Electricity Reform That Works by Chris Trayhorn, Publisher of mThink Blue Book, April 1, 2003 The near meltdown of the California electricity markets prompted many, both inside and outside government, to question whether deregulation can work and, if so, how. Looking at the successes and failures of reform efforts worldwide, it is clear that electricity restructuring can work — if it meets the needs of the local economic and political environments. During the last decade more than 60 countries restructured their electricity industry with varying degrees of success, although it is a misnomer to refer to these efforts as “deregulation.” In all cases, sectors such as generation or marketing may be deregulated, but the transmission of power remains regulated. The underlying long-term objective of these reform efforts has been to provide reliable electricity service at reasonable cost for all consumers. Successful reforms share two main features: an effective regulatory framework and workable competitive markets. An effective regulatory framework restrains private firms from abusing their market power and constrains the political and administrative actors from directly or indirectly expropriating investors’ assets. Competition reduces the need for command-and-control forms of regulation, provides incentives for private investments, and improves the industry’s performance. The reforms have often involved unbundling vertically integrated utilities into generation, transmission, distribution, and retail marketing sectors, introducing competition into the generation and retail marketing sectors, and providing suppliers and buyers access to the regulated transmission and distribution systems. In countries where the industry was mostly state-owned, the reform efforts sought to transform state-owned and centralized electricity sectors into decentralized, market-oriented industries with private sector participation. Experiences over the past two decades, however, have shown that achieving the goals of electricity reform generally is more complex than initially anticipated. Key Factors Providing effective regulatory governance is paramount to attract private investment. The disappointing experiences with reforms observed in various countries are generally the result of design flaws in the regulatory governance regime rather than market design flaws. California’s experience, however, clearly illustrates that market design is also critical to success. In that sense, developing competitive generation and retail market sectors in turn requires: limiting the potential for the exercise of market power; allowing parties to enter long-term forward contracts; providing a workable spot market; and allowing retail customers access to wholesale prices. Fundamental to any reform effort is ensuring that an effective regulatory governance structure with the right incentives is in place. The electricity industry has traditionally been regulated because of three distinguishing features: large sunk investments, economies of scale and scope, and universal consumption of its products. These features imply that firms may be willing to continue operating even if prices do not recover sunk investments and that market prices will be politically sensitive. This combination exposes investors to the potential for governmental opportunism. An effective regulatory governance structure requires institutional arrangements that limit the government’s discretionary powers once investments are in place. Weak regulatory governance structure offers no credible assurance against direct or indirect expropriation of private property and makes it difficult, if not impossible, to encourage private investment. Developing workable competitive generation markets, and to a lesser extent retail service markets, has been the goal of many restructuring efforts around the world. The complexity of the electricity industry, however, makes achieving a workable competitive market a work in progress, with no detailed blueprint available for all circumstances. A competitive commodity market requires that no single participant have the ability to set prices artificially high for a sustained period of time. This is usually a problem in the generation segment, as a market with few sellers may not be immune to price manipulation. The structural and preferred approach to dealing with horizontal market concentration is to disaggregate the sectors into numerous firms with market share limits. When not practical, the government will usually take the behavioral approach and regulate the commodity price through price caps or cost-of-service pricing. This approach to market power misses a basic point. Market power exists when buyers have few alternatives. In the electricity market wholesale buyers are few and relatively large — distribution companies, large users, or brokers. As long as their purchasing strategies are unrestricted, including entering into long-term contracts with incumbent generators and new entrants alike, or vertically integrating, the exercise of market power will be a difficult undertaking, even in a concentrated capacity market. Competitive wholesale markets require liquid long-term contract (forward and futures) markets. Long-term contracts facilitate hedging against price risk for both buyers and sellers. The most common forward trading mechanism is bilateral contracts with its obligation to deliver a physical product at a specified location. In electricity markets, there is no way of directly linking the energy put into the system at one end and taken out at the other end. As a result, many experts argue that bilateral physical contracts for power are irrelevant unless the plant is next door to the load. These experts argue that contracts for power should be strictly financial contracts (contracts for differences) that essentially assure buyers and sellers a given price for a certain amount of power injected or actually taken from the system. Emphasis is, therefore, placed on developing an “efficient” spot market where all physical sales will take place, with forward contracts used only to cover price risk. Heavy reliance on spot markets, however, makes the industry vulnerable to price manipulation. The alternative is to make contracts physical or dispatchable, moving trading away from spot or real-time markets. A third requirement for a workable electricity market is a well-designed wholesale spot or balancing market that allows market participants to take their forward contracts to delivery. For the balancing market to work effectively — we emphasize effectively, not efficiently — there must be rules concerning trading of energy and capacity in the real-time market, allocating common transmission costs, pricing of congestion, and allocating responsibility for ensuring system reliability. Given the complexity of the system, translating theoretically efficient models into workable market models, which are simple to implement everywhere, may not be feasible. The most common structure chosen is a single-price auction where supply bids and offers to buy are matched to create a single market-clearing price and where participation is voluntary. An alternative approach is to minimize the role of the spot or balancing market as the focus for determining investment decisions by letting the forward contracting market play that role. Under this model the forward contract prices will reflect the players’ estimates of the relevant long-run marginal cost. With limited barriers to entry, these prices will be less susceptible to market power manipulation. The fourth requirement of a competitive electricity market is providing retail consumers full access to prices in the wholesale market. If retail customers remain captive of the distribution utilities they need to rely on the effectiveness of the regulatory regime to derive benefits from competition. Instead, the retail market can be deregulated and all customers allowed to negotiate their own supply contract directly with suppliers, as successfully done in as varied jurisdictions as Norway, New Zealand, the United Kingdom, or El Salvador. Successful Market Reforms There is substantial variability in the nature of the reforms undertaken during the last decade. Some countries have focused only on attracting private investment while keeping the system state-owned or tightly regulated. Others have attempted to vertically separate and privatize the industry in addition to creating competitive generation and retail service markets. Here we will focus on the much smaller second group. The emerging consensus is that unbundling and introducing competition into the generation and marketing sector has been successful. Examining a few of these major reform efforts provides instructive examples of the role the key factors discussed above played in these markets success. United Kingdom The United Kingdom was one of the first countries to restructure its electricity industry in 1990. The United Kingdom’s initial effort has been proclaimed a success, having resulted in lower prices, substantial public sector receipts from the privatization of public assets, and vigorous investment in new power plants. However, this success did not come right away. Wholesale electricity prices initially increased from 1990 to 1993, and remained above 1990 levels (in constant dollar terms) until 1999. This occurred in the face of a 30 to 40 percent decrease in coal and gas prices during this period. Economists and government regulators attributed the wholesale market outcomes to capacity market concentration (three companies with 80 percent market share) and market design flaws (in particular, generators being required to sell the vast majority of their output through the spot market with long-term contracts limited to contracts-for-differences, and no demand-side participation). The combined concentration of market share and the emphasis on the spot market allowed generators to develop trading strategies that manipulated the spot market price. The country’s regulatory agency quickly attempted to correct these market flaws through the introduction of price caps and other regulatory measures. While government actions and high market prices encouraged new entry, concentration remained high until the government forced the two largest generators to divest 6,000 megawatts in 1996 and required further divestiture such that no generator had more than a 20 percent market share by 1999. In 1999, retail service was also completely deregulated. The U.K. reform process is still a design work in progress. On March 27, 2001, the New Electricity Trading Arrangement (NETA) replaced the former power pool. Under NETA, the prior uniform price auction spot market was replaced by a contract market and pay-as-bid residual balancing market. The rationale for the change was to shift most transactions into the bilateral contract market and to minimize the use and gaming of the balancing market. Since the NETA reforms were proposed in 1998, month-ahead wholesale prices have fallen by 40 percent (see Figure 1). Since the NETA started operating in March 2001, residential customers’ prices decreased by 8 to 15 percent, depending on whether customers stayed or switched suppliers, and industrial and commercial prices decreased by 20 to 25 percent, according to the Office of Gas and Electricity Markets. Figure 1: Spot Prices, United Kingdom Chile Chile is an even earlier reformer with the restructuring and privatization of its industry occurring between 1982 and 1991. Chile’s restructuring effort has also been proclaimed a success with 40 percent reduction in wholesale prices between 1987 and 1998, large decreases in retail rates (see Figure 2), more than $6 billion in private investment between 1990 and 1999, about 40 percent increase in capacity, and a reduction of almost 20 percent in retail consumer prices. Figure 2: Average Annual Electricity Prices in Chile, 1987-1999 Source: NCI based on CNE However, Chile’s reform effort ran afoul of our rule on a workable balancing market. Chile’s initial reformers worried about the potential exercise of market power by a relatively concentrated industry. While Chile’s initial restructured industry had 11 generating companies, the largest generator controlled 50 percent of the system capacity, and the three largest generators controlled 67 percent of capacity (down to 54 percent in 1999). Rather than relying on long-term contracting to solve whatever market power problem that existed, the government regulated, in a forward-looking manner, the price of spot transactions to distribution companies. Although Chile’s reform effort has resulted in a successful privatized electricity market, it encountered serious problems when a seemingly unexpected drought limited supply drastically in 1998-1999. Wholesale prices were unable to adjust to the new reality, so consumer demand did not fall, nor did supply increase substantially. Drastic blackouts followed, encompassing the whole country. Much of this negative development could have been avoided if Chile had relied more on freely negotiated contracts rather than regulation for mitigating market power excesses. Nevertheless, given the stable investment climate and apolitical regulatory framework in Chile, their reform effort was able to continue successfully attracting investments. Australia The Australian state of Victoria represents another case where restructuring has been proclaimed a success. Reformers in Victoria attempted to learn from the experiences in the United Kingdom and Chile and adopted slightly different approaches as a result. Their restructuring effort met with initial success, with wholesale prices decreasing by one-third since 1993, while average retail prices for commercial and industrial users decreased by 22 percent from 1994, the time of introduction, to 1998. Over this period there was also significant foreign investment in the Australian electricity market. Their initial strategy was to encourage competition by atomizing the generation segment. Each large-scale thermal plant was sold independently. The distribution sector was restructured into five regional suppliers with initial monopoly rights to small customers. Legal limits were imposed on vertical and horizontal cross-ownership, with no company owning more than one generation or distribution supplier. Retail competition was phased, starting with large customers and leading up to all customers by 2000. The wholesale markets were viewed as the main mode of competition, and in 1998 the federal government created a national wholesale market and merged the local state markets into the National Energy Market. The Australian spot market was fashioned from the original U.K. market, with its requirement that all generators bid their capacity into the market and all accepted bids pay the market clearing price. Generators were required to provide long-term contracts to retail companies before they were privatized. In addition to being a financial hedge for both generators and retail customers, the bilateral (vesting) contracts significantly decreased the incentives of generators to increase wholesale prices. Higher prices would only benefit a net long position on the spot market while putting them at risk if they were net short compared to their contract obligations. With high contract coverage, generators could not benefit from manipulating the spot market. Low wholesale prices in the spot market, however, have been blamed for the perceived lack of investment in the generation capacity addition, which has resulted in a gradual exhaustion of excess capacity as demand has risen. Since 1999 wholesale prices have increased by 20 percent. With the expiration of these vesting contracts, Australian regulators, mistakenly in our view, decided not to encourage distribution utilities to enter new contracts under the assumption that retail consumers and their service providers will do a better job of negotiating the price risk return tradeoffs with generators. California’s Failure Like the Australian markets, California also borrowed heavily from the U.K. reform effort. California’s reformers put little effort on regulatory governance issues. Rather, the focus of the reform effort was on developing a workably competitive market. California provided incentives to its incumbent utilities to divest their generation assets. The result was that by the summer of 2000 no company had more than 21 percent of generation capacity. This, however, did not prevent generators from being able to exercise market power. When increased demand due to hot weather in the summer of 2000 was combined with reduced hydroelectric production, and some unanticipated generation outages resulted in an imbalance of supply and demand, even marginal suppliers had the ability to influence wholesale prices. The rest is history. California’s reforms had two basic design flaws: It discouraged long-term contracting by distribution utilities, and it put a cap on the utilities’ retail prices while supposedly promoting retail competition. In the regulators’ attempts to stimulate the spot market, to facilitate retail bypass, and to avoid self-dealing, they not only encouraged the utilities to divest most of their generation assets, but also discouraged them from entering into long-term contracts. The lack of long-term contracts and/or captive supplies exposed the distribution utilities and their customers to price risk in a volatile spot market. When spot prices skyrocketed in the summer of 2000, large increases in retail prices were necessary to keep the distributors whole. Regulators could have deregulated retail rates; instead they balked. With most sales going through the spot market, and with almost no demand responsiveness due to fixed retail rates, generators had few incentives to moderate their spot price bids. Distribution companies, then, became insolvent. Eventually, state regulators had to pass those high costs on to the retail customers. To prevent customers from fleeing the utilities, the legislature rescinded the direct access provision. Deregulation and reform for the retail sector was essentially eliminated. Many critics of the California market have pointed to design flaws in the spot or balancing market as the main reason for the market collapse. The Federal Energy Regulatory Commission now proposes a standard spot market design for the entire country in an effort to avoid future market meltdowns à la California. We do not see this as a promising avenue of reform. There are multiple ways of reaching a workable wholesale spot market. The key requirements are that these balancing markets should be relatively effective in allowing suppliers and consumers to take their forward contracts to delivery, and they should account for only a small fraction of market trades. Filed under: White Papers Tagged under: Utilities About the Author Chris Trayhorn, Publisher of mThink Blue Book Chris Trayhorn is the Chairman of the Performance Marketing Industry Blue Ribbon Panel and the CEO of mThink.com, a leading online and content marketing agency. He has founded four successful marketing companies in London and San Francisco in the last 15 years, and is currently the founder and publisher of Revenue+Performance magazine, the magazine of the performance marketing industry since 2002.