44399 noTE no. 34 ­ May 2008GRIDLINES Sharing knowledge, experiences, and innovations in public-private partnerships in infrastructure Protecting electricity retailers against price volatility The Electricity Tariff Equalization Fund in New South Wales Michel Kerf and Eric Groom M ost commentators agree that the excessive price volatility, to be fully compatible benefits of competitive electricity with the functioning of the spot market, and to markets will materialize only if whole- be financially self-sustainable. sale prices are allowed to fluctuate more or less freely so as to provide adequate pricing signals All standard retailers in New South Wales are to generators. Most also agree, however, that government owned and, like other retailers, small electricity users need to be protected purchase energy through the national electricity against wholesale price volatility through market. They have to offer small users a regu- stable, predictable retail rates. That raises a lated electricity tariff that includes a regulated difficult question about whether the retailers energy cost component, both of which are set by or distributors, caught in the middle, also need the state's Independent Pricing and Regulatory some protection, especially early in the devel- Tribunal (IPART). opment of competitive markets. The Australian state of New South Wales has used a transi- In setting the regulated energy cost, IPART was tional mechanism to provide such protection. directed by the government to take into account Lessons learned from this experience could be the long-run marginal cost of generation. The of interest for other countries. ETEF mechanism is designed so that retailers supplying customers at regulated rates must New South Wales introduced full retail competi- contribute to the fund when spot market prices tion for electricity in 2002, allowing all customers fall below this reference price and are compen- to switch to competitive suppliers. Wholesale sated by the fund when spot market prices rise prices were allowed to fluctuate widely, up to a cap above it (figure 1). Thus, a retailer's positive of $A 10,000 per megawatt-hour, but regulated or negative settlement amount with ETEF is: "default" rates remained in place for customers (regulated energy cost - spot price) * (quantity using no more than 160 megawatt-hours a year. of regulated load, i.e. load on regulated tariffs). Customers could switch retailers, switch to a new In effect, surpluses from lower wholesale market tariff with their existing retailer, or remain on prices are "banked" for periods of higher prices. the regulated default tariffs. This "protection" was considered necessary to make retail compe- tition politically palatable. It was also decided that the standard retailers--those that have to offer regulated rates to small users--needed some protection against wholesale price risks. The Michel Kerf holds graduate degrees in Law and in Electricity Tariff Equalization Fund (ETEF) was Economics. He is currently Sector Leader, Sustainable established to provide that protection. Development, for Bolivia, Ecuador, Peru and Venezuela, at the World Bank. The fund's main features PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY Eric Groom is currently Principal Advisor, Independent Pricing and Regulatory Tribunal of New South Wales. Eric ETEF had three main requirements: to protect worked at the World Bank from 2004 to 2007 as a Senior small retail customers and standard retailers from Regulatory Specialist. Helping to eliminate poverty and achieve sustainable development through public-private partnerships in infrastructure PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY The fund's experience so far Figure 1 To ease the transition to the ETEF regime, the How the electricity Tariff equalization Fund Operates government made an initial contribution of $A Operation of the ETEF 50 million to the fund. ETEF started operations during the summer peak and in less than four $ MWh pool price exceeds weeks had exhausted that initial balance. Genera- generation cost tors were called on to contribute to the fund. In component addition, spot price volatility proved every bit as in IPART NSW price -- pool high as expected: prices were sometimes as low as retailers price compensated $A 10 per megawatt-hour, but when the supply- out of ETEF demand balance was particularly tight, they were regulated energy cost as high as the cap of $A 10,000. component in IPART recommended Over time, however, periods of high prices alter- price nated with periods of low prices, and money flowed into the fund as well as out (figure 2). The government's contribution was transferred back to the Treasury after six months as planned. While generators were required to put money into the fund a few times, they tended to be repaid within pool price less than generation cost component a few weeks. The financial sustainability of the in IPART price -- surplus paid into ETEF fund, however, is never ensured once and for all. time In 2007, for example, a period of severe drought reduced hydroelectric capacity and caused an Source: New South Wales Treasury. increase in electricity prices. As a result, over the course of a few months, the substantial reserves that had accumulated in the fund were wiped out and generators had to contribute to the fund.2 Funding shortfalls--which occur if the fund lacks The regulator itself declared that setting the regu- The fund sufficient reserves to compensate retailers when lated energy cost at the right level amid rapid and substantial variations in wholesale electricity "banks" wholesale spot market prices are above the regu- lated energy cost--are made up by publicly owned prices was far from an easy task.3 surpluses generators. Each generator's mandatory contribu- from lower tion to the fund is proportional to its previous Criticisms benefit from high spot market prices. When funds market prices again accumulate in ETEF, the fund transfers Observers have leveled several criticisms against for periods of money to the generators to reimburse them for ETEF. In particular, they have argued that ETEF higher prices the payments they made into the fund. In effect, may discourage retail competition, discourage ETEF offers a two-way financial hedge against the energy efficiency and load management, and spot price for the retailers. While such contracts distort the wholesale market. are common, in this case: Limits on retail competition · The volume is more flexible to allow for In spite of the negative impact on ETEF's assets demand uncertainty from default customers. of the recent increases in wholesale electricity · The "strike" price is the regulated energy cost prices, most observers agree that retail prices tend set by IPART. to be set at a level compatible with ETEF's long · The "contracts" are with the fund, not gen- run financial sustainability. Some observers have argued, however, that retail prices have been set too erators. low to enable full retail competition. The purchase arrangements under ETEF eliminate risks for the ETEF started operations in January 2001. The default retailers as well as the costs of manag- state government has indicated that it will start ing contracts with end users. To be competitively progressively phasing out both ETEF and the neutral, the regulated rate offered to small users default retail tariff controls in October 2008, should price in these risks faced by other retail- eliminating both by June 30, 2010. ers. Some observers argue that the regulated tariff Protecting electricity retailers against price volatility A model for developing countries? Figure 2 In newly liberalized electricity markets there are Payments have flowed into as well as out of the electricity Tariff equalization Fund good reasons to protect retailers (or distributors) that have to offer regulated rates to end users, The fund inflows especially when they are financially or technically offers a 400 weak or when their failure would mean interrup- potential 300 tions in supply--conditions relatively common in 200 developing countries. So an ETEF-type mecha- model for nism has some appeal. Moreover, steps can be 100 developing taken to mitigate the main concerns discussed in million$ 0 the previous section. countries -100 but only -200 Solutions to the main concerns As pointed out above, to maintain the potential when a -300 outflows for retail competition, regulated retail tariffs need number of 01-r 1 1 02-r 2 2 03-r 3 3 04-r 4 4 05-r 5 5 06-r 6 6 to include not only the costs of electricity genera- pre-conditions 06-Jan-01 06-Ap 06-Jul-0 06-Oct-0 06-Jan-02 06-Ap 06-Jul-0 06-Oct-0 06-Jan-03 06-Ap 06-Jul-0 06-Oct-0 06-Jan-04 06-Ap 06-Jul-0 06-Oct-0 06-Jan-05 06-Ap 06-Jul-0 06-Oct-0 06-Jan-06 06-Ap 06-Jul-0 06-Oct-0 tion, transmission and distribution but also the settlement week costs faced by non-standard retailers (or distribu- for the tors) because of commercial risks and contract retailers generators ETEF balance management. successful development Source: New South Wales Treasury. To foster energy efficiency, ETEF-type mechanisms Note: Inflows are payments into the fund by retailers and of competitive generators; outflows are payments from the fund to retailers could be structured to offer less than full protec- and generators tion to retailers. That would increase retailers' electricity incentives to take steps to protect themselves against wholesale price risks and increase end markets users' incentives to use energy more efficiently. does not reflect these risks and that because of this have a smaller share of users chose to switch to a differ- To minimize market distortion, regulated tariffs can been met. ent retailer or to unregulated rates in New South be offered to users accounting for only a small Wales (16 percent) than in such states as South part of total energy consumption. In New South Australia (42 percent) and Victoria (44 percent) Wales the regulated load accounts for less than after three years of open competition.4 10 percent of total energy consumption, which means that ETEF only marginally affects the over- Limits on energy efficiency all demand for contract cover. Environmental advocates have argued that because ETEF fully protects the standard retailers from Potential issues in developing countries market risks for their regulated loads, it removes In developing countries, however, three factors their incentives to minimize risks by working with might make it difficult to replicate the success of customers through load management and energy ETEF: efficiency programs. Similarly, because the end users do not see the true cost of energy in peak · In many countries retail tariffs tend to be set periods, they have no incentive to manage their below costs. In this situation the reference price own energy use. will likely be set below the long-run marginal cost of generation (or retailers will be unable to Wholesale market distortion cover their costs) and an ETEF-type mechanism will be chronically short of funds. Retailers and There have been concerns, especially among distributors (and users) will remain dependent private generators, about the reduction in demand on continued payments by the fund's contribu- for contract cover from the standard retailers. A tor of last resort. high level of contract cover is generally consid- · Accumulated earmarked revenues, a tempting ered to be a desirable feature of a competitive target, often are diverted to uses other than electricity market, and private generators tend to those originally intended. When that happens, seek higher contract cover than public generators the fund will not be financially sustainable. because of higher debt levels. · Relying on generators as contributors of last resort might impede the privatization of public tion) will likely prove very challenging in many generators or the entry of new generators. This developing countries. Even a technically compe- is a drawback for developing countries, which tent and politically independent regulator such as often attempt to combine market reform with IPART admits to finding that task difficult. It is private participation programs. important to point out, however, that the above issues do need to be addressed not only to increase Once again, measures can be taken to try to address the chances of success for a stabilization fund but these concerns. First, the regulatory regime can be more fundamentally to enable competitive elec- designed so as to increase the chances that tariffs tricity markets to function. Indeed, retail prices will cover costs. In New South Wales regulations reflecting market conditions and robust regula- state that the regulated energy cost (the reference tory and governance mechanisms are essential price) must reflect the long-run marginal cost of pre-conditions to successful competitive market generation and that the regulated retail tariff must reforms in the electricity sector. include the regulated energy cost plus a margin to cover the distribution costs of standard retailers. In addition, IPART has recently decided to review Conclusion retail tariffs more frequently in order to be able to reflect variations in wholesale prices more quickly.5 A mechanism similar to ETEF--perhaps with modi- Finally, steps have been taken to protect IPART fications to encourage retail competition, promote against undue political pressures to keep electric- energy efficiency, maintain sufficient demand for ity prices below costs. For example, the IPART contract cover, and preserve incentives for new Act requires its members be chosen based on their entry in generation--deserves consideration as a professional qualifications and that its decisions way to ease the transition to a competitive elec- be independent of any government minister. tricity market. However, such a mechanism will meet its objectives only when certain precondi- Second, governance mechanisms can be designed tions--required to make competitive electricity to help ensure that earmarked resources are markets sustainable--are met. In particular, retail allowed to accumulate in the fund. The manage- prices must be compatible with a reference price ment of ETEF has been entrusted to a ministerial that reflects conditions in the wholesale electricity corporation subject to strict reporting and audit market and regulatory mechanisms must be robust requirements designed to ensure that public enough to ensure that revenues accumulated in resources such as ETEF funds can be used only the fund remain in the fund to be available during for their intended purposes. periods of high wholesale prices. Third, arrangements can be set up to maintain an Notes attractive environment for investment in genera- 1. The authors wish to thank Danny Price of Frontier Economics for tion. The government, rather than generators, can sharing his experience in designing the New South Wales Electricity be designated as contributor of last resort. That Tariff Equalization Fund and Peter Hoogland of the New South Wales Treasury for commenting on a draft of this note. was the option chosen for the Electricity Tariff Equalization Fund in Argentina. Alternatively, 2. ETEF's financial reports reveal that as of June 30, 2006, the fund had net assets of $A 271 million, while the net assets of the fund agreements can be reached with generators on as of June 30, 2007, were a negative $A 822,000. See New South adequate compensation for the obligations Wales Treasury 2006 and 2007. they are asked to undertake as contribu- 3. Keating, Michael, Evaluating Energy Prices in NSW, NSW Energy GRIDLINES tors of last resort. Summit, 20 November 2007. 4. Moran, Alan. 2006. "The Electricity Industry in Australia: Problems Along the Way to a National Electricity Market." In Gridlines share emerging knowledge While it is thus possible to address Feirdoon P. Sioshansi and Wolfgang Pfaffenberger, ed., Electricity on public-private partnership and give an these three issues, the experience Market Reform: An International Perspective. Amsterdam: Elsevier overview of a wide selection of projects from Science. various regions of the world. Past notes can be of New South Wales shows that found at www.ppiaf.org/gridlines. Gridlines are a this is far from easy. In particu- References publication of PPIAF (Public-Private Infrastructure lar, maintaining retail tariffs at PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY New South Wales Treasury, Annual Report 2005­2006, Crown Advisory Facility), a multidonor technical assistance levels that will ensure the finan- Entity, 2006. facility. Through technical assistance and knowledge cial sustainability of the fund dissemination PPIAF supports the efforts of policy New South Wales Treasury, Annual Report 2006­2007, Crown Entity, 2007. makers, nongovernmental organizations, research (and promote retail competi- institutions, and others in designing and implementing strategies to tap the full potential of private involvement in c/o The World Bank, 1818 H St., N.W., Washington, DC 20433, USA infrastructure. The views are those of the authors and do PHONe (+1) 202 458 5588 FAX (+1) 202 522 7466 not necessarily reflect the views or the policy of PPIAF, PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY geNerAL eMAiLppiaf@ppiaf.org Web www.ppiaf.org the World Bank, or any other affiliated organization.