Implementing best practices in electricity sector evolution in Saudi Arabia

1. Implementing best practices in electricity sector evolution in Saudi Arabia Prepared by: A.J. Goulding ajg@londoneconomics.com November 6, 2006 Riyadh, Saudi Arabia

2. Key messages • Restructuring will strengthen the Saudi electricity sector, and create a set of vibrant new entities • Saudi Arabia is able to learn from the experiences of other jurisdictions, and improve upon global best practice • Tariff design process has been specifically designed to allow the maximum degree of flexibility in future market design • Whatever arrangements are decided upon, they must provide revenue sufficiency for efficient providers • Overall structure should embody incentives for efficient production, transportation, and usage of electricity • Suppressing tariffs in the short run inevitably leads to even more difficult policy choices in the long run

3. Plan of presentation Best practices in electricity sector restructuring Creating an independent grid company Using a Principal Buyer to provide stability

4. Vertically integrated self regulated monopolies often starting point for restructuring VERTICALLY INTEGRATED MONOPOLY • Vertically integrated quasi-self regulating monopolies were the starting point in many jurisdictions: • Chile • Colombia • Hungary • Italy • Poland • Romania • Singapore • UK (England and Wales) • …many others… • Often, internal transfer pricing not even established appropriately Generation IPP contracting Transmission Network O&M Potentially competitive sector Distribution Retail Metering Billing and settlements

5. Strong, independent institutions are at the heart of a successful restructuring process Case study: initial E&W structure Key success factor checklist • Competent regulator with clear mandate • Phased in process of market opening • Multiple gencos created • Contract cover stabilizes prices during transition • Policymakers able to ride out periods of price volatility • Performance based rates for monopoly elements • Attention to affiliate abuse issues Central Electricity Generating Board evolved into Office of Electricity Regulation Gencos Regional wire companies National Power Transmission 1 7 National Grid 2 8 PowerGen 3 9 British Energy Power Pool 4 10 Price discovery 5 11 6 12

6. Saudi Arabia can draw upon twenty years of restructuring experience Offer established (regulator) Electricity sector unbundled Open access to grid established NETA replaces power pool Full retail competition BETTA implemented UK 1983 1989 1998 2001 2005 Victoria electricity market established NSW and Victoria full retail competition NSW electricity market established NEM begins operation AER established Australia 1994 1996 1998 2002 2004 New electricity law – sector unbundled Last govt. –owned utility privatized CNE (regulator) established CDEC (power pool) created Privatization process begins Chile 1978 1982 1986 1998 Electricity Utilities Act –deregulation AEUB (regulator) created Power pool begins operation Retail competition introduced MSA created Alberta 1995 1996 2001 2003

7. Benefits of restructuring arise from several sources In Singapore, restructuring resulted in a more efficient use of fuel • In 2000, oil accounted for 77% of generation • In 2005 the more efficient natural gas accounted for 70% of generation output • Resulted in a5% increase in gross system efficiency • Innovation in product offerings and delivery • Reduced costs and prices of generation and supply • Improved resource utilization and allocation, through improved economic dispatch and generation planning (medium- and long-term) • Reduced conflict of interests in the regulatory process After restructuring, the UK witnessed annual electricity sector productivity gains of 3.5%

8. Cause of most accidents: • over-power, • over-brake, and • over-steer Failures were a result of poor regulatory decisions, not of markets Flaw/Jurisdiction • Insufficient number of generators created/UK, Ontario, Italy, France • Prices to final consumers held below cost/California, Ontario, Maryland, Argentina • Transmission not independent/most of US, Germany • Failure to honor regulatory contracts/California, Argentina Policymakers tend to forgot the first lessons from Driver’s Ed 101

9. Plan of presentation Best practices in electricity sector restructuring Creating an independent grid company Using a Principal Buyer to provide stability

10. Independent grid companies are the norm in many well-designed jurisdictions Jurisdiction Entity Setup date Primary role Transmission owner & system operator UK 1990 Transmission owner & system operator Spain 1997 NED 1998 Transmission owner & system operator AUS 1996 Transmission owner Transmission owner & system operator BC 2003 Transmission owner Chile 1993 Transmission owner Michigan 2002 Transmission owner & system operator Italy 1999

11. US shows the drawbacks of failing to force full separation of transmission and generation • Some companies accused of deliberate underinvestment in grid so as to prevent access for competing generation • Preferential knowledge of planned expansion • Risk that gridco may favor affiliated gencos for connections • Constant suspicion that transmission capacity reservations rigged Substantial number of the transmission challenges have been in the Southeastern US

12. Newly formed gridcos may take on a variety of roles, including system operations Process for choosing new transmission providers: • 10 yr system plan approved by regulator • RFP issued on BOOT basis for new corridors • Technical and financial phases to bidding • Bids consist of 40 year stream of payments • Lowest NPV chosen • Some performance standards apply • No need to set efficient opex or choose cost of capital • Own and maintain existing transmission lines • Coordinate flows across the entire transmission system, including lines owned and maintained by others • Create 10 year generation and transmission system plans, updated annually and with major assumptions examined and revised every five years • Provide system access under non-discriminatory, transparent, and economically rational tariff • Assist in implementing pilot market and ultimately spot market • Coordinate with Principal Buyer regarding solicitations for new generation and transmission

13. Gridcos can be established in a one to two year period with careful planning • Gridco creation process typically occurs in two major phases • Phase I is the period when the new gridco is granted time for organizational purposes before it officially takes on transmission operations ~ 3 months – 1 year • Phase II is the period it takes the institution to become fully independent ~ 7 months – 2 years

14. Calculated as the transmission revenue requirement divided by available capacity Designed so that if all customers were to migrate to wheeling, the entire transmission revenue requirement would be recovered Increase in wheeling revenue decreases transmission cost of captive load Denominated in currency/MW-month and has peak/off-peak differentiation Steps to setting up gridco are straightforward, and may coincide with start of wheeling tariff Gridco setup Create independent company Hire staff to operate system control room Physical separation of system control room Process 1 Step 3 Step 1 Step 2 Identify transmission assets and their book value Hire efficient number of staff from SEC Transfer assets and staff to gridco Process 2 Wheeling tariff

15. Plan of presentation Best practices in electricity sector restructuring Creating an independent grid company Using a Principal Buyer to provide stability

16. Principal Buyers focus on sector stability and market development POSSIBLE PRINCIPAL BUYER KEY RESPONSIBILITIES • Serve as counterparty to existing PPAs and new ECAs • Procure new generation and transmission through competitive auction process until market is sufficiently robust • Schedule power via gridco to meet captive load • Purchase fuel necessary under ECAs • Remarket capacity under contract consistent with the schedule for market opening • Promote and implement demand response programs • Be the recipient of any subsidies necessary to assure financial viability of the sector Principal Buyers often remain in existence longer than their creators intend, though sometimes their role becomes simply the management of residual contract obligations • Principal Buyers we will hear about today: • Ontario Power Authority • Northern Ireland

17. Principal Buyer staff will need to have a fundamental knowledge of economic and financial drivers of the electricity business Staff background to be in finance/trading rather than engineering Contract administration and procurement experience will be crucial Principal Buyer staffing may require unique skill sets Step 1 Step 2 Step 3 Legal establishment Obtain ECRA license Staff hiring Step 4 Step 5 Step 6 Establish credit arrangement Establish flow of funds Creation of ECAs

18. Independence and strong credit are essential for a successful Principal Buyer • In nascent markets with history of below cost tariffs, sovereign support may be necessary • Principal Buyer should still be subordinate to regulator, and operate in a transparent fashion • Procures according to plan developed by gridco and approved by regulator • Provided auction competitive contracts incorporated into rates • Non-contract operating costs subject to periodic scrutiny • Government must resist temptation to bypass institutions once they are created

19. Concluding remarks • Properly done, restructuring can make Saudi Arabia a regional electricity hub, providing benefits in reliability and pricing • Revenue sufficiency is important component for long run success of restructuring agenda • Stakeholder education and human resource development also essential • Biggest lesson from international experience is that “big bang” approach does not work; process must be deliberative but steady • At the same time, the alternative of simply throwing more money into existing structure may also be suboptimal • Over the near term, restructuring effort should not obscure focus on reserve margin and investment planning

20. Background on presenter

21. LEI provides global perspective on electricity sector restructuring A.J.Goulding Economic, financial and strategic advice to the energy and infrastructure industries • President of LEI • Experience advising regulators worldwide, including Eastern Europe, North and South America, and Asia • Professor at Columbia University • Working with private equity funds investing in power sector assets • Testified as expert before a number of legal and regulatory bodies • Firm is currently in midst of multimillion dollar engagement to design generation procurement process for state of Connecticut • Performed Industry Structure Review in Alberta • Australian counterpart and team member is former regulator • Firm’s power sector asset revenue projections have supported financings for billions of dollars of investment Our Saudi partners at Al Hoshan and KFUPM have also made a large and valuable contribution to our team