Electricity Reform That Works

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

Figure 1: Spot Prices, United Kingdom



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

Figure 2: Average Annual Electricity Prices in Chile, 1987-1999     
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

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.


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.