17728 _U B L I C P O L I C Y F O R T H E MARCH 1998 P ri½±esector 5 Competition intheNatua& Gas Industry The Emergence of \ Spot, Financial, and Pipcline Capacity Markets Andrhejjuris 13 Natural Gas Markets in the United Kingdom-Competition, Industrn Structure. and Market Power of the Incumbent Andrejfiiris 21 Developmtent of Comnpetitive NatMial Gab Markets in the United States 29 Mitigating Risks in Power ReformD -A New World Bank Lending I Approach in the Indian State of Haryanai Dja ;oal IVl'ostej/h 37 Developing International PoweF r ' Markets in East Asia Eizrique C]rootsiillat A~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~- 45 ReformTing the Russian Electricity Sector ~'Ira'tWi/so) n 49 Tapping International Equity Marketsi throuigh Depository Receipts-Lessons h-om the Telecorrs Sector X C.lrsoe1l niadt -1 - alst/ and ~~,Vo-,:amn z ei l , C, (krniten FTnnk LIU ~~~~~~The World Bank Group u Finaince, Private Sector, and Infrastructure Network Private Sector is an open forum intended to encourage dissemination of and debate on ideas, innovations, and best practices for ex- panding the private sector. The views pub- lished are those of the authors and should not be attributed to the World Bank or any of its affiliated organizations. Nor do any of the con- clusions represent official policy of the World Bank or of its Executive Directors or the coun- tries they represent. Private Sector is a quarterly publication distrib- uted free of charge. To subscribe, please send your name, mailing address, telephone number, and fax number to the editor (Suzanne Smith, The World Bank, 1818 H Street, NW, Washington, D.C. 20433, email: ssmith7@ worldbank.org, fax: 202 522 2961, telephone: 202 458 1111). Most Notes from Private Sector are also avail- able on-line. There is full text in HTML format for on-screen viewing or a downloadable file in Adobe's PDF format (http://www.worldbank. org/html/fpd/notes/notelist.html). 0< 4;  '<4. "'<4<44)4 4< #8? 44 44< 4 4ˇ4 'z4<'">-'<¸. <4 l 4 -' A 4)4 - - -4"- 4 '-'-'4 44)44' A /7 1A$"'- - 4 4' -/ '44' 4' 'ist ˇ4! 4' 4'4 4ˇ I .4 4' 44-4" 172 "4- ,, 1 44< "A 44 -4 4 4-; 44.44 ˇ444< A  '>E 4-fl' ˇ4 S A '' "-4' 4- g 7ˇ' <'-4-4-4 / Ii 444 £4 4-7ˇ- isc\ 4-' 4- 4' 4-is 44 / "'-'4 I -4' 44- P rivatesector Quarterly No. 13, March 1998 a Competition in the Natural Gas Industry-The Emergence of Spat, Financial, and Pipeline Capacity Markets 5 Countries in Asia, Europe, and North and South America are introducing reforms to boost efficiency and attract new private investment in their natural gas industries. The trend has been to unbundle along vertical and horizontal lines and to open wholesale gas markets to new entrants. These new entrants stimulate competition and the development of new markets in gas supply, in financial gas contracts, and in pipeline capacity. Such has been the success of these new markets-especially in the United States and the United Kingdom that it has prompted a search for other potential markets in the industry. This Note describes the underlying structural and trading arrangements in newly deregulated gas and pipeline markets and looks ahead to future developments. Natural Gas Markets in the United Kingdom-Competition, Industry Structure, and Market Power of the Incumbent 13 Deregulation of the U.K. natural gas industry has facilitated new entry and competition in almost all segments of the industry. The new regulatory framework, developed largely by the Office of Gas Regulation, has allowed market forces to stimulate a variety of specialized services and market transactions to meet customer needs. But deregulation has been difficult because of a flaw in the initial industry structure: the government privatized British Gas as a vertically integrated company. The U.K. experience shows that leaving gas supply integrated with pipeline transportation and tying up gas in long-term contracts impede competition. This Note reviews the U.K. reform and the development of new spot, on-system, and "Flexibility Mechanism" markets. ~~~~~~~~~Development of Competitive Natural Gas Markets in the United States 21 The United States has the world's largest natural gas market. Fifteen years of deregulation have delivered significant gains to consumers in the form of lower prices and more services. The experience shows that liberalizing wholesale gas prices and the bulk supply of natural gas frees market forces in segments where competition is feasible. But regulators must focus on improving the regulation of pipeline transportation and minimizing its distortive effect on competitive gas markets. Introducing flexibility into pricing and other conditions of transportation contracts-such as delivery locations or the balancing of gas shipments-and standardizing pipeline operations promote more efficient use of pipelines and benefit all industry participants. The U.S. experience also shows the important role of gas marketers and spot markets in increasing the efficiency of gas transactions and prices. Deregulation of the U.S. gas industry is far from complete, however. The most important task, and the biggest challenge for regulators, remains t the deregulation of retail gas markets in individual states. Mitigating Risks in Power Reform-A New World Bank Lending Approach in the Indian State of Haryana 29 U r$~$.y-~. ~t The World Bank has agreed to support electricity reforms in the Indian state of Haryana with a new lending instrument-the adaptable program loan-recently approved by its board of directors. Under this approach the Bank will provide loans totaling US$600 million over eight to ten years, but will commit the loans only when the state government has reached agreed milestones. This approach allows state government milestones-not the covenants of standard World Bank loans-to determine the timing of controversial actions. The flexibility is intended to improve the reform program's chances of success and avoid a stop-start lending pattern. The project has important potential demonstration effects for other agricultural states because Haryana borders Delhi and has a high profile. Developing International Power Markets in East Asia 37 There is significant potential for international power trade in the Greater Mekong subregion, which comprises Cambodia, Lao PDR, Myanmar, Thailand, Vietnam, and the Yunnan province of China. The subregion faces big increases in demand for power over the next few decades. The opportunity for trade arises out of the mismatch of supply and demand among countries in close proximity. Initial interest in this market is being spearheaded bv private developers negotiating bilateral cross-border trade agreements. But experience from other power trade zones in Europe and North America shows that to achieve the benefits from fully fledged trade, the countries in J the subregion need to closely coordinate electricity sector policy, operations protocols, and netwzork develop- ment. This Note sets out the market development options, reviews sector reforms so far, assesses the obstacles to ; full power trade, and outlines Tnultilateral efforts to support international trade. Reforming the Russian Electricity Sector 45 i P Russia's power system is enormous-consisting of more than 200 gigawatts of generation capacity, most of it interconnected by 2.5 million kilometers of high-voltage transmission lines spanning an area only slightly smaller than the United States and Canada combined. In early 1997 the Russian government approved in principle the now-common model of electricity sector reform: vertically separating generation, transmission, and distribution: introducing competition where possible; strengthening the regulation of functions less amenable to competition; and divesting government ownership. This model has been implemented in many countries, and the story of the reform would be relatively routine if not for special characteristics of the Russian power system: its size, diverse . : ownership, high level of nonpayments, and the combined heat and power role of many generating plants. This Note outlines the challenges posed by these characteristics and reports on reform achievements so far. Tapping International Equity Markets through Depository Receipts-Lessons from the ; Telecoms Sector 49 Ongoing privatization and financial liberalization in emerging economies have let to continuous growth in the number of depository receipt offerings from these countries. Asian and Latin American companies have been the biggest source of offerings. The main advantages of depository receipts stem from the greater market depth and , liquidity offered by international capital markets: telecommunications companies are sometimes too big for local markets to absorb, and more active trading attracts a wider shareholder base, implies continuous evaluation of a cornpany's value, and increases management's accountability for a company's financial performance. International ' offerings also enhance the legitimacy of shares because companies must comply with transparent accounting rules and strict disclosure standards in the host market. Experience has shown that to guard against failure of a deposi- - tory receipt issue, much effort needs to be put into choosing the right type of depository receipts, marketing the issue, forecasting invest or dertiand, and determining the share price. 4 S **I~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ For a free subscription to Privatesector 1 Fill out and mail this card to Suzanne Smith, Managing Editor, The Wtorld Bank, 1818 H Street NW, Washington, D.C. 20433, or fax it to 202 522 2961 FIRST NAME Mi LAST NAME Topics of interest JOB TITLE COMPANY : Banking and capital markets STREET ADI)RESS - Privatization __ Competition CITY ST,AfE P'OSTAL CODE and regulation _ Telecoms and COUNTRY EMAIL technology _ Energy WORK PHONE FAX Transport 2 Call 202 458 1111 to record this information 7 WAater Suzanne Smith 3 Email this information to ssmith7@worldbank.org All Managing Editor The World Bank 1818 H Street, NW Washington, D.C. 20433 Telephone: 202 458 7281 Fax: 2t2 522 2961 Email: ssmith7l_ worldbank.org Cover illustration by Roth Sofair Ketler. Photos on pages 1, 2, and 3 by FPG The sntire contents of Pitte sector Private Sector © 1998 World Bank. You are authorized to reproduce, duplicate, and disseminate all or part of this publication I | so long as youi include 11 tg, (2M),, tn iindi I~ig 1hX a mi, of) h the name of the ,w 8J publication and the E,. .\ , LAa M 'iy~up l - I'jss Iit )IL J name of the respective author. You MaY not, however, modify, alter, el £ or otherwise change w ON5 E O., - P 0 3r rt 5 8 S5 RS sr any part of this STYSTsSAIF g-P, ot g5I i publicatisn or sell, I 'K5E~~ l~~K OK KOTRiKItK05, a2~sRt'I Kil,o.t fk-& wilift4 r.K publication or sell, . Cffikrffmp t ckwl 1,}X" W r ...... t-P Wtl 414t1>X 2w8wplP8 .... .... Pt' 5iet< ;t3- -8Rr 8 vm3S tl-fiX 33Z transfer, or otherwise Ap' P3t 'B sooro 5.8T.vJi P z A disseminate any part of RI S 5.'1 .. the publication for 0' Spot market -------------------- > Traders and suppliers --- t _ Electric utilities Gas transportation ---- Gas supply transactions 8 Competition in the Natural Gas Industry The physical gas market ditions. For example, the economic value of natural gas tends to be high during extremely Participants in the physical gas market trade cold weather, when gas supply and transporta- contracts for the physical delivery of natural tion capacity are generally constrained. If the gas-arrangements known as physical gas contract price of natural gas is fixed, supply and contracts (sometimes referred to as cash gas demand do not adjust in response to the higher contracts). These contracts differ in two main value. Demand may exceed supply, and gas dimensions, the purpose of the transaction and shortages may occur. In such a situation demand the duration of supply, and thus divide the must be rationed by administrative rules-an physical gas market into several segments. A interruption of supply-rather than prices. purchase of gas for resale takcs place in the Deregulation of the gas industry and greater flexibility in natural gas supply change the im- Pa rticip nts in spot markets, inable portance of long-term supply contracts. Par- ticipants in deregulated gas markets need to topredictfutureprices of gas, are balance their supply and demand in both the long and the short term so they can react to exposed to price risk. Their need to changing market conditions. Short-term balanc- ing can be achieved by trading in the short- minimize this risk leads to the term (spot) market, where producers, traders, suppliers, distribution utilities, and large end development of a financial gas market. users enter into daily trades. Spot market par- ticipants can acquire natural gas supplies rela- tively quickly and choose the time and quantity wholesale gas market, and a purchase for end of supply based on needs and price. That flex- use in the retail gas market. Wholesale trans- ibility allows them to form a portfolio of long- actions are concluded among producers, and short-term contracts that minimizes sup- traders, suppliers, pipeline companies, and dis- ply and price risks in both the long and the tribution firms, while retail transactions occur short run. between suppliers and industrial or residential consumers. Spot markets typically develop where buyers and sellers are concentrated, such as at a pipe- Differences in the duration of gas supply di- line interconnection near a large metropolitan vide gas contracts into three classes: area or at a major terminal in a gas-producing * Short-term gas contracts, for supply of up to region. The Henry Hub in Louisiana and the one calendar month. Bacton terminal in the United Kingdom, for * Medium-term gas contracts, for supply of one example, are both located at the entry point to to twelve months. a major pipeline network in a large producing * Long-term gas contracts, for supply of more region. By aggregating supply and demand, than one year. spot markets offer industry participants the benefits of high liquidity, intensive competi- Natural gas transactions were traditionally based tion among buyers and sellers, and greater ef- on long-term supply contracts between inte- ficiency in the pricing of natural gas. grated gas companies and their customers. Be- cause these contracts fixed the price and volume In a well-functioning spot market short-term of gas to be supplied over a specified period, (spot) prices reflect the economic value of natu- they reduced supply and price risks. But they ral gas. Gas industry participants use spot prices provided little flexibility to reflect the economic to value supply contract portfolios and make value of natural gas under changing market con- decisions about the size and timing of con- The World Bank Group 9 sumption. Thus spot markets in natural gas managing risk and can therefore better absorb serve the same function as other commodity the price risk. A transfer of price risk from the or stock exchanges-they reveal the market distribution utility to intermediaries minimizes value of the commodity traded. In the United the overall exposure to price risk and the costs States spot prices of natural gas at Henry Hub of risk management. are a common indicator of market value. A financial gas market will emerge in coun- Spot prices tend to be volatile, however, re- tries where the physical gas market has reached sponding to changes in underlying factors of a certain level of maturity and a large share of supply and demand such as the weather, avail- natural gas is traded under short-term contracts. able pipeline capacity, or consumption patterns. Since only a few countries have a mature spot Participants in spot markets, unable to predict the ftiture prices of natural gas, are exposed to price risk. Their demand for tools to minimize Transactions in thefinancial gas this price risk leads to the development of a financial gas market. market involve the transfer of risks The financial gas market between mcrket partici'pants with The contracts traded in the financial gas mar- different risk characteristics and risk ket serve two main purposes: they minimize the price risk in the natural gas spot market, management skills. and they minimize the basis risk resulting from the changing price differential between physi- cal and financial gas contracts. Financial gas market, the financial gas market is a relatively contracts also serve as an instrument for specu- new concept. Only the United States and the lation and price arbitragc in the gas market. United Kingdorn have active financial gas mar- They are seldom used for physical delivery of kets today. Nymex, in the United States, devel- natural gas. oped and actively trades three natural gas futures and options contracts for delivery in The most common financial gas contracts are three major spot markets in the United States forward contracts, swaps, futures, and options. and Canada. 'T'he international Petroleum Ex- Forward contracts and swaps are typically change, in London, trades a natural gas futures custom-tailored, with every aspect negotiated contract for delivery at the National Balancing by the parties to the contract. Futures and op- Point, a notional balancing point in the pipe- tions are standardized contracts typically traded line system of BG (the pipeline transportation in established commodity exchanges such as spin-off of British Gas). Financial gas markets the New York Mercantile Exchange (Nymex) are likely to emerge in other countries as de- in the United States. regulation continues. Transactions in the financial gas market involve The transportation market the transfer of risks between market partici- pants with different risk characteristics and risk Contracts traded in the transportation market management skills. For example. a distribution cover transportation services-the supply of company with an obligation to serve final cus- pipeline capacity and delivery of natural gas tomers tends to be exposed to price risk be- deliver to a desircd location. Pipeline compa- cause it cannot adjust its demand in response nies sell transportation contracts to shippers- to changes in spot prices. Intermediaries such any industry participants that want to move as traders or brokers tend to be experts in natural gas-in the primary transportation 10 Competition in the Natural Gas Industry market. In some instances holders of firm trans- Deregulation of natural gas markets creates a need portation contracts may resell them to other for flexible transportation services. Market par- market participants in the secondary transpor- ticipants need to be able to match their gas sup- tation market. plies with transportation services. And they often require short-term balancing of natural gas sup- The primary transportation market ply and demand to optimize the cost and reli- ability of natural gas deliveries. They can achieve The contracts purchased by shippers in the pri- such balancing only if they can match their port- mary transportation market give them the right folio of gas supply contracts with a correspond- to transport natural gas under specified condi- ing portfolio of transportation contracts. Thus tions. The most important distinctions among pipeline companies need to offer medium- and transportation contracts are the duration and short-term transportation contracts and flexibil- the reliability of the services provided. Con- ity in the choice of injection and delivery points. Such services are typically preceded by the de- velopment of a more flexible regulatory envi- lf transportation contracts establish ronment for pipeline companies and the creation of a secondary transportation market. tpcansferaIble property Tights to pipeline The secondary transportation market capacity, contract holders can trade the Holders of unused firm transportation contracts contractsfreely aId the secondaiy can resell these contracts in the secondary transportation market. Buyers and sellers in this inarket can flounsh. market may be almost any participant in the primary transportation market, though pipeline companies are excluded because of their mar- tracts can be long, medium, or short term. And ket power. they can provide firm or interruptible service, a distinction that determines the priority given Secondary transportation markets came into ex- to a shipper during capacity shortages. Trans- istence in the United States in 1992, when the portation contracts also specify the location, Federal Energy Regulatory Commission intro- timing, and volume of natural gas shipments. duced a capacity release program requiring in- terstate pipelines to allow holders of firm The natural monopoly characteristics of pipe- transportation contracts to release, or sell, any line transportation require that the primary unused portions of their reserved pipeline ca- transportation market be regulated to limit the pacity to other network users. The United King- market power of pipeline companies and dom introduced a similar program of pipeline promote efficient allocation of resources. A capacity resale in 1996 under the Network Code pipeline company must incur substantial fixed of British Gas. costs to construct the pipeline system before it can provide transportation services. These fixed The resale of transportation contracts promotes costs dominate the company's cost structure efficient allocation of transportation capacity. As because the variable costs of shipping natural a result of short-term changes in supply and gas through the system tend to be relatively demand, some pipeline users will not utilize all low. Pipeline transportation exhibits economies their contracted capacity, while others will lack of scope as well as scale. Once the pipeline is capacity to ship their gas. In thie absence of a constructed, a company typically uses the same secondary market holders of unused capacity facilities to offer different transportation cannot sell it to those who need it and pipeline services. capacity may go unused. A pipeline company The World Bank Group 11 can use spare capacity for interruptible services, Short-term transportation contracts may be but efficiency may be compromised because in- traded in a transportation spot market. To pro- terruptible tariffs tend to undervalue available mote liquidity and efficient pricing in this market, capacity. transportation contracts need to be sLandardized in all important dimensions. The resale of short- By contrast, the resale of firm transportation contracts allows contract holders to realize market value for unused pipeline capacity. Thus The services needed to support retail it can lead to optimal allocation of transporta- tion capacity among market participants, based coinpetition, such as metering and billing, on their willingness to sell or pay. The effi- ciency of capacity allocation is sometimes con-. are also targets for the introdcuction of strained, however, by regulation of the resale price, which tends to be capped to reduce the coflpetitive provision. potential for exercise of market power. To promote efficiency in the secondary trans- term transportation contracts not only promotes portation market, it is important to assign prop- efficient allocation of contracts, but it also fa- erty rights to transportation capacity to a large cilitates the simultaneous clearing of gas and number of shippers. If transportation contracts transportation markets by enabling market par- establish transferable property rights to pipe- ticipants to match their spot gas transactions with line capacity, contract holders can trade the short-term transportation contracts. Spot mar- contracts freely and the secondary market can flourish. But if transportation contracts estab- lish property rights that are not transferable, ActiIve trading of shsot-term trans- the resale of contracts is impossible unless it is C intermediated by the pipeline company. Con- portation contracts will eventually give tract holders may still engage in side-dealing by using their spare capacity for delivery of rise to a financial transportation market third-party gas, but these deals often involve high transactions costs. Firm capacity contracts where participants can minimize the that give their holders the right to reserved pipe- line capacity typically establish property rights, pnrce risks in the physical market. But the transferability of such contracts depends on prevailing regulation. kets in transportation contracts are developing The resale of transportation contracts can take in the United States, where electronic systems several forms. Auctions in which shippers bid for trading natural gas and transportation con- by price can be used for trading both long- tracts link large numbers of buyers and sellers. and short-term transportation contracts, al- though they may be too time-consuming for Market prospects resale of short-term contracts. Transactions in which shippers mutually agree on the condi- Having achieved considerable success in whole- tions for contract resale give the parties a great sale market competition, the United Kingdom deal of flexibility and so are well suited for all and the United States are moving toward com- types of transportation contracts. But this form petition in retail gas supply to small consumers, of trading may be too costly for smaller and under arrangements that will allow consumers less informed participants that have to shop to choose among gas suppliers and reap effi- around for the best deal. ciency gains like those in the competitive 12 Competition in the Natural Gas Industry wholesale gas market. The services needed to support retail competition, such as metering and billing, are also targets for the introduction of competitive provision. The unbundling of pipeline transportation has led to marketlike op- eration of natural gas storage facilities, with stor- age operators taking advantage of seasonal and daily price variations in nearby spot markets. Active trading of short-term transportation con- tracts will eventually give rise to a financial trans- portation mnarket in which participants can minimize the price risks in the physical trans- portation market. And with continued advances in technology and in the understanding of howv the natural gas industry operates, more oppor- tunities for competitive provision of goods and services will surely emerge. Andre]Juris (andrej juris@nera.com), A7ERA, Washington, D.C. 13 Natural Gas Markets in the United Kingdom Competition, industry structure, and market power of the incumbent AndrejJfits Deregulation of the U.K. natural gas industry has facilitated new entry and competition in almost all segments of the industry except pipeline transportation. The new regulatory framework, developed largely by the Office of Gas Regulation (Ofgas), has allowed market forces to stimulate a variety of specialized services and market transactions to meet customer needs. But deregulation has been difficult because of a flaw in the initial industry structure: the government privatized British Gas as a vertically integrated company. The U.K. experience shows that leaving gas supply integrated with pipeline transportation and tying up gas in long-term contracts impede competition. This Note reviews the U.K. reform and the development of new spot, on- system, and 'Flexibility Mechanism" markets. Structural problems The government opened the wholesale and contract gas markets to promote efficiency and 'Until 1986 British Gas operated as the publicly lessen the dominance of British Gas. It permit- owtned, vertically integrated transporter and sup- ted large consumers to contract for natural gas plier of natural gas in the United Kingdom. Only directly with producers. And it allowed inde- gas production was open to competition. and pendent gas shippers, traders, and suppliers this segment was dominated by multinational to arrange gas supplies for large consumers in oil companies. In 1986 the government priva- order to create competition in 'wholesale sup- tized British Gas, choosing to leave it a single, ply.' The tariff market remained closed to com- vertically integrated company in order to speed petition, and British Gas continued to be the the transaction and maximize the sale proceeds. sole supplier of natural gas to small consum- At the same time it separated the gas market ers. The government believed, rightly at the into three major segments: time. that competition in gas supply to small • The wholesale market, where gas is traded consumers was not economically feasible. between producers, traders, British Gas, and Wholesale and contract gas prices were liber- independent suppliers. alized. while Ofgas regulated retail tariffs to * The contract mark-et, where gas is supplied to protect consumers from the market power of large consumers (initially those consuming British Gas. more than 25,000 thermns a year, nowv those consuming more than 2,300 therms a vear) The decision not to unbundle British Gas in by British Gas or independent suppliers. 1986 hindered the development of a competi- * The tariff market, where gas is supplied to tive gas market. Because British Gas controlled small consumers (those with annual con- the entire pipeline system and held long-term sumption belovwT the threshold for large con- gas supply contracts with produccrs, it was able sumers) by British Gas. to retain a de facto monopoly in the wholesale 14 Natural Gas Markets in the United Kingdom and contract gas markets and control entry by age business. This separation, or "demerger," of independent gas suppliers. In an attempt to British Gas was completed in 1997. improve access to gas supplies and transporta- tion, Ofgas introduced the 90:10 rule in 1989, The demerger finally corrected the gov- which prohibited British Gas from contracting ernment's failure to restructure the industry at more than 90 percent of gas deliveries from the time of privatization. The costs of the fail- any field on the U.K. continental shelf. The ure had been significant. The industry's flawed 90:10 rule effectively forced producers to mar- structure resulted in frequent regulatory inter- ket their gas to independent suppliers, promot- ventions in the markets and disputes between ing the development of wholesale gas trading Ofgas and British Gas. This increased the regu- at the "beach," the entry terminals of the Brit- latory risk and cost of capital for British Gas, ish Gas pipeline system. which saw a big drop in the market value of its assets. Between the fall of 1993 and mid- The 90:10 rule did not, however, remove the 1996, when the disputes were particularly in- main source of the problem: the ability of British tense, the market value of the assets fell by Gas to control access to its pipeline network. half-from £.15.5 billion to £7.7 billion. And Complaints about the company's market power the demerger itself was a costly exercise, with prompted another set of regulatory measures in the company paying millions of pounds in ac- counting and legal fees. Between late 1993 and mid-1996 when The U.K. experience shows that if a single company controls access to gas supplies and regulatoy disputes wvere intense, the transportation capacity, as British Gas did, com- petition may be inhibited. Simply removing ad- maczrket valuc1e of British Gags s ass etsfell ministrative barriers to entry in gas supply and deregulating gas prices are not enough to en- by half sure competitive gas markets. A move from mo- nopolized to truly competitive gas markets requires structural and regulatory changes that the early 1990s, when Ofgas asked British Gas protect new entrants from the market power of to release more natural gas to independent sup- the incumbent. It took almost a decade to rem- pliers and to build 'Chinese walls" separating edy the failure to unbundle British Gas before its gas supply and pipeline transportation busi- its privatization. Only after U.K. regulatory au- nesses. The intention was to increase indepen- thorities intervened in the acquisition of natural dent suppliers' access to natural gas from gas from producers and the incumbent's opera- producers and to level the playing field for sup- tion of the pipeline network could real compe- pliers contracting for pipeline transportation. tition emerge in natural gas supply. British Gas complied by selling about 5 billion New markets cubic meters of natural gas (roughly 3 percent of the total gas supply) to independent suppli- Competition has fostered new ways of trading ers and by creating two divisions, British Gas natural gas, reflecting market participants' need Energy and British Gas TransCo. But the prospect for more flexible gas supply arrangements. Spot of further regulatory intervention on liberaliza- markets have formed at major terminals, allow- tion of the retail gas market led the company to ing market participants to balance their short- seek more permanent structural change. In 1996 term supply and demand by trading natural gas. it decided to split its assets into two companies: As a result of new pipeline operating rules, a Centrica, a gas production, sales, and supply flourishing spot market has developed within business, and BG plc, a transportation and stor- the pipeline system. The pipeline operator also The World Bank Group 15 uses market pricing to determine the costs of contract gas markets. Independent suppliers and balancing supply and demand over the pipeline large consumers demanded contractual and sup- network. ply flexibility to allow them to efficiently balance their short-term supply and demand. Indepen- While natural gas markets are substantially de- dent suppliers also sought a trading location that regulated, gas transportation remains heavily would give them unrestricted access to gas de- regulated because of the natural monopoly liveries, outside the control of Britislh Gas. characteristics of pipeline transportation. Brit- ish Gas-followed by its transportation spin-off, Aided by regulatory measures, the market BG-has remained the single operator of the response to the demand for greater flexibility U.K. pipeline system, and transportation and better location was the development of spot charges are regulated. The secondary transpor- markets. First, wholesale gas trading moved to tation market is just beginning to emerge, with the 'beach." Here natural gas supply from more resale of pipeline capacity amnong shippers al- than forty producers promised sufficient avail- lowed only since 1996. ability of natural gas and flexibility in delivery conditions. Second, the concentration of trading As markets for wholesale (and, increasingly, at entry terminals promoted the development retail) gas supply have become more competi- of spot markets, where natural gas is continu- tive, the quantity and quality of services avail- able to market participants have improved, and consumers have benefited from declining real The on-system market bas become prices for natural gas even as consumption has been increasing. Residential prices fell by 24 increasinglypopular among shippers percent in real terms between 1986 and 1995, and industrial prices by 47 percent. During *he becautse of its cen tral location same period consumption increased by 38 per- cent.2 Deregulation of wholesale and contract accessibility, and low transactions costs. markets has attracted more than forty suppli- ers, all competing fiercely. The increased com- petition in the contract market is reflected in ously traded. More tradiing opportunities were the diminishing market share of British Gas, created when British Gas separated its gas sup- which fell from 80 percent in 1992 to 33 per- ply and pipeline transportation operations. The cent by the end of 1996. The industry operates introduction of the British Gas Network Code much more efficiently than it did before 1986, in 1996, which set out the rights and responsi- and consumers have been able to benefit. bilities of users of BG's pipeline network, cre- ated two additional gas markets within the Market dynamics pipeline system of British Gas. The trading and contracting of natural gas in Participants in the U.K. gas market now use four the United Kingdom have changed dramatically mechanisms for trading natural gas (figure 1): since the privatization of British Gas in 1986. - Bilateral contracts. Traditionally, most natural gas was sold under - Spot markets. long- and medium-term contracts between pro- - The on-system market. ducers and British Gas at the wholesale level - The Flexibility Mechanism. and between British Gas and consumers at the retail level. After the contract market was liber- Bilateral contracts alized in 1986. long-term contracting became insufficient to meet the needs of the growing Bilateral contracts are the traditional form for number of participants in the wholesale and trading natural gas in the United Kingdom. Until 16 Natural Gas Markets in the United Kingdom privatization British Gas typically concluded with deliverv provisions to meet specific demand long-term take-or-pay, or "depletion," contracts and supply characteristics of contracting parties. under which British Gas covered a share of the financing of a producer's field development cost Such a move is not without costs, however. in exchange for assured future gas deliveries. The opening of the gas market to competition exposed British Gas to transition costs, in the The opening of natural gas supply to competi- form of net liabilities resulting from tion, however, has introduced new contractual overcontracting. In 1996 the companv held relations in the gas market as producers and take-or-pay obligations to purchase about 4.6 independent suppliers look for ways to achieve billion cubic feet of gas a day (bcfd) from pro- greater supplv and price flexibilitv. This has ducers over the next five v-ears, while gas sales spurred the development of a wid'e range of were projected at 4.35 bIcfd, on the assump- long-, medium-, and short-term supply contracts tion that BG would maintain a 90 percent share The World Bank Group 17 in the tariff market in 1998. That resulted in an or on a brokerage basis, with traders often act- estimated surplus of 0.25 bcfd, or 5 percent of ing as intermediaries. Spot trading started in take-or-pay obligations, with a value of £528 1989-90 as a bilateral telephone market be- million.3 Although this surplus is not a signifi- tween producers and independent suppliers, cant volume, it represented almost 30 percent but trade volumes were low because most pro- of spot market sales in 1996. Thus if BG deliv- ducers' gas supply was contracted by British ered its surplus gas to spot markets, it would Gas. Over time there has been a large increase drive down spot market prices and potentially in volume and in the number of traders. harm its position in the retail gas market. In any event, the losses have probably been miti- The most active spot markets are at the Bacton gated by delays in the introduction of retail and St. Fergus terminals, which are well con- competition. nected with large producer and consumer ar- eas. The most conmmon contracts traded in these Spot markets markets are day-ahead and monthly gas Spot market trading has developed with the opening of natural gas supply to competition. The strong prospects of the on-s ystem As the large number of contractual relations between producers and suppliers made it in- market and its potentialfor efficient feasible to always negotiate all aspects of supply contracts, demand arose for the standardized pricing ofphysical gas contracts have led contracts suited for spot market trading. An- other factor in the development of spot mar- the International Petroleuim Exchange in ket trading has been the gradual shift in natural gas transactions to locations where producers London to develop itsfist natural gas and suppliers can rely on standardized deliv- ery conditions and have the best access to the fuitures contract. pipeline systerm. Natural gas spot markets have developed at contracts, specifying delivery on the next day six onshore terminals of the British Gas pipe- and in the coming month. Other contracts line network, where the concentration of traded in spot markets include: producers' gathering pipelines and the trans- * Balance gas contracts, for delivery in the rest portation pipelines of British Gas promised of the current month. good availability of both gas supplies and trans- * Quarterly and annual gas contracts, for de- portation capacity. The spot markets enable livery in a specific quarter or year. participants to balance their supply and de- * Time spread contracts, for the exchange of mand in the short term by buying or selling contracts with different delivery periods. natural gas in one or more central delivery lo- cations. The high volume of natural gas trad- Despite the increasing volume of gas traded in ing in the spot market has led to greater spot markets, trading remains relatively thin standardization in supply conditions, such as and illiquid. In 1996 trading volumes at Bacton in the duration of delivery, and thus in gas sup- ranged from 2 million to 8 million therms a ply contracts. This standardization of contracts day, only 5 to 10 percent of the total daily sup- promotes market liquidity and efficiency in spot ply. Prices at the terminal varied accordingly- gas prices. from 9 pence to 14 pence a therm. The U.K. gas market appears to be too small to support Spot market gas trading in the United Kingdom efficient functioning of five to six spot mar- is bilateral, involving producers and shippers, kets. Perhaps a more central location is needed 18 Natural Gas Markets in the United Kingdom where most of the country's natural gas sup- Gas supply and trading spin-off) in the liberal- plies could be traded. British Gas, inspired by ized retail market diminishes and more gas the growing use of natural gas spot trading, becomes available from producers as a result. introduced a central location within its pipe- line system when it launched its on-system The strong prospects of the on-system market market in 1996. and its potential for efficient pricing of physical gas contracts have led the International Petro- The on-system market leum Exchange (IPE) in London to develop its first natural gas fuitures contract based on deliv- The on-system market is basically a natural gas ery at the National Balancing Point. The intro- spot market with the delivery point at the Na- duction of the IPE Natural Gas NBP contract on tional Balancing Point (NBP), a notional point January 31, 1997, marked the beginning of fi- in BG's pipeline netvwork at which BG balances nancial gas trading in the United Kingdom and its high-pressure pipeline system. In effect, all in Europe. The contract has found broad ac- gas supplies transported through BG's high- ceptance among gas traders because of its cen- pressure pipelines can be traded at the NBP. tral delivery location and smooth administration. By July 31, 1997, the volume traded under such A transaction in the on-system market typically contracts had reached almost 30 million therms, involves shippers that own transportation equal to about 40 percent of the United contracts and are willing to sell or purchase Kingdom's daily production of natural gas. natural gas. Selling shippers use their reserved pipeline capacity to deliver natural gas to the BG's Network Code requires all shippers to NBP, where they sell it to interested buyers. balance their gas shipments through the pipe- line system-that is, to maintain their injections and withdrawals of natural gas below a speci- The Flexibility Mec acanism allows market- fied tolerance level-on both a daily and a monthlv basis. Shippers can balance their ship- based determination of the valHe of the ments by buying or selling natural gas in the highly liquid on-system market, where the price natuiralgas needed to restore balance in of natural gas determines the cost of maintain- ing their balance. But shippers do not always BGs pipeline system. maintain their daily balance, and the whole pipeline system may become unbalanced if the sum of individual imbalances exceeds a cer- Buying shippers then use their pipeline capac- tain tolerance level. The pipeline operator must ity to transport the gas from the NBP to the then inject or withdraw natural gas to restore desired location. Transactions are facilitated by the balance in the pipeline system. The value BG, which keeps track of traded volumes and of the natural gas in these transactions is not provides transportation services. reflected in the on-system price, because BG cannot participate in on-systein tradinlg. To fa- The on-system market has become increasingly cilitate the pricing of this gas, British Gas in- popular among shippers because of its central troduced the Flexibility Mechanism in 1996. location, accessibility, and low transactions costs. The whole range of natural gas contracts, The Flexibility Mechanism much the same as those traded in a spot mar- ket, are traded daily in the on-system market. The Flexibility Mechanism allows market-based Traded volumes in the on-system market, and determination of the value of the natural gas possibly in other spot markets, are likely to needed to restore balance in BG's pipeline sys- increase as the share of Centrica (the British tem. BG trades this natural gas in an auction. The World Bank Group 19 Interested shippers post their bids, specifying be supported by an appropriate industry volumes and the prices at which they want to structure and regulation to protect new entrants buy or sell, on an electronic network. BG buys from the market power of the incuimbent. To natural gas if it expects that injections into the promote competition, the liberalization of en- system will be less than withdrawals, and sells try to gas supply and of gas prices must be natural gas if it expects the reverse. BG ac- accompanied by open access to gas supplies cepts the bids that cover the expected system from producers and to transportation capacity imbalance and that either minimize the cost of for delivering natural gas to consumers. The buying natural gas or maximize the revenue practices of tying up natural gas in long-term from selling it. The price of the last accepted supply contracts and integrating gas supply with bid determines the system marginal price at pipeline transportation must be eliminated to which transactions between BG and shippers are concluded. BG solicits bids from shippers daily, so that they are always available. It is important to introduce structural As in any auction, competition among ship- changes at the beginning of the reform to pers promotes efficient pricing of natural gas traded under the Flexibility Mechanism. If ship- set the stage for developing mi ar-kets anf d pers want to ensure that BG accepts their bids, they will reveal their true willingness to buy or competition later in the reform. sell natural gas. BG can construct a market (sup- ply and demand) from shippers' bids, and de- cide which ones minimize the cost of restoring enable independent suppliers to acquire natural system balance. Since the last accepted bid de- gas in the wholesale market, gain equal access termines the price for all transactions, the svs- to pipelines, and start to compete on equal foot- tem marginal price reflects the economic value ing with the incumbent gas company. of natural gas needed to restore balance in BG's pipeline system. Developing competitive natural gas markets can require frequent regulatory changes and inter- The cost of restoring system balance under the ventions, as it did in the United Kingdom. But Flexibility Mechanism is recovered from the ship- these interventions can lead to many contro- pers that cause the imbalance. Undisciplined versies and disputes among industry partici- shippers must either pay the system marginal pants and between the industry and the price for the natural gas below the tolerance regulator, often with harmful effects for both level of their shipments or accept the system companies and consumers. The cost of in- marginal price for natural gas that is above the creased regulatory risk and the risk of political tolerance level. Since the system marginal price intervention discourage investment in the gas is typically higher than the price of natural gas sector. So it is important to introduce struc- sold or low er than the price of natural gas pur- tural changes at the beginning of the reform to chased in the spot market, undisciplined shippers set the stage for developing markets and com- experience losses on their imbalances in addi- petition later in the reform. tion to any imbalance penalties imposed by BG. These potential losses deter shippers from vio- Market forces have proved to be vital and lating the balancing rules of the Network Code. effective in the gas industry, once appropriate structural and regulatory measures establish Conclusion some breathing room. New entrants in gas trading, shipping, and supply can emerge over- The U.K. experience shows that the develop- night and introduce new methods of transacting ment of competitive natural gas markets must business, such as spot market trading. By 20 Natural Gas Markets in the United Kingdom concentrating trading in one location, spot mar- kets like the U.K. on-system market can fill a vital role for market participants that require flex- ibilitv in gas supply and efficient pricing of natu- ral gas. And spot market pricing of natural gas can be used for valuation of system balancing, as it is in the Flexibility Mechanism of BG. Categories of market participants are defined in the Network Code of BG plc, the pipeline transportation spin-off of British Gas. Ship- pers are firms with shipper licenses that huy gas from producers, sell it to suppliers, asd contract with BG to transport the gas to consumers. Suppliers are firms with supplier licenses that buy gas fronm shippers and sell it to consumers. They do not deal directly with producers or BG. Since many companies in the United King- dom have both supplier and shipper licenses, these terms are used interchangeahly here. Traders are firms that buy and sell natural gas in a spot market and do not deal directly with con- sumers or BG. 2 Based on data from the U.K. Department of Trade and Industry. 3 Gundi Royle, 'British Gas: Light at the End of a Long Tunnel," (Morgan Stanley International, Investment Research U.K. and Europe, Londonl, 1996). AndrejJuris (andrejjuris@nera.com), NVERA, WV'ashington, D.C 21 Development of Competitive Natural Gas Markets in the United States AndrejJuris The United States enjoys a highly competitive natural gas market and an increasingly efficient market for pipeline transportation. Consumers have benefited from changes to both the structure and regulation of the industry in the past ten to fifteen years. These changes have lowered natural gas prices and broadened thie range of services offered by gas companies. This Note reviews the forces driving the regulatoryr changes and the effects of the changes on the functioning of gas markets. It also provides an overview of natural gas trading mechanisms in the United States. The focus is primarily on the wholesale natural gas market, the market most affected by deregulation. Deregulation of the gas industry when the Natural Gas Act established a basis for regulating the prices and activities of gas The U.S. natural gas market is the world's largest, companies. Over the next forty years regula- with a total supply in 1996 of 25.6 trillion cubic tion gradually increased its reach as new regu- feet. About 75 percent of this supply is pro- ]atory institutions and policies emerged. duced domestically, with the balance from stor- Interstate transactions came under regulation age withdrawals and imports (12 percent each). by the Federal Power Commission (FPC), later Gas production is concentrated in the South, succeeded by the Federal Energy Regulatory along the Gulf Coast in Louisiana and Texas, Commission (FERC), while intrastate transac- and in smaller producing regions in Alaska, the tions were regulated by state agencies. Southwest, and the central United States. But most natural gas consumers are in the North- Overregulation east, the Midwest, and the Pacific Coast region, all areas where imports of Canadian gas play an By the 1970s regulatory agencies controlled important part in meeting demand. The geo- almost all aspects of business in the industry. graphic imbalance between producers and con- Regulation was applied not only to industry sumers means that large quantities of natural segments dominated by natural monopolies, gas must be transported long distances across such as pipeline transportation, but also to com- the country and the continent. So even small petitive segments, such as production and inefficiencies in production or transportation of wholesale supply. The excessive control bur- natural gas can have a large economic effect on dened companies and distorted natural gas the gas industry. prices and consumption patterns. The U.S. natural gas industry has gone through Excessive regulation of gas producers, for a full cycle of government regulation in the example, led to gas shortages in the 1970s.' In past sixty years. During the first several decades the 1950s the FPC had started to regulate well- of the century the industry enjoyed limited over- head prices in areas where interstate pipeline sight by the government. That changed in 1938, companies purchased natural gas from 22 Development of Competitive Natural Gas Markets in the United States producers. But with hundreds of active well- to supply contracts concluded after 1975. Supply heads in the country, the commission was un- contracts concluded earlier were priced at low able to process all the tariff applications. By historical tariffs. Since interstate pipelines had a 1960 it had completed 10 out of 2,900 applica- large portfolio of old gas contracts, the average tions. It was forced to adopt an "area rates` wellhead costs of natural gas were well below approach, setting a uniform tariff for all pro- the economic value. Consumer demand was ducers in the same geographic area. Although therefore much higher than it would have been this step decreased the number of tariff cases, in a competitive market. This aggravated supply the approval process was still very slow, aver- shortages. The costs of gas shortages in the 1970s aging ten years per case. were estimated at US$2.5-5.0 billion a vear. The area rates were based on average histori- Deregulation cal costs of production. These averages became very low relative to the increasing costs of pro- Gas shortages prompted deregulation in order duction in the 1960s and early 1970s. Produc- to promote efficiency in production and bulk ers found sales of natural gas to interstate supply of natural gas. The main approach was to allow free competition among producers and suppliers in the wholesale gas market. The pro- Even smalll inefficiencies in production cess was launched in 1978 when Congress adopted the Natural Gas Policy Act, authoriz- or transportation of natural gas can ing the FPC to partially liberalize interstate natural gas markets. The FPC adopted a num- have a large economic impact on the ber of regulatory measures that partially liber- alized wellhead prices of gas, allowed gaqs industry. competition in the wholesale gas market, and enhanced regulation of interstate gas pipelines. Congress adopted additional legislation in 1989 pipelines unprofitable and curtailed gas sup- and 1992 further liberalizing wellhead gas ply to the interstate market. They found it more prices and interstate natural gas transactions. profitable to supply gas to the intrastate mar- ket in Texas or Louisiana, for example, where Among the most important measures adopted wellhead prices were unregulated or consider- by the FPC was Order No. 436 of 1985, which ably higher than in the interstate market. As a introduced open access to interstate pipeline result interstate pipelines faced shortages of gas transportation and limited the use of long-term supply and consumers in the Northeast and contracts. Local distribution uLilities and large Midwest experienced supply interruptions. end users were allowed to purchase natural gas directly from producers, bypassing inter- To attract producers back to the interstate mar- state pipeline companies. Companies that ket, the FPC adopted new regulation in the mid agreed to provide open access to their interstate 1970s. A uniform national wellhead tariff was pipclines were allowed to chargc an open ac- set at an average of current and expected costs cess tariff, regulated by FERC, for provision of of gas production, leading to a quintupling in transportation services. To promote competi- wellhead prices. However, the new regulation tion in the bulk supply of natural gas, FERC did not eliminate the main cause of gas short- allowed gas marketing companies to arrange ages-the regulation itself. Average cost-based purchases and sales of natural gas on behalf of national tariffs seldom reflected the true eco- other industry participants. nomic value of natural gas as it would be set in a competitive market. And even if national tar- Deregulation of the gas industry followed when iffs did reflect economic value, they applied only FERC adopted Order No. 636 of 1992, which The World Bank Group 23 FIGURE 1 TRADITIONAL STRUCTURE OF THE U.S. GAS INDUSTRY, BEFORE 1985 Producers End users-II VI1 Prd--e - companies -- - companies -------- End users Gas transportation - Gas sales FIGURE 2 OPEN ACCESS TO PIPELINE TRANSPORTATION, 1985-92 Residential -,s Distribution - - - -, -" companies F'~ - X Commercial Producs -------- Pipeline - - P roducers __________ companies - A. , _ ~~Industrial --------------- -- -> Wholesale market ------- F Marketers Electric utilities Gas transportation ---- Gas sales FIGURE 3 UNBUNDLING OF GAS SALES FROM PIPELINE TRANSPORTATION, 1992 AND BEYOND Residential - - - F Distribution companies - - - Commercial Producers Piei companies Y ' X ~~~~~~~Industrial '--F Marketers --F X -_ Gas - MeSpotmarketers - - :1 F Electric utilities Gastransportation ----Gas sales 24 Development of Competitive Natural Gas Markets in the United States required the interstate pipeline companies to costs of gas purchases at the wellhead were unbundle natural gas sales from pipeline trans- borne by distribution companies and final con- portation by setting up separate affiliates to sumers, since regulators allowed a pass-through handle these activities. This removed an incen- of gas purchase costs to consumers. Order No. tive for interstate pipeline companies to dis- 436 allowed distribution companies to exit tort bulk supply competition through restricting these long-term supply contracts with pipeline access to pipelines. companies and purchase natural gas directly from producers. But pipeline companies were To minimize distortions in the gas market not allowed to exit their contracts with pro- caused by regulated prices for interstate pipe- ducers and so were left with large contractual line transportation, Order No. 636 also obligations that they were unable to meet. The enhanced the method for calculating transpor- pipeline companies challenged the order in tation tariffs and introduced a program for the court, and FERC had to issue a new order (Or- resale of firm transportation contracts. This pro- der No. 500 of 1987) allowing the companies gram, the capacity release program, allows ship- to pass on up to 75 percent of the transition pers (any users of pipeline transportation) to costs to producers, distribution companies, and purchase pipeline capacity from shippers that large consumers. Only then did the interstate have temporary or permanent excess reserved pipeline companies begin to implement the capacity. The capacity release market promotes open access regime on a large scale. the efficient allocation of transportation con- tracts among shippers and allows gas market Order No. 636 completed the deregulation of participants to match transportation contracts the wholesale gas market by liberalizing entry to their gas supply contracts. into gas marketing. It was followed by a series of FERC orders to promote competition in the The two orders dramatically changed the op- wholesale gas market and increase flexibility eration of the gas industry, from tight regula- in interstate pipeline transportation FERC is tion to free competition in the wholesale gas now focusing on developing short-term capac- market. But implementation of the orders ity resale and standardizing gas supply and imposed large transition costs on some indus- transportation contracts. try participants, which naturally opposed changes. Opposition to Order No. 436 was Deregulation has changed the structure of the particularly strong. The transition costs related U,.S. gas industry. Until 1985 the industry was to Order No. 436 were estimated at US$11.7 vertically separated into production, pipeline billion in 1986, half the total book value of transportation, and distribution (figure 1). How- interstate pipelines in 1984, at US$23.4 billion. ever, all transactions were tightly regulated and The actual value of transition costs was $10.2 completed under long-term contracts. The in- billion as of 1995 .2 Only after FERC worked troduction of open access to interstate pipe- out a mechanism to distribute the costs among line transportation in 1985 gave rise to the all industry participants could the orders be competitive wholesale gas market, and gas mar- successfully implemented and competition keting emerged as a new segment of the in- flourish. dustry (figure 2). The unbundling of interstate pipeline transportation completed the whole- Before 1985 interstate pipelines entered long- sale market's transformation into a fully com- term supply contracts to purchase from pro- petitive market in 1992 (figure 3). ducers and sell to distribution companies. Many of these contracts were concluded at very high The liberalization of gas marketing and whole- wellhcad prices, which pipelines, fcaring a re- sale gas prices attracted many new companies currence of the supply interruptions of the into the wholesale gas market. The fierce com- 1970s, were willing to pay. The uneconomic petition that ensued among marketing firms and The World Bank Group 25 FIGURE 4 AVERAGE i'MiTillFAl NATURAL GAS PRICES IN THE UNITED STATES, 1984-95 US. dollars perthousand cubic feet 7 7 6 3 3 2 Wellhed 2 198M ¶985 ¶986 1987 1988 1989 M99 1991 1992 1993 1994 1995 Source:.Energy Information Administrationr Washington,. DC. gas producers increased the pressure on whole- The functioning of a competitive sale gas prices. The price competition benefited gas market not only wholesale market participants, but also final consumers of natural gas. Nominal prices After fifteen years of deregulation, the whole- of natural gas decreased or remained stable sale gas market in the United States is fully for all consumer categories after 1985 (figure liberalized and vrery competitive. Producers, 4). This meant a substantial decrease in real pipeline companies, marketers, distribution prices. Wellhead prices dropped on average companies, and large consumers trade natural 26 percent in real terms between 1988 and 1995, gas in a large number of regional markets. while prices at city gates (the entry points to Natural gas transactions are mostly arranged pipeline networks for local distribution) fell by by gas marketers, which buy and sell natural 24 percent. gas on behalf of producers, distribution com- panies, and large consumers. Most trading takes Although there was an overall decline in retail place in spot markets at major market centers gas prices, the distribution of benefits was un- and hubs on interstate pipelines (figure 5). even. Large consumers such as electric utilities Important trading activity also occurs in finan- and industrial consumers, -which now purchase cial gas markets (futures and options), where about 75 percent of their gas requirements in participants minimize the price risks in natural the competitive wholesale market, saw a 26 to gas spot markets. And recently electronic trad- 31 percent decline in real prices between 1988 ing systems have developed that allow the and 1995. Most small consumers, however, are trading of natural gas and pipeline capacity in still captive to local distribution companies, and all major markets in the United States and only about 25 percent of gas consumed by com- Canada. mercial users is purchased directly in the whole- sale gas market. As a result, commercial and Gas marketers residential consumers saw only a 12 percent decline in the average real price of natural gas Gas marketing companies are a dynamic and between 1988 and 1995. competitive segment of the U.S. natural gas in- 26 Development of Competitive Natural Gas Markets in the United States dustry. The share of deliveries they arrange As natural gas markets have become increas- increased from 20 percent of the total in 1987 ingly complex, marketing companies have to 49 percent in 1995. The first marketing com- sought to expand their size and scope in order panies emerged in the late 1980s, but the main to accommodate the diverse needs of their cli- boom occurred after implementation of Order ents. In 1995 and 1996 a wave of mergers in- No. 636 in 1992, as producers, pipeline creased the concentration of sales. In 1994 the companies, and distribution companies formed top ten marketers arranged average daily sales marketing subsidiaries to take over natural gas of about 31 billion cubic feet of natural gas, 42 acquisition and sales. percent of total U.S. daily consumption. In 1996, after mergers between several large players, Marketing companies benefit other participants the top four marketers alone accounted for this in the gas market by minimizing transactions volume of sales. Despite this concentration, costs and supply and price risks. They group small marketers continue to play an important the supply and demand needs of market role, particularly in local markets, which are participants and match them with appropriate commercially unattractive for major players. contracts on a large scale. This intermediation reduces the costs of transactions by freeing buy- Hubs and spot markets ers and sellers from having to shop for the best contract. At the same time, by aggregating con- Over the past ten years natural gas transactions tracts, marketers can diversify the supply and in the wholesale market have gradually moved price risks of individual contracts. These risks from wellheads to hubs at major interconnec- often arise when market participants with dif- tions of interstate and intrastate pipelines. Today ferent supply and demand characteristics try most gas trading in the United States takes place to arrange transactions on a bilateral basis. Be- in large hubs and market centers. Hubs are typi- cause marketers can pool contracts in one port- cally operated by one or several interstate pipe- folio, they are better able to absorb fluctuations line companies, which own the pipelines in supply or demand. interconnected at the hub. Hubs allow market The World Bank Group 27 participants to acquire natural gas from several gas prices occasionally become highly volatile. independent sources and ship it to several dif- A cold spell in February 1996, for example, ferent markets. This eliminates the need to con- caused extreme changes in spot prices at the tract natural gas and pipeline capacity all the way Henry Hub. The average spot price in Febru- from the welllhead to the consumption site. In- ary 1996 was US$4.41 per million British ther- stead, shippers can combine supply routes across mal units (Btu), a record high compared to the several hubs to diversify supply risks and mini- average annual price of about US$2 per mil- mize costs. Hub operators off'er a wide variety of lion Btu. The spot price at Henry Hub peaked services-ranging from physical transportation of at more than US$15 on February 2, 1996. and natural gas to storage, processing, and trading- some industrial customers in Chicago paid a providing great flexibility for shippers and mar- city gate price of USS45 per Btu.2 keters in trading and delivering natural gas. Most players in the gas market dislike high vola- Hubs have become very popular among mar- tility in gas prices and seek ways to diminish keters and other players in the wholesale gas the price risk in the financial gas market. They market. More than fifty have been created are aided bv a large number of intermediaries- across the United States since the first one, the gas marketers that compete fiercely to struc- Henry Hub, was established in May 1988 in ture the best ways of minimizing price risk for Erath, Louisiana. The Henry Hub, which is also customers. the largest hub in the United States, is a major natural gas interchange operated by Sabine Pipe The U.S. financial gas market had its begin- Line Company, a subsidiary of Texaco. At this nings in the late 1980s, when several financial hub marketers and traders have access to large institutions began to offer custom-tailored natu- consumer markets in the Midwest, Northeast, ral gas futures contracts. As noted, the first stan- and Southeast and along the Gulf Coast through dardized financial gas contract was introduced nine interstate and three intrastate interconnect- by NYMEX in April 1990, in the form of a natu- ing pipelines. The market participants trans- ral gas futures contract with delivery at the ported about 550 million cubic feet of gas a Henry Hub. In April 1992 NYMEX added a day through the Henry Hub in 1995. natural gas options contract for delivery at the same location. NYMEX and the Kansas City Almost all major hubs in the United States have Board of Trade have since introduced three developed into spot markets where natural gas more natural gas futures and options contracts, is traded continuously. The most important with three different delivery locations, to re- natural gas spot market is at the Henry Hub. flect regional differences in the market value This highly liquid and efficient spot market de- of natural gas. termines the market price of natural gas on a continuous basis. The Henry Hub spot price Financial gas trading has proved popular among plays a key role in the U.S. gas industry. Gas gas market participants. Between 1991 and 1995 industry participants use the spot prices to the volume of natural gas futures contracts traded evaluate their contract portfolios and make increased from 0.42 trillion cubic feet to 80 consumption or investment decisions. And the trillion-four times the physical consumption of Henry Hub is the pricing point for the first fi- natural gas in 1995. The turnover in futures trad- nancial gas contract, the New York Mercantile ing was USS125 billion in 1994, about 60 per- Exchange (N:YMEX) natural gas futures contract. cent more than the turnover in physical gas that year. Most financial gas trading is conducted by Financial gas market marketers (which held 34 percent of the open interest on natural gas futures in the first quar- Participants in natural gas spot markets in the ter of 1996), producers (25 percent), and finan- United States face substantial price risks, as spot cial institutions (20 percent). 28 Development of Competitive Natural Gas Markets in the United States Electronic trading and market centers tive gas markets must be supported by con- tinuing improvement of the regulatory frame- The introduction of electronic trading systems work for the gas industry. Such measures as in the past two years has led to the develop- liberalizing wholesale gas prices and the bulk ment of market centers connected to multiple supply of natural gas free market forces in seg- hubs by electronic networks. Electronic trading ments where competition is both feasible and allows market participants to trade not only socially desirable. Regulators also must focus natural gas, but also pipeline capacity and stor- on improving the regulation of pipeline trans- age services at all interconnected hubs and pipe- portation and minimizing its distortive effect lines. It also facilitates communication between on competitive gas markets. Introducing flex- pipeline companies, shippers, and hub opera- ibility into pricing and other conditions of trans- tors. Many electronic trading systems are linked portation contracts-such as delivery locations to other commercial networks that supply in- or the balancing of gas shipments-and stan- formation and newrs relevant to the gas industry. dardizing pipeline operations promote more efficient use of pipelines and benefit all indus- Electronic trading has its origins in the electronic try participants. bulletin boards established by interstate pipe- line companies in 1993 to support resale of pipe- The U.S. experience also shows the viability of line capacity. Standardization of these electronic competition in the deregulated wholesale gas bulletin boards simplified the trading of pipe- market and the important role of gas market- line capacity and showed the advantages of elec- ers and spot markets in increasing the efficiency tronic trading. In late 1994 three commercial of gas transactions and prices. Liberalized electronic trading systems were introduced that wholesale prices create many profit opportu- allowed market participants to trade natural gas nities in the gas market, and these attract new and pipeline capacity electronically across sev- entrants to production, marketing, and supply. eral markets and pipelines. By the end of 1996 Many of the new entrants bring new services almost all major pipeline companies in the and products that increase the range and qual- United States had introduced electronic systems. ity of choices for gas industry participants. The largest electronic trading system in the Deregulation of the U.S. gas industry is far from United States today is Altra Streamline, which complete, however. Regulation of charges for is linked to eight market centers and forty-five interstate pipeline transportation and capacity interstate pipelines in the United States and release still limits the efficient allocation of Canada. The average daily volumes traded in transportation contracts. But the most impor- this system range from 10 million to 200 mil- tant task, and the biggest challenge for regula- lion cubic feet of natural gas. Many small sys- tors, remains the deregulation of retail gas tems are integrating with larger ones to offer markets in individual states. These issues will shippers and marketers a wide variety of ser- continue to keep U.S. gas regulators busy. vices across all major gas markets in the United States. Electronic trading systems have great ' This example draws on Richard J. Pierce Jr., "Reconstituting the potential in the world of deregulated natural Natural Gas Industry from Wellhead to Burnertip," Energy Law gas and power industries: thev can link mar- jooural 9 (anuary 1988): 1-57. k Pierce (1988) and U.S. Department of Energy. Energy Policy Act keters to all major regional gas and electricity Transportation Study InterimReporton NaturaiGasFlowsandRates markets in the United States. (DOE/EIA-0602[951, Energy Infommation Administration, Washing- ton, D.C., 1995) Conclusion AndrejJuris (andrej4juris@nera.con), NERA, The U.S. experience in gas industry deregula- Washington, D.C. tion shows that the development of competi- 29 Mitigating Risks in Power Reform A New World Bank Lending Approach Power Sector Reform in the Indian State of Haryana Djainal Mostefai The World Bank has agreed to support power sector reforms in Haryana with a new type of lending instrument-the adaptable program loan-recently approved by its board of directors. Under this approach, being applied for the first time, the Bank will provide a series of loans totaling US$600 million over eight to ten years, but will commit the loans only when the state government has reached agreed milestones. This approach allows state government milestones-not the covenants of standard World Bank loans-to determine the timing of controversial actions. The flexibility is intended to improve the reform program's chances of success and avoid a stop-start lending pattern. This Note explains Haryana's reform strategy and how the adaptable program loan applies. The power sector of the northern Indian state power producers in the early 1990s, there were of Haryana is in poor physical and financial con- no takers. Project sponsors were unwilling to dition. To put the sector on more solid footing, enter the market given the power offtaker's dis- the state government has announced a ten-year mal financial condition and the federal program of comprehensive reform to restore its government's unwillingness to extend sovereign creditworthiness, create an environment condu- guarantees.) As Harvana's policymakers now cive to private investment, and eliminate the largely recognize, the root cause of the sector's power deficit. The governrnent will create an independent regulatory commission, unbundle the sector, privatize distribution, and rely on the The loan sflexibility is intended to private sector to create additional generation ca- pacity. It will also rationalize tariffs, notably for impr ove the reform program s chances power supplied to agriculture, the state's domi- nant sector. The strategy is expected to help of success and avoid a stop-start mobilize about USS5 billion in investment in generation, transmission, and distribution from lending pattern. independent power producers, distributors, cen- tral and regional utilities, and Haryana's state- owned central utilities. problems is the lack of a commercial outlook in operations and investment and the multiplicity Implementing the reform program will be com- of goals the Board has to pursue (box 1). The plex, however, and will entail significant risks, Board has been required to charge low tariffs particularly political ones. The sector is domi- to farmers and residential consumers and to re- nated by the Haryana State Electricity Board, a frain from using normal remedies to collect bills state-owned, integrated utility with a monopoly and to eliminate large nontechnical losses. Over on transmission and distribution. (Although gen- the years the Board has been transformed into eration was opened to private independent an extension of the state government. 30 Mitigating Risks in Power Reform separating the Board into a generation com- pany, a transmission company, and several dis- tribution companies. Initially the industry structure will follow the single-buyer model; TheIlayaa Sat Elctrciy Bar, astae-wne, nteratd tiltylater, it is expected to evolve to wholesale wit a onoolyon rasmisio an ditriuton,canot eethecompetition. Third, the government will privatize distribu- Haryanas economy some US$350 million to US$400 million a year,4.0tion and rely on the private sector to develop to .5pecen o te ros sat dmesicprduc. oreiht eas headditional generating capacity through a competitive bidding process. It may also allow which rmains a about2400 megwatts.power imports from neighboring states and from Nepal. The distribution companies, which serive about 3 million consumers, will be priva SystemTlosseshaeestimtedtoexceed40pecent,ndmorttized through the sale of equity to private strategic investors, with the state keeping a mi- u ltbsoTheft, c pilferae). Powefrms s operate at e ynority equity stake. The first privatization anbavera a fcto y sabut 4ercent m las feain resutu . of rshould be completed by the middle of 1999 and the rest before the end of 2001. There is supplyF(dueiinparst,t the Boar oovrnament rrd) o agrowing consensus in India that privatizing distribution is the best way-if not the only way-to reduce the huge nontechnical losses ByrMarch997thegBoardthadeaccumulatedfiancialossesplaguing the sector. Generation and transmis- tutnUS$Omilio,itianes, tivewoofU millio,andsion assets may also be considered for overdueiabitiesto uppriverseotor.u suppiern s o lagend sprivatization in the long run. In the short term, ex eed U 0 miion. spin thepaitizingh y the sectorate fehowe er, the government of Haryana prefers hasgrantedthepowrseducin ntorfrethancUS$ billionsintdirn to focus its privatization efforts on what is most indirectsubsidiespecuivalen ttaboutllperiffs. f fiscessential to the success of the reform-distri- diabution. Success on that front is expected to ease later privatization efforts in generation and transmission. The reform strategy Fourth, bulk power, tranismission, and retail tariffs will be rebalanced. Over the next four The comprehensive reform program announced years retail tariffs will be progressively adjusted by the state government has five main features. to restore the creditworthiness of the utilities and to reduce the subsidies given to agricul- First, the government will develop an autono- tural and domestic users. By 2001-02 utilities mous regulatory agency that will issue licenses should achieve a return on net worth of at least to transmission and distribution companies and 16 percent, with a self-financing ratio of at least regulate the tariffs and performance of power 20 percent. utilities, whether ow,ned by the government or the private sector. Creating this agency should Finally, the sector will undergo comprehensive be a major step in depoliticizing the sector and financial restructuring. The state government reducing interference by the state government, will forgo its equity and loans to cover accu- especially in tariffs. mulated losses, write off losses and contingent liabilities, and provide temporary support to Second, the government will unbundle gen- the new utilities. In addition, the Board will eration, transmission, and distribution, thus discuss with its creditors the possibility of re- The World Bank Group 31 scheduling some current liabilities and other concern about undue increases in tariffs, and obligations. This financial workout would in- unwillingness among vested interests to give volve restructuring about US$1 billion of liabili- up their benefits. ties. But after 2002 the power sector will be able to meet its debt service obligations and And third, the utilities must be allowed to become a net contributor to the state budget function as autonomous, accountable, and com- by paying returns on the state's equity. mercial entities without any external daily in- terference or micromanagement. They should Under the investment program new generation be expected to pursue only commercial and capacity will be developed by central and re- gional utilities (20 to 30 percent of the addi- tional capacity needed) and private interests (70 7here is a growing consensus in India to 80 percent). Rehabilitating the existing gen- eration facilities and rehabilitating and expand- that privatizing distribution is the best ing the transmission and distribution network will require about US$1.8 billion. Funding will way to reduce huge nontechnicalpower come from the World Bank (33 percent), bilat- eral donors (14 percent), the Haryana state gov- losses -unmetered and unbilled supply, ernment (16 percent), and internal resources generated by the new power companies (12 per- uncollected bills, power theft and cent), with private equity and Indian and for- eign commercial banks providing the balance. pilferage. Implementation risks efficiency objectives; they should not be ex- The success of the proposed reforms hinges pected to pursue any social objectives that the on the state government's ability to achieve state government may have and that in any three main goals. case would be better achieved through other means. First, the state government must be able to sig- nificantlv increase tariffs over the next four The complexity of the reform poses another years, especially for electricity supplied to ag- important risk. The program will be both tech- riculture, which accounts for about 45 percent nically and administratively challenging, as of the market (compared with 23 percent for demonstrated by a similar reform program industrv and 19 percent for residential consum- launched about two years ago in the Indian ers). Haryana is one of the few states in India state of Orissa and partly funded by the World in which power rates for agriculture are more Bank. The proposed changes are based on than the roughly 1.3 U.S. cents per kilowatt- concepts and mechanisms new to most of the hour minimum set by a conference of chief people who will have to implement them. The ministers at the end of 1996. Most states still program will require increased institutional ca- provide farmers with free power (as in Punjab pacity and a new management culture and at- and Tamil Nadu) or charge them less than the titudes. Full implementation will take about ten minimum. years. Among the complex issues that the gov- ernment of Harvana will have to address: Second, the state government must be able to - Moving from an integrated, monopoly utility privatize distribution. The move toward priva- to a structure in which several generating tization will generate forceful opposition from companies, a transmission company, and different constituencies and on various grounds: several distribution companies will trade ideology, employee fears of massive layoffs, power and operate on a commercial basis. 32 Mitigating Risks in Power Reform * Moving from a culture dominated by engi- Privatizing distribution, which will require neering and technical performance standards, carrying out extensive preparatory work (as- physical targets, administrative controls, and set valuation, financial viability analysis, for- a complex system of accountability to a cul- mulation of bidding documents), defining a ture in which the overarching principles, be- privatization strategy, negotiating joint ven- yond technical excellence, will be quality of tures, and dealing with labor, legal, and other complex issues. *Executing an investment program over the Farmers and households willpay higher next ten years of about US$1.8 billion, five to six times the size of the Electricitv Board's rates as long as they see more and better past programs. quality power and do not bear the costs One indication of the complexity of the pro- gram is the amount of technical assistance re- of inefficiencies. quired. Despite all the benefits that Haryana is gaining through learning from the Orissa ex- perience, the technical assistance budget ex- service, customer satisfaction, economic and ceeds US$30 million. financial cfficiency, and clcar accountability. * Moving from a regulatory mechanism in Mitigating risk which the key players are the state govern- ment and the State Electricity Board to a regu- Mitigating the risks of the reform program poses latory mechanism based on an autonomous challenges not only for the reformers in Haryana, commission acting independently, following but also for the Bank (as adviser and partner to quasi-judicial procedures, conducting pub- the state government) and for the bilateral agen- lic hearings, and assessing tariff adjustment cies that have agreed to provide assistance.' The cases from an efficiency perspective. first challenge was to set the right expectations. • Transferring staff, assets, and liabilities from The state government needed to get the assur- a single entity to several new corporations, ance of long-term financial support and it needed to deliver better service early in the reform pro- cess to show that something concrete was hap- 7The highestpriorityfor the government is pening. But from the Bank's perspective it was important to reconcile the need for early sup- to undertlke investments that would port with the risk that the reform could be slowed or even reversed. The Bank's past ex- reduce system losses-and thereby perience in lending to state electricity boards has been disappointing: of about US$1,800 mil- reduce the tariff hikes needed to cover lion in loans committed for state electricity boards, only one-quarter has been disbursed, cost~--improvepowersupply, andX with the balance canceled because covenants and other commitments could not be met. enbance revenue collection. The second challenge is to break a vicious circle. Farmers and other consumers will pay and delineating new service territories for the higher rates as long as they see more and bet- distribution companies. ter-quality power and do not bear the costs of * Procuring additional power of about 3,000 mega- inefficiencies. Experience in Rajasthan bears this watts, largely from private sources and through out: a scheme in which farmers without elec- competitive bidding, in five to eight years. tricity but ready to pay the full cost for it will The World Bank Group 33 receive immediate service connections (rather pleted, in an attempt to ensure irreversibility than waiting for years) has elicited broad of the reform. This is the approach used to interest. In most states farmers use diesel gen- support the pioneering Orissa power sector re- erators as a backup or substitute for grid- form; a US$350 million investment loan was supplied power, producing power at a much approved by the Bank in 1996, when the adapt- higher cost (3.5 to 4 rupees per kilowatt-hour) able program loan was not yet available. With than that for power from the grid (about 0.6 strong political support from the start and com- rupee). Thus the acceptability of the reforms mitment from reform-oriented administrators, and the state government's ability to sustain Orissa was able to take the up-front measures them are directly linked to progress in improv- that enabled the Bank to approve the loan. ing the quantity and quality of supply. The high- est priority for the government is therefore to undertake early investments that will reduce A significant difference between the system losses-and thereby reduce the tariff hikes needed to cover costs-improve power traditional and adaptcable progrcam loans supply, enhance revenue collection, and lower energy requirements through end-use efficiency lies in the wav commitments from the improvements. clients are handled. The third challenge is to deal with the uncer- tainties and complexity of the reform program. Clearly, it would have been impossible to de- Some of the circumstances under which the fine at the beginning of the program all the reform was initiated in Orissa were unique: parameters of the policy measures and of the agriculture's share of the power market is quite physical components of the Bank's support- low (about 7 percent of power sales), tariffs something that would have been required us- have been regulatory adjusted, and the state ing existing loan instruments. does not incur power shortages to the same extent as other states, including Harvana. What is different about the adaptable program loan? A World Bank sectoral adjustment loan might, by contrast, be used, when a country faces bal- The situation Haryana's government faces is ance of payments problems. For Haryana this not unique. The Bank recognized its clients' lending instrument would have been less need for a new instrument allowing a long- appropriate than an adaptable program loan term commitment from the Bank to support for several reasons. A sectoral adjustment loan long-term programs and policies, early support is disbursed in tranches, after specific condi- to help overcome initial difficulties, and flex- tions have been met, not against expenditures, ibility to benefit from the lessons of experi- so the link between the physical components ence and adapt to evolving situations of the investment program and the reform pro- -something existing instruments did not al- gram would have been lost. Extending a low for. The adaptable program loan is the in- sectoral adjustment loan over ten years would strument it developed to meet this need. have been too long for this type of instrument (and a commitment to provide several shorter This loan offers several advantages over invest- loans would not have been possible), and the ment loans and sectoral adjustment loans to commitment fees paid by Haryana's govern- address situations like Haryana's. The World ment would have been very high. And, finally, Bank's standard investnent loan covers only the conditions under which the tranches can about five years and is committed only after a be released would mean the loss of an number of reform measures have been com- important element of flexibility. 34 Mitigating Risks in Power Reform A significant difference between these tradi- loans. In January 1998 the Bank's board of di- tional loans and the adaptable program loans rectors endorsed Haryana's reform program and lies in the way commitments from clients are approved a first loan of US$60 million as part handled. In the traditional approach these com- of a long-term assistance program of up to mitments are covenanted in the legal agree- US$600 million, dispersed over eight to ten ments among the Bank, the borrower, and the years. The subsequent loans for which the beneficiary institutions. Under an adaptable board has delegated approval authority to the program loan the commitments are milestones Bank's management (subject to certain proce- that trigger the processing of subsequent loans. dural conditions) will be processed once agreed A covenant and a milestone are two very dif- milestones have been achieved. ferent things (box 2). The loan was approved after the state govern- Loan structure ment had demonstrated its political commit- ment to reforms. It had conducted an extensive The Bank has agreed to support the reform public debate on the reform program, and the program through a series of adaptable lending State Assembly had passed the Haryana Electricity Reform Bill, a major step in imple- menting the reform. (A standard lending op- eration would have required much more ____ _ progress on the reform agenda before com- _ I I mitment of a Bank loan. But that would have delayed Bank support at a time when this sup- Acovenntisprtofa etoiglomhetsnhcthfakport is critical.) The loan will help finance in- haspreise it deison o lnd.A brroer falur tomee avestments in transmission and distribution to increase the supply and quality of power in selected areas where the results will be most have to take remedial actions, includingsuspendingdisburvisible. It will also finance improvements in andcanelig lans Thse ctins re ssetialy uniiveandcustomer service (for example, in the opera- almostXinevitably lead to difficulties inthe dialoguebetweenthe tion of complaint centers and in billing proce- Bank and thesborrower. dures) and new safety equipment for staff. Several bilateral donors have agreed to finance A mleson isa trgt st b te brrwertha te Bnk asagreda comprehensive program of technical assis- tance to start the institutional development of to consider a triggerfor processing subsequent loans.Thedecision the new power sector entities.2 2 avalig isef f alonfom heBak i oly neofthefatos i tatIf Haryana's government keeps its current decsio. I acievmet o th miestne s elaed,addtioalreform schedule and makes timely procurement leningmaybe ostone, btth ons wll estwit th clentdecisions, the second loan, of UiSS 150 million to 11S5200 million, could be extended in late An ssesmet o th difernce btwen cvenntsandmilstoes1998 or eadly 1999. This loan would be aimed at helping to sustain the major reforms and mus tae i acoun animprtat dscontig fcto. Fr te Bnk,supporting tariff adjustments, notably for power takng emeialactonsis eneall moe dffiuithansimly otsupplied to agriculture. The loan would finance procssig aloa whnmiestnes re ot et hisdisouningthe continuation of the investment program in facor ay omeims lad lietsto gre oncoenatatat retransmission; basic distribution equipment dificltt met,wih te xpetaio tht urig rojctimpemn-(meters, transformers, capacitors) and the rehabilitation of more distribution segments; and demand-side management and energy conservation measures (such as replacing The World Bank Group 35 inefficient water pumps) to ease the impact of risk: its initial financial commitment is limited, rural tariff increases. and additional commitments are contingent on the completion of concrete reform steps. But The second loan's schedule and amount will once each loan is committed, the funds will nor- depend on progress in the investments financed mally remain available for disbursement unless under the first loan, new investment require- there is a clear indication that the reform pro- ments, the pace of procurement decisions, and contributions from other sources Japan's Over- seas Economic Cooperation Fund and Germany's A slowdown in reform would defer the Kf'W are actively considering financing part of the second phase of Haryana's investment pro- next loan but support to investments gram). The milestones that HaryanaIs govern- ment will have to achieve before this loan is initi'ated under preceding loans may not committed include establishing the regulatory commission and the new power utilities, com- be aiffected. pleting the financial restructuring, and achiev- ing significant progress toward privatization of the first distrihution company. gram is being reversed or there is a continuous beach of basic covenants. A slowdown in reform would A third loan, for about US'S200 million, could defer the next loan, but support to investments ini- be committed in 2001 or 2002. This loan would tiated under preceding loans may not be affected. support the expansion and rehabilitation of the That ensures continuing stipport to Haryana cluring transmission and distribution network. Again, times of difficulty in implementing reform, even if the schedule and amount of the loan will de- additional lending remains on hold. pend on progress in the reform and investment programs and the sector's ability to mobilize fi- The progress of the reform program will depend nancing from other sources. The loan would be on how well Haryana can manage multiple con- committed once most of the distribution busi- stituencies to maintain a consensus for reform. The ness has been privatized, tariffs have been ad- adaptable program loan approach will enhance the justed to meet agreed financial targets, and all other reforms have been implemented as agreed. Depending on the sector's needs, one or two Theproposedpower reforms could have more loans amounting to about US$200 mil- an impolrtant demonstration effect. lion would be committed around 2004-05. As with the previous loans, the schedule and HIaryana is a high-profile agricultuiral amount of these loans would be based on progress in implementing the reforms and re- state nearDelhi. lated investments. The milestones triggering these loans have been broadly defined. They include full privatization of distribution, full res- reform program's chances of success if the flex- toration of the sector's creditworthiness, and ibility of the loans and of the milestones can further evolution of the power industry (for be maintained, so that Haryana's government, example, toward a multiple-buyer model). not strict dated covenants, determines the tim- ing of controversial actions. This flexibility pro- Conclusion vides important reassurance to the government, and to other states governments, that the Bank From the Bank's point of view this proposed will remain an active partner in the reform pro- approach greatly mitigates the implementation gram, including during times of trouble. 36 Mitigating Risks in Power Reform The proposed power reforms could have an important demonstration effect. Haryana is a high-profile agricultural state near Delhi. If suc- cessful, the program could help trigger reforms in other agricultural states facing similar prob- lems and challenges. These are the Canadiani Inaternational Developmiienit Agency, the U.K. Department for International Development, and the U.S. Agency for International Development. 2 See note 1. Djamnal Mostefai (drnostefai@worldbank. org). Senior Energy Specialist, South Asia Energy Division, World Bank office, New Delhi 37 Developing International Power Markets in East Asia Ennique Crouisillat The Greater Mekong subreogion has good potential for international power trade. Initial interest in this market is being speairheaded by private developers negotiating bilateral cross-border trade agreements. But experience in power trade zones in Europe and North America shows that to achieve the benefits of fully fledged trade, the countries in the subregion need to closely coordinate electricity sector policy, operating protocols, and network development. This Note sets out the market development options, reviews sector reforms so far, assesses the obstacles to full power trade, and briefly outlines multilateral efforts to promote an infrastructure that will support international power trade in the subregion. The Greater Mekong subregion-Cambodia, Lao People's Democratic Republic, Myanmar, Thailand, Vietnam, and the Yunnan Province FIGURE 1 THE POTENTIAL EAST ASIAN POWER MARKET of southern China-has significant potential for cross-border power trade (able 1). The subre- gion is well endowed with low-cost hydro re- sources-the Mekong River Basin is the world's twelfth largest river systern-and China, Lao PDR, Thailand, and Vietnam have large coal and natural gas reserves. The potential for trade stems from imbalances in costs and in supply M River and demand between countries in close prox- Mekong River imitv: the low-cost hydro potential is in Lao PDR, Myanmar, and Yunnan Province, but the main markets are Thailand and the more dis- VIETNAM tant Malaysia-Singapore grid (about 1,000 kilo- meters away). CAMBODIA Potential benefits Recent studies comparing scenarios of electric- ity self-sufficiency in each country with a full trade scenario show that full trade could yield Ku MALAYSIA cost savings of at least US$10.4 billion in 2001- 20 and a reduction of airborne pollutants valued SINGAPORE at US$160 million a year. (These estimates assume a significant slowing in power demand 38 Developing International Power Markets in East Asia over the next few Pears in Thailand as a result Lower greenhouse gas emissions an57 other of the current financial crisis.) The savings pollutants, largely due to a shift from would arise from: thermal to hydro generation in the long * Lower operating costs due to economic power term. exchange, postponed and lower investments in generation due to least-cost development There is growing interest in cross-border bilat- of regional energy resources, and reduced eral power trade in the subregion, spearheaded spinning reserve costs. by private developers in Lao PDR selling power * Lower coincident peak load (compared with to Thailand. The government of Thailand has the sum of individual peak loads), mutual ac- agreed to buy 3,000 megawatts from these pri- cess to generation reserves for interconnected vate power developers by 2006, and several systems, a more robust power supply to meet independent power producer (IPP) projects are such unexpected events as load growth above moving ahead. China's Ministry of Electric forecast or delayed commissioning of genera- Power is encouraging studies of the export tion and transmission projects, and increased potential of Yunnan's planned Jing Hong hy- system reliability. dropower plant and associated transmission lines to Thailand, through Lao PDR, with the support of the Lao and Thai governments. The Vietnam and Lao governments have signed a memorandum of understanding on purchases of ahout 2,000 megawatts of power hy 2010. lon dstnce btwen n-outr lod eners schas ani ndDeveloping international markets ratertantrasferig pwerfrnt ort t soth,Vitna coldExperience in power pool development in Eu- rope and the United States suggests that to get meeteergyemandtaloercotbyexortigsurpusesnthethe full henefits of that trade, countries in the norh t Thilad ad iporingthesam amuntfrot Lo PB.Greater Mekong subregion will have to go he- yond the proposed hilateral power purchases. The World Bank Group 39 BOX 2 SECTOR OPERATORS The power sectors in the Greater Mekong subregion are structured They will have to ensure compatibility in their differently. power sector structures, conditions for private entry, and market competitiveness. An inter- Cam60dia Electricite du Cambodge is a state-owned utility respon- national power market requires coordinated de- sible for the supply of electricity nationwide. Electricity supply is velopment and operation. largely restricted to the capital, Phnom Penh, and a few provincial towns; there are no transmission facilities in Cambodia. The three main models for international power markets can be regarded as three phases of a China. In Yunnan Province, the Yunnan Provincial Electric Power continuug r: Corporation operates as a fully integrated power company, wholly * The thirdle-ptyeor open access model. owned by the government The South-East China Electric Power * The spot market or wholesale market (power Corporation (SCEP) was set up as a joint venture company in pool) model. Guangzhou by China's central government, the State Energy Invest- ment Corporation, and Guangdong, Guangxi, Guizhou, and Yunnan Single buyer province in 1991. The SCEP constructs and manages jointly funded ageneration and transmission projects. It is exploring the feasibility of In a single-buyer market a single entity, such as a regional power pool. the Electricity Generating Authority of Thailand (EGAT; see box 2), purchases power from all producers on a contractual basis. This approach Lao POR. The national utility Electricite du Lao, established in 1961, is does not require a radical separation of inte- responsible for all supply in the country. But electricity supply is grated utilities or significant power sector re- largely restricted to the capital, Vientiane, and a few provincial form. But the long-term contracts should be towns,sincetransmissionfacilitiesarelimited. structured like IPP contracts, providing for sepa- rate payments for capacity and energy to com- Malaysia. Tenaga Nasional Berhad operates as a fully integrated pensate producers that maintain high levels of power company, it purchases all power produced by independent plant availability. This model would provide lim- ited benefits for competition because sales would power producers. tend to be based on long-term contracts. It might alsoleadtoinefficiencies ininvestment,sMyaamar. Myanmar Electric Power Enterprise was constituted in also lead to inefficiencies in investment, suchr as duplication in transmission. 1989 as a government-owned, fully integrated utility. It is responsible for planning, designing, constructing, maintaining, and operating More competitive single-buyer models require electricity supply facilitiesthroughoutthe country. some vertical and horizontal separation of gen- eration, transmission, and distribution. Vertical Thailand. The country has three govemment-owned utilities: separation facilitates competition among power Electricity Generating Authority of Thailand (EGAT), Metropolitan generators and makes it possible to identify Electricity Administration (MEA), and Provincial Electricity Authority the costs of transmission and to set prices for - ' grid use. These prices normally need to be regu- (PEA). EGAT is responsible for bulk supply, MEA for distribution in lated through a transparent and predictable Bangkok, and PEAforsupply intherestofthe country. These utilities price review mechanism. To get the benefits are well established, profitable, and well managed. The government of competition, though, governments should plans to privatize them through public stock offerings. ensure that no large generators command ex- cessive market power. Vietnam. Electricity of Vietnam was established in 1995 as a wholly Open access government-owned holding company for the power sector. It coordinates the three formerly fully integrated power companies, The open access, or third-party, model opens which had been based in Hanoi, Danang, and Ho Chi Minh City. the transmission system to generators so that 40 Developing International Power Markets in East Asia they can wheel power directly to distributors Power pool or large bulk customers. Access to transmis- sion must therefore be regulated, and pricing The final stage in developing an international policies compatible, transparent, and efficient. power market is to form a regional power pool Vertical separation of transmission avoids the or wholesale market allowing regional power conflicts of interest that can arise if a producers to sell directly to anv distributor or transmission entity favors its own generation bulk customer. This model requires a regula- source. Under the open access model most ex- tory framework to guarantee a fair and effi- changes would still be based on long-term cient market, including mechanisms to contractsw but short-term trade could occur if facilitate and coordinate trade. Again, govern- countries have spare capacity or energy. ments must ensure that a few large generators The World Bank Group 41 do not dominate the market and inhibit com- Market barriers petitive power pooling. There are many barriers to achieving the full Market reforms so far potential of power trade in the Greater Mekong subregion. The following are the most crucial. All governments in the subregion have fostered the beginnings of power trade by opening the Institutional and public policy generation market to IPPs, though their suc- cess in attracting private investment has var- * Leadership and priorities. Only Lao PDR and ied. IPPs have been active in Lao PDR, Malaysia, Thailand rate cross-border trade highly. There and Thailand, but they have shown less inter- is no authoritative regional group or agency est in other countries. Nearly all goverinments to provide leadership in network develop- are iiioving toward a single-buyer model (table 2). In Thailand, for example, EGAT's transmis- sion entity is responsible for power purchases- The lack of flexibility to reassign parts of though IPPs (with 10 percent of generating capacity) will have some access to the grid for the uenerationpurchased under a long- direct sales to large consumers. In Malaysia Tenaga Nasional Berhad (TNB), the govern- term power pu rchase agreement uwill ment-owned, fully integrated utility, purchases all power produced by IPPs (which have about limit the scopefor introducing more 30 percent of generating capacity). Thailand has made the most progress in un- competition in the near term. bundling transmission, distribution, and gen- eration. In China the central government is ment. Environmental issues must also be ad- moving slowly to encourage competitive gen- dressed at a regional level to resolve con- eration. The Yunnan provincial power corpo- flicts and ensure that no country bears an ration is developing the single-buyer model and environmental burden so that others can have has signed long-term power purchase agree- clean power. Failure to mitigate the environ- ments with projects sponsored by other govern- ment entities. The Lao government plans to establish a separate transinission company to Transmission constr-uction needs to be provide wheeling services to the region. It also is considering separating export power plants coordinated to minimize the cost of long- from local supply. The government of Vietnam plans to operate generation and transmission term investment-developinig a robust as profit centers, but whether it will permit full unbundling is unclear. The governments of market will require a network offacilities Cambodia, Lao PDR, and'Vietnam seem reluc- tant to relinquish control over the sector. rather than point-to-point links. No government has yet contemplated intro- ducing open access to transmission, though mental impact of dams will become a barrier Malaysia is well placed to do so, with IPPs ac- to hydro development and thus a barrier to counting for such a large share of its generat- trade. ing capacity. Nor has any country made much Laws, regulations, and contracts. In every progress in setting up independent regulation country laws, regulations, and power pur- and designing coherent pricing policies. chase contracts include long-term provisions 42 Developing International Power Markets in East Asia that hamper the move to more competitive into Thailand). Transmission facilities should markets. For example, the lack of flexibility be open to all generating plants on a non- to reassign parts of the generation purchased discriminatory basis. under a long-term power purchase agreement * Independent regulation. The absence of in- will limit the scope for introducing more com- dependent regulatory agencies increases the petition in the near term. risk for developers of arbitrary changes in tariffs. Where cross-border transmission is Technical barriers being developed, costs are bundled into Network development. Transmission con- struction needs to be coordinated to mini- a delivered capacity and energy price. mize the cost of long-term investment. There are plans to develop project-specific facili- ties :o transmit output from one country to another. But developing a robust market will *Transmission ownership. Some governments require a network of facilities rather than have not vet decided which agency or entity point-to-point links. A network would pro- will be responsible for building and operat- vide parallel facilities to ensure delivery of ing transmission. electricity in the event of outages. *Open access rules. Governments have not es- * Transmission protocol. There is no protocol rablished open access rules for transmission to govern the operation of a regional facilities. Thus where private developers are transmission network. If as a result one building a transmission line to connect their system constructs facilities to a standard lower plant to load-serving points, it is unclear than that of another, it could impose a reli- abilitv risk on the system with higher standards. Lack of a protocol also puts the Funding forpower generationfor export reliability and quality of service at risk if op- erators in different countries are unsure about may be hampered byfinancier)s what procedures govern routine and emer- gency operations. perception of risk related to country- Commercial and financial barriers specific issues or to the multinational * Transparency of costs. Whether trade devel- character ofprojects. ops will depend on the relative cost of power in neighboring countries. But comparing elec- tricity rates in the region is extremely diffi- whether a second generator could connect cult because most currencies are to this line. A need to construct additional nonconvertible, power suppliers do not sepa- transmission facilities could put a proposed rate generation and transmission costs, and project at a competitive disadvantage, par- accounting procedures vary. ticularly if the first plant added a unit at the Generation tariffs. Generation dispatch de- existing site. There also is no policy allow- cisions appear to be based on one-part en- ing through-flows-required, for example, if ergy tariffs. Yet dispatch decisions should be Lao PDR were to permit sales from Vietnam made by comparing generators' variable costs to Thailand (though the Lao government has of production-information not provided by agreed in principle to allow output from a one-part tariff. Only Thailand is moving China to be transported through its system toward a two-part tariff, however. An ap- The World Bank Group 43 proach to pricing bulk electricity based on a Future development of the power one-part tariff acts as a harrier to economic market trading both within a country and across borders. Developing an international power market in Transmission tariffs. The transmission tariff the Greater M/lekong subregion will be a long,- plays a key part in financing the creation and term process. Because of the long construc- expansion of a transmission network. But no tion periods, most benefits will accrue after country has a separate transmission tariff. In- 2010. Thus while the current financial crisis may stead, where cross-border transmission is slow the process initially, it should not have a being developed, costs are bundled into a major impact on the overall benefits of devel- delivered capacity and energy price at a re- oping international trade. mote point from the plant. Transmission tar- iffs have been defined only on a case-by-case Market development is under way. Potential basis. channels for regional cooperation have been Construction uncertainty. Many plants for de- established. The regional Electricity Power Fo- livery of power to EGAT are in the planning rum (sponsored by the Asian Development stage, but there is much uncertainty about Bank) provides governments an opportunity which will be built. This uncertainty has in- to discuss how to develop this cooperation. creased because the East Asian financial cri- The Mekong River Commission has been con- sis may make it harder to raise finance for ducting regional studies on the interconnec- projects. Moreover, recent low bids for plants tion of the subregion's power systems. Under in Thailand threaten the viability of the least the umbrella of the Association of Southeast competitive hydro plants in Lao PDR. Uncer- tainty about which generation projects will be developed impedes sound decisions about transmission investments. And where govern- BOX 3 PROPOSED MARKET DEVELOPMENT STRATEGY ments have agreed to build and operate trans- mission facilities, there are doubts among : generation developers about whether some Reach agreementto make powertrade a high priority. of the facilities will be completed on time * Set up a regional coordinating body to establish a protocol for the for the scheduled completion of generation frorecthescheduled.completionof new interconnected system and handle environmental issues. projects . Country and cross-border risk. Funding for - lneachcouatrydecidewhowillownandoperatetransmission power generation for export may be ham- and adopt regulations requiring nondiscriminatory open access. pered by financiers perception of risk re- lated to countrv-specific issues or to the - Ensure that domestic laws and regulations and long-term power multinational character of projects. The na- purchaseagreemnentsarecompatiblewithpowertrade. ture and degree of risks vary by country, but the most common are the financial weak- X Develop a master plan for plant and transmission locations and get ness of buying utilities, currency non- governments to committo the transmission facilities. convertibility, government interference, breach of contracts or concession agreements, * Develop an operating protocol to ensure safe, reliable, and and the seller's possible lack of access to efficientoperationofthetransmissionsystem. transmission lines. All these can undermine. - -: tpransmission ines.iall theseliy cand * Design a two-part tariff and a transmission tariff that will a project s financial viability and thus make financial closure more difficult. For many encourageinvestmentintrensmissionfacilities. projects, official credits, loans, or guarantees Setstabletaxandroyaltypoliciesforexport may be needed to give comfort to commer- cial banks. 44 Developing International Power Markets in East Asia Asian Nations (ASEAN) governments have es- tablished a technical working group to coordi- nate interconnection efforts. And the World Bank has just completed a study to help pro- mote power trade, assessing the potential ben- efits and proposing a strategy for developing a regional market (box 3). This strategy system- atically addresses the barriers outlined in this text and will be discussed at a regional semi- nar scheduled for June 1998. This Note is bascd on a World Bank-sponsored stody, "Power Trade Strategy for the Greater Mekong Sub-region" (Report 17033-EAP, World Bank, East Asia and Pacific Region, January 1998). Enrique Crousillat (ecrousillat@worldbank. org), Senior Energy Economist, East Asia Energy Sector UTnit 45 Reforming the Russian Electricity Sector Mm. igaret Wilson In early 1997 the Russian government approved in principle the now common model of electricity sector reform: vertically separating generation, transmission, and distribution; introducing competition where possible; strengthening the regulation of functions less amenable to competition; and divesting government ownership. This model has been implemented in many countries, and the story of the reform would be relatively routine if not for special characteristics of the Russian power system: its size, diverse ownership, high level of nonpayments, and the combined heat and power role of many generating plants. This Note outlines the challenges posed by these characteristics and reports on reform achievements so far. The first challenge to reform is the sheer size was in Riga (now in Latvia), and one of the and scope of the network. The Russian power primary transmission lines from the central system consists of more than 200 gigawatts of region to the Caucasus region passes through generation capacity, most of it interconnected Ukraine. by 2.5 million kilometers of high-voltage trans- mission lines spanning an area only slightly smaller than the United States and Canada com- hined (table 1). Most of the generation capac- TABLE 1 THE RUSSIAN ELECTRICITY SECTOR ity is thermal (70 percent), with hydro (20 percent) and nuclear (10 percent) making up Size Morethan200,000 megawatts. the balance. Regionally, however, there are Generation 827 billion kilowatt-hours (kWh) (1996). major differences. More than 50 percent of the Fuel mix 45% gas, 20% hydro, 18% coal, 10% nuclear, 7% oil. hvdro capacitv is in Siberia and the far east, while 80 percent of the nuclear capacity is in Demandmix 50%idustrl,11%residental,39%other the central (Moscow) and northwest regions. (includingservicesandagriculture). Tariffs Industrial: more than US$0.05/kWh, residential: The regions jealously guard their hydro US$O.O2IkWh, with large regional differences. capacity. They regard it as a source of low- Investment Low, financed through cash flow. Almost no debt cost power for local industries and have little orexternalequity financeorpeivateproject desire to see it blended into a national power supply. Moreover, the system was originally designed to provide a fairly high degree of re- Collections 11%cash,59%noncash,30% unpaid. gional self-sufficiency (transmission links Employees 921,000(1996). between regions are often weak), and in many cases large parts of these self-sufficient regions Note.Dataarefor1997exceptwhereotherwisespecified. are now in other countries. The main dispatch Source:UESandRussianFederalEnergyCommissioi. center for the northwest region, for example, 46 Reforming the Russian Electricity Sector networks, and some of their stock was sold to employees and managers under the voucher * ~~~privatization program. UJES retained at least a 49 percent interest in most of these new enter- prises, however. The government also divested part of its holding in UES. It now owns about 52 percent of the shares, foreign companies 5* i 4 jj hold about 28 percent, and Russian companies Xii N 10_ 1 2 and individuals, including company employ- * | ;; = | ! iees and managers, own the balance (figure 1). a. Oe nulearplan is wne dirctlyby te goernmnt.As a result of this decentralized ownership, the h. IE oneshp n hre nerosisles ha 4 prcntUESan te edra gvenmntrestructuring program requires the support of hXeenoownerahipinnegos. ; X Xa wide range of stakeholders. The Energos in particular need to be persuaded of the ben- efits of change, since they own or manage more Consequently, restructuring generation to create than 60 percent of installed capacity. The a competitive market is not a straightforward Energos regard the move to a competitive process. Regional opposition, combined with wholesale market as a threat to their autonomy, serious risks that technical constraints will al- a change that will end their control over dis- low generators to game the system and extract patch and oblige them to purchase high-cost monopoly prices, has led the government to power from the market rather than distribut- adopt a cautious timetable for moving to a com- ing low-cost power from their own plants. Some petitive market. of the Energos understand that their power would be dispatched first and that they would Diversified ownership receive the system marginal price for it. But they remain concerned about nonpayments on The second challenge lies in the electricity the wholesale market and about having to pay sector's ownership structure. While many coun- market service charges to sell and repurchase tries began reform with a vertically integrated, what they regard as their own power. state-owned monopoly, the Russian government in 1996 faced a sector that had already been Outside shareholders of UES also will have to partially restructured and privatized. Until 1992 be persuaded of the merits of restructuring, par- the electricity sector had been organized in ver- ticularly with regard to any divestiture of gen- tically integrated companies, called Energos, in eration assets. While these shareholders would each of the seventy-two oblasts or regions. But theoretically retain an equivalent ownership when mass privatization began that year, the stake in newly formed generation companies, federal government moved to maintain its con- they might not perceive these holdings as trol over the power sector. equivalent in risks or returns to their existing holdings in an integrated UES. The government formed a new company, RAO EES Rossii (commonly referred to as Unified Nonpayments Energy Systems, or UES), and gave it owner- ship of the country's largest hydro and thermal The third challenge is nonpayments. The root generating stations (nuclear excepted), the causes are many. They include tax avoidance, high-voltage transmission network, and the profiteering on barter settlements, legal and po- dispatch systems. The Energos were set up as litical barriers to cutting off supply to "strate- separate companies to own and operate the gic" customers, and simple failure by the smaller generating plants and the distribution government to collect adequate taxes or intro- The World Bank Group 47 duce sufficient spending discipline to ensure Achievements to date that energy supplies to budget-funded agen- cies can be financed. The lack of cash pay- Despite these challenges, the government has ments has jeopardized the financial viability of taken meaningful steps toward reforming and many power sector enterprises, hampering their restructuring the electricity sector and has ability to introduce or maintain efficient oper- defined further steps as part of its 1998 program ating systems or to respond to changing mar- for economic reform. In 1997 the emphasis wvas ket conditions. Moreover, barter and other on consolidation at the center, with the federal noncash instruments are an inefficient and government strengthening its governance of the costly basis for market transactions. electricity sector and bringing new management into UES. The new management team has fo- Restoring payment discipline is key to moving cused its initial efforts on restoring the company's forward with the proposed restructuring and financial viability. To this end, unbundling of the sector. Without this discipline, * New financial controls and audit procedures many of the newly formed enterprises would were introduced. UES and ten of the Energos risk financial failure, which would both discredit are being audited, and UES is moving to full the reforms and invite renewed government in- IAS accounting. tervention. Nonpayments can be fully resolved * The investment program has been reviewed only at the interface with t.he customer, how- and rationalized, and funding withdrawn for ever, which is typically through the regional dis- about forty projects deemned nonviable. tribution company. Thus the federal authorities u Collections have been improved, increasing cannot unilaterally address the problem, but cash payments to the UES transmission divi- must work through local entities. sion by 250 percent and overall cash pay- ments from 5 to 20 percent of revenues. Competition and regulattion * New sources of capital are being explored, including private sector participation in The fourth challenge lies in the fact that many planned new investment projects and a pos- of the generation assets controlled by the sible convertible bond issue for placement in Energos are combined heat and power plants. international financial markets. These plants were built primarily to meet local heating demands and are an integral part of The government has also taken initial steps to the extensive district heatirng networks that in introduce competition. It created an independent many large cities serve the majority of the popu- financial operator to establish a competitive lation. In the absence of competitive heating wholesale market among large industrial cUs- markets, heat prices for these plants are regu- tomers and generators. Model contracts were lated by local authorities, generally at a level established for transactions, using the network equivalent to the cost of heat-only boilers. as a common carrier. Principles for access to Regulators and municipalities are concerned the transmission and distribution networks and about the integration of competitive and regu- for regulation of wheeling tariffs are being es- lated activities in a single entity, about the im- tablished. A wholesale market, being piloted in plications of this under the current procedures one region, counted two generators and four for allocating joint and common costs, and customers among its participants by the end of about their ability to ensure that the Energos the year. To participate, buyers must agree to do not use the regulated heat market to ex- pay cash, in advance, and to eliminate payment tract windfall profits from electricity cogenera- arrears. In return they receive a 35 percent dis- tion. With the system of regional regulation still count on tariffs. in its infancy and many of the local regulators lacking experience and expertise, this added The government has also undertaken to re- complexity is a serious concern. organize generation, to boost operating efficiency 48 Reforming the Russian Electricity Sector while laying a foundation for a competitive gen- are to be in place in at least one zone (of seven) eration market. It has evaluated several restructur- by the end of June. If the pilot efforts are suc- ing options in recent months, and the 1998 cessful, they will be extended to other zones. program calls for finalizing and initiating the re- organization plan. Among the options is group- The reorganization of generation, particularly ing the existing plants into generating companies, the increased focus on competition among sup- or Gencos, to create enough potentially viable, pliers, is also expected to reduce electricity independent entities for a competitive market. prices. As new generatinig plants begin to com- Finally, the government has begun removing elec- pete with existing plants, investment proposals tricity pricing distortions, increasing tariffs to are expected to become more rational and out- households by 32 percent and making a com- of-date, inefficient units are expected to close mitment to eliminate cross-subsidies by 2000. (plans for their closure are to be developed, including programs to mitigate social impacts). Next steps Electricity prices still need to be adjusted to better In 1998 reform efforts will be extended out- reflect the economic cost of supply. Wholesale ward from the center, and pilots will be ex- and industrial prices need to fall, and prices to panded to more regions. The four target areas households to rise. Efficiency improvements (in of the 1998 program are increasing cash col- dispatch and operating practices) should help lections, improving dispatch of generators to to bring down wholesale and industrial prices, lower average fuel costs, boosting operating as will rebalancing when household tariffs are efficiency, and reducing pricing distortions. increased. Improved access to investment financ- ing is another potential source of tariff reduc- The government views financial viability of the tions. Because of limited access to capital sector, particularly increased liquidity, as key to markets, electricity tariffs currently incorporate the success of the reform. While UES more than full self-financing of new investments. But with tripled its cash collections in 1997, further im- improved financial viability, UES and the Energos provements can be achieved only by resolving should be able to attract debt financing for at the nonpayment problem at the customer inter- least part of the investment program. That would face, that is, at the Energo level. Initial efforts in allow prices to fall and would subject proposed 1998 will be mainly diagnostic, though arrange- investments to the discipline of review by the ments have been made for the private sector to financial community. run the commercial operations of one Energo under a management contract. Diagnostic efforts Many problems remain to be resolved, and the initially will focus on ten regions. Consultants commitment to reform periodically loses steam will work with the Energos to identify the causes as pressing political issues arise. But on bal- of the nonpayments in each region and test solu- ance the Russian government has taken im- tions. Actions to complement these initiatives will pressive steps toward creating a more efficient include increasing the electricity traded for cash and effective electricity sector. on the wholesale market and improving payment discipline among budget-funded agencies. The World Bank has been a partner in the RLissian electricity sector refonr program for more tlan mto years. It mobilized grant financing Improving dispatch could save an estimated to help the government formulate the reform, provided technical as- USSI billion or more a year in fuel costs, and sistance loanstosupponraestnsct rigprogrs,and extendedadjust- initial steps to realize these benefits will take place in 1998. UES, the federal regulatory agencv,~~~~ an coslatsaedvloiga argaret Wilson (mwilson3 @world bank. org), agency, and consultants ate developing an Consultant, Europe and Central Asia Energy improved incentive system, including dispatch- Conit ing guidelines and procedures. New guidelines S 49 Tapping International Equity Markets through Depository Receipts Lessons from the telecoms sector MoacnmznadA. M41ustafa and Caisten Finik Although international offerings are now a well-established privatization route for telecommuni- cations companies (in addition to local offerings and sale to a strategic partner) and governments have raised billions of dollars using this method, some governments of emerging economies still fail to give it serious attention. The main advantages of international offerings stem from the greater market depth and liquidity provided by international capital markets: telecommuni- cations companies are someltimes too big for local markets to absorb, and more active trading attracts a wider shareholder base, implies continuous evaluation of a company's value, and increases management's accountability for a company's financial performance. International offerings also enhance the legitimacy of shares being offered because companies must comply with transparent accountincg rules and strict disclosure standards in the host market. This Note outlines the offer process and implementation risks. When companies make a public offering in a traded on major international exchanges out- market other than their home market, they must side the United States-mainly the London launch a depository receipt program.1 Deposi- Stock Exchange (LSE)-and in the U.S. over- tory receipts represent shares of a company the-counter market. A company issuing GDRs held in a depository in the issuing company's does not have to comply with U.S. Generally country. They are quoted in the host country's Accepted Accounting Principles (GAAP) or full currency and treated in the same way as host disclosure requirements of the U.S. Securities country shares for clearance, settlement, trans- and Exchange Commission (SEC). Thus, GDR fer, and ownership purposes. These features programs allow companies to enjoy the benefits make it easier for international investors to of an internationally traded security without evaluate the shares than if they were traded in changing their reporting practices. Companies the issuer's home market. They also enable in- that wish to offer their securities to U.S. insti- ternational investors to invest in foreign com- tutional investors and list their shares on a U.S. panies with low transactions costs and without stock exchange use American depository re- the tax and paperwork complications of ac- ceipts (ADRs), which usually require adherence quiring foreign stock. to U.S. GAAP and more stringent SEC disclo- sure requirements. Both GDRs and ADRs must Types of depository receipts also meet the listing requirements of the ex- change on which they are traded. [ssuing companies have a choice of several types of publicly traded clepository rcceipts. A company can also access the U.S. market Global depository receipts (GDRs) are usually through a private placement of depository 50 Tapping International Equity Markets through Depository Receipts receipts, under SEC Rule 144a. So-called Rule propriate number of depository receipts and 144a depository receipts, which trade only delivers them to the members of the under- among large U.S. institutional investors, can be writing syndicate. Trading then begins. Al- used to raise capital in the U.S. market without though depository receipts are traded extensive disclosure, because the issuing exclusively in the host market, continuous ar- company does not need to register with the bitrage between the host market and the issuer's SEC. Offerings of GDRs outside the United home market tends to minimize the price dif- States are usually combined with Rule 144a de- ferential between the two markets. pository receipts. Depository receipt issues are usually marketed The choice of type of depository receipts and through a book-building route, an offering of the international markets to access depends method that leads to efficient price discovery. on the related disclosure and reporting standards Typically the lead manager, or book runner, and, if the securities are to be listed, on the builds the order book by forming a syndicate requirements of the stock exchange. Although that fans out on a marketing run among insti- ADRs usually offer higher visibility and attrac- tutional investors. The price and size of the tiveness compared to GDRs, they require higher issue are determined on the basis of both an standards of disclosure. Other factors influenc- in-house valuation of the issuing company's ing the choice include the potential demand from intrinsic worth and the bids received. Because investors and the objectives of the offering. depository receipts trade mainly among large institutional investors, shares can be sold in Process bulk and thus quickly and cheaply. An offering of depository receipts usually starts A useful advantage of depository receipt offer- with the appointment of a financial adviser-a fi- ings is that the question of foreign ownership is nancial institution such as an international invest- addressed when the shares are first registered ment bank-to manage the process. The adviser in the name of the depository institution. This is sets the number of shares to be represented by of special importance in emerging markets, one depository receipt-that is, the depository where foreign equity investment is often receipt ratio (when the Chilean telephone com- restricted. pany Compahia Telecomunicaciones de Chile, or CTC. issued depository receipts, for example, each Implementation risks-lessons from one represented seventeen common shares). The Indian issues ratio is set so that the price of a depository receipt is comparable to that of similar securities in inter- Ongoing privatization and financial liberaliza- national markets. The adviser also appoints a de- tion in emerging economies have led to con- pository bank in the host market and a custodian tinuous growth in the number of depository bank in the country of the issuer. The depository receipt offerings from these countries (table 1). bank has responsibilities relating to shareholder The amount raised and the equity share sold rights (such as payment of dividends and voting vary depending on the size of the company, at shareholder meetings), which are stated in the the privatization strategy, and financial market depository receipt certificate, and must also main- conditions. Asian and Latin American compa- tain a share register of depository receipt owners. nies have been the biggest source of offerings. The issuing company determines the number India, which has heavily relied on depository of shares to be sold in the international market receipts as a method of introducing private and delivers the shares to the custodian bank. ownership, has been one of the largest issuers The custodian registers these shares in the name of these securities among emerging markets, of the depository bank, which issues the ap- raising more than USS4 billion in capital since The World Bank Group 51 TABLE 1 SELECTED ISSUES OF DEPOSITORY RECEIPTS BY TELECOMMUNICATIONS COMPANIES IN EMERGING ECONOMIES _ 0 1 ! Depository receipts Amount raised as a percentage of Company (millions of U.S. dollars) company equity Stock exchange VSNL (India) 1997 GDR 448 17a LSE MTNL (India) 1997 GDR 360 1L LSE BPL Cellular Holdings (India) 1997 AOR 100 11W NASDAO SK Telecom (Republic of Koirea) 1997 ADR 100 .. NYSE, LSE CANTV (Venezuela) 1996 ADR 1,200 41a NYSE PT Telecomunikasi (Indonesia) 1995 ADR 540 7 NYSE, LSE Pakistan Telecommunications Corporation 1994 GDR 898 lea LSE PT Indosat (Indonesia) 1994 ADR 873 25 NYSE Telmex (Mexico) 1991 ADR 2,200 15 NYSE CTC (Chile) 1990 ADR 100 12 NYSE Not available. a. Estimated. Source: Company reponts and newspaper atticles. 1992. In 1997 alone Indian telecommunications BPL Cellular Holdings companies raised more than US$1 billion in depository receipt offerings. GDR issues by two BPL Cellular Holdings, which includes US NVest state-controlled telecommunications companies as a joint venture partner, operates greenfield cel- -Mahangar Telephone Nigam Ltd. (MTNL) and lular services in three telecommunications circles Videsh Sanchar Nigam Ltd. (VSNL)-accounted in India: Kerala, Maharashtra, and Tamil Nadu. for more than 80 percent of this amount. Its successful ADR issue followed a failed attempt in December 1996, an issue pulled out only hours Until recently all Indian issues were GDRs that before it went on offer. At a share price of US$16, traded on the LSE, and most included Rule 144a this initial public offering was expected to raise depository receipts. Indian companies have been USS200 million by selling 12.5 million shares, 22.3 kept away from the lucrative U.S. market and percent of the company's equity. listings on the New York Stock Exchange (NTYSE) and NASDAQ by stringent disclosure require- Where did the ADR offer go wrong? Market ments, higher listing costs, and more transpar- analysts have cited several reasons for the fail- ent accounting standards that put dubious ure. First, the issue price, initially US$16 a share, corporate governance practices under scrutiny. seemed unjustifiably high to most investors. The But in May 1997 BPL Cellular Holdings issued lead underwriters found few takers, even after US$100 million worth of ADRs, becoming the deferring the issue twice and reducing the price first Indian company to be listed on NASDAQ. to US$12 and then to US$10. The discounts, Three more companies-Bharti Cellular. JT unusual in the ADR market, made investors Mobile, and Infosys Technologies-are planning even more wary of the offering. depository receipt issues in the U.S. market. Second, investors prefer mature companies to Still, some of the Indian issues have been prob- new ventures that are about to take off. Several lematic, and the experience shows what can potential investors made their preferences go wrong if an issue is not carefully designed. known by not attending the road show. A better 52 Tapping International Equity Markets through Depository Receipts route for start-up companies is to first establish and marketing between the U.S. market and the a network, invest the company's own funds, and European and Asian markets. Two road show then approach international markets. teams circled the world twice in marketing the issue, attracting about 650 institutional inves- Third, the offering was poorly timed. Several tors from twenty-eight countries to the offering. telecommunications issues were offered in the same period, including a US$1.2 billion issue Second, with unrealistic pricing cited as the from Venezuela's CANTV, a USS450 million is- main reason for the previous failed attempts, sue from Russia's Vimpel Communications, and the government had by then realized that it a US$12 billion issue from Germany's Deutsche could not dictate the share price. It instead Telekom. The offering by BPL Cellular ilold- adopted the market-driven book-building ap- ings fared poorly relative to those of the other proach to price the issue. telecommunications companies. Investors' gen- eral cautiousness toward Indian equity issues Finally, changes in investor sentiment toward at the time of the offering may also have influ- Indian equity issues and India's improved eco- enced U.S. investors' judgment. nomic fundamentals favored VSNL's offer. A prudent government budget further boosted Fourth, potential investors were concerned about investor confidence before the offering. the financial health of BPL Cellular Holdings. The ADR offering document indicated negative net Conclusion worth, large liabilities, and operating losses of USS117 million in the year of the offering. The Depositor' receipts offer a well-established route document also contained qualifications by the for telecommunications companies in emerging company's independent international auditors. economies to access foreign capital markets. And they help improve corporate governance in these Finally, the absence of an independent regula- companies by increasing accountability and up- tory agency at the time of the offering was an- grading financial accounting standards. But ex- other reason cited for the failed ADR. When perience has shown that to guard against failure BPL Cellular Holdings concluded its success- of a depository receipt issue, much effort needs ful US$100 million ADR issue in May 1997, the to be put into choosing the right tvpe of deposi- Telecommunications Regulatory Authority of tory receipts, marketing the issue, forecasting India had just been established. investor demand, and determining the share price. Issuers cannot control all the conditions, how- VSNL ever. The health of financial markets, the sector's regulatory environment, and the overall economic Another success that followed a failure is the and political risk of the issuer's home country GDR issue by VSNL, the exclusive provider of influence the perceptions of international inves- international telecommunications services in tors and thus the success of an international public India. After two failed attempts in 1994, VSNL offering through depository receipts. successfully issued India's largest-ever GDR of- fering in March 1997, raising about US$448 mil- The New York Stock Exchange iaunchng an toatave to allow lion. The issue was listed on the LSE and was companies to list directly. several times oversubscribed. It reduced the government's ownership in VSNL to 65 percent tiohammadA. MHustafa (rnnustafa@ (15 percent of VSNL's equity is owned by In- worldbank.org), SeniorFinancialAnalyst, dian institutional investors). and Carsten Fink (cfink@w'orldbank.org.) Consultant, Telecomnmunications and Why did VSNL's 1997 GDR issue succeed? First, Informatics Division there was better balance in demand forecasting