Posts Tagged ‘Electricity’

Privatization and Liberalization of the Downstream Electricity Market

May 5th, 2021

Who is responsible for an energy policy?
There are a number of reasons why the responsibility for (of) an energy policy is fundamentally that of the government. In historical terms, most electricity and gas supply industries (as opposed to production systems) were formerly under the complete ownership and control of governments. In countries like the United States and Germany where the facilities were typically privately owned, they were still operated in accordance with directions given by the government regulator. There is little or no difference between the operation of a state monopoly and the operation of a private sector monopoly under direct governmental regulation.

Given that state control is usually the starting point, it follows that structural problems associated with transforming monopoly markets into liberalized, competitive markets can only be dealt with by the government. The government has to carry out the enabling act (usually legislation) in order to transform the existing structure into whatever structure is demanded by the policy of liberalization and/or privatization. The relationships of the newly created players must also be addressed by government in order to set out the ground rules of the new market. The government creates the policy which in turn is implemented to establish the new market structure, and addresses any structural problems associated with the introduction of competition and new participants.

Structural problems that necessitate the government taking responsibility for energy policies
These structural problems may include the issue of tariff/pricing, barriers to entry (access to networks) owing to the natural monopoly element in the downstream sector, availability of supply, etc. Moreover infrastructures for the industry require medium and long term coordination and guidelines for all players. Centralized policies and guidelines reduce uncertainty while government policies will make up for market deficiencies. Governments have a proper role in setting national energy policy objectives but these should be kept to a minimum and applied in a fair and easy to understand way.

Governments in adopting energy policies have embraced different forms of privatization and liberalization for overhauling the electricity industries. The starting point for privatization and liberalization in most of these countries is quite similar. Important issues to note in this respect include the following: Electricity industry has undergone some form of privatization in many countries. Private sector participation in electricity (outside those countries with regulated privately-owned systems) generally began in the 1980s, leading to the introduction of a degree of competition in the downstream energy industries.

Private sector participation also saw the beginning of a move by government to allow others to participate in the making of energy policy. This has however proved controversial and has led to an intense debate in the United States, particularly in the light of the failure of Enron (at the time of its collapse it was the world’s largest privately owned electricity company) and the involvement of Enron executives in the workings of the Department of Energy and the Vice President’s Task Force on Energy.

One of the reasons for supporting others in participation and in the making of energy policy is that the government, especially in developing countries, needs private sector experience to make energy policies effective and efficient. One of the reasons for opposing the idea of others participating in the making of energy policies is that it may be difficult to get an impartial energy policy maker outside government. This makes it difficult to achieve a level playing field which is necessary for the introduction of competition in the energy sector.

Privatization and liberalization
Privatization and liberalization are key government policies for regulating the energy industries. As a starting point it is important to understand what privatization is all about before discussing the issue of liberalization.

What is privatization?
It is the act of selling existing state assets – no more and no less. It is to be noted however that there is conceptually no need to break up the state company, or to create competition, or to adjust the regulatory structure significantly. All that is needed for privatization is a decision (and then follow up action) to sell the state assets to a third party. Privatization does not require liberalization, although in practice most governments would incorporate an element of liberalization within a privatization policy. Moving a company from the state sector to the private sector, even with regulation, tends to create problems in making future adjustments to the sector.

Privatization without competition implies that there is replacement of the state monopoly with a private monopoly. Privatization alone does not change the natural monopoly element in the downstream energy sector. By itself, privatization does not introduce competition. By itself, privatization does not change the pricing structure of the industry. Private sector monopolies are profit oriented rather than service oriented.

Any efficiency gains are incentivized by regulation, not by markets. Once the decision to privatize has been taken, the state is removed from the direct provision of energy. The sale means that someone else (a new participant) will be providing energy and the role of the state changes from service provider to creator of the enabling legal environment to permit others to provide that service. The function of government changes with privatization.

Privatization will require new laws, if only to change a monopoly status of the incumbent. Typically the incumbent is a state company in which case the law will give the government permission to sell, and probably also to restructure. Restructuring a state company (but leaving its ownership within the state) to meet the future challenges of liberalization is called corporatization, and is a process which attracts great debate. The debate is essentially about the nature of equal (or non-equal) competition between state companies and private companies. The idea of corporatization is unimpeachable, that the state company will be prepared for possible future privatization by being run on the same basis as a private company. But given that state companies and private companies have different objectives, it can be difficult to equate the two.

The objectives of a state energy company may include the following: Availability and accessibility of supply (state companies tend to aim for redundant or excess capacity to ensure provision of service), Creation of employment, Energy supply at reduced/controlled price (the government may subsidize the full cost of energy supplied), Focus on customer service as opposed to profitability, Protection of national interest- the energy industry is usually a key industry in the national economy and the state energy industry is frequently used as an instrument of general economic policy.

While the objective of a private energy company may include the following: Availability and efficiency of supply (extreme care needs to be taken in relation to the incentive to hold redundant or excess capacity), Maximization of shareholder value and profit (adequate return on investment). The business is focused on profitability not just prices and Market leadership.

Having said that, there are examples of companies which are owned by governments but which do not exist simply to reflect the national interest. For example BP was formerly British Petroleum, a company owned by the British government since the purchase of the shares of the Anglo Persian Oil Company by the Minister before World War I. The company does not appear to have ever acted as a state company indeed during the Rhodesian oil embargo declared by the British Government; the company appears to have continued to trade with Rhodesia. The company does not appear to have regarded itself as required to act in the public interest, and accordingly did not have the same need for a corporatization process before its privatization in the 1980s. Similarly, it is difficult to see why state companies which invest abroad are acting in the public interest of their own country; for example Electricite de France (now partly privatized) bought assets in several countries.

Corporatization may not need new laws, but removal of monopoly usually does. Similarly, if the state company is to be broken up legislative permission is usually required. If regulatory changes are to be made (and such changes are inevitable at privatization or liberalization) then it is to be expected that the legislation will also provide for such changes. Normally the regulatory changes are made by secondary legislation, in terms of a consent granted in the primary law.

Conceptual problems with privatization
The primary question is whether or not privatization should take place. This is a policy as well as a political question to be addressed by any individual government considering adjustment of the downstream energy industries. The political aspect of this question can be seen from the tones of the debate that precede every privatization policy of the government. The United Kingdom gas privatization debate in the House of Commons; parliamentary debate over the Gas Bill 1986 in Hansard emphasizes this aspect of the privatization issue.

The other problems of privatization will naturally arise after a decision to privatize has been made by the government, and would include the following: the form of the privatization (i.e. what is created through the sale of the state company) ensuring that government sells state assets for proper value and the new role of government as the creator of a suitable legal environment for business difficulty in sustaining the traditional gains of monopoly provisions especially those in the nature of Public Service Obligations (eg obligation to supply; connection rights; uniform price for similar categories of consumer etc.).

Problem that may arise from the obligation to supply consumers at Uniform Price
The problem is that a private energy company may not agree to supply different consumers at uniform price without government’s subsidy especially as transport costs increase with distance. Supply at uniform price may create losses for the company particularly where the losses cannot be mitigated by increased supply to surplus consumers. This will affect government’s policy of having cheap and affordable energy supplied to consumers which will encourage industrial growth. It is one of the arguments against privatization particularly for a developing country.

The political aspect of the privatization process will require a political decision on the part of the government. An integration of the political and economic aspect of the decision will tend to create a proper balance in theory, for the reform of the downstream energy sector. This balance between political and economic need may however be difficult to achieve in practice. The question of what should be done is therefore difficult to answer as it requires a careful look at each country. The primary function of this paper is to set out the options. Determining which option is “best” for a country is a matter of economic

The electricity world can be regarded as divided into two separate categories. There are those countries which have sufficient capacity (the simple test being that the lights are on); and there are countries which are in short capacity. These two requirements present completely different challenges for liberalization and privatization. Liberalization in category one countries (those with sufficient capacity) is predominantly designed around the concept of delivering the service at lower price. Liberalization and competition are designed to improve efficiency. Privatization is designed to change management and bring in profit incentives to improve efficiency. From a regulatory viewpoint, the key is that the incentive for state monopolies is based on command and control, whereas the incentive for private monopolies can be more subtly directed towards revenues.

The privatization debate – should governments allow privatization at all? Is largely in the past, particularly in those (first category) countries looking at liberalization. The debate is less over whether privatization should take place and more with respect to the form of the privatization and how to ensure that the government sells state assets for proper value. The lack of recent debate may however simply reflect the fact that a majority of countries with sufficient capacity have already embraced some degree of Privatization.

In category two countries, the argument is slightly different. Category two countries (those with insufficient capacity) tend to create policies designed to increase capacity. Liberalization does this by allowing new participants into the generation sector, and privatization achieves this goal by allowing the new entity access to new funding sources. In such countries, there is less emphasis on competition at the beginning of the process and indeed recognizing that competition may create undesirable results including price rises. The result is that category two country liberalization and privatization schemes tend to be complex and couched in regulatory restrictions to prevent abuses as the market gradually takes off.

Monopoly, privatization and security of supply
Monopoly systems tend to reduce the complexity surrounding concepts such as security of supply. Security of supply is an extremely simple concept in general terms, it is the risk that the system will be subject to interruption owing to lack of fuel (or lack of the correct fuel), or a lack of capacity. In more detailed terms, Security of supply means different things to different entities depending on the perspective one looks at it from. See below for a sample of the meaning of security of supply.

Government is able to take a very broad view and ask if overall capacity (either for fuel, generation, or transport) is sufficient. However, the individual consumers look at matters differently. Security of supply is the risk that there is no gas or electricity available to them. Conceptually, the consumer’s view is closer to the issue of reliability of supply.

Using that term allows “security of supply” to be restricted to the broad view rather than contaminate it with the difficulty of looking at countries with a sufficient amount of capacity, but who find that the capacity is simply in the wrong place or is served by an inadequate transportation network. In such cases the problem is one of reliability rather than security. The solution will lie in infrastructure building rather than addressing new capacity.

Monopoly makes security of supply conceptually easy; the government has one place to look to and one entity to direct to address the issue. That entity can also be asked to reflect the government’s view of security of supply. Government views on security of supply frequently start with the idea of self-sufficiency. The state electricity company is directed to purchase domestically produced coal, gas or oil. Privatization by its nature of bringing in the private management and a profit motive tends to make it difficult for government to take a simplistic view of security of supply through equating it with self-sufficiency. The government no longer has the same tools or the instruments to direct purchases.

Privatization, where it is accompanied by a breakup of the monopolist, tends to create more than one company which no longer automatically reflects the public interest. A private company exists to make profit, not to reflect the public interest. Obligations surrounding security of supply can be difficult to reconcile with the interests of an individual energy provider. Governments will try to make the reconciliation through regulatory means (typically a license condition on the participant).

Privatization does not change the natural monopoly element. The natural monopoly element means that regulation of (at minimum) the price of transmission and distribution will continue even after privatization. There will always be a role for public interest regulation. In practice that role is usually greater than simply setting the transmission and distribution price, as it is rare for full competition to be introduced immediately, and usually impossible to introduce immediate full competition in category two countries. Pockets of non-competitive provision will remain and need to be regulated. The usual example is supply prices to domestic consumers.

Natural Monopoly
An industry is said to be a ‘natural monopoly’ if the fixed cost of the capital goods for that industry is so high that it would not be profitable for another company to compete with it. The reason for this is that the economies of scale for that industry naturally require one rather than several companies to provide that service as small scale ownership of the industry will make it less efficient.

Why are utilities like natural gas, water and electricity cited as typical examples of natural monopoly?
For water and natural gas it will be expensive (due to high cost of laying pipelines) to build a second or third set of water, sewerage or gas distribution pipelines within a city or town. The delivery service for both has a high fixed cost and low variable cost. This makes it difficult for a second company to come in and provide that service without doing so at a loss. Thus the initial company to set up the service enjoys a ‘natural monopoly’ status. The same goes for electricity. But deregulation of the electricity sector has made it possible for the generators of electric power to now compete. However the infrastructures, the wires that carry the electricity, remain a natural monopoly because a second set of wires will be very costly to run along the same lines within a city, hence the various companies generating electricity have to distribute it through the same grid.

It is also possible that the first infrastructure owner will be able to set access prices in such a way as to prevent alternative (second) infrastructure being built. New pipes or wires need customers to use them. If those customers are offered better deals by the existing pipe, the new pipe will not be built. Clearly competition law has a role to play in pricing decisions; such strategies may fall foul of predatory pricing provisions.

It is the removal of a monopoly right and the introduction of competition and choice. It is not necessary for there to be privatization first before liberalization. New plant or new entrants may simply be allowed to compete with the former monopolist. But it may be difficult to have fair competition as the regulator may lean favorably to the government entity. This may be worsened where the competing government entity also acts as a regulator.

Types of liberalization
Liberalization may either be partial (limited) or full.

1. Partial or limited liberalization: In the case of electricity supply, there is massive range of options with respect to liberalization. At one extreme is a decision simply to lift the exclusive monopoly right in a particular sector, usually generation. That decision would permit new generators to enter the sector and build new plants, but without a greater degree of liberalization they would be compelled to sell the power to a single wholesale supplier (typically the state company). In such a model there is no competition except competition for the right to build. This is partial or limited liberalization. This is discussed further in my next paper coming up under build-operate-transfer (BOT) arrangements; there is some debate over whether competition for the right to build is equivalent to competition in generation. Generally speaking it is not, although clearly both are aimed at the same goal and that of obtaining the cheapest possible electricity.

2. Full Liberalization: At the other end of the spectrum is an electricity supply industry with full competition in all sectors. Full liberalization involves an understanding of each sector of the industry. Although the terminology to describe the various parts is occasionally different. The most striking similarity is that both are network based – both are reliant on the natural monopoly in the transmission and distribution sectors. Refer to the meaning of natural monopoly.

Very few countries have full liberalization, although some come close. The United Kingdom is regarded as one of the most liberalized energy markets in the world. Others which are near full liberalization are Finland, Sweden, to a lesser extent Norway and Denmark (the other members of Nordpool); and some of the individual US States such as Texas. Other US states have relatively little liberalization, usually dictated by the pre-existing position such as dependence on hydropower.

Other EU member states are gradually becoming more liberalized as the European Commission compels greater openness, but it should be borne in mind that the EU rules require a minimum level of liberalization not a maximum. It is notable that the examples nearest to full liberalization are all category one countries. It is conceptually difficult to create markets where there is a shortage of capacity; the result tends to be a rise in price. It follows that category two countries tend to be less liberalized. There is also a need to consider the issue of long term power purchase contracts which underpin investment.

Liberalization of the supply and distribution of electricity
Electricity distribution systems are liberalized for different reasons. No two countries will offer the same justification for making a change. Most will offer a series of reasons alongside the enabling legislation, but at the most basic level electricity systems can be put into two distinct categories:

In the first category are those systems which have sufficient capacity to meet demand. Here, liberalization is carried out to create competition between existing facilities in an effort to bring down the price or at least minimize price rises. Into this category fall most of the European Union, the United States, Canada, Australia, and parts of South America. It is not coincidental that those countries were amongst the first to announce privatization or liberalization of electricity industries.

The second category are those systems which have insufficient capacity to meet demand. Numerically this second category is larger than the first, and typically presents a fundamental difficulty. The basic reason to liberalize in the countries in this category is to provide additional access to funds for investment.

Many countries in this category simply cannot afford to build new plant and infrastructure, and are effectively forced to undertake a degree of liberalization to permit (foreign) companies to build new plant.
Liberalization of category two presents’ greater challenges as it is far from certain that the act of liberalization will lead to lower prices but indeed it may precipitate higher prices to pay for new plant. Contracts to secure investment (PPAs) can also make it difficult to develop competition between generators. This difficulty is often complicated by the existence of a subsidy on the existing consumer price. Omitting that subsidy, as strongly encouraged by the World Bank can lead to significant price rises.

Liberalization has therefore attracted considerable political and social opposition in some countries. It should be possible to set the gains in reliability and capacity against the potential price rises, but it appears to be surprisingly difficult to create that link in practice. The general aims of liberalization are to raise money (where accompanied by privatization); reduce payment of subsidies; lower prices, improve quality and efficiency of services through competition, take liabilities off the government balance sheet and meet other ideological objectives. Though liberalization generally aims to create competition with a view to lowering prices to consumers or at least minimize price rises; there is a strong possibility that in a country which is capacity short, liberalization to attract investment may lead to higher prices particularly where the liberalization programme is accompanied by a reduction or removal of consumer subsidies.

Privatization and liberalization – some distinctions
Liberalization is an entirely separate concept from privatization. Liberalization is the introduction of competition to the industry. In the downstream energy sectors, liberalization can take many forms. Liberalization is not a single concept but is instead a scale; it can be partial or full. It can be applied in one sector but not another; that is it is possible to liberalize generation without liberalizing supply; it is theoretically possible to liberalize supply without liberalizing generation. Although there is no practical example of that latter option, given that the only basis for competing suppliers would be quality of service rather than price.

Liberalization does not require privatization, and although privatization does require liberalization (at minimum in the form of a new entrant), privatization does not by itself create competition. A limited degree of confusion is probably inevitable given that the first examples of electricity industry reform include both elements of both privatization and liberalization, although legally the two concepts are quite distinct. It is important to note in this respect that Chile; United Kingdom; and most European Union countries have undergone some privatization alongside liberalization with the notable exceptions of France (which is yet to privatize fully either of its state downstream energy companies) and Germany (where the monopolies were already privately owned).

The privatization debate is largely ignored now in Europe, and is probably most focused in West Africa (particularly Nigeria) and in the Pacific Rim (particularly Indonesia). State companies continue to play a crucial role in energy provision in numerous countries and some have stated their intention to continue in that mood, despite small increases in the degree of liberalization (e.g. China, India).

Liberalization theoretically requires little or no legislation, given that it is simply the creation of competition in similar fashion to any other industry. But in the case of the downstream energy sector, it is considered normal practice for the government (or the regulator) to maintain control over the identity of the participants. This simply reflects the strategic importance of the sector, and also usually the imperfect competition which the liberalization model creates in practice. Such control is easily established by means of a licensing system established under primary legislation.

The other reason for new legislation underpinning liberalization is that it typically requires little legislation to run a state monopoly. The law may simply grant the monopoly to a state company and then everything else is done by agreement between the state company and the Minister. There is no real need for a law until liberalization is introduced, and a law is needed to establish the parameters of the market as the Minister cannot directly influence a private company.

Principles underlying privatization and liberalization
Privatization is usually driven by a number of competing factors. There are “good” aims and “bad” aims, although it can occasionally be difficult to place a particular goal in one camp or the other. Privatizing simply to raise money may be more difficult for a government to justify than privatization as part of a liberalization aiming to reduce energy costs. There are also privatizations designed to take liabilities (primarily subsidies) off the government’s balance sheet, frequently but not always occurring in countries which are capacity short. Other privatizations are designed to support a liberalization programme by breaking up the former state monopoly.

Irrespective of the view on the aims, there are clearly examples of privatizations and liberalizations which have structural integrity and those that do not. Perhaps the classic mistake is the United Kingdom privatization of the state gas monopolist, the British Gas Corporation. It would appear that that privatization was driven by ideology, a belief by the then Thatcher Government that the private sector could by definition provide a superior service to anything that a state company could provide (a belief partly driven by the government’s adherence to the Chicago School of economic thought). In that case, the fundamental structural error was to privatize the company intact, creating a private sector monopoly. The savior of the structural error was the creation of an extremely powerful independent regulator (and the appointment of a regulator prepared to use the full extent of their powers) who oversaw a gradual introduction of competition.

The legislation provided for a liberalized market in 1986. It took a decade for the reality of a competitive market to emerge. That terrible precedent has been an object lesson for numerous privatization and liberalization schemes created since 1986. Most have sought to learn the lessons and avoid the obvious mistakes and it is clearly a mistake to structure privatization and liberalization in such a way that it does not deliver the potential benefits of competition for a decade.

The energy industry is characterized by its natural monopoly element, but creating a private sector monopoly simply adds to the inevitable information asymmetry. The regulator is always second-guessing. The companies, specifically the monopolists know far better than the regulator the precise cost of doing business. They can seek to hide costs in cross subsidies between the various elements of the business. That makes regulation more difficult, and tends to lead to incentive regulation rather than pure rate of return regulation where it is inevitable that the regulator will have to second guess the cost structure of the business.

Privatization leads to a change in the role for government. The state is no longer the provider of energy, but rather is the creator of a suitable legal environment in which others will elect to enter the business of energy production and supply. Privatization also means as said earlier on, that it is difficult to sustain the traditional gains from monopoly provision. Monopoly is traditionally granted on various conditions being imposed in the public interest. Typically these conditions will include an obligation to supply, and an obligation of universal service.

It is apparent that energy policies have resulted in positive but modest gains in the electricity industry. However it has not shown visible lasting benefits to consumers. Its merit has included restructuring of monopoly through the independent regulators, initiating competition and innovation, creation of opportunities for a rise in employee remunerations via increased efficiency and emission control through the development of the electricity market. It has also improved the policy making mechanism of the industry, ensuring expensive policies are adequately scrutinized and criticized before implementation. This scrutiny is unlikely in a monopoly system, and has so far brought important benefits by increasing choices and creating a greater responsiveness to consumer needs.