ENERGY MARKET REFORM—LESSONS LEARNED AND NEXT STEPS

1. ENERGY MARKET REFORM—LESSONS LEARNED AND NEXT STEPS Presentation to 13th Forum – Energy Day in Croatia 26 November, 2004 : Zagreb by Gerald Doucet Secretary General, World Energy Council

2. WORLD ENERGY COUNCIL www.worldenergy.org • End-use Efficiency • Performance of Generating Plant • Market Reform

3. THE BROAD CONTEXT Reforms are aimed at easing the evolution and adaptation of the institutions. Without reforms, economic development will stop. • Legal: property rights, gender equality, rule of law • Social: education, health, social justice, pensions • Infrastructures: energy, water, telecommunications

4. PRIORITIES DIFFER • 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

5. NO SINGLE MODEL FOR ALL • The priorities for reforms may be different, e.g. enhance security or create competition • The agendas for reforms may be different, e.g. start by privatisation or by competition • The market features and regulated aspects may be combined in different ways Hence, what set of simple trade-offs to achieve the desired benefits at minimum cost and risk?

6. INFANCY PROBLEMS • Gas & electricity: are not “pure” commodities but key drivers of modern growth. Supply has to be secure • Electricity: Wholesale competition may create too much market power and retail competition costs may exceed the potential benefits for small users • Natural gas: Competition calls for ST transmission tariffs reflecting whether some capacity is available (<LRMC) or not (>LRMC in case of congestion) • Regulatory uncertainty is costly (higher hurdle rates for investment) and needs to be reduced

7. OWNERSHIP • Governance covers integrity, labour & investment costs, quality of service, strategy & management, organisation, technology • Public ownership brings lower financing costs & economies of scale/scope (e.g. hydro in China) • Private ownership brings better governance rules and competition discipline • No dogmatic answer: public ownership may be preferred for large investments & few employees, and private ownership for other cases e.g. LDC

8. BACK TO SCHOOL ON: • Mechanics of gas-electricity convergence • Long-term diversification of supply • Need to restructure distribution • Extent to which market power is a threat • Responsibility chain for supply continuity • Costs of Regulatory uncertainty/risk • Potential benefits of retail competition • Optimal tariffs, e.g. for stranded costs

9. PART I EMPOWERING END-USERS

10. UNBUNDLING RETAIL SUPPLY FOR USERS? Large: Industries ~ 1/3 of consumption ~ 0.01% (few tens) Medium: SMI and large commercial ~ 1/3 of consumption ~ 1% (few thousands) Small: Commercial & household users ~ 1/3 of consumption ~ 99% (few millions)

11. THE US RETAIL SITUATION

12. AVERAGE US TARIFFS Public service Deregulation delayed Deregulation suspended Deregulation active

13. Electricity prices for large base-load users Energy % Capacity % Autriche 70 30 Belgique 33 67 Danemark E 100 0 Danemark W 100 0 Angleterre et Pays de Galles 24 76 Finlande 100 0 France 46 54 Allemagne 19 81 Irlande 58 42 Italie 71 29 Pays-Bas 59 41 Norvège 5 95 Portugal 41 59 Espagne 72 28 Suède 64 36 AVERAGE 57 43 EUROPEAN ELECTRICITY TARIFFS Close to base-load consumers should be expected to pay mostly for energy

14. UK AVERAGE HOUSEHOLD WEEKLY SPENDING 1998 1968 £ per week (1998 prices) % of total expenditure £ per week (1998 prices) % of total expenditure Leisure 59.8 17 21.1 9 Food 58.9 17 63.9 26 Housing 57.2 16 30.7 13 Motoring 51.7 15 25.4 10 Home services 48.6 14 28.8 12 Clothing 21.7 6 21.5 9 Beer & wine 14.0 4 9.9 4 Personal goods 13.3 4 6.2 3 Fuel & power 11.7 3 15.0 6 Travel costs 8.3 2 6.3 3 Tobacco 5.8 2 12.6 5 Miscellaneous 1.2 0 0.7 0 TOTAL 352.2 242.3 UK EXPERIENCE: WORTH THE COST?

15. FIVE QUESTIONS FOR THE LDC • A/ Private or public ownership? • B/ Competitive franchising or not? • C/ Appropriate size of LDC? • D/ Economies of scope for LDC? • E/ Retail supply competition or not? Most developed countries have privileged E/ but A/ and B/ are key for developing countries and C/ and D/ are worth asking everywhere

16. PART II SECURING SUPPLY

17. SECURITY AND INFRASTRUCTURE • Broad inter-connectivity is key for security, market contestability, and moderate/stable prices • For electricity, an historic legacy of limited inter-connections (~7%) whereas spot competition calls for much larger inter-connections (~30%) • For gas, the reliance on remote sources calls for LT tariffs with capacity reservations, but ST flexible tariffs are also needed to maintain competition • For both, the responsibility chain of security must be maintained despite the unbundling

18. SECURITY OF SUPPLY • With long-term planning and costs for capacity:New capacities are awarded to the lowest bid and capacity costs are guaranteed, e.g. paid annually • With “insurances” subscribed by the buyers: This additional revenue will make up for capacity costs and be part of the competitive game • With “ad hoc” measures such as uplift/LOLP which have no proven track record yet

19. COST OF MONEY Required ROR reflects perceived risks. The larger the capital costs (e.g. hydro), the higher the impact on electricity costs • Annuity of investment ~ I*(1/n + 0.6*ROR + O.C.) • For n = 25 years, operating costs = 0.02 capital cost and ROR = 10% per annum, A = 0.12 • If ROR = 20%, A = 0.18 (i.e. a 50% increase) • ROR has less impact on turbines which have higher fuel costs

20. THE TOOL BOX Large customers (industry, power plants, LDC) may either manage, or ask suppliers to manage, at a cost, their LT security thanks to: • Long-term contracts, • Diversified portfolio, • Price responses to reduce demand, • Excess capacities of supply, e.g. “DG”.

21. PART III WHOLESALE MARKET DESIGN

22. THREATS • Market power: exists because of the very nature of electricity and can only be avoided by less short-term competition (e.g. with annual auctions) • Function unbundling: too much independance between transmission and supply creates the risk of under-optimisation • Complexity: a pool system is complex/unreliable. Bilateral contract systems are less risky. « Single buyer » systems with annual auctions are even less

23. MARKET POWER Loyal competition is often difficult to develop… • Too small price elasticities because only ~10%? of users receive true price signals • Too few actors: large incumbent dominate the market with market shares >>10% • Too small over-capacities in generation or in transmission (creation of “niches”) • Too many markets (day-ahead, intra-day, capacity…): opportunities for cheating Market power is not innocuous. It prevents the normal play of competition and may not always be contestable.

24. EXAMPLES OF MARKET POWER Market power results from dominant, i.e. >10%, market shares and/or cooperative strategies fostered by frequent interactions (up to 300/day) • UK (PowerGen & Innogy) • Spain (Endesa, Iberdrola, Union Fenosa) • France (EDF), Italy (ENEL), Germany (RWE & E.On)… • California, Texas, … & Croatia?

25. GAS-ELECTRICITY INTERFACE • Natural gas price is set by the competition with petroleum in interruptible uses • Electricity price is set in the marginal mid/peak plant using the most expensive fuels • The most expensive fuel is gas or the petroleum product that gas substitutes at the margin • Convergence because the spot gas price determines the spot marginal electricity price

26. TRADE-OFFS NEEDED 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: cyclical prices & market power episodes versus capacity payments? • Second trade-off: competitive wholesale market with many (> 10) actors versus “single buyer”? • Third trade-off: security of supply versus freedom of supplier choice, e.g. for “captive” consumers?

27. PART IV TARIFF SETTING AND THE POVERTY ISSUE

28. ACCESS

29. NO GROWTH WITHOUTELECTRICITY

30. EFFICIENT TARIFFS Cost-reflective tariffs based on LRMC are key to sustainable energy systems • Distorted spot access tariffs (i.e. not based on SRMC) prevent competition to occur • Stranded costs (or rents, e.g. for amortised hydro) should not impact the LRMC-based tariffs • Cross-subsidies prevent tariffs to reflect how much and when (load profile) energy is used

31. FIXED COST COMPONENT • “Stranded costs” are costs that are not recovered by LRMC-based tariffs (e.g. additional costs of grass root infrastructure) • Initial connection and meter investments are also “once for all” costs • These extra costs may be subsidised, for all users or only for the poor, without creating distortions

32. VARIABLE COST COMPONENT • LRMC averages SRMC. The larger the share of high-price peak SRMC (because SRMC then cover expansion costs), the higher the LRMC • Small capacity meters (say 0.7 kW) may be used for the poor. By reducing peak demand, they result in lower LRMC, hence cheaper tariffs • Additional subsidies. For the poor, defined as those having low levels of consumption, lowered tariffs can be used, yet up to a maximum threshold

33. ACCESS FOR THE POOR • 1000 kWh/capita/year target: for 2 billion poor with no or little access, represent 400 GW • Investment cost: if generation, transmission, and distribution cost 5 $/W, the total additional bill is 2 T$ to be paid over 15-20 years • Order of magnitude: compare with the 9.3 T$ of capital stock of these countries if property rights were correctly enforced (Hernando de SOTO) • Conclusion: Reforms need to be broader than, and extend beyond, the energy domain alone

34. WEC NEXT STEPS • Be clear on priorities:Balance public policies (security or environment), monopoly aspects, and competition at different stages. • Be pragmatic: A blend of market and regulated features may bring real competitionand deliver benefits similar to more complex designs. • Be wary of risks: The simplest approach should be used that will achieve the desired benefits at minimum cost and risk

35. WEC NEXT STEPS BIS • Individual strategies evolve to create diversified portfolios and use non-distorting market power • Competition should be seen as a contestability tool for new IPP, new merchant lines, franchised LDC • Regional integration is key to attract investments because regional markets are larger and more secure • Energy market reforms are only a sub-set of the broad reform agenda (legal, social, infrastructures) • Ownership: privatisation and competition should be the response to identified governance problems