NOTE NUMBER 332 73638 viewpoint PUBLIC POLICY FOR THE PRIVATE SECTOR FINANCIAL AND PRIVATE SECTOR DEVELOPMENT VICE PRESIDENCY OCTOBER 2012 Electricity Reforms Ioannis N. Kessides What Some Countries Did Right and Others Can Do Better This Note was written Since 1982 more t ha n ha lf t he wo r ld ’ s c o unt r ie s ha v e r e f o r me d t h e i r as part of the Investment Climate Impact Project, electricity se cto r s . I m p le m e nt e d c o r r e c t ly , t he s t a nd a r d r e f o r m a joint effort of the World mod e l—with comp e t it io n, unb und ling , a nd e f f e c t iv e r e g ula t i o n — c a n Bank Group’s Investment le ad to b ig gain s in p e r f o r m a nc e . B ut m o s t d e v e lo p ing c o unt r i e s l a c k Climate Department, IFC’s Investment Climate institutional p re c o nd it io ns f o r f ully a d o p t ing t he m o d e l— a n d h y b r i d Business Line, and the electricity marke t s a r e e m e r g ing . De v e lo p ing p r ic ing s c he m es t h a t World Bank’s Development Research strike a b ette r b a la nc e b e t we e n e c o no m ic e f f ic ie nc y a nd s o c i a l e q u i t y Group, in collaboration re mains a b ig ch a lle ng e . An e v e n g r e a t e r c ha lle ng e is t o m e et g l o b a l with IFC’s Development Impact Department, the energy nee d s wh ile r e d uc ing t he t hr e a t o f c lim a t e c ha ng e d i s r u p t i o n . Development Impact Views about how the electricity supply industry simplifying licensing, and improving incentives Evaluation Initiative, the should be owned, organized, and regulated have for investment and generation. Technical assis- FPD Chief Economist’s Office, and the Global changed dramatically in the past three decades. tance for potential private investment is of great Indicators and Analysis Since 1982, when Chile began a radical program importance in navigating novel regulatory and Unit. The project is of restructuring and privatization, more than half market structures. funded by the U.S. Agency the world’s countries have introduced institutional for International reforms in their electricity sectors. These reform The standard reform model Development, the programs have included privatization, vertical and Pressure for change in mature industrial econo- U.K. Department for horizontal unbundling, and the introduction of mies grew with the emergence of excess capacity THE WORLD BANK GROUP International incentive-based regulation by independent regu- and the disillusionment with expensive, capital- Development, and the latory agencies (Newbery 2002). intensive generation projects caused by the oil World Bank Group’s The introduction of more competition, crisis of the 1970s. Developing countries faced Investment Climate institutional reforms, and effective, transparent different circumstances. While investment needs Department. regulation has led to performance gains in many were low in mature industrial economies with countries. The sectorwide restructuring efforts excess capacity, they were high in many develop- described in this Note also are critical to provid- ing countries, most of which had rapid demand ing the basis for substantial private investment growth for electricity, a tight demand-supply bal- opportunities. In addition, they serve as broad ance, and periodic blackouts. While electricity principles for other, less researched regulatory utilities in mature industrial economies had toler- interventions, such as reducing entry barriers, able performance, those in developing countries ELECTRICITY REFORMS WHAT SOME COUNTRIES DID RIGHT AND OTHERS CAN DO BETTER suffered from poor service quality, low labor pro- that entails a complex set of interactions between ductivity, chronic revenue inadequacy, deteriorat- the state and the market. Reforms have progressed ing facilities and equipment, and serious problems furthest in Australia, Canada, the United States, of theft and nonpayment (Kessides 2004). most European countries, and parts of Latin Against this background, a new paradigm America. They have been slow and unstable in Asia emerged for the organizational restructuring of and Eastern Europe and highly problematic in Sub- the electricity industry. The reform steps have Saharan Africa. Indeed, no developing country in included some of the following (Joskow 2008): Africa and very few outside Latin America have fully Q Corporatizing and commercializing state-owned adopted the standard reform model. Moreover, 2 utilities to legally separate them from the govern- introducing IPPs has been second only to corpo- ment and restore financial discipline. ratization as the step most frequently undertaken Q Enacting laws to provide a legal mandate for (Gratwick and Eberhard 2008). the restructuring, and creating independent Emerging international evidence suggests that regulatory agencies with adequate informa- the standard reform model, if implemented cor- tion, capacity, and statutory authority. rectly, is a sound guide for restructuring electric- Q Using vertical and horizontal restructuring to ity markets; significant departures from it are separate potentially competitive generation likely to lead to performance problems. This and retail activities from the natural monopoly evidence is based on cross-country econometric segments of transmission and distribution and analyses, firm-level efficiency and productivity thus facilitate competitive entry and reduce assessments, and single-country case studies market power. (Joskow 2008; Jamasb, Newbery, and Pollitt 2004). Q Establishing regulatory rules to promote effi- cient access to the transmission network and Cross-country econometric studies provide signals for the efficient location of The literature focusing on cross-country econo- generation facilities. metric estimation of the effects of electricity Q Privatizing operating entities to restore finan- reforms is limited. The multifaceted nature of cial discipline, provide incentives for cost the institutional reforms implemented and the efficiency, and insulate them from damaging diversity of electricity sectors across countries lead political interference. to challenging model specification issues. There Q Introducing independent power producers are also severe data and measurement problems. (IPPs) to facilitate investment in generation Even so, it is possible to identify a set of even in the absence of comprehensive sectoral empirical regularities on the effects of electric- reform. ity reforms: Q Designating an independent system operator Q Efficiency gains (higher labor productivity, to direct the safe, reliable, and economic oper- higher capacity utilization, lower system losses) ation of the interconnected electricity system, from privatization are modest, unstable, and determine the order of dispatch, and make contingent on regulatory efficacy, especially arrangements for expanding and enhancing in the absence of competition—efficiency may the transmission system. depend more on the form of regulation than Q Unbundling retail tariffs to separate prices for on the form of ownership (Newbery 1995). competitive retail supply activities from the Private sector participation is beneficial only regulated network (transmission and distribu- when coupled with an independent regulator. tion) charges. Independent regulation without privatization Q Creating markets and trading arrangements (in effect, regulation of state-owned utilities) for voluntary energy and ancillary services. seems to be ineffective (Zhang, Parker, and Kirkpatrick 2008). Assessing the reform experience Q There is strong evidence that introducing The standard model notwithstanding, electricity competition leads to significant improve- reform in developing and transition economies has ments in performance (Zhang, Parker, and been an incomplete, uneven, and irregular process Kirkpatrick 2008). Q Part of the efficiency gains may be passed on to Colombia was the first country in Latin consumers, with prices falling for some classes America to implement a bidding system for of electricity users. But liberalization does not its pool electricity market. The high-powered always lead to lower retail electricity prices. In incentives created by the competitive electricity many developing countries regulated prices market led to significant gains in the efficiency were inefficiently low, and in these countries of power distribution. As the market was liber- liberalization should lead to higher prices and alized, US$6 billion in foreign investment took better incentives (Nagayama 2007). place and additional gas-fired capacity of some Q Liberalization has reduced the historical 2.5 gigawatts was built, prompted in large part 3 pricing distortions in developing countries. by the capacity charge mechanism put in place Cross-subsidies from industrial customers (Pombo and Taborda 2006). to households have been gradually reduced The reforms in Brazil were much more as prices for households are realigned with cautious and gradual than those in Chile and underlying costs (Kessides 2004). Argentina. They were characterized by mixed ownership, feeble vertical restructuring, and Country case studies market competition in some areas. More impor- Analysts generally agree that Latin America is tantly, in contrast to the sequencing prescribed where the standard reform model has been by the standard reform model, distribution was most influential and far-reaching. Most if not all privatized before an independent regulatory reforming countries in the region implemented body was established and without a comprehen- incentive-based regulation for setting multiyear sive blueprint for reform. The distribution and tariffs and monitoring the compliance of distri- supply companies showed large gains in labor bution companies with service quality standards. productivity after privatization in 1995 (figure This mechanism was very effective in Argentina, 1). But the reform program was overwhelmed by Chile, El Salvador, and Peru and is largely respon- the drought and long-lasting water shortages that sible for the improvements in the operating effi- followed—problems whose effects were exacer- ciency of the region’s electricity systems. bated by the incomplete implementation of the Chile is often identified as the country that reforms. Brazil’s experience raises serious doubts first started electricity reforms. Recognizing about the efficacy of private ownership of genera- the importance of cost recovery in public utility tion in countries with large multiuse dams that services, it reformed tariffs before privatization. require coordinated regulation (Newbery 2002). But its postreform market involved less restruc- In India the incentive-based, multiyear regula- turing, less competition, and more regulation tory regime (whose performance targets include than some of the subsequent reform cases. Still, an allowance on system losses) seems to have privatization, incentive-based regulation, entry provided the right incentives to improve operat- by incumbent suppliers in response to adminis- ing efficiency, in an electricity system plagued by tratively set generation prices, and service obli- significant technical and especially nontechnical gations imposed by regulation on distribution losses (Bhatia and Gulati 2004). companies have all contributed to large efficiency gains (Joskow 2008; table 1). Emergence of hybrid power markets Argentina followed most of the features of the Full implementation of the standard reform standard reform model: it sought to aggressively model—especially effective regulation, vertical reduce horizontal market power and developed or horizontal unbundling, and wholesale and one of the world’s most competitive wholesale retail competition—has several institutional electricity markets. Growing competition led to prerequisites that most developing countries a substantial decline in the spot price of electric- lack, including issues relating to commitment ity while investments in generation and network to reform, scale of the industry, and legal and expansion increased rapidly—until the economic financial infrastructure. Thus in recent years crisis in 2002 (Pollitt 2008). Service expansion also growing doubts have been expressed about the accelerated in Peru after reforms were introduced. applicability of the standard template to many ELECTRICITY REFORMS WHAT SOME COUNTRIES DID RIGHT AND OTHERS CAN DO BETTER Table Performance effects of electricity sector reforms 1 Country Studies Reform program and year Performance effects Chile Fischer, Gutierrez, and Privatization without vertical or horizontal Labor productivity: increase for Chilectra from 1.4 gigawatt-hours Serra 2003; Nagayama unbundling; wholesale competition; market per employee in 1987 to 13.8 in 2002; for Endesa from 6.3 in 2007 liberalization (1982) 1991 to 34.3 in 2002 Total energy losses: reduction from 22% in 1982 to 5% in 2009 Wait time for repair service: reduction from 5 hours in 1988 to 2 in 1994 Installed capacity: increase from 2.7 gigawatts (GW) in 1982 to 6.7 in 2002 Length of transmission network: increase from 4,310 kilometers in 1982 to 8,555 in 2002 Argentina Rudnick and Solezzi Privatization with full-scale vertical Nonavailability of thermal plants: reduction from 50% in 2001; Fischer, and horizontal restructuring (1992) 1992 to 20% in 2002 Gutierrez, and Serra Installed capacity: increase from 13.2 GW in 1992 to 22.8 in 2002 2003; Pollitt 2008 Distribution losses: reduction from 20% in 1992 to 10% in 2002 Spot price of electricity: reduction from US$50 per megawatt- hour (MWh) in 1992 to US$20 in 2002 Peru Perez-Reyes and Partial privatization; vertical and Productivity: increase from 415 customers per employee in 1993 Tovar 2009; Anaya horizontal unbundling; single-buyer model to 1,210 in 2007 2010 (1993) Coverage: increase from 48% in 1992 to 80% in 2007 Distribution losses: reduction from 22% in 1993 to 8.2% in 2007 Colombia Pombo and Taborda Privatization with unbundling; bid-based Interruption time: reduction from 6.3 hours in 1997 to 2 in 2002 2006 pool market (1994) Brazil Mota 2003 Vertical unbundling; privatization of Labor productivity of distribution and supply: increase of 147% in distribution with generation remaining largely MWh per employee between 1994 and 2000 state owned; gradual transition to competition in generation and supply (1995) India Bhatia and Gulati 2004 Unbundling and privatization of some state Distribution losses: reduction for Andhra Pradesh State Electricity electricity boards (1991) Board from 38% in 1999 to 20% in 2008; for Delhi Vidyut Board from 53% in 2002 to 15% in 2009 Sub-Saharan Gratwick and Eberhard Introduction of IPPs with some unbundling and Addition of about 4 GW of IPP capacity since early 1990s, with Africa 2008; Eberhard and limited progress in establishing independent IPPs generally showing better technical performance than region’s Gratwick 2011 regulatory mechanisms; incumbent state-owned state-owned incumbent utilitiesa utilities still dominant (early 1990s) a. For example, the state-owned Kenya Electricity Generating Company (KenGen) has an average availability factor of 60 percent compared with a 95 percent average for the IPPs in Kenya. of these countries—especially in Africa. A new and the host countries, are more likely where hybrid model has emerged in which IPPs play an effective regulatory governance (characterized important role alongside the state-owned utilities by coherence, independence, accountability, (Gratwick and Eberhard 2008). transparency, predictability, and capacity) is put IPPs have been an important source of new in place, preferably before the IPPs are negoti- investment in many developing countries. In ated. Effective regulatory oversight can lead to parts of Africa their introduction has led to a lower capital costs (per unit of installed IPP capac- big increase in generating capacity. Moreover, ity) as well as to improved operating efficiencies many IPPs have shown better technical perfor- (Eberhard and Gratwick 2011). mance than the state-owned utilities. But the suc- India’s experience highlights the importance cess of IPP schemes is contingent on a coherent of credible regulatory and political commitment policy framework that pays explicit attention for the viability of IPP investments. Substantial to planning, procurement, and contracting variation in regulatory systems and political com- issues. Successful outcomes, for both investors mitment across Indian states has led to enormous variation in outcomes—ranging from the disastrous Figure Labor productivity of distribution and supply businesses in Brazil, 1991–2000 Dabhol power project in Maharashtra to the mod- 1 estly successful GVK project in Andhra Pradesh and Thousands of megawatt-hours per employee Paguthan project in Gujarat (Lamb 2006). 6 5 Persisting problems of cost recovery Underinvestment, driven in large part by under- 4 pricing, was one of the most important causes 3 of the secular deterioration in the performance of electricity industries in developing countries 2 before the reform era. The challenge of cost 1 recovery has been widespread. In Africa under- pricing and revenue inadequacy have been per- 0 vasive. While two-thirds of the region’s power 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 utilities set tariffs that cover their operating Source: Mota 2003. costs, only a fifth charge prices high enough to cover their full capital costs (Foster and Briceño- utilities. Still, these effects were more than off- Garmendia 2010). Cost-coverage ratios have also set by greater access for poor consumers, better been low in many parts of Asia and in Central service quality, and changes in public finances and Eastern Europe. that benefited poor people more (McKenzie and Past public policies in developing and transi- Mookherjee 2003). tion economies also led to prices with systematic cross-subsidization—from industrial customers to Lingering concerns about investment households. The publicly articulated rationale Planning for expansion of transmission has for these policies was that they fostered desirable become much more complex in unbundled social goals (for example, helping classes of cus- electricity markets. In these markets the coordi- tomers who would otherwise be disadvantaged). nated planning that enabled integrated utilities But a large share of the benefits often flowed to to adjust generation and transmission capaci- those outside the intended beneficiary groups. ties and internalize their interdependencies has As expected, electricity reform—especially been replaced by a series of decentralized deci- privatization—generated pressures for revenue sions based in part on prices. This new decision adequacy, which required realigning prices with structure involves many independent agents and underlying costs. Moreover, market liberalization entails a mix of regulation and market signals. undermined the sustainability of cross-subsidies. There is an ongoing debate about the ability of During the postreform era many countries have liberalized markets to fund the optimal amount gradually reversed the historical policies of of transmission investment (Sauma and Oren underpricing and cross-subsidies. 2009). One drawback of unbundled electricity systems is that often no member of the industry Distributional effects has the combination of incentives and ability In recent years concerns have been expressed needed for systemwide planning. about the distributional effects of electricity priva- Even greater concerns have been expressed tization and market liberalization—especially about the ability of competitively restructured their effects on the provision of basic services electricity markets to provide appropriate incen- to poor households and other disadvantaged tives for investment in new generating capacity groups. Empirical evidence increasingly shows that is socially optimal—in timing, location, and that these concerns have been largely misplaced. choice of technology (Joskow 2008). In deregu- It is true that the reforms led to price increases lated, competitive electricity markets it is power in countries where prices were inefficiently low. company investors, not ratepayers, who must bear They also had adverse distributional effects most of the financial risk of new generating capac- because of the large layoffs in the privatized ity. In this market environment investors will ELECTRICITY REFORMS WHAT SOME COUNTRIES DID RIGHT AND OTHERS CAN DO BETTER naturally tend to favor investments that are less tecting households and industries against the capital intensive and have shorter construction risk of costly voltage fluctuations and power lead times (such as combined-cycle gas turbines). outages—especially in developing countries, But there is no empirical evidence justifying the where these power swings can be extreme. But concerns about too little investment in generat- problems of intermittency persist for wind and ing capacity in liberalized markets. solar, and these power sources can still cost significantly more than traditional fossil-fired Distributed generation—a paradigm shift? generation. The centralized electricity supply model with its 6 underlying countrywide network has traditionally Lessons and emerging challenges offered important economies of scale and, by and There is an emerging consensus, supported by large, high reliability. But because of its historical growing empirical evidence, that in the electric- focus on fossil fuels, it has also led to environmen- ity sector: tal degradation. And in developing countries it Q When well designed and implemented in has ignored the energy needs of rural areas and proper sequence, a combination of insti- poor people (Hiremath and others 2009). tutional reforms—vertical and horizontal In recent years there has been a resurgence restructuring, privatization, and effective of interest in distributed generation—the pro- regulation (particularly incentive-based regu- duction of energy on or very near the site of lation)—can lead to significant improvements use by relatively small, modular generating units in operating performance, in a variety of coun- (typically less than 30 megawatts). In several try settings. developing and transition economies distributed Q There is a strong link between good and cred- generation already accounts for a significant ible regulation and the objective of securing share of the electricity generated. Classic forms foreign direct investment—and privately of distributed generation include combined financed investment more generally—while heat and power, industrial gas turbines, and delivering efficient service at sustainable but small petroleum generators. More recently the just and reasonable prices. definition has expanded to include renewable Q As a consequence of the reforms, retail prices technologies—solar, wind power, small hydro, have become more closely aligned with under- biomass, landfill gas to energy, and waste to lying costs, and cross-subsidies have been energy (box 1). reduced and in some countries eliminated. Renewable distributed generation technolo- Q There is a logical sequence of reforms, and gies are especially well suited for off-grid remote undertaking reforms in the wrong order is applications in rural areas where consumption costly. Ideally, reforming countries should first is low and the distance to the nearest distribu- raise prices to cost-recovering levels (with a tion center is great. Most of these opportunities return on capital to finance investment), then are in Africa, Asia, and parts of Latin America. create regulatory institutions and restructure Distributed generation can be effective in pro- the sector, and only after that privatize. Box Sugar mill cogeneration in India 1 In India interest in bagasse cogeneration began in the 1980s, when the supply of electricity started falling short of demand. A national program to promote biomass power and bagasse cogeneration was launched in 1992. With policy support and assistance from the Indian government and the U.S. Agency for International Development, state electricity boards began offering sugar mills long-term power purchase contracts at competitive prices and with a large reduction in interconnection fees. By 2009 sugar mills in Andhra Pradesh, Karnataka, Maharashtra, Tamil Nadu, and Uttar Pradesh were contributing 2,000 megawatts to the national electricity grid. Today, of the roughly 650 sugar mills in India, 107 have cogeneration plants. Efficient bagasse cogeneration is receiving increased attention in India because of its potential for reducing greenhouse gas emissions and providing other development and environmental benefits. Source: Haya, Ranganathan, and Kirpekar 2009. Q Many if not most developing and transition economies lack some of the institutional and other preconditions for the full and effec- Note tive implementation of the standard reform Ioannis N. Kessides (ikessides@worldbank.org) is a lead model. In many parts of the world electric- economist in the World Bank’s Development Research ity markets have evolved or are evolving into Group. The author would like to thank Ricardo Arias, hybrid forms—not completely unbundled, Vyjayanti Desai, Katharina Gassner, Vivien Foster, Cecile privatized, or competitive. Fruman, David Newbery, Michael Pollitt, Christine Pricing reform remains one of the most impor- Zhenwei Qiang, and Massimiliano Santini for valuable 7 tant and challenging tasks facing policy makers in comments and suggestions. developing and transition economies. The histor- ical policies of underpricing and cross-subsidies References are being reversed but only very gradually. In Anaya, K. 2010. “The Restructuring and Privatisation many countries efforts to rebalance tariffs have of the Peruvian Electricity Distribution Market.” been encountering much public opposition on Cambridge Working Papers in Economics no. 1017, social equity grounds. There is an urgent need Cambridge University, Cambridge, UK. to identify pricing schemes that strike a better Bhatia, B., and M. 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Kirkpatrick. 2008. “Elec- Bank or of its Executive Developing Countries.” Energy Policy 35 (6): 3440–62. tricity Sector Reform in Developing Countries: An Directors or the countries Newbery, D. 1995. “A Template for Power Reform.” Pub- Econometric Assessment of the Effects of Privatiza- they represent. lic Policy for the Private Sector Note 54, World Bank, tion, Competition and Regulation.” Journal of Regula- Washington, DC. tory Economics 33: 159–78. To order additional copies ———. 2002. “Issues and Options for Restructuring contact Ryan Hahn, Electricity Supply Industries.” Cambridge Working managing editor, Papers in Economics no. 0210, Cambridge University, Room F 4P-252A, Cambridge, UK. The World Bank, 1818 H Street, NW, Washington, DC 20433. Telephone: 001 202 473 4103 Fax: 001 202 522 3480 Email: rhahn@worldbank.org Produced by Carol Siegel Printed on recycled paper This Note is available online: http://www.worldbank.org/fpd/publicpolicyjournal