their bidding behavior into the experience with a price-bidding power pool offers many market. These constraints are common in newly established useful lessons for countries considering this type of competitive power markets because transmission networks power market (the appendix). The cost-based bidding were configured for a different pattern of power flows approach used by South American countries allows under the former vertically integrated industry structure. competition for market share based on auditable costs of generators that give incentives to producers to reduce Competition or antitrust policy as it is applied to other their costs (chapter 3). industries may be insufficient to protect electricity consumers. The past two decades of international A major concern about power pools is whether some experience with wholesale electricity markets has shown form of regulatory intervention is needed in order to the significant harm to power consumers that can avoid serious shortages of power generation capacity. result from firms simply engaging in unilateral profit- Underinvestment in generation capacity can arise under maximizing behavior given the actions of their competitors. uncertainty about the future level of demand in a power Unlike other product markets, coordinated actions among pool, as well as investment risks arising from deficiencies suppliers or the concentration of production capacity in in a country's investment climate (Finona, Johansen, the hands of small number of firms is unnecessary for and Midttun 2004). Capacity contracts can be used electricity suppliers to raise prices substantially above (as in Guatemala--see box 18), but this type of market competitive levels.72 Consequently, the relevant competition should be designed carefully to be effective (von der authorities have not been able to find conclusive evidence Energy rationing is the ultimate recourse in the case of a long-term shortage of capacity or energy (for more than one year, as can happen in 70 hydropower systems through droughts). The Brazilian experience with energy rationing is interesting (Maurer, Pereira and Rosenblatt 2005). This paragraph and the following paragraphs on problems with market power and regulatory oversight of competitive markets draw on Wolak 71 2005. Some wholesale electricity markets have had severe market power problems even though they had Herfindahl-Hirschman Index values that 72 would not raise concerns about market power in other industries. of coordinated actions among suppliers to raise prices (such as Spain) where several approximately equal-sized in violation of the competition or antitrust law during private generators could have been created. Experience these market power episodes. in the early years of the England and Wales competitive power market indicates that no entity should operate or In a competitive power market, a combination of regulatory control more than 20­25 percent of total generation oversight and competition law is needed to provide capacity in this type of market. Thus the size of the power consumers with the protection from market power that system should be able to accommodate at least four or conventional competition law provides in markets for five generation companies, as well as have the appropriate other products. In the case of electricity, an industry- economic characteristics.73 These characteristics are specific regulator endowed with a prespecified set of (a) the technological mix used in generation (competitive responsibilities is necessary to react to unanticipated generation is more practicable without a large proportion events because unilateral market power problems can of nuclear power or hydropower), and (b) the extent be extremely difficult to predict. Even small market of power system interconnection, with competitive design flaws that cause little harm during most system reform being more practicable where load centers are conditions can lead to substantial consumer harm when interconnected (including interconnection with power the load on the power system approaches the limit of networks of neighboring countries). the system's supply capacity. Clearly specified regulatory safeguards tailored to the electricity supply industry are Some Latin American countries have adopted measures needed to prevent the harmful exercise of unilateral market to control market power in competitive power markets 75 power before it can occur, and to rapidly implement (table 9). Argentina deliberately designed the reform so that remedies if it does occur. no firm could have more than 15 percent of the market, and Brazil and Colombia also kept down concentration of Restructuring the generation sector for a competitive ownership. Chile (where one firm has 60 percent of its wholesale market should focus on control of market market) has a very high ownership concentration. Bolivia power while allowing investors to manage their risks and Peru are small countries with relatively few generating efficiently, such as by forward hedging of contracts in plants that managed to avoid creating high levels of market the market. The selected structure created considerable power (Bacon and Besant-Jones 2002). market power even in some large industrial countries TABLE 9. Market Concentration in Selected Latin American Power Markets, 1998 LARGEST HERFINDAHL- EQUIVALENT NUMBER OF MARKET HIRSCHMAN NO. EQUAL- GENERATORS SHARE (%) INDEXa SIZED FIRMS Argentina 38 14 0.06 16.7 Bolivia 6 26 0.19 5.2 Brazil 14 25 0.15 6.7 Chile (main system) 4 60 0.43 2.3 Colombia 26 24 0.14 7.1 Peru (main system) 8 35 0.23 4.3 a. The Herfindahl-Hirschman Index is defined as (Si)2, where Si is the share in the market of the capacity of the ith firm. The index varies from unity for a monopoly toward zero for perfect competition (a very large number of equal-sized firms). Source: Bacon and Besant-Jones 2002, based on data from Berrah, Lamech, and Zhao 2001. In a good competitive market, four or five companies should compete not only for base load power, but also for peaking power and 73 intermediate power (that is, all along the load curve). The primary goal of the regulatory process in competitive given to the transmission company, especially when it power markets should be to prevent market participant is state-owned and so not under the control of private behavior that significantly degrades system reliability and traders in the market. This arrangement provides a market efficiency. The regulatory process should ensure practical solution in the weak institutional and financial that the conditions necessary for vigorous competition environments found in many developing countries. exist and to limit the economic harm associated with the Separate licenses should be issued for transmission exercise of unilateral market power when they do not system operation and market operation to allow exist. Regulators cannot prevent firms from exercising market operation to be spun off into a separate entity if, unilateral market power.74 Regulatory mechanisms that for example, government later decides to allow private attempt to prevent all exercise of unilateral market shareholding in the transmission entity or the regulator power can introduce market inefficiencies that cause becomes concerned about the manner in which more economic harm than the market power they are the transmission system operator is managing attempting to prevent. market operation.75 The regulator should have access to all information The governance of a separate power system operator needed to analyze the behavior of market participants. should be kept independent of the market participants. The regulator should be able to replicate market- This lesson is reinforced by the Californian experience clearing prices and quantities, given the bids submitted (Besant-Jones and Tenenbaum 2001). This independence 76 by market participants, total demand, and other can be achieved by prohibiting market participants from information about system conditions. This is necessary having any ownership in the system operator and requiring for the regulator to verify that the market is operated in that the system operator's governing board is composed a manner consistent with the market rules. In addition, of nonmarket participants. If governance boards are all data submitted to the real-time market and produced composed of market participants, however, they should by the system operator should be immediately released not be too large or dominated by one or more classes to the public to help system reliability. In a bilateral of market participants. The system operator should trading system (net power pool), the real-time market monitor markets carefully and continuously for signs of should handle little energy trade because it is operated trouble--such as unusual price movements that may primarily for reliability reasons, and all market participants indicate abuse of market power--and have the authority have a common interest in the reliability of the transmission to penalize those who violate market rules. network. The regulator's access to data submitted to the system operator by market participants or produced by Competition in the Power Markets of Developing the system operator should not be limited. The regulator Countries should also have the ability to request information from market participants on a confidential basis to perform Competitive power markets have been developed further analyses. successfully in some Latin American countries (see chapter 3), but tried unsuccessfully in other countries. The institutional arrangements for market operation are Some countries in the latter category have been reluctant important for developing a competitive wholesale power to provide nondiscriminatory or even regulated third party market. Appropriate regulatory tools--including grid access to their wires services, even to large consumers. codes, access rules, and commercial tools for the operation In Poland such access is not available for the import of of the transmission system--should be established before power from abroad. In Hungary such access is available competitive power trading arrangements are introduced only if the buyer buys at least 50 percent of annual (Arizu, Dunn, and Tenenbaum 2002). Responsibility for needs from domestic generators. In Ukraine a competitive control of power system dispatch and administration of pool never functioned as intended because it was power trading arrangements should be placed in an introduced prematurely in an environment of extensive entity beyond the control of competing sellers and nonpayment and reluctance by government to let retail purchasers of electricity. This responsibility could be prices move up or down with wholesale market prices. In fact, markets function most efficiently when suppliers have high-powered incentives to exercise all available unilateral market power provided 74 that there are few barriers to entry to the market. A separate entity for market operation is found in some OECD countries. In the United States. many transmission networks are owned by 75 investor owned utilities that also buy and sell power in the wholesale power market. In England and Wales the transmission entity is a separate privately owned corporation. A shortage of real competitors is a major obstacle to requires adequate supply capacity to meet all developing competition in the power markets of most segments (base, peak, and shoulder) of the load on developing countries. This is because of the small sizes the power system.79 of these markets with limited scope for international trade. It is also because of the difficulty in attracting new · Many existing markets are too small to support the entrants to an industry characterized by high sunk costs number of viable sellers and purchasers needed for in investments with virtually no alternative economic uses full competition in the market. and in countries with inefficient financial sectors, lack of credibility of institutions, and weak enforcement of laws. · Lack of diversity in fuel supply markets needed for A key issue for competition policy is the rate of return competition among power generators. that will attract the optimal level of investment. In most developing countries, however, this issue can be resolved · Inadequate development of the power transmission more easily through concession contracts with regulated system and power system control system necessary for prices than with competition in power markets (Beato managing the complex pattern of power flows in a and Laffont 2002).76 competitive market. Liberalization of fuel markets is an essential requirement · The insolvency of most power utilities that prevents for the development of competition among power them from paying their suppliers in full and which generators. This requirement is often overlooked, deters IPPs from developing large power projects. 77 even though fuel costs are a critical area for competition among generators, since these costs amount to at least · Domestic capital markets are too undeveloped to 60 percent of the total costs of thermal power generation. provide financing on the scale and terms needed Fuel costs and availability of fuel types (coal, natural gas, for investment in supply capacity. and liquid fuels) and specifications for each type (in regard to energy content and contaminants) not only · Difficulty in controlling abuse of market power if affect operating costs directly, but also affect choices of generators and suppliers are allowed to charge plant types by investors. The greater the options for fuel market-based prices. Market power in a mixed choice, the greater the potential for competition among hydropower and thermal power system is generally investors in the power generation market. In many more difficult to control than in an all-thermal power developing countries, fuel markets are tightly controlled system.80 under state-owned monopolies that usually produce a limited range of fuel products under rigidly controlled · Policy makers have limited tolerance for the substantial prices, and they struggle to meet even existing levels of price volatility that occurs with competition in the market. domestic demand. They are likely to favor their contracts to supply state-owned power generators in this situation.77 · Lack of respect for property rights and obligations Governments have to choose between protecting these under contracts, notably keeping to merit order of monopolists and allowing competition to flourish in their dispatch of generating capacity and to agreements on wholesale power markets.78 tariff revisions. In summary, only limited competition can work in the · Also lacking is the availability of the legal infrastructure power markets of most developing countries for the for dispute resolution in a rapid, fair, and competent following reasons: manner, and mechanisms to enforce court decisions and property rights through courts and arbitration. · Insufficient power generating capacity to cover fast- growing power demand--including demand for The general absence of the necessary conditions for access to electricity supply from currently unconnected open competition in power markets in developing households, because the development of competition countries indicates that competition should be introduced Such concessions are in fact widely used in both power generation--with IPPs and distribution--as in Latin America. 76 IPPs often gain specific import rights for their fuel requirements in these circumstances. 77 This was the case in Panama at the time of privatization of power generation and distribution assets, when the government allowed private 78 generators to bypass the monopoly seller of oil products in the country to obtain fuels on a competitive basis (Rufin 2002). This concern applies even to effective demand after allowing for the impact of below-cost tariffs and nonpayment of electricity bills by users. 79 See García and Arbeláez 2002 for Colombia's example of this problem. Panama and Chile have retained centralized models of their power 80 systems to determine the optimal dispatch of their hydroelectric capacity (Walker and Benavides 2002). gradually to the wholesale power trade in these countries. In summary, the following lessons from experience This could be done by the following means: (a) generation should guide developing countries in deciding how to capacity is distributed among many owners; (b) open introduce competition into their power markets. access to transmission and distribution networks is provided to third parties; allowing multibuyer trading on · Price-based spot markets are generally too risky for a bilateral basis between generators and distributors small to medium-sized power systems, because these and other parties, instead of trading through a single systems lack sufficient bidders to maintain effective buyer of wholesale power; (c) the system operator competition. represents the interests of all wholesale market participants without being under undue influence of any group of · Cost-based spot markets, such as those developed in participants when dispatching system supply capacity; Latin America, offer a simpler and less risky alternative and (d) distributors pay generators fully and promptly that can yield competitive benefits for medium-sized and, in turn, generators pay their fuel suppliers fully and power systems. promptly, preferably on liberalized fuel markets that enable generators to reduce their fuel costs. · Most developing countries should start with limited forms of competition that can evolve to wholesale Under weak regulatory capacity for monitoring and competition once the sector can manage competition preventing abuse of market power, simple regulatory without uncontrollable market power. The creation of 78 instruments are more prudent than theoretically more bid-based spot markets should generally not be their efficient, but complex rules. For example, simple limits top priority. on vertical integration or horizontal concentration avoid the need for collecting and processing the extensive · Bilateral trading among multiple buyers and multiple amounts information necessary to identify behavioral sellers should be considered instead of gross power changes in the market. They also help regulators avoid pools, but only when distributors are creditworthy disputes in court when they oppose mergers and purchasers. takeovers proposed by market participants. Complex rules tend to yield erratic results in courts that either do · A temporary single-buyer arrangement can be not share the regulatory philosophy or lack the capacity considered--that is, one without a legal monopoly-- to grasp the highly technical issues involved in such in situations where bilateral trading or spot markets cases (Benavides 2003). need substantial time to develop viable power purchasers and sellers. Third-party access would allow entry by new types of suppliers, including industries that own power generators · Full retail competition should be implemented last. to meet their own power needs and that can sell excess Countries that have not achieved substantial power from these plants, developers of small power household electrification should focus on encouraging plants ("distributed generators") fueled by both competition to serve those who do not have access to conventional and unconventional renewable energy electricity (see chapter 7), instead of on retail forms, IPPs able to conclude sales agreements directly competition for those who already have access. with industrial and other large power consumers, and small service providers in rural areas that sell to local grid-connected power markets. Regulatory support in the form of reasonable wheeling and backup charges is essential to the success of open access for third parties to the power grid. 6. REGULATION OF POWER MARKETS OGN's Guidance on Regulation of Power Markets The development of capabilities and institutions to regulate power markets is an important part of sector reform. It is unrealistic, however, to expect that a new regulatory system will be fully functioning and credible soon after it is formally created. Experience shows that developing robust regulatory frameworks and strong institutions to manage them can be hampered by underfunding and a reluctance on the part of governments to transfer real independence in decision making to regulatory authorities even when required to do so by law. Private sector investors contend that a credible regulatory system requires more than a formally independent regulatory entity, especially in the critical early years right after it is created. Since many regulators begin performing their functions with the disadvantage of limited independence and capacity, other transitional arrangements may need to be established to provide stability and predictability for a new regulatory regime. This could include limiting the amount of discretion that regulatory bodies have in setting prices and key parameters, particularly during the initial years of public private partnerships where the private sector is investing significant amounts of capital. 79 This can be achieved by setting out details on key terms, such as initial price controls in the key regulatory instruments (licenses or contracts), or by having clear tariff-setting principles in the country's legislation. This chapter covers regulation of power markets for all arm of governance that balances the interests of market types of market structure. These structures range from a participants--power generators, suppliers, network and single integrated power supplier responsible for all market service providers, and users. It should also publicly supplied electricity to a decentralized competitive consider the interests of those who aspire to participate wholesale power market with many participants. in the market--new entrants that are either power The structure of the regulatory system is linked to the suppliers that want to sell their product or power users market structure, since regulation is an important that want access to the public power system. It is used to component of power market governance. In particular, control prices and ensure efficient provision of services. the need for a separate, autonomous regulatory agency Regulation is applied both as a public good to protect operating under transparent processes is much stronger the public interest through a public entity, or as a private with private sector participants in a power market than good for market members through a private organization-- when all public power supply is under state ownership. as in a power market exchange. Even in large middle-income countries, various forms of contractual arrangements and third party guarantees Public regulation is the dominant form of arm's length against regulatory risk are needed for attracting large regulation for power utilities. It forms part of a broader amounts of private investment in the power systems with regulatory framework that encompasses public safety, a new regulatory agency that has not had time to employment conditions, and environmental safeguards, develop a track record for credibility. In small low- and more broadly the legal framework in which the income countries, contracting out of regulatory functions power market operates. The following characteristics of is an option under their weak institutional capacity. the electricity supply industry make public regulation both necessary and difficult (Stern and Holder 1999). 6.1 The Need for Public Regulation of Power Markets · The assets are capital intensive and become sunk costs once invested, since they cannot be profitably Regulation of electricity service providers and consumers redeployed, so investors need protection from is the means of applying governance to the power expropriation. market, complemented by competition where feasible. Economic regulation of the power market is the formal · The electricity supply industry has considerable Environmental regulations are an important component economies of scale and scope, especially in the of power market regulation. Regulatory processes for network segments, which limits the number of firms environmental standards should guide, rather than that can support the power market viably. This means hinder, the operation and development of power markets. that governments cannot rely on the development of They should address important aspects that include competition in the market to protect consumers from permissible levels of emissions--especially during times the abuse of market power by these firms. when the power system, as well as local environments, are particularly under stress--as occurred in California · The price of electricity services is highly political (Besant-Jones and Tenenbaum 2001). They should because these services are important for the welfare of provide the means for handling environmental concerns households. by community groups and nongovernmental organizations (NGOs) about the siting of power plants, the selection · The quality of electricity services matters for economic of fuels, and the development of hydropower resources growth because these services are important intermediate for power generation (World Commission on Dams inputs for the industrial and service sectors. 2000). They should not be open to capture by vested interests to get round environmental regulations or at Public regulation works better under a clear formal the other extreme to block the siting and operation of regulatory process, rather than by informal oversight new power facilities. 80 and noncommercial objectives typically imposed on state-owned utilities. Once a government decides to 6.2 Institutional Approaches to Power Market attract substantial private investment to the power Regulation sector, it is faced with the need to put regulation at arm's length from its executive agencies. The main The development of capabilities and institutions to governance elements of power market regulation consist regulate power markets is an important part of power of the following interrelated features: clear roles and market reform. This development covers both regulatory objectives, regulatory independence and accountability, governance (who does what under which laws, rules, stakeholder participation, and transparency and and procedures) and regulatory substance (how tariff predictability. These features promote legitimacy for levels and structures are established and approved, market reform and the regulatory process, and enhance and mechanisms for coordination of tariffs and subsidies the credibility and reputation of the regulatory institution and the establishment of quality of service standards). (Rodríguez and Jiménez 2005). If a government is Developing economies need to find appropriate ways unable or unwilling to create these arrangements, state to balance the costs and benefits of regulation in their ownership and financing of the electricity supply industry circumstances. The design of new regulatory structures becomes the fall-back solution (Levy and Spiller 1993). should take account of the political, legal, and constitutional arrangements under which they have to Price-setting arrangements under state ownership of function. It should be consistent with country endowments power supply usually result in severe distortions to (including constitutional checks and balances), technical electricity prices, especially low prices for households expertise, auditing competence, and fiscal resources, and influential consumer groups (such as irrigation as well as the economic characteristics of the power farmers in India--Monari 2002). Under state ownership, market (Kessides 2004). regulation of the power market has traditionally been carried out implicitly by governments in combination The regulatory systems of developing economies tend to with numerous other roles. Setting prices tends to be a operate within legal frameworks modeled on one of the process of negotiation between government ministries, three frameworks used in OECD countries (Stern and the power utility, and influential consumers in which Holder 1999): political considerations are as influential as financial requirements. The regulatory function is usually carried · The U.S. model of regulation, which operates under a out by the line ministry responsible for the power sector strong and well-established constitution, an under a command-and-control approach. This tendency administrative law code and a tradition of using the can be observed in many countries in Asia and Africa. legal system to resolve issues. · The U.K. model of regulation, which relies on compromise with the efficiency goal in order to establish achieving compromises between parties, rather than the kind of commitment that induces the private sector resorting to the courts, in the absence of a written to participate (Levy and Spiller 1993). constitution and a formal code of administrative law. The approach that emphasizes regulatory flexibility · In many European countries, whose regulatory systems focuses on creating autonomy in the regulatory agency operate within Napoleonic law codes with traditions of in an environment that allows discretion, but restrains public service obligations. arbitrary, unexpected, and undesired actions by the agency. Such actions include domination or excessive Thus, Latin America generally follows the European influence over the regulatory system by investors in their framework, Asia follows either the U.S. or U.K. framework, own interests, and expropriation of investors' assets by and Africa follows either the U.K. or European framework.81 the government responsible for the regulatory system.83 Although many developing countries follow the U.S. This approach is generally suited to the conditions found structure of independent regulatory commissions, they in OECD countries. Many developing countries constrain lack the legislative background and substantial resources regulatory discretion in various ways, both formally needed to replicate the regulatory processes of U.S. style through incorporation of regulatory procedures and cost-of-service regulation developed for investor-owned rules in concession contracts, and informally through vertically integrated utilities. covert pressure on regulators and regulated entities. 81 The core issue for designing a new regulatory structure The approach that emphasizes regulatory commitment is how to manage the tradeoff between flexibility and under limited discretion embeds highly specific substantive discretion. The need for flexibility in applying regulations rules in licenses provided to operators or in legislation under changing market conditions must be balanced ("regulation by contract"). This contractual approach rules and procedures by limiting the regulator's discretion (section 6.4), however, entails considerable loss of in applying them. Achieving a balance depends on flexibility. The Chilean system provides a good example which course risks more economic inefficiency under of this approach, since it consists of very precise the prevailing institutional framework. Flexibility is more benchmark regulations and leaves little room for important under rapid technological change, such as discretionary action on the part of the regulator. Such a with telecommunications, whereas commitment is more system relies on a set of institutions that can resolve important under great social needs, such as with water conflicts, of which a judiciary is the most important, and supply. The power sector lies somewhere between. an administrative apparatus. This regulatory model Flexibility and commitment can be in conflict.82 How a requires a strong institutional framework, since the country resolves this conflict depends on the specific parties involved must understand the basic logic of institutional environment of the country. capital asset pricing models (for example, rate of return and marginal cost pricing), the need for technological Countries can choose from two distinct institutional change, and what efficient regulation looks like. approaches to achieving regulatory flexibility and commitment. The approach chosen should fit the particular A well-designed regulatory system reduces the cost of country setting in the most credible and plausible way as private capital for the power sector. Such a system a workable system. Some countries have the institutional ensures that regulatory responsibilities for financially background to get substantial efficiency and flexibility, important decisions for the investors--such as license while having the commitment that is needed for the awarding and tariff setting--are based on technical, system to be workable and for private investment to be rather than political, factors. Otherwise, private capital forthcoming. Other countries may have to accept some would be attracted only on costly terms to the country. In Latin America power supply entities were privatized under the "Washington consensus" that the quality of institutions have an important 81 impact on economic growth. Attention was given to modernizing the regulatory frameworks of power markets for the newly privatized entities as part of the so-called second generation of reforms (Basañes and Willig 2002; Basañes, Saavedra, and Soto 1999). These approaches draw on agency theory that stresses the asymmetry of information between regulator and the firm (Lafont and Tirole 1993), 82 under which the regulator proposes a contract in order to make the firm reveal its private information. Price cap regulation and cost plus regulation are forms of this contract. This approach draws on transaction economics that emphasizes the need to minimize transaction costs over the long term. It views 83 concessions as incomplete contracts, where the utility is guaranteed a fair rate of return and the regulator retains the residual rights of control. This would be apparent by either high rates of return International guarantees against regulatory risk can sought by investors, or mitigation of risk exposure at support these approaches for those countries where the more competitive returns by earning high returns to domestic institutions do not provide a basis for credible equity during the early years of operation, take-or-pay commitments to any set of rules. This situation can exist contracts as used in PPAs by IPPs for their first projects in if these institutions were created too recently to develop many countries, and by sovereign guarantees or third a good track record. Without adequate assurances of party guarantees. an effective regulatory framework (such as an effective BOX 21. Partial Risk Guarantees for Privatizing Distribution in Romania and Uganda Romania: A Partial Risk Guarantee (PRG) from the World Bank for 60 million was used to support the privatization through majority asset sale of the Banat and Dobrogea distribution companies in April 2005. The investor--Enel SpA of Italy--acquired a 51 percent shareholding through equity injection, and the balance of the shareholding was retained by the state through its distribution holding company. The licensing framework consisted of a distribution license for 25 years and a supply license for 8 years (renewable) subject to European Union policy. Revenues are regulated by the National Energy Regulatory Authority (ANRE) on the basis of a price cap or price basket methodology introduced prior to the privatization. The PRG backstops a Letter of Guarantee issued by Citibank Romania for a term of five years, which provides for 82 payment to the distribution companies for loss of revenues resulting from a change or repeal by the government or ANRE or noncompliance by ANRE with the provisions of the preagreed regulatory framework comprising (a) the distribution formula; (b) the full pass-through of electricity costs; and (c) pass-through of PRG-related costs. The PRG Guaranteed Events and the claims mechanism are outlined in a Government Support Agreement (GSA) concluded between the Government of Romania and the distribution companies. In the event of a claim under the Letter of Guarantee, the Government of Romania, through the Ministry of Public Finance, has the primary obligation to reimburse Citibank Romania, with the World Bank guaranteeing repayment to Citibank Romania under the PRG if the Government of Romania fails to meet its obligation. In this way, the PRG-facilitated closing of the first electricity privatizations in Romania in the context of a new regulatory framework for the country and ANRE's limited track record. PRG's mitigation of regulatory risk during the transitional period resulted in an agreement by Enel to reduce its return of investment by two percentage points per year. The resulting reduction in the revenue requirements of the distribution companies will yield substantial savings for the country over the life of the distribution companies, even though the PRG is available only for five years. Moreover, the PRG has established a lower investment return benchmark for subsequent privatizations of Romanian distribution companies, thereby generating further significant savings for the country. Uganda: An IDA PRG of US$5.5 million was issued in March 2005 in support of a 20-year concession of the Uganda Electricity Distribution Company for the benefit of UMEME Ltd. (a private consortium of Globeleq Ltd. of the United Kingdom and Eskom Enterprises of South Africa). Under the PRG structure, UMEME will have recourse to a Liquidity Facility in the form of a Standby Letter of Credit Facility issued by Citibank Uganda and backed by the PRG. The PRG is for a term of seven years and specifically provides protection for the following risks: · Regulatory framework: Noncompliance by Uganda's Electricity Regulatory Authority (set up in 2000) with the preagreed framework relating to the distribution tariff; full pass-through of the bulk electricity supply from the domestic power transmission company acting as a single buyer; timely adjustments of tariffs. · Government payment arrears: Nonpayment of electricity bills by government and its agencies. · Termination payments: Buyout amount for underdepreciated investments resulting from early termination of the concession caused by breach of concession agreements by the government or any of its relevant entities. The PRG helped to implement the first power distribution concession in Sub-Saharan Africa by catalyzing US$65 million of investment commitment from UMEME for the rehabilitation and expansion of the distribution network. This transaction is likely to have an important demonstration effect for similar privatizations in the region. Source: World Bank staff. regulatory agency) and rules (for example, predictability A regulatory agency offers a number of institutional about pricing and quality standards), private investors advantages. It can attract and develop the highly would be reluctant to commit their capital to the specialized technical skills needed for a complex country's power sector. Export credit agencies provide sector to relieve overstretched and under-resourced guarantees against political risks for repatriation of government departments of this burden. It can also use profits and debt servicing (OECD 2003). Guarantees, its powers of arbitration to relieve the judicial system of such as the World Bank's Partial Risk Guarantee a heavy caseload arising from disputes and clarifications (PRG--World Bank 2002), have been specifically of electricity regulations, and thus provide a faster and adapted to backstop a government's commitment to more flexible service than available under the formal, a predefined regulatory framework and a process of lengthy, and costly procedures of the typically overburdened dispute resolution, thereby helping mitigate regulatory law courts in developing countries. Such an agency also risk for private investors and facilitating a smooth avoids the problems associated with industry self- transition to a credible regulatory framework. The PRG regulation combined with anti-monopoly laws in the has recently been used successfully for this purpose in case of the power system, even when these laws are well Romania and Uganda (box 21). A PRG cannot, developed and enforced. Experience with this approach however, substitute for a basically poor regulatory in New Zealand showed up problems, such as the framework (Gupta and others 2002). difficulty in finding a firm guilty of abuse of market power because of the technology-intensive nature of 6.3 Regulatory Credibility for Private the industry (Patterson and Cornwall 2000). 83 Investment In practice, regulatory agencies in many developing The regulatory credibility necessary for attracting long- countries have not been allowed to discharge their term private investment in electricity services covers functions properly. Even in some countries where autonomy, transparency, and accountability.84 The legislation explicitly provides the appropriate framework, pressing need for this investment gives governments the government ministries and their power utilities have incentive to improve the credibility of power market restricted the activities of the agencies. Regulators have regulation. been excluded, for example, from overseeing new private investment in the sector, such as by approving The principal means for developing credibility is by PPAs with IPPs. They have not been able to review tariffs establishing a designated regulatory agency that without being subjected to political pressure--or they discharges its duties in a neutral and depoliticized have been excluded from tariff decisions. They have manner. This agency is an institutional solution to lacked the powers to pressure managements to improve keeping entities responsible for formulating policy apart the performance of their utilities. And they have not from entities responsible for providing services. From the been able to help expanding access to affordable early 1980s to the present, 134 countries around the electricity services. Examples of these cases can be world--both OECD and developing--have set up found among Indian states (Prayas 2003), as well as separate regulatory agencies for their infrastructure in Africa (Eberhard 2005). These problems have markets as a prelude to or in tandem with sector stimulated interest in modifications to this regulatory unbundling and private participation (Environmental model, particularly contracting out of regulatory Resources Management 2004).85 In the developing functions (covered later in this subsection) and world, Latin America has advanced furthest, Central and regulation by contract (covered in section 6.4). Eastern Europe have advanced far, Asia is advancing, and Africa is starting to make progress.86 The term "autonomy" is used in this context in preference to "independence" because a regulatory agency is an arm of government. Autonomy 84 does not carry as much political controversy as independence when applied to sector regulators (for example, Rao 2004 discusses so-called independent regulation in India). This large number of countries relative to the lower number of countries that have undertaken some restructuring of their power systems 85 (chapter 3), indicates that establishment of many of these regulatory agencies was a first stage that has yet to be followed by structural reforms. See Kirkpatrick and Parker 2004 for a review of experience with infrastructure regulation in low- and middle-income countries. 86 A regulatory agency should have the autonomy to carry · Limiting government's ability to delay or overrule out its duties. Autonomy applies to both the agency's commission decisions, by making these decisions organization, procedures, processes, and finances subject only to appeal to the judiciary or some other from arbitrary political and bureaucratic interference, impartial source (Tenenbaum 1996). and to undue influence from regulated companies and consumer interests. This autonomy is needed for providing Many developing countries provide for operational the stability and enforceability of laws and contracts that autonomy in the enacting legislation, which is followed are important to private investors (Lamech and Saeed in practice to varying degrees among these countries, 2003).87 Regulatory agencies need to show autonomy to but few of them meet the requirements for financial establish a track record that builds up their credibility. autonomy. Autonomy for regulatory agencies from governments can The autonomy of regulatory agencies should be never be total. This is because ultimately governments protected by appointing its staff on the basis of technical are responsible for providing regulation, and therefore competence. This principle has not been followed to regulatory agencies must be accountable for their date in many countries, including China and India. performance in conformity with government policies. In India, the selection of regulatory commissioners Most laws that establish a regulatory framework allow has been biased toward retiring government servants, governments to give policy directives to the regulatory often from the sector they are to regulate. This policy 84 agencies under their jurisdiction. A tariff policy directive perpetuates civil service mindsets and attitudes, and the from government, for example, should not reduce the resulting regulatory actions are unlikely to promote the regulatory commission to the status of a mere calculating commercial practices needed in the reformed power machine. It should not take away discretion from regulators market (Rao 2002). Likewise in China, the national on rates of return, risk evaluation, rates of depreciation, regulatory commission was set up with a small staff incentives, and such elements of tariff regulation. It could, composed of engineers lacking economic training, however, direct that subsidies to a particular class of which seriously affected the commission's ability to fulfill consumers would continue for a given period at specified its mandate of regulating complex markets, preventing levels, propose a development charge for new investments, market power manipulation, and arbitrating industry encourage hydro investments through preferential disputes (Yeh and Lewis 2004). In both countries, treatment, and ask for multiyear tariffs (Rao 2002). the regulatory staff faced the difficulty of keeping at arm's length from the regulated entities because often A regulatory agency needs the legal status for autonomy these entities were managed by their former colleagues. from political and market influences, as well as for the authority to set parameters and monitor implementation Transparency in a regulator's procedures and processes of contracts. This can be achieved with the following key is critical for public credibility, especially for tariff setting, measures: as well for attracting investors. A transparent tariff revision process at least helps unearth data that was · Making the regulator accountable to the legislators shielded from public scrutiny. It also helps develop that provided its legal status, instead of to an public understanding of the issues involved, including executive ministry. their serious nature and the symptoms and sources of problems (Prayas 2003). Transparency supports the · Funding the agency independently of government public interest in controlling the environmental and budget allocations, such as through a small surcharge social impacts of power system development. It gives on consumer's bills or a levy on the utility's revenues confidence in the fairness and predictability of the in a process not open to diversion by the government application of regulations to investors, as well as (Kelley and Tenenbaum 2004). allowing them to see their regulatory risks clearly and make provisions to manage them. Transparency can be · Appointing commissioners on fixed, staggered terms with ensured through (a) regulations that prohibit off-the- limitations on government's powers to dismiss them. record communications between the parties involved in This finding is supported by an analysis of private investment in Latin American infrastructure (Pargal 2003). The analysis concluded that 87 legislation that creates the legal basis for reform, rather than specific aspects of the institutional framework, is the most significant determinant of private investment volumes. regulatory processes, (b) the obligation for the regulator · Competence can be increased by providing access to to publish its reasoned decisions, and (c) the availability specialized skills and building core in-house skills of all documentation presented and used in the processes through training. to all participants and the public (except for commercially sensitive data). · Autonomy can be strengthened by enabling the regulatory body to benefit from the reputation of an The powers of the regulator should depend on how external agent, and giving the regulator a higher degree much autonomy it is likely to have. Regulation of the of control over who does the work, particularly in power sector applied by a regulatory agency with countries where there are constraining civil service substantial autonomy is appropriate for countries that rules. intend to attract private investment, and whose political and judicial systems have the capacity to limit the risks · Legitimacy can be established in countries with weak of regulatory failure. Countries with weak political and or fledgling institutional capacity where external studies judicial commitments to transparent and fair regulation, may be perceived to be more credible and can increase but which still intend to open their power sectors to the transparency of the regulatory process. private investment, should focus on contractual approaches to improving sector performance. In Africa and Asia, Contracting out is particularly helpful for newly the new regulatory agencies have fewer decision-making established regulators that need external support for powers and autonomy from government than those in their initial start-up phase. Suitable tasks for contracting 85 Latin America and Central and Eastern Europe.88 out include gathering and analyzing information, monitoring compliance with existing rules, determining Where the regulator is likely to act autonomously, it can new rules, and enforcing rules. be given substantial decision-making powers without undue risk of regulatory capture by one of the regulated Contracting out of regulatory tasks is particularly parties. The reverse risk, that of a lack of checks widespread by water and telecommunications regulators and balances on the use of regulatory power, in Africa and Latin America, but it is less prevalent became an issue in Argentina and--according to some among electricity and energy regulators in developing commentators--in the Indian state of Orissa. This risk countries (Bertolini 2004; Environmental Resources can be managed within the broader legal framework. Management 2004). The functions most contracted out Where this risk is perceived to be serious, the regulator include monitoring compliance with physical and quality could be given a semi-autonomous status with mainly targets, monitoring compliance with quality parameters, advisory roles, and other agencies would be vested with and legal opinions. Most regulators contract out rulemaking and enforcement powers. This tradeoff is an functions that are advisory or nonbinding in nature, and option for countries with little separation of legal and few agencies use contracting out to produce binding executive powers (Brown and others 2006). inputs into the decision-making process because the agencies are accountable by law for their decisions. A new regulatory agency should not be allowed to become a roadblock in the view of investors, utilities, and customers. An independent nongovernmental expert panel would In the Philippines, for example, an Energy Regulatory Board be a novel way to conduct periodic price reviews to was created during the initial reform stage to make shield regulatory decisions from political influence. regulation of the power sector more efficient and This approach is an extension of the concept of transparent. However, utilities used the right to judicial contracting out regulatory functions to private entities. review of the board's verdicts extensively, and the regulatory It has been used for a few long-term concession process became gridlocked. Instead of streamlining agreements in the water and sanitation sector, but not regulation, the new system made matters worse. so far in the power sector. It could be organized in one of three ways: Contracting out of specific tasks can help regulators improve their competence, autonomy, and legitimacy and, hence, their credibility in the following ways: See Stern and Cubin 2003 for a review of regulatory governance arrangements. 88 · The panel replaces the regulator for the periodic This form of "regulation by contract" limits the amount review of prices, and it is empowered to take binding of discretion that regulatory bodies have in setting prices decisions--subject, perhaps, to limited-scope appeal. and targets for key performance parameters in this situation. It is particularly suitable for the initial years-- · The panel gives a recommendation, without binding such as for the initial tariff-setting period of about five force, before the case goes to the regulator. years--of public-private partnerships where the private sector is investing substantial capital. Since this form is · The panel serves as an appeals body for a decision expected to transit into "normal regulation," the contract made by the regulator. should also specify the tariff principles that will be applied by the regulatory agency after the contract to reassure The concession agreement or the enabling law and investors initially at the time of negotiating the agreement. regulations should specify in detail the method of Governments may have a role in setting the initial terms appointing the expert panel to ensure true independence and conditions of key regulatory instruments, since they and high competence, the requirements for information are best established as an outcome of the transaction and reporting from the company, and the principles and process with private investors (Bakovic, Tenenbaum, rules governing the periodic review. The amount of and Woolf 2003). discretion given to the expert panel should be limited to ensuring that tariffs are set at a level sufficient to enable the Under regulation by contract, the discretion of the 86 service provider to meet specified service standards. Setting regulator is limited in areas that are known to deter these service standards, tariff structures, and the like should investment, while the autonomy of the regulator is used be the responsibility of the relevant public authority, not the to avoid uncertainties for investors. Such uncertainties expert panel (Shugart and Ballance 2005). arise from political micromanagement and changes of government or governmental policy. The objective is to 6.4 Regulation by Contract to Support a New define the tradeoffs between the regulatory objectives of Regulatory Regime protecting the interests of both consumers and investors. Hence, regulation by contract specifies in one or more Specific contractual arrangements may be needed to formal or explicit agreements the formulas and sustain private investment under a new regulatory procedures that determine the prices that a distribution regime. Private sector investors contend that a credible company will be allowed to charge for the electricity regulatory system requires more than a formally that it sells. These formulas can be based on either autonomous regulatory entity soon after it is created cost-of-service regulation or incentive regulation, (Bakovic, Tenenbaum, and Woolf 2003). This is because or sometimes a combination of both. The key component many regulatory agencies begin performing their functions of the contract is a performance-based, multiyear, tariff- with the disadvantage of limited autonomy and capacity. setting system. The development of robust regulatory frameworks and strong regulatory institutions can be hampered by a The credibility of regulation by contract requires that variety of constraints, in particular underfunding and the underlying principles and initial parameters of the reluctance by governments to transfer real autonomy in contracts should be clearly specified in the country's decision making to regulatory agencies, even when primary or secondary electricity legislation (as in Argentina, required to do so by law.89 Bolivia, Chile, and Peru). Regulation by contract is less likely to survive if the concession agreement is poorly The incorporation of regulatory procedures and rules specified or exists only within a stand-alone concession in concession agreements can provide stability and or license agreement with little clear support in national credibility during the transition to regulatory autonomy. laws (as in Brazil). Hence, the performance of regulation This is achieved by setting out details on important by contract has been variable in the power markets of terms, such as initial price controls, in the main regulatory developing countries. Regulation by contract has been instruments (licenses or contracts) or by having clear combined with autonomous or partially autonomous tariff-setting principles in the country's legislation. regulatory commissions in many Latin American countries, For example, it would be unreasonable to expect a new regulatory commission to close the gap between revenues and costs and rebalance 89 tariffs across classes as merely technical adjustments when its government had previously failed to tackle these issues because of political opposition. and this combination has generally been successful in Concessions under regulation by contract cannot inducing and sustaining private sector investment in absorb major economic shocks to the regulatory system. more than 60 privatizations of electricity distribution Long-term PPAs with IPPs and long-term contracts for systems.90 distribution concessions in Latin America have been highly vulnerable to exchange rate shocks--but neither Concessions for power distribution under regulation could any other regulatory system absorb such shocks. by contract resemble PPAs with IPPs for investments in Following the time that Argentina abandoned its power generation. This familiarity appeals to private Convertibility Law in December 2001, for example, investors. These concessions, however, are more difficult which led to a major devaluation, government overruled to negotiate and less able to be subjected to competitive the regulatory commitment under concession agreements bidding than PPAs, because of the large number of to allow pass-through of increased supply costs to retail customers, the high visibility of retail power prices, electricity tariffs. It was motivated by its desire to protect and the need for ongoing investments, as well as their the economic welfare of power consumers, but at basic monopolistic features.91 The experience in Argentina considerable cost to private investors in power with regulation by contract was similar to the pressure distribution. on IPPs from governments to lower the sale price of power under their long-term PPAs in East Asian countries following Robust and workable mechanisms for resolving disputes the 1997 financial crisis. Unlike concession agreements should be incorporated into concession agreements. under regulation by contract, however, PPAs and The possibility of contract reopening poses a major risk 87 concession agreements do not require an autonomous for investors in the highly politicized conditions found in regulator when these agreements specify the investments most developing countries. These countries don't have to be undertaken. a tradition of separation of legal and executive powers, nor do they have well-developed parliamentary and legal Risk allocation is a major design issue for regulation by systems. This limitation applies particularly when such contract, just as for PPAs and concessions. This concerns contracts involve many parties, investment in sunk which parties bear risks, especially risks from pass-through assets, and politically accountable governments that of power purchase costs, technical and nontechnical cannot or are unwilling to legally bind their successors. loss-reduction targets, foreign exchange fluctuations, Contract features that appeared to increase the incidence and obligation to supply. Under regulation by contract, of renegotiation of infrastructure concessions in Latin the parties to the concession act as agents for their America are awards based on the lowest tariff bid, principals, so it is the principals that bear these risks. investment requirements specified in the contract, The regulator acts for the electricity users served under price cap regulation (see the next section, 6.5), absence the contract, the government acts for the citizenry, and of a regulatory body, and the regulatory framework the management acts for the investors and shareholders embedded in the contract (Guash 2004). Alternative in the company that wins the contract. In addition, the dispute resolution mechanisms to going through local government sustains the credibility of the regulator's courts are often preferable, including international position (Stern and Holder 1999). arbitration. Regulation by contract is sustainable only if the underlying The presence of a regulatory agency allows for simpler economics to the concessions are viable. The concession contracts that are easier to monitor, enforce, and revise. agreement will not work if revenues are much less than In particular, the presence of a regulator operating costs. The gap must be closed by lowering costs or under a defined regulatory process helps deal with increasing revenues, or both. Investors must be protected, substantial renegotiations (Stern and Holder 1999). and the agreement might need to be combined with From this perspective, regulation and contracts are transition subsidies. Even in those countries where complements for network industries, rather than substitutes effective autonomous regulatory decision making has (Stern 2003). Renegotiation occurs because it is not been achieved, regulators are not likely to follow policies possible to write enforceable long-term contracts that that balance consumer and private investor interests can cover all necessary contingencies in a power market. where the financial, institutional, and technical performance Often events during the term of concessions lead to are poor at the outset, and the transition to commercial pressure to reopen them. Concession agreements may standards takes longer than expected. also set out the terms and conditions incompletely, See Guash 2004 for an extensive bibliography on experience with infrastructure concessions in Latin America. 90 See Littlechild 2002 for a review of issues and some experience with competitive bidding for long term distribution contracts. 91 which can lead to problems between the regulator and authentication required under cost-of-service and the investors early in the life of the concession, regulation. as has occurred in the case of the electricity distribution concessions in New Delhi (Agarwal, Alexander, and · Helps power suppliers to adapt to competition, if and Tenenbaum 2003). Moreover, governments often delegate when some or all of their markets are liberalized, their monitoring responsibilities to their regulator in the because it offers incentives similar to those that face case of distribution concessions (as in the Latin American firms in competitive markets. cases) because of the heavy monitoring workload when they have concluded many concession agreements. Incentive regulation that induces cost-minimizing Ideally, of course, avoidance of renegotiation should behavior by power suppliers yields large gains to the be the aim of contract design and the behavior of the most efficient suppliers, while cost-of-service regulation parties to the contract (Bell 2003). controls those gains, but creates weak incentives for minimizing costs. Incentive regulation is also appropriate 6.5 Incentive Regulation to Promote Efficiency for developing countries because of their generally weak capacity to audit the costs of power suppliers--which is Incentive regulation is designed to give suppliers critical to the effectiveness of cost-of-service regulation. incentives to behave as if they were subject to These suppliers can exploit their advantage over competition.92 It promotes innovation, cost containment, regulators in information about their costs by padding 88 and service tailored to the needs of power users, and it their allowable rates. allows regulators to reward suppliers for good performance and penalize them for poor performance. Power suppliers Cost-of-service regulation (or rate-of-return regulation) are given explicit financial and other incentives to achieve can be considered for countries where rules can be certain performance goals, as well as significant enforced but complex regulatory arrangements cannot discretion on how to achieve the goals. Performance be managed. Jamaica's environment suited this approach goals are typically to improve investment and operating by using highly precise binding contracts as the basis for efficiency or connect a target number of new consumers substantial private investment. However, the contract (Alexander and Harris 2001). This discretion is the main could not be written in the way that Chilean contracts distinction in principle between incentive regulation and are written (see below), because enforcing that type of old-style cost-of-service regulation.93 Another important contract would not be feasible in Jamaica's institutional distinction is that the link between suppliers' authorized environment. In this particular setting, cost-of-service prices and their realized operating costs are weaker regulation was the best that could be done for providing and less explicit under incentive regulation than under commitment, even though it is second best for efficiency cost-of-service regulation. when applied in a manner that increases risks to the profitability of investments.94 Incentive regulation is designed to offer the following advantages over cost-of-service regulation: Price cap regulation has emerged as the most popular form of incentive regulation.95 Incentive-based regulation · A stronger incentive to reduce costs, because the typically puts limits on prices by one of the following supplier keeps more of its gains under the weaker link means:96 indexation of tariffs to specific input costs between rates and costs. (for example, fuel); price index less x on regulated services; price capping for markets that could become · Lower costs of administering regulation plans, competitive in time; and yardstick competition for because these plans avoid the micromanagement of monopolistic functions--typically power distribution. the regulated entities and intensive data collection An incentive regulatory scheme typically specifies a Incentive regulation was first proposed during the 1980s for infrastructure sectors in the United Kingdom. In the United States, incentive 92 regulation is often called performance based regulation--see NARUC 2000 for a full description of performance-based regulation for distribution utilities. Cost-of-service regulation is sometimes called rate-of-return regulation. 93 In India, for example, electricity regulatory statutes for many states require annual reviews of tariffs, which poses the risk that regulators will 94 continually pass through to tariffs the benefits of investments that cut costs, and thus reduce the returns to these investments for the owners of distribution companies. Even in the United States, where cost-of-service regulation for electricity suppliers has prevailed since the early twentieth century, 28 electric 95 utilities (about 10 percent of the total number) were identified in a survey as being subject to incentive regulation (Sappington, Pfeifenberger, Hanser and Besheda 2001). A workable form of economically rigorous price regulation based on marginal costs has yet to be developed. 96 commitment period (such as five years) during which · If the regulator sets the productivity offset too low, the regulated company can adjust its rate as long as, the regulated firms can make super profits as they cut on average, its rates rise no faster than inflation less a costs, but at the risk of arousing public ire and productivity offset (the x in the price formula), which demands for price reductions, as occurred in England allows consumers to share in the productivity gains. and Wales during the years following privatization of A variant on this approach is to cap revenues, but this the electricity supply industry in the early 1990s. has the disadvantage for many developing countries of discouraging connections to new consumers because · The rate freeze form of incentive regulation, under more profits can be earned by increasing sales to existing which a company cannot change its rates during the consumers under the allowable growth in sales revenue.97 commitment period, is dangerous in the absence of provisions for pass-through of significant costs outside the In practice, the application of price cap regulation control of the regulated firms, especially in the presence has tended to incorporate aspects of cost-of-service of other factors unrelated to the implementation of regulation, and vice versa. This reflects differences in incentive regulation that provoke a crisis in the power outcomes between price cap forms of incentive regulation market, as shown dramatically in California in 2001 and the cost-of-service form of regulation, because price (Besant-Jones and Tenenbaum 2001). cap regulation focuses more on short-term operational efficiency, whereas cost-of-service regulation focuses more · In some cases of price cap regulation, regulators on long-term investment efficiency. Power distributors in have reacted to politically controversial high returns 89 Latin America have performed at a better level under price to investment earned by suppliers under price caps, cap regulation than under cost-of-service regulation. The by such means as periodically reviewing the level performance of distributors under regulation that combines of the cap.99 This has the disadvantage of creating elements of price cap regulation with elements of cost-of- unpredictability about returns on investment, thus service regulation lies between these levels. Under cost-of- indirectly raising the cost of capital for investment. service regulation, however, privately owned distributors are at most as efficient as publicly owned distributors (Estache Benchmarking involves comparison of a measure of and Rossi 2004). actual performance against a reference benchmark performance. The yardstick form of this approach can The policy and regulatory framework based on incentives be used to promote indirect competition among regulated should cover not only the entities targeted for privatization, firms operating in geographically separate markets, but also the entities that are likely to remain under state under which the performance of a regulated firm is ownership in the medium term, especially the natural compared against that of a group of comparable firms. monopoly segments. This principle applies even though The National Energy Commission in Chile was the first incentive regulation is based on the fundamental to apply this approach to its electricity distribution firms. assumption that the regulated entity responds to economic Benchmarking has been applied to many OECD incentives, such as those that increase profits if efficiency countries for electricity distribution, and to Argentina, targets are exceeded, yet publicly owned service providers Brazil, Chile, Colombia, El Salvador, Guatemala, generally do not respond strongly to economic incentives. Panama, and Peru in Latin America, as well as to the Indian State of Orissa among developing countries. Regulation by contract and regulation by benchmarking are designed to overcome difficulties in applying incentive Regulators have adopted a variety of benchmarking regulation.98 They can help address the following three methods and techniques in incentive regulation. types of problems that have been encountered under These approaches can be classified by whether the severely inadequate information about service costs benchmarks represent the best ("frontier") practice or (found in many developing countries): some measure of representative ("average") performance There are other variants to incentive regulation which are much less common than price cap regulation (see Jamasb and Pollitt 2001). 97 Benchmarking of power distribution and transmission utilities is reviewed in Council of European Energy Regulators 2005, Edvardsen and 98 Førsund 2003, Jamasb and Pollitt 2001, and Shuttleworth 1999. In the case of England and Wales, the incoming government in 1997 imposed windfall profits tax suppliers on the grounds that price caps had 99 not fully reflected the scope for cost reduction. (Jamasb and Pollitt 2001). The former focuses more grid supply. Otherwise regulation becomes unworkable, strongly on performance variations between firms, such as when using individual cost-of-service calculations and is suitable for the initial stages of regulatory for the 119 electricity cooperatives in the Philippines reform when a priority calls for improving performance. (Reich, Tenenbaum, and Torres 2006). Average benchmarking may be used to mimic competition among firms with relatively similar costs or when lack The Government of India has adopted a variant of of sufficient, reliable data and comparators prevents benchmarking to provide incentives for improving the application of frontier methods. performance of State Electricity Boards. Performance is measured and ranked on a series of indicators related Benchmarking is particularly useful for regulating small to improvements in transmission and distribution, off-grid power systems, particularly in its average form, installation of meters, and institutional reform, with less because it costs relatively little to administer under the emphasis on financial results. Simple and transparent wide variety of production technologies and local market measures are intended to make it easier to allocate characteristics found in these systems. Benchmarked cost resources according to true performance--rather than to levels will seldom be optimal, but this disadvantage is states that are politically better connected to the central often outweighed by ease of application. The essence of government--thus creating competition between states off-grid regulation should be light-handed with a focus and, it is hoped, incentives for innovation. Two ratings on lower but affordable service standards and fewer firms produced the first such ranking in 2003 90 regulatory requirements than applied to the main power (Tongia 2003).100 http://powermin.nic.in/report/Rating%20of%20State%20Power%20Sector-January%202003.pdf. 100 7. ACCESS AND AFFORDABILITY TO ELECTRICITY SERVICES OGN's Guidance on Access and Affordability to Electricity Services Improvements in access to electricity services do not automatically follow comprehensive reforms that generate increased resources for investment in system expansion. The cause--lack of access to credit, high connection costs, and affordability constraints--should first be diagnosed, and the findings should guide policies to address access and equity issues in the sector. Various regulatory and policy approaches have been tried to expand access and affordability. They include the use of connection or coverage targets in concession and license agreements, the obligation to offer service, liberalizing entry by other suppliers to unserved or underserved areas, allowing different levels of service for consumers, and the provision of subsidies for system expansion and consumption. Governments should also recognize that electricity may be appropriately provided by cooperatives or other community organizations operating minigrids or reselling power purchased from the grid or by private entrepreneurs offering solar home or battery recharging systems. In general, targeting subsidies at connections would be preferable to subsidizing consumption. Governments should 91 assess the extent to which proposed subsidy schemes would benefit the poor and whether there is sufficient fiscal space for these subsidies. Schemes that ensure competition for subsidies on the part of the service provider should reduce the fiscal burden. Cross-subsidies from other consumers can also be employed, but this approach should not unduly distort electricity prices or burden those consumers. Governments may seek to introduce new, local service providers into the rural electrification business to meet demand in areas currently not served by the incumbent(s). They should consider how best to deliver this support, and in particular whether it should be provided through such existing facilities as small and medium enterprise (SME) development windows and NGO-supported microfinance and business development entities. They should factor in the state of private sector and financial sector development when assessing the possibilities for SMEs or community-driven models in the power sector. Where subsidies are needed, they must be well targeted and based on a clear policy rationale, and include output- based aid (OBA) approaches, as well as more traditional input-based approaches. Power market reform entails a number of important 7.1 Context and Background social dimensions for the poor. These dimensions include the prices of electricity services, access to electricity services, Developing countries face major challenges to improve and quality of electricity services. Without access to services, access and affordability to electricity services for households other social aspects of power supply are irrelevant. on low incomes. These countries have responded to The higher power prices that have followed power market the challenges according to their income levels in the reform in many developing countries raise concerns following two main ways: about affordability for low-income households and the role of subsidies in the new power markets. Quality of · Some developing countries--generally in the middle- electricity service is closely linked to investment in supply income group--have met these challenges with some capacity needed to meet growing demand for power by success since the 1990s, partly by attracting private all types of power users, including low-income users investment. These countries have an extensive energy located on the margins of power grids and in areas not infrastructure and basic coverage service of electricity connected to these grids.101 services. This observation applies irrespective of the size of the power system. See World Bank and ESMAP 2000 for a review of issues and options for providing energy services for the poor. Surveys of the social impact of 101 power market reform in Brazil, Guatemala, Georgia, and India are reported in PA Government Services Inc. 2002. · Small low-income countries, such as those in Sub- hardest, since they cannot afford to repair damage to Saharan Africa, face low and stagnant growth in their electrical appliances caused by high voltage access to electricity. Their share of households fluctuations and power surges, nor purchase protection with access has sometimes even declined as their equipment. They experience long waits for utilities to population has grown faster than their power supply. restore service after local network failures and to rectify Their challenges are particularly daunting because inaccuracies in billing. Consumers on unauthorized typically less than 10 percent of the population is connections to the network are exploited by dishonest electrified, mostly in urban areas. utility employees for informal payments. Extending access to affordable modern energy services-- Households that can only afford to meet their basic including electricity services--for poor households is one needs sometimes prefer to receive electricity service of the most practicable ways of supporting their welfare.102 from informal vendors rather than from utilities. In many This is because expanding access--and therefore cases, this happens because these consumers expend consumption--of these services from the low levels found less on purchasing the small amounts of services in numerous developing countries helps to increase income that they can afford from vendors than they would and meet basic needs, such as improved health and by paying the relatively high fixed charges levied by primary education, as well as support social empowerment utilities to cover the high up-front costs of their networks. and environmental sustainability, and hence achieve the Vendors also deliver services--such as recharging 92 Millennium Development Goals (U.N.-Energy 2005).103 12-volt batteries for lighting and radios--directly to The cost of these services to users is often considerably households where the formal network does not extend lower than the corresponding traditional energy alternatives to their communities. used by poor households without access to these services.104 Many governments actively discourage informal electricity Households that are not connected to electricity supply distributors that serve many off-grid communities around are generally poor. The main reason is that the access the world. These distributors may be illegal where the charges levied by power utilities amount to the equivalent incumbent utility has an exclusive franchise. They lack of many months of the low incomes of these households, access to subsidies and to the capital markets. They may especially for residential premises situated far from the be disadvantaged by regulatory provisions suited to electricity grid. In addition, the premises occupied by formal network providers because they create public many poor households are precluded from connection hazards, high unit costs, low service quality, and harmful to public electricity supply because they are too poorly fumes from generators. Small operators may also form constructed to be safe for electrical wiring. Households cartels and charge exorbitant prices to consumers. may also experience long waits to obtain new connections Nevertheless, in many countries informal providers are to electricity service from poorly performing utilities needed because services from the network operators are and face demands for informal payments from utility too expensive for poor areas, or the operators take too employees to get connections. Their multifamily long to expand service. dwellings create uncertainty about liability for payments that deters traditional utilities from serving them. Most of the poor in developing countries--especially Finally, householders without formal title to the land the rural poor--tend to be avoided by private operators they occupy face legal obstacles to obtaining electricity and have benefited little from private capital flows into service from utilities. developing country electric power sectors. One reason is because the poor do not have access to public electricity Low-income households that are connected to electricity supply, and lack of access is far more prevalent in rural supply also suffer from low-quality technical and customer areas than in urban areas.105 Another reason is that private service. Low quality of power supply hits these households operators are reluctant to serve low-income clients Access for a household to electricity services from a public supplier encompasses a connection from a local distribution network to the place of 102 residence and a legally valid agreement between the supplier and the householder for the supply of electricity services. Low access rates are examined in chapter 3. 103 Households in Guatemala without electricity, for example, pay implicit prices of more than US$11 per kWh (more than 80 times the price of 104 electricity) for lighting with candles and wick lamps and to power appliances with dry cell batteries (Foster and Araujo 2004). Four out of five people without access to electricity live in rural areas of the developing world, mainly in South Asia and Sub-Saharan Africa. 105 Globally about 1.6 billion people lack electric power (IEA 2002b). In Sub-Saharan Africa only 8 percent of the rural population has access to electricity, compared with 51 percent of the urban population. In South Asia only 30 percent of the rural population has access, compared with 68 percent of the urban population. because these markets are not financially viable on a 7.2 Reform Policies for Improving Access and freestanding basis.106 Investment and operating costs Affordability of rural energy projects are high relative to revenue potential, making returns unattractive to private investors. The impact of reform to power markets on the affordability Meanwhile, few private rural energy and renewable energy of electricity for the poor has been a recurring issue. investments have been commercially viable or competitive This is because of concerns that reform will unwind with investment opportunities in the generation subsector subsidies in power tariffs for poor households under (World Bank 2003b). policies that enable electricity service providers to recover their costs through user fees or subsidies. Unless efforts are targeted at urban areas, as well as This issue has been studied for many countries.108 rural areas, much of the urban poor will not gain in Power market reforms designed and implemented by access to electricity (Saghir 2005). Poor areas-- technical groups working at the national level, for example, especially slums and shantytowns--in many large allow users little say in the design and delivery of electricity cities have been virtually abandoned by the traditional services and can end up hurting--rather than benefiting-- electricity service providers because their staff are reluctant the poor. to enter these areas, particularly those areas that are known for their violent crime. Moreover, a large proportion Power market reform in developing countries is of the growth in low-income households requiring access generally perceived as providing limited support to is expected to be in urban markets, since much of the poverty alleviation (Estache, Gómez-Lobo, and Leipziger 93 population increase in developing countries will occur in 2001; Wamukonya 2003). The main factors behind urban areas, partly caused by migration from rural this perception are outlined in chapter 3. The focus on areas.107 Fast population growth, rapid urbanization, commercial performance by power suppliers that comes and rising demand for electricity are overloading supply with reform is also viewed as detrimental to the interests capacity and creating strong demand for new investment. of the poor because this focus reduces the scope for addressing social objectives through cross-subsidies Extending electricity service to the urban low-income from better-off consumers to poor consumers. This view households requires improvement to the existing power would not be valid, however, in a well-conceived reform system. Since power service providers in most urban program, because reform offers the opportunity to introduce areas are already serving better-off populations, new ways for expanding access to electricity supply by the they face modest demands for new capital investment-- poor, and it also helps target subsidies efficiently on the such as extending the grid to new periurban areas-- poor in place of current approaches that largely favor relative to the cost of extending supply to rural areas. the better-off consumers. Indirectly, reform should also Even with lower connection costs and higher incomes help the poor by allowing governments to redirect fiscal relative to rural areas, though, many urban low-income resources from supporting power utilities to expanding households cannot afford the connection charges or social programs that benefit the poor. monthly rates for electricity. Reforms can produce services that are better matched to Policies for reforming urban power markets should the needs and ability to pay of low-income households. consider the impacts on access and affordability in These services can emerge from making a power utility rural electricity markets. Despite differences in economic adopt commercial objectives or by allowing alternative characteristics, these two markets are usually linked-- suppliers to create new delivery mechanisms. The challenge in some cases physically, as well as technically, is to discover an appropriate price-quality combination institutionally, and economically. Many rural areas are by offering service options to these consumers that lie supplied from the national power grid and are subsidized between a high-quality service offered by a utility that is from urban power markets. In these cases, scalable models too expensive for low-income households or not available for improving rural service provision can work only by to them at all, and a low-cost service offered by informal improving the overall governance and management of suppliers but whose low quality imposes other costs or the national power sector. In Bolivia, for example, coverage of access to power supply did not change much in rural areas but grew in urban areas during the decade 106 following power sector reform (Bojanic and Krakowski 2003). World Urbanization Prospects: The 2001 Revision, United Nations Department of Economic and Social Affairs--Population Division. 107 For example, see Dodonov, Opitz, and Pfaffenberger 2004, Fankhauser and Tepic 2005, Freund and Wallich 1995, and IPA Energy Consulting 108 2003 for countries in Eastern Europe; McKenzie and Mukherjee 2003 for Latin America; and Monari 2002 for India. limits the benefits to these consumers. One option, for 7.3 Removing Regulatory and Institutional example, involves trading off fewer hours of electricity Constraints on Electricity Services supply at a steady frequency for a lower price. The causes of poor electricity access and service for Power market reform provides an opportunity to rectify low-income households originate in regulatory and the policy and regulatory constraints on electricity access institutional constraints: and service for low-income households by overcoming entrenched attitudes to providing electricity services and · Institutional arrangements may impede the flow of developing different kinds of service. Opening up the private finance to the power sector and discourage main power market to new entrants can stimulate innovation in service delivery methods. In many incentives specifically designed to attract new entrants countries, for example, it is illegal for local private or into markets serving poor areas. The establishment of a cooperative generation and distribution enterprises to new regulatory system for the main power market enter the power market. provides an opportunity to introduce regulations that specifically help the poor. Reforms that place the power · Regulatory frameworks often raise the biggest barriers sector on a sound commercial footing, however, will not to decentralized options for electricity supply, including automatically improve access and affordability of barriers to alternative power technologies for locations electricity services to low-income households. They may not served by electricity and fuel distribution networks. 94 make little difference to this situation, or even worsen it. It is important to ensure that reforms do not adversely Setting up efficient regulatory and institutional structures impact access and affordability. The ways in which is an essential part of supporting electricity services for market reforms can impact access and affordability to low-income households. electricity services are shown in table 10. TABLE 10. Impacts on Access and Affordability of Different Types of Utility Reform PUBLIC MARKET PRIVATE SECTOR REGULATORY MARKET REFORM PARTICIPATION REFORM RESTRUCTURING Price of service Prices may adjust Prices should adjust Prices should adjust Prices should fall toward efficient cost toward efficient cost toward efficient cost because of reflective levels. reflective levels. reflective levels. competitive pressures. Quality of service Quality may improve Quality may improve Quality should Quality should because of better because of better improve because of improve as a result management. management. increased oversight of competition. and accountability. Access to service Access may improve Access may improve Access should Access should because of improved because of improved improve because of improve as new finances. finances. increased oversight providers widen and accountability. consumer choice. Fiscal flows Subsidies to the sector Subsidies to the Subsidies to the Entry fees may may be reduced. sector should be sector should be generate revenues, reduced, and tax reduced as tariffs and tax revenues revenues from the converge to cost should increase. sector may increase. reflective levels. Note: May indicates possible impact; should indicates probable impact. Source: Adapted from Foster, Tiongson, and Laderchi 2005. Regulation of Electricity Markets Serving Low- · Set affordable service standards for rural customers-- Income Users covering distribution codes and standards for service quality, customer metering, and enforcement of Electricity regulators have an important role in protecting disconnections. the interests of poor consumers. They perform this role by promulgating service standards, guidelines, and codes · Allow rival technologies to be selected on the basis of of practice for electricity service. Many regulators of power their economic merits without discrimination through markets have not issued these standards and codes, barriers for entry to markets. with such exceptions as the state energy regulator for Andhra Pradesh in India.109 They need to find the right · Apply wheeling charges and fair terms for providing balance between protecting the commercial interests backup support from the grid that facilitate the of the electricity service providers and the social interests creation of multivillage power systems as an of consumers. In the case of protecting poor consumers, alternative to power supply from the main grid this may not be achievable without funding arranged by operator. government. The license conditions for distributors in some South American countries also spell out these · Encourage participatory approaches to rural standards and codes in some detail. electrification to improve interaction between the electricity service providers and rural consumers. The regulatory system for rural electrification should not 95 simply mimic the regulatory system for existing urban · Lighten the information and reporting requirements distribution systems. This is because of large differences imposed on service providers. in market characteristics, especially lower load densities and higher supply costs in rural areas. The following Regulation of off-grid electrification providers should regulatory measures help create a business environment be treated specifically for three reasons. First, off-grid conducive to private sector participation and investment electrification will become more important because many in rural electrification: of the communities and households that have yet to be electrified are in relatively isolated locations for which · Ensure that rural service providers face sensible incentives off-grid electrification is the economically rational choice. for supply under tariff reforms. Such incentives may Second, the regulatory issues associated with off-grid include deregulation of retail prices to facilitate entry electrification have received little attention in the general by suppliers to rural service areas in the absence of literature of power sector regulation. Third, a poorly public funding. designed or implemented regulatory system can destroy an electrification initiative, often by imposing too much · Focus regulation on the price at which bulk service or regulation, even for a commercially viable business model. network access is provided to competing providers. The traditional strategy of one national electricity regulator · Add an antitrust or competition law element to "doing it all" is often not sensible for enterprises that regulation, or issue nonexclusive licenses to prevent provide off-grid electrical services. Successful electrification providers that have a dominant position in a market requires that the traditional regulatory functions and from using that position to prevent competition in that tasks are often best performed by entities other than the or related markets. national electricity regulator. Nontraditional regulatory techniques need to be developed and implemented for · Simplify legal mechanisms for extending electricity different forms of electrification. Four basic regulatory service to unserved or poorly served customers to principles are presented in box 22 for designing and reduce the legal barriers to entry to a rural electricity implementing regulatory systems that promote electrification market. in ways that maximize benefits and minimize costs (Reiche, Tenenbaum, and Torres 2006). The Andhra Pradesh Energy Regulatory Commission's order Regulation No. 6 Standards of Performance in Connection with Electricity Supply 109 to Consumers, issued in the AP Gazette of September 4, 2000, covers: restoration of supply in the event of power outage, quality of power supply, period of scheduled outage, complaints about meters, applications for new connections or additional load, paying off accumulated dues by customers, disconnecting seriously delinquent payers, and complaints about consumer's bills. BOX 22. Regulatory Principles for Promoting Off-Grid Electrification The following four basic regulatory principles provide guidance for designing and implementing regulatory systems that promote electrification in ways that maximize benefits and minimize costs. Principle 1: Adopt light-handed and simplified regulation--especially for off-grid electrification. This principle embodies the concept that a well functioning regulatory system is one that minimizes the costs of regulation for service providers and hence avoids undermining their commercial viability. Principle 2: The national or regional regulator should be allowed (or required) to temporarily or permanently "contract out" or delegate regulatory tasks to other governmental and nongovernmental organizations. Although it may be legally necessary for the national or regional regulatory to have final formal responsibility over all entities within a country that provide electrical services to consumers, it does not logically follow that the regulator should be required to perform all regulatory functions and tasks. It is often more efficient for the regulator to "delegate" or "contract out" traditional regulatory functions for entities that are providing off-grid electrical service. These functions can be delegated to a functioning rural electrification agency or rural electrification fund. Principle 3: The regulator should be allowed to vary the nature of its regulation depending on the entity that is being regulated. A regulator should be allowed to vary its methods of regulation depending on the type of entity that is being regulated, rather than adopt a "one-size-fits-all" view of grid versus off-grid electrification that risks 96 unnecessary disputes about what the regulator can or cannot do under the existing statute. The electricity or regulatory law should be written (or amended) to give the regulator explicit authority to vary its regulatory rules and procedures (concessions vs. licenses vs. permits) depending on the nature of the entity that is being regulated (small vs. large, grid vs. off-grid, private vs. community based). Principle 4: Quality of service standards must be realistic, affordable, monitorable, and enforceable. Quality of service standards need not be uniform across all customer categories or geographic areas. Instead, standards should be based on customers' preferences and their willingness to pay for the costs of providing the specified level of quality. In the absence of subsidies, quality-of-service standards should not be imposed on an operator unless its customers are willing and able to pay for the costs associated with meeting the standards. This is of special import in remote off-grid markets, where users requirements can vary greatly and many households will be happy to get a lower service level (for example, more frequent short power outages) for less money, as long as that service level is clearly defined ex ante­ideally chosen from a menu of options. Source: Reiche, Tenenbaum, and Torres 2006. Institutional Reforms for Supporting Access and Where this is not feasible, as is the case in many Affordability places, the policy choice is whether to subsidize capital costs for extending national power grids to Extending access to electricity for rural households rural areas or for developing off-grid solutions. often involves creating the entire energy infrastructure network and developing viable new electricity service The interests of low-income consumers should be providers. Rural areas often lack any infrastructure for specifically represented on policy bodies for the providing energy services--whether electricity or other power sector. Otherwise these consumers tend to modern forms of energy. The remote locations and be outweighed by pressure from politically well- low density of demand raise the costs of electrification organized and influential consumer groups who to unaffordable levels for many rural users. This lack benefit from preferential services and low tariffs. of affordability challenges business models for rural NGOs that specialize in consumer protection have electricity supply that are economically sustainable and sprung up in various countries, such as India, and financially replicable. Policies are needed for reducing consumer watchdog organizations exist in many the capital and operating costs of supplying electricity countries to monitor issues that affect consumer services to affordable levels for rural households. interests generally. Nevertheless, consumer representation is usually limited to the likes of regulatory In the Republic of Yemen, for example, electricity use in advisory councils, where they exert little influence over rural areas is high compared to other middle-income major policy issues. countries because small-scale electricity providers supply rural towns and villages not served by the public utility. Meeting the major specific challenges of expanding These providers range from individual households that electricity services--as part of wider energy services-- generate for their own use and to supply a few to rural areas usually requires dedicated institutional neighbors, to larger operators supplying up to 200 arrangements. A common problem for meeting this households using diesel generators (Ehrhardt 2000). challenge is dispersion of responsibilities for rural electrification among numerous ministries and agencies, Decentralized generation can be incorporated into in which rural electrification needs receive little attention the rural energy service company model. It can among the demands of mainstream energy sectors. augment power supply, provide voltage support, Hence, an interministerial or interdisciplinary mechanism and reduce energy losses in the transmission network. supported by a dedicated agency is required that can Decentralized generation by the private sector has tackle the essentially local nature of many challenges for expanded significantly in many countries, largely with delivering electricity services in rural areas. This institutional financial assistance provided through local institutions. arrangement is important for formulating policies for It has grown in the power deficit situations that many rural electrification, such as for the roles of public and developing countries face, where expanding grid private sectors, incentives and subsidies, appropriate connections is of little value because the available bulk 97 quality standards, and prioritizing the areas covered by power supply cannot fully meet the demand on the power these policies (Barnes 2005).110 grid. The smaller niche market­based and community- based systems are applicable for remote areas where New entrants can bring many advantages to serving the small village-level, minigrid systems are powered by electricity needs of low-income households: microhydro or diesel generation, or both, as in Nepal. Private companies and suppliers would be best suited · They can increase the available range of service to provide individual solar photovoltaic (PV) systems, options. possibly with sales and maintenance support provided through a local NGO. · They may be able to provide a "basic needs" level of service more cheaply than formal network operators. Opening the electricity markets to new service providers involves the development of private, · They may offer cost-quality combinations better suited community, or cooperative distribution companies to poor people's willingness to pay. that are responsive to consumers. Some approaches to attracting new entrants have had some success, · They may offer innovative tariff and payment systems including the dealer model, the concession model, that enable low-income households to access service. and the retailer model (box 23). Under these approaches, suppliers can provide a range of services besides power · They are only likely to flourish if they provide a better supply, including metering and billing, rehabilitation and service than the incumbent's service to electricity maintenance, system improvement, quality improvement, consumers, or if they serve areas that do not receive and demand-side management. Approaches should be service from the incumbent utility. selected according to their potential for widespread adoption in the specific circumstances of a country, · They are more likely to encourage more of the given the prevailing constraints from financing for population to connect to their systems, involve local subsidies, technical assistance inputs, and the pace of leaders in the collection of bills to lower costs, provide overall market reform. flat rates for minimum service, and develop lower-cost systems to provide service to consumers who have low demand for electricity. This referenced document--Barnes, Douglas F. (ed). 2005. Meeting the Challenge of Rural Electrification in Developing Nations: The Experience 110 of Successful Programs--has case studies of rural electrification programs in the following developing countries: Bangladesh, Chile, China, Costa Rica, Mexico, the Philippines, Thailand, and Tunisia. BOX 23. Three Models for Attracting New Electricity Service Providers The dealer model centers on developing dealers that can sell equipment (such as solar PV systems) to people living far from the grid. Many countries already have retailers that serve rural areas, but they are typically weak and undercapitalized, and they serve limited territories. Kenya has a robust solar PV market (EAA, RAEL, and ERG 1999). Programs based on this model have tried various ways to strengthen dealer networks, with mixed results. In Indonesia such a program failed in part because it was implemented just before the financial crisis, although it had become evident that participating retailers preferred to sell PV systems for cash rather than providing them on a lend-lease basis. In Sri Lanka a project started out successfully, but multinational companies soon took over the local retailers. The concession model is aimed at minimizing subsidies and encouraging private sector participation. The model depends on regulation by contract of large-scale competitive licensees or sublicensees more than by market forces, but it helps to ensure that projects achieve scale economies. In Argentina and Chile, for example, competitive bidding is used to award franchise rights for rural service territories to concessionaires providing service for the lowest subsidy. Concessionaires can choose from a range of off-grid technologies, although PV systems are expected to be the most cost-effective choice in many cases. Users pay a connection fee and monthly service tariff (set by the government), and the government pays the concessionaires a declining subsidy determined by their contract (Jadresic 2000). The retailer model involves a decentralized approach to providing electricity to households without access to grid service. Variations include rural electric cooperatives and competitive licensees (rural energy service companies), 98 models based on various small market service providers, and various community-based models. A community, organization, or entrepreneur develops a business plan for meeting local demand for electricity, and then submits the plan to a project committee. If the committee approves the plan, it grants a loan or subsidy for developing the business. The retailer uses a fee-for-service arrangement to recover costs, repay the loan, and earn a profit. This approach ensures significant local involvement and consumer choice. Source: Saghir 2005. 7.3 Financial Viability and Affordability Reducing Service Costs The financial viability of electricity service providers is Low-cost services should be emphasized in policies for essential for the sustainability of affordable services to providing electricity services to low-income households. low-income households. Market segments serving low- These policies should support technologies for low-cost income consumers raise important issues for viability electricity generation and distribution. They should allow that need to be considered under reforms to the power some flexibility in regulated service standards, since the market as a whole. These issues cover delivery costs, levels of electricity service applied to the main power service prices, and subsidies. markets are generally unaffordable for low-income households. Special programs for service delivery can Unless electricity can be produced and delivered more be developed to cater to their needs by adopting lower cheaply than presently, it can be unaffordable without construction and supply reliability standards, so as to subsidies for many low-income households. The costs reduce the costs of extending access and delivering services that matter are not only the unit energy costs, but also without compromising safety and environmental standards. the costs of extending the network into an urban slum, for example, or to a rural town. The low demand for Connection costs can be reduced by exploiting cost- services would raise tariffs--including access charges-- effective technical designs and the scope for reducing to recover the costs of extending a power network to the construction costs of rural networks. In many cases, unaffordable levels for low-income households and as in South Africa, careful attention to system design small or isolated communities. As a result, these users reduces construction costs by up to 30 percent, benefit from power market reform that brings down contributing significantly to the pace and scope of rural the average cost of extending power networks in urban electrification. Adopting urban system design standards and periurban areas and spurs alternative solutions-- for the electrification of rural areas has led to the poor including minigrid services--for rural areas (Powell and service, high losses, and low collection efficiency facing Starks 2000). the power sector. For example, low-hanging bare conductors on low-tension lines facilitate energy theft by New entrants may also offer innovative tariff and unauthorized connections to the lines, old meters are payment mechanisms more suited to the services easily tampered with, and low voltage levels over long demanded by low-income households. These entrants lines create large line losses of energy. are more likely than power utilities to charge flat rates for their services without imposing periodic fixed charges. The following policy instruments are available for This enables low-income households to match the amounts promoting access to electricity services by low-income of electricity purchased according to changes in their households: actual cash incomes and other expenditures. Informal providers are also more likely to design payment · Instruments that require service providers to extend mechanisms that can accommodate noncash transactions access--universal service obligation and connection for the poor who operate outside the traditional cash or coverage targets in concession and license economy and engage in bartering activities to meet agreements--in order to overcome a reluctance to their needs. serve customers whose business is not commercially attractive to service providers. Even incumbent power utilities can be pushed under regulatory pressure to implement flexible payment · Instruments that increase supply options under mechanisms suited to the poor. These utilities are often restrictions on alternative ways to provide services unwilling to provide service to predominantly poor areas under privatization when connection to the public because of the risk of nonpayment. Their periodic bills 99 network is mandatory--broader service obligations, for accumulated consumption tend to strain the cash licensed entry to unserved or underserved areas of resources of low-income households. Prepayment alternative service providers, and promotion of mechanisms increase payment security to the service partnerships between utilities and alternative service provider and ease budgeting by low-income households. providers. Prepayment meters and cards have been widely adopted, for example, in South Africa (Tewari and Shah 2003). · Instruments that reduce connection costs using the Another example is the recharging for a fee at privately private cost of capital for financing network expansion-- operated charging facilities of 12-volt batteries used for lower-cost technologies, labor contributions in kind, electricity supply in many African households. For credit lines, connection subsidies, and connection customers with low and variable cash incomes, these cross-subsidies. advantages offset the disadvantages of higher unit costs and lower payment convenience relative to grid-based These instruments have the advantages and electricity supply. disadvantages summarized in table 11. Appropriate services to low-income households can be Designing Appropriate Tariffs provided through nonstandard service delivery mechanisms, service types, and tariff and payment mechanisms. Well-designed tariffs can lower customers' bills while This requirement arises from geographical features, increasing the service provider's profits. Such tariffs economic capabilities, social patterns, and land tenure cover pricing for specific service quality standards and arrangements. Traditional power utilities, however, tend the payment arrangements for electricity. Where necessary, to have a one-size-fits-all approach to service standards they also incorporate subsidies provided through service and charging. Few utility managers have much contact providers. Well-designed tariffs allow consumers to choose with poor areas or a real understanding of the needs of tariff options that best meet their specific demands. potential customers there. Private sector participation in For example, a customer could choose to pay a lower utility management can help, but it may not overcome monthly fee, but a higher per-unit charge, or to pay a the tendency to ignore poor and marginal areas. higher monthly fixed fee and a lower per-unit charge. Monopoly providers seldom offer such services because The following policy instruments are available for jointly they do not face market risk. This practice is common, promoting the financial viability of service providers and however, in competitive markets for other goods and the affordability of electricity by low-income households: services, such as telecommunications. TABLE 11. Policy Instruments for Promoting Access to Electricity Services INSTRUMENT ADVANTAGES DISADVANTAGES INSTRUMENTS THAT REQUIRE OPERATORS TO PROVIDE ACCESS Universal service obligation Provides a legal obligation to serve The obligation is rather vague and may not be all customers, including those that meaningful if poor customers cannot afford may not be commercially attractive. connection charges or if others live far from existing networks. Connection targets Forces a concrete definition of Requires users to accept an obligation to connect. realistic coverage targets, ensuring Affordability of connection charges can be an that unprofitable customers are issue. served. Can be monitored and enforced by use of financial penalties. 100 INSTRUMENTS THAT INCREASE SUPPLY OPTIONS Broader service obligations Ensures that an alternative is Poor households prefer private connections. available for households that are Communal supply points tend to be unprofitable. not able to connect to the network. Licensed entry of alternative Provides choice to consumers. May make investment unattractive to utility. providers Increases competitive pressures on Difficult to regulate small suppliers for adequate the dominant utility. quality of service. Promotion of partnerships Improves supply quality to May be difficult to achieve collaboration between communities lacking utility the formal and informal sectors. connections. Reduces utility commercial risk from serving marginal communities. INSTRUMENTS THAT REDUCE CONNECTION COSTS Labor contributions Allows households to contribute There may be significant costs in training and their time rather than money. supervising community volunteer labor. Reduces external financing requirement. Credit lines Addresses what is sometimes the Provided by private operator could lead to real underlying problem--credit increased risk exposure. Requires collaboration of constraints--rather than absolute microcredit institutions. affordability of access. Source: Derived from Estache, Foster, and Wodon 2003. · Instruments that facilitate payment of bills by low- electricity usage more affordable, but they have often income households arising from requirements to applied this policy indiscriminately by failing to ascertain improve revenue collections--billing frequency and whether electricity rates are really unaffordable to low- prepayment devices. income households.112 They have also applied this policy regressively when the richest users received a large share · Instruments that protect low-income households of this subsidy because they consume the most electricity. from increases in costs of service arising from more Under some tariff structures, the average payment per demanding quality-of-service standards--different kilowatt-hour of electricity by rich users is actually lower levels of service for consumers and consumption than the payment by poor users. Moreover, subsidies are limiting devices. generally ineffective in many developing countries where chronic power shortages reduce consumption by subsidized The advantages and disadvantages of these instruments users to well below their needs. In these countries, are summarized in table 12. power rationing tends to reflect the greater political influence of better-off consumers by favoring the areas Subsidizing Electricity Services to Low-Income that serve them at the expense of low-income areas. Households Generally, therefore, the substantial empirical evidence questions the effectiveness of many subsidy schemes as Governments have traditionally subsidized electricity a means of helping low-income electricity consumers rates as a means of income support for the poor.111 (Komives and others 2005). 101 They have usually chosen below-cost tariffs to make TABLE 12. Policy Instruments for Promoting Affordability of Electricity Services INSTRUMENT ADVANTAGES DISADVANTAGES INSTRUMENTS THAT FACILITATE PAYMENT OF BILLS BY LOW-INCOME HOUSEHOLDS Billing frequency Facilitates budgeting for low- Increases administrative costs of revenue income households. collection, but may improve revenue collection rates. Prepayment devices Facilitates budgeting for low- May lead to "self-disconnection." May be costly income households. and subject to fraud. Requires the creation of a network for selling "smart cards" if electronic technology is used. INSTRUMENTS THAT PROTECT LOW-INCOME HOUSEHOLDS FROM INCREASES IN THE COSTS OF SERVICE Different levels of service Allows consumers to choose their May not always be technologically possible to preferred balance between the cost differentiate quality of service provided through a and quality of service. common network. Consumption limiting Prevents low-income households May lead to hardship if basic needs exceed devices from consuming beyond their imposed consumption ceiling. Required metering means. technology may be too expensive. Runs against the private operator's commercial incentives. Source: Derived from Estache, Foster, and Wodon 2003. The countries of the former Soviet Union subsidized electricity tariffs as rewards for acts of bravery, patriotism or other achievements. 111 These subsidies were also given to victims of disasters (such as at Chernobyl nuclear power station), war veterans, old age pensioners and others. In some countries, such privileged tariffs applied to more than 50 percent of the population (Krishnaswamy and Stuggins 2003). Ascertaining the affordability of electricity rates for low-income households should usually be carried out at the local level, since the necessary 112 understanding of the consumption characteristics of these households is seldom found in national institutions. Governments have also subsidized connection charges households to afford a limited amount of electricity to help low-income households gain access to electricity consumption when electricity tariffs are increased toward services. This is a better policy than subsidizing the cost-recovery levels under reform. Subsidizing the cost of operating costs of service providers, because the latter bulk power to privately managed distributors in situations are poorly targeted at the intended beneficiaries. where revenues fall below the full cost of supply-- The initial connection charges demanded by power utilities including financing costs--can ameliorate tariff increases are often a greater barrier to obtaining electricity service for low-income households, but only regressively since for households than monthly electricity bills. These charges most of this subsidy goes to other electricity consumers. can be reduced through subsidies, such as a preset Governments should provide financial support for payment per connection to a private investor, to meet subsidies that it requires, as shown by experiences in two annual targets of new connections to the power system Indian states.114 under rural distribution concessions, as in Guatemala (Economic Consulting Associates and Mercados The following instruments are available for implementing Energéticos 2002a; Foster and Araujo 2004).113 These these subsidy policies. Their advantages and charges can also be spread over several years without disadvantages are summarized in table 13. subsidies as a surcharge on the recurrent costs of electricity, where the need is to correct for a weakness in financial · Instruments that help low-income households gain markets rather than to overcome constraints on access to electricity services. 102 affordability. These practices allow larger numbers of low-income rural households to pay for the low levels · Instruments that protect low-income households from of electricity consumption that they value highly. general increases in tariffs arising from cost recovery requirements and removal of major cross-subsidies-- Well-designed subsidies can be used to attract private lifeline tariffs, targeted tariff discounts, vouchers, and sector participation through concessions and asset sales. tariff rebalancing. A "good" subsidy scheme is one that enhances access for low-income households while sustaining incentives The design of subsidies to help low-income users may for efficient delivery and consumption, as well as being be enhanced by a number of considerations when practicable within the financial and administrative implementing power market reform: capacities of the subsidy provider--usually the government (Barnes and Halpern 2000). They meet the three criteria · Subsidies should not be incompatible with of efficiency, equity, and effectiveness. They are efficient commercialization of power supply. They should because they maximize the social (or economic) benefits therefore be transparent to show their full cost to the relative to the opportunity costs of the subsidies. parties that benefit from them and to those that They are equitable because they reach the poor people finance them. that do not have electricity service, rather than better-off people that can afford to pay the full cost of services. · Subsidies should be well targeted so that users who And they are effective because they deliver sustainable really need them receive subsidies while improving the support to the intended population (Barnes 2005). affordability of the total subsidy. There are practical issues for designing targeting mechanisms where affordability is Electricity services for the poor generally meet the a binding constraint on providing electricity services to economic criteria of suitability for subsidies. low-income households (Komives and others 2005). Subsidies for extending access meet these criteria better For example, a "lifeline rate" should be available only than subsidies for consumption. Even under successful to users of small amounts of electricity (since this reform, low-income households need help with financing class of users is a fairly reliable proxy for low-income the costs of connecting their premises to the network households). General subsidies for electricity use could and installing meters at the points of consumption. impose unsustainable burdens on financial resources. Lifeline rates serve a social purpose by enabling these See Economic Consulting Associates and Mercados Energéticos S.A. (2002b) for lessons from the private provision of rural electrification in 113 Southeast Asia--Cambodia, Laos, and Vietnam. The government of Andhra Pradesh provides a good example of implementing this policy, but the government of Orissa did not provide 114 subventions to cover subsidies and also blocked tariff increases needed to cover deficits, thus undermining the willingness of the private owners to undertaken critical investments for improving services (chapter 4). TABLE 13. Subsidy Instruments for Helping Low-Income Electricity Consumers INSTRUMENT ADVANTAGES DISADVANTAGES INSTRUMENTS THAT HELP LOW-INCOME HOUSEHOLDS GAIN ACCESS TO ELECTRICITY SERVICES Connection subsidies Targets subsidy funds to low- Requires government finance and is relatively income individuals with low costly per household connected. User cofinancing administrative costs. Costs of should be required to ensure commitment. community-level subsidies can be kept down by competitive bidding. Connection cross-subsidies Does not require external source of Requires the unconnected population to be small funding and spreads cost over a relative to the connected population. The large connected population (often connected population may be unwilling to with greater ability to pay than the shoulder the subsidy. unconnected population). INSTRUMENTS THAT PROTECT LOW-INCOME HOUSEHOLDS FROM GENERAL TARIFF INCREASES Lifeline tariffs Entails minimal administrative Based on the questionable assumption that poor 103 costs. customers are small consumers, because of large families, shared dwellings, and reliance on secondary retailing (sales between neighbors). Targeted tariff discounts May provide a more reliable way of It is difficult to find good targeting variables, and identifying low-income households. administrative costs may be significant. May be difficult to raise subsidy or cross-subsidy funds. Vouchers May provide a reliable way of May be administratively complex and open to identifying low-income households. abuse. Remains difficult to identify good targeting Adds flexibility for user to select variables and raise fiscal funds. service provider. Low-income customers can be commercially attractive. Tariff rebalancing Reduces burden of fixed costs on The overall impact on affordability may not be small consumers. large Utilities may need to cover fixed costs of billing. Source: Derived from Estache, Foster, and Wodon 2003. · Subsidies and taxes should avoid undermining · Subsidies should be targeted to make access more electricity service markets by favoring one fuel over affordable in ways that bring down the one-off fixed another, giving consumers distorted price signals, or costs associated with electricity consumption, rather creating disincentives for entrepreneurial solutions to than the recurring costs of electricity consumption. electricity supply. BOX 24. Output-Based Aid Output-based aid (OBA) is a form of output-based mechanism for supporting the delivery of basic services that warrant some degree of subsidy to address affordability or to obtain social benefits when these services have the characteristics of a merit good. Traditional responses have focused on financing assets or other inputs used by public sector service providers, often with disappointing results. In contrast, OBA involves delegating service delivery to a third-party (typically private firms, but also NGOs) under contracts that tie payment of the subsidy to the particular outputs or results delivered. The public payments may complement or substitute for user fees, and may be funded from Bank loans, other sources of development assistance, or from a government's own resources. OBA approaches can also help to mobilize private financing in support of development outcomes. OBA schemes take a variety of forms. Examples include the contracting out of services under performance-based contracts, the award of concessions or franchises for the delivery of services on the basis of least subsidy required, and voucher-type schemes, which give consumers a choice of supplier. The choice of approach, the specification of performance requirements and payment structures, and the design of detailed implementation arrangements need to take account of a variety of sector- and country-specific features. Although some of the design and implementation issues can be challenging, much can be learned from experience dealing with similar issues in private infrastructure arrangements, and many of the lessons can be transferred not only across countries, but also across sectors. Source: Brook and Smith 2001. 104 · Some degree of cross-subsidy will always be public contributions to the cost of extending access. possible, even with open access to the power market, Finally, they help develop market testing of alternative because of the economies of scale in network services. approaches to see which ones work best in the specific The scope for large cross-subsidies could become circumstances of a country or region (Townsend 2002).115 unsustainable, though, if new entrants are able to take the most profitable consumers away from the customer The design of subsidy delivery mechanisms should be base used for cross-subsidizing low-income households. compatible with the design of a new power market structure. This would improve the efficiency of subsidies Approaches have been developed for delivering and reduce the need for cross-subsidies (Ehrhardt subsidies to extend access to electricity services by 2000). The delivery mechanism should be selected low-income households. They include OBA approaches according to the following sequence of decisions: (Brook and Smith 2001--box 24) and other competitive approaches (Wellenius, Foster, and Malmberg-Calvo · If government can afford to allocate fiscal resources 2004), as well as more traditional input-based approaches to subsidizing low-income users, providing subsidies (World Bank 2004b). For example, a competitive auction for electricity access and consumption from direct for subsidies for rural electrification was developed in taxation is economically the most efficient way. Chile in association with the reform of the power sector, with successful results (Jadresic 2000; Gómez-Lobo · If the government is fiscally constrained, a Universal 2001). Competitive auctions for payments to cover the Service Fund should be considered that is designed to capital costs of new connections to rural households by provide cross-subsidies without distorting competitive private contractors and operators were successfully forces in the power market. All service providers must implemented in Gabon (Environmental Resources pay a levy into a fund, and providers supplying poor Management 2002), Guatemala (Harris 2002), customers at below cost receive subsidies from the and Mozambique (Sakairi 2000). fund. This fund may be difficult to administer, however, particularly if it involves numerous small-scale Competitive approaches offer the advantage of allowing providers. private innovation for finding solutions to extending electricity services. They allow governments and donor · If a subsidy is required, but administrative capacity is agencies to structure projects and provide a mechanism too limited for a Universal Service Fund administered for donor contributions. They allow all types of projects through several service providers, government needs (grid, off-grid, and solar) to be considered. They to decide whether competition or cross-subsidies is leverage private sector investment while keeping down more helpful to the poor. A cross-subsidy would See Econ One Research, Inc. (2002) to see how a private distribution operator was able to improve service quickly in Namibia. 115 require restrictions on free entry and unbundling. Alternatively, free entry and unbundling should be considered if entrants can serve the poor without a subsidy. This choice should be assessed on a case-by- case basis. This process can be represented by the decision tree shown in figure 8. FIGURE 8. Decision Tree for Source of Subsidy Funding Fiscal capacity sufficient? yes no Subsidy from Administrative 105 taxation capacity sufficient? yes no Universal Competition more service fund pro- poor than subsidy? yes no Free entry Cross-subsidy and unbundling Source: Ehrhardt 2000. 106 8. IMPLEMENTING POWER MARKET REFORM OGN's Guidance on Implementing Market Reform The extensive range of economic and institutional endowments found across developing countries rules out "cookbook" solutions for reforming power sectors. This lesson applies regardless of the choices made for roles of public and private sectors for power supply. Power sector reform strategies should be designed to fit an overall framework for delivery of modern energy services to promote poverty alleviation and economic growth. Meeting these two objectives requires the provision of reliable electric power services in sufficient quantity to meet affordable demand at the lowest cost reflecting the resources and impacts involved in their production and transportation. Competition, unbundling, private participation, and other reform elements are not ends in themselves, but rather intended to contribute to the achievement of broad goals for poverty reduction, economic growth and environmental sustainability. In particular, these reforms should improve the economic efficiency of the sector and the commercial and operational performance of service providers. Given the differing points at which they find themselves, countries must fashion power sector reform strategies that reflect the strategic priorities for the sector, and the immediate country conditions that influence the suitability of particular approaches. 107 Governments face critical decisions in reforming their power sectors. The following valuable policy lessons have been learned 8.1 Challenges for Implementing Power Market from experience with implementing reforms to power Reform sectors in developing countries (chapter 3): Reform strategies must address a generic set of · The role of the private sector in the power market interrelated challenges. The main challenges are the should be suited to the prevailing country and sector following: ensuring that consumers pay fairly and promptly conditions (chapter 4). for their electricity consumption; changing the manner in which new investments are financed; increasing the · Competition in the power market is open to serious efficiency and development effectiveness of those abuse of market power and is best started by limited investments; and increasing operational efficiency, forms under the conditions generally found in while addressing equity concerns as the power market developing countries (chapter 5). expands. However, the process of comprehensively reforming power markets through industry and market · The form of the regulatory framework should be restructuring, private sector participation, arm's length chosen to produce credibility and predictability for regulation, and competition is technically complex, private investors and operators (chapter 6). time-consuming, resource-intensive, and politically risky. It requires phasing and good sequencing to create the · Power market reform should take account of the conditions for market transformation (World Bank 2003b). needs of the poor on the grounds of equity and political sustainability (chapter 7). Reform of power markets should cover the whole power market--not just discrete parts. For example, rural power Additional policy lessons are provided in this chapter markets should be included in reforms carried out in about the implementation of power market reform, urban markets because these markets are linked physically including the need for careful consideration in the by grid interconnections and financially by cross-subsidies sequencing and pacing of power market reforms to and joint costs. Regulatory reform should also apply to manage risks for investors, consumers, and governments all suppliers--both state-owned and privately owned-- during the transition period to the reformed structure. to ensure economically efficient operation and development of the power market. Furthermore, reforms should be Arranging the large amounts of financing for covering extended to energy markets rather than be concentrated the costs of power market reform can be a major on the power market, where reforms to these markets challenge. Some of the main cost items are discussed in have many spillover effects. For example, fuel supply chapter 4 in the context of justifiable public investment. markets usually need to be liberalized to support Major reform programs usually incur substantial costs restructuring of the power market. for the following items: Developing countries face many formidable priorities · The cost of new metering for a competitive wholesale for reviving power investor interest in their power market, which can be enormous if a low threshold markets in a challenging global environment (figure 9). allows a large number of participants. The priorities concern the following areas: · Substantial investments that are usually needed to · Legal framework for private investors. upgrade the power system control and communications system needed for a decentralized trading system. · Consumer payment discipline and enforcement. · The substantial cost of establishing a new regulatory · Regulatory predictability. agency. 108 · Administrative efficiency for approvals and licenses. · Extensive consulting services to help draft legal and regulatory documentation and system technical · Credible arbitration available for investors. documents, such as grid codes; plan and implement the restructuring of the incumbent power utility into new · Investment grade (country) credit rating for foreign corporate entities; and draft the legal agreements and exchange debt. design the market bidding, dispatch, and settlement systems for establishing new trading arrangements. · Positive view of private investment by civil society. · Hiring transaction advisers for carrying out due · Commitment to new sector structure by key diligence and preparing and marketing entities for stakeholders. privatization. · Good country reputation for preventing corruption. FIGURE 9. The Challenging Global Environment for Developing Countries Backlash against liberalization The Millennium post-California power crisis Development Goals Climate change: Devaluation concerns UNFCC, Kyoto protocol ELECTRICITY post-Argentina crisis World Commission Greater concern about on Dams Report risk post-September 11 Withdrawal of investors (post-Enron) These costs can amount in total to hundreds of millions competition where feasible, including unbundling and of U.S. dollars, even excluding the cost of restructuring the development of power markets; and reform of the sector debts.115 governance and regulatory arrangements to improve oversight of the power market and introduce incentives Reforming power sectors is a long-term process that for service providers to be efficient and responsive to carries many political risks for governments (chapter 2). consumer needs. They should also incorporate priorities This situation applies especially to countries starting with for access, equity, and environment in the policy weak governance structures for power suppliers and framework. poor investment climates. Risks arise from the following features of reform: Governments should address the challenges for reforming power markets in ways that credibly show commitment · Unavoidable substantial costs in the short term. to the reform strategy. This emphasis on policies and commitment recognizes that policy constraints and lack · Uncertainty about when reforms will yield benefits in of political commitment cannot be overcome and sustained the long term because unanticipated events can derail by contracts and regulation alone. Governments create reform programs. credibility by establishing a track record of keeping to its commitments under its laws and contracts (Bakovic, · Opposition from politically influential interest groups that Tenenbaum, and Woolf 2003). Maintaining momentum lose under reform (subsidized consumers, employees of for reform involves political costs and thus requires political 109 the former state-owned enterprise who will be made commitment through successive phases of the reform redundant, bureaucrats and politicians who lose powers process over one or more electoral cycles. Governments of patronage). must be confident that the legislative changes required for reforms are politically feasible. Here, the strength of a · Opposition by society at large to privatizing an government's parliamentary majority, the nearness of the essential public service, especially to foreign parties. next election, and the mandate of the previous election all impact on the willingness and ability of the government to · Difficulty in improving service quality needed to gain institute the required changes. public acceptance for tariff increases needed for reform, and vice versa. Opponents of reform have blamed A good indicator of a government's political commitment private investors for tariff increases needed for financial is its day-to-day support to distribution companies and viability, and have generated a backlash against regulators. Government's support is needed for reducing private power supply in some countries that raises the theft of electricity and materials and nonpayment of bills by prospect of renationalization. electricity users, providing subsidies for a transition period, and ensuring that its departments and agencies · Mobilizing the financing for the heavy costs of reform pay their electricity bills regularly. Payment arrears can (debt restructuring, investments essential for restructuring) often be settled through financial restructuring, but private under strained public budgets, as well as for expanding operators are often helpless in enforcing policies for supply capacity to keep up with growing demand until disconnecting power supply to consumers in payment the reformed sector can attract substantial risk capital. arrears in the public sector, in particular for essential services, such as water supply, hospitals, army, and police. 8.2 Government Roles and Responsibilities In some countries, government and its agencies account for more than 50 percent of a power utility's sales, so failure to Governments have important roles and responsibilities pay their electricity bills becomes a real obstacle to reform. in reforming their power markets. They must decide on A government can publicly demonstrate its commitment by the relative roles of public and private sectors in the passage and enforcement of antitheft legislation that providing power services, the governance and reform allows for disconnection and prosecution of those who steal of public enterprises operating in the market, the new electricity, and by successfully prosecuting politically well- structure of power supply arrangements to introduce connected thieves.116 The cumulative costs of advisers and consulting services needed for implementing a major power reform program alone can amount to tens of 115 millions of U.S. dollars, based on the experience of reforms in Ukraine and Orissa (India), for example. The case of Andhra Pradesh shows how this can be done (chapter 4). 116 Government's implementation strategy should include · Mobilize financing of access costs to modern energy the following elements: services for the poor where usage is socially worthwhile. · Ways to compensate or reassure losers in reforms to · Provide or arrange guarantees to mitigate political the power sector, with appropriate social safety nets. risks that are exceptional and deter private suppliers of electricity services. · A build-up in trust between private entrepreneurs and the other parties, which can be achieved by seeking · Provide limited performance undertakings on behalf of modest levels of private participation initially to state-controlled enterprises to help privately financed overcome mutual suspicions. investments and concessions in difficult business environments. · Mobilization of public support for the reform process by involving the main interest groups in the planning stage. · Reduce barriers to market penetration for energy service providers and for promising new technologies · Initial steps to establish government's commitment (including some renewables). to reform to manage the political risks involved in restructuring the supply structure, establishing the · Build a good track record for paying subsidies to new regulatory framework and introducing private support its social development policies so as to help 110 participation. reduce risk for the viability of investments that depend on these payments. · A transition process that takes into account the political realities facing reform. Decisions about the level of government financial support should be consistent with decisions about power market Governments have to radically change their roles to support development and electricity prices. This requirement reform strategies based on private sector participation. reflects the reality that electricity must be paid for either by Their current roles are multiple, because they encompass consumers or by taxpayers.118 Revenue shortfalls are costly policy maker; legislator; power producer and supplier as since they lead to deterioration in the quality of supply and owner, system operator, and majority or only investor in the assets, as well as an inability to meet demand, as seen in power sector; user of power services through its numerous many countries. Robust reform strategies, regardless of the agencies; and employer when power workers are subject to choices made for the different roles of the public and civil service employment conditions. The scope for conflict private sectors, must confront these issues, often in a among these roles is usually too great to manage through situation where prices are well below full-cost recovery tradeoffs. In a reformed power market, governments should (World Bank 1994b). Without credible steps adopt more selective roles, focusing mainly on being policy to improve suppliers' commercial and operational maker, legislator, creator of an enabling environment and performance and to align revenues with costs, reform risk mitigator for private investors, and financier of subsidies strategies are unlikely to succeed in improving sector for low-income consumers.117 Even governments' role as performance and contributing to economic growth and consumers would diminish under programs to privatize poverty reduction. state-owned businesses. Government's responsibilities do not cease at privatization. One of government's key roles is to facilitate the Instead, its oversight role often becomes more complex, development of power markets. This role carries the partly because its support is needed to sustain private following responsibilities: investment (as outlined in chapter 4). Government has to maintain stable sector policies and keep to the letter and · Ensure that regulation of the power market achieves a spirit of privatization agreements by avoiding actions that go fair balance between protecting the interests of electricity against these agreements. It has to work jointly with consumers and attracting the investment needed to investors to solve local problems as they arise and maintain meet demand for electricity. fair and transparent mechanisms for dispute resolution. It Governments would, of course, retain their responsibility for representing national interests in energy--related international affairs, such as 117 transboundary emissions, international rivers, energy producer associations, climate change initiatives and international energy trade. A major drawback with payment by taxpayers is the high economic cost to developing countries of public funds raised through general 118 taxation. has to quickly adapt to the concept of the autonomous structures of corporate entities, and eventually for functioning of the regulatory body. The types of post- some countries to a fully unbundled structure, as privatization actions to be avoided include the action of discussed in chapter 4. Hungarian government in allowing retail tariffs to rise at a lower rate than wholesale tariffs, the actions of Ukrainian · Restructuring of wholesale power trading arrangements government in preventing and later staggering retail tariff progresses from internal transactions within an integrated adjustments called for in the tariff compacts of the power utility to the entry of IPPs selling their output to privatization agreements, and government of Orissa's a single buyer, then to opening access to power networks inability to resolve the heavy financial problems in the by large users of power, and eventually to bilateral power sector after privatization. trading between generators and distributors or to a central power pool under competitive trading, 8.3 Sequencing of Power Market Reform as discussed in chapter 5. Sequencing of power market reform raises both strategic · Major organizational and financial restructuring and tactical issues. Strategic issues concern the design precedes the creation of private ownership rights to avoid of the new structure of the power market and wholesale problems with stranded costs, as discussed in chapter 5. power trading arrangements with the attendant reforms to market regulation and the roles of public and private Power market reforms in most of the developing countries participants. The logical sequences for addressing that have progressed substantially have broadly followed 111 strategic issues are as follows: the logical sequence. The sequences followed by 20 of these countries are summarized in table 14. All of these · The legal and regulatory framework for creating the new countries passed primary legislation for power market market structure and trading arrangements is put in place reform, established sector regulation, transacted with before restructuring the power supply arrangements, IPPs, and privatized some of the power supply industry. privatizing power suppliers, and setting up new market Fourteen these countries implemented corporatization or trading arrangements, as discussed in chapter 6. passage of primary legislation for reform as their first step. Conversely, none of them started with restructuring, · Restructuring of power markets progresses from an privatization, or the introduction of wholesale competition integrated structure--under which the power utility to the power market. IPPs entered the power supply chain may not even be corporatized--to partially unbundled at various steps in the reform sequence, which shows the TABLE 14. Sequence of Power Market Reform Measures in 20 Developing Countries NUMBER OF COUNTRIES AT EACH REFORM STEP FIRST SECOND THIRD FOURTH SUBSEQUENT TOTAL REFORM MEASURE STEP STEP STEP STEP STEPS COUNTRIES Corporatization 7 2 5 2 1 17 Electricity law 7 6 3 2 2 20 Establish regulation 3 5 5 5 2 20 First IPPs 3 -- 3 3 11 20 Restructuring -- 3 3 5 4 15 First privatization -- 3 1 3 13 20 Wholesale competition -- -- -- -- 9 9 Note: These countries are Argentina, Bolivia, Brazil, Chile, China, Colombia, Czech Republic, El Salvador, Hungary, India--Orissa, Indonesia, Jamaica, Malaysia, Morocco, Pakistan, Panama, Peru, the Philippines, Poland, and Thailand. Source: Derived from Jamasb 2006. adaptability of this form of transaction. The nine countries substantial privatization receipts. Hungary, Poland, that introduced wholesale competition undertook the and Turkey (as well as Lithuania and Moldova to some necessary main reform steps beforehand. extent) focused on (a) improving their laws on electricity supply and theft, (b) establishing professional and Tactical issues for sequencing concern the implementation competent regulatory bodies to improve the levels and of a reform program. These issues include the number structure of tariffs to cover costs of supply, and (c) of stages to a reform program, how much improvement comprehensively commercializing the operation of their to entities slated for private ownership or concessions utilities. With these reforms, they met with reasonable should be attempted before handing the entities over to success in restructuring their sector, attracting private the private sector, the timing of tariff increases relative investors and moving toward competitive markets. to service improvements, and the order of privatizing distribution and generation entities. Although generic Other countries in Eastern Europe and the FSU were sequences can be put forward for strategic sequencing not able to attract significant investor interest because issues, such an approach would not be useful in the of poor sequencing of reforms. In Georgia, Kazakhstan, case of tactical sequencing issues, given the wide variety and Ukraine, privatization of poor commercial performers in starting conditions for power market reform found was conducted by direct negotiation on the basis of among developing countries. Tactics should be specifically an impractical market structure, and resulted in poor designed for each set of local conditions. privatization receipts, chaotic market conditions, 112 no palpable improvement in sector performance, Government should incorporate its strategic and tactical and eventually in disinvestments by disenchanted investors. decisions in an explicit policy for reforming its power These countries did not focus adequately on creating sector. This step should be undertaken at the start of the the right conditions before embarking on privatization. reform process to ensure that all parties to the reform Consequently, they have been facing investor have a clear and common understanding of the planned disenchantment and disinvestments, and stalled reform, to carry out the consultations needed to develop privatization programs (Krishnaswamy and consensus for supporting the reform, and to develop the Stuggins 2003). roadmap for implementing the reform. The reform policy should be developed under the guidance of a senior The sequencing of tariff increases with investments to member of the cabinet to ensure cooperation among improve the quality of service is often problematical. the numerous ministries and government agencies Probably the most contentious reform issue is raising involved in the reform. The policy should be documented the overall level of tariffs to cover supply costs--even and presented to the legislature for discussion and to efficiently incurred costs--and removing most of the obtain political support. Once this is obtained, the policy heavy cross-subsidy to households and other subsidized should be officially published. Nigeria is a good example consumer groups (such as farmers in India) from industrial of this process.119 This document can then be used as and commercial consumers.120 From the consumers' the blueprint for drafting the legislation needed for introducing viewpoint, matching tariff increases to actual service some of the radical reforms, such as the abolition of a improvements has economic merit, but it causes investors legislated monopoly for the state-owned power utility, to face the difficulty of raising the large amounts of funding the establishment of new regulatory arrangements, required for investments to upgrade service quality while and the introduction of private service providers. tariffs remain below cost. Some countries in Eastern Europe and the FSU were able The sequencing of private investment in the power to attract considerable investor interest by following sound sector depends on conditions in the power market. In the sequencing of reforms. In Hungary, Poland, and to some conditions of many developing countries, investment in extent Moldova, privatization followed substantial new generation capacity alone is insufficient in the absence improvement in the sector's commercial performance of the institutional capacity needed to manage retail on the basis of an appropriate market structure and operations, and efficiency improvement in customer service transparent competitive procedures, and resulted in usually requires substantial investment in upgrading supply The power reform policy document, "Federal Republic of Nigeria: National Electric Power Policy Adopted by the Electric Power Sector Reform 119 Implementation Committee and Approved by the National Council on Privatisation," can be found on the Nigerian Bureau of Public Enterprises Web site (http://www.bpeng.org) under Publications/Power/Sector Policy/Electric Power Policy. Subsidies do not run universally to households from industries. In Brazil, for example, the cross-subsidy runs to large industries from other 120 consumer groups. capacity. These relative needs, however, indicate the TABLE 15. Private Power Investments in following basis for sequencing the introduction of Latin America and Asia 1990­2002 private participation: (US$ million) · Private participation is steered first to investments in DIVESTITURES GREENFIELD TOTAL PPI power generation if more physical capacity is the COUNTRY CONCESSIONS PROJECTS INVESTMENT priority, usually to meet rapidly growing demand for electricity, as in East Asia, since this segment of the LATIN power supply chain accounts for 60­70 percent of AMERICA the total investment in the power sector. Brazil 34,644 9,913 44,557 Argentina 11,046 5,070 16,116 · Private participation is steered first to the distribution Chile 4,163 4,330 8,493 sector of the power supply chain if increased efficiency Colombia 4,348 2,210 6,557 is the priority, because of huge losses--both technical Peru 3,166 1,137 4,303 and nontechnical--as in Latin America. Mexico n.a. 3,897 3,897 This divergence in priority for private participation is Dominican shown in the differences between East Asia and Latin Republic 1,208 1,101 2,309 America in composition of private investment that took Guatemala 651 782 1,433 113 place between 1990 and 2002 (table 15). This table Panama 937 128 1,065 shows that these Asian countries attracted much more Total 60,163 28,568 88,730 private investment in power greenfield projects (around ASIA US$68 billion) than the Latin American countries China 4,084 15,599 19,684 (around US$29 billion) over the same period. In total Philippines 2,683 10,730 13,412 private investment in power, however, the Latin American India 378 11,960 12,338 countries attracted about US$10 billion more than the Indonesia n.a. 9,960 9,960 Asian countries because of high receipts from privatization Thailand 1,545 6,471 8,016 of state-owned assets and businesses in the power sector. Malaysia 1,395 6,296 7,691 The privatization sequence for poorly performing power Pakistan 291 5,646 5,937 sectors should start with distribution entities. A prerequisite Bangladesh n.a. 1,040 1,040 for implementing reforms in these sectors is to stem Total 10,376 67,702 78,078 the accumulation of operating losses and enable sector n.a. Not applicable. revenues to exceed sector operating expenditures Source: World Bank PPI Database. (PA Consulting Group 2005). Investors will pay more for generation assets when they see good prospects for selling their output to solvent purchasers, which usually these entities before bringing in private participation. occurs when the distribution entities are passed into If it is difficult to improve the commercial performance private management. Latin American countries that of distribution entities under current managements, privatized generation entities after they privatized the preferred alternative is for private participation distribution entities obtained greater privatization through the use of leasing or concession arrangements. receipts than Latin American countries that privatized in However, if attracting private participation in any form the reverse order.121 In Brazil, for example, privatization is not feasible for some time, a reform strategy should began with distribution entities to realize the quickest address how to improve the performance of these available productivity gains where the power system had entities before attempting to attract private participation, been most abused politically, and to create creditworthy as happened in the case of the Indian State of Andhra buyers of energy for generators in preparation for their Pradesh (chapter 4). privatization (Brown 2002). For a power sector with loss-making utilities or distribution entities, the choice of sequence involves whether to improve the commercial performance of This finding is based on unpublished research conducted within the World Bank and IFC. 121 Even in a situation of bulk power shortages, investments many countries in reforming their distribution businesses, in new generating capacity should follow investments in even with options for dealing with investors concerns distribution when the distributors are insolvent, for the about risk (chapter 4). In this situation, a government following reasons: can choose from the following options for phasing the reform of distribution entities: · Distributors do not generate sufficient cash revenue to pay fully for the costs of power from new generation · Concurrent privatization of all distribution companies capacity in their current operating condition. with mixed urban-rural areas as soon as practicable. This is the most direct approach for meeting reform · Commitments to significant additions to new objectives, but it runs the risk of failing to sell the generation capacity should be deferred until the level weaker distribution companies. Substantial amounts of of economically effective demand can be assessed commercial and regulatory risks would probably have reliably.122 Technical improvements to reduce technical to be ring-fenced from the investors during the and commercial losses are usually the least-cost transition period. means of closing the shortfall of supply relative to demand. · Sequential privatization of distribution companies with mixed urban-rural areas over time. This approach · The incumbent utility should not sign many long- might be suitable for achieving some privatization 114 term power off-take agreements with IPPs to avoid soon if not all distribution entities were performing overcomplicating the restructuring of its PPAs when it sufficiently well to be privatized without the government is restructured. assuming too much risk during a transition period. · IPPs are more likely to seek credit support on terms that · Sequential privatization of distribution companies in impede market reform, such as escrow of revenues from separate urban and rural areas. This approach might the best-paying customers of distributors, when they sell come into contention if the other options are infeasible. power to insolvent distributors. A possible transition path would be (a) management contracts, (b) concessions (perhaps investment The economically rational priority is to deal with tariff management contracts), and finally (c) divestiture distortions, theft, metering, and local capacity bottlenecks of assets. Smaller rural areas may be concessioned through relatively low-cost investments to improve the off to rural entrepreneurs or community organizations. performance of distributors, while creating a sound Although performance-based returns should be built regulatory framework to govern future tariff changes. into these contracts, innovative measures to bring in The need for additional generating capacity should be the capital needed also have to be developed. assessed once the response of demand to these measures becomes evident. · Full privatization could be tried later. This approach provides time for meeting the conditions for attracting Governments have to make tradeoffs in choosing their private participation and only if government wanted to reform sequence for distribution businesses that cover privatize all the distribution entities at the same time. urban and rural service areas. Their options depend It requires government to credibly maintain a strong primarily on their ability to bear the political and financial political commitment to reform. This approach works costs for creating the conditions for attracting private if the distribution entities would be able to access the participation, the risks that they should accept during the debt markets on the strength of their balance sheets transition period, and the prevailing investor interest in once they have been substantially commercialized and such assets. The scale of the challenge in meeting these the tariff regimes (including social protection conditions is illustrated by the slow progress to date of measures) are appropriate. System load can be pushed above effective demand by a combination of tariffs that are well below supply cost for some consumer categories, 122 and uneconomical consumption that is encouraged by unmetered supply and high losses that arise from theft and poorly designed distribution networks. However, system load can be depressed below effective demand by tariffs that are well above supply cost for other consumer categories, but below the cost of own-generation, and by supply interruptions caused by lack of maintenance and by inadequate feeder and substation capacity in the distribution network. 8.4 The Transition Stage for Power Market Countries in the lower-income group with small power Reform systems typically have the weakest starting conditions for reforming their power markets. Electricity prices are well The transition stage from the old power market to the below costs in many of these countries, but they are new power market is a vulnerable period when derailment near to cost-recovery levels in others, which gives rise of the reform process is possible. Under the starting to politically sensitive concerns about affordability of conditions for the power market found among most electricity for low-income households. Access rates developing countries, the transition stage usually covers to electricity by the population are low. Poor quality intermediate reform stages. For the market structure, and shortage of public power supply cause numerous transition concerns the less than full unbundling of the consumers to install private power generators. Poor industry structure and the adoption of a single buyer governance of state-owned power utilities leads to trader for wholesale power (chapter 4). For private sector poor technical and financial performance, the need for participation, transition focuses on private sector roles substantial credit support, very low operating efficiency that fall short of full risk taking, such as management that drives up unit supply costs under lack of maintenance, contracts and other forms of private participation, theft of electricity and utility property including cash, with temporary risk mitigation mechanisms, such as ring- inefficiency in collecting revenues owed to utilities, fencing, vesting contracts, and political risk guarantees and lack of investment caused by the inability of utilities (chapter 4). Transition arrangements to provide credibility (and governments) to mobilize financing. These countries for a new regulatory regime revolve around regulation have very low ratings for corruption and country 115 by contract (chapter 5). creditworthiness. The Importance of Starting Conditions Countries in the middle-income group with larger power systems tend to have better starting conditions for Starting conditions in the power market are important reforming their power markets. Access rates to electricity for designing power reform strategies. They critically by the population are higher than among the low- influence the main parameters of a reform, such as the income small system group. Power systems are roles of public and private sectors, the new market and sufficiently large for breaking up their power generation industry structures, and the design of the regulatory and distribution sectors, as well as vertically unbundling framework. Given the wide range of starting conditions their supply arrangements. Rapidly rising power demand among developing countries, power market reforms are requires large investments in expanding power supply also likely to vary, as shown by the experience to date capacity. Households and other favored or influential with reform (chapter 3). These conditions include the consumer groups benefit from substantial subsidies and size of the country and its power system and market, cross-subsidies through the structure of power prices. the country's location relative to other power markets, Many of these countries have low ratings for corruption its income level and macroeconomic condition, and governance. Some countries have local institutional its political situation, and the capacity of its domestic investors, but generally investors face substantial financial markets and institutions. political risk. The extensive range of economic and institutional The composition of power market reform should endowments found across developing countries rules out therefore be adapted to starting conditions in countries. "cookbook" solutions for reforming their power sectors. This policy is illustrated in table 16 for the two groups of This lesson applies regardless of the choices made for developing countries--large middle-income countries the roles of the public and private sectors in power and small low-income countries--described above. supply arrangements. Reforms based on substantial market restructuring that may be adapted to large Quick versus Gradual Approaches to Reforming middle-income countries would be infeasible for small Power Markets low-income countries. Conversely, modest reforms designed for the weak economic and institutional Strong regional patterns influence the time taken to capacities of small low-income countries would have accomplish the transition stage. In Latin America, unacceptably low reform outcomes in large middle- where reform has generally been the most comprehensive income countries. among the regions, the time taken to cover the transition stage has been the shortest. In contrast, countries in Asia substantial proportion of the power supply business, have been tentatively reforming their power markets for and set up competitive wholesale trading long periods without advancing far. Countries in Eastern arrangements for power. Europe fall between the two other groups in the rate of their reform progress. This pattern is evident among the sample · Among the three Eastern European countries in this of 20 countries whose reform sequences are summarized in sample, Hungary's performance corresponds to that of table 14 (Jamasb 2006). the Latin American countries with a transition stage of four years, while the other two countries (the Czech · Eight Latin American countries in the sample took Republic and Poland) have carried out most of the between one and four years from the passage of an reforms since the early 1990s, but have yet to complete electricity law to restructuring the supply chain, the transition stage. Bulgaria and Romania are now establish the regulatory framework, privatize a proceeding along the same reform path relatively quickly. TABLE 16. Types of Power Market Reforms with Different Starting Conditions DEVELOPING COUNTRY GROUP 116 SMALL LOW-INCOME COUNTRIES LARGE MIDDLE-INCOME COUNTRIES COUNTRY STARTING CONDITIONS Power system size Very small Small to large Access to electricity Low High Investment climate Too poor to rate Low to medium Institutional capacity Very weak Low to good Governance rating Poor Poor to good INITIAL REFORM CHARACTERISTICS Market structure Limited vertical unbundling. Single Substantial vertical and horizontal unbundling. buyer with some simple bilateral Bilateral trading or a central exchange for trading for wholesale power. wholesale power. Regulation Semi-autonomous regulatory Autonomous regulatory agency with power to agency mainly responsible for issue licenses and approve retail tariffs and oversight of concessions. trading arrangements. Role of private sector Mainly IPPs in generation; Privatized generators and IPPs. Privately owned concessions in distribution under and financed distributors under long-term public-private partnerships. licenses. Role of public sector Continued ownership of most State ownership in sensitive generation sectors power supply facilities. Primary (hydro, nuclear), transmission, and nonviable responsibility for financing sector distribution service areas. development. Role of competition Limited to bidding for PPAs by IPPs Competitive bidding for wholesale power and by private operators for contracts under bilateral trading or bidding into a distribution concessions. power exchange. · Finally, the seven Asian countries in the sample the "winners' side." The advantages claimed in theory (counting India as a whole instead of just Orissa) for this process are that it allows government to plan have progressed least among these countries, despite and sequence its reforms coherently, ensure democratic also starting their reforms in the early 1990s, partly buy-in, prevent policy reversals, and make all major because of weak commitment to the reform vision political parties associate themselves with the reform adopted by Latin American countries. agenda through the election cycle. The design of the transition stage should never lose The advantages claimed for the gradual approach sight of the fiscal reasons for reform, because an overly may be less elegant in practice and do not conform cautious approach runs the risk of delaying real reform to sanitized theories of transparent, consultative, benefits and losing political momentum for reform. democratic functioning, or good governance. Consumers expect much more from private companies These advantages enable reformist politicians to use than from state-owned enterprises. Consumers skills and networks to keep their own incentives in the understandably lose patience if tariffs go up immediately, process alive by enabling them to devise rules and but service improvements lag behind. When this happens, stratagems that will augment their own resources and the regulators are blamed. Therefore, it is not surprising reward their supporters or collaborators. Furthermore, that most regulators, when faced with this situation, will they gain time for politicians to divide, lull, or inveigle try to find a way not to raise tariffs, especially if their opponents of the reform; to resolve, avoid, defer, or shift legal mandate consists of nothing more than principles, conflict through compromise, obfuscation, deal-making, 117 goals, and objectives (Bakovic, Tenenbaum, and Woolf blame-shifting, or stalling; and to identify and harness 2003). The preservation of protective features, such as incipient supporters of the reform who will help push "lifeline" rates, may be necessary, even though they subsequent reform. This explanation recognizes that would likely mean the continuation of subsidies within much of reform is politically unmarketable either because income classes, as well as from industry to residential it runs up against powerful interests, does not coincide consumers. with the politician's time cycles, or fails to address legitimate concerns. Implementing reform thus depends on stealth, Pressures for rapid results, however, should not obscure ambiguity, and following the path of least resistance.123 the point that power market reform is designed for the long haul and requires patience. Kazakhstan shows the The relative merits of the quick approach versus the risks of not following a well-planned and sustainably gradual approach to reforming power markets have yet paced reform sequence. It unbundled its electricity supply to be settled. This is because the outcomes of these functions, tried to establish a wholesale power market, approaches are still evolving in developing countries. and privatized much of its generation and distribution In the reformed power sectors of Latin America, assets at rock bottom prices. It did so at the height of an the quick approach worked effectively for reforming economic crisis with low retail tariffs and cash collections the power market structure, but most of these countries in the power market and before establishing a credible have had to revisit several aspects later in an effort to regulatory framework for investors. As a result of this, address concerns about processes for market regulation power trade became chaotic, and investors pulled out and social issues under weak or nascent institutions (Kennedy 2002). (Benavides 2003). The gradual approach followed in Asia allows time to develop institutional capacity and The gradual approach of incremental reform may public consultation about the proposed reforms and succeed by helping reformers develop the necessary their social impacts, as well as to integrate environmental support, at least according to one theory. This approach concerns into policies for the new power market helps reformers create an initial constituency of early (World Resources Institute 2002). This approach, "winners" who sense real benefit in further reform, however, could prolong the reform process and while lulling "losers" into believing they have achieved a perpetuate the culture of poor governance, leading good compromise. These initial winners develop into an eventually to its collapse from political intrigue and interest group with a stake in reform, and provide the public skepticism, as shown by India's early reform politician with confidence to push further. The "losers" experience (box 25). begin to cede ground, and over time lose members to The views given in this paragraph and the preceding one are taken from an unpublished paper by Sumir Lal entitled "Political Factors Affecting 123 Power Sector Reform in India." BOX 25. India's Experience with a Gradual Approach to Power Market Reform India has generally followed a gradual approach to reforming its power market. Trained on broad reform goals, the detailed steps required to unravel the old system were worked out along the way through trial and error. Much of the gradual structural reform focused on the State Electricity Boards (SEBs)--the vertically integrated dominant power suppliers at the state level--because they were particularly inefficient and created huge losses for which the state governments were ultimately liable. From the mid-1980s, under an economywide approach for state-owned enterprises in general, the central government had attempted to improve the efficiency of SEBs by giving them greater managerial autonomy and increasing their access to capital, with the hope that they would become more entrepreneurial. The central government adopted a new approach in 1991 because of India's financial crisis, under which it sought immediate remedies. Since many years would be needed to rectify the SEB's inefficiencies, the new approach focused on the immediate problem of meeting the shortfall in generating capacity that had been perpetuated by the SEB's poor finances. The government hoped that private investors would provide large amounts of efficient and inexpensive power capacity, even though there was little track record in developing countries to provide credibility for this approach. A focus on private investors was also consistent with the reformist agenda of attracting foreign direct investment. There was a broad consensus supporting this approach to reform because of the lack of viable alternatives. 118 The central government created the legal conditions needed to attract private investors in electricity generation, and it set tariff rules that would be particularly attractive to investors, with a guaranteed 16 percent return on equity (after tax) and full repatriation of profits in dollars. To jump-start the process, the government awarded "fast track" status to eight projects (many with foreign participation), promising rapid clearances and central government repayment guarantees to assuage investors' concerns about selling their output to insolvent SEBs. Most of these projects included a cost-plus PPA between the operator and an SEB. Only three of the fast track projects, however, have produced power more than a decade after the fast track initiative. Despite promises of rapid regulatory approval, many of the fast-track projects became mired in controversy. The projects were touchstones for anti-globalization lobbies that used protests and public interest litigations on environmental grounds to slow approvals until investors withdrew. Although hundreds of Letters of Intent or even Memorandums of Understanding were signed in the early to mid-1990s for projects without fast-track status, most of them did not result in serious investment. In addition to the obvious failure to attract much new capacity, this first wave of reforms yielded electricity from private plants that was much more expensive than power from the SEB's existing plants and even from new plants built by state-owned enterprises. Take-or-pay clauses in the PPAs, high rates of return, and a contracting structure that gave upside earnings potential to investors and saddled the SEBs with fuel and currency risks, were all the product of a power at any cost mentality. After this experience, India reverted to a gradual approach to power sector reform. Source: Tongia 2003. The comparison between quick versus gradual approaches approach, even if tied to good economics, can make to reform reflects views about the leadership of the for undesirable politics by undermining democratic reform process and the need for a public consensus. institutions. The gradual approach reflects the opposing The quick approach reflects a view that economic view about the central importance of forging a social reforms must be carried out by a strong executive, consensus around reform. This consensus requires unhampered by the need to consult or seek consensus, consultation to improve policy and, by addressing the in order to stop vested interests from obstructing a concerns of the general population, to increase the reform agenda. From this perspective, although reforms probability of continued public support for the reform may be rational for society as a whole, myopia on the program and support for democratic institutions. part of the general public and a collective irrationality The distinction between these two approaches is blurred nonetheless can obstruct reform. However, this autocratic somewhat by noting that while the initiation of reforms may require a firm and autonomous executive with a course, specific to a particular reform for a power relatively free hand, consolidation of reforms may rest in market. It can take many forms depending on the building consensus (World Resources Institute 2002). institutional arrangements for reform.124 Reform Road Map The road map should be adapted during reform implementation in response to unexpected developments. A road map is a vital component of the reform process. The following examples of such developments have It shows how the key strategic and tactical reform issues been encountered: will be handled under a coherent reform strategy. This includes showing how a commercially oriented business · Unexpectedly strong and persistent opposition of the environment will be developed and how other reform power utility's labor force to new employment conditions objectives will be achieved. The road map sets out the that make them accountable for performance. sequence of reform and shows the process for changing governance by restructuring the institutional, regulatory, · Failure of the regulatory process to perform consistently industry, and market arrangements for power supply. It with expectations because of political interference in covers what, when, and how the reform will be done; tariff filing, regulatory bodies being subject to political who will do what; and how the substantial costs of interference, or governments nullifying regulators reform will be financed (box 26). A road map is, of decisions by offering additional subsidies in lieu of tariff 119 BOX 26. Road Map for Power Market Reform A road map for power market reform answers the following questions: What business-enabling environment will be created through legal, regulatory and competitive frameworks? What markets are being created, and how will property rights be protected? What roles will be taken by the private and public service providers, respectively? How will the new businesses be managed and financed from tariff revenues and funding for capital expenditure, and how will the subsidies that are needed to meet social objectives be provided in ways that do not undermine the commercial incentives and orientation of sector governance? What transition path will be taken from the starting conditions to reach the desired end conditions with regard to, for example, corporate and market restructuring or change in governance arrangements for financing? Who will mitigate the risks and soften the tradeoffs associated with the transition? How will any required financial restructuring of the state-owned power utility be undertaken? What options will be considered for dealing with unexpected developments during the transition period that delay progress? How will the reform process be organized in relation to allocating responsibilities for implementing reform stages, such as corporate and financial restructuring, transacting sales to private investors and operators, mobilizing resources needed to carry out reform, and retaining technical experts? When and how will consultation take place with interested and affected stakeholders? What points in the reform process will trigger key actions and milestones? What is the basis for checking that proposed reform steps conform to the overall reform strategy? For example, a road map can be developed in a series of resolutions recorded in the minutes of a reform management committee that are 124 supported by working papers prepared by technical task forces and technical reports prepared by consultants. increases (which in effect postpones the hard · Unexpectedly severe disruptions to power supply, decisions needed for private sector participation and such as a drought in a predominantly hydropower commercialization). system (as in Cameroon three years after privatization of the power utility) or typhoons that wreck networks · Absence of budgetary discipline at the level of the (as in the case of Orissa shortly after privatization of the power utility that undermines incentives to ommercialize. distribution companies). · Difficulties in recovering the costs of operational · A change of government that threatens to hold up key inefficiency (typically large technical and commercial stages of the reform or even require substantial changes losses) under tariff orders, both for losses incurred in to significant elements. the year covered by the order and for unrecovered losses in previous years. 120 APPENDIX: REFORM OF POWER MARKETS IN OECD COUNTRIES This appendix briefly compares and contrasts the distribution are regulated to support competition in conditions for power market reform in OECD countries production and supply. The new guiding principle was to and developing countries. introduce competition by restructuring the electricity supply industry where possible, and to simulate as far as possible Power market reform for OECD countries has the effect of competition on the natural monopoly network conventionally been interpreted for radical market through price cap regulation. The passage of the 1989 restructuring with the introduction of competition where Electricity Act and the restructuring of the Central Electricity feasible in both the wholesale and the retail markets Generating Board of England and Wales combined for the for electricity. Economic regulation of the wholesale first time privatization with restructuring to introduce and retail power markets is used to promote competition competition. The benefits of competition showed initially in and protect consumer interests. Regulation of electricity rapid substantial reductions in wholesale electricity costs, prices is essential since experience shows that competition followed later by a sharp decline in wholesale electricity is not sufficient to control pricing in the presence of prices under regulatory pressure and bargaining by the the transmission and distribution natural monopolies. government or competition authority with the electricity This movement has been led by Australia, England and supply industry to introduce further competition (Newbery Wales, the Scandinavian countries, and some regional 2004). The current competitive power trading groups in the United States. Chile was also a leader arrangements in England and Wales are described 121 with these OECD countries. The extensive reach of this in box 27. reform movement is shown by the existence of regionwide monitoring reports for the United States (Center for the The drivers for reform have differed between OECD Advancement of Energy Markets 2003; Public Utility countries and developing countries, partly reflecting the Commission of Texas 2005) and the European Community differences in their starting conditions. Power market (Commission of the European Communities 2004). restructuring evolved in OECD countries to achieve further efficiency gains, even though the electricity supply industry The initial restructuring of the England and Wales power in most of these countries worked well technically under market showed that radical restructuring of an integrated vertically integrated, largely state-owned structures. OECD power supply chain of functions is feasible, contrary to countries offered favorable conditions for restructuring forebodings about disrupting technical coordination of a because of their well developed power sectors, excess vertically integrated power supply. The generation, power supply capacity and moderate power demand transmission, and distribution functions can be separated growth that allowed time for introducing radical changes, from one another and traded at arm's length in a and the availability of natural gas that allowed the entry of wholesale power market. It was made possible by gas-fired generating plants into the power market at rapid changes in technology that occurred in both the modest scale and relatively low cost. Within OECD generation of electricity and in the computing systems countries, reform drivers have reflected particular pressures used to meter and dispatch power. There is now sufficient within countries and can generally be classified as follows: track record to provide assurance about the technical feasibility of coordinating these power supply functions · In the United States, the passage of the Energy Policy and maintaining security of supply to power users. Act of 1992 aimed at fostering competition to enhance This experience countered widespread concern about efficiency, encourage technological innovation, and lower the technical feasibility of decentralizing corporate prices. Criticisms of the inefficiency of rate-of-return control (but not control over power system operation) regulation for encouraging gold-plating and cost in power markets. inefficiency (Averch and Johnson 1962) became decisive in the restructuring movement in the United States.125 The experience of England and Wales also showed that the production and supply of electricity could be subject to competitive pressure, provided that transmission and Utilities were given incentives to invest as much as they could and only penalized for underinvestment. This led to waste in how they used 125 resources. The attitude often was "better safe than sorry" and "we can pass it on to consumers." Significant amounts would be spent on efforts to woo the key politicians and regulators since they had more direct control over profits than did consumers. BOX 27. New Electricity Trading Arrangements for England and Wales The system for trading electricity under the England and Wales power pool was changed on March 27, 2000, to the New Electricity Trading Arrangements (NETA). (NETA became BETTA--British Electricity Trading and Transmission Arrangements--in 2005 when the fully competitive wholesale power market was extended to Scotland.) Under NETA, market participants wishing to buy and sell electricity, including nonphysical traders, as well as generators and suppliers, are able to enter into any freely negotiated contracts to do so. There now exists a three-tier contract driven market: · Forward and futures markets, including short-term power exchanges, which allow contracts for electricity over a time scale ranging from several years to day-ahead markets. · A balancing mechanism in which the system operator accepts offers of, and bids for, electricity to balance generation and demand and resolve any constraints on the transmission system. · A settlement process for charging participants whose contracted positions do not match their metered volumes of electricity, for the settlement of accepted balancing mechanism offers and bids, and for recovering the system operator's costs of balancing the system. The system operator is responsible for ensuring balance one hour ahead of the beginning of the trading period. 122 All trading except through the balancing mechanism, ceases at that time ("gate closure"). Bilateral contract markets for firm delivery of electricity operate from a year or more ahead of real time (the actual point at which electricity is generated or consumed), typically up to 24 hours ahead (the day-ahead market), and occasionally up to gate closure. These markets allow a buyer and seller to contract for delivery on specified date of a given quantity of electricity at an agreed price. Currently three power exchanges operate over similar timescales, although trading tends to be concentrated in the last 24 hours. Offers and bids can be posted, modified, or withdrawn at any point until they are accepted in these exchanges. Once accepted, they represent firm financial commitments and are settled at prices specified in the offer or bid. For settlement purposes, generators and suppliers must notify the system operator about their overall contract volume of production and demand for the trading period by gate closure; thereafter, further trading for these periods is prohibited. Price discovery in these markets is provided through on-screen display of the last accepted trade, live offers, and bids, and by price reporting services. The balancing mechanism operates from gate closure to the completion of each trading period. The system operator administers the balancing mechanism to balance generation and demand, taking into account and resolving any constraints on the transmission network. Every half hour generators, suppliers, and large customers are required to notify their intended physical positions for the periods ahead. Trades in the balancing mechanism are visible to all participants who can see competitors' bid or offer acceptances and choose to adjust their bids or offers accordingly. Although participation in bilateral markets, power exchanges, and the balancing mechanism is optional for generators and suppliers, participation in the settlement process is mandatory. All generators and suppliers must comply with the Balancing and Settlement Code, which provides a framework within which participants comply with the balancing mechanism and settlement process. The code is administered by a nonprofit entity called Elexon. After the trading period, Balancing and Settlement Code participants' metered output and off-take are compared with their contractual volumes (as notified at gate closure) and adjusted for balancing mechanism accepted offers and bids to determine the magnitude of imbalance. All generators and suppliers that are out of balance are subject to an energy imbalance charge. Energy imbalance (sometime called cash-out) prices are calculated for each half hour as the net volume-weighted average of all trades accepted by the system operator in the balancing market. · In Europe, the desire to bring about a single market in Eventually wholesale prices fell under increased electricity--as well as other industries--has been a competition in the market following regulatory key driver of change. The countries of Eastern Europe intervention that forced the companies to extensively have been motivated by the requirements of the divest substantial amounts of their generating capacity European Union's Electricity Directive of 1996 for (Newbery and Pollitt 1997). accession to European Union. · Regulators have to work hard to translate efficiency · In Britain, privatization was driven by more political gains into lower consumer prices. Securing efficiency motives, to "roll back the frontiers of the State" and improvements in transmission and distribution requires because "the business of government is not the tough regulatory price controls. Britain sought to provide government of business." Economists argued that a new kind of regulation to improve the incentives to competitive pressures were more likely to deliver cost efficiency in the monopoly sectors and encourage improvements and hence politically attractive price innovation (Littlechild 2005). The performance of the reductions. British distribution companies has improved after privatization relative to the counterfactual of continuing In contrast: under public ownership. Improvements in the first five years under the initial price controls were modest, with · In much of the developing world, the driving most of the price cuts, efficiency gains, and transfers forces have been fiscal pressure--in particular, to consumers confined to the second and subsequent 123 disenchantment with the poor performance of publicly regulatory reviews (Domah and Pollitt 2001). owned utilities, and the need for new investments and modernization to meet rapid growth in demand. · Well regulated network companies can deliver adequate Often these forces arose in the context of a major infrastructure investment. Britain has invested £16 billion economic crisis for the country which made restructuring in transmission and distribution since privatization and privatization politically feasible. This was particularly in 1990. the case in Latin America during the 1990s, where restructuring of power markets reflected the replacement The economic lessons of restructuring are reinforced by of the import substitution model led by public investment evidence from the Nordic power market: by a market-oriented model of economic development. · Effective competition in generation under private The restructuring of the electricity supply industry in ownership reduces costs and passes those cost England and Wales produced a number of key lessons reductions through to consumers in price reductions. (Newbery 2004): · Effective competition in generation requires regulated · Competitive pressure on generators is needed to third party access to separately owned networks to reduce costs, which requires separating generation lower the barriers to the power market. from transmission and distribution. All generating companies dramatically increased productivity and · This in turn requires ex ante regulation by specialized drove down costs immediately following restructuring. utility regulators, since competition law alone is The original approach that was adopted to regulating inadequate, given the special properties of electricity. the privatized utilities can be viewed as "competition where possible, regulation where not." Regulation was · Cost reductions will be passed through to price seen as a last resort, appropriate only where competition reductions under many competing generating was unlikely to be applicable (Littlechild 2005). companies and a well-designed market for the various ancillary and balancing services, as well as adequate · Whether these benefits will be passed on to consumers supply capacity to meet demand reliably. The number through lower prices depends upon the intensity of of actively competing generators may be increased by competition--particularly the number of competitors improving transmission links, as among the countries and the existence of an open access wholesale market. of the Nordic market. Otherwise, enforcing or These benefits were initially almost entirely captured as encouraging divestiture of plant by the incumbent may higher profits by generation companies, since wholesale be necessary, as in England and Wales. prices did not fall in line with the fall in costs. The major concerns arising from restructuring of OECD incurring substantial economic costs if they are power markets are that reforms have frequently failed to imperfectly designed, as shown by the California address issues of market power, and conversely that electricity crisis of 2001. competition in the market may not be sustainable. Since generating companies benefit from a shortage of The California power crisis of 2001 gave reform an supply through higher prices for their output, they may unjustified bad image. It showed that competition could delay investment and increase scarcity.126 The complex lead to high prices and price volatility in the presence reforms involved in market restructuring also run risks of of serious faults in the design of a competitive market BOX 28. Lessons from California with Competition in the Power Market The California power crisis produced the following useful lessons: · A mandated, deregulated, wholesale bid-based spot market was shown to be highly complex to operate and difficult to monitor for abuse of market power. It should be pursued only if certain conditions are likely to be satisfied. Some of these prerequisites are also required for other, more limited forms of competition, but the consequences of not satisfying these conditions are most dramatic and harmful in a mandated and deregulated spot market. 124 · It is simpler and less risky to impose obligations on generators and distributors to provide ancillary grid support services as a condition for being connected to the grid, rather than trying to synchronize separate markets for ancillary services with an untested spot energy market. · Vesting contracts should be allowed as a form of insurance for distributors purchasing from a new spot market. A vesting contract that fixes the sale price for trade between existing or new generators and distributors for five or more years should be established before the market goes into operation. They also provide at least initial protection against market power. · Close attention is needed to the starting points for reform, the particular problems that need to be solved, and the appropriateness of the reform path selected for solving these problems. · A poorly designed power market will not operate properly, and inadequate attempts or delays in correcting market distortions will spill over into a serious financial crisis. · There is no way out of a crisis in a poorly designed power market that is quick, painless, or cheap. "Quick-fix" solutions to basic design flaws usually fail and may aggravate the problems. Any real solutions will impose heavy costs on stakeholders, such as suppliers, consumers, shareholders, and legislators. · Retail tariffs should be aligned with the costs of wholesale power. Regulators should avoid rate freezes that expose distributors to the possibility of an unsustainable squeeze on their cash flow occurring when rising wholesale power costs approach or even exceed fixed retail rates. · Regulators should encourage and even require suppliers to allow large users to adjust their demand for power in real time, through smart metering and other means, since competition works properly only when prices are seen by both the demand and supply sides of the market. · Power suppliers should be given regulatory scope to absorb through risk management techniques the high price volatility that can occur in spot markets for power. · One or more commercially viable entities must have a legal obligation to provide adequate supplies for small retail power users who prefer to deal with a default supplier rather than shop around in the market for a supplier and face volatile spot market prices. Source: Besant-Jones and Tenenbaum 2001. Easy entry and a profitable market can also lead to excess entry. Competition in the English electricity wholesale market drove prices to cover 126 only just variable costs, which are well below total costs. (box 28). In the light of the experience in California, · The outcome of helping the poor has much greater many governments are afraid of immediate and full relevance to developing countries than to OECD restructuring of the market and total reliance on full countries. The low affordability in relation to per market restructuring. Hence, a phased approach to capita incomes and the substantial proportions of market restructuring is advocated for developing countries, households without access to electricity are serious provided their governments don't use this approach to concerns in developing countries, whereas affordability indefinitely postpone necessary reform steps (Besant-Jones concerns are extremely limited, and the access rate is and Tenenbaum 2001). virtually 100 percent in OECD countries. The different outcomes of power market reform in Confidence in the findings of the empirical analysis to date developing countries and OECD countries show the about the outcomes of power market reform is constrained need for caution in applying OECD reform experience by concerns about methodological rigor and inadequacy of to developing countries: the data (both cross-country and longitudinally over time) available for analysis (Jamasb and others 2004). · Efficiency improvements in OECD countries usually Econometric studies can pick up the effects of reforms apply to power suppliers whose technical and financial and restructuring on prices, investment, and productivity, performance satisfies prevailing commercial standards. although the length of time under most reforms is still rather Competition and regulatory incentives are required short for the long-term effects to be clearly identified. to raise these standards and thus apply pressure to Cost-benefit case studies can identify the net social gains 125 improve performance. In most developing countries, from restructuring, but they are few and far between, however, the priority is to find ways to raise technical and are also restricted to a relatively short period and financial performance standards up to commercial (Newbery 2004). However, it is certainly early enough levels from much lower levels under much weaker to say that poor market design and poor regulation can regulatory capacity and less scope for introducing make matters considerably worse, as the case of California competition. Hence, positive reform outcomes can differ, demonstrates. as in the case of retail electricity prices. In OECD countries, reform is expected to lower prices by lowering Different analyses can result in differing conclusions about costs, but in many developing countries reform requires similar issues. For example, two studies (Steiner 2001; substantial price increases to cover costs fully--at least Hattori and Tsutsui 2004) examine the impact of regulatory for some consumer groups, such as households. reform on power supply using panel data for 19 OECD countries. They reach different conclusions about the · The main fiscal impact of power market reform in OECD effect of creating a wholesale market on the industrial countries occurs through the receipt of privatization price of electricity, probably caused by slightly different proceeds. Although this was also important for some definitions of regulatory reform indicators. However, South American countries (Argentina, Brazil, Chile, both of them find that third party and retail access tend and Colombia), such proceeds are seldom substantial to lower industrial electricity prices and the ratio of elsewhere because of the poor investment climate, industrial to domestic prices, which in many countries and sometimes these proceeds are used to recapitalize represents an improvement in allocative efficiency. the sector, as in Bolivia (Moen 2000). The main fiscal One of them (Steiner 2001) finds that privatization impact in developing countries is through reduction in improves operating efficiency and capacity utilization. subsidies for below-cost tariffs to certain consumer groups and state guarantees to long-term debt financing and power purchase commitments by state- owned power entities. 126 GLOSSARY Access: Access for a household to electricity services from a huge sunk costs, which any rival must match to compete public supplier encompasses a connection from a local effectively, but which have no value if the attempt to distribution network to the place of residence and a legally compete should fail. valid agreement between the supplier and the householder for the supply of electricity services. Base load: The minimum average electric load on a given system over a given period. Affermage: An extension of the management contract approach, of French origin, which involves the award Bilateral contracts: A contractual system between a buyer of a concession (by competitive bid or by negotiation) and a seller to obtain generation or ancillary services, or to a private enterprise to run a state-owned power both, of a given type, duration, timing, and reliability to (or other) system usually for a long term (up to 20 years). It preestablished specifications over a contractual term. differs from the management contract insofar as the concessionaire receives all the revenue and costs of the Brownfield project: A project in which productive operation, and it usually allows a greater degree of facilities--including power generation plants--are freedom for the managers to determine the commercial constructed on sites once occupied by industrial or strategy. commercial installations. In many cases, these sites require substantial cleanup because they were developed and in 127 Affordability: With regard to access for a household to operation before current environmental regulations came electricity, affordability refers to the ability of the household into in effect. See greenfield projects. to finance the charge levied for a connection to public electricity supply, taking account of available subsidies and Build-own-operate-transfer (BOOT): A contract whereby credit support. With regard to the consumption of electricity an investor undertakes to finance, construct, operate, and by a household, affordability refers to the ability of the maintain a project for producing or providing an household to pay for a desired amount of electricity under infrastructure service for a specific period. The investor may prevailing tariff rates--including subsidies. It is usually be permitted to charge user fees during the period of expressed as a share of total household expenditure, which operation of the project as specified in the contract. The is assessed against an empirical upper limit to this share. investor is required to transfer the project to an agency in accordance with the contract after the expiry of the period Ancillary services: Services provided by power producers of operation. This contractual concept has a number of in addition to energy and capacity for the operation and variations, including build-operate-transfer (BOT), Build- stability of the power system. These services cover the Own-Operate (BOO), Build and Transfer (BL), Build-Lease- regulation of frequency, black start capability, cold reserve, Transfer (BLT), Build-Transfer-Operate (BTO), Rehabilitate- fast reserve for emergencies and contingencies, and the Operate-Transfer (ROT), Rehabilitate-Operate-Maintain production or absorption of reactive power. (ROM), and Supply-Operate-Transfer (SOT). Average cost: The revenue requirement of a utility divided Bulk power supply: The aggregate output of electric by the utility's sales. Average cost typically includes the generating plants, transmission lines, and related costs of existing power plants, transmission, and distribution equipment. This term is used interchangeably with lines, and other facilities used by a utility to serve its wholesale power supply. customers. It also included operating and maintenance, tax, and fuel expenses. Capacity: The maximum power that a machine, such as an electrical generator or a system, such as a transmission Barriers to entry (or exit): These barriers are how line, can safely produce or handle. incumbent firms keep out competitors. The main sorts of barriers include (a) a big firm with economies of scale Capacity factor: The measure of the energy production of that may have a significant competitive advantage because a generating plant during a period compared to it can produce a large output at lower costs than can a the total energy production if the plant had operated smaller potential rival, and (b) an incumbent firm that may continuously at full output during the period. This factor is make it hard for a would-be entrant by incurring usually expressed as a percentage. Capital intensive: A production process that involves applies to competition in a wholesale power market, comparatively large amounts of capital to other factors whereby distributors and large users of electricity of production, such as labor. Electricity generation is a purchase electricity directly from generators they choose good example of this type of process. either in a power exchange or bilaterally, and transmit this electricity under open access arrangements over the Captive customer: A customer who does not have power networks to the points of electricity consumption. realistic alternatives to buying power from the local Independent power suppliers are allowed to compete utility, even if that customer had the legal right to buy with distributors for the custom of large users. from competitors. Concession: An arrangement in which a firm obtains Central dispatch: The process of scheduling by the from the government the long-term right to provide a market operator and issuing direct instructions to electric particular service under conditions of significant market power industry participants by the system operator to power. Unlike a management contract, a concession achieve the economic operation of the transmission system involves considerable private capital expenditure. It is a while maintaining its quality, stability, reliability, and security. legal arrangement suitable for creating competition for the market. Cogeneration: The simultaneous generation of electricity and usable heat for industrial processes, or Contestable market: A market in which an inefficient 128 the use of "waste" heat from electricity generation in an firm, or one earning excess profits, is likely to be driven industrial process. out by a more efficient or less profitable rival. A market can be contestable even if it is dominated by a single Combined cycle: A two-stage electrical generation firm, which appears to enjoy a monopoly with market process. In the first stage, electricity is generated by a power, and the new entrant exists only as potential gas turbine. The waste heat is then used to generate competition. more power by steam turbine. Contract for differences: A financial instrument Combined heat and power: See cogeneration. negotiated between the buyer and seller of electricity for an agreed quantity of electricity at a specified price (the Commercialization: The application of commercial contract price or strike price). In the energy pool, the principles to a state-owned enterprise, as far as generator of electricity always receives the clearing possible. price, and the purchaser always pays the clearing price. With a financial instrument, if the market clearing price Competitive bidding: The process of acquiring supply- is below the contract's strike price, the purchaser pays side or demand-side energy resources from private or the difference to the generator. If the clearing price is public sector companies or organizations. above the strike price, the generator pays the difference to the purchaser. This mechanism creates an agreed Competition for the market: One way of bringing profile of prices for the contracted quantity of electricity competitive forces to bear on natural monopoly for the duration of the contract. segments of an industry is to delineate a monopoly franchise and auction it off to the bidder offering the Corporate governance: The relationship of a company lowest price to consumers (or the best bid in relation to to its shareholders or, more broadly, to society, another output variable, such as a number of new especially in terms of how to secure and motivate connections). Monopoly franchises, however, especially efficient management of corporations by the use of long-term ones, still involve regulation--indeed, some incentive mechanisms, such as contracts, organizational commentators argue that this form of competition is designs, regulation, and legislation. simply a way of facilitating regulation. Prices and related terms of the franchise (often known as a concession) Corporatization: Subjecting a state-owned enterprise to have to be adjusted in response to events. the principles of corporate law. This is often accompanied by a range of other initiatives, including providing greater Competition in the market: Competition to provide management autonomy and clear commercial objectives, electricity services among two or more rival providers in performance monitoring, and competitive neutrality. the same service area. In the power market, it typically Corruption: The abuse of public office for private gain, Distribution margin approach: A method of providing either illegally or unethically. a predictable, performance-based payment to equity investors for providing electricity distribution services during Cost of capital: The amount a firm must pay the a transition period for privatizing a distribution entity. owners of capital for the privilege of using it. This It gives for first charge of distribution entity's revenues to includes interest payments on corporate debt, as well as the equity investors, typically consisting of a base revenue the dividends generated for shareholders. It is used as component and incentive charge component. the rate of return that an investor would otherwise be able to earn at the same risk level as the rate of return Divestiture: A private entity buys an equity stake in on the selected investment. a state-owned enterprise through an asset sale, public offering, or mass privatization program. Demand: The amount of a good or service that people are both willing and able to buy. Econometrics: Mathematics and sophisticated computing applied to economic data in search of Demand-side management (DSM): The measures economic relationships that have statistical significance. taken by a utility to encourage conservation of electric usage or to reschedule electric usage for more uniform Economic rent: The difference between what a factor of usage throughout the day or year so as to reduce the production is paid and how much it would need to be cost of generation. paid to remain in its current use, which is a measure of 129 market power. Deregulation: The process of removing legal or quasi- legal restrictions on the amount of competition, the sorts Economies of scale: Reduction in the average cost of a of business done, or the prices charged within a product in the long term, resulting from an expanded particular industry. level of output. One reason is that overheads and other fixed costs can be spread over more units of output. Developing country: A country with a relatively low standard of living, undeveloped industrial base, and Economies of scope: The situation that arises when moderate to low development of health and education the cost of performing multiple business functions standards. These countries are classified by the World simultaneously is more efficient than performing each Bank on their per capita income, namely low-income business function independently. countries (US$765 or less), lower-middle-income countries (between US$766 and US$3,035), and upper-middle- Energy services: The benefits produced by using income countries (between US$3,036 and US$9,385). energy supplies. They include lighting, heating, cooking, motive power, mechanical power, transport, and Distribution company (disco): The regulated entity telecommunications. They can be generated from a variety that constructs and maintains the distribution wires of primary energy sources--oil, gas, coal, and renewables. connecting the transmission grid to the final customer. They can be delivered using different energy carriers and The disco can also perform other services, such as systems for the transformation and transportation of energy, aggregating customers, purchasing power supply and ending with the delivery of energy services within the transmission services for customers, billing customers operation and regulation of energy markets. and reimbursing suppliers, and offering other regulated or nonregulated energy services to retail customers. Externality: Costs or benefits arising from an economic The "wires" and "customer service" functions provided activity that affect somebody other than the people by a distribution utility could be split so that two totally engaged in the economic activity and that are not separate entities are used to supply these two types of reflected fully in prices. distribution services. Fiscal policy: One of the two instruments of Distributed generation: Small amounts of generation macroeconomic policy, the other being monetary policy. located on a utility's distribution system for the purpose It comprises public spending, taxation, and any other of meeting local (substation level) peak loads or government income or assistance to the private sector displacing the need to build additional (or upgrade) (such as tax breaks) and consumers (such as subsidies). local distribution lines, or both. Fixed costs: Production costs that do not change when the Horizontally integrated: A situation in which all or most of quantity of output produced changes, for instance, the cost the capacity within a segment of production--such as of production overheads and debt servicing. Contrast with generation--is owned by a single entity. variable costs. Horizontal unbundling: The breakup of the capacity of a Force majeure: An unexpected and disruptive event that dominant seller in a segment of electricity supply, such as may relieve parties to a contract from some or all generation or distribution, into multiple entities. of their obligations under the contract. Incentive regulation: See performance-based Forward contract: A contract that commits the user to regulation. buying or selling an asset at a specific price on a specific date in the future. Independent power producer (IPP): An entity that owns facilities to generate electric power for sale to utilities and Future: A forward contract that is traded on an exchange. end users and that has no affiliation to a transmission or distribution company. Generation company (genco): A regulated or nonregulated entity (depending upon the industry structure) Independent system operator (ISO): A system operator that operates and maintains power generating plants. The that is independent from control by any single market 130 genco may own the generation plants or interact with the participant or group of participants, and therefore has no short-term market on behalf of plant owners. financial interest in generating facilities. Governance: The traditions and institutions by which Independent power supplier: An entity that specializes in authority in a country is exercised for the common good. energy trading, but does not own or operate distribution This includes the process by which those in authority are networks. selected, monitored, and replaced (the political dimension); the government's capacity to effectively manage its Lease: A form of concession of shorter duration that can resources and implement sound policies (the economic involve both public and private financing of investments, dimension); and the respect of citizens and the state where applied to infrastructure services. for the country's institutions (the institutional respect dimension). Liberalization: Relaxation of government restrictions, usually in areas of social or economic policy. In the context Greenfield project: A project in which a private entity or a of electricity supply, removal of a legal or de facto public-private joint venture builds and operates a new monopoly by opening electricity market to entry by rival facility for the period specified in the project contract. The service providers under arm's length regulation and facility may return to the public sector at the end of the competition, with unbundling of the monopolist's functions. concession period. Lifeline rate: A lower rate than the general rate charged Grid code: The set of rules, requirements, procedures, and to households for electricity consumption that helps low- standards that users of the transmission system must follow income households afford a level of consumption to ensure the safe, reliable, secured, and efficient considered nondiscretionary for their social and economic operation, maintenance, and development of the high- needs (such as a minimum requirement for lighting of voltage backbone transmission systems and its related 30­50 kWh per month). Higher charges are levied on facilities. electricity consumption above that level. Gross power pool: A power pool in which all energy Management contract: An arrangement under which generated and consumed is included in the system operational control of an enterprise is vested by contract in operator's settlement process. In a gross pool, all contracts a separate enterprise that performs the necessary for commodity energy must take the form of contracts for managerial functions in return for a fee. It can involve a differences. wide range of functions, such as technical operation of a production facility, management of personnel, accounting, marketing services, and training. Market failure: When a market left to itself does not and are willing to pay nondiscriminatory prices for that allocate resources efficiently. Its presence is the main service. This obligation is rendered in return for the justification for regulation. Four main sorts or causes of granting of exclusive rights to serve a geographic area market failure are identified: the abuse of market power, at the retail level. the presence of externalities, the existence of public goods, and existence of incomplete or asymmetric Opportunity cost: The true cost of producing or information or uncertainty. acquiring a good or service. This cost includes not only the money spent in this process, but also the economic Market power: When one buyer or seller in a market benefits that are foregone from the use of the resources has the ability to exert significant influence over the consumed (including time) in this process. quantity of goods and services traded or the price at which they are sold. Performance-based regulation: A process by which a utility's rates are set by linking rewards (generally profits) Merit good: A good that is underconsumed if provided to desired results or targets, as opposed to setting rates by the market mechanism because individuals typically based on cost plus an allowed return on investment. consider how the good benefits them as individuals These rates, or components of rates, can be based on rather than the benefits that consumption generates for external indices, rather than on a utility's cost-of-service. others in society. In economic terms, this is because the Also known as incentive regulation. positive externalities of the good are not internalized by 131 consumers. To increase efficiency, the state may choose Power pool: A wholesale electricity market in which to encourage greater production or consumption of a electricity produced by generators and the electricity merit good through regulation or subsidies, or may required by distributors and other suppliers is "pooled" choose to produce the good itself. in a power exchange. The pool establishes short-term market-clearing prices based on bids by suppliers and Merit order dispatch: The process of meeting the purchasers. It provides price bids to the system operator, demand on a power system at least cost by dispatching who may then use the sets of price bids provided by the electricity from generating units connected to the system power exchange to establish congestion prices, match under a merit order. This order ranks units according to actual demand to available supply, and facilitate the their variable operating costs with the lowest cost units efficient short-term operation of the integrated generation ranked first for dispatch, and other units ranked in and transmission system. A separate pool for ancillary ascending order of variable operating cost so that the generation services may be established in parallel. highest cost units are dispatched last. Power purchase agreement (PPA): A legally binding Monopoly: The only seller in a market that controls contractual agreement by which an entity, such as a sales in that market. single buyer or a distribution company, undertakes to purchase the power generated by an independent or Monopsony: A market dominated by a single buyer. affiliated power producer under specified terms for a See single buyer. multiyear period. Natural monopoly: A market in which demand can be Power utility: A regulated entity that exhibits the satisfied at lower cost by a single firm rather than by characteristics of a natural monopoly. For the purposes multiple firms. Natural monopolies occur in industries of electric industry restructuring, "utility" refers to the that exhibit decreasing average long-term costs because regulated, vertically integrated electric company. of size (economies of scale). "Distribution utility" refers to the regulated owner or operator of the distribution system that serves retail Net power pool: A design of the power pool under customers. which power buyers and sellers can choose to trade under bilateral contracts outside the pool. Price cap regulation: Price cap regulation of power utilities--whether they are vertically integrated utilities, Obligation to serve: The concept governing the retail transmission entities, or distribution entities under long- or end-use provision of electric service in which a utility term concessions--fixes the prices (or the price paths is required to serve all customers who request service over time) for their electricity services. The entities thus bear the risks associated with varying exogenous input Public utility: A utility providing essential services to the prices and shifting demand. At the same time, the entities public, such as water and electricity, usually involving have full incentives to reduce their costs, as their prices elements of natural monopoly. are not adjusted downwards when they succeed. This contrasts with rate-of-return regulation or cost-of-service Purchasing agency: See single buyer. regulation, where prices track observed costs closely. Rate-of-return regulation or cost-of-service Private sector participation: Private sector participation regulation: This form of regulation caps a power in power supply is generally classified in four categories: utility's realized rate of return on capital employed in the management contracts, concessions, greenfield business by making the utility's prices track its observed projects, and divestitures. costs closely. The utility faces lower risks than under a price cap regulation, but it is unlikely to earn excess Privatization: The transfer--usually by sale--of assets profits for long. The downside is that the utility has little or service delivery from the public sector to the private incentive to pursue efficiency gains because the profitability sector. of such activity is reduced by the expectation that its prices will be cut by the regulator in response. Project financing: An arrangement in which a lender provides the needed capital to build a facility, and the Regulation: Rules governing the activities of enterprises, 132 security for the lien is the value of the project itself, particularly private sector enterprises. Regulation is often rather than the security being the full faith and credit of imposed by government, either directly or through an the owner of the project. appointed regulator. However, some industries and professions impose rules on their members through self- Public good: A good that can be consumed by everybody regulation. Regulation is often introduced to tackle in a society, or by nobody at all. It has three characteristics: market failure. one person consuming it does not stop another person from consuming it; if one person can consume it, it is Regulatory capture: The theory that regulation is a impossible to stop another person from consuming it; process by which interest groups seek to promote their and people cannot choose not to consume it even if private interest by obtaining over time some influence-- they want to. It can be beneficial--as in the cases of or even dominance--over the agencies that regulate them. clean air and the judiciary--and harmful--as in the case of an epidemic of a disease. Regulatory failure: A situation in which regulation generates more economic costs than benefits. Public interest: In the specific case of power market reform, it refers to the interest of power consumers in Regulatory risk: A risk faced by private sector firms that particular and to all members of society in general that regulatory changes will hurt their business. In competitive are affected by the production, transportation, trade, markets, regulatory risk is usually small, but in natural and use of electricity. In the course of these activities, monopoly industries, such as electricity distribution, acting in the public interest covers such aspects as it may be huge. protecting public health and safety, detecting or exposing crime or serious impropriety, exposing misuse of public Rent: The commonplace definition is the income from funds or other forms of corruption by public bodies, and hiring out land or other durable goods. See also correcting misleading public actions or statements. economic rent. Public-private partnership: Use of a private firm to Rent-seeking: Trying to make more money without adding provide a public service under contract with a public any value, such as producing more for customers. agency. The public sector can have a financing or a risk- Examples of legal rent-seeking include lobbying the bearing role, or both, by means of investment financing government for tax, spending, or regulatory policies and provision of subsidies. The main forms of this type that benefit the lobbyists at the expense of taxpayers or of partnership are management contract, lease, consumers or some other rivals, and a labor union concession, and divestiture. demanding higher wages without offering any increase in productivity. Illegal rent-seeking activities are usually classified as corruption. Retail competition: A system under which more than generating facilities and preestablished long-term one electric service provider can sell to retail customers, contractual obligations. and retail customers are allowed to buy from more than one provider. Strategic investor: In the context of power markets, a major corporation--which can also include a state-owned Ring-fencing: The internal separation of business entity--that invests in the power sectors of many countries functions within an enterprise for management and according a defined strategy of business development. Such accounting purposes. In the context of power market a strategy can seek opportunities for business growth outside reform, this type of separation can be used to limit a the corporation's home market, or be a defense against the contractor's exposure to financial or regulatory risk. aggressive business strategies of rival corporations in its home market. It often seeks to leverage the corporation's Risk: The possibility of outcomes not turning out as strengths, such as in project development, financing, expected. construction, and management. Risk premium: The extra return required by investors to Subsidy: Money paid, usually by government, to keep hold a risky asset instead of a risk-free one, or the prices below what they would be in a free market, difference between the expected returns from a risky or to enable businesses to remain viable in providing investment and the risk-free rate. unprofitable, but socially desirable services, or to make a service affordable to a particular group of consumers, 133 Single buyer--also known as a purchasing agency: or generally to make activities happen that otherwise An entity that is granted--sometimes by law--an exclusive would not take place, such as the development of new right to purchase and sell power in a wholesale electricity forms of service delivery. market. It generally has a monopoly for supplying distribution companies and large power users. It can Supplier: Any person or entity licensed to sell, broker, manage competition for long-term market share among market, or aggregate electricity to end users, that is generators and IPPs. The functions of this agency are registered with the market operator as a customer. carried out by many types of entities in different countries, including a national vertically integrated utility, a nationalSystem operator: The party identified as the system generation entity, a national transmission entity, a national operator pursuant to the grid code that is the party distribution entity, a combined national generation and responsible for generation dispatch, the provision of transmission entity, and a combined national transmission ancillary services, and operation and control to ensure and distribution entity. safety, power quality, stability, reliability, and security of the grid. Spot price: The price quoted for a transaction made in a spot market that is to be made on the spot--that is, Sunk costs: Costs that have been incurred and cannot paid for now for delivery now. Contrast spot prices with be reversed or reclaimed by resale. Investments in most forward contracts and futures, where payment or immovable infrastructure assets that have no alternative delivery, or both, will be made at some future date. Also use to a particular infrastructure output or service fall contrast with a long-term contract, such as a concession into this category of costs. to provide a public service, in which a price is agreed for repeated transactions, such as the sale of electricity Supply: The amount of a good or service that is available under a tariff over an extended period. at any particular price. Stakeholders: All the parties that have an interest, Take-or-pay: The terms of an agreement between a financial or otherwise, in a company or a market, buyer and seller in which the buyer pays an agreed including shareholders, creditors, bondholders, amount even if it is does not accept the product or employees, customers, management, the community, service. In the power market, this arrangement used to and government. prevail in power purchase agreements with IPPs, under which an off-taker--typically a power utility or a single Stranded costs: Liabilities incurred before the reform of buyer--agreed to pay for a prescribed level of electricity the electricity industry and which cannot be recovered in produced by the IPP in a defined period--usually a a new market environment. Examples are undepreciated year--even if the off-taker actually took less electricity. Tariff: A document, approved by the responsible Utility: A regulated entity which exhibits the regulatory agency, listing the terms and conditions, characteristics of a natural monopoly. For the purposes including a schedule of prices, under which utility of electric industry restructuring, "utility" refers to the services will be provided. regulated, vertically integrated electric company. "Distribution utility" refers to the regulated owner or Third party access (TPA): Open access for parties operator of the distribution system that serves retail other than a vertically integrated power utility to use its customers. transmission system, which enables independent power producers to sell power directly to suppliers and consumers Variable costs: Part of a firm's production costs that and end users, and allows suppliers and end-users to change according to how much output it produces. purchase electricity directly from the wholesale market Contrast with fixed costs. Examples include purchases rather than through a local distribution utility. of fuel in the case of electricity generation. In the long term, most costs can be varied. Transition economies: The formerly centrally planned economies of the former Soviet Union and Central and Vertical integration: An arrangement whereby the same Eastern Europe that are becoming market economies. company owns all the different aspects of making, selling, and delivering a product or service. In the electric industry, Transmission company (transco): The corporation it refers to the historically common arrangement whereby a 134 organized pursuant to an electricity law to acquire, power utility owns its own generating plants, transmission operate, and maintain transmission assets. system, and distribution lines to provide all aspects of electric service. Transmission system: The system used to deliver electric power at higher voltages in bulk quantity from generating Vertical unbundling: The functional separation of facilities to local distribution facilities (and a few large the vertically integrated utility into smaller, individually industrial customers), for final retail use. owned business units (that is, generation, dispatch or control, transmission, and distribution). Transaction cost: A cost incurred in making an economic exchange, such as for buying and selling Vesting contract: A contract that fixes the price of electricity, in addition to the price at which the exchange is power traded between generators and distributors for made. It can cover the costs of search and information, a set period (up to five years in some cases) before an negotiation, monitoring, and enforcement. open bulk power market goes into operation. It removes trading price uncertainty for investment in the early years Two-part price: A price structure under which one part of power market reform, thereby providing a significant is a periodic availability charge that covers fixed costs, advantage for financing the renovation of dilapidated and the other part is applied to the actual amount of and undersupplied power distribution systems, as well as service that is provided and covers variable costs. for dilapidated generation plant, which helps sell these businesses, provided that the contracts are in place Unbundling: The act of disaggregating the total electric at the time of sale. These contracts are a transition service provided by a power utility into its basic components mechanism that should eventually be replaced by and offering to sell each service separately with separate trading arrangements that give stronger incentives for rates for each component. Thus, generation, transmission, distributors to be efficient buyers of power. and distribution services could be functionally unbundled into separate entities and offered as discrete services. Wholesale competition: A system whereby a distributor (See vertical unbundling and horizontal unbundling.) of power would have the option to buy its power from a variety of power producers, and the power producers Unserved energy: The expected amount of energy would be able to compete to sell their power to a variety curtailment caused by power demand that exceeds of distribution companies. available capacity. Wholesale power supply: See bulk power supply. Yardstick competition: See yardstick regulation. Yardstick regulation: A form of incentive regulation that involves comparison of a measure of the actual performance of a power utility or utilities against a reference benchmark performance. 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Center for the Study competitive power markets, particularly in the OECD of Energy Markets Working Paper CSEM WP 105, countries that are most advanced in introducing University of California Energy Institute, Berkeley, CA. competition in their power markets. http://repositories.cdlib.org/cgi/ viewcontent.cgi?article=1005&context=ucei/csem Arciniegas, Ismael, Chris Barrett, and Achia Marathe. 2003. "Assessing the Efficiency of U.S. Electricity Brown, Matthew H., and Richard P. Sedano. 2003. Markets." Utilities Policy 11(2):75­86. A Comprehensive View of U.S. Electric Restructuring http://ndssl.vbi.vt.edu/Publications/ with Policy Options for the Future. Electricity Industry EfficiencyUSElecMarkets_Achla.pdf Restructuring Series. National Council on Electricity Policy. Baumol, William J. 2001. "Economically Defensible http://www.ncouncil.org/pdfs/restruc.pdf Access Pricing, Competition and Preservation of Socially Desirable Cross Subsidy." 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