Deregulation of Electricity in India -4

2.7           Economic Consideration

2.7.1    Introduction:

The regional trend of electricity sector reform is being driven largely by the perceived benefits in terms of improved economic efficiency, lower electricity prices, and access to much needed capital to fund infrastructural growth. Apart from a few cases, reform is replacing vertically- integrated structures with ones in which there are vertically and horizontally disaggregated competitive elements.

While the maximization of economic efficiency is a primary goal, security of supply is another interacting consideration of some importance. In developed economies with established energy infrastructures, demand growth tends to be relatively low, and in many instances significant generation over-capacity has existed over the last few years. With market liberalization, this reserve capacity has tended to diminish substantially, leading to public concern about supply security, especially with respect to potential disruptions (which can result from abnormal weather patterns, natural hazards, or a mechanical failure of some kind in the supply system). In developing economies, security of supply is also a major issue, but for a different reason. In many cases, capacity growth can’t keep up with the potential demand, and an urgent requirement exists to draw more capital into the sector to improve the adequacy of the electricity supply system, and hence supply security. Market liberalization in this situation, may be seen as a means of increasing investment in the sector, and hence bolstering security.

2.7.2    Conventional Electricity Sector Structure:

Historically, it has been assumed that a vertically-integrated, state-owned monopoly would deliver electricity at least cost, and with the greatest degree of security. Because electricity was considered a strategic asset, and security of supply was vital during the industrializing process, there was some merit in this idea. It also made sense to believe that it was much more efficient to have electricity dispatched and delivered by internal commands within one organization. This idea was rooted in the fact that electricity is no ordinary product – the electrons cannot be stored in large quantities, and supply must match the load from instant to instant to maintain the voltage and frequency within acceptable limits.

In a vertically-integrated business, costs are internalized. Vertical desegregation raises the issue of the transaction costs imposed by the need for upstream to downstream products and services to be negotiated through contracts.

2.7.3    Efficiency Gain in Competitive Market:

Although vertically-integrated, bureaucratic structures can be efficient at undertaking certain functions, significant inefficiencies can creep in over time due to the lack of competitive pressure and efficiency benchmarks, and a lack of transparency. Because of the nature of the electricity industry, requiring a high degree of contingency capability, the generation capacity of state operated systems in many economies were typically “gold plated”. Many instances can be found where generation facilities existed solely for contingency purposes, and to manage infrequent peak demand situations.

Another source of cost reduction relates to fuel choice, and more specifically to attempts to maintain security of supply by favoring one particular fuel through subsidization. When a cheaper fuel becomes available, regulations designed to protect certain fuels become an obstacle to overall cost reduction. Coal has usually been protected through subsidies on price, or through regulations preventing alternatives. In the UK prior to deregulation, the relatively expensive domestic coal was subsidized, and gas was barred from use in generation. After deregulation, the “dash for gas” brought about not only a large shift from coal-fired generation to gas combined cycle generation, but substantial savings in fuel costs.

There are also considerable cost savings possible from improvements of performance in the existing generation, transmission and distribution system. In the past, little incentive existed to replace old, inefficient plant, as costs were not overly transparent. Generation plants have traditionally been kept in operation well past their commercial lifetime, which can be long anyway, so, a lot of old infrastructure exists in the sector.

Of great significance today in the sector are the efficiencies now available through recent technological advances. Combined cycle gas turbines are available “off-the shelf” at much lower capital cost per MW than most other forms of plant. These allow small-scale units to be quickly installed, and providing the gas is available, allow for flexibility in sitting. CCGT plants are leading the trend towards more distributed forms of power, a trend that may gather significant momentum in the decades ahead, with consequences for the established network infrastructure.

Technology has also had a very large impact on the processes of dispatching and wholesale pooling. Wholesale markets can now be set up easily and cheaply, and can be operated at a distance using the Internet and other electronic means of communication. As long as the market participants agree to the rules, it can operate with high efficiency. Dispatching can be handled just as easily and efficiency, regardless of firm ownership.

2.7.4    Power Supply Industry Cost Structure:

The power generation sector has the largest share in terms of total electricity supply cost, and so is likely to be the major source of cost reduction. As seen in the table below, in case of the practical ways, the generation sector shared about 65% of the total supply cost of electricity.

Function	Fraction of Total Cost
1. Generation	65%
2. Transmission	10%
3. Distribution	20%
4. Supply	5%

Table 2.2 Structure of the power sector supply chain

 

2.8 Stranded Costs

2.8.1    What is stranded Costs?

Stranded costs can be defined as costs utilities have incurred historically, but may not be able to recover in the prices they are able to charge as a result of policy changes. In order to meet national and public service obligations, many utilities, both public and private, have made substantial investments - including the construction of nuclear power plants. A significant percentage of this investment may not be recoverable in a competitive environment. The term, ‘strandable’ may be more suitable than ‘stranded’ as some part of past investments may be recovered over time.

In all states the level of utility profit was tied to the level of capital investment made by the utility. As profit would increase with amount of invested capital, utilities had an incentive to maximize their capital investment, so long as they could show that it was “prudent” and providing benefits to consumers. Given this regulatory framework, not all utility expenditures have been wise investments. Stranded costs represent a significant policy problem, especially where attempts have been made to recover these costs over the short-term by allowing retail electricity prices to rise significantly above marginal costs. The difference between the current low marginal cost of electricity generation and existing tariff rates set to cover the past investment has been a major driving force for the introduction of competition. As the difference becomes greater and more apparent, consumers are likely to leave incumbent electric power suppliers in an attempt to lower their electricity bills. In this case, the investment cost may not be recovered by those utilities that made large capital investment in generation and networks under a past regulatory regime.

Stranded costs are of great importance to economies in transition to competition because the financial burden can be very large, no matter who bears it. If government is held responsible for the debt such as in the ‘regulatory compact’ argument, it would be redistributed as a tax on all citizens. If electricity consumers are forced to pay the debt (through higher tariffs), this creates an un-level playing field with respect to new entrants not burdened by these costs. The utilities straddled with this burden under free market conditions will likely suffer serious financial losses, possibly leading to bankruptcy.

Classic examples are nuclear power plants in the United States. Early retirement of most nuclear plants to date has uncovered a number of factors that deserve attention. One problem is the inability to collect funds for the decommissioning of plants that have been (or will be) retired early, preventing the accumulation of sufficient funds to manage the decommissioning process. This problem exists largely because of a gross underestimation of decommissioning costs. For example, interim waste storage costs have not been adequately reflected in decommissioning trust funds in the United States, and nuclear decommissioning liabilities in general were not financially covered. As seen in the case of the decommissioning of Yankee Rowe in Massachusetts, which was retired early, the cost over-run in decommissioning created serious financial problems for utilities as well as regulators.

Some economies may face the stranded costs problem with respect to nuclear plants sooner or later. In particular, nuclear power generation, and may find it difficult to avoid this issue in the future if these plants prove to be uneconomic in a competitive environment. The problem could be heightened if nuclear power plants must be shut down earlier than originally planned, for reasons other than economic ones.

2.8.2    Types of Stranded Cost:

There are four main types of stranded costs. The first results from a combination of increased competition and technology development, which brings in new competitors with cheaper electricity production capacities than existing plants. These new competitors could put old plants out of business by charging customers less for the electricity generated.

The second type originates from long-term fuel or power purchasing contracts with governments to which regulated utilities are committed to ensure security of electricity supply. As competition could provide lower cost alternatives, those utilities tied to uneconomic obligations would inevitably be faced with higher input costs, resulting in loss of earnings. Eventually this will make cost recovery difficult.

The third type is associated with “regulatory assets.” Regulatory assets are an assortment of regulator-approved ‘extended payment plans’ for certain kinds of large expenditure incurred by regulated utilities. Easing utilities’ financial obligations from such expenditure, regulators allow them to amortize costs over an extended period of time. However if the regulatory regime changes during the middle of the amortization period, utilities may not be able to complete the amortization due to deregulation-induced low prices.

The fourth type of stranded costs are miscellaneous public-policy programs ranging from Demand Side Management (DSM) programs paid for by all customers, and support for energy research and development. Investment in all these policy programs would be stranded as their cost recovery becomes impossible after deregulation.

2.8.3   Stranded Cost Estimation:

Stranded costs are differences between the projected and realized net values of an investment, taking into account revenues and expenditures, which come into being where retail electricity prices are above marginal costs. When utilities cannot produce electricity at prices equal to marginal costs, customers are likely to leave them for other utilities, putting investment at risk of being stranded.

Fig 2.7 Graph between RR and MV

Estimation of stranded cost seems simple, but is complicated in practice due to a number of factors. Among them are the projected market prices of electricity, operating and maintenance costs including fuel prices, interest rates, technology development, and government regulations, to list a few. For example, rising fuel prices for inefficient facilities3 would shift the RR curve in Figure upward, which will lead to higher stranded costs. The same is true of rising interest rates. Thus projections of stranded costs for a single economy could vary widely with assumptions about these variables.

Stranded cost could be calculated with the following formula:

Stranded Cost (SC) = Required Revenue (RR) – Market Value (MV) – where;

RR = g{Load Factor (-), Fuel Cost (+), Interest Rates (+), Deferred Cost (+), etc}, and

MV= f{Avoided cost (+), Costs for new entrants (+), etc}

2.8.4   Who Should Bear The Cost:

Presuming that stranded costs are incurred as a result of regulatory changes, the question of who should bear them becomes a key policy question. The utilities who made investments under pressure from regulatory agencies - over and above what would be prudent in a free market - and who are looking to recover these costs to the greatest extent possible, argue that they must be fully compensated, because the investment decision was forced on them at the request of governments.4 At the time of the investment, an ‘implicit social contract’, was made to ensure full recovery of investment costs. Contracts, however detailed, cannot cover all contingencies, mandating cost recovery in the event of a regulatory regime change. Further it has been argued that deregulatory actions constitute the government’s taking of private property, which was prohibited under the Constitution’. This is known as a “taking” argument in favor of full recovery of stranded costs.

Regulators have argued that the chance of non-recovery of costs was just as implicit in the contract because contracts (in these case, franchise agreements) do not explicitly specify liability for stranded costs. Further they claim there is evidence in the contracts made under regulation that regulators never prevented utilities from recovering costs, but on the contrary encouraged this. The existence of contracts that specified a minimum term for customers to stay with a particular utility or face cancellation charges for service termination has strengthened their argument.

There is no easy solution to this issue as every contract was made under different circumstances, and interpretations even with respect to a particular contract could differ quite substantially. Both legal and economic reasoning could help address this problem. On a spectrum between no compensation and full compensation, most experts take the middle ground, suggesting that there is an implicit deal in the contract, but it does not necessarily imply a guarantee of full recovery for the investment made under regulation. In a nutshell, a general view is that the size of recoverable costs should be determined on a case-by-case basis, depending on the specific attributes, and without discouraging cost saving efforts by those who want compensation. If a fixed rule for cost recovery is applied, utilities may simply shift costs into the account of stranded costs.

2.8.5   How to Pay for Stranded Cost:

There have been a number of studies on the ways to recover stranded costs. The most important factors for consideration include the economic consequences, both in the short and long run.  Given the economic situation there are a number of ways that have been implemented or suggested. There are other methods of collecting stranded costs. It is possible to view these strategies from the perspective of whether they are transaction or non-transaction related. The classification is as follows:

Transaction-Related Recovery Devices:

·         Access charge tied directly to continued transmission or distribution service

·         Exit fees charged to departing customers but unrelated to costs incurred on behalf of those customers

·         Exit fees charged to departing customers and calculated to recover costs incurred on behalf of those customers

·         A share of net generation savings realized by departing customers over time

Non-Transaction-Related Recovery Devices

·         Shifting costs to captive customers

·         Charging ratepayers above-cost prices where market exceeds cost

·         Accelerated and decelerated depreciation

·         Price cap on performance-based rates

Broader Bases

·         Entrance fees charged to new generation

·         All sellers pay a per-kWh tax on generation

·         Taxes to include credits for financial write-downs or trust funds to subsidize buyout of contracts from non-utility generators

There is no best way for all cases. Each of the above 11 strategies has to be evaluated to determine its applicability in comparison with other strategies considering differences in economies or regions. The criteria must include consideration of static and dynamic efficiency, consistency with evolution to a competitive market, consistency with regulatory and difficulties in implementation.

2.8.6   Security of Supply:

 The question of supply security has been much debated within economies undertaking electricity sector reform. Two issues are important, the securing of long-term supplies of generation fuels at affordable prices, and the reliability of the electricity system. The maintenance of adequate generation reserve capacity is a component of the system reliability concern.

The introduction of competition into electricity generation results in strong pressure to reduce investment and operating costs. The incentives to void over-building and over-designing power plants, and to reduce operation and maintenance costs, raises the possibility that reserve capacities could drop to levels well below what is prudent to manage contingency situations.

Arguments about reserve capacity can be considered a component of long-term reliability, which requires the planning and the construction of enough aggregate capacity (generating and network) to balance total demand and supply at prevailing prices at all times. Short-term reliability requires adequate reaction to load fluctuations over time scales ranging from microseconds to months.

Reliability in De-regulated Power Markets:

Electricity sector reform has had a short history worldwide. Although some economies undertook partial reform measures during the 1970s and 1980s, most substantial reform has occurred in the 1990s. This leaves a very short timeframe over which to try and assess whether the impacts with respect to the overall reliability of the system will be positive or negative. This question will also obviously be affected by policy decisions made in the near term to address real or perceived problems in this area.

From a theoretical perspective, appropriate market signals with respect to the need for additional generation capacity or network upgrading, along with market incentives to maintain the provision of high quality services, should ensure sustainable and efficient allocation of capital. If true competition develops through the supply chain, suppliers will compete to provide a range of products and services, including the level security of supply demanded by customers.

Electricity Prices for Industrial Customers:

Deregulation in the electricity industry is considered to have brought efficiency improvements in industrial sectors as well as in related sectors. Evidence suggests electricity price reductions have occurred in the industrial sector in some economies.

With regard to the availability and reliability of electricity sold by utilities, large industrial companies may prefer to build their own electricity generation on-site. This is often the case for the pulp and paper and chemical industries. Some economies also set their regulations to provide incentives for industries to develop self-generation.

In India, a number of industrial companies that have on-site cogeneration plants have excess capacity, and are able to sell their surplus electricity to the national grid. The impact of restructuring on the future of cogeneration systems will be influenced by the wholesale price of electricity. A lower market price may discourage manufacturers to build generation capacity, while higher price may increase incentives for cogeneration, especially for small industries with small electricity loads.

Transparency:

In a fully competitive market, all electricity consumers should be able to choose their retail supplier, based on price and/or quality of services provided. In such a situation, consumers need good price and service information, in order to make informed purchase choices. In the past, electricity bills were normally comprised of a tariff and delivery charge, and this is still a widespread practice.