ENERGY MARKET REFORMS

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ENERGY MARKET REFORMS
Buenos-Aires, July 2003

• INITIAL THOUGHTS RESULTS

Jean-Marie Bourdaire
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CONTENTS
A personal compilation of the views of the WEC
study group on different aspects of energy
(electricity gas) market reforms

• I. The broad context of reforms
• II. Empowering end-users
• III. Ensuring security of supply
• IV. Making good compromises
• V. Caring for the poor

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PART I
THE BROAD CONTEXT OF REFORMS
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THE DYNAMICS OF DEVELOPMENT

• Legal property rights, gender equality, rule of
  law
• Society education, health, social justice
• Infrastructures energy, water, telecommunications

This institutional framework has to evolve. They
need to adapt to sustain the pursuit of economic
development
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WHAT ENERGYDYNAMICS?

• Least developed countries agricultural economies
  based on traditional energies. Availability is
  key
• Developing countries industrial take-off based
  on base-load fuels. Access is becoming key also
• Tiger economies full industrialisation based
  on oil, gas, electricity. Versatility needs to
  increase
• Mature economies growth of services based on
  energy services. Environment adds to the rest

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ENERGY ACCESS

• Energy access lies at the crossing of several
• general framework conditions
• property rights (and associated citizenship)
• social justice (not too inequitable society)
• development of physical infrastructures

Mostly a domestic problem that requires political
will courage
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THE ROLE OF EMR

• Energy access lies at the crossing of several
• general framework conditions
• property rights (and associated citizenship)
• social justice (not too inequitable society)
• development of physical infrastructures

Mostly a domestic problem that requires political
will courage
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THE ROLE OF EMR

• Improve the overall efficiency
• Create proper price signals
• Determine who pays what and how - LRMC to be paid
  by consumers - Public money should pay the
  rest - Specific load profile-based LRMC

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WHAT FORMER WEC STUDIES SAY

• Priorities must be established among public
  policies (e.g. security), monopoly aspects, and
  competition at different stages
• A blend of market/regulated features often may
  simplify market reforms - yet deliver benefits
  similar to more complex market designs
• The simplest approach should be used that will
  achieve the desire benefits at minimum cost and
  risk the message is keep it simple!

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WHAT FORMER WEC STUDIES LEFT ASIDE

• Little said on distribution and retail
• No analysis made on the case of natural gas and
  on the convergencewith electricity
• No specific approach for the urban poor (most WEC
  studies on rural electric)
• Very little said on network congestion
• No discussion on the link between retail and
  security

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THE ANSWERS
WEC study will not be completed before 2004 WEC
Sydney Congress. However, some conclusions
already appear

• Consumers gain from competition with the largest
  gains possibly in distribution
• Gas electricity are not commodities users are
  partly (gas) or totally (electricity) captive
• Hence, wholesale markets cannot be created before
  understanding their workings

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BENEFITS OF REFORMS
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PART II
EMPOWERING END-USERS
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A FOCUS ON LDC
The philosophy of market reforms is to replace
the top-down utility approach by a bottom-up
empowerment of end-users

• Reforms are for end-users and their starting
  point should be the local distribution companies
  (LDC)
• Distribution represent 30-40 of total costs, and
  more than 50 for the captive users of the LDC
• Yardstick regulation may be combined with some
  competition to regulate LDC monopolies

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COST SPLIT
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QUESTIONS

• Definition and role of LDC?
• Retail wheeling or not?
• Contractual set-up of LDC?
• Competitive franchising or not?
• Private or public ownership?
• Appropriate size of LDC?
• Economies of scope for LDC?

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OWNERSHIP

• Public companies tend to create golden status,
  over-staffing, and risks of strike
• Private management is not better if it left in
  the hands of a single actor. Competition is
  needed
• Captive users should be aware of the services and
  costs of their neighbouring LDC. This is the only
  way to choose to retain it or not

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ECONOMIES OF SCALE?

• Are the LDC economics improving up to 4 million
  of customers?
• If yes, to what extent do the customers lose in
  terms of control?
• Should one prefer small LDC (hundreds of
  thousands of customers) for better control
  competition, yet economies of scale thanks to
  large mother companies at regional scale

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THE UK EXAMPLE
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ECONOMIES OF SCOPE

• Traditional public utilities were mono- energy
  (gas, heat...) or mono-service (water, cable)
• Countries like the Netherlands show strong
  multi-energy, multi-services LDC
• Should one favour the one-counter shop with an
  unique local correspondent for all network
  services (electricity, gas, heat, cable, water,
  sewage, garbage collection)?

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FRANCHISES OR NOT?

• In France, since the 19th century the public
  water monopoly is partly delegated to private
  sector
• Private market share is growing at the expense of
  public managed LDC even with left governments
• Introduction of privately managed franchises
  avoids to rely on public sector or on tightly
  regulated private monopolies (e.g. Transco)

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SMALL LOCALLY,LARGE GLOBALLY

• Most captive end-users do not wish the freedom
  of choice which is a waste of time for them
• On the contrary, as shown by Centrica success,
  they prefer to have a single identified
  interlocutor
• To be known locally and feel the pressure of the
  franchise renewal is a strong incentive to do
  well
• Hence the idea of many small LDC, subsidiaries of
  a few (say 5 per region) large service providers

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PART III
ENSURING SECURITY OF SUPPLY
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FORMER WEC RECOMMANDATIONS

• Indicators of the available capacity margins
  (or LT planning for generation/transmission)
• Fair/transparent rules for wholesale markets (or
  choice of central dispatch, e.g.single buyer)
• Creation of regional electricity / gas markets
  (or integration by increasing inter-connections)

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DEFINITION OF MARKET POWER

• A firm is said to have market power when it acts
  in a manner that is intended to change market
  prices and can maintain prices at non-competitive
  level for a significant period of time (Sophie
  MERITET, assistant-professor, CGEMP, Paris IX
  Dauphine University)
• A company has market power if it can move the
  market price by unilateral actions (Graham
  THOMAS, WEC consultant)

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LT CONTRACTS
The most natural incentive to provide security,
reliability and diversity is to have to minimize
the LT cost of penalties in case of non-delivery

• Electricity and natural gas, having captive
  users, should not be seen as pure commodities
• Free wheeling does not allow suppliers to know
  what possible liabilities they face
• But LDC captive users are well identified the
  obligation to serve can then be monetized

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SECURITY OF SUPPLY TOOLS

• Interruptible customers
• Diversified portfolio
• Price responses
• Incremental supply

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INTERRUPTIBLE CUSTOMERS

• For natural gas interruptible customers are
  large industries or power-plants. In efficient
  gas systems, they are at the heart of the price
  setting against other energy competitors.
• For electricity interruptible customers rarely
  exist unless they are created thanks to the
  introduction of adequate technologies, e.g. for
  aluminium smelters

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DIVERSIFIED PORTFOLIO

• For natural gas different sources suppliers
  with a combination of long-term contracts (to
  cover the minimum captive uses) and short-term
  balancing deals
• For electricity different primary fuels from
  different sources. Long-term coal/hydro/nuclear
  for base-load and short-term gas/oil products for
  mid peak load
• For both resilient (redundant) infrastructures
  with no potential critical logistics

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PRICE RESPONSES

• For both large industrial users already have
  time meters and price sensitive responses
• For natural gas largest captive users may reduce
  demand in response to a pressure drop as a
  counterpart of lower tariffs
• For electricity large captive users may use
  (cheap?) smart meters to rebalance the load (time
  management) when SRMC increases

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INCREMENTAL SUPPLY

• For both market reforms contribute to enlarge
  interconnections and increase resilience
• For natural gas spot price signals can trigger
  the change of destination of LNG cargoes
  providing that enough logistic flexibility exists
  
• For electricity decentralised co-generation or
  tri-generation systems (power, heat and cold) can
  replace peak demand by peak supply

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COMPETITIVE INCENTIVES

• All types of insurances are sold in competitive
  markets. Regulation ensures that prudential rules
  are respected and financial guarantees exist
• LDC may also provide insurance of security of
  supply. They will minimise the cost by an
  appropriate combination of strategies
• Charged costs to the users may be controlled and
  benchmarked against other LDC. Costs will be
  cheaper for LDC subsidiaries of large Groups.

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PART IV
MAKING GOOD COMPROMISES
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ELECTRICITYTRADE-OFFS
Electricity is not a true commodity because its
users are mostly captive, and is not either a
true market because of its monopolistic sectors

• First trade-off security of supply versus
  freedom of supplier choice for the captive
  sector?
• Second trade-off competitive wholesale market
  with many (gt 10) actors versus single buyer?
• Third trade-off cyclical prices market power
  episodes versus capacity payments?

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RETAIL WHEELING?

• Retail wheeling transforms electricity/gas into a
  commodity where users shop around with no easy
  means to have supply security
• Retail wheeling often leaves distribution in the
  hands of the same incumbent operator. This is not
  a driver of competition and efficiency
• Retail wheeling creates large additional costs
  that, at the end, will be paid by the customers
  do the expected benefits pay for these costs?

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HOW MANY GENERATORS?

• Short-term price elasticity of electricity/gas is
  very small Most users have fixed tariffs and
  inflexible short-term requirements
• Oligopoly power when the market share of the
  largest generator is larger than the short-term
  price elasticity, say 0.1 or less
• Hence, true competition only temporarily exists
  in markets with many small generators and large
  over-capacities, as the UK today

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LOYAL COMPETITION OR MARKET POWER?
Loyal competition is often difficult to develop

• Too few actors large incumbent dominate the
  market and exercise market power
• Overcapacities are too small or inexistent as it
  happens in many developing countries
• There are too many markets and opportunities for
  cheating (day-ahead market, several intra-day
  markets, markets for differences, reactive power,
  other ancillary services, etc)

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INCUMBENT SHARE IN CONTINENTAL EUROPE
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NATURAL GASTRADE-OFFS
Wholesale natural gas is a commodity because
large users, including LDC, compete among
themselves and with other fuels at the margin

• First trade-off security of supply versus
  freedom of supplier choice for the captive sector
  
• Second trade-off transportation over-investment
  versus the creation of isolated local niches
• Third trade-off relevant, yet volatile, spot
  prices or long-term contracts with indexed prices

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RETAIL WHEELING?

• Retail wheeling transforms electricity/gas into a
  commodity where users shop around with no easy
  means to have supply security
• Retail wheeling often leaves distribution in the
  hands of the same incumbent operator. This is not
  a driver of competition and efficiency
• Retail wheeling creates large additional costs
  that, at the end, will be paid by the customers
  do the expected benefits pay for these costs?

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GAS PRICE VOLATILITY?

• Price volatility also exists for oil and does not
  prevent long-term investments or commitments
• Large gas volatility occurs during transitions
  related to supply/demand imbalances
• But a combination of storage locally and regional
  seasonal swaps drives stability back
• Since long-term deals can provide a basis for
  building infrastructures, the only governments
  role is to fasten the administrative process.

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CONGESTIONSCOMPETITION OR NOT?
Congestions, e.g. in California, create niches
little/no competition and much market power

• The historic legacy of state markets is at the
  origin of too small inter-connections
• The choice is to increase inter-connections (30
  of state markets) or to avoid competition
• PJM (nodal pricing) or Nordpool (bidding) are not
  convincing examples

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PART V
CARING FOR THE POOR
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MARKET REFORMS AND ACCESS
Pricing access are central to WECs concerns.
Market Reforms study concentrates on the poor
accessed by the network (urban poor).

• No sustainable growth exists without access
• Yet, access has not much improved since 1973
• Market reforms as an additional momentum

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ACCESS
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HISTORIC ENERGY EVOLUTION
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FOR 30 YEARS, ACCESS HAS NOT IMPROVED

• Access to modern energy had been regularly
  improving up to the first oil shock
• But since 1974, the market share of traditional
  energies has remained constant at about 11
• 1/3 of the world population has no access or
  insufficient access to modern energy
• Market reforms should aim at creating the
  adequate framework for improving access

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WECS VIEWS
Caring for the poor is not a morale imperative
only. It is also an economic imperative to ensure
stable, peaceful, and sustainable growth.

• Subsidies are generally not sustainable on the
  long-run and may work against their beneficiaries
  
• Yet, energy costs are a larger share of budget
  expenses for the poor than for the wealthy people
  
• Hence the need to find approaches that are fair
  and sustainable on the long-run

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HARMLESS SUSIDIES

• Market reforms have revealed the evidence of
  stranded costs that need to be recovered
• They are the difference between initial sunk
  costs and long-run marginal costs (LRMC)
• Hence, initial infrastructure sunk costs may be
  fully paid by third parties, e.g. the State
  budget
• But LRMC, i.e. the running costs costs of
  expanding the network, need to be paid in full

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LOWER LRMC?

• LRMC reflect the average SRMC, including the
  periods of scarcity that pay for expansion costs
• Hence, the largest contributors to the LRMC are
  those who create the scarcity with peak demand
• By reducing peak demand, small capacity meters
  (say 0.7 kW) are a means for cheaper tariffs
• Subsidised connection/meter costs and small
  meters with lower tariffs may be a solution

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SOME EARLY EVIDENCES

• Many examples show that poor are willing to pay
  their electricity supply if the service is
  reliable
• Natural gas is rarely an option in developing
  countries because of the small unit consumptions
• In some cases, e.g. in shanty towns of Brazil,
  electricity bills is an evidence of citizenship
• The case of rural electrification has already
  been discussed by WEC and is not treated in this
  study

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WHERE THE MONEY WILL COME FROM?

• 500 kWh per capita for the 2 billion poor with no
  or little access represents 200 GW
• With generation - transmission distribution at
  2/W, total cost is 200G over say 10 years
• Little as compared to the 9.3 T of capital in
  developing countries if property rights were
  correctly enforced (Hernando de SOTO)
• Hence, a need of even broader market reforms to
  free their still sterilised capital

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CONCLUSION - 1

• Electricity natural gas are not commodities
  because of their captive users
• Security-continuity-diversity of supply are key
  and cannot be fulfilled without LT contracts
• Trade-offs should aim at more simplicity, lower
  reform costs and lesser reform risks
• Access to the poor is a key driver of equity and
  economic development

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CONCLUSION - 2

• Man as human being and consumer is central to the
  idea of market reforms
• An efficient distribution sector should combine
  yardstick regulation competition
• Distribution and retail should remain bundled, in
  particular for security reasons
• Within distribution, access to the poor needs to
  be the priority