J4S 13 Viewpoint The World Bank September 1995 Note No.54 A Template for Power Reform DavidGfM. In the electricity supply industry, high-tension to justify their investment. Experience, however, Xeuwberv transmission and low-tension distribution svs- shows that the politics of pricing are often tems are natural monopolies, but generation is heated. For social reasons, many governments potentially competitive. Because competition have set unremunerative prices, and many have is more effective than regulation in promoting failed to index public utility prices adequately efficiency, separating the potentially competi- to offset the effects of inflation. tive parts of the electricity supply industry from the natural monopoly parts that must inevita- Therefore, to give investors the confidence to bly remain regulated is good public policy. But tie up money in an investment that might not the potential for this kind of industry reform pay off for years, governments must reassure will vary by country-depending on whether them that the rule of law-specifically prop- the system is government owned, investor erty law-is sufficiently strong to ensure prop- owned, or under mixed ownership. If a coun- erty rights. And to reassure consumers and try can de-integrate its electricity supply indus- investors, a regulatory system must set rates try in this way, however, it should do so, or at satisfactory to both. Investors, in turn, must co- least keep the possibility open through contin- ordinate investment in transmission and gen- ued public ownership of the transmission sys- eration to find least-cost ways to expand the tem. And to create effective competition, system and to prevent system failures, fuel governments should privatize generation-and shortages, and price shocks. And because elec- possibly distribution-to pave the way for a tricity is vital to production, they need to reas- market in bulk power. This Note provides a sure governments that supplies will be available template for such industry reform. at all times. How to satisfy this set of objec- tives constitutes the regulatory problem. The regulatory problem What industrial countries have done A natural monopoly arises when a single firm can provide a range of goods or services at lower The history of the electricity supply industry in cost than a set of firms. Electricity networks are different countries illustrates the variety of so- natural monopolies in this sense. Moreover, their lutions that have been found to the regulatory monopoly is in the supply of a necessity, and problem. The solutions are of three main types. they have a direct connection to consumers. This The industry may be entirely publicly owned, combination of necessity and direct connection and thus subject to direct political control: it implies large potential exploitative power and may be entirely private. but regulated explic- ensures that regulation or public ownership is itly or implicitly; or it may be a mixed system politically inevitable. Investors in the electricity in which the private sector is implicitly con- industry must therefore expect limits on the trolled by the potential of the remaining pub- prices they caii charge and sometimes onerous licly owned system to take over its function. obligations relating to safety. supply, and stabil- ity. In exchange, though, investors need reas- The simplest structure is a publicly owned na- surance that future prices will be set high enough tional monopoly such as exists in Belgium, Private Sector Development Department * Vice Presidency for Finance and Private Sector Development A Template for Power Reform A GLOBAL FINANCING PROBLEM Th prmn of the state-in power sectors was frequently unmresveprtclal whe:;i 000000:on high inflationfollowedthe oil industrial countries' demandtfor electricity increased sharply shocks of the 1970s. Despite excess demand, prices hovered after World WarIla Improvemens inreliability and high but below long-run marginal costs, andthe rate of return fell so that falling electricity prices financed the huge investment profitscould not finance needed investments. In 1991, with only 60 prografms needed to meet demand and to modernize genera- percent of power sector costs covered by revenues, self- tion and transmission. Until the oishocks of the 1970s and financing ratios fell to only 12 percent of investment requirements. : 000growing fear ab:out nuclearpower, therefore, public criticism; In 0 ;j0tffSfact, by the late 1980s, continuing inthis vein was no longer of the power sector was muted. P Ofinanciallyfeasiblefor utilities orfor governments, especially in Ini t000J t ndeveloping co untries, the electricity supply idustry was;000 t0t;000Latin America. Fundamental seor reform(icluding privatiza- 0; :0 almostinvari:abily state-controlled, w>ithintUernational orgia-0 0 i i: tion) was proposed as the solution. In 1978, Chile had begun 000 0 0 0 nizations such as the World Bank helping;to meet investment 0t radically restructuring its electricity industry as a prelude to requirements. In 198-91, nearly 9 percent of jofficial develop-0000000000 .-jprivatization. Deregulation was on the agenda in the United 9 ment fiSnance went t hepower sector, and power accounted States, with modest beginnings in the power sector under the :; for abouit 15perenXt of World Bank glendingf until 1991.t Inthei ii ii tPublic UtilitiesiRegulatory Policies Act of 1978. But the pace 0010000S00 1980s, infrastructure ac ounted fo-rmore than 55 percent of 00quickenedl with the simultaneous restructuring and privatization 0 000 Xpublic investment in middle-income countries, and rougyhly 41J 0 o 0f the electricity supply industry in the United Kingdom in 1990-91. percent of that share-or a quarter of total public investment- This reformin demonstrated the importance and feasibility of went to power. Official development assistance financed about restructuring the industry and changing the system of regulation, 10 percent of the annual power sector investment-rughly usually as preconditions for privatization Ithough, as Norway US$80 billion-andthe World Bank financed about3percent. shows, this laststep is not logicallyimplied bythe firsttwo). France, Italy, and Portugal and used to exist in Structural choices and the design England before 1990. Austria, the Netherlands, of regulation and Spain have de-integrated their industries to varying degrees and formed cooperative Reforming the electricity supply industry in power pools that dispatch in order of cost. In countries with nationalized industries (owned the Netherlands, four regional generation com- and controlled by the central rather than the panies own the grid and the dispatch company, local government) raises different prohlems and the industry draws up plans subject to gov- than in those with private (investor-owned) ernment approval. In Spain, the grid is under industries or mixed systems. Governments with- public control, and the government determines out direct control over assets will be constrained the investment plan. And in Austria, the na- in regulatory reform by the rights of the exist- tional power company owns the grid and also ing owners. Radical restructuring is far easier has ultimate responsibility for ensuring sup- under public ownership, although in countries ply, but c(oordination of power sector invest- with unclear or overlapping property rights (of ment is decentralized. workers, local municipalities, and ministries), it may require clarifying the state's control over Unlike most other European electricity supply the industry. For countries undertaking reform, industries, those in Germany and Switzerland advisers will need to answer the following ques- are complex and fragmented. This reflects the tions: How should the industry be structured? federal structures of these countries and the Which parts should be public and which fact that, because their power sectors were not private? And which parts should be regulated nationalized, they have not been restructured. and how? The Scandinavian electricity supply industries are under mixed public and private ownership Industry structure and are largely self-regulating, coordinating electricity supply through cooperation and Since generation is potentially competitive and negotiation. transmission is a natural monopoly, separating the ownership of the two systems might allow riding private property rights or paying expen- competition to effectively take the place of regu- sive compensation. If generation is to be trans- lation in generation. But for competition to be ferred to private ownership, transmission should effective, there must be enough independent be kept separate, perhaps initially in public own- generators actively competing in setting the price. ership, or as a separate company with restric- This active competition may be difficult to achieve tions on control by generators or by large users if new power stations are large relative to the or distributors. total capacity of the country or if the transmis- sion system is unable to ensure adequate com- Public or private ownership? petition in each region. If competition fails to keep prices low, regulation may be necessary. Most studies comparing the performance of pri- vate electric utilities with that of publicly owned When generation and transmission are inte- utilities conclude that there is little difference grated, only the delivered power price neecds in technical or cost efficiency, though very re- regulation. But if transmission is separate, cent studies indicate better performance un- charges for access to and use of the transmis- der private ownership. sion system will need to be regulated to en- sure efficient generation in the short run and eAperience suggests that efficiency efficient choices in plant type and location in ' the long run-a challenging task. depends more on theform of regulation Some of the considerable benefits of competi- thani on the form of olnership. tion in generation can be achieved by inviting competitive tenders for the constriction of new plant, built and operated under long-term con- In the United Kingdom, privatizing the genera- tracts with the transmission company. But verti- tors and forcing them to compete in the bulk cal de-integration offers potentially greater electricityn market doubled labor productivity in benefits. It creates competitive pressure at stages three years and improved control over invest- where entry is feasible, and it may result in over- ment costs. The publicly owned Nuclear Flec- all improvements in efficiency sufficient to offset tric and British Coal, both forced to sell in the inefficiencies of transactions through the net- markets Nvhere there was competition from pri- work. -Vertical de-integration also hinders cross- vate firms or imports, also inmproved their pro- subsidization and makes pricing more transparent. ductivity dramatically. In Argentina, generation availability improved within a short period after Given these considerations, what course should privatization, with Central Costanera increasing be taken by a government contemplating a po- availability from 20 percent to 50 percent and tentiallv radical restructuring of the industry? doubling its output. Norway introduced com- Such opportunities are rare and should not be petition in the bulk electricity market and in wasted. The guiding principle should be whetlher 1993 created Statnett Marked (as a subsidiary of the proposed reform forecloses options or keeps the state-owned owner of the transmission sys- them open. If cle-integration is possible, a gov- tem, Statnett) to operate the power pool, with- ernment should choose that course-or at least out altering the ownership structure of the keep that option open through continued pub- industry. The result has been substantial trade lic ownership of the transmission system. Con- across former franchise boundaries and de- tinued, centralized public ownership keeps most creased dispersion of prices. In due course, the options open, but municipal ownership appears Norwegian reform should provide a good test to create obstacles to further reform, at least in of whether, in creating contestable power mar- some political systems. Reforming a privately kets, it is more important to restructure the in- owned, vertically integrated generation system dustry or to privatize it. Note, however, that the appears most difficult, because it requires over- Norwegian system allows private generators to A Template for Power Reform compete with state and municipally ownged sys- and new investment in transmission and gen- tems. In the United Kingdom, as in Argentina eration is required, prices will need to be ad- and Chile, distribution companies remain natu- equate to revward private investors. ral monopolies, and the rate of improvement in their performance has not changed markedly The major challenge in designing regulation since privatization-although neither has it de- for a de-integrated industry is to provide ad- teriorated. Altogether, this experience suggests equate assurances of investor protection, so that that efficiency depends more on the form of the necessary expansion will take place, while regulation than on the form of ownership. preserving the benefits of market competition. Policymakers must ensure that the bulk elec- Criteria for regulation tricity market is adequately competitive to avoid a need for the burdensome regulation that un- A good system of regulation should do two dermines investor confidence. things. It should enable a utility to raise finance for investment at an acceptable cost. And it Priorities in developing should provide incentives for efficiency in op- and transition countries eration, pricing (and thus use), investment (in choice of type, location, size, and cost), and In developing countries, the main problem is innovation. These requirements may conflict, to improve the financial and economic perfor- however. Rate-of-return regulation guarantees mance of the industry-by rebalancing tariffs, an adequate return on capital and thus enables eliminating costly interruptions in supply, re- a utility to finance investment cheaply, but it ducing construction and operating costs, and gives little incentive to increase efficiency. Price avoiding construction delays. Private invest- cap regulation does provide good incentives to ment in generation-and possibly in transmis- reduce costs. But by increasing profits, it ends sion and distribution as well-looks attractive This series is published up creating pressure to tighten price regulation, on all scores, as long as entry is competitive to share ideas and invite which increases regulatorv risk and raises the and the regulatory environment keeps risks and discussion. It covers financial and private cost of investment. Regulatory reviews must be costs low. The evidence from Chile in particu- sector development as carefully designed to ensure investor confidence lar-where regulatory reform and the restruc- well as industry and and continued political support. The U.K. solu- turing of state enterprises occurred first and energy. The views rvt'a' expressed are these ef tion is to grant licenses to the utilities that clearly privatization proceeded quite slowvy-shows the authors and are nat specify their rights and obligations and can be the importance of creating a sound, indepen- intended to represent defended or enforced in the courts. dent system of regulation, commercialization, an official statement of Bank policy or strategy. and competition, even for state-owvned utili- Creating competition ties, and the relative unimportance of rushing Comments are welcome. into privatization. In Eastern Europe efforts to Please call the FPD E Note line to leave a Creating effective competition requires separat- privatize utilities to reduce public debt have message (202-458-1111t ing transmission from generation and privatiz- been hampered by low tariffs and unsatisfac- or contact Suzanne ing generation (and possibly also distribution) tory regulation. Solving these problems would Smith, editor, Room G8t05, The Iorld Bank, in order to create a market for bulk electricity. remove the financial urgency of privatization. 1818 H Street, NW, This restructuring has far-reaching effects on the Washington, D.C. 20433, relative price structure, reducing the ability to This Note is based on a chapter hv the atohor in Cliniclio Frischtak, or Internet vddress ssmith7@worldbank.org. cross-subsidize and putting competitive pressure ed., Regolatorn Policies ancl Reform: A Comparative Perspective on fuel supply industries, making subsidies (World Bank, Private Sector Development Deparinenrt `shington0 on fiLielsupply idi-istrie, makingsubsicli s .C.. forthcomaing~). To ordec.r connact Cinidy Wong at (202) 473-3606 DPrinted on recycled harder to justifv. Paradoxically, when costs fall or hy email (cwongav&wofldhank.orgY. paper. as efficiency increases, labor is shed, and costly fuels such as coal and nuclear are replaced by David -,I. Newbe;y, Department of Applied gas, prices may rise as subsidies to capital and Economics, Cam biridge Utniversity. Cambridge, fuel are removed. If demand growth resumes England