Chapter 2

PART TWO (Literature Review)

2.    Electricity Reform

Electricity is a very vital necessity in the world today; it is widely used in homes, businesses and industries, as it is essential to the production of goods and services. With the wide-range use of a lot of electricity appliances for everyday use in both households and businesses, there is need for constant electricity supply because, these electrical appliances performs enormous tasks in our everyday lives. Due to all these, adequate, reliable, competitively priced electricity is essential for modernization, domestic growth and international competitiveness and is among the most urgent challenges facing developing and transition economies (Kessides, 2004).  

Looking at major keywords that would be used in this paper, it is best to understand what they mean, words such as Restructuring, Liberalization, Privatization, Corporatization and also, Deregulation. According to Sioshansi (2006), he described these words as:

·      Restructuring: A broad term, referring to attempts to reorganize the roles of the market players, the regulator and/or redefine the rules of the game, but not necessarily “deregulate” its wholesale market by lifting nearly all restrictions to how wholesale prices could be set by generators, but kept its retail market fully “regulated”, in this case capped.

·      Liberalization: Synonymous with restructuring but it refers to attempts to introduce competition in some or all segments of the market, and remove barriers to trade and exchange.

·      Privatization: This generally refers to selling government-owned assets to the private sector. It must be noted that one can liberalize the market without necessarily privatizing the industry, as has been done successfully in Norway and in New South Wales, Australia.

·      Corporatization: This generally refers to attempts to make state-owned enterprises (SOE) look, act, and behave as if they were for-profit, private entities. In this case, a SOE is made into a corporation with the government treasury as the single shareholder.

·      Deregulation: This is essentially a misnomer. No electricity market has been (or, in fact, can be) fully deregulated. Experience suggests that even well functioning competitive markets need a regulator, or at a minimum, a market monitoring and anti-cartel authority. Until recently, Germany was the only major country attempting to go without a regulator, although they had an anti cartel office monitoring the behaviour of market participants.

In the past, electricity industries were characterized as vertically integrated monopolies owned by national, state, or municipal governments. In the electricity sector, there are four primary components and these are: Generation, Transmission, Distribution and Retail Supply and all these were being controlled under one body otherwise known as monopoly. The electricity industries varied across various countries, notably the developed countries and the developing countries and “in many developing countries, the sector were characterized by low labour productivity, poor service quality, high system losses, inadequate investments on power supply facilities, unavailability of service to large portions of the population, and prices that were too low to cover costs and support new investment” (Joskow, 2003). Because of all these, there was lack of constant power supply but industries had to go on, so in responding to the poor power supply, they have their own generating facilities on site but in doing this, it increases their costs of doing business but they have no choice. Not only industries do this, also, in the residential areas and small to medium business enterprises, they get alternate power supply, which for the residential areas, increase the cost of living and for the businesses, increase the costs of doing business also. Whereas in developed countries, the electricity sector’s performance is generally much better but there were various factors that had to be addressed to bring about change to reduce costs and retail and these factors were: high operating cost construction cost overruns on new facilities, costly programs driven by political pressures, and high retail prices required to covers these costs etc.

Since the early 1980s, when Chile began a radical restructuring and privatization program, more than 70 countries have introduced electricity reforms and especially in the past decade, views have changed dramatically on how electricity should be owned, organized and regulated (Kessides, 2004). These countries engaged in the market reform initiatives that includes, liberalization, privatization and/or restructuring the electricity supply industry. Electricity reform sounds too good to be true but there are also issues that surround it as well and based on several examples, lessons to be learnt on best policy options. Some of those examples that can be noted are: the crisis with electricity reform in California (United States), the blackouts in Europe (Bialek, 2004). All these brought focus the crisis that can also be associated with electricity reform and if these crisis can still happen in developed countries which are advanced technologically, then care should be taken in planning a reform in developing countries.

The overriding reform goal has been to create new governance arrangements for the electricity sector that provide long-term benefits to consumers (Joskow, 2003). If this goal is to be reached, there should be reliance on competitive wholesale markets for power to provide better incentives for controlling construction and operating cost of new and existing generating capacity, innovation in power supply technologies should be encouraged and also, shifting the risk of technology choice, construction cost and operating mistakes to suppliers and away from consumers. Introducing retail competition whereby consumers can choose between electricity retailers who offers the best price/service quality combination that meets their needs the most. There are different situations where a consumer might need electricity, it could be to power a large building where a lot of electricity is required and there is meant to be a constant electricity supply or it could be a small building like residential homes, where electricity will not be needed throughout the day as there are situations where there could be no one in the house and less electricity is needed. So, the competing retailers would be expected to provide an “enhanced array of retail service products, risk management, demand management, and new opportunities for service quality differentiation to better match individual consumer preferences” (Joskow, 2003).

According to Joskow (2003), the basic architecture for restructuring and competition are:

·      Privatisation of state-owned utilities

·      Vertical separation of competitive segments (e.g. generation, marketing and retail supply) from regulated segments (distribution, transmission, systems operations) either structurally (through divestiture) or functionally (with internal “Chinese” walls separating affiliates within the same corporation)

·      Horizontal integration of transmission and network operations to encompass the geographic expanse of “natural” wholesale markets and the designation of a single independent system operator to manage the operation of the network, to schedule generation to meet demand and to maintain the physical parameters of the network (frequency, voltage, stability).

·      The creation of public wholesale spot energy and operating service reserve market institutions to support requirements for real time balancing of supply and demand, to respond quickly and effectively to unplanned outages of transmission or generating facilities consistent with the need to maintain network voltage, frequency and stability parameters within narrow limits, and to facilitate economical trading opportunities among suppliers and between buyers and sellers.

·      The application of regulatory rules and supporting network institutions to promote access to the transmission network by wholesale buyers and sellers in order to facilitate efficient competitive production and exchange, including mechanisms efficiently to allocate scarce transmission capacity among competing network users.

·      The unbundling of retail tariffs to separate prices for retail power supplies and associated customer services to be supplied competitively from distribution and transmission services that would continue to be provided by regulated monopolies. This means that, consumers would be able to choose from competitive power suppliers to purchase their power and also in turn, these power suppliers buying their power from wholesale markets or from their own generating facility (if they have one) to support their retail supply commitments and then supplied over the regulated distribution network for a fee, to meet their customers’ electricity demand.

·      Where retail completion is not available (e.g. for domestic and small commercial customers), distribution companies would continue to have the responsibility to supply these customers by purchasing power in competitive wholesale markets or, if they choose, to build their own generating facilities to provide power supplies. However, in the latter case the associated charges for power would be subject to wholesale market-based regulatory benchmarks.

·       Independent regulatory agencies with good information about the cost, service quality and comparative performance of the firms supplying regulated network services, the authority to regulate effectively the prices charged by distribution and transmission companies and the terms and conditions of access to these networks by wholesale and retail suppliers of power, are also an important but underappreciated component of successful reforms.

All these shows the channel restructuring should go through and as seen, there are several keywords that were mentioned, like “competition” and “regulation”. These form the basis for which reform should go through, they bring about the success in reform and without them, reform would not be successful and the electricity sector of the country undergoing the reform would revert back to the monopoly they dreaded so much. So, the two keywords would be looked into for more understanding.

2.1.Competition

Competition has been seen as, the backbone of electricity reform which brings good performance, lower electricity tariffs and options towards where to get your electricity from. “Competition in the electric industry generally means competition only in the production (generation) of electricity and in the commercial functions of wholesaling and retailing” (Hunt, 2002). These two generation and supply are the functions that competition should be introduced in other words, deregulated, so, the prices would be set in the competitive markets and not by regulators. “The transportation functions (transmission and distribution) cannot be competitive – they are natural monopolies. It doesn’t make economic (or environmental or esthetic) sense to build multiple sets of competing transmission systems; everyone has to use the same wires” (Hunt, 2002). A lot of authors has made this same statement, transmission lines should be regulated and competition should not be introduced, and almost all of them also adding that, it becomes very complicated and extremely volatile if it is deregulated. Accordingly to Newbery (1997), “Competitive electricity spot markets should be expected to be extremely volatile. The unpredictable element in this volatility can hedged with financial contracts, and if the timing of the peak is very uncertain, the range of contract prices may be more moderate (the chance that any hour is the peak may be quite low for a large number of apparently similar hours)”. So, competition would be discussed in subsequent sub-chapters but most importantly, competition in production (Generation) because, it is through competitive generation that the long-term benefits of restructuring is achieved. Competition in supply (Retail or Wholesale) cannot bring any benefits if there was no competition in the production branch of the electricity industry. The production end has been the major problem why restructuring had to be introduced, under the state-run monopoly, there were several things that couldn’t bring about the success in the electricity industry. Things like: the inefficiencies in choice of technology, the politics of the state, construction and maintenance, and also, the difficulties in regulation and pricing. So, in this situation where competition can be a key factor in addressing the issues that brought about restructuring, introducing competition in production makes sense worldwide.

2.1.1.   Competition in Generation

The generation part of the electricity industry accounts for about 35% to 50% of the final cost of electricity delivered to the electricity user. Thousands of generating plants all over the world, produces electricity commercially and the way this is done is by wires turning in a magnetic field that produces the electricity. There have been theoretical arguments, statistical evidence and the ever-increasing importance of creating a competitive market for the generation of electricity. With competitive generation, there can be assurance of good performance with everybody involved in generation trying to do a better job so, they can profit from it. As the name reform implies, it means replacing state ownership or governmental regulation with competitive markets all to bring about an improved output. Introducing competition in generation is dependent of the current structure of the electricity industry, usually, there are two kinds of structure that it could be, it could be either the industry is a state-owned monopoly or consists of investor-owned utilities that is subject to government regulation. If it a state-owned monopoly, then the reform would mean full privatization and the separation of generation from both the distribution and transmission functions and if the industry is the one that consists of investor-owned utilities which is subject to regulation by the government, as it is in the United States, then the requirement would be, the deregulation of generation capacity coupled with the separation of generation from transmission and distribution.

There are several elements of reform and according to Moorhouse (2001), thoroughgoing reform has four major elements:

·      Private ownership of electricity industry facilities;

·      Open access for generators to transmission facilities;

·      A minimum of three independently owned generating stations that could potentially compete for consumers within each regional electricity market or service area;

·      Separation of generation from transmission and distribution

All these can bring about thorough reform in the generation function of the electricity industry. By bringing in people who privately own their electricity industry facility, it eradicates the state-owned monopoly and by doing so, the people that replaces the government, go into generation for profit and will endeavour to keep their business running by ensuring that there would be steady electricity that would be generated and also, would be held accountable for the maintenance of the facility to prevent a breakdown of equipment. The element stated by Moorhouse (2001), “Separation of generation from transmission and distribution”, has been widely stated by a lot of authors and has been done by a number of countries (for example, United Kingdom) and has been shown to be a success. This is because, it has been seen to be controversial when privatization, restructuring and complete deregulation of the distribution and transmission sectors has been tried.

Taking the United States into focus, competitive markets at the generation phase of the electricity industry have not only been desirable, but also becoming increasingly important. It has been observed that, the entry if new companies into the electric power industry are becoming the norm and the new companies that enter are mostly unregulated industries and they compete with the regulated electric companies. With this, by 1990, ten years after the reform in the United States was on going, unregulated IPPs (Independent Power Producers) and cogenerators were building more generating capacity than were traditional utilities.

2.1.2.   Advantages of Competition in Generation

The market that is targeted in competitive generation is that which independent firms compete price to sell electricity directly to large customers, and supply electricity through common carrier transmission, to distributors who in turn sell power to final users (Moorhouse, 2001). In this situation, competing producers may prefer to compete for different parts in the generating sector of the electricity industry. For example, they may want to compete for long-term base-load contracts, where by in this case, they may own hydro or nuclear power plants which produces high amounts of electricity while others might want to compete for the supply base and cycling base loads contracts and these firms might own a fossil fuel plant that doesn’t produce large amounts of electricity. Then, firms that own gas combustion turbines or any kind of turbine generating plant and cogenerators could also compete to meet the peak loads. So, in this case, there is competition for base loads, cycling loads and also peak loads. In a calendar year, electricity is defined by peak and off-peak and so do the generators require the loads. Peak and off-peak loads are defined by, the day, week and also, season. Prices of electricity are charged for each type of service, whether peak or off-peak and also, daily to seasonal and this could be established by the contract signed, a 24-hour advance notice, and also, in spot markets. The customers would face more service options and with unit pricing being variable by the amount of electricity purchased per period, could also face more complex pricing scheme.

With the variety of different types of generators linked to the transmission grid, advantages of competitive generation can be seen. The advantages are:

·      It involves cost saving, power is supplied to the transmission grid at any given moment by the firm that has the lowest marginal cost. The dispatch according to merit, which is from the lowest to highest marginal cost, would save resources and also, reduce the cost of generating electricity. Generating capacity can be more fully utilized and additional capital resources saved due to the different plants which may have different load characteristics, load and peak duration curves. With previous problems like equipment failure, the variety of generating equipment and the larger number of independent producers adds diversity to the system which in turn lowers the probability of widespread equipment failure, thereby, reducing the amount of excess capacity required to provide a given level of service reliability.  This means that, generators can have routine plant maintenance with the availability of electricity from alternative suppliers and this added flexibility in scheduling repairs in the generating sector, lowers plant maintenance costs. All these mean that, there would be lower prices of electricity to customers.

·      A spot market for electricity would develop; this will create flexible scheduling in the production of electricity by generators. With flexible generation, fluctuating electricity demands can be met with the excess generated electricity not being wasted as they sell electricity to the spot market instead of waiting for the customer to demand electricity (like its done in a monopolistic environment) and also, the competitive generators are able to reduce their idle spinning capacity and simply schedule efficient production. With efficient production, production cost is reduced.

·      Innovation is another advantage in competitive generation; firms would keep advancing in order to keep up with their rivals. Upgrading their systems, their generators, ensuring better customer service, being able to keep up with the customer demand to stay ahead of their rival, do everything possible to at least have an advantage over their rivals and also, bringing in new technology is the need arises. The ensures better long-serving working generators and also, better services to the customers

2.1.3.   Competition in supply (Retail and Wholesale)

The last line of the chain of the electricity industry is supply and as the generation part needs competition to bring about more efficiency and better service to customers, so does the supply aspect as well. The supply branch in the electricity industry comprises of the quality of service received and also, the pricing of the electricity as well. For instance, if the electric industry is under monopoly, the prices gotten by the customer is final, the customer would have no choice in the matter, cannot choose the kind of plan you want, and also the service received by the electricity company would be poor. The customer could be treated whichever way (sometimes rudely in some developing countries) that may not sit well with them and because there is only one choice in getting electricity supplied to you, the prices are fixed and sometimes, the customer would not know how the bill would have amounted to that. In a competitive environment on the other hand, the option of choice comes into play, the customer would be able to choose the service they want, choose the electricity company they want as well, the choice could be based on their prices and services. Due to this fact, electricity supply companies have to come up with several ways to reduce their prices and also, provide better customer service so as to get more customers getting electricity from them as they seek to earn profits. Also, with the cost of electricity dependent on peak and off-peak period, a more elaborate pricing system would emerge under competitive conditions.

The supply of electricity varies between industrial customers and residential customers, for the industrial customers, they would require more electricity (wholesale), so they would have the option of getting their electricity from supply companies or they could get it from the spot market itself or even directly from the generators via bilk wheeling. This would be dependent on the size of the industry. As for the residential customers, they would not need as much electricity as the industrial customers would need, so they can get their electricity from a variety of supply companies. Residential customers can shop for their most desired type of prices and services with the option of paying set prices from a menu establishing time-of-day and time-of-year rates, and premiums and discounts based on reliability of service. The residential customers would be unlikely to get their electricity from the spot markets as the industrials customers do because, most residential customers want to estimate their expenditures on electricity, so with the fluctuating spot prices, there would be too much uncertainty for the residential customer.

2.2. Regulation

Regulation is another key aspect of the electricity market restructuring, a reform of regulation of electricity markets has the potential to cause substantial changes in the way in which consumers and as mentioned in the previous sub-chapter, to succeed with electricity reform, various key aspects would play a role. Regulation plays a key role in both the transmission branch and the distribution branch of the electricity channel, also, minor roles in both the generation and supply in terms of putting the private firms in check while competition handles the rest. The biggest problem with regulation and regulators has been, to keep up with the fast-moving markets and the inability to do that have proved costly. According to Hogan (2009), “there is a tension in choosing regulation to address immediate market failures and to deal with the continuing challenge of improving electricity market design”, so he differentiated regulation into the little “r” and the Big “R”. The little “r” regulation was stated as, “the design and policies that are the ‘best mixture’ to support competitive wholesale electricity market” and the Big “R” was stated as the “frame every problem in its own terms-inadequate demand response, insufficient infrastructure investment, or market power-and design ad hoc regulatory fixes that accumulate to undermine market incentives. The little “r” meant the ability to figure out different scenarios for a proposed solution while the Big “R” created a slippery slope problem, where one solution created another problem. There are regulatory bodies in every country of the world that helps with the electricity reform, for example, FERC (Federal Energy Regulatory Commission), have used their regulatory powers to restructure electricity markets to rely on competition in generation markets to promote lower prices and innovation (Shapiro et al, 2005). Also, in the UK where the utility industries were state-owned as at 10 years ago, but now taken over by private sectors and in the process of regulatory reform, “markets have been liberalized, industries have been restructured, and new regulatory methods and institutions have been created” (Armstrong et al, 1994). Regulation and regulators play a significant role in electricity market success, as the saying goes, “regulators regulate, they control, command, dictate, adjudge and enforce” (Eisen, 2005) but they can easily fall short of the task at hand, it is quite difficult to deal with the every changing scene of the electricity market, where there needs to be improvement, or in other words, “reinvention” and when this happens, they face serious challenge and maybe, even immediate rejection. With this, the regulators had to be more innovative and more precise to deal with the ever-changing electric market to convince the decision makers. Regulators and regulation defers in both developed and developing countries because, developed countries have gone through a period where they could have a sustainable solution to the ever-growing market and now, have set the yardstick to follow and sharpened all the rough edges in regulation and in developing countries, they are still trying to figure out the best approach to use in getting the best out of the electricity reform in which they are currently undergoing or have done before and have failed.

The price of electricity sold to the consumer is dependent on the marginal cost of producing this electricity that is being regulated at the transmission and distribution stage. Regulators would be dynamic as the spot market is, know how to balance out the difference in electricity produced and the ones needed to be consumed, in other words, both the distribution and transmission sections cannot have competition in their mist, as it would create so much confusion.

2.3. Government

The government of any given nation that wants to undergo electricity reform has a huge part to play in the reform. So far, it has been learnt that, reform is mainly about bringing in private investors and the word “private” is put in perspective. These investors come on their own accord and invest their private capital, it is a voluntary action and if the condition in the country is not suitable, private investors will not even bother to come in. In other for the government to get that private capital from the investors, “the investors must perceive that they will have an opportunity to earn return of and an adequate return in their investment including compensation for risks” (Rosenzweig et al, 2004). This is not common with developed countries but with developing countries because, they are just embarking on the electricity reform. Most developing countries that want to do this reform currently have a state-run electricity industry where there is commercial uncertainty. Most times, it is completely funded by the government, whereby the country record losses each year in trying to fund the electricity sector. The switch of the government in trying to make the sector marketable, is dependent on good regulation already in place, this is because, the utilities have to provide assurances by maintaining adequate revenue and profit streams to balance sheets and to do this, their tariffs must be able to provide revenues that cover operations and maintenance costs including fuel, and provide a return of and an adequate return on the investor’s investments. On that note, a regulated utility would be expected to provide “safe and adequate service at just and reasonable rates” (Rosenzweig et al, 2004), thereby good regulation in place would balance the interests of shareholders and also, consumers in the short term. The country’s political, legal and regulatory institutions would play a critical role in determining the level of risk that investors would face (Henisz et al, 2002) and initiate a contracting strategy to attract investors to the country. According to Hogan (2009), the International Energy Agency (IEA) examined the international experience and guidance for electricity restructuring was produced.

·      “Governments must ensure a stable and competitive investment framework that sufficiently rewards adequate investments in a timely manner.

·      Governments urgently need to reduce investment risk by giving firmer and more long-term direction on climate change abatement policies.

·      Governments should pursue the benefits of competitive markets to allow for more efficient and more transparent management of investment risks.

·      Governments need to ensure that independent regulators and system operators establish transparent market rules that are clear, coherent and fair.

·      Government must refrain from price caps and other distorting market interventions.

·      Governments must implement clearer and more efficient procedures for approval of new electricity infrastructure.”

This can simply be called; the role the government of any given country would have to play in ensuring successful electricity reform.

2.4. Economic, Social and Environmental Aspect

In electricity reform, apart from the usual components of competition, regulation, government involvement and others, the economic, social and environmental aspect are also looked into. They all make up sustainable development which is about “making sure that people throughout the world can satisfy their basic needs now, while making sure that future generations can also look forward to the same quality of life” (DEFRA, 2011). The World today is trying to switch their actions towards sustainable development, so theses reforms in the electricity industry does so as well. The situation is different for both developed and developing countries in that, the developed countries have already began to direct the electricity industry towards the sustainable path, where with the help of commercialisation, privatisation, deregulation (or regulation) and competition as key elements, they are often nested within the broader economic restructuring (Wamukonya, 2003). With electricity reform being successful, the economy of that given country will certainly see a boost as then, there would be no situation where there is power outage, therefore, industrialisation would grow, bring about a rise in GDP. Businesses would be smoother, both large and small scale businesses, the hassle of looking for alternate means to generate power would be eliminated and then, profits can be counted in that respect. The government of that country would benefit as well as, in most developing countries where the government funds the electricity industry, that would be replaced by competitive private investors, so the funds used initially would be averted to other parts of the nation that needs help.

 In terms of the social and environmental aspect of electricity reform, Dubash (2003) showed that the social aspect is based on the accessibility and pricing and the environmental aspect, it is based on balancing efficiency and sustainability. Mainly in developing countries, the social benefit is what is mostly needed with the access to electricity being limited mainly to the urban areas. With steady electricity; there would be greater potential for education due to better lighting, there would be savings in time and effort spent gathering traditional fuels, there would be greater productivity, improved access to information and digital connectivity and also, there would be improved indoor air quality (Waddams Price 2000). The reason why most of the rural areas in developing countries have limited access to electricity is because of their remote locations and low population density, high transmission line losses, poor credit and minimal collateral damage, and a lack of purchasing and political power (Ehrhardt, 2000). This problem is unlikely to be fazed out by electricity reform as, the private firms would be looking at a capitalized market, where they can make profit and less towards the rural areas, where there is little to none avenue for profit making. This should be addressed as it has been done in most developed countries, to ensure that electricity is accessible to everyone after the reform has successfully been carried out.

As for the environmental aspect, the electricity sector has a large environmental footprint with most of the sector being power by fossil fuels, which after combustion emit local pollutants such as particulates and lead; regional pollutants such as sulphur dioxide; and most importantly, the global pollutants such as carbon dioxide. These pollutants as a whole have negative impacts on both human and the ecosystem health. Electricity reforms can aid to minimize the carbon footprint with most nations having the notion of going green, using renewable materials for electricity production. Some of the developed countries have embarked on using renewables like wind turbines, anaerobic digestion etc. already in electricity generation, thereby reducing their carbon emissions from their electricity sector. In developing countries as well, the reform will also, aid in reducing carbon emission. Most households use fuel-run generators as a back up for electricity when the power is not steady and these generating sets emit a lot of carbon dioxide. So with electricity reform in developing countries, the use of these generating sets would be less and hopefully, no more and then, the carbon footprint would be reduced as well.