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[13]
Overseas territories (DOM) are an exception, since they virtually all use lease
arrangements. The only possible explanation we can see for that is political and/or
administrative origin.

[14]
In our sample, size of population is strongly correlated with demographic density. Therefore,
we infer that it is per capita investment, not the absolute value of investment, which explains
the result.

[15]
It must be mentioned here that duration of contract is regulated. A law adopted in 1993 (Loi
Barnier) stipulated that duration cannot exceed twenty years. Lease contracts usually have
duration within the seven-twelve years' range. Concessions are almost all for more than
fifteen years (and now less than twenty by the Loi Barnier).

[16]
Indeed, we do not suggest that local decision-makers are purely oriented towards
maximizing the well being of the population; but they make their choice with awareness of the
political consequences of responsibility for water of bad quality being delivered to their
constituencies.

[17]
The error in applying an ordered model to a non-ordered variable is much higher than the
converse (Maddala 1983).

[18]
Some of these parameters, e.g. turbidity, pose no risk to public health.
6 Conclusion
Very few empirical studies have analyzed the trade-off among different contractual
arrangements in provision of public utilities. There is a vast literature on the decision to
integrate or not, including econometric tests, particularly in TCE. But, to our knowledge,
there have been no previous econometric tests that used the same theoretical apparatus
for understanding decisions made by governments either to provide a service directly
("in-house") or to outsource part of the service (lease) or all of it (concession or
privatization) to a private operator.

Our chapter proposes a test of that type. Our study relies on a detailed set of data that
have never been used for that purpose so far. We used these data to explore with the
help of econometrics two questions that are central in industrial organization: What
determines the choice of a specific mode of governance among a set of possible forms?
How do alternative modes of governance perform with regard to the same type of
transactions? The first question has generated many econometric studies in TCE but to
our knowledge, none on the decision by a government to outsource or not. As for the
second question, there is an extremely small set of empirical tests of this issue, since it is
very unusual to have data on several alternative arrangements, operating on the same
type of transactions, with no interference of changes in technology or the institutional
environment. In the French water system, we found such a set of data, and have
developed preliminary results on our two questions.

Although this is still an exploratory chapter, with more data to analyze in future studies,
our initial results are very encouraging. In a sector in which most interpretations of the
choice of the mode of governance have relied heavily on political factors, we have shown
that there is room for an economic explanation. Characteristics of transactions at stake
do impose at least part of their logic on the choice of decision-makers. Our results also
strongly suggest that there is no absolute advantage for one specific mode of
governance. We observe instead some comparative advantages that depend crucially on
the characteristics of the transactions that modes of governance organize. In our sample,
the integrated form with public ownership ("r©gies") often performs well, sometimes even
better than privately operated utilities. But this occurs only when transactions have some
specific characteristics that we have identified here. We are now developing our data set
in order to include more direct measures of investments and costs. We are also
collecting data on prices, and extending the period under review. More results can be
expected.
Notes
Chapter 24 was originally published as "Contractual Choice and Performance: The Case
of Water Supply in France," in Revue d'Economie Industrielle (92, 2000).
1. A forthcoming study will complete these data by a set of contracts that
covers all the main cities, with information about a wide variety of
variables (such as size, demography, and geological factors).
2. The United Kingdom is the only significant exception so far, with the
privatization of water in England and Wales in 1989. The sector remains
highly regulated by OFWAT (the Office of Water Services).
3. In an on-going project we are planning case studies to examine their
performance.
4. Corsica and Oversea Territories (DOM) are exceptions: they correspond
to an area, not a basin.
5. What follows is a highly simplified summary of the different approaches.
Space constraints notwithstanding, it is important to make explicit and in
comparative terms some reasons for our choice of the approach
developed in this chapter.
6. For surveys of this empirical literature, see Joskow (1988a); Klein and
Shelanski (1995); Crocker and Masten (1996); Coeurderoy and Quelin
(1997), and Masten and Saussier see chapter 16 in this volume, pp.
273“291.
7. The heuristic model is in Williamson (1985, chapter 4). More is
developed in Williamson (1996) and, with more technical details, in
Saussier (1997, 1999).
8. A previous study, based on a limited number of cities, concluded that the
political orientation of local authorities did not play any significant role in
the choice of the mode of governance (Derycke 1990). But political
factors may still be involved that transcend delineation of political parties
(e.g. influence, corruption).
9. France being a highly developed country, we assume that all population
is connected. Rate of connection is a major issue in developing countries
(see Shirley and M©nard 2002).
10. General quality standards are based on those established by the World
Health Organization (WHO) in 1986. Sanitary standards for water for
human consumption are defined more precisely in another decree (no.
98-3, from January 3, 1989). Also relevant are the decrees adopted by
the EU (no. 75-440, no. 79-869, and no. 80-778).
11. Indeed, in transportation and distribution, several factors can interfere to
change the quality of water without the responsibility of the WSU being
involved (e.g. negative effects of roadwork, or of pollution originating
outside of the water system).
12. We have already mentioned that for towns of more than 5,000
inhabitants in France, which is the base of our data set, there are not
enough cases of fully privatized modes of governance to be significant in
our tests.
13. Overseas territories (DOM) are an exception, since they virtually all use
lease arrangements. The only possible explanation we can see for that is
political and/or administrative origin.
14. In our sample, size of population is strongly correlated with demographic
density. Therefore, we infer that it is per capita investment, not the
absolute value of investment, which explains the result.
15. It must be mentioned here that duration of contract is regulated. A law
adopted in 1993 (Loi Barnier) stipulated that duration cannot exceed
twenty years. Lease contracts usually have duration within the seven“
twelve years' range. Concessions are almost all for more than fifteen
years (and now less than twenty by the Loi Barnier).
16. Indeed, we do not suggest that local decision-makers are purely oriented
towards maximizing the well being of the population; but they make their
choice with awareness of the political consequences of responsibility for
water of bad quality being delivered to their constituencies.
17. The error in applying an ordered model to a non-ordered variable is
much higher than the converse (Maddala 1983).
18. Some of these parameters, e.g. turbidity, pose no risk to public health.
Institutional or Structural”Lessons
Chapter 25:

from International Electricity Sector Reforms
Guy L. F. Holburn, Pablo T. Spiller
1 Introduction
The widespread privatization of national electricity sectors across both the developing
and developed world provides a broad base of experience to assess the relative
performance of various countries in attracting private sector participation in the industry.
Since 1980, when Chile commenced a radical restructuring, and later privatization
program, over sixty countries have introduced reforms in the electricity sector. These
reforms have been generally designed with the purpose of increasing the levels of
private ownership and investment, thereby reducing the dominance of the state-owned
vertically integrated enterprise, the traditional mode of organization. There is substantial
variability in the nature of these reforms. Some countries have invited private investment
in the generation sector only, financed by long-term supply contracts to state-owned
utilities (e.g. China, India, Indonesia, Mexico); some have vertically separated the
industry but privatized only part of the sector (e.g. Colombia, El Salvador, Kazakhstan,
New Zealand); while others have privatized the entire industry and additionally created
competitive generation markets (e.g. Argentina, Chile, United Kingdom).
The degree of private sector interest, however, has been markedly mixed across
countries. There have been some notable successes in attracting significant levels of
private investment in all sectors of the industry (e.g. Argentina, Australia, United
Kingdom). On the other hand, private investors have shown little interest in purchasing
state-owned enterprises or in financing de novo infrastructure assets in countries such
as Mexico, Turkey, or the Ukraine, to name only a few. Indeed some countries, including
Hungary and Venezuela, have had to postpone planned privatization programs owing to
lack of investor interest. In these countries, despite substantial state encouragement,
governments have been unable to reverse sustained periods of under-funding in state
ownership with large inflows of private capital.
As a consequence of the mixed experiences, and of the variety of alternative approaches
undertaken, a debate has emerged on the design of "optimal" restructuring policies.
Much of this debate has focused on classic industrial organization issues, such as the
optimal degree of vertical integration between transmission, distribution and generation
functions (Newbery 1999), the extent of horizontal fragmentation, the design of
competitive generation markets, the sequencing of reforms, and so on. In practice,
however, there is no clear empirical correlation between the method of restructuring
implemented and the ultimate success of the reforms, casting some doubt on the notion
of an "optimal" structural approach. Rather, the main lesson that emerges from the
accumulated reform experience since 1980 is different. Here we claim that the design of
what Levy and Spiller (1994) call the sector's "regulatory governance" regime is more
important for attracting long-term private investment than the specific choice of industrial
structure. Levy and Spiller's (1994) approach to regulation is rooted in the transactions-
cost framework. They see regulation as having the features of an implicit contract
between the government and the company. Under this contract, one of the parties, the
operator, undertakes heavy specific investments, while the other party, the government,
has strong incentives to behave opportunistically. In such an environment, governance,
and in this case, regulatory governance, becomes crucial in order to motivate the
operator to invest and to restrain the opportunistic behavior of the government. Thus,
regulatory governance frameworks that provide a credible commitment to safeguard the
interests of potential investors and customers alike, particularly when economic shocks
create political pressure to shift the balance of power among competing interest groups,
are better suited to attracting the levels of long-term private capital necessary for
securing an adequate and reliable supply of electricity. Weak regulatory governance
institutions, however, offering few or no credible assurances against direct or indirect
expropriation of private property, have difficulty in encouraging private investment.
Indeed, the disappointing experiences with sectoral reforms observed in various
countries are generally the result of design flaws at the level of the regulatory
governance regime, and also of weaknesses in national political, legal, and
administrative institutions, rather than the result of the chosen industry structure. For
policy-makers, our analysis suggests that the key to successful reforms is first to
establish a credible regulatory environment, and only then to ponder on refinements of
the chosen organizational structure for the industry.

We illustrate the critical role of regulatory governance and institutional structure by
considering how several countries have responded to a common problem that has
afflicted many wholesale generation markets, namely the alleged presence and exercise
of market power. While each of the countries we examine has recently experienced
strong political forces for policy reform in the generation sector, the speed and nature of
adjustments to regulatory policies varies dramatically among the countries. This "natural
experiment" therefore allows us to analyze the extent to which different regulatory
institutions protect investors' interests while simultaneously providing sufficient flexibility
to adjust to the appearance of unexpected shocks, some of which may require some
tinkering with the "rules of the wholesale market game."

We provide first a general discussion of the utilities' problem, and of the meaning of
regulatory governance and regulatory incentives. Then, based on this framework, we
discuss some common myths on structural reforms, showing how these common
presumptions, normally found in international aid agency recommendations, are
unsupported by the existing evidence, and how "having the institutions right" is more
important than "having the structure right." Finally, we go into the detail of three specific
countries' responses to the appearance of high wholesale electricity prices.
2 The utilities' problem: regulatory governance and
regulatory incentives[1]
In order to understand the relationship between the design of regulatory institutions and
performance in the utility industries, it is helpful first to appreciate the particular features
of the utilities sector that distinguish it from other industries: first, their technologies are
characterized by large specific, sunk investments;[2] second, their technologies also
exhibit important economies of scale and scope; and third, their products are massively
consumed. What separates the utilities sector from the rest of the economy is then the
combination of three features: specific investments, economies of scale, and widespread
domestic consumption. These features are at the core of the contractual problems that
[3]
have traditionally raised the need for governmental regulation of utilities. In turn, they
make the pricing of utilities inherently political.
The reason for the politicization of infrastructure pricing is threefold. First, the fact that a
large component of infrastructure investments is sunk implies that once an investment is
undertaken the operator will be willing to continue operating as long as operating
revenues exceed operating costs. Since operating costs do not include a return on sunk
investments (but only on the alternative value of these assets), the operating company
will be willing to operate even if prices are below total average costs.[4] Second,
economies of scale imply that in most utility services there will be few suppliers in each
locality. Thus, the whiff of monopoly will always surround utility operations. Finally, the
fact that utility services tend to be massively consumed implies that politicians and
interest groups will care about the level of utility pricing. Thus, massive consumption,
economies of scale, and sunk investments provide governments (either national or local)
with the incentive and opportunity to behave opportunistically vis-à-vis the investing
company.[5] For example, after the investment is sunk, the government may try to restrict
the operating company's pricing flexibility, it may require the company to undertake
special investment, purchasing or employment patterns, or it may try to restrict the
movement of capital. All these are attempts to expropriate the company's sunk costs by
administrative measures. Thus, expropriation may be indirect and undertaken by subtle
means.
Expropriation of the firm's sunk assets, however, does not mean that the government
takes over the operation of the company, but rather that it sets operating conditions that
just compensate for the firm's operating costs and the return on its non-specific assets.
Such returns will provide sufficient ex post incentives for the firm to operate, but not to
[6]
invest. Indeed, the expropriation of sunk assets has been more prevalent in Latin
[7]
America than direct utility takeovers or expropriation without compensation. While the
government may uphold and protect traditionally conceived property rights, it may still
attempt to expropriate through regulatory procedures.

2.1 The political profitability of expropriation
Sunk assets' expropriation may be profitable for a government if the direct costs
(reputation loss vis-à-vis other utilities, lack of future investments by utilities) are small
compared to the (short-term) benefits of such action (achieving reelection by reducing
utilities' prices, by challenging the monopoly, etc.), and if the indirect institutional costs
(e.g. disregarding the judiciary, not following the proper, or traditional, administrative
procedures, etc.) are not too large.

Thus, incentives for the expropriation of sunk assets should be expected to be largest in
countries where indirect institutional costs are low (e.g. there are no formal or informal
governmental procedures “ checks and balances “ required for regulatory decision-
making; regulatory policy is centralized in the administration; the judiciary does not have
a tradition of, or the power, to review administrative decisions, etc.), direct costs are also
small (e.g. the utilities in general do not require massive investment programs, nor is
technological change an important factor in the sector), and, perhaps, more importantly,
the government's horizon is relatively short (i.e. highly contested elections, need to
satisfy key constituencies, etc.). Forecasting such expropriation, private utilities will not
undertake investments in the first place. Thus, government direct intervention may
become the default mode of operation.
2.2 The implications of government opportunism
If, in the presence of such incentives a government wants to motivate private investment,
then it will need to design institutional arrangements that will limit its own ability to
behave opportunistically once the private utility has undertaken its investment program.
Such institutional arrangements are the design of a regulatory framework, stipulating,
inter alia, price-setting procedures, conflict resolution procedures (arbitration or judicial)
between the parties, investment policies, and so on. In other words, regulation, if credible,
solves a key contracting problem between the government and the utilities by restraining
the government from opportunistically expropriating the utilities' sunk investments.[8] This,
however, does not mean that the utility has to receive assurances of a rate of return
nature, or that it has to receive exclusive licenses.[9] In some countries, however, such
assurances may be the only way to limit the government's discretionary powers.[10]

Unless such a regulatory framework is credible, though, investments will not be
undertaken or, if undertaken, will not be efficient. Investment inefficiencies may arise on
[11]
several fronts. A first-order effect is underinvestment. Although the utility may invest, it
will do so exclusively in areas where the market return is very high and where the
payback period is relatively short.[12] Second, maintenance expenditures may be kept to
the minimum, thus degrading quality. Third, investment may be undertaken with
technologies that have a lower degree of specificity, even at the cost of, again, degrading
[13]
quality. Fourth, up-front rents may be achieved by very high prices which, although
they may provide incentives for some investment, may be politically unsustainable.[14]

A non-credible regulatory framework then, by creating strong inefficiencies and poor
performance, will eventually create the conditions for direct government take-over. Thus,
government ownership may become the default mode of operation, reflecting the inability
of the polity to develop regulatory institutions that limit the potential for opportunistic
government behavior.

2.3 Sources of regulatory commitment

In Levy and Spiller (1994) it is argued that the credibility and effectiveness of a regulatory
framework “ and hence its ability to facilitate private investment “ varies with a country's
political and social institutions. Political and social institutions not only affect the ability to
restrain administrative action, but also have an independent impact on the type of
regulation that can be implemented, and hence on the appropriate balance between
commitment and flexibility. For example, relatively efficient regulatory rules (e.g. price
caps, incentive schemes, use of competition) usually require granting substantial
discretion to the regulators. Thus, unless the country's institutions allow for the
separation of arbitrariness from useful regulatory discretion, systems that grant too much
administrative discretion may not generate the high levels of investment and welfare
expected from private sector participation. Conversely, some countries might have
regulatory regimes that drastically limit the scope of regulatory flexibility. Although such
regulatory regimes may look inefficient, they may in fact fit the institutional endowments
of the countries in question, and may provide substantial incentives for investment.

Levy and Spiller (1994) look at regulation as a "design" problem.[15] Regulatory design
has two components: regulatory governance and regulatory incentives. The governance
structure of a regulatory system comprises the mechanisms that societies use to
constrain regulatory discretion, and to resolve conflicts that arise in relation to these
constraints.[16] On the other hand, the regulatory incentive structure comprises the rules
governing utility pricing, crossor direct subsidies, entry, interconnection, etc. While
regulatory incentives may affect performance, one of the main insights from Levy and
Spiller (1994) is that the impact of regulatory incentives (whether positive or negative)
comes to the forefront only if a regulatory governance framework has successfully been
established.[17] Regulatory governance is a choice, although a constrained one, since the
institutional endowment of the country limits the menu of regulatory governance
mechanisms available. Thus, regulatory commitment has two sources: the institutional
endowment and regulatory governance.
2.4 Institutional endowment[18]
Levy and Spiller (1994) define the institutional endowment of a nation as comprising five
elements. First, a country's legislative and executive institutions. These are the formal
mechanisms for appointing legislators and decision-makers, for making laws and
regulations (apart from judicial decision-making); for implementing these laws; and for
determining the relations between the legislature and the executive. Second, the
country's judicial institutions. These comprise the formal mechanisms for appointing
judges and for determining the internal structure of the judiciary, and for resolving
disputes among private parties, or between private parties and the state. Third, custom
and other informal but broadly accepted norms that are generally understood to
constrain the action of individuals or institutions. Fourth, the character of the contending
social interests within a society, and the balance between them, including the role of
ideology. Finally, the administrative capabilities of the nation. Each of these elements
has implications for regulatory commitment. We focus here on the first two.

The form of a country's legislative and executive institutions influences the nature of its
regulatory problems. The crucial issue is to what extent the structure and organization of
these institutions impose constraints upon governmental action. The range of formal
institutional mechanisms for restraining governmental authority includes: the explicit
separation of powers between legislative, executive, and judicial organs of
[19]
government; a written constitution limiting the legislative power of the executive, and
that can be enforced by the courts; two legislative houses elected under different voting
rules;[20] an electoral system calibrated to produce either a proliferation of minority parties
[21]
or a set of parties whose ability to impose discipline on their legislators is weak; and a
[22]
federal structure of power, with strong decentralization even to the local level. Utility
regulation is likely to be far more credible “ and the regulatory problem less severe “ in
countries with political systems that constrain executive discretion. Note, however, that
credibility is often achieved at the expense of flexibility. The same mechanisms that
make it difficult to impose arbitrary changes in the rules may also make it difficult to
enact sensible rules in the first place, or to efficiently adapt the rules in the face of
changing circumstances. Thus, in countries with these types of political institutions, the
introduction of reforms may have to await the occurrence of a drastic shock to the
political system.

Legislative and executive institutions may also limit a country's regulatory governance
options. In some parliamentary systems, for example, the executive has substantial
control over both the legislative agenda and legislative outcomes.[23] In such countries, if
legislative and executive powers alternate between political parties with substantially
different interests, specific legislation need not constitute a viable safeguard against
administrative discretion, as changes in the law could follow directly from a change in
government.[24] Similarly, if the executive has strong legislative powers, administrative
procedures and administrative law by themselves will not be able to constrain the
executive, who will tend to predominate over the judiciary in the interpretation of laws. In
this case, administrative procedures require some base other than administrative law.

A strong and independent judiciary could serve as the basis for limiting administrative
discretion in several ways. For example, the prior development of a body of
administrative law opens the governance option of constraining discretion through
[25]
administrative procedures. Also, a tradition of efficiently upholding contracts and
property rights creates the governance option of constraining discretion through the use
of formal regulatory contracts (licenses). This option is particularly valuable for countries
where the executive has a strong hold over the legislative process. Further, a tradition of
judicial independence and efficiency opens the governance option of using
administrative tribunals to resolve conflicts between the government and the utility within
the contours of the existing regulatory system. Finally, it provides assurances against
governmental deviation from specific legislative or constitutional commitments that
underpin the regulatory system.
The regulatory challenge therefore lies not just in designing regulatory incentive
structures that restrain utilities' monopoly behavioral tendencies but also in designing
regulatory governance frameworks that constrain the political and administrative actors
who have ultimate jurisdiction over the industry. Designing regulatory institutions that are
flexible enough to make balanced policy decisions in response to unanticipated events
but that are also rigid enough to insulate policy from political pressures is a difficult task,
however. In the United States, the country with the longest history of private ownership in
the utilities sector, the regulatory solution that emerged in the electricity industry during
the early twentieth century was to move regulation one step up from local politics.
Regulatory authority over electric distribution utilities was moved away from the highly
politicized municipal environments towards state-wide independent administrative
agencies (state Public Utility Commissions or PUCs) with statutory authority to monitor
utility performance and to set final rates. Since PUCs normally operate in systems where
legislative power is divided among the executive and two legislative chambers, they
generally have substantial autonomy to determine regulatory policy without the threat of
legislative over-ride or overwhelming political interference. While PUCs operate under
vague statutory objectives ("reasonableness" is the typical criterion for rate structures)
and have the power to disallow imprudent or anti-competitive managerial behavior, their
decisions cannot be made in an arbitrary fashion. First, the evolution of constitutional
interpretation implies that utilities are allowed to earn a fair return on their investments.
Second, due process requirements enshrined in states' administrative procedure acts
also ensure that PUC rulings must be based on the facts and evidence of the case
(Vanden Bergh 1998). In the event of disputes, utilities are able to challenge the PUC on
both statutory and constitutional grounds in state and federal courts which, given the
nature of judicial appointments (and in the state courts, of the reelection process),
normally operate independently of the political establishment (Spiller and Vanden Bergh
1997). In the electricity sector, a second level of protection against local opportunistic
behavior resides in the fact that wholesale electricity generation markets, given the
interconnection across states of transmission grids, are regulated at the federal rather
than at the state level.[26] Given their independence and nation-wide range of interests,
federal agencies are less able to be manipulated by local or state officials. Private
investors thus have some assurance that regulatory policy will be protected from
immediate political pressures as well as from agency arbitrariness. Although hard to
assess, it appears that this regulatory arrangement has balanced utility and political
tensions reasonably well: electricity costs, for example, are low compared to most other
countries (IEA 2000), and investment levels in generation, distribution, and transmission
capacity have usually ensured reliable network operations. Furthermore, since the
deregulation process started across the states, electricity costs and prices have been
falling (see figure 25.1),[27] and investment levels in generation have been gathering
speed (Rose 2000).




Figure 25.1: US retail electricity rates, 1990“1999 Note: Price is calculated as average
revenue per kWh. Source: US Energy Information Administration.

In contrast to the United States, the utilities sector in almost all other countries operated
under state ownership for most of the second half of the twentieth century. This, however,
did not exempt utilities from the risk of governmental opportunism.[28] As many of these
countries have sought to partially or fully privatize their electricity sectors over the last
two decades, they have needed to create regulatory institutions that simultaneously
restrain private operators from exploiting their incumbency advantage and yet credibly
commit to not expropriate their returns. Designing regulatory frameworks that
satisfactorily achieve this balance is not a straightforward task, though. The ability to
infuse credibility depends not only on the willingness of the current government, but also
on the country's broader political, administrative, and judicial institutions. Regulatory
institutions, then, must be tailored to the specific circumstances of the country at hand
and may not be simply transplanted from other countries (Levy and Spiller 1994).
In sections 3 and 4 we illustrate the critical role that regulatory institutions play in the
performance of privately-owned electricity sectors. In section 3, we examine some recent
international aid agency proposals for electricity sector reforms that emphasize industry
structural solutions over regulatory institutional reform. By introducing an institutional
perspective, as described above, we suggest that structural reform by itself, without
attention to the reform of regulatory institutions, will have only a minimal impact on
industry performance. While we propose these arguments at a general level, we go on in
section 4 to explore in detail the impact of regulatory institutions on industry outcomes in
three countries, El Salvador, the United Kingdom and the United States (California),
each of which differs in its regulatory incentive and governance frameworks.

[1]
This section draws heavily on Spiller (1996).

[2]
Specific or sunk investments are those, once undertaken, whose value in alternative uses is
substantially below their investment cost.

[3]
See, among others; Goldberg (1976); Williamson (1988b); Barzel (1989); North (1990); Levy
and Spiller (1993, 1994).

[4]
Observe that the source of financing does not change this computation. For example, if the
company is completely leveraged, a price below average cost will bring the company to
bankruptcy, eliminating the part of the debt associated with the sunk investments. Only the
part of the debt that is associated with the value of the non-sunk investments would be able to
be subsequently serviced.

[5]
Observe that this incentive exists both for public and private companies. (See Spiller and
Savedoff 2000.)

[6]
The company will be willing to continue operating because its return from operating will
exceed its return from shutting down and deploying its assets elsewhere. On the other hand,
the firm will have very little incentive to invest new capital as it will not be able to obtain a
return. While it is feasible to conceive loan financing for new investments, as non-repayment
would bring the company to bankruptcy, that will not however be the case. Bankruptcy does
not mean that the company shuts down. Since the assets are specific, bankruptcy implies a
change of ownership from stock holders to creditors. Now creditors' incentives to operate will
be the same as the firm, and they would be willing to operate even if quasi-rents are
expropriated. Thus, loan financing will not be feasible either.

[7]
Consider, for example, the case of Montevideo's Gas Company (MGC). Throughout the
1950s and 1960s the MGC, owned and operated by a British company, was denied price
increases. Eventually, during the rapid inflation of the 1960s it went bankrupt and was taken
over by the government. Compare this example to the expropriation by the Perón
administration of ITT's majority holdings in the Unión Telefónica del Rio de la Plata (UTRP),
(UTRP was the main provider of telephones in the Buenos Aires region). In 1946 the
Argentinean government paid US$95 million for ITT's holdings, or US$623 million in 1992
prices. Given UTRP's 457,800 lines, it translates at US$1,360 per line in 1992 prices (deflator:
capital equipment producer prices). Given that in today's prices, the marginal cost of a line in
a large metropolitan city is approximately US$650, the price paid by the Perón administration
does not seem unusually low. See Hill and Abdala (1996).
[8]
See, Goldberg (1976) for one of the first treatments of this problem. See also Williamson
(1976).

[9]
Indeed, the Colombian regulation of value added networks specifically stipulates that the
government cannot set their prices, nor that there are any exclusivity provisions. Thus,
regulation here means total lack of governmental discretion.

[10]
On this, see more below.

[11]
Williamson's basic contracting schema applies here. See Williamson (1995).

[12]
An alternative way of reducing the specificity of the firm's investment is by customers
undertaking the financing of the sunk assets.

[13]
In this sense it is not surprising that private telecommunications operators have rushed to
develop cellular rather than fixed-link networks in Eastern European countries. While cellular
has a higher long-run cost than fixed link, and on some quality dimensions is also an inferior
product, the magnitude of investment in specific assets is much smaller than in fixed-link
networks. Furthermore, a large portion of the specific investments in cellular telephony is
undertaken by the customers themselves (who purchase the handsets).

[14]
The privatization of Argentina's telecommunications companies is particularly illuminating.
Prior to the privatization, telephone prices were raised well beyond international levels. It is
not surprising that, following the privatization, the government reneged on aspects of the
license such as price indexation. The initial high prices, though, allowed the companies to
remain profitable, even following the government's deviation from the license provisions. See
Levy and Spiller (1993).

[15]
The concept of regulation as a design problem was first introduced in Levy and Spiller
(1993). Here we use the terminology subsequently developed in Levy and Spiller (1994).

[16]
Williamson would call such constraints on regulatory decision-making "contractual
governance institutions." (See Williamson 1985, p. 35.)

[17]
Commenting on the interaction among technology (institutions), governance, and price
(regulatory detail) Williamson (1985, p. 36) says, "[i]n as much as price and governance are
linked, parties to a contract should not expect to have their cake (low price) and eat it too (no
safeguard)." In other words, there is no "free institutional lunch."

[18]
This section draws heavily on Levy and Spiller (1994).

[19]
For analysis of the role of separation of powers in diminishing the discretion of the
executive, see Gely and Spiller (1990) and McCubbins, Noll and Weingast (1987, 1989), and
the references therein.

[20]
Non-simultaneous elections for the different branches of government tend to create natural
political divisions and thus electoral checks and balances. (See Jacobson 1990.) For an in-
depth analysis of the determinants of the relative powers of the executive, see Shugart and
Carey (1992).

[21]
Electoral rules also have important effects on the effective number of parties that will tend
to result from elections, and thus, the extent of governmental control over the legislative
process. For example, it is widely perceived that proportional representation tends to
generate a large number of parties, while first-past-the-post with relatively small district
elections tends to create bipolar party configurations. This result has been coined Duverger's
Law in political science. More generally, see Taagepera and Shugart (1993). For analyses of
how the structure of political parties depends on the nature of electoral rules (with applications
to the United Kingdom) see Cain, Ferejohn and Fiorina (1987) and Cox (1987).

[22]
On the role of federalism in reducing the potential for administrative discretion see
Weingast (1995), and the references therein.

[23]
While parliamentary systems grant such powers in principle, whether they do so in practice
depends upon the nature of electoral rules and the political party system. Parliamentary
systems whose electoral rules bring about fragmented legislatures would not provide the
executive “ usually headed by a minority party with a coalition built on a very narrow set of
specific common interests “ with much scope for legislative initiative. By contrast, electoral
rules that create strong two-party parliamentary systems “ as well as some other kinds of
non-parliamentary political institutions “ would grant the executive large legislative powers.
For an in-depth discussion of the difference between parliamentary and presidential systems,
and the role of electoral rules in determining the relative power of the executive, see Shugart
and Carey (1992).

[24]
In the United Kingdom, regulatory frameworks have traditionally evolved through a series of
acts of Parliament. For example, major gas regulation legislation was passed in 1847, 1859,
1870, 1871, 1873, and 1875. Similarly, water regulation legislation was passed in 1847, 1863,
1870, 1873, 1875, and 1887. Systematic regulation of electricity companies started in 1882,
only four years after the inauguration of the first public demonstration of lighting by a public
authority. The 1882 Act was followed by major legislation in 1888, 1899, 1919, and 1922, and
culminating with the Electricity (Supply) Act of 1926 creating the Central Electricity Board. See
Spiller and Vogelsang (1993), for discussions of the evolution of utility regulation in the United
Kingdom, and the references therein.

[25]
This has traditionally been the way administrative discretion is restrained in the United
States, as regulatory statutes have tended to be quite vague. For an analysis of the choice of
specificity of statutes, see Schwartz, Spiller and Urbiztondo (1994). Observe, however, that
administrative law may not develop in a system where the executive has strong control over
the legislative process.

[26]
They are under the supervision of the Federal Energy Regulatory Commission.

[27]
The US Energy Information Administration estimates that competitive pressures in the
generation sector will reduce retail electricity prices from an average of 6.3¢/kWh in 1996 to
4.2¢/kWh by 2005 (J. Alan Beamon, "Competitive Electricity Pricing: An Update," 1998).

[28]
See Spiller and Savedoff (2000).
3 "Optimal" restructuring myths in the electricity industry
The decision to privatize state-owned electricity assets naturally raises a series of
questions about the optimal organizational approach to transferring assets to private
owners. Should all asset types, whether generation plants, high-voltage and distribution
networks, be privatized or should private ownership be limited to the sectors where
competitive markets can be feasibly implemented? And, if markets are small, should
competition be attempted? In the former case, what is the optimal degree of vertical
integration between privately owned generation, transmission, and distribution activities,
bearing in mind that investments or operational decisions in one sector can have
important consequences for operational efficiency in other sectors? Similarly, given the
need for investment and real-time operational coordination between, as well as within,
geographic regions, what is the optimal level of horizontal fragmentation?

Although policy-makers and government advisors have paid considerable attention to
these and other issues in the development of reform programs, there is little empirical
evidence to suggest that one particular structural configuration of a fully or partially
privatized electricity industry is more conducive for long-term private investment than
another. In spite of the heated debate among advocates of particular reform policies, the
experience of various countries suggests that no single organizational structure
obviously trumps another.[29] To illustrate, we examine several of the common structural
prescriptions for encouraging private investment in transmission, distribution, and
generation assets.

3.1 Transmission investment

Myth 1 Large economies of coordination imply that vertical separation of transmission
and generation or lack of a transmission monopoly will lead to inefficient investments

Transmission networks play a critical role in ensuring a low-cost and reliable supply of
electricity. In the absence of transmission-capacity constraints, electricity generated in
one region is able to flow to other regions where local generation supplies are either
insufficient to meet demand, or else are relatively costly compared to out-of-area
supplies. The construction of additional transmission infrastructure can therefore serve
as a partial substitute for building extra generation capacity when demand and supply
are uneven across regions. For this reason, vertical integration between transmission
and generation functions is sometimes seen as an efficient organizational structure for a
newly privatized industry, particularly when the size of the market is small. A vertically
integrated owner faces incentives to invest in generation and/or transmission assets in a
manner that minimizes combined generation and transmission costs, whereas under
separate ownership contracting difficulties may prevent such an outcome, potentially
leading to under-investment.

While efficiency rationales have led to proposals for vertically integrated, horizontally
concentrated industry structures, concerns about the exercise of market power on the
other hand have led to opposing recommendations. Difficulties in setting and regulating
efficient transmission charges, so it is argued, enable vertically integrated suppliers to
devise charging structures that favor their own generation plants over those of
competitors in dispatch decisions (Newbery 1999). By separating the ownership of
transmission and generation assets, the incentives for transmission owners to
discriminate against particular generation companies are reduced, thereby encouraging
[30]
efficient entry into the generation sector.
The presence of market power concerns thus suggests that the policy of vertically
integrating transmission and generation ownership will not necessarily be the optimal
restructuring approach, and that the decision will depend on a careful consideration of
the pros and cons in each individual situation. Indeed, among countries adopting
competitive wholesale markets, there is no uniform preference for vertical separation or
integration; approximately 40 percent allow integration, 60 percent forbid it (see table
25.1), suggesting that a "one-size-fits-all" policy of integration is inappropriate.
Table 25.1: Organizational and ownership structure of competitive wholesale electricity markets

Ownership # Firms




Country Generation Distribution Transmission Installed Vertical Transmission Distribution
capacity integra
1 tion
[]
(MW) allowe
2
[]
d


Argentina Private Private Private 22,000 No 7 25+

Australia Private Private Private 6,700 No 1 5
(Victoria)

Chile Private Private Private 8,000 Yes 4 20

UK Private Private Private 70,000 No 1 12

Peru Mostly Mostly public Public 5,000 No 2 7
private

Bolivia Mostly Mostly public Private 950 No 1 24
private

Colombia Mostly Mostly public Public 15,000 Yes 1 25+
private

Spain Mostly Mostly Mostly private 43,000 No 1 17
private private

USA Mostly Mostly Private 779,000 Yes 200+ 3000+
private private

Guatemala Mostly Mostly public Public 1,300 Yes 1 15
public

El Mostly Mostly Public 850 Yes 1 5
Salvador public private

Finland Mostly Mostly public Mostly private 16,000 No 2 130
public

New Mostly Mostly public Public 8,000 Yes 1 42
Zealand public

Norway Mostly Mostly public Mostly public 27,000 No 1 240
public

Portugal Mostly Mostly public Mostly public 9,000 Yes 1 4
public

Sweden Mostly Mostly public Mostly public 34,000 No 1 270
public

Ukraine Public Public Public 55,000 No 1 27

1
[]
Source: Energy Information Administration, US Department of Energy.


2
[]
Vertical integration between transmission and functions generation.


For the same reasons motivating vertical integration proposals, it has been argued that
since efficient investment in national transmission networks also requires coordination
among operators in various regions, the optimal degree of horizontal fragmentation in
transmission under private ownership should be low. Dynamic concerns again contradict
efficiency-driven policy recommendations. Generation companies require access to
transmission networks in order to compete effectively against rival generation companies.
When transmission is organized as a monopoly franchise, implying that generation
companies are not free to invest in their own transmission assets, transmission owners
are in a position to "hold up" generators through a variety of means. Monopoly
transmission owners have an incentive to extract rents from generation companies by
manipulating access to the network; for example, by using uncontracted network
upgrades or maintenance schedules as bargaining points. A natural solution to this
problem is to remove ownership restrictions in the transmission sector to allow
generation firms to invest in their own competing transmission assets, thereby creating
an a priori argument for horizontal fragmentation.
Turning again to the evidence, we find no common consensus in the degree of
transmission concentration or fragmentation, raising further doubts about the optimality
of the former policy prescription. Out of the eight countries with predominantly privately-
owned transmission networks, three have systems that are quite fragmented with four or
more owners (see table 25.1).

Myth 2 Public ownership of transmission assets is required to facilitate coordination and
efficient investment
Recognizing the plethora of conflicting tensions under private ownership, still others (in
particular Labor Party-led European governments) have argued that the best policy is in
fact to retain transmission networks under public ownership (Newbery 1999). An
important assumption underpinning this proposal is that the government has less
incentive to hold up private generators than a private owner of the transmission network.
As we discuss below, however, the highly politicized nature of electricity consumption in
all countries makes the industry especially susceptible to government control,
irrespective of the ownership structure. Under public transmission ownership, the
government may actually find it easier to hold up private generation firms since it has
direct control over day-to-day managerial decisions than in the private ownership case
where the government may have to pressure a regulatory agency to implement its
preferred policy. Thus, while public ownership may allay concerns over the exercise of
private market power in transmission it also exposes generation firms to greater political
hazards. Indeed, by transferring transmission assets to private owners and by
establishing an independent regulatory agency - both actions that are politically difficult
to reverse - the government can send a strong signal to the private sector that it will not
readily meddle in operational affairs for political ends, thereby encouraging higher levels
of private entry in all parts of the electricity sector. Eight out of seventeen countries
implementing competitive wholesale markets during the 1990s have done so under
private transmission ownership regimes (see table 25.1).[31]

3.2 Generation markets

Myth 3 Economies of scale in generation limit the potential for competition in relatively
small markets

In addition to the organization of transmission, governments have several options for
reform in the generation sector. Chief among these is the decision to create a
competitive wholesale generation market where sellers bid against each other to supply
electricity on a continuous basis, with prices determined by a market-making mechanism.
Following the lead of Argentina in the 1980s, a number of jurisdictions have made
competitive generation markets a central component of privatization and restructuring
programs (e.g. Australia, California, Chile, Finland, Norway, Sweden, United Kingdom,
Ukraine). Although the introduction of wholesale markets is generally perceived as being
a desirable policy goal, questions have been raised about the feasibility of implementing
similar reforms in smaller countries where, it is argued, only a small number of
generation companies can be supported, leading to an oligopolistic situation.
Competitive markets have been established, however, in several small countries where
installed capacity is a small fraction of that in larger wholesale markets, such as Bolivia,
[32]
El Salvador, and Guatemala. Similarly, there have been disastrous results in some
large countries; in Ukraine, for instance, repeated attempts by the government and
international aid agencies to breathe life into the spot generation market have failed
since 1996, and most generation trades are now arranged on an ad hoc bilateral basis
[33]
among generators and distributors or final consumers. Legal uncertainties about the
status of contracts and private property in Ukraine, as well as strong concerns over
bureaucratic corruption,[34] have undermined the incentives for entrants to invest in new,
more efficient generation capacity, to write long-term contracts and to engage in the spot
market. The experience of Ukraine suggests that, rather than geographic or population
size, the main constraint on the operational feasibility of wholesale markets is the ability
of new generation companies to enter the market, access transmission resources on a
non-discriminatory basis, and enter into enforceable contracts with new or existing
buyers.

3.3 Distribution investment

Myth 4 Large economies of scale in distribution imply that too much fragmentation of
distribution facilities will lead to high distribution costs

Within the distribution sector, perceptions about the degree of scale economies have
also led to prescriptions for the optimal level of geographic fragmentation for inducing
private sector investment. A common concern is that while horizontal fragmentation of
the distribution sector creates regulatory benefits - in that a larger number of companies
facilitates "yardstick" regulation - it may also increase distribution costs and encourage
inefficient investment decisions if economies of scale are ignored. For this reason, low
levels of fragmentation are frequently prescribed in reform programs.
The hypothesized relationship between geographic fragmentation and distribution costs
and investment is questionable, however, on several grounds. First, economies of scale
in distribution are driven by the density of customers, implying that optimal geographic
footprints can be very small, and that the degree of fragmentation can be quite large.
Thus, in Norway, distribution activities are divided among more than 240 firms and in
New Zealand among more than forty. Chile, which started its reforms with a dozen
distribution companies, has doubled its number over the period. Secondly, the ability to
induce efficient levels of distribution investment depends on private sector expectations
about future regulated rates of return and the possibility that once assets have been put
in place, attempts will be made by political actors to expropriate their rent streams.

3.4 Summary
Although it is hard to empirically identify the relative success of alternative structural
reform policies in terms of encouraging new private investment, the absence of a clear
pattern linking the structural nature of industry reforms to performance casts some doubt
on the assertion that a single structural approach is uniformly optimal. We suggest that
the lack of empirical consensus is not an accident but the indirect result of a commonly
held implicit assumption in the debate on optimal restructuring policies, specifically that
the supporting regulatory institutions have a neutral impact on the players' behavior. In
practice, however, the design of the regulatory governance of the sector has a critical
effect on investors' incentives to make long-term asset commitments. In section 4 we
explore this proposition in some detail by focusing on the recent experiences of three
countries, each of which differs substantially in its regulatory institutions but each of
which came under significant political pressure during the period 2000-1 to reform its
wholesale electricity market. As we shall argue, the nature of the regulatory institutions,
by more or less insulating regulatory policy from political forces, played a critical role in
determining the direction of regulatory reforms.

[29]
For example, private investment in transmission networks has been secured under a
variety of ownership and structural arrangements. Substantial investment has occurred in
Argentina (private, vertically separated, fragmented transmission) and in Chile (private,
vertically integrated between generation and transmission, concentrated transmission). Low
levels of transmission investment have occurred in the United Kingdom (private, vertical
separation between generation and transmission, concentrated transmission), in California
(private, vertical integration between distribution and transmission, and some generation), and
in New Zealand (public, vertical separation, concentrated transmission). Similarly, among
countries implementing competitive wholesale markets, there is no discernible pattern of
vertical integration between transmission and generation functions or in the ownership of
transmission assets and their relative performance (see table 25.1).

Indeed, it could be argued that independently of market structure, as long as the
regulatory governance of the sector is properly designed, the following six structural
conditions are sufficient for generating incentives for private investment in liberalized
electricity markets, and hence for developing a competitive generation market:
a. free entry into generation
b. some amount of direct access, including access to large users
c. fragmented demand (in most cases this implies a fragmented
distribution sector)
d. dispatch operations run by an entity independent of the generation
companies
e. open access to transmission and distribution grids (f) incentive
regulation of transmission and distribution charges.

[30]
This, however, assumes that dispatch is run by the transmission company, which violates
condition (d) in the list of sufficient conditions for a competitive environment in n. 29.

[31]
As we discuss below, the proposal by the California Governor in 2001 to take over the
transmission system was designed not to alleviate investment or market power issues, but
rather to effect a cash transfer ("bailout" according to critics) to the utilities that would
otherwise have been politically infeasible.

[32]
For further analysis of this particular issue, see Spiller (1999).

[33]
Power Economics, September 30, 1998; East European Energy Report, October 25, 1996
and August 1, 1997; Utility Week, June 1, 1998; International Private Power Quarterly, Fourth
Quarter 1998.

[34]
The Electricity Daily, May 10, 1999.
4 Regulatory responses to market power allegations in the
generation sector
Market power allegations have emerged as an unanticipated major policy concern in
many jurisdictions that have implemented competitive wholesale power markets over the
last decade (Borenstein and Bushnell 2000; Joskow 2000). Unlike most other industries,
power generation firms with small as well as large aggregate market shares are
sometimes in a position to exploit local market power by raising prices above a
competitive level. Given the physical characteristics of electricity network operations,
including the need to maintain system reliability, the impossibility of storing electricity,
and the existence of local transmission constraints, individual generation plants must
occasionally be operated under certain demand and supply conditions to maintain the
stability of the network. If generators anticipate that they will be called upon by the
system operator to supply electricity to the network almost independently of the offered
price, they can bid very high prices for their services in auction settings. Since the short-
[35]
run price elasticity of demand is relatively low, such prices can reach almost any level
unless restrained by demand or capped by administrative rules. Thus, under specific
supply and demand rules and scenarios, generators will enjoy substantial local market
power. This market power may be limited, however, by contracts between the dispatch
entity or final users and the generator, by transmission investments that relieve
congestion, or by de novo entry.

In addition, the auction rules that govern wholesale generation markets in many
jurisdictions are highly complex and susceptible to "gaming" by generators. In the United
Kingdom, for example, generation firms were able to withhold capacity from the market
in order to drive up the spot market prices for other generating plants, and also employed
bidding strategies that achieved the same result but without withholding capacity
(Wolfram 1999; Ofgem, 2000). Similar results obtained in California, particularly in the
market for ancillary services, leading to significant increases in wholesale prices and in
[36]
retail rates in some regions. El Salvador also experienced a serious increase in
wholesale prices during early 2000, leading to drastic retail price increases.
As a result of the increasing concern with generators gaming trading systems to their
[37]
advantage, political actors came under pressure during the late 1990s to "fix the
system" and to reform regulatory policy through a variety of means. In spite of common
political forces, however, regulatory policy responded in dramatically different fashion in
the three countries whose recent experiences we examine in greater detail below. While
the United Kingdom redesigned the rules governing the power market taking care as
much as possible to follow established administrative rules, providing a level of
protection for the generation companies, El Salvador responded by shifting ex post some
of the costs of increased wholesale market prices onto the distribution companies,
effectively expropriating some of their quasi-rents, and also by diminishing the role
played by the wholesale market. California also reduced the role of the wholesale market
though political attempts to move the accumulated costs of high wholesale prices onto
the distribution companies, and also onto the generation companies, were limited by the
prospect of independent judicial review.

We argue that differences in regulatory governance frameworks, in particular in the rules
governing the relationships between regulatory agencies, the courts, and political
institutions, played a central role in explaining why different countries adjusted their
regulatory policies differently to an unexpected common shock.

4.1 Market power and regulatory reform in the United Kingdom

After the Conservative government privatized and restructured the UK electricity industry
in 1990, concerns were voiced about the structure and operation of the generation sector,
notably over the degree of competition in the newly created power pool. Critics argued
that two characteristics of the generation market reforms enabled incumbent generators
to exert a strong degree of market power. First, at the time of privatization the
government essentially established a generation duopoly by dividing the state-owned
Central Electricity Generating Board (CEGB) into two private companies, National Power
and PowerGen, with a combined share of national capacity of more than 80 percent, and
a third state-owned corporation, Nuclear Electric, holding the CEGB's nuclear assets.
Studies have suggested that the presence of two dominant players in the electricity pool
facilitated Cournot-style implicit collusion, raising prices, on average, 20-25 percent
above marginal costs (Wolfram 1999).[38] The second source of market power lay in the
design and governance arrangements of the power pool, the electronic quasi-
marketplace that balanced demand and supply on a continuous basis and that generated
a single spot price, the System Marginal Price (SMP), in the process. Unlike other
competitive wholesale markets, such as in California, El Salvador, or Scandinavia, the
UK power pool did not allow negotiated bilateral prices and trades among buyers and
sellers, either within or outside the pool, and operated purely on a day-ahead basis.[39] It
was compulsory for licensed generators to sell the vast majority of their output through
the pool, and contracts were based on the SMP.[40]

The emphasis on the day-ahead price as the lone market clearing mechanism created
strong incentives for the generation companies to develop trading strategies that
manipulated the pool price through a variety of means. A chosen one was the
withholding of capacity to drive up the capacity payments for electricity purchased from
other plants in the company's portfolio.[41] The limited involvement from the demand side
in the pool also reduced buyer pressure on prices, leading to higher prices overall and
[42]
taller price spikes than otherwise. Since the committee responsible for the operation of
the pool was governed entirely by the industry,[43] administrative attempts by the Director
General (DG) of Ofgem, the regulatory agency, to significantly reform the system - so as
to reduce the inherent biases in favor of the generation firms - were not surprisingly
[44]
stymied.

As a consequence of these features, while fuel, operating, and capacity costs for
generation fell by 50 percent in the decade after 1990, and in the face of substantial
entry by combined cycle operators, wholesale prices for electricity remained largely
unchanged,[45] lending considerable support to the claim that incumbent generators
exploited a position of market power.
The United Kingdom's de facto single-chamber parliamentary system that unites
legislative and executive functions might offer the government unbridled opportunities to
implement regulatory reforms through legislative means or else by directly pressuring
regulatory agencies. As a consequence, at the time of industry privatization, the
government undertook a variety of institutional designs precisely to, on the one hand,
provide the government with flexibility in the design of regulatory policies while at the
same time safeguarding the rights of interested parties. This allowed the UK government
to respond to the market power issue and to commence a broad consultative process of
redesigning the generation sector.

At the administrative level, regulation is primarily implemented through the award of long-
term licenses to generators that specify their rights and obligations, as well as those of
the regulatory agency, Ofgem, which has broad oversight responsibility for the industry.
Licenses include the procedures for firms to appeal Ofgem decisions, which in this case
consists of a complex set of checks and balances involving appeals to the Competition
Commission (the UK anti-trust agency, formerly known as the "Monopolies and Mergers
Commission") and a potential veto by the Secretary of State.[46] Thus, the appeals
process provides some protection to the firms by limiting the ability of the DG to
unilaterally change regulatory policy. Within this framework, Ofgem retains considerable
flexibility in the design of policy since few quantified objectives or constraints are written
in statute. For example, Ofgem has considerable discretion over final rates, making
periodic determinations about price cap levels, without requiring formal political approval.

The formal authority enjoyed by Ofgem to regulate the industry on an independent basis
is reinforced by the existence among the highly expert civil service of a strong norm of
administrative independence, making direct political interference in the design of
regulatory policy, except in highly unusual circumstances, damaging to the government
in terms of its public reputation and support within the administration. In addition, the
judicial system has a strong tradition of probity in upholding contracts. Indeed, the courts
have ruled against the government in the past, providing further reassurance for license
[47]
holders against administrative expropriation (Baldwin and McCrudden 1987).

The balance of flexibility (through administrative means) and protection of private-
property rights (through the use of licenses, administrative constraints, and judicial
norms) inherent in the UK regulatory governance framework is apparent in the way that
the Labour government reformed the generation sector after coming to office in 1997. In
the first instance, the government enacted reforms mostly through the existing "rules of
the game" (i.e. administrative procedures specified in company licenses), and did not
initially resort to legislation.[48] The DG sought to introduce a "market abuse" clause in the
generation companies' licenses - allowing the DG to penalize anti-competitive behavior
in the new wholesale market - using the amendment procedure specified in the licenses,
[49]
rather than relying on the government to achieve a similar end with targeted legislation.
Indeed, two generation companies, after exercising their right to refer the matter for
independent determination to the Competition Commission, succeeded in gaining a
[50]
ruling from the Competition Commission that struck down the DG's proposal. While
the Secretary of State for Trade and Industry could have overridden the Competition
Commission, using the powers provided by the Utilities Act 2000 to unilaterally modify
existing licenses as part of the provisions for establishing NETA, it elected instead to
defer to the agency's decision.

Reforming the workings of the wholesale market (i.e. the pool), on the other hand,
required the government to resort to legislation since under the original system the DG
had no administrative authority to initiate changes in the rules governing the pool. After it
became clear that the generation plant divestments that occurred under the
Conservative government during the mid-1990s had not effectively reduced the ability of
incumbents to manipulate the pool price, the Labour government elected in mid-1997
quickly initiated a consultation exercise on reform options. Although the government
announced its intention to legislate, it placed considerable emphasis on allowing Ofgem,
and interested parties, through an extensive consultation process, to shape the design of
[51]
the NETA. The DG published initial proposals for reform in July 1998. These were
[52]
accepted by the government in October 1998 in the form of a White Paper, which
commenced a lengthy public review exercise,[53] and which culminated with the issue by
the DG and the Secretary of State for Trade and Industry of the NETA in October
[54] [55]
1999. Implementation of the NETA eventually occurred during mid-2001. Affected
parties, then, had substantial opportunity to organize, to lobby ministers and Ofgem, and
in general to make their views known publicly and privately.[56] As a result of this process,
although the NETA implied a drastic reform of the operation of the wholesale market,[57] it
achieved a substantial level of consensus among industry players.

4.2 Market power and regulatory reform in California

While the new Labour government in the United Kingdom moved relatively quickly and in
a considered manner to mitigate market power issues with a series of significant
legislative and administrative reforms, regulatory reform in California proceeded at a
slower and more ad hoc pace. This was not the result of a more smoothly operating
generation market, however. The California Power Exchange (PX) and the Independent
System Operator (ISO)[58] differed from the original UK "Pool" in that buyers and sellers -
excluding, however, most of the demand that arose from the main investor-owned
utilities who had to buy all their requirements from the PX - were able to negotiate
bilateral trades, which were then submitted for dispatch to the ISO. The presence of local
transmission constraints meant that individual generation plants were sometimes able to
charge prices well above long-run competitive levels, especially in the market for
ancillary services. One study estimated that energy purchase costs in California
averaged 16 percent above competitive levels during 1998 and 1999, with substantially
greater multiples during periods of peak demand - including the summer of 2000
(Borenstein, Bushnell and Wolak 2000).[59] Such discrepancies over long-run marginal
costs were also reinforced by a lengthy and cumbersome state-approval process for new
generation projects. Out of 20,000MW of new capacity that reached the planning stages
after deregulation (representing a 44 percent increase on the installed capacity base of
45,000MW), only a small fraction had come on-line by 2001 (Oren and Spiller 2000).
Also, new entry by Energy Service Providers (ESPs) was impeded by the original
restructuring legislation (Assembly Bill AB 1890) in 1996 that fixed retail rates at a 10
percent discount over June 10, 1996 levels, reducing the incentives for ESPs to market
stable rate plans to consumers. Market structure and impediments to new entry thus
both contributed to increased wholesale electricity prices.
Crisis level was initially reached during the summer of 2000 when the combination of
high natural gas prices, warm weather, and extremely limited spare capacity reserves
pushed spot energy prices to unprecedented levels (see figure 25.2). In the PX Day-
Ahead market, for example, spot prices reached a peak of $470/MWh during May 2000,
more than nine times the peak during the previous May.[60] For the investor-owned
distribution utilities, who had been required to purchase all their supplies through the PX
and were subject to retail rate caps, this meant a substantial postponement in the
recovery of their uneconomic costs, as increased power purchase costs could not be
[61]
passed through to consumers. When retail caps were released for one utility in the
southern parts of the state, as per the original legislative schedule, PX prices were
passed straight through to consumers leading to final bill increases of two or three times
[62]
in magnitude. Naturally, these large and unexpected wealth transfers away from final
consumers increased political pressure for regulatory reform.




Figure 25.2: Unit spot price, California wholesale market, January 1999-November 2000

By December 2000 the crisis had intensified rather than abated. Sustained high spot
prices throughout the latter half of 2000 had substantially depleted utilities' cash reserves
and generated accumulated operating losses of $12 billion, leading to concerns about
their ability to finance fuel supply and non-utility energy purchases. Independent power
producers, who in early 2000 had been willing to sign long-term contracts with the
utilities but were prohibited from doing so by the CPUC, were now unwilling to sell
[63]
electricity on any credit terms, demanding immediate payment up-front. When the
utilities defaulted on nearly $1 billion in short-term debt in early February 2001, by which
time credit agencies had already downgraded their bond ratings, fuel supplies were
assured only by a FERC emergency ruling ordering natural gas suppliers to continue
sales to the Californian utilities. The rapid deterioration in the utilities' financial position,
as well as that of the ISO, eventually led to a precipitous fall in the stock prices of Pacific
Gas and Electric (PG&E) and Southern California Edison, the two major Californian
utilities, and PG&E's filing for bankruptcy in early 2001.

In addition to the financial stresses in the electricity sector, increasing strain was being
placed on the physical infrastructure as available generation capacity, both within and
outside the state, proved insufficient during peak demand periods. Although Stage 1 and
Stage 2 network emergencies had occasionally been declared in previous months,
January was the first time that Stage 3 emergencies were declared and, in addition, for
successive days and weeks, with large sections of the customer base experiencing
[64]
rolling blackouts. Thus, for the first time, large numbers of voter-consumers were
feeling the real and financial effects of what was commonly referred to as the "energy
crisis,"[65] ultimately forcing the state governor, Gray Davis, to declare a state of
emergency on January 17, 2001.
Compared to the United Kingdom, implementing regulatory reforms at legislative and
administrative levels in California, and in the United States more generally, is frequently
a more difficult and lengthy exercise, lending considerable weight to status quo policies.
First, as a result of the nation's federal structure, as well as of its separation of political
powers, legislative policy changes require the agreement of multiple institutions, all of
which are subject to judicial review. Thus, in the presence of divergent interests it can be
[66]
difficult to find mutually preferable new proposals that also survive judicial review.
Consequently, drastic changes in regulatory policy - those that entail a redistribution of
wealth among competing interest groups - are difficult to implement as the losing
coalition will lobby against adoption. Thus, when political interests are fragmented,
dramatic legislative proposals tend to be watered down with compromises reflecting
political rather than economic logic.
Second, while the US system of political checks and balances insulates interest groups
against unfavorable legislative reforms, the logic of political delegation also ensures that
regulatory agencies do not rapidly implement substantial policy changes against the
wishes of their political principals through administrative means. A variety of governance
mechanisms are used to safeguard against rapid administrative decision-making which
may distort legislators' preferences. Legislators undertake committee hearings,
appointments of officials are reviewed, and agencies are subject to administrative
procedures and due process requirements that provide interest groups with a role in
decision-making procedures. Thus, even if the threat of legislative over-ride is not
[67]
credible, agency decisions cannot drift too far too fast from the status quo.

The combination of multiple legislative veto points, administrative controls, and
independent judicial review tends to insulate status quo public policies and the interests
of stakeholder groups from dramatic reform. This is especially apparent in the political
acrobatics undertaken by the Calfornia legislature and governor in their attempts to
[68]
reform the wholesale market and at the same time to protect ratepayer interests.

Owing to potentially adverse electoral consequences, the government, which consisted
of the first Democrat legislative and executive coalition in several decades, was unwilling
to make consumers directly feel the pressure of high wholesale prices. Although higher
retail prices were needed both to promote conservation and to bring the utilities back to
credit-worthiness, the legislature instead enacted a bill, AB 1X, that made the state the
main intermediate energy purchaser, by-passing almost completely the wholesale PX
market. In early February the state commenced negotiations for up to $10 billion in long-
term supply contracts with generation companies within and outside California, which
would then be sold on to the distribution utilities, eliminating the credit risk inherent in the
poor financial situation of the utilities. This had two politically beneficial effects. First, by
effectively disbanding the PX in favor of negotiated contracts, the governor claimed to
have eliminated the exercise of market power by generation companies during times of
peak demand, thereby substantially lowering average energy prices. The operating
losses of the utilities would therefore be staunched and consumers would be protected
against future additional rate increases. Secondly, by controlling the price at which the
distribution utilities purchased their power, the government gained the option to not pass
on the full costs of energy purchases to final consumers. Thus, although consumers
would ultimately pay for this arrangement indirectly through higher state taxes and/or
through partially increased rates, the impact would be less visible than in the case of full
rate increases, and the government retained greater flexibility to spread the tax burden
away from voter-consumers and over future tax-paying generations. This would limit the
immediate political damage of the crisis but also postpone the resolution of the problem.

While ratepayers found a natural ally in the governing Democrat political coalition,
institutional structures afforded a strong degree of protection for the generation
companies and their shareholders, in this case from the intense adverse political
pressure within California. The original governance arrangements of the California ISO,
which was responsible for the operation of the transmission network, reflect the principle
of incorporating multiple interest groups in administrative structures. The enabling statute
specified that the governing board consist of representatives of "investor-owned utility
transmission owners, publicly owned utility transmission owners, nonutility electricity
sellers, public buyers and sellers, private buyers and sellers, industrial end-users,
commercial end-users, residential end-users, agricultural end-users, public interest
[69]
groups and nonmarket participant[s]." Since ISO decisions required a majority vote,
the diversity of interests represented on the board ensured that radical proposals would
likely be vetoed.[70] The generation companies could thus organize against, and
potentially veto, reforms proposed by competing stake holder groups that would threaten
their interests, for example regarding price cap levels or sanctions for facility operation or
maintenance transgressions.

Further protection for the generation companies stemmed from the fact that most major
policy decisions concerning the operation of the power markets still required the
agreement of FERC, which had jurisdiction over transmission pricing issues. Proposals
for changes in ISO price cap levels, for example, had to acquire FERC approval before
being implemented. Similarly, ISO decisions to impose sanctions on transmission facility
owners for inadequate operation or maintenance practices were also subject to FERC
approval. Although dramatic proposals for regulatory reform were unlikely to emanate
from the ISO, FERC had the authority to implement changes at the ISO that reduced
incumbent generation companies' market power. However, as a federal agency, FERC
had little incentive to make changes that simply gained political capital within California.
Although it could "punish" generation companies and appropriate past financial gains
without demonstrating abuse of market power, as a federal agency the implications for
investments throughout the nation would overcome any rush to expropriate rents within
the California market.

In sum, the plurality of interests embedded within the administrative structure of the
wholesale markets implied that agencies could not drastically swing regulatory policies to
consumers' short-term advantage - tightening wholesale price caps or otherwise
recouping windfall profits - in response to external political pressure. The generation
companies and shareholders that profited from relatively high wholesale energy prices
were therefore fairly secure from having their gains directly or indirectly expropriated.

While political and institutional factors insulated the interests of two major stake holder
groups, ratepayers and generators, in the reform process, the experience of the
distribution utilities was more mixed. The utilities' profits were highly exposed to
wholesale price fluctuations since the 1996 restructuring legislation originally froze retail
rates at a specified level until either the utilities' stranded generation costs had been
recovered or until January 2002 at the latest. Without the fulfillment of either of these
conditions, the utilities were unable to automatically pass on higher purchased energy
costs to consumers in the form of higher rates, resulting in substantial accumulated
financial losses by early 2001.

The utilities' financial distress need not have been the default outcome, however, since
the CPUC had some discretion to revalue the utilities' generation assets during 2000 and
hence to relax the fixed retail rate constraint. According to the original 1996 restructuring
legislation, AB 1890, the CPUC was required to value the utilities' generation assets, in
order to estimate their stranded assets, by the end of December 2001 at the latest.[71]
Despite repeated requests by the utilities to revalue their assets during 2001, the CPUC
refused to do so. Given the high wholesale energy prices at the time and thereafter, a
revaluation would have resulted in a large downward revision of the magnitude of the
utilities' stranded costs, thereby triggering the removal of the retail price caps. Exposing
consumers to the full cost of wholesale energy purchases, however, could have created
a political backlash similar to that which took place in San Diego. The Governor, and the
CPUC, however, did not seem interested in releasing retail rates. Instead, the CPUC
utilized its discretion to avoid having to evaluate PG&E's stranded assets, and, thus,
force it to finance the rate freeze. This is the type of opportunistic behavior which by not
following the intent of the 1996 legislation - to provide a fair valuation of the utilities'
stranded assets - effectively expropriated much of the utilities' sunk investments.

Despite the apparent opportunism of the CPUC in this instance, the US regulatory
governance system provides measures that can reverse such outcomes or else restrict
their frequency of occurrence. Specifically, the courts provide an additional check in the
determination of regulatory policy. Agency decisions are subject to judicial review and
federal legal precedent stipulates that utilities are entitled to a fair rate of return on their
investments.[72] Furthermore, agency decision-making procedures are governed by a
well-developed body of administrative law, limiting their ability for making rulings, and
agencies and legislatures cannot penalize utilities without first demonstrating managerial
imprudence or malfeasance. The role of the courts in the broader public policy process
was evident in California where the utilities turned to the state and federal courts in an
attempt to shift regulatory policy in their favor. PG&E filed a case in the California
Supreme Court concerning the losses it had sustained in the PX during 2000 and also a
case in a federal court requesting an injunction against the CPUC to raise consumer bills
by more than $3.4 billion.[73] Although PG&E ultimately filed for bankruptcy, its timing
may be interpreted as a strategic move to seek judicial resolution in the absence of a
political solution to its inability to pay creditors. Southern California Edison also adopted
a judicial strategy, using a previously filed lawsuit against the CPUC to gain leverage in
negotiating a settlement with the agency in October 2001.

Litigation thus provides utilities with an additional avenue to protect their interests,
though the emphasis on due process in the judicial system guarantees that in complex
cases with multiple intervenors, ultimate resolutions are reached only after a substantial
time interval.

While market events in the Californian electricity industry eventually catalyzed political
pressure for regulatory reform, the complex set of checks and balances characteristic of
the US policy-making environment suggests that the market power issue would be
unlikely to trigger policy changes that drastically disadvantaged the major interest groups
involved. Although one of the California utilities was driven towards bankruptcy, and
another lost half of its market value, the political acrobatics undertaken by the governor
and the legislature were intended to avoid both judicial review and a political backlash.
Thus, the web of judicial protection and multiple layers of authority in a fragmented polity
assure investors, to a large extent, that their quasi-rents will not be easily taken away by
administrative fiat. Although the unexpected shock associated with the increase in
wholesale market prices generated a serious financial crisis for the utilities and
substantial political heat, the basic governance provides for multiple checks on arbitrary
decision-making, such that a resolution of the crisis could be in sight without affecting the
[74]
long-term investment incentives of the various players.

4.3 Market power and regulatory reform in El Salvador

El Salvador started to consider the reform of its electricity market in 1991 when the
government created the Executive Committee for the Energy Project as an inter-
ministerial committee to participate in a World Bank funded project whose purpose was
to promote competition in the sector. In 1995 a private generation company started
operating a 127MW thermal plant in the form of a Build-Operate-Own (BOO) project with
CEL, the public generation and transmission company.[75] In 1996 the Salvadorean
Assembly passed the 1996 General Electricity Act. Among other things, the 1996 Act
created a wholesale market with programmed dispatch based on bilateral or multilateral
contracts coupled with a balancing market, eliminated franchise monopolies in the
distribution and transmission sector, created an independent dispatch operator
(composed, as the California ISO, of stake holders), instituted open access to
transmission and distribution facilities, regulated charges for the use of both types of
networks, and required the publicly owned generation and transmission company to
create a separate transmission company.
The wholesale market started operating in January 1998 following the privatization of
four distribution companies. The initial effect of the creation of the wholesale market was
a slight drop in wholesale prices. While prior to the start of the wholesale market in 1998
prices to distributors were around 8 per kWh, from January 1998 onwards, prices
tended to move in the 6-8 range (see figure 25.3). In August 1999, CEL sold its
thermal park composed of three thermal plants to Duke Energy International. As figure
25.3 shows, prices started to increase shortly thereafter, reaching a peak of 17 per
kWh in April 2000, and falling then to more normal levels in May 2000 following the
signature of a long-term contract between CEL and Duke for approximately 50 percent of
Duke's capacity.




Figure 25.3: Unit spot price, El Salvador wholesale market, January 1998-May 2000

The drastic price increase in early 2000 generated substantial political problems. The
1996 Act required the indexation of the retail tariffs to the evolution of wholesale market
prices. An Executive Decree interpreted the indexation to have two components: a
quarterly indexation and an annual indexation. Once a year tariffs would be "reset" so
that the average increase in the previous year would be translated into the new tariff
structure. Within the year, tariffs were adjusted quarterly if the price increase during the
quarter exceeded 10 percent. In July 2000 the quarterly indexation would have implied a
substantial increase in prices, as wholesale prices in the first quarter of 2000 were more
than 50 percent above prices in the prior quarter. This, on top of an important increase in
[76]
the retail tariffs for the first quarter, triggered substantial political concerns. Although a
careful analysis of the situation shows that Duke and CEL were essentially keeping
prices high during the last quarter of 1999 and the first quarter of 2000,[77] the
government and the press placed the emphasis on imports from Guatemala and on the
presumed high profits of the private distribution companies. Pressure grew to reverse the
1996 Electricity Act to regulate wholesale prices and to further regulate the profits of the
distribution companies.

The government responded to the political pressure in three fundamental ways: first, it
amended its interpretation of the 1996 Act, second it instituted direct subsidies to the
residential users, and, third, CEL entered into a contract with Duke Energy for a
substantial portion of Duke's capacity. The impact of these three acts was, first, to
expropriate a substantial part of the distribution companies quasi-rents: the change in the
Executive Decree interpreting the 1996 Act was undertaken in August 2000, just prior to
when the third-quarter indexation was to take place. It essentially eliminated the
adjustment that would have compensated the distribution companies for the losses they
had incurred when the wholesale price was above the retail tariff. By modifying the
interpretation of the law just prior to the introduction of the compensating adjustment, the
intertemporal compensation was eliminated. The second effect was to expropriate a
substantial portion of the public generation company's quasi-rents: during 1999 the
subsidies that the government required CEL to provide to the distribution companies
were approximately equal to all of its pre-tax operating profits.[78] Finally, via the contract
with Duke, the government monopolized the operation of the wholesale market in the
[79]
hands of CEL.

Although these three actions had a direct impact on retail tariffs, thus alleviating an
important short-term political problem, they may have a major impact on the viability of
the competitive framework, creating a long-term problem for the country. On the one
hand the contract with Duke eliminated the incentive that Duke might have had to limit
[80]

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