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

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Energy market reforms l.jpg

Buenos-Aires, July 2003

ENERGY MARKET REFORMS

INITIAL THOUGHTS & RESULTS

Jean-Marie Bourdaire


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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


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PART I

THE BROAD CONTEXT OF REFORMS


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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


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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


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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


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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


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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


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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!


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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


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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


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BENEFITS OF REFORMS


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PART II

EMPOWERING END-USERS


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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


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COST SPLIT


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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?


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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


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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


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THE UK EXAMPLE


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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…)?


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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)


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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


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PART III

ENSURING SECURITY OF SUPPLY


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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)


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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)


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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


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SECURITY OF SUPPLY TOOLS

  • Interruptible customers:

  • Diversified portfolio:

  • Price responses:

  • Incremental supply:


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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


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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


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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


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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


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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.


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PART IV

MAKING GOOD COMPROMISES


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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?


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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?


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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


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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…)


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INCUMBENT SHARE IN CONTINENTAL EUROPE


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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


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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?


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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.


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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


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PART V

CARING FOR THE POOR


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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


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ACCESS


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HISTORIC ENERGY EVOLUTION


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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


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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


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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


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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


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SOME EARLY EVIDENCES

  • Many examples show that poor are willing to pay their electricity supply if the service is reliable

  • Natural gas is rarely an option in developing countries because of the small unit consumptions

  • In some cases, e.g. in shanty towns of Brazil, electricity bills is an evidence of citizenship

  • The case of rural electrification has already been discussed by WEC and is not treated in this study


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WHERE THE MONEY WILL COME FROM?

  • 500 kWh per capita for the 2 billion poor with no or little access represents 200 GW

  • With generation - transmission – distribution at 2$/W, total cost is 200G$ over say 10 years

  • Little as compared to the 9.3 T$ of capital in developing countries if property rights were correctly enforced (Hernando de SOTO)

  • Hence, a need of even broader market reforms to free their still sterilised capital


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CONCLUSION - 1

  • Electricity & natural gas are not commodities because of their captive users

  • Security-continuity-diversity of supply are key and cannot be fulfilled without LT contracts

  • Trade-offs should aim at more simplicity, lower reform costs and lesser reform risks

  • Access to the poor is a key driver of equity and economic development


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CONCLUSION - 2

  • Man as human being and consumer is central to the idea of market reforms

  • An efficient distribution sector should combine yardstick regulation & competition

  • Distribution and retail should remain bundled, in particular for security reasons

  • Within distribution, access to the poor needs to be the priority


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