2.6
Operational Models
For the purposes of this study, four models have been
constructed to describe the prevailing range of situation. The models have been
largely adapted from the excellent study on competition and choice in
electricity markets undertaken by Experts. Although these models can be viewed
as sequential, with the full competition model representing the end-point of
full competition with the least regulatory distortion, other models may be more
suited to the conditions existing in some economies. The models are described
in terms of their major characteristics:
- Vertically-integrated monopoly
- Monopsony
- Wholesale competition
- Full customer choice
Understanding the generic functions of the electricity
sector allows us to see the value added by each function and to construct a
framework for evaluating different theoretical models of the industry.
Governments contemplating changes in their national monopoly electricity
sectors have a broad range of issues to consider. These include changes in
management and ownership, and changes in structure, introducing competition and
choice. The introduction of fully competitive energy markets through
desegregation and privatization could be considered an end-point of reform
changes, especially if the intent is to maximize economic efficiency and
private capital availability. The box below describes in broad terms some of
the processes associated with reform of the electricity supply industry.
2.6.1 Vertical Integrated
Monopoly Model:
Characteristics:
In this model, there is no competition and no consumer
choice. Typically this model is characterized by the existence of one
vertically and horizontally integrated system. In some cases, a number of
vertically-integrated monopolies may exist, but each has their own separate
franchise area of operation – usually mandated in law.
The monopoly utility owns and operates all generation
plants, and transmission and distribution networks. It may be under an
obligation to supply consumers, but consumers for their part are captive and
have no choice of supplier. The service area may be national in coverage. The
utility is usually also tightly regulated – usually through price control.
Advantages:
Historically, this model developed as a logical way of
dealing efficiently with a number of the rather unique characteristics of the
electricity supply industry at a time when rapid industrialization required
rapid growth in supporting infrastructure. Electricity is physically more
complicated to deliver to final consumers than most other goods. Transmission
requires split-second control to coordinate supply and demand at any moment. In
the early days of development of an electricity infrastructure, it was easy to
imagine, and argue, that generation, transmission and distribution were
intimately inter-related, were natural monopoly components of the overall
supply system, and best handled by a single monopoly structure. This approach
also allowed for the construction of large-scale generation plants and
transmission systems at a time when economies of scale were important in the
industry.
This model allows subsidies and cross-subsidies - as there
is no competitive market - as well as investment in public goods such as rural
electrification and distribution of power to poor communities.
 |
| Fig 2.4 Flow chart of Vertical Integrated Monopoly Model |
Disadvantages:
The shortfalls of a vertically-integrated monopoly
structure have really only become evident in recent years, and in economies
with relatively large and mature electricity supply industries. With
technological advances allowing for the construction and sitting of
smaller-scale generation plants closer to demand centers, advances in
information technology, the deregulation and development of competition in
other infrastructural industries, and the realization that the sale of the
product (electrons) can be separated from the means of transport, it has become
increasingly difficult to sustain the argument that a vertically-integrated
monopoly structure is the only way of structuring the electricity sector. The
major deficiencies of the vertical monopoly structure that have been identified
include: a lack of incentives to improve services and lower costs; a lack of
transparency; poor investment decision-making; “gold-plating” of
infrastructural components; and political interference.
Transitional
Issues:
Dismantling the above monopoly structure normally will
involve separating out the potentially competitive generation, wholesaling and
retailing elements from the natural monopoly elements of transmission and
distribution. The difficulties in achieving this depend on who owns the assets
to begin with, what regulatory regime will be instituted to deal with abuses of
market power, and what subsidies and cross-subsidies exist.
In the US and Canada, where utilities are largely privately
owned and operated, substantial hurdles have existed to electricity industry
reform. Because private capital was involved in the creation of the system, and
this capital was heavily influenced by decisions made by regulators, there are
many political, financial and legal thorns involved in unbundling the system.
Where the electricity supply industry was owned and operated by governments on
behalf of all taxpayers, the issues are easier to deal with. Provided the
separation process is achieved prior to any privatization, it is a relatively
straight-forward matter to disaggregate the system and put in place the
regulatory requirements under which the competitive markets and natural
monopoly elements will operate.
2.6.2 Monopsony Model:
Characteristics:
This model may be considered as a first step towards
deregulation, and is actually quite common in India. One or several
vertically-integrated monopolies still control the sector, but some private
investment is made possible by licensing Independent Power Producers (IPPs) to
build generation capacity. These may be created from existing utilities by
divestiture, or they may be new producers who enter the market when new plant
is needed.
With this model, it is possible to have competition in
generation, with a single buyer purchasing the wholesale electricity. In
reality, this may not happen; instead each IPP might negotiate a separate
long-term Power Purchasing Agreement (PPA) with the respective government,
often on terms quite favorable to the IPP. Another possible problem with PPAs
is that they are often structured so that the energy payment is designed to
match, as accurately as possible, the marginal cost of running the plant.
Setting energy payments to actual costs incurred gives the generators poor incentives
to reduce these costs.
The vertically-integrated utility may encourage competition
at the generation level, but still has control over transmission and
distribution. Retail consumers are still captive.
Advantages:
The major advantage of this model is that it allows for
direct inward investment by private investors, and allows investment risks to
be shared. This can be particularly desirable where emerging economies are
struggling to meet all social priorities out of the public purse. This model still
allows governments to use the electricity industry to meet social policy
obligations and create public goods, as there is still no competitive market at
the electricity retailing level. An important social policy objective common
for both this and the previous model, is an “obligation to supply”. Although
consumers cannot choose their supplier, or generate their power usually under
these models, it is common for the utility to be obligated to supply all
consumers, even those in remote areas. It is also possible to maintain uniform
tariff pricing to all consumers, regardless of their remoteness from major
centers of supply or the transmission grid.
Disadvantages:
This model suffers the same problems as the previous model;
there is no competitive market, so it is difficult to maintain economic
efficiency. Another potential problem can arise if the single buyer
discriminates unfairly between generators.
Transitional
Issues:
The purchasing agent should ideally be independent of the
owners of generation, but this is not usually the case when an economy moves
from the VIM model to this one. The problem arises where the purchasing agent
is accused of discriminating in favor of its own generation facilities. Against
this is the fact that the purchasing agency is taking the market risk in this
model (as sole buyer, usually under long-term contracts), allowing IPPs to be
financed with high proportions of debt. This can allow IPPs to keep their
overall cost structures down, and hence be more competitive than the incumbent
utility.
 |
| Fig 2.5 Flow chart of Monopsony Model |
If the utility is also the system operator, and is
responsible for the dispatch of contracts, there is considerable potential for
conflict if the utility uses its position to discriminate against other
generators. This is the reason there has been strong support in the US for the
formation of Independent System Operators (ISOs). An ISO can manage the
dispatching function, or have overall responsibility of the management of the
whole transmission system. This would be a further step towards sector reform,
and would be more adequately accommodated under the Wholesale competition
model.
Despite the potential problems, the Monopsony model can
represent a good transitional structure, where the sophisticated arrangements
needed for a more complete market structure are not in place and would be hard
to establish. For example, an economy where there are as yet no reasonable
accounting systems in the industry, proposing a more complicated model may not
make sense.
2.6.3 Wholesale Competition
Model:
Characteristics:
This model allows a distribution company that retails
electricity to consumers to choose their supplier. This brings competition into
generation and wholesale supply. In this model, separate distribution companies
purchase electricity from any competing IPP generator. The distribution
companies maintain a monopoly over energy sales to the final customers (usually
within franchise areas). As there is no longer a single buyer, the market and
technology risks are pushed back onto generators, who in return have open
access to the transmission network. In this model, an existing generation
company has to compete against new entrants. The ability of governments to
direct the choice of new generation technology is, by and large, no longer
desirable or necessary.
As there can now be a power pool or wholesale power market,
it is possible to have a relatively competitive wholesale trading market, where
the cost structure of generators is determined by the electricity wholesale
price. It is still possible with this model, to have relatively few traders,
and have “wheeling” contracts where distribution customers and generators make
bilateral contracts to move power from one utilities’ transmission system
through that of its competitors. Without very heavy regulation, this form of
operation is difficult because of the intrinsic conflicts of interest in a
transmission owner opening his network to his competition to steal his
customers.
There is still monopoly market power in the sector, as
final consumers still have no choice of supplier. This allows for the delivery
of certain public goods at the retail level, and some subsidies can be
maintained, although it limits the form in which they can be imposed.
Advantages:
As the choice of generation assets (in terms of capacity
additions and fuel type) is left to the market, economic efficiency can be
improved, and risks transferred from government to private investors. Although
investors may seek a long-term contract before building generation capacity,
the existence of a wholesale electricity market (which normally includes a spot
market) means that such contracts are not essential.
The importance of this model lies in the fact that a
decision to introduce wholesale electricity competition indicates that
policy-makers have taken the important philosophical step of rejecting heavy
handed regulation as an adequate tool to manage the sector, and have instead
taken the leap of faith that competition can be introduced into the electricity
supply industry, and that social and economic benefits will flow from this
decision.
Disadvantages:
The ability of generators
to accommodate social policy obligations connected with generation virtually
disappears under this model.
 |
| Fig 2.6 Flow chart of Wholesale Competition Model |
Transitional
Issues:
Because generation assets are being valued by the wholesale
market (in terms of their comparative competitiveness), the issue of stranded
costs begins to arise.
This model represents only a partial step towards the
introduction of competition in the electricity supply industry. Consumers are
still captive, and so the full economic benefits of a fully deregulated market
are not achieved. However, once the introduction of competition at the
wholesale level has been achieved it becomes easier to devise the means to
introduce competition at the retail level, and this step usually follows soon
after the introduction of a wholesale market.
2.1.4 Full Customer Choice
Model:
Characteristics:
In this model, competition has been introduced into all
levels of the industry, ideally from wholesaling down to individual domestic
consumer. A key component of this model is direct (or third party) access to
transmission and distribution networks. With the right regulatory structure in
place, any electricity consumer should theoretically be able to purchase from
any retail supplier, who in turn is purchasing electricity from a competitive
wholesale market.
Ideally, the network functions of transmission and
distribution (natural monopolies) are completely separated from the functions
of generation and retailing. Dispatch can be handled by the transmission
network owner, but where more than one transmission network exists, this is
best handled by an ISO.
With this structure, there should be free entry by firms
into the competitive functions of generation and retailing. For example, in New
Zealand the only impediments to investors building generation capacity are
environmental requirements under the Resource Management Act. There are no
permitting or licensing requirements. This allows anyone, including
householders, to build their own generation plants.
The wholesale market operates as an auction, buyers and
sellers meet and exchange goods (electrons) on the basis of longer term
(hedged) contracts and spot contracts. There is no single buyer. The operators
of the market never own the power and never assume the market risk; they merely
act as auctioneers, making their income from the transactions.
Advantages:
The advantage of this model is that it optimizes economic efficiency;
at least once the regulatory regime has been optimized to minimize any market
imperfections and control abuses of market power.
The experiences of economies where this model has been
introduced suggest that a number of benefits become obvious. Firstly, costs in
the generation sector are driven down substantially, and this usually is
expressed in lower retail tariffs. At the retail level, competition is
beginning to become evident, with the range of goods and services being offered
by electricity retailers increasing in both quantity and quality.
Because of the competition in the generation sector, the
utilization factors of individual plants are driven up as non-competitive plant
is decommissioned or revamped, and planning is better optimized to match
incremental increases in demand. Driving this has been advances in technology,
in particular the CCGT.
Disadvantages:
As with the previous model the ability to use the electricity
sector as a tool to deliver social policy obligations disappears under this
model. If there is a need to provide power to poor and/or isolated communities,
or to promote a certain sector of the economy (such as industry), this has to
be handled using other, market oriented, social policy tools.
It can be argued that the transaction costs involved with
managing the contracting aspects of this model are not negligible. The response
to this is that advances in material and information technologies reduce such
costs sufficiently to ensure that the overall benefits of full electricity
market competition outweigh the disadvantages of increased transaction costs.
With this model, firms in the industry are free to engage in joint venturing,
acquisitions and other market activities. If the initial market conditions are
sub-optimal after reform, significant firm-driven industry restructuring can be
expected, including vertical and/or horizontal re-integration. The job of the
regulators is to ensure that individual firms do not acquire excessive market
power, or engage in anti-competitive behavior.
Transitional
Issues:
A
substantial issue still under development is that of metering. With the
possible introduction of sophisticated meters in individual households in the
near future, the demand side management, and customer choice issues could be
dealt with by technology. Consumers may be able to optimize their end-use to
take advantage of lower tariffs in certain periods, and be better placed to
shop between retailers. The stranded costs problem, if it exists, becomes much
more acute under this model.
 |
| Fig 2.6 Flow chart of Full Customer Choice Model |
Model of Power
Sector Structure
|
VIM Model
|
M Model
|
WC Model
|
FCC Model
|
Definition
|
Monopoly
|
Monopoly
|
Competition among power generators
|
Competition among power generators
|
At every level
|
With single buyer
|
Plus choice for distributors
|
Plus choice for distributors
|
|
Competition in Generation?
|
No
|
Yes
|
Yes
|
Yes
|
Retailer choice?
|
No
|
No
|
Yes
|
Yes
|
Customer choice?
|
No
|
No
|
No
|
Yes
|
Table 2.1 Characteristics of theoretical power sector models
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