It is important to start by clarifying what is meant by my use of the
term “liberalization.” To “liberalize” has a number of shades of meaning,
two of which are of particular relevance to the electricity reform that
is currently sweeping the world’s power industries:

• To effect progress and reform

• To promote individual freedom

Liberalization carries with it, therefore, both reference to a process
of the removal or reduction of barriers, regulation, and control, and
the implication that this process is a beneficial one. In the energy sector
context, liberalization is concerned with developing the freedom of suppliers
to take an active role in the extraction, refining, generation, distribution,
or supply of energy products and the freedom of customers to choose, on
price and quality, between different energy products and suppliers. It
is not a single process affecting only limited elements of a whole; it
is a process with many facets, affecting a wide-ranging number of elements
of the sector.

The motivations for liberalization to be entered into can be summarized
into three main categories :

• The need to address energy sector inefficiencies and deficiencies
  such as the supply/demand gap; the lack of the necessary power asset
  infrastructure; and wider economic inefficiencies such as the inefficient
  use of fuel and heat brought about by uneconomic tariff arrangements

• International pressures including momentum for reform brought about
  by international accords such as the Kyoto agreement; the need in
  some territories for a coordinated approach across various countries
  or states in order to develop an interconnected infrastructure; and
  finally, the process of globalization (creation of large global companies)
  causing international companies to seek parity of fuel pricing for
  all their operations

• Various other practical reasons such as the lessening of reliance
  on imported fuel sources; the raising of capital – the inclusion of
  the energy sector on capital markets, through its sheer size, can
  bring much needed critical mass to fledgling capital markets; and
  also the removal of energy-related liabilities from the public sector.

Trends In Regulation

There are four distinct stages to liberalization: commercialization,
privatization, unbundling, and competition (both wholesale and retail),
although in practice, two or more of these stages may be combined in one
piece of legislation and one need not necessarily follow the other. In
Norway, for example, the electricity industry remains largely state-owned
but competition has been introduced.

Commercialization involves the initial application of commercial
practices to government-owned bodies such that there is more of an emphasis
on efficiency and cost-cutting. A commercialized body that is focused
on costs will need to find the least expensive route to supply rural areas,
since generally they are the areas least well supplied at present and
are thus in need of investment.

Privatization is the sale of public bodies into the private sector,
leading to an emphasis on both cost reduction and on revenue maximization
as profitability becomes the key performance measure. As the industry
moves towards a privatized state, its cost of capital generally increases.
Emphasis on costs is strengthened but a further emphasis on revenues,
profitability, and returns on investment has mixed effects on renewable
strategy. In addition, responsibility for social objectives is usually
passed to regulators who seek to balance these objectives with the utility’s
economic well-being.

Unbundling then brings about the separation of the industry into
transmission, generation, distribution, and supply, and with it, the requirement
to introduce a system for the allocation of costs and the introduction
of structural and tariff regulations to protect the consumer. Once unbundling
has taken place, competition can be introduced into the supply and generation
sectors, although within the natural monopoly areas of transmission and
distribution, it is not possible to introduce competition directly, so
regulation must act as a surrogate for competition.

Only a handful of countries have achieved, or come close to achieving,
truly competitive retail and wholesale electricity markets (Argentina,
Chile, Sweden, the U.K., and some U.S. states have achieved the former
while Victoria state, several Latin American countries, and U.S. states
have achieved the latter). This scarcity of examples indicates the challenge
of making the transition to competition, however large the potential benefits.
The vast majority of global electricity markets still have at least one
or two of the stages of liberalization to undertake.

A 1998 WEC study classified 71 percent of Asia-Pacific countries, 80
percent of Eastern European countries and 97 percent of African and Middle
Eastern countries as having governmental or regional government control
of the electricity industry. 36 percent of Asia-Pacific countries, 40
percent of Eastern European countries, and 14 percent of African and Middle
Eastern countries had either commenced or were planning for privatization
to take place at that time. Since then, even more countries have moved
into the liberalization process. A recent survey of the European Power
Markets by PricewaterhouseCoopers entitled “Electricité sans Frontieres
2000” showed that approximately 60 percent of the European Union (EU)
electricity markets were open to competition during 1999, compared to
the 25 percent required by current EU legislation.

While the process of liberalization may differ in detail from country
to country, there are certain common features that are demonstrated to
some degree across most liberalized power industries:

The commercialization of state-owned entities and their eventual privatization

In many countries, the boundary between these two stages may be unclear
or even nonexistent, as full or partial privatization may take place without
previous structural or operating changes to the entities. In other countries,
such as in many of the Nordic states, privatization may not take place
at all, though competition is introduced and the market can be classified
as “fully liberalized.”

The removal of entry barriers to an industry or country; monopoly status
for existing entities; unusually high tax burdens; and price-setting,
wherever this is possible

The removal, or at least the dilution, of entry barriers and monopoly
status of existing players is a key feature of liberalization programs.
One key way in which this is achieved is for regulation to contain restrictions
on the size of players in a newly-liberalized market, and there are a
variety of approaches to be seen. For example, in the U.K. the generating
capacity of National Power, PowerGen, and British Energy was, and still
is, closely monitored and restricted by the regulator and the government.
In Argentina, no one generating company is permitted to operate more than
10 percent of the country’s total generating plant. In Chile, there are
no such restrictions.

The removal of fixed price-setting arrangements and their replacement
with an alternative market structure provides further opportunity for
comparison. Some regimes have introduced a centralized System Operator
that has responsibility for setting the price based on bids made by generators,
like in the U.K., and New South Wales and Victoria states in Australia.
Others operate a single-buyer system although often these markets have
not yet entered into significant market liberalization (e.g., France and
Australian states other than New South Wales and Victoria).

As established liberalized markets continue to evolve, there is often
a move toward the introduction of bilateral contracts between interested
parties, as well as the shorter-term pooling arrangements supervised by
the Independent System Operator. This is already the case in the Nordic
countries and forms the basis of the proposed restructuring of the trading
arrangements in the U.K. At present in California, there is only an Independent
System Operator, but bilateral trading will be allowed from 2002 when
the five-year transition period ends.

The establishment of open access regimes for transportation infrastructure;
separate markets for different products; an independent regulatory function;
and tax incentives to promote investment

One of the main differences across liberalized markets is the approach
taken on the level of independence assigned to the regulatory function.
In some markets such as New South Wales, the proposed regulator will be
independent from government while in others the regulator forms a part
of government, such as in Denmark and Finland.

There is a range of regulatory bodies that incorporates an independent
council or consumer committee (or both), but the government still retains
the right to guide or issue advice to the regulator. In the U.K., for
example, the government has recently published proposed reforms that would
enable it to pass “guidance” on certain issues to the regulator, though
it is not clear how the final legislation will look.

The focus of the regulator is another area where different approaches
can be seen. The job of a regulator is to balance the interests of various
stakeholders, and therefore necessarily has to ensure that the producers
of power obtain an adequate return while ensuring certain standards of
supply to consumers.

The unbundling of vertically integrated operations

In most liberalization programs, there is provision for unbundling of
the industry, even if the regulation is restricted to separate accounting
functions and regulatory reporting within the same vertically integrated
company.

There is a variety of regulatory approaches to the amount of vertical
integration that may remain or be developed. In the U.K., while vertical
integration has been allowed, with National Power, PowerGen, and British
Energy (the U.K.’s privatized nuclear generator) acquiring parts of regional
electricity companies, disposals of generating plant were required by
the government before the English generators could complete their acquisitions.
Also, Eastern Electricity (originally a Regional Electricity Company,
now renamed TXU Europe) has acquired significant generating capacity.

In Argentina and Mexico, regulation does not allow generation or distribution
companies to have an interest in the transmission monopoly and vice versa.
In addition in Mexico, distribution and generating companies are allowed
to hold no more than a minority stake in each other.

An interesting contrast can be seen in Chile, where no restrictions were
placed on vertical integration and two separate scenarios developed in
the North and South of the country. In Northern Chile, a number of large
companies were formed and intense competition developed in the market
while in Southern Chile, although subject to the same regulation, the
market is dominated by one investment company holding both the main generating
company and the largest distribution company, as well as owning the transmission
operator.

Practical Effects

Industry Realignment

The Future of Vertical Integration

During the initial stages of the liberalization process, there is a tendency
for power companies to vertically integrate, if they are permitted to
do so, in an attempt to hedge against price volatility risk. In the short
and medium-term, while wholesale and retail markets are only partially
competitive, incumbent generators will seek to remain or become vertically
integrated because of the secure market and margin shifting opportunities
it offers. These advantages, however, will diminish in the long-term.

European companies, in particular, have adopted vertical integration
strategies and these will require continual review as the new markets
develop. The need for multi-product retailing as a minimum entry ticket
to the mass market will constrain the scope for vertical integration of
generators and retailers, as retailers will need to source aggressively
the lowest cost supply of a portfolio of products. Retailers will not
be able to compete effectively if they are integrated with the supplier
of one element of a multi-product offer.

International Expansion

Ownership patterns are fast becoming international. There is heavy participation
in European markets from U.S. companies, and there is an equally high
level of transatlantic and wider international activity and ambition among
the big European companies. The leading players from the U.S. and Europe
now have truly international portfolios spanning several continents. National
Power, for example, one of the four non-nuclear British generators created
in the U.K. privatization process, currently has investments in 22,500
MW of generating capacity outside the United Kingdom in Australia, China,
Czech Republic, India, Ireland, Kazakhstan, Malaysia, Pakistan, Portugal,
Spain, Thailand, Turkey, and the United States.

Global merger and acquisition activity in electricity continues to intensify
as liberalization spreads across the world. PricewaterhouseCoopers global
mergers and acquisitions survey “Electric Deals” reveals that in 1999,
for the second year running, the number of announced cross-border electricity
deals rose by more than 35 percent on the previous year, to a record 124
cross-border deals. While the number of cross-border deals increased in
1999, the total value of deals decreased by 24 percent from $49.7 billion
in 1998 to $37.9 billion in 1999, and the average size of disclosed deals
fell from $740 million in 1998 to $440 million in 1999. This confirms
that the pace of change in the electricity industry is accelerating, although
a more cautious approach is being adopted when it comes to large deals.

Europe was the leading target continent, with 64 percent of total investment
and $19.7 billion worth of deals focused mainly on generation assets.
The emerging markets of Latin America and Asia that suffered an economic
decline in 1998 have now partially recovered, although the level of cross-border
activity has not returned to the records set in 1997. Chile was the main
target in this region, taking 50 percent of inward investment, followed
by Brazil.

After a large fall in 1998, the Asia Pacific region saw an increase in
cross-border activity in 1999 with 26 disclosed deals worth $5.4 billion.
New Zealand, India, and the Philippines were the target countries for
the majority of these deals, although the largest deals in value terms
took place in Australia ($2.3 billion).

U.S. electricity companies remained the leading bidders globally in number
terms in 1999, although the value of U.S. cross-border acquisitions fell
by over 20 percent to $13.9 billion. The most active U.S. bidder was AES
with nine cross-border deals in Australia, Brazil, the Dominican Republic,
Georgia, India, and the U.K. totalling $4 billion. European bidders made
fewer transactions but at a higher value, accounting for 41 percent of
deals by number but 52 percent by value.

Another trend arising as a result of international expansion is the change
in the competitor profile highlighted in the “Electricité sans Frontieres”
2000 survey. In the survey, respondents were asked whether they expected
their major competitors for large customers to be either other domestic
utilities, foreign utilities, on-site generation, or other suppliers.
Over the past year, companies have become much more concerned with competition
from within their home markets and from neighboring countries than from
across the Atlantic.

Key Players

The trend toward global power companies is accelerating. Many European
and American power companies can already claim to be global players and,
as highlighted above, cross-border international deals are increasing
at a consistently high rate. Successful players in their chosen sector
will draw on global economies of scale and expertise to compete effectively.

Over 90 percent of electricity companies (and all the major players)
in Europe expect to form part of a larger combined entity. Utility leaders
are fairly unanimous on those companies that they expect to be the main
players in the future European electricity generation and supply markets.
The three dominating companies are EdF of France, RWE/VEW and Veba/Viag
of Germany, with Enel of Italy and Endesa of Spain showing slightly better
positions than the rest. The dynamics of the industry, however, suggest
that there will be room to accommodate a handful of other major players
– possibly companies choosing to seek success from focusing on new business
models rather than sheer size.

As power markets across other continents start to liberalize, the structure
of the regulation across those regions will determine the extent to which
players in those countries are able to compete with these existing global
players.

Business Diversification

The face of the electricity industry has changed beyond recognition in
those countries that have fully-liberalized power markets. Liberalization
has allowed companies to become increasingly active and innovative in
seeking to create additional value through new sources of efficiency,
synergies, and customer services across the utility sectors and beyond.
Divisions between electricity, gas, and oil sectors are disappearing and
companies operating in these sectors are fast evolving into energy companies.

In the U.K., faced with increasingly stringent price controls and modest
growth in electricity demand, the regional electricity companies began
to diversify to secure income from new business activities. Electricity
generators and suppliers in the U.K. now compete in gas supply, while
Centrica is competing in electricity generation and supply.

TXU Europe Group PLC is one of the examples of a complex business structure,
which evolved in response to new business opportunities resulting from
liberalization of the energy markets. The Group comprises approximately
80 companies encompassing a wide range of businesses from electricity
generation, distribution and supply, to gas wholesaling and supply, insurance,
and project financing. Owned by TXU Inc. in the U.S., it has extensive
interests in the U.S.A., Australia, and elsewhere.

Regulatory Tensions

There is a host of contributory factors to the sorts of internal regulatory
tensions that can arise as a result of liberalization within a region
or country:

The Right to Electricity: Shareholders and Customers

First, there are tensions associated with electricity being a basic living
requirement and regarded by most citizens as something that they are entitled
to by right. Taking ownership of and responsibility for the supply of
power out of the hands of a directly electable and thus accountable government
and placing them under the control of a private (possibly even foreign)
company, which is often not directly accountable to government ministers,
causes understandable tensions. The political realities of life, however,
are that any organization that consistently ignores the political environment
in which it operates will reap only a short-term benefit at best.

Customers worry that organizations, which previously existed to serve
consumers and had as their main objective the reliable supply of electricity,
will suddenly change their focus to their shareholders who expect a return
on investment. Governments seek to overcome this problem by establishing
some sort of regulatory body over which they retain some influence or
power. The structure of this regulatory body and the level of governmental
influence over it is key to the success of the liberalization process.
It is also worth noting that a business that does not focus on its customers
is unlikely to succeed in providing acceptable returns to shareholders.

Customers’ Champion or Market Referee

A related problem is that by introducing competition, not only do consumers
have a choice in their provider of electricity, but companies theoretically
have a choice in the types of customers that they want. This could give
rise to unattractive customers (e.g., low-income families unable to enter
into direct payment arrangements) being unable to buy any electricity
at all. Any government with the ambition of continuing in power would
need to introduce or maintain measures designed to protect such customers.
However, any legislation designed to limit the freedom of electricity
providers runs contrary to the theme of liberalization and thus further
tensions arise. This issue of “Customer’s Champion and Market Referee”
is a difficult balance to make.

There is a clear theme of customer focus throughout the regulatory structures
that exist. In Mexico, the principal function of the Comision Reguladora
de Energia is the protection of short and long-term consumer interests,
and the regulatory reforms included a transparent and effective policy
of subsidies with explicit social welfare objectives.

In the United States, the Public Utility Commissions are mandated to
frame rules for consumer protection against fraud and other unfair trade
practices. In the state of Orissa in India, the electricity regulator
has to consider the interests of consumers during its price-setting process
and is also required to advise the government on a tariff policy which
is fair to customers.

Domestic or International Focus

A further practical effect of liberalization is the possible international
competitive disadvantage that can be caused by a regulatory structure
designed solely to focus on creating a fully competitive national market
without considering the impact of globalization. This has been a particular
complaint of many of the U.K. power companies as the U.K. government has
forced them to divest of generating plant, or blocked their plans completely
when they have sought to expand within the U.K. to develop their asset
base.

While this has prevented the domination of the U.K. market by any one
U.K. player, it has not prevented external investment on a large scale
by European and U.S. players, and it has not allowed U.K. companies to
expand to the same international competitive scale as, say, Electricité
de France.

Cross-Border Issues

There is considerable disquiet within the utilities industry about the
progress made toward dismantling the hurdles that lie in the way of a
fully open and competitive European market. One of the biggest issues
impeding full competition is unequal access to networks and markets, or
a lack of reciprocity. As discussed briefly above, one of the main practical
effects of the varying pace of liberalization across different countries
has often meant that companies in those countries further down the liberalization
road are disadvantaged when it comes to reciprocal investment and expansion
into non-liberalized countries.

The different regulatory regimes in different countries across Europe
have meant that some companies are able to expand across borders while
retaining a virtual monopoly position at home.

Stranded Assets

This constitutes one of the leading barriers to market liberalization,
and two-thirds of Electricité sans Frontieres 1999 respondents cited it
as the leading barrier to liberalization in their home country. The problem
arises when expensive and uneconomical assets have been built and run
under a pre-liberalization regime whereby the costs of the assets can
be recovered through the tariff structure. This arrangement has been built
up in order to encourage the production of sufficient electricity to meet
a country’s energy requirements. As such regimes are liberalized, the
tariff structure is changed or abolished, leaving these assets unable
to compete against newer, more efficient assets built more recently.

A range of responses to this issue can be seen across liberalized states
or countries. In California, the regulatory recovery of $6 billion of
stranded costs has been allowed each year to 2002, and in Spain, $135
billion of stranded costs has been identified and will be recoverable
to 2007. However, in the Nordic electricity and the U.K. gas markets,
no stranded costs have been earmarked for recovery in the adopted regulatory
regimes.

The knock-on effect of stranded assets can reach entirely separate industries
such as the coal industry. In the U.K., one unforeseen impact of liberalization
combined with falling gas prices was the move away from coal-fired toward
gas-fired power stations. Prior to privatization, coal accounted for 67
percent of the U.K.’s energy source, compared to 33 percent in 1998. A
gas-fired power station moratorium was introduced for a period as an attempt
to overcome this effect, and recently the government has announced a new
subsidy to the coal industry that may reach £100 million.

Conclusion

In conclusion, it is clear that liberalization yields many benefits for
companies, governments, and consumers. There are, however, clear lessons
to be learned from observation of those countries and continents where
it is far advanced. With planning and awareness, many of the practical
difficulties encountered in Europe can be overcome. In Autumn 1999, a
wide-ranging study into best practices for encouraging private sector
investment and competition in the power industry was carried out by specialists
at PricewaterhouseCoopers Securities. Eighty-nine separate best practices
were identified that included guiding principles and specific actions.
The top six of these were as follows:

• The need to achieve lasting benefits for customers in the shortest
  possible time should drive the restructuring process

• The power sector should be unbundled into separate generation, transmission,
  distribution, and possibly retailing sectors to achieve the maximum
  benefits for customers

• Privatization should include the sale of power distribution as well
  as generation utilities and should include existing assets as well
  as new generation projects

• Open access to transmission and distribution wires, and the ability
  to trade power between buyers and sellers in an open market, are critical
  to achieving a competitive framework

• In a competitive market, it is critical to define a new role for
  the regulator, separate and apart from the role played in the past
  by the ministry overseeing the industry

• Multilateral institutions should be partners with developing countries
  to help them achieve maximum benefits for customers, though their
  role may shift toward becoming facilitators of competition rather
  than just direct lenders in the power sector.

As increasing numbers of countries enter into the liberalization process,
those which follow these best practices will succeed in the vibrant and
active global power market.