Privatesector P U B L I C P O L I C Y F O R T H E The World Bank June 1996 Note No. 83 The Dynamics of Independent Power IPPs seed top-to-bottom reform Elliot Roseman The desirability of government ownership of the seeds for a top-to-bottom change in the and Anil power generation has increasingly been called structure and operation of the government- Malhotra into question, particularly in the past five years. owned utility—seeds that are hard to stop from Around the globe, many incumbent power com- growing once they take root. Other vehicles panies have offered independent power pro- for private sector entry that are gaining in popu- ducers (IPPs) the opportunity to tender for new larity include privatizing management and leas- or existing generation. Outside the United States ing and franchising utility operations. From and Canada, there are now more than 600,000 modest beginnings, IPPs and these other megawatts (MW) either on line or under devel- mechanisms can lay the groundwork for an opment in more than 1,500 project initiatives. upheaval ending in private ownership of much In the Philippines, for example, private devel- of the generation, transmission, and distribu- opers have, just in the past two years, brought tion sectors of utilities. on stream 1,200 MW of the 8,000 MW in place, for sale of power to the national utility, and are Such top-to-bottom restructuring is now under developing more than 6,500 MW of additional way in a number of countries, some of which capacity. In Australia, several existing plants were among the first to use IPPs, including owned by provincial utilities have been auc- Argentina, Australia, Bolivia, New Zealand, the tioned off to IPP bidders, and other developers United Kingdom, and the United States. In the have won the right to develop new plants for United States, restructuring is well under way sale of power to these utilities. In Argentina and even though most generation was not govern- the United Kingdom combined, well over 12,000 ment owned when IPPs were introduced. MW of government-owned hydro and fossil fuel– based generating capacity have been sold, The process of change largely to private developers from Chile, France, the United Kingdom, and the United States. In At first sight, IPPs seem innocuous and desir- the United States, which has allowed private de- able in reasonable doses. Properly done, they velopers to own new generation since 1978, generally are. But during their development, about 7 percent of existing capacity—nearly they raise nagging questions about the effi- 60,000 MW—is owned by IPPs. ciency and competitiveness of the integrated, government-owned utility and the means by The reasons supporting the introduction of IPPs which it is regulated. Once IPPs are introduced (outside the United States) into government- into the mix, these questions tend to ferment, owned utilities are legion: reducing public leading the more progressive forces within and spending, expanding capacity, improving reli- outside the country to seek answers, explore ability, introducing foreign capital, introducing alternatives, and set about to change the exist- competition, transferring technology, respond- ing industry’s structure. The phasing of the re- ing to pressure from large consumers seeking structuring process revolves around three main more cost-effective alternatives, and so on. Less sets of questions that IPPs raise—about whether recognized is what may be an unintended con- the existing utility is efficient in generation and sequence of the introduction of IPPs: they plant what the proper level of prices should be, about Industry and Energy Department ▪ Vice Presidency for Finance and Private Sector Development The Dynamics of Independent Power the regulatory framework, and about the struc- system? Underlying question: Is the govern- ture of the entire industry. ment-owned utility’s transmission system ad- equate and well planned? The pace of these phases, their overlap, the ▪ Did the regulatory, permitting, and political resistance they meet, and their outcomes dif- approval process work well for the IPP? Un- fer from country to country, depending on the derlying question: What decisionmaking and initial structure of the industry and the relative approval process for procuring capacity strength of the stakeholders. Regardless of the should be in place for the long haul? country, however, the questions do get asked, ▪ Was the IPP’s contract financeable—given the and the very asking leads to incremental—and guarantees, if any, that the utility provided— sometimes wholesale—change. and did it bring in new capital? Underlying questions: Is the utility creditworthy? Does Phase 1: Generation and project development the country need model contracts? Do IPPs really leverage domestic capital? Will guar- Assume, for example, that an IPP is introduced, antees be required in the long term? through negotiation, into a national, govern- ▪ Was the project financed using primarily for- ment-owned, vertically integrated utility that is eign capital and multilateral loans? Underly- largely or wholly unregulated. If this IPP rep- ing question: Can the country improve its resents a substantial amount of capacity (a domestic capital market? A number of coun- small, inside-the-fence cogeneration plant, for tries are trying to determine how to emulate example, might not be noticed), it will raise a Malaysia’s success in raising all the debt and set of issues relating to developing, construct- equity capital domestically for its 1,300-MW ing, financing, operating, and maintaining a Lumut project. generation unit that is not part of the govern- ▪ Was the IPP efficient in construction, and does ment-owned utility system. This is a plant that it operate efficiently? Underlying questions: can allow more foreign control in the power Should the utility modify the operation of its industry than ever before, and that takes much existing generation? Should the government of the decisionmaking for a power plant out of consider private sector operation while retain- the utility’s hands. And it raises questions that ing ownership, or set up incentives for the not only require negotiation with the IPP, but utility to be more efficient? Does the country also reveal underlying issues about how IPPs have the capability to produce the equipment compare with the utility, how the process of for its own modern power plants? adding generation capacity should be changed, ▪ How should the IPP procure fuel—on the and whether there are inadequacies in the cur- open market or from a state-owned mo- rent utility system. nopoly? Which is most efficient for the IPP? ▪ Does the IPP deliver power at a lower price Underlying question: Is the way the govern- than the utility? If the costs of production ment oversees fuel procurement for all power are not broken out and tariffs are highly sub- stations efficient and conducive to private sidized, as is true in many countries, how sector investment? can the country know? Underlying questions: ▪ Was the IPP developed by a company from At what price should the utility buy power? an industrial country? Underlying question: Should retail rates be restructured? Are there local firms that could do the job ▪ Is the way the IPP was selected—through ne- just as well, keeping the revenues in the gotiation—the best way? Underlying ques- country, or that could establish a regional tion: Should there be a competitive bidding presence? The initial wave of IPP projects process that gives IPPs the right to compete were carried out by developers from such for all future generation? countries as the United Kingdom, the United ▪ Can the power generated by the IPP be States, and other Western countries, but cur- smoothly integrated into the transmission rent IPP projects include many with strong lead participation from companies headquar- ▪ Should generation, transmission, and distri- tered in such countries as China, India, Ma- bution be regulated differently, depending laysia, and Thailand. on whether they are natural monopolies? ▪ Shouldn’t the country standardize the provi- The IPP negotiation process can reveal weak- sions relating to country and commercial risk nesses in the government-owned utility sys- in its contracts with IPPs? tem—including in the way power plants are ▪ What is the best bidding and approval pro- authorized, financed, granted permits, con- cess for IPPs? How should it be implemented? structed, operated, and priced. The first IPPs Should prices paid to IPPs be determined can plant the seeds of change, as one question through bidding, or through some other leads to another. Even an initial failure with method? IPPs does not necessarily lead to a reactionary ▪ Should foreign developers be required to return to the traditional government-owned util- work with local firms? ity. In the Philippines, for example, the failure of contract negotiations with a U.S. developer Phase 3: The structure of the industry in the early 1990s forced questions about why the process did not work, and made it easier By the third phase, the introduction of IPPs to consider IPPs when the country was in the has already affected the generation and regu- midst of a power crisis in 1992. latory framework, and the entire structure of the power industry is at stake. The overriding Phase 2: The regulatory framework goal shifts to creating a competitive framework. The key questions become: In many countries, government-owned utilities ▪ Should all new generation be allocated to are largely self-regulating monopolies. No in- IPPs? dependent regulator charged with protecting the ▪ Should the government utility continue to public interest reviews their rates, and the util- own existing generation, or sell it? ity itself oversees the quality of service. There is ▪ Should there be a power pool into which all little input by public interest groups or others generation, by both IPPs and the utility, into decisions affecting tariffs or service. Financ- would be sold? How would this pool be ing comes from the public treasury or, for the administered? more efficient utilities, from internally generated ▪ Can the country allow private sector owner- cash, not from capital markets. After one IPP ship of transmission and distribution? Should has come to financial closure, country officials parties be allowed to own shares in more may be tempted to put off any changes in regu- than one sector of the industry? latory structures and financing arrangements un- ▪ Should power generators be able to sell only til they see what happens. But at this point, the to the utility and at wholesale? Should direct underlying questions become explicit. contracting between power users and sup- ▪ Shouldn’t there be a permanent, independent pliers be allowed? regulator with sufficient authority to ensure ▪ How should utilities streamline their opera- that the utility delivers the best service the tions to remain competitive, and should they public has the right to expect? Should this diversify into related businesses (for ex- regulator oversee both wholesale and retail ample, third-party plant operation, or real prices? estate)? ▪ Rather than an ad hoc IPP negotiating team, ▪ How can the country provide equal access shouldn’t there be a standing, transparent to the transmission system to private parties, approval process? yet still provide incentives to build new trans- ▪ What should the country’s import and for- mission when and where it is needed? eign exchange policies with respect to power ▪ How must the regulatory framework adapt generation be? to the new industry structure? The Dynamics of Independent Power Phase 4: Competitive markets system are compared with those who stand to benefit from the new one. Who can expect to In the final stage, the government-owned util- win under the new system? Consumers can be ity starts to operate more like a private sector big winners if reliability increases and prices firm, with regulatory controls in place to guard fall. But whether tariffs can be lowered depends against business abuses and for oversight of on the subsidies built into rates and on how the sectors that remain natural monopolies. Util- much utilities can improve their operations and ity monopolies are broken up or prepared for pass on the savings. Politicians can position sale, and regulatory frameworks are reformed. themselves to win if they support change as a Some countries, most of them among the first way to make power cheaper and more reliable. to use IPPs, are at this stage. Others may “win” by being initially opposed to ▪ In the United Kingdom, distribution compa- IPPs and utility restructuring, or by driving a nies have been opened to private ownership. hard bargain. IPP developers win if their con- A power pool with open access to transmis- tract and the industry’s new structure allow them sion has been set up. Existing generation has to earn adequate returns at acceptable levels of been sold to break up generating monopo- risk. Commercial banks and foreign fuel and lies. And a new regulator was set up with equipment suppliers are also usually winners. sweeping powers to oversee the industry. ▪ In Argentina, existing generation, transmis- Utility distribution companies are potential los- sion, and distribution companies have been ers. Jobs and control by existing managers may auctioned to the highest qualified bidders. be at risk from private ownership—though in Federal and provincial regulators oversee the the longer term the distribution entities and their setting of prices. End users can negotiate employees should benefit if their ability to serve freely with power generators for supply. customers improves. Utility procurement offic- The Note series is an open forum intended to ▪ In Bolivia, all sectors of the formerly public ers could also lose influence. Still others could encourage dissemina- power industry are being sold, building on be winners or losers depending on how things tion of and debate on the examples of Argentina and Chile. Colom- play out. Ministry officials may gain new IPP ideas, innovations, and best practices for bia may soon follow suit. review responsibilities in the short term, but in expanding the private ▪ In Indonesia and the Philippines, private the medium term they could lose control to sector. The views firms have successfully bid to develop and newly created regulators. Local workers and sup- published are those of the authors and should finance new plants. The breakup of the gov- pliers can learn new skills from IPPs, or they not be attributed to the ernment-owned monopoly is scheduled to may lose out on business until new manufac- World Bank or any of its take place in the near future. Other reforms turing capabilities are set up. And multilateral affiliated organizations. Nor do any of the con- are being implemented, such as open access institutions, with fewer loans needed to build clusions represent to transmission for private parties. power plants, may have to redirect their focus. official policy of the ▪ In the United States, some utilities (for ex- World Bank or of its Executive Directors ample, Consolidated Edison) have begun to The benefits of restructuring may sometimes or the countries they sell existing generation. The Federal Energy be hard to prove and to quantify, and there is represent. Regulatory Commission (FERC) is promoting a risk of backlash against IPPs and industry Comments are welcome. an agenda of open access to transmission, and reform if improvements are not realized and Please call the FPD a number of states and utilities are consider- recognized. But there is nevertheless no re- Note line to leave a ing restructuring the industry to set up power turn to the old system. message (202-458-1111) or contact Suzanne pools, separate generation from other func- Smith, editor, Room tions, and provide better customer service. This Note is an abbreviated version of an article that appeared in G8105, The World Bank, Electricity Journal [9 (2): 21–27, March 1996]. 1818 H Street, NW, Washington, D.C. 20433, Winners and losers or Internet address Elliot Roseman, Resource Management Inter- ssmith7@worldbank.org. Once this process of change has begun, it is national, Washington, D.C., and Anil 9 Printed on recycled hard to stop. Its spread depends largely on how Malhotra, Regional Energy Adviser, Asia paper. powerful those who benefit from the current Technical Department