Deregulation of Electricity in India -3

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