David Renton, a partner in Herbert Smith’s Hong Kong practice, looks at the impact of the California experience on Asian Governments plans to restructure their electricity industries – in many cases an unavoidable necessity. This article first appeared in Project Finance International – Asia Pacific Review Supplement July 2001 and is used with their kind permission.
There is no alternative…
Passing the Philippines’ Electric Power Industry Reform Act of 2001 – a law that was more than six years in the making – should be seen not so much as a vote of confidence in competitive electricity markets as an admission that the way that the electricity industry is currently organised in the Philippines and throughout much of Asia is unsustainable. President Macagapal-Arroyo’s announcement, even as the electricity reform bill was being passed, that amending legislation may be required to protect electricity consumers against "arbitrary" price increases betrays a nagging worry over whether it really is a good idea to leave electricity pricing to market forces. What forced the hand of the bill’s opponents, who were mainly concerned about the size of the liabilities that the Philippines Government would have to assume as part of any restructuring and privatisation of the National Power Corporation (NPC), was the realisation that, until NPC’s monopoly over the supply of bulk power is broken, there would be no way of raising sufficient finance to satisfy the growing demand for electricity in the Philippines.
The same picture is emerging throughout Asia. Governments initially viewed electricity competition as a way of getting cheap electricity without the need for government subsidy. California served as a timely reminder that competition can cause electricity prices to go up as well as down, something that had evidently escaped the California Legislature when it pegged retail electricity tariffs at 10% below pre-competition levels whilst deregulating wholesale prices. Worse was the huge transfer of wealth from electricity consumers to generating companies that occurred in California as a result of the imbalance between supply and demand. If repeated in Asia, such an imbalance in a competitive market could threaten political stability and provide independent power producers, many of whom would be foreign, with a huge windfall at the country’s expense. Despite such nightmarish thoughts, Asian governments continue to pursue plans to restructure their electricity industry though more slowly than before.
…but getting the policy right can take time
Competition remains an important element in the restructuring of the electricity industry in Asia and, in the case of India, is being given a much greater role now than before the California crisis. In 1992, the government of Prime Minister Narashima Rao announced a package of measures designed to attract foreign investors willing to finance new power stations using the BOO/BOT model, including a tariff that offered guaranteed minimum returns on equity, protection against local currency depreciation, generous tax breaks and government guarantees. These measures succeeded in getting the attention of foreign investors but very few projects were actually implemented because the Government of India quickly got cold feet about its own policy. It worried that it had been far too generous in the returns it was offering and, above all, it worried about the irresponsibility of the State Electricity Boards (SEBs), the monopoly purchasers of power in their States, which were blithely signing long term commitments for thousands of megawatts of generating capacity at higher prices than they could re-sell it for. Although the Government of India had agreed to give counter-guarantees for only eight projects, it was concerned that the deficits that the SEBs would incur as a result of these contracts would spell economic disaster for the country.
The Government of India then turned its attention to reforming the SEBs, a delicate matter because the SEBs are under the jurisdiction of the State Governments rather than the Union Government in New Delhi. Several States, beginning with the State of Orissa, were persuaded to embark on a programme to reform their SEBs with funding provided by the World Bank, the Asian Development Bank and bilateral agencies such as the UK’s Department for International Development. The reforms consisted of separating the SEBs’ power generation, transmission and distribution businesses into separate companies to promote greater transparency, privatising the generation and, in some cases, the distribution businesses and creating new independent regulatory agencies to supervise the new electricity companies and increase their autonomy from government by acting as a buffer between the electricity companies and the politicians.
Although these reforms are widely regarded as a step in the right direction, there has been disappointment that they did not achieve the improvements in the State electricity sector that were hoped for. The main problem was that there was no competition to spur the new electricity companies to improve their performance. The new transmission companies continued to be wholly owned by the State Governments and, as a result, inherited many of the problems that had plagued the unrestructured SEBs. These Gridcos and Transcos continue to enjoy a monopoly over the purchase of power for resale within their States and their financial and operating weakness affects the performance of the rest of the industry.
Electricity reformers in India are now to put pressure on the SEBs and their successors to reform. The Indian Power Minister has announced that the Government intends to seek Parliament’s approval of a new law that will allow generating companies to sell power at market prices directly to large consumers and other bulk purchasers instead of selling it exclusively to a State owned transmission company. At first blush this seems like a revolutionary step since it would tend to undermine the tariff of cross-subsidies that large consumers pay for the benefit of agricultural and residential consumers. On closer inspection, however, it is clear that the advocates of the proposed new market structure intend to keep the existing cross-subsidies largely intact to ensure that electricity remains affordable for the poorest sections of Indian society; the cross-subsidies will simply be made transparent and imposed as a separate levy rather than being bundled into electricity prices as they are at present.
When will they ever learn?
India, like California before it, may be falling into the trap of thinking of competition as a cure for all ills instead of simply a way of allocating resources that may have negative as well as positive consequences.
- Is it really possible to create a market that leaves the pricing of electricity to market forces whilst at the same time ensuring that prices remain affordable for vulnerable groups, particularly in India where the consumers that regard themselves as vulnerable are a very large percentage of the voting population?
- Has India really considered the legal and political disputes that are likely to arise in a federal system over the level of subsidy to be offered in a particular State and whether the way that the subsidies are provided is a barrier to the development of an efficient national wholesale power market?
- Is deregulation desirable at the present time in view of the shortfall of generating capacity in many parts of the country and the inadequacy of the interconnections between the different regional grids ?
- How quickly could the market respond tohigh prices in view of the obstacles to commissioning new generation and transmission projects, including red tape, corruption, lack of finance and investor doubts about the enforceability of contracts as a result of the disputes over Enron’s Dabhol project?
The mistakes that were made in California could easily be repeated in Asia. The power pool that is to be established in Thailand, for example, seems to have been heavily influenced by the California model, judging from a report dated November 2000 and posted on the National Energy Policy Office’s website in March 2001. One area of concern is the extent to which Thailand proposes to rely on a spot market to set electricity prices. Although the spot market will not be mandatory – generators will be able to contract directly with eligible customers, retailers and other intermediaries outside the pool – a company responsible for supplying ineligible customers or eligible customers who do not wish to contract directly outside the Pool will be required to buy all of its electricity in the spot market. It will be prohibited from contracting forward, though individual consumers will be able to hedge their exposure to the spot price by contracting with unregulated "retailcos" if they wish, though few consumers are likely to buy enough electricity or have the necessary interval metering to make hedging worthwhile.
The US Federal Energy Commission blamed similar restrictions on contracting forward for the unreasonably high prices in the California market because they prevented the companies subject to the restriction from influencing market behaviour – they simply became passive price takers. This should not matter if no one in the market has market power but this will rarely be the case. Significant barriers to building new generating and transmission capacity may allow generating companies, either individually or through tacit collusion, to keep generation prices above the levels that would prevail in a more open market. Insufficient competition in the Pool can also dry up the forward market for those customers who can contract outside the Pool – generating companies may prefer to remain exposed to a spot price they can influence than contract forward at prices that may turn out to be significantly below the market price. This is why the UK Government chose to abandon its relatively successful electricity pool in which most power purchasers participated as passive price takers and replace it with a market that relies on forward contracting. For now, electricity prices in England and Wales have fallen significantly as a result.
If you have to ask, you can’t afford it.
The greatest concern of most Asian governments in the aftermath of the California crisis is the risk of price volatility. Most Asian governments now agree that the root cause of the California crisis was not the flaws in the market model but the fact that the demand for electricity was growing much faster than the growth in generation and transmission capacity. Given the roller coaster ride that Asian economies have experienced in recent years, similar imbalances between supply and demand are likely to occur repeatedly in Asia and, in some countries, are a fact of life. The willingness of electricity consumers to pay high electricity prices when capacity is tight will be much less in developing countries than it is in the West, particularly when the high prices are being paid to foreign investor companies.
Competition with Asian characteristics
Because of the concern about the effects of liberalising electricity prices, it seems unlikely that a truly competitive market model will emerge in Asia. What is more likely is that governments will introduce highly managed pools that will be used for trading marginal quantities of power at market prices. Pools will be designed primarily to facilitate third party access to transmission networks. They will allow newly privatised companies to trade surplus power with each other and improve the utilisation of their assets. They will also allow independent power producers to sell power to several different off-takers, thereby diluting their credit risk and mitigating the impact of an off-taker’s default. Allowing generating companies and off-takers even limited choice will help reduce the market power of the State-owned monopolies and help put pressure on them to reform in order to stave off demands from discontented captive customers for the right to buy their power in the market. Governments are unlikely to rely on pools to match supply and demand on a long term basis; governments will continue for the time being to plan their electricity systems and decide which transmission and generation projects to approve.
Pricing in these managed pools may be based on bids from competing generators, though governments will almost certainly retain the power to intervene and punish generating companies for abusive bidding in order to keep market prices within an acceptable range. Alternatively, generation bids may be regulated by reference to underlying costs. In India, the Central Electricity Regulatory Commission has proposed a wholesale spot market in which prices are calculated every fifteen minutes by reference to system frequency. When frequency is high, indicating too much generation, the market price drops to zero to encourage generators to back down their plants. When frequency is low, indicating insufficient generation, the pool price will increase, depending on frequency, to a level sufficient to incentivise standby generation to begin producing power. These prices are paid only in relation to "imbalance energy", that is the difference between the quantity of energy that a market participant contracted in advance to supply or take in a particular 15 minute period and the quantity actually supplied or taken. The CERC intends to review pool prices from time to time to ensure that they continue to provide the right incentives and will adjust them as necessary to reflect changes in fuel prices.
The concept of a managed pool may well be anathema to economists but pools must also serve political objectives. There is little sign that liberalisation has taken politics out of the electricity industry – quite the reverse. In California, the market designers and politicians failed to connect, with disastrous results. The same mistakes must be avoided in Asia. Managed pools will not look much like the competitive electricity markets in Europe, Australia or North America. Generation prices may well be regulated instead of being left to market forces. They will not necessarily use marginal or nodal pricing since the decision where and when to build new generating and transmission capacity will still be influenced more by governments than by price signals in the market. Although governments will want prices in the pool to be reasonably cost reflective to promote economically efficient trading, they will also want market prices to be fair and reasonable in the eyes of the public.
The passage of the Philippines’ Electric Power Industry Reform Act of 2001, despite the California crisis, indicates how far governments in Asia have come in thinking about how the electricity industry should be structured and the role of the private sector but the California crisis has made them cautious about embracing Western market models. We now face the challenge of developing a trading model for electricity that will work in Asia. If we don’t, we may all be dancing in the dark.
"© Herbert Smith 2002
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