ENERGY MARKET REFORMS

1. Buenos-Aires, July 2003 ENERGY MARKET REFORMS INITIAL THOUGHTS & RESULTS Jean-Marie Bourdaire

2. CONTENTS A personal compilation of the views of the WEC study group on different aspects of energy (electricity & gas) market reforms • I. The broad context of reforms • II. Empowering end-users • III. Ensuring security of supply • IV. Making good compromises • V. Caring for the poor

3. PART I THE BROAD CONTEXT OF REFORMS

4. THE DYNAMICS OF DEVELOPMENT • Legal: property rights, gender equality, rule of law • Society: education, health, social justice • Infrastructures: energy, water, telecommunications This institutional framework has to evolve. They need to adapt to sustain the pursuit of economic development

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

6. ENERGY ACCESS • Energy access lies at the crossing of several • general framework conditions: • property rights (and associated citizenship) • social justice (not too inequitable society) • development of physical infrastructures Mostly a domestic problem that requires political will & courage

7. THE ROLE OF EMR • Energy access lies at the crossing of several • general framework conditions: • property rights (and associated citizenship) • social justice (not too inequitable society) • development of physical infrastructures Mostly a domestic problem that requires political will & courage

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

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

10. WHAT FORMER WEC STUDIES LEFT ASIDE • Little said on distribution and retail • No analysis made on the case of natural gas and on the “convergence”with electricity • No specific approach for the urban poor (most WEC studies on rural electric) • Very little said on network congestion • No discussion on the link between retail and security

11. THE ANSWERS WEC study will not be completed before 2004 WEC Sydney Congress. However, some conclusions already appear: • Consumers gain from competition with the largest gains possibly in distribution • Gas & electricity are not commodities: users are partly (gas) or totally (electricity) captive • Hence, wholesale markets cannot be created before understanding their workings

12. BENEFITS OF REFORMS

13. PART II EMPOWERING END-USERS

14. A FOCUS ON LDC The philosophy of market reforms is to replace the top-down utility approach by a bottom-up empowerment of end-users • Reforms are for end-users and their starting point should be the local distribution companies (LDC) • Distribution represent 30-40% of total costs, and more than 50% for the captive users of the LDC • Yardstick regulation may be combined with some competition to regulate LDC monopolies

15. COST SPLIT

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

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

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

19. THE UK EXAMPLE

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

21. FRANCHISES OR NOT? • In France, since the 19th century the public water monopoly is partly “delegated” to private sector • Private market share is growing at the expense of public managed LDC even with left governments • Introduction of privately managed franchises avoids to rely on public sector or on tightly regulated private monopolies (e.g. Transco)

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

23. PART III ENSURING SECURITY OF SUPPLY

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

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

26. LT CONTRACTS The most natural incentive to provide security, reliability and diversity is to have to minimize the LT cost of penalties in case of non-delivery • Electricity and natural gas, having captive users, should not be seen as pure “commodities” • Free wheeling does not allow suppliers to know what possible liabilities they face • But LDC captive users are well identified & the obligation to serve can then be monetized

27. SECURITY OF SUPPLY TOOLS • Interruptible customers: • Diversified portfolio: • Price responses: • Incremental supply:

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

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

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

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

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

33. PART IV MAKING GOOD COMPROMISES

34. ELECTRICITYTRADE-OFFS Electricity is not a true “commodity” because its users are mostly captive, and is not either a true market because of its monopolistic sectors • First trade-off: security of supply versus freedom of supplier choice for the captive sector? • Second trade-off: competitive wholesale market with many (> 10) actors versus “single buyer”? • Third trade-off: cyclical prices & market power episodes versus capacity payments?

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

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

37. LOYAL COMPETITION OR MARKET POWER? Loyal competition is often difficult to develop • Too few actors: large incumbent dominate the market and exercise market power • Overcapacities are too small or inexistent as it happens in many developing countries • There are too many markets and opportunities for cheating (day-ahead market, several intra-day markets, markets for differences, reactive power, other ancillary services, etc…)

38. INCUMBENT SHARE IN CONTINENTAL EUROPE

39. NATURAL GASTRADE-OFFS Wholesale natural gas is a commodity because large users, including LDC, compete among themselves and with other fuels at the margin • First trade-off: security of supply versus freedom of supplier choice for the captive sector • Second trade-off: transportation over-investment versus the creation of isolated local niches • Third trade-off: relevant, yet volatile, spot prices or long-term contracts with indexed prices

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

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

42. CONGESTIONS:COMPETITION OR NOT? Congestions, e.g. in California, create niches: little/no competition and much market power • The historic legacy of state markets is at the origin of too small inter-connections • The choice is to increase inter-connections (30% of state markets) or to avoid competition • PJM (nodal pricing) or Nordpool (bidding) are not convincing examples

43. PART V CARING FOR THE POOR

44. MARKET REFORMS AND ACCESS Pricing & access are central to WEC’s concerns. “Market Reforms” study concentrates on the poor accessed by the network (“urban” poor). • No sustainable growth exists without access • Yet, access has not much improved since 1973 • Market reforms as an additional momentum

45. ACCESS

46. HISTORIC ENERGY EVOLUTION

47. FOR 30 YEARS, ACCESS HAS NOT IMPROVED • Access to modern energy had been regularly improving up to the first oil shock • But since 1974, the market share of traditional energies has remained constant at about 11% • ~ 1/3 of the world population has no access or insufficient access to modern energy • Market reforms should aim at creating the adequate framework for improving access

48. WEC’S VIEWS Caring for the poor is not a morale imperative only. It is also an economic imperative to ensure stable, peaceful, and sustainable growth. • Subsidies are generally not sustainable on the long-run and may work against their beneficiaries • Yet, energy costs are a larger share of budget expenses for the poor than for the wealthy people • Hence the need to find approaches that are fair and sustainable on the long-run

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

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