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supply into the market. Since the CEL/Duke contract price is based on Duke's
operating costs, Duke will not benefit from limiting the availability of its remaining 15
percent of the generation capacity.[81] Thus, the fall that took place in prices in May 2000
can be directly related to the CEL/Duke contract. On the other hand, the subsidies
[82]
granted by CEL and the reform of the interpretation of the 1996 Act softened the
impact of the price spike on consumers.[83] Indeed, following the reduction in the spot
price, the government substantially reduced the subsidies.[84]

The speed with which the government, and government entities like CEL, moved, and
the redistributive character of the reforms, raises substantial questions about the nature
of the governance structure of the sector. Indeed, a close examination shows that the
regulatory governance of the sector is very weak, raising questions about its ability to
sustain private investment in the long run.

El Salvador is a Presidential republic with a single-chamber Legislative Assembly.[85] The
Salvadorean Supreme Court justices do not have life tenure, and the legislature renews
the justices' appointments. As a consequence, the judiciary is highly sensitive to political
issues and is subject to substantial legislative control. The lack of judicial independence
is particularly problematic given the ability of the president to interpret legislation via
Executive Decrees.[86] Since attempts to overturn Executive Decrees that have support in
the legislature are unlikely to be supported by the courts, it is not surprising that, differing
from the distribution companies in California, the Salvadorean utilities have not filed suits
against the government for a change in its interpretation of the 1996 Act which has cost
them several million dollars.

The regulatory governance regime, then, provides for a high level of regulatory flexibility,
and hence may generate credibility problems which, in the long run, will tend to
discourage private investment. The 1996 Act, however, provides no further instruments
to limit the government discretion. Although the Act could have been substantially more
specific and, in particular, it could have not granted the government the ability to regulate
retail prices, it did. Granting the government the ability to regulate final tariffs, the
legislature opened a Pandora's box, where the executive, via decrees, can modify more
or less at its pleasure the nature of such regulation. Had the 1996 Act not granted the
government the right to set retail prices, the government could have still expropriated
[87]
CEL's quasi-rents and entered into a contract with Duke, but it would not have been
able to affect the profitability of the distribution companies.

This case shows, then, that in institutional environments with few checks and balances,
regulatory frameworks have to place particular emphasis on limiting the discretion of the
government, rather than in granting flexibility. The 1996 Act failed to do so, and thus
created a serious credibility crisis.

[35]
The demand elasticity is often made lower by not allowing the demand side to bid into the
spot or balancing markets.

[36]
Similarly, in California, auction rules and particular regulations (particularly, the requirement
that the large distribution companies trade exclusively in the formal power exchange, and that
wholesale market prices are capped), provided some distributors with the incentives to bring
down their costs by under-scheduling demand in the day-ahead market. Under-scheduling
demand generates prices in the day ahead market which are below the price cap. The
remaining demand traded in the real-time market would be priced at the cap. Were the
distribution company to schedule its whole demand on the day-ahead market, the day-ahead
price would have hit the price cap limit, increasing the distribution company's overall energy
payments.

[37]
It should be emphasized that so far there has not been a claim of the coordinated exercise
of market power, an action that is illegal in both the United Kingdom and the United States but
not in El Salvador, which has no antitrust legislation.

[38]
See also Green and Newbery (1992) and Newbery and Pollitt (1997) for theoretical and
empirical analyses of the operations of the UK electricity pool.
[39]
Buyers and sellers are free, though, to enter into financial forward contracts known as
"Contracts for Differences."

[40]
See Gilbert and Kahn (1996) for an extensive discussion of electricity regulation
arrangements across fifteen countries including an insightful chapter by Newbery and Green
(1996) on the UK electricity industry.

[41]
Capacity payments have been extensively criticized as an ineffective way of promoting
capacity investment. For a critique, see Oren (2000).

[42]
Office of Gas and Electricity Markets, The New Electricity Trading Arrangements (NETA),
July 1999, p. 3.

[43]
The Pool committee consists of generation and supply company representatives. In order
to protect minority interests, such as small generators and suppliers, and potential entrants,
changes in the operational rules of the pool may be implemented only upon a supermajority
vote of the committee.

[44]
Ibid., pp. 28-9.

[45]
Ibid.,p.2.

[46]
See Spiller and Vogelsang (1997) for a discussion of how the UK system of administrative
checks and balances provides a measure of credibility to the UK regulatory process not
otherwise found in its polity.

[47]
See also Spiller and Vogelsang (1997).

[48]
Office of Gas and Electricity Markets, NETA, October 1999, p. 1.

[49]
Competition Commission, Statement by Callum McCarthy, Director General of Ofgem
Addressing the Scope for, and Experience of, the Abuse of Market Power by the Generators
Under the Wholesale Electricity Pool in England and Wales.

[50]
AES and British Energy challenged the DG's move at the Competition Commission.
Similarly, in the mid-1990s the DG promoted plant divestitures from the main generators
under the threat of a reference to the Monopolies and Mergers Commission (MMC) for a
forced license modification (through the Electricity Act) or a structural remedy (through the
Competition Act). The ability to make a reference to the MMC requesting a license
modification forces the generators to consider to what extent the MMC will side with the DG.

[51]
Office of Electricity Regulation, Review of Electricity Trading Arrangements: Proposals, July
1998.

[52]
White Paper on Energy Policy, HMSO Cm 4071.

[53]
Office of Electricity Regulation, Review of Electricity Trading Arrangements: Framework
Document, November 1998.

[54]
See, Ofgem/DTI, "The New Electricity Trading Arrangements: Ofgem/DTI Conclusions
Document," October 1999, available from http://www.ofgem.gov.uk/elarch/anetadocs.htm.

Using the power granted to the Secretary of State for Trade and Industry by the Utilities
Act 2000, the Secretary designated new license conditions requiring the licensees to
sign the required documents to implement the NETA. These documents include the
Balancing and Settlement Code, licensing changes and the implementation schedule.
See Ofgem Press Release August 14, 2000, PN 89.
[55]
See Ofgem Press Release October 27, 2000, PN 114.

[56]
See http://www.ofgem.gov.uk/elarch/05forums.htm for a list of industry forums undertaken
by Ofgem.

[57]
The NETA will base dispatch on a system of bilateral and multilateral trading coupled with a
balancing market in which the buyer is the dispatch operator who buys balancing services
from both demand and supply utilizing - so as to discourage the use of the balancing market
as a scheduling device - "pay as bid" rather than a single price to all participants. The bilateral
trading and balancing mechanism will be accompanied by a series of forward markets to be
developed by the industry.

[58]
These institutions were established in late 1996 by the state legislature as the two central
institutions to develop and operate a competitive wholesale market.

[59]
See also Joskow (2000, pp. 79-107), and California ISO Market Surveillance Committee
Report, October 1999, for discussions of the California electricity wholesale market.

[60]
At one point, ISO prices for replacement reserves reached just shy of $10,000 per MWh
until the ISO requested Federal Energy Regulatory Commission (FERC) authority to cap
prices at $250 per MWh.

[61]
Distributors subject to the price cap regulation started charging their customers negative
Competition Transmission Charges (CTCs), which meant that the CTC became an instrument
to subsidize customers, rather than for customers to pay for stranded assets, as originally
intended. As a consequence, their recovery of the uneconomic generation costs - as defined
in the Electricity Restructuring Act 1996 (AB 1890) - was postponed further into the future,
which increased their risk of never recovering such amounts, driving them closer to
bankruptcy.

[62]
The California Public Utilities Commission (CPUC) Decision of May 27, 1999 limited price
increases for the summer of 1999, but completely liberated prices thereafter.

San Diego Gas & Electric (SDG&E) ended its "transition period" during mid-1999 and
hence was allowed to start passing through the energy costs to its - so far - captive
customers. See CPUC Decision 99-05-051 of May 27, 1999, which approved the end of
the transition period, implying that SDG&E had recovered all its uneconomic generation
costs subject to AB 1890 provisions. The decision can be found in
http://www.cpuc.ca.gov/static/electric/electric_restructuring/decisions.htm.

[63]
San Francisco Chronicle, "PG&E Bargains with Wary Gas Suppliers," February 3, 2001.

[64]
A Stage 1 Emergency Notice is declared by the ISO any time it is clear that an Operating
Reserve shortfall is unavoidable or, when in real-time operations, the Operating Reserve is
forecast to be less than the minimum after utilizing available resources. A Stage 2 Emergency
Notice occurs when the Operating Reserve is forecast to be less than 5 percent after
dispatching all resources available. During 1999 there were four Stage 1 and one Stage 2
Emergency Notices. A Stage 3 Emergency Notice is declared when the Operating Reserve is
forecast to be less than 1.5 percent after dispatching all resources available. No Stage 3
Emergencies occurred during 1998 or 1999 and only one occurred in 2000 (see ISO Event
Log).

[65]
Although some have emphasized that the crisis of winter 2001 was more a liquidity than an
energy crisis.

[66]
In the case at hand, judicial review of legislative acts would be based on their
constitutionality, while judicial review of administrative acts would be based both on their
legality (i.e. whether they follow the various statutes) and their constitutionality.
[67]
On the relationship between regulatory agencies and legislatures, and on the role of
administrative procedures, see McCubbins and Schwartz (1984); McCubbins, Noll and
Weingast (1987, 1989); Epstein and O'Halloran (1994, 1996); Tiller and Spiller (1996); Tiller
(1998); Holburn and Vanden Bergh (2000).

[68]
The need for political compromise is also evident in the 1996 bill that restructured the
Californian electricity industry, which was enacted by a Republican governor and Democrat-
controlled legislature who held differing positions on a wide range of policy issues including
electricity reform. While incumbent utilities were allowed to recover their stranded assets
through a CTC levy on all bills, consumers were guaranteed retail rates fixed at 10 percent
below their historic levels during a pre-specified transition period. This approach was
politically expedient - it gave consumers a rapid benefit from restructuring - but a major
consequence was the elimination of retail competition in the supply market. At the same time,
it generated the presumption of price stability even in the presence of substantial wholesale
energy cost changes, reducing large users' incentives to enter into demand-side management
programs. Once the transition period in southern California finished in July 1999 and retail
price caps were removed, retail customers were confronted with volatile prices but with no
options to buy alternative rate plans offering price stability, triggering substantial calls for
regulatory reform. As discussed above, the retail price cap also generated a negative CTC
when wholesale prices skyrocketed, bringing the major utilities close to bankruptcy. To a large
extent, therefore, the foundations of the Californian energy crisis were rooted in the political
logic that shaped the initial restructuring legislation of 1996.

[69]
AB 1890, Section 337

[70]
FERC disbanded the existing ISO Board on December 15, 2000 and ordered its
reconstitution with new members who were not stake holders or participants in ISO
operations.

[71]
Article 367, AB 1890.

[72]
The Hope Natural Gas and Bluefield cases set the precedent of "just and reasonable"
profits as the norm for regulated industries (see Bonbright 1961).

[73]
San Francisco Chronicle, November 9, 2000, "New Angle to PG&E Bid to Raise Rates:
Utility Files Complaint in Federal Court."

Although a federal court decision in early February 2001 cast some doubt on whether the
utilities would be allowed to raise final rates in order to gain full compensation for their
distribution business losses, the determination of this issue is made by a disinterested
party (i.e. the courts) on the merits of the case (while the distribution operations of the
utilities made large financial losses during 2000, their generation businesses naturally
benefited from high PX prices, leading some to argue that full compensation is not
required). The courts therefore provide an important check against the risk that the state
government, seeking political favor with its constituents, may prevent the utilities from
recovering their sunk costs (see Southern California Edison v. Lynch (California Public
Utilities Commission), US District Court, Central District of California, Case no. 00-
12056-RSWL (Mcx).

[74]
More than anything, the California example shows the political risk of placing all the weight
in spot markets, and the need for promoting long-term contracts between load-serving
companies and generators.

[75]
CEL, which stands for Comisión Ejecutiva Hidroel©ctrica del Río Lema, was also the owner
of various distribution companies.
[76]
See, "Cargo de Energía sube 52 percent," El Diario de Hoy, Thursday April 6, 2000, San
Salvador, and "Energía: el alza no tocará los hogares," El Diario de Hoy, Tuesday April 4,
2000, San Salvador.

[77]
See Spiller (2000).

[78]
See Memoria de Labores, CEL (1999).

[79]
Prior to signing the contract with Duke, CEL had control over approximately 70 percent of
the domestic generation, and Duke of the remaining 30 percent. Since the contract transfers
to CEL control more than half of Duke's generation capacity, it essentially granted CEL
control almost completely over the wholesale market.

[80]
Spiller (2000) claims that such restrictions were what triggered the increase in price during
the fourth quarter of 1999 and the first quarter of 2000.

[81]
See "Costosa energía no generada," El Diario de Hoy, El Salvador, October 18, 2000.

[82]
See "La fuerza de la Generación," Más!, El Salvador, October 3, 2000.

[83]
See "Subsidio cuesta a CEL c1, 470 millones," La Prensa Gráfica, October 17, 2000.

[84]
See "CEL invierte más de mil millones en generación," La Prensa Gráfica, El Salvador,
October 17, 2000.

[85]
The nature and timing of presidential and legislative elections imply that the President does
not necessarily have a majority in the assembly.

[86]
Indeed, a simple reading of the original Executive Decree interpreting the 1996 Act would
suggest that such an interpretation violates the Act. The Act says in its article 79that retail
prices should be adjusted based on "the average price of the energy in the wholesale market
in the respective node during the year prior to the filing of the tariffs." The Executive Decree
introduced a 10 percent adjustment clause and a quarterly adjustment.

[87]
Since the contract with Duke is voluntary, it is reasonable to expect that Duke receives
from CEL at least what it could obtain from the wholesale market.
5 Final comments
Electricity reforms are being undertaken throughout the world. Much emphasis is being
placed on industry-structure issues. This chapter emphasizes that although industrial
structure is important “ affecting market power and efficiency considerations “ a more
fundamental issue is the regulatory governance of the sector. By looking at how three
countries reacted to alleged instances of exploitation of market power in wholesale
energy markets, we show how governance structures determine the degree to which
regulatory policies respond to partisan political pressures. The case of El Salvador
illustrates how weak governance regimes, characterized here by a paucity of legislative
checks and balances, a politicized judiciary, and considerable executive discretion, can
lead to policy reforms in the presence of economic shocks that effectively expropriate
certain interest groups. Here, the government insulated final consumers from the full
impact of increased wholesale prices by implementing substantial subsidies. It did so at
the expense of the private distribution companies by ex post manipulating the pricing
mechanism such that the distribution companies could not fully adjust final rates to
compensate for higher wholesale prices in the recent past, thereby expropriating some of
their quasi-rents. The government also appropriated the profits of the state generating
company to further subsidize final consumers.
On the other hand, countries such as the United Kingdom, with stronger regulatory
governance structures can weather the political storms associated with spiking
wholesale prices without engendering credibility crises in the industry. In the United
States, the presence of multiple checks and balances, at legislative, administrative, and
judicial levels, limits the scope for implementing policy changes that drastically
redistribute rents between interest groups. The generation companies, being regulated
primarily by federal agencies, were insulated from direct state-level political pressures to
appropriate some of their financial gains previously earned in the power market. The
distributors, however, were exposed to opportunistic behavior by the CPUC. However,
the option of independent judicial review, including bankruptcy proceedings, provides an
opportunity for the distribution companies to recoup some of their losses by challenging
agency and legislature policy decisions. In the United Kingdom, strong norms of judicial
and agency independence, and a complex system of administrative checks and
balances, also provided reassurance for investors while simultaneously allowing the
government to implement policy reforms.

In the United Kingdom and to some extent in California, strong regulatory governance
structures protected regulatory policy, and investors' interests, from the immediate
political pressures to implement industry reforms that would directly or indirectly
expropriate their assets or revenue streams.

Finally, for policy-makers, our chapter argues that governments should emphasize the
appropriate match of the sectoral regulatory governance framework to the nature of their
political, judicial, and administrative institutions. In instances where institutions do not
provide for a system of substantial checks and balances, the regulatory governance
regime should be substantially rigid, so that unexpected shocks, which will always come,
do not reverse the progress already undertaken in reform programs.
Notes
We would like to thank Ioannis Kessides and David Newbery for their persistent
questioning and Richard Green for helpful comments. All remaining errors are naturally
our own.
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).
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.
35. The demand elasticity is often made lower by not allowing the demand
side to bid into the spot or balancing markets.
36. Similarly, in California, auction rules and particular regulations
(particularly, the requirement that the large distribution companies trade
exclusively in the formal power exchange, and that wholesale market
prices are capped), provided some distributors with the incentives to
bring down their costs by under-scheduling demand in the day-ahead
market. Under-scheduling demand generates prices in the day ahead
market which are below the price cap. The remaining demand traded in
the real-time market would be priced at the cap. Were the distribution
company to schedule its whole demand on the day-ahead market, the
day-ahead price would have hit the price cap limit, increasing the
distribution company's overall energy payments.
37. It should be emphasized that so far there has not been a claim of the
coordinated exercise of market power, an action that is illegal in both the
United Kingdom and the United States but not in El Salvador, which has
no antitrust legislation.
38. See also Green and Newbery (1992) and Newbery and Pollitt (1997) for
theoretical and empirical analyses of the operations of the UK electricity
pool.
39. Buyers and sellers are free, though, to enter into financial forward
contracts known as "Contracts for Differences."
40. See Gilbert and Kahn (1996) for an extensive discussion of electricity
regulation arrangements across fifteen countries including an insightful
chapter by Newbery and Green (1996) on the UK electricity industry.
41. Capacity payments have been extensively criticized as an ineffective way
of promoting capacity investment. For a critique, see Oren (2000).
42. Office of Gas and Electricity Markets, The New Electricity Trading
Arrangements (NETA), July 1999, p. 3.
43. The Pool committee consists of generation and supply company
representatives. In order to protect minority interests, such as small
generators and suppliers, and potential entrants, changes in the
operational rules of the pool may be implemented only upon a
supermajority vote of the committee.
44. Ibid., pp. 28-9.
45. Ibid.,p.2.
46. See Spiller and Vogelsang (1997) for a discussion of how the UK system
of administrative checks and balances provides a measure of credibility
to the UK regulatory process not otherwise found in its polity.
47. See also Spiller and Vogelsang (1997).
48. Office of Gas and Electricity Markets, NETA, October 1999, p. 1.
49. Competition Commission, Statement by Callum McCarthy, Director
General of Ofgem Addressing the Scope for, and Experience of, the
Abuse of Market Power by the Generators Under the Wholesale
Electricity Pool in England and Wales.
50. AES and British Energy challenged the DG's move at the Competition
Commission. Similarly, in the mid-1990s the DG promoted plant
divestitures from the main generators under the threat of a reference to
the Monopolies and Mergers Commission (MMC) for a forced license
modification (through the Electricity Act) or a structural remedy (through
the Competition Act). The ability to make a reference to the MMC
requesting a license modification forces the generators to consider to
what extent the MMC will side with the DG.
51. Office of Electricity Regulation, Review of Electricity Trading
Arrangements: Proposals, July 1998.
52. White Paper on Energy Policy, HMSO Cm 4071.
53. Office of Electricity Regulation, Review of Electricity Trading
Arrangements: Framework Document, November 1998.
54. See, Ofgem/DTI, "The New Electricity Trading Arrangements: Ofgem/DTI
Conclusions Document," October 1999, available from
http://www.ofgem.gov.uk/elarch/anetadocs.htm.
Using the power granted to the Secretary of State for Trade and Industry by
the Utilities Act 2000, the Secretary designated new license conditions
requiring the licensees to sign the required documents to implement the
NETA. These documents include the Balancing and Settlement Code,
licensing changes and the implementation schedule. See Ofgem Press
Release August 14, 2000, PN 89.
55. See Ofgem Press Release October 27, 2000, PN 114.
56. See http://www.ofgem.gov.uk/elarch/05forums.htm for a list of industry
forums undertaken by Ofgem.
57. The NETA will base dispatch on a system of bilateral and multilateral
trading coupled with a balancing market in which the buyer is the
dispatch operator who buys balancing services from both demand and
supply utilizing - so as to discourage the use of the balancing market as
a scheduling device - "pay as bid" rather than a single price to all
participants. The bilateral trading and balancing mechanism will be
accompanied by a series of forward markets to be developed by the
industry.
58. These institutions were established in late 1996 by the state legislature
as the two central institutions to develop and operate a competitive
wholesale market.
59. See also Joskow (2000, pp. 79-107), and California ISO Market
Surveillance Committee Report, October 1999, for discussions of the
California electricity wholesale market.
60. At one point, ISO prices for replacement reserves reached just shy of
$10,000 per MWh until the ISO requested Federal Energy Regulatory
Commission (FERC) authority to cap prices at $250 per MWh.
61. Distributors subject to the price cap regulation started charging their
customers negative Competition Transmission Charges (CTCs), which
meant that the CTC became an instrument to subsidize customers,
rather than for customers to pay for stranded assets, as originally
intended. As a consequence, their recovery of the uneconomic
generation costs - as defined in the Electricity Restructuring Act 1996
(AB 1890) - was postponed further into the future, which increased their
risk of never recovering such amounts, driving them closer to bankruptcy.
62. The California Public Utilities Commission (CPUC) Decision of May 27,
1999 limited price increases for the summer of 1999, but completely
liberated prices thereafter.
San Diego Gas & Electric (SDG&E) ended its "transition period" during mid-
1999 and hence was allowed to start passing through the energy costs to its -
so far - captive customers. See CPUC Decision 99-05-051 of May 27, 1999,
which approved the end of the transition period, implying that SDG&E had
recovered all its uneconomic generation costs subject to AB 1890 provisions.
The decision can be found in
http://www.cpuc.ca.gov/static/electric/electric_restructuring/decisions.htm.
63. San Francisco Chronicle, "PG&E Bargains with Wary Gas Suppliers,"
February 3, 2001.
64. A Stage 1 Emergency Notice is declared by the ISO any time it is clear
that an Operating Reserve shortfall is unavoidable or, when in real-time
operations, the Operating Reserve is forecast to be less than the
minimum after utilizing available resources. A Stage 2 Emergency Notice
occurs when the Operating Reserve is forecast to be less than 5 percent
after dispatching all resources available. During 1999 there were four
Stage 1 and one Stage 2 Emergency Notices. A Stage 3 Emergency
Notice is declared when the Operating Reserve is forecast to be less
than 1.5 percent after dispatching all resources available. No Stage 3
Emergencies occurred during 1998 or 1999 and only one occurred in
2000 (see ISO Event Log).
65. Although some have emphasized that the crisis of winter 2001 was more
a liquidity than an energy crisis.
66. In the case at hand, judicial review of legislative acts would be based on
their constitutionality, while judicial review of administrative acts would be
based both on their legality (i.e. whether they follow the various statutes)
and their constitutionality.
67. On the relationship between regulatory agencies and legislatures, and on
the role of administrative procedures, see McCubbins and Schwartz
(1984); McCubbins, Noll and Weingast (1987, 1989); Epstein and
O'Halloran (1994, 1996); Tiller and Spiller (1996); Tiller (1998); Holburn
and Vanden Bergh (2000).
68. The need for political compromise is also evident in the 1996 bill that
restructured the Californian electricity industry, which was enacted by a
Republican governor and Democrat-controlled legislature who held
differing positions on a wide range of policy issues including electricity
reform. While incumbent utilities were allowed to recover their stranded
assets through a CTC levy on all bills, consumers were guaranteed retail
rates fixed at 10 percent below their historic levels during a pre-specified
transition period. This approach was politically expedient - it gave
consumers a rapid benefit from restructuring - but a major consequence
was the elimination of retail competition in the supply market. At the
same time, it generated the presumption of price stability even in the
presence of substantial wholesale energy cost changes, reducing large
users' incentives to enter into demand-side management programs.
Once the transition period in southern California finished in July 1999
and retail price caps were removed, retail customers were confronted
with volatile prices but with no options to buy alternative rate plans
offering price stability, triggering substantial calls for regulatory reform.
As discussed above, the retail price cap also generated a negative CTC
when wholesale prices skyrocketed, bringing the major utilities close to
bankruptcy. To a large extent, therefore, the foundations of the
Californian energy crisis were rooted in the political logic that shaped the
initial restructuring legislation of 1996.
69. AB 1890, Section 337
70. FERC disbanded the existing ISO Board on December 15, 2000 and
ordered its reconstitution with new members who were not stake holders
or participants in ISO operations.
71. Article 367, AB 1890.
72. The Hope Natural Gas and Bluefield cases set the precedent of "just and
reasonable" profits as the norm for regulated industries (see Bonbright
1961).
73. San Francisco Chronicle, November 9, 2000, "New Angle to PG&E Bid
to Raise Rates: Utility Files Complaint in Federal Court."
Although a federal court decision in early February 2001 cast some doubt on
whether the utilities would be allowed to raise final rates in order to gain full
compensation for their distribution business losses, the determination of this
issue is made by a disinterested party (i.e. the courts) on the merits of the
case (while the distribution operations of the utilities made large financial
losses during 2000, their generation businesses naturally benefited from high
PX prices, leading some to argue that full compensation is not required). The
courts therefore provide an important check against the risk that the state
government, seeking political favor with its constituents, may prevent the
utilities from recovering their sunk costs (see Southern California Edison v.
Lynch (California Public Utilities Commission), US District Court, Central
District of California, Case no. 00-12056-RSWL (Mcx).
74. More than anything, the California example shows the political risk of
placing all the weight in spot markets, and the need for promoting long-
term contracts between load-serving companies and generators.
75. CEL, which stands for Comisión Ejecutiva Hidroel©ctrica del Río Lema,
was also the owner of various distribution companies.
76. See, "Cargo de Energía sube 52 percent," El Diario de Hoy, Thursday
April 6, 2000, San Salvador, and "Energía: el alza no tocará los
hogares," El Diario de Hoy, Tuesday April 4, 2000, San Salvador.
77. See Spiller (2000).
78. See Memoria de Labores, CEL (1999).
79. Prior to signing the contract with Duke, CEL had control over
approximately 70 percent of the domestic generation, and Duke of the
remaining 30 percent. Since the contract transfers to CEL control more
than half of Duke's generation capacity, it essentially granted CEL control
almost completely over the wholesale market.
80. Spiller (2000) claims that such restrictions were what triggered the
increase in price during the fourth quarter of 1999 and the first quarter of
2000.
81. See "Costosa energía no generada," El Diario de Hoy, El Salvador,
October 18, 2000.
82. See "La fuerza de la Generación," Más!, El Salvador, October 3, 2000.
83. See "Subsidio cuesta a CEL c1, 470 millones," La Prensa Gráfica,
October 17, 2000.
84. See "CEL invierte más de mil millones en generación," La Prensa
Gráfica, El Salvador, October 17, 2000.
85. The nature and timing of presidential and legislative elections imply that
the President does not necessarily have a majority in the assembly.
86. Indeed, a simple reading of the original Executive Decree interpreting the
1996 Act would suggest that such an interpretation violates the Act. The
Act says in its article 79that retail prices should be adjusted based on
"the average price of the energy in the wholesale market in the
respective node during the year prior to the filing of the tariffs." The
Executive Decree introduced a 10 percent adjustment clause and a
quarterly adjustment.
87. Since the contract with Duke is voluntary, it is reasonable to expect that
Duke receives from CEL at least what it could obtain from the wholesale
market.
Electricity Sector Restructuring and
Chapter 26:

Competition”A Transactions-Cost
Perspective
Paul L. Joskow
1 Introduction
One of the most important changes in industrial organization that has taken place around
the world in the last fifteen years is the restructuring of industries which were historically
considered to be natural monopolies and were subject to strict government price and
entry regulation (and were often state-owned as well). These industries include
telecommunications, electric power, natural gas transportation, and railroads. The
primary goals of these restructuring initiatives have been to promote competition in those
horizontal segments of these industries which are conducive to it, to shrink the scope of
industry output organized as a regulated monopoly, and to introduce new regulatory
mechanisms for residual regulated monopoly segments to provide better incentives for
[1]
cost reduction and efficient pricing.

In Joskow (1991) I argued that transaction-cost economics (TCE) provides an
indispensable set of tools for understanding how the organizations subject to reform had
emerged, how they are likely to respond as economic and regulatory conditions change,
and how effective industry restructuring can be accomplished.[2] A major thrust of these
restructuring initiatives has involved vertical separation of potentially competitive
segments (e.g. electricity generation) from natural monopoly segments (e.g. electricity
transmission).[3] It has been my view that there are very sound TCE reasons why these
industries evolved with vertically integrated structures.[4] Other things equal, vertical
integration conserves on a variety of transactions costs compared to an unintegrated
governance structure. Accordingly, vertical restructuring to promote competition in
certain horizontal segments must necessarily confront a trade-off between the potential
benefits of market forces replacing inefficient regulated monopolies and the potential
costs associated with various inefficiencies arising from vertical de-integration. The
challenge for the development of new governance arrangements in these industries is to
keep the costs of vertical separation low while obtaining the benefits of competition.
These challenges are especially great when the performance of the competitive
segments (e.g. electricity generation) depends critically on the details of relationships
with segments which were previously under common ownership (vertical integration) and
that continue to be regulated monopolies (e.g. electricity transmission) which buyers and
sellers in the competitive segments depend upon to support competitive trading
[5]
relationships:

Major vertical restructuring of industries that involve significant non-redeployable sunk
investments, the operation of complicated networks, and significant costs of system
failure, necessarily raise precisely the kinds of organizational issues that transaction cost
economics is supposed to be able to deal with well. However, while transaction cost
economics has played a role in the debates about vertical restructuring in these
industries, and the precise form that such restructuring would take, it is my sense that
the direct role of transaction cost considerations in influencing the direction of public
policy has, so far, been quite modest.[6]

We now have an additional decade of experience with industry restructuring in these
industries since I made these observations in 1991. I focus here on the experience with
electricity sector restructuring and competition programs. I first wrote about the
challenges that must be confronted to create well-functioning competitive wholesale
electricity markets, drawing heavily on the early TCE, literature almost twenty years
ago.[7] I have continued to follow the evolution of electricity sector reforms and evaluate
[8]
their results since then. While the electricity sector reform programs in many countries
have been successful in the sense that the benefits of the reforms exceed the costs of
the reforms,[9] a number of common problems have emerged in many of them.[10]
Moreover, in countries whose "traditional" electricity sectors performed reasonably well,
recent experience has raised questions about whether in reality, rather than in theory,
the benefits of these reforms necessarily exceed their costs.
There are two important elements of TCE thinking that I will focus on here. First, I want
to emphasize the importance of adopting the conceptual framework of "comparative
institution choice" to evaluate whether structural regulatory and competition reforms are
[11]
desirable, and, if they are, what form the new governance arrangements should take.
Resource allocation to and within an industry can be organized in a variety of different
ways. None of these alternative institutional or governance structures will yield "perfect"
performance compared to some abstract "social planner's" ideal. Each set of alternative
institutional arrangements will have some net costs compared to that abstract ideal. The
task of policymakers is to choose among alternative institutional designs to find the one
that minimizes the total costs of governing the transactions at issue, carefully accounting
for direct production costs, transactions costs, including the costs of opportunistic
behavior and costs incurred to mitigate it, and other market and institutional
imperfections. That is, to choose the best governance structure from a set of imperfect
governance structures. From this perspective, concluding that some industry structure
and associated governance arrangements are "inefficient" compared to some abstract
ideal is not enough to justify a proposed reform. The alternative market structure,
governance, and institutional arrangements must be defined and their performance
properties carefully evaluated. A movement to the alternative governance arrangements
is justified when the new institutional framework is less costly than the incumbent
framework “ that is, the reform makes things better than the status quo. And ideally, the
reforms will adopt the governance structure from the set of potential alternatives that
maximize these gains.
The second important set of issues that I emphasize is associated with a variety of
potential transactional problems that arise when a complex existing market structure and
supporting institutions are fundamentally changed. I will focus here on transactional
problems that arise because of the presence of long-lived capital investments that had
been made in the past under then-prevailing institutional arrangements and are now not
easily redeployable. The historical pattern of investments that created the existing
configuration of generating, transmission, and distribution assets was well adapted “ in a
transactions-cost conservation sense “ to the governance arrangements in which they
were made “ regulated vertically integrated monopolies. In particular, the asset
configuration did not reflect efforts to economize on the transactions costs that could
arise in an industry with a very different structure. These incumbent or "legacy" long-lived
sunk investments create potential hold-up and coordination problems ex ante when the
existing industry structure is deintegrated vertically and horizontally into independent
firms pursuing their own self-interest. As I will discuss presently, these problems are
revealed post-restructuring in the form of supplier market power problems, coordination
difficulties between the generation, transmission, and distribution segments, sub-optimal
investments in transmission capacity, and excessive consumer prices. Historical
investments in metering and communications equipment which make it virtually
impossible quickly to provide end-use consumers with good price signals reflecting
supply and demand conditions in the wholesale market reduce the effective elasticity of
demand and further enhance the ability of suppliers to engage in opportunistic behavior.

When industries are subject to mandatory restructuring and the imposition by
governments of new sets of firm structures, market designs, and supporting institutional
arrangements, long-lived sunk investments cannot be expected to adapt instantly to the
new governance structure. If the new governance arrangements are not sensitive to the
configuration of non-redeployable sunk investments inherited from the past, and take into
account this configuration of sunk investments and the potential for opportunistic
behavior and coordination problems in designing new market and regulatory institutions,
then the new market organization is likely to run into costly opportunism problems, costly
responses to them, and coordination and investment inefficiencies. Obviously, the key to
avoiding these problems is for responsible policy-makers to take these problems into
account in the design of new firm structures, market rules, contractual arrangements,
and regulatory mechanisms.

[1]
See for example, Peltzman and Winston (2000).
[2]
Joskow (1991, pp. 76“8).

[3]
This includes both "structural separation," where one or more horizontal segments are
organized into separate corporate entities and then sold to an unrelated entity or floated as a
new company, as well as "functional separation," where activities in one or more vertical
segments are operated separately both physically and financially from the rest of the firm.
Meaningful functional separation implies that although the horizontal segments are owned by
the same firm, they operate separately. That is, they must behave as if they are not vertically
integrated.

[4]
See Joskow (1996) regarding the electricity sector.

[5]
See Joskow (1997) regarding the nature of the potential short-run costs and the potential
long-term benefits associated with reforms in the electricity sector.

[6]
Joskow (1991, p. 77).

[7]
Joskow and Schmalensee (1983).

[8]
Joskow (1997, 2000). A longer version of the second paper can be found on my web page
at http://web.mit.edu/pjoskow/www/.

[9]
Joskow (1998).

[10]
Joskow (2000) provides a detailed discussion and evaluation of electricity sector
restructuring, competition and regulatory reforms in the United States. The California
electricity crisis is discussed in Joskow (2001); see also chapter 25 in this volume.

[11]
Williamson (1985, 1996).
2 Basic characteristics of electricity supply and demand
The supply of electricity is generally divided into three or four separate functions:
1. The generation (G) of electricity using falling water, internal combustion
engines, steam turbines powered with steam produced with fossil fuels,
nuclear fuel, and various renewable fuels, wind-driven turbines, and
photovoltaic technologies. In most developed countries there are typically
many generating plants in service dispersed over a large geographic
area.
2. The distribution (D) of electricity to residences and businesses at
relatively low voltages using wires and transformers along and under
streets and other rights of way.
3. Related to distribution, a set of power procurement and retailing (R)
functions. They include making arrangements for supplies of power from
generators, metering, billing, and various demand management services.
The dividing line between distribution and retailing is still murky and
controversial.
4. The transmission (T) of electricity involving the "transportation" of
electricity between generating sites and distribution centers, the
interconnection and integration of dispersed generating facilities into a
stable synchronized network, the scheduling and dispatching of
generating facilities that are connected to the transmission network to
balance demand and supply in real time, and the management of
equipment failures, network constraints, and relationships with other
interconnected networks. These latter functions may be aggregated into
a set of System Operating (SO) responsibilities.

The attributes of electricity demand, electricity supply, and physical constraints
associated with the operation of synchronized alternating current (AC) networks are
highly relevant for understanding the organizational structure of the electric power sector
that evolved over the twentieth century. These attributes are also highly relevant for
designing transmission network and competitive wholesale power market institutions with
good performance attributes.

Electricity usually cannot be stored or inventoried economically, and demand varies
widely from hour to hour during an individual day and from day to day over the year. The
aggregate short-run elasticity of demand is inherently very small and the effective short-
run elasticity of demand reduced further by the absence of hourly metering,
communications, and pricing arrangements. Moreover, there is generally no meaningful
direct physical relationship between a specific generator and a specific customer and no
economical way to curtail an individual customer's consumption when specific
[12]
generators fail to perform. Since consumers continue to draw power as long as the
circuits are closed and they are connected to the network, the aggregate generation of
electricity and the consumption of electricity must be balanced continuously for the entire
network to meet certain physical constraints (frequency, voltage, stability) on network
operations. That is, electricity consumed at a specific point in time must be manufactured
in a generating plant virtually contemporaneously with its consumption; it is the ultimate
in "just-in-time" manufacturing.

A modern AC transmission network makes it possible to utilize generating facilities
dispersed over wide geographic areas efficiently in real time to meet continually
changing demand levels through the substitution of increased production from low
marginal cost facilities (say, in New Mexico) for production from high marginal cost
facilities (say, in California). In principle, an efficiently operated network would constantly
equate the marginal costs of supplying an additional kWh of energy at all generating
nodes adjusted for marginal losses, thermal and operating constraints throughout the
network. It would also economize on the reserve capacity required for any given level of
reliability (responses to equipment outages and unanticipated swings in demand) by
effectively aggregating loads and reserve generating capacity over a wide geographic
area and by providing multiple linkages between loads and resources that can provide
service continuity when transmission facilities fail. To accomplish these tasks, the
network must be operated to maintain its frequency and voltage parameters within
narrow bands and to respond to rapidly changing system conditions on the demand and
supply sides, especially short-term demand swings and unplanned equipment outages.
Generating facilities must be called upon almost continuously to provide a variety of
network support or reserve services in addition to providing energy to run customer
appliances and equipment. These "ancillary services" include spinning reserves, standby
reserves, blackstart capability, frequency regulation (Automatic Generation Control),
scheduling and dispatch control, and others.
Electric power networks are not switched networks like railroad or telephone networks
where a supplier makes a physical delivery of a product at point A that is then physically
transported to a specific customer at point B. A free-flowing AC network is an integrated
physical machine that follows the laws of physics (Kirchoff's Laws), not the laws of
financial contracting. Electricity produced by all generators goes into a common pool of
electric energy and demand by consumers draws energy out of that common pool. The
network operator must ensure that the pool stays filled to a constant level, balancing
inflows and outflows. The electric energy produced by a particular generator cannot be
physically associated with the electricity consumed by a particular consumer. When a
generator turns on and off, it affect system conditions throughout the interconnected
network. Large swings in demand at one node affect system conditions at other nodes. A
failure of a major piece of equipment in one part of the network can disrupt the stability of
the entire system if resources are not available to the network operator to respond
quickly to these contingencies. Moreover, efficient and effective remedial responses to
equipment failures can involve coordinated reactions of multiple generators located
remotely from the site of the failure. These attributes create potential network externality
and network "commons" problems. The physical attributes of AC networks also make is
difficult to define a well-defined set of property rights. As a result, it is unlikely that market
mechanisms can be relied on entirely to internalize network externality problems
effectively.
Everywhere on earth electric power systems evolved with similar governance structures,
which I have previously argued reflect these special attributes of electricity supply and
demand.[13] Electricity suppliers typically had de facto exclusive rights to serve all
consumers in a particular geographic area and an obligation to supply them with reliable
supplies of electricity at "cost-based" regulated prices. Electric utilities typically met their
supply obligations by vertically integrating into all four supply segments, owning
generation, transmission and distribution facilities, operating them in an integrated
fashion using internal operating protocols, and providing consumers in their franchise
[14]
areas with a single bundled electricity supply product. The physical and economic
attributes of generation and transmission in particular led to vertical integration as an
efficient governance arrangement.[15]
The economic rationale for vertical integration between G&T is that it internalizes the
operating and investment interrelationships between generation and transmission inside
public or private organizations where the potential public goods and externality problems
that arise as a consequence of the physical attributes of electric power networks, as well
as the challenge of coordinating operations in real time to adapt to changing demand
and supply conditions, can be solved with internal operating hierarchies rather than
markets. However, vertical integration between the network functions which have natural
monopoly characteristics and the generation function effectively turns the supply of
generating service into a monopoly as well even if there are numerous generating plants
connected to the network and limited economies of scale associated with generation per
se in isolation from the coordination functions performed by the network (Joskow and
Schmalensee 1983). This in turn leads to the extension of public regulation of prices,
costs, investment decisions, service quality, etc. and in most countries state ownership
of the entire vertically integrated entity “ both the potentially competitive segments and
the "natural monopoly" segments.

In many countries, especially those with a government-owned electricity sector,
regulation of prices, costs, investment decisions, etc. was the responsibility of a
government ministry, with varying degrees of legislative oversight. The regulatory
process in these countries was generally closed to public scrutiny, based on often
opaque cost of service principles, and often became highly politicized. In some countries,
these regulatory responsibilities were fully or partially decentralized to the state,
provincial, or municipal level, with ministries or councils at these levels of government
responsible for regulating the behavior of local monopoly electricity suppliers. Both the
United States and Canada have a long tradition of relying on independent regulatory
commissions which operate with clear regulatory responsibilities, well-established
principles governing cost accounting and price setting, and very open administrative
procedures in which various interest groups have opportunities to participate. The
original rationale for independent commissions in the United States was to create expert
regulatory bodies that followed well-defined public interest principles and which would be
insulated from political pressures created by powerful interest groups. Complete
insulation from political pressures is, of course, impossible when regulators are
appointed by government officials, depend on government for the funds they need to
perform their jobs effectively, and are ultimately subject to changes in the laws under
which they operate. Nevertheless, the open independent commission system places
significant constraints on special political deals and corruption because they are more
difficult to hide.

[12]
At considerable cost, metering, communications, and control equipment can be installed so
that a specific set of generators can be dispatched to match a specific customer's demand
and that demand curtailed if those generators do not perform. This is a very inefficient way to
supply a customer with electricity. In addition to the metering, communications, and control
costs, such an arrangement would sacrifice the network economies associated with a large
electric power network.

[13]
Joskow (1996).

[14]
In all countries generation and transmission were vertically integrated. Separate distribution
companies existed in many countries, but they typically purchased all of their power supply
needs from neighboring vertically integrated generation and transmission (G&T) companies
under long-term contracts.

[15]
Joskow and Schmalensee (1983); Joskow (1996).
3 Performance problems with regulated electricity
monopolies
Successful reform requires understanding how resource allocation decision were made
under the existing governance arrangements and the nature and magnitude of their
performance problems. All resource allocation tasks that had to be accomplished under
the old governance structure will still need to be accomplished under a reformed
governance structure, but are likely to be performed differently - e.g. through
transactions between firms subject to competition rather than within regulated monopoly
firms. The combination of legal supply monopolies, "cost-plus" pricing rules and political
pressures on price levels, price structures, and resource utilization decisions should be
expected to lead to inefficiencies compared to the social planner's ideal allocation of
resources. Electricity sector reforms are generally based on the proposition that these
production and allocational inefficiencies can be reduced by narrowing the expanse of
economic activity organized around legal monopolies and public regulation, turning as
much of the resource allocation decisions as possible to competitive markets, while
reforming residual regulatory tasks so that they induce more efficient sector performance.
The historical performance of the traditional electric power sectors around the world
varies widely. The sectors in most developed countries have performed fairly well based
on a variety of "macro" performance criteria. In particular, the systems provide electricity
with high levels of reliability, investment in new capacity can generally be readily
financed to keep up with (or often exceed) demand growth, system losses (both physical
and those owing to theft of service) are low, electricity is available virtually universally,
customers can get hooked up for service relatively quickly and cheaply, there is a long
record of rapid productivity growth (at least until the early 1970s), the average price of
electricity typically covers the total cost of supplying it, including a reasonable return on
investment, and the real price of electricity fell almost continuously until the early 1970s
and then again in the 1990s. Moreover, the rate of growth in the demand for electricity in
most developed countries has slowed considerably since 1980 in response to slower
overall economic growth, shifts in industry composition, rising real electricity prices (until
the mid- to late 1980s) in many countries, and improvements in end-use energy
efficiency. On average in the OECD countries, projected electricity demand growth over
[16]
the decade to 2010 is about 2 percent per year.

However, a closer examination of various performance indexes across developed
countries and across electric companies in countries with multiple suppliers (especially
the United States), reveals substantial performance variation within these general sector
performance attributes. There was significant variation in the cost of building reasonably
comparable generating facilities across countries and between suppliers within the same
country. These variations have been revealed most starkly in the context of nuclear
generating facilities, but are revealed as well for large fossil-generating plants (Joskow
and Rose 1985). The operating performance (e.g. availability) of both fossil and nuclear
units also varied widely even after controlling for age, size, and fuel attributes (Joskow
and Schmalensee 1987). There were also wide variations in the labor intensity of power
sectors. For example, the pre-reform sector in England and Wales had about twice as
many workers per unit of output as did the US sector. Other costs were incurred as a
result of the use of public and private utilities to pursue a variety of social goals via
"taxation by regulation." Whether it was protecting the domestic coal industries in
England and Wales, Germany, and Spain, or promoting domestic equipment
manufacturing enterprises, as in France and other countries, or promoting costly
renewable energy and energy conservation programs as in the United States, or
extensive cross-subsidies among customer classes, the costs of these programs were
hidden from the public in electricity prices and these prices were necessarily distorted
from efficient least-cost based levels.

These inefficiencies are properly attributed to the combination of cost of service
regulation, public ownership, and severe limitations on competition. Price regulation
weakens incentives for cost minimization, public ownership often further exacerbates the
problems by softening budget constraints and further weakening incentives, and the
institution of regulated private or public monopolies is conducive to the politicization of
input choices and cross-subsidization.
Whatever the performance problems of the traditional electricity sectors in developed
countries, in the broader scheme of things they are small compared to the performance
problems of the traditional sectors in many developing countries.[17] Under pre-reform
institutional arrangements, the electric power sectors in many developing countries have
been unable to mobilize the capital necessary to finance needed investments in
generating, transmission, and distribution capacity at a time when these countries are at
a phase in their development when the demand for electricity should increase rapidly.
The performance of existing facilities is often poor by world standards, with high losses,
poor distribution system reliability and power quality, high heat rates, and poor generator
reliability. There are long queues for service hookups, and extraordinary levels of excess
employment of workers in many electricity sectors in developing countries. The average
price of electricity often does not recover costs on an historical accounting cost basis and
is often far below the long-run incremental costs of expanding the system, making it
difficult to finance new investments and to maintain capital facilities in good operating
order, increasing the extent and social costs of supply shortages. The poor performance
of the electricity sectors in many developing countries could have significant adverse
consequences for economic development in these countries.

Accordingly, the performance targets that electricity sector reforms are aimed at are
clear: more efficient operation of existing facilities; shedding of excess labor and other
cost burdens in the fuel and equipment areas resulting from the sector's historical
politicization; creating a contractual, regulatory, and industry structure framework that will
attract investment to support new supply facilities required to meet electricity demand at
least cost; improving system reliability; bringing electricity prices into balance with the
costs of supplying it; and de-politicizing the sector. The best way to go about achieving
them quickly will vary from country to country, and, most importantly, between developed
and developing countries. Nevertheless, the basic restructuring and competition models
being pursued in many countries are based on the electricity restructuring program
introduced in England and Wales in 1990.[18]

[16]
The average rate of growth in electricity consumption was 2.9 percent per year over the
1973-94 period and 7.8 percent per year for the 1960-73 period for the OECD countries. See
Electricity Information 1995, International Energy Agency, Paris, OECD, July 1996.

[17]
See for example Organización Latino Americana De Energía (1991).

[18]
In March 2001, major changes were made to the wholesale market institutions upon which
this program was built. It is too early to evaluate the benefits and costs of these changes.
4 The basic reform model[19]
In response to real or imagined performance problems with these traditional governance
arrangements, many countries have or are in the process of implementing a new model
for their electricity industries.[20] The new model has the following general features:
generation would be fully separated from transmission and distribution; regulated
distribution and transmission charges would be "unbundled" from generation and retail
service charges; wholesale generation service prices would be deregulated; generators
would compete de novo in regional markets both to supply distribution companies
purchasing on behalf of their retail customers (full wholesale competition with exclusive
retail supply) and to supply retail customers as well ("retail wheeling") either directly or
through financial intermediaries (wholesale marketers and retail Energy Service
Providers, or ESPs). This model of a restructured electric power sector that would
reduce the expanse of regulated monopoly to transmission and distribution functions and
rely on competition to supply generation and transmission services at wholesale and
retail is depicted in figure 26.1.




Figure 26.1: Competitive wholesale and retail markets

The core of most electricity sector reforms is the creation of reasonably competitive
wholesale spot and forward (financial) markets for electric energy, capacity, and a variety
of operating reserve services (also referred to as ancillary services).[21] In addition, free
entry of new generating capacity to make sales in these unregulated power markets in
response to economic opportunities is a critical component of these reforms. Competitive
generation markets on electric power networks are most appropriately conceptualized as
spatial markets with demand (or loads) and differentiated generators dispersed across
the network's geographic expanse. These demand and supply locations are generally
referred to as "nodes" on the network. Though the generation suppliers produce more or
less the same product - electric energy (reserve services and differences in adjustment
speeds complicate this) - they are differentiated from one another along three major
dimensions: (a) marginal costs of production, (b) transportation costs owing to
congestion and thermal losses, and (c) the speeds with which they can adjust their
output from one supply level to another, including starting up from zero. The
transportation costs in turn vary widely with system conditions - supply and demand - at
all nodes on the network. In additional, generators can produce multiple services,
consisting of both energy and various reserve services.

Accordingly, the basic framework for thinking about competition among generators
should be based on a fairly complicated spatial competition model with competing
multiproduct firms at different locations which are "separated" by congestion costs and
thermal losses. The suppliers of generation service are asymmetric, the costs of
transportation vary widely over time as congestion varies, and the elasticity of supply
around the competitive equilibrium varies widely over time as demand that must be met
by just-in-time (JIT) production fluctuates between very low and very high levels. Markets
with these attributes are unlikely to be perfectly competitive and policies designed to
facilitate competition and to constrain inefficient strategic behavior should be an
important feature of the reform program.

As in other commodity markets, wholesale and retail electricity markets play the
traditional role of balancing supply and demand and allocating supplies among
competing generators in the short run and provide economic signals for entry of new
suppliers in the long run. However, wholesale electricity market mechanisms also play
another important role. They are relied upon to provide generation resources, and
economic signals for using these resources efficiently, that the operator of an electric
power transmission network must rely on for maintaining the reliability and power quality
of the network (frequency, voltage, and stability) and to manage congestion and related
network constraints at the same speed at which electricity supply and demand attributes
change - which is very fast. These resource-allocation functions were traditionally
performed within vertically integrated firms using internal scheduling, dispatch, and
emergency response protocols that depended on a combination of computer
optimization routines, marginal cost signals, and "band aids" applied by system
operators to deal with unusual circumstances. The short-run operating functions and the
associated physical attributes of electric power systems just listed are perhaps the
primary factors that led to vertical integration between generation and transmission. They
are also the most challenging resource-allocation activities to mediate through market
mechanisms.

All of the credible models for creating new competitive electricity markets, recognize that
there must be a single network operator responsible for controlling the physical operation
of a control area, coordinating generator schedules, balancing loads and resources in
real time, acquiring ancillary network support services required to maintain reliability, and
coordinating with neighboring control areas - performing Systems Operations (SO)
activities. In most countries, organized spot auction markets have also been created both
to allow generators to trade energy with buyers and with each other and to allow the
network operator to purchase options on capacity to allow it to manage network
congestion and other reliability and physical constraints. The performance of these
auction markets depends critically both on there being robust competition among
generation suppliers and the implementation of a set of auction rules that are compatible
with the physical operating constraints on the system and do not facilitate gaming and
market power problems that may be exacerbated by these physical constraints.

[19]
The discussion that follows draws heavily on Joskow (1998, 2000).

[20]
Joskow (1998).

[21]
This discussion focuses on countries which have large enough electricity supply systems,
commercial and regulatory institutions that can support competitive power markets. This
excludes many developing countries, especially small developing countries with small isolated
electric power systems.
5 Performance improvements resulting from recent
electricity sector reforms
Regulated monopoly electricity supply sectors, especially those that were state-owned,
tended to have more workers than was necessary to produce their services efficiently.
From England and Wales to Chile and New Zealand, restructuring for competition has
led to significant labor shedding.[22] However, because electricity is not a labor-intensive
production activity, the overall effect on prices of improvements in labor productivity is
relatively small. At the same time, the magnitude of the costs involved may make it
possible to structure early retirement and other worker incentive programs to facilitate
staff downsizing without causing major labor unrest.

The experience in England and Wales also indicates that significant cost savings can be
achieved by moving away from procurement based on national politics toward
procurement that reflects least-cost principles. In those countries with a "coal problem,"
electricity restructuring simply places more pressure on coal sector restructuring efforts
that are already underway.

Another dimension of performance improvement is related to increases in generating unit
availability, as well as savings in both physical and financial losses (theft of service) on
the distribution system. These cost-saving opportunities are most significant in
developing countries with objectively poor sector performance, but have also been
observed in developed countries that have restructured. The increases in the availability
and the operating cost savings in the nuclear sector in England and Wales since 1990,
and the increases in availability of fossil and hydro facilities in Argentina since 1992, are
especially impressive examples, as are the improvements in the performance of nuclear
power plants in the United States.

Cost-based regulatory rules and political constraints have historically led electricity
suppliers to continue to operate some generating facilities beyond the date they would
be retired if they had to live on the revenues they could obtain in competitive markets.
Many old inefficient generating plants have been retired in England and Wales since
restructuring in 1990. The pressures of emerging competition have also led to the early
retirement of nearly a dozen nuclear reactors in the United States in the early 1990s.
Many electricity sector restructuring programs have also been very successful in
attracting investment in new generating plants and in controlling the construction and
operating costs of these new facilities. Traditional electricity sectors in developed
countries were generally reasonably successful in attracting investment capital to expand
production and distribution capabilities. This is the case because the institution of
regulated monopoly effectively shifted risks associated with construction cost over-runs
(and under-runs), as well as market risks that change the economic value of generating
facilities, to consumers. Regulated electricity firms were generally viewed as having
relatively low financial risks for equity investors and high credit ratings for bond investors.
Indeed, one of the standard criticisms of traditional regulated monopolies in the United
States was that they built too much capacity and had poor incentives to control
construction costs. In these countries, capital attraction has not been the problem.
Rather, the problems have been associated with pervasive excess capacity and
construction cost over-runs. The challenge for reform is to rely on markets to increase
incentives to control construction and operating costs, and to reduce any tendencies for
excess capacity, by shifting market and cost risks to investors from consumers, without
creating markets that have so much market and residual regulatory risk that they veer to
the other extreme, discouraging investment in adequate generating capacity to properly
reflect consumer preferences for reliability. Replacing a system that is "too reliable" with
one that has a significant number of blackouts owing to the failure to attract investment in
new capacity at the right time and in the right places will not be viewed favorably by
consumers.

The experience with investment in new generating plants in the restructured markets in
England and Wales, Argentina, Australia, and the United States has generally been
[23]
favorable. There has been substantial entry and costs and market risks have been
transferred to suppliers providing high-powered incentives to them to control costs. The
experience with investment in new transmission capacity has been more mixed, with
network investment problems emerging in a number of countries, including the United
States.
On the other hand, electricity sectors in many developing countries had a great deal of
trouble attracting adequate investment to expand networks to reach the entire population
and to balance supply and demand efficiently. The cause of this problem typically was
the inability of the regulated monopoly suppliers to charge prices high enough to cover
their operating costs and to service their financial obligation and to finance new
investment. Internal cash flows could not fund needed new investments, government
subsidies or capital grants were generally limited by general fiscal constraints, and
private capital markets would not provide investment capital to entities that were not
credit-worthy. From this perspective, it is important to understand that no electricity
supply framework will yield good performance if prices are constrained to levels that do
not allow for cost recovery and if theft of service is widespread. Accordingly, any
successful reform in developing countries typically requires price increases and a
crackdown on thefts of service. Privatization and competition may be the excuse for
implementing broader reforms on the price and theft of service fronts that are unlikely to
be politically popular.

[22]
Rudnick (1996), Newbery and Pollitt (1996), for example.

[23]
Despite the recent supply problems in California, there is a huge amount of new merchant
generating capacity in the construction pipeline in the United States. A tight supply situation
today may become an excess supply situation in a couple of years.
6 Problems encountered by reforms
A number of market performance problems have also arisen in several of these new
electricity markets. These problems fall into several categories. First, there have been
problems that appear to be a consequence of the legacy of long-lived sunk investments
made in the context of a vertically integrated monopoly system. These long-lived sunk
investments create potential hold-up problems when the system is broken up and
decentralized. Investments in generation and transmission facilities in particular were
made under the assumption that they would be under common ownership and operation.
Opportunistic behavior that may arise when separate profit maximizing organizations
own and operate these assets were not taken into account when the investments were
made since they were under common ownership and integrated operating control. As I
will discuss, the opportunism problems of particular concern include "local market power"
problems caused by transmission network constraints, the management of network
congestion, and generator market power problems that are exacerbated by the absence
of metering and communications infrastructure which limits the ability of the system to
give end-use consumers good short-run price signals and further reduces the effective
short-run elasticity of demand.

One might view these problems as transition issues, though with longlived investments
the transition can take a long time. Ideally, the potential for opportunistic behavior
associated with the existing stock of non-redeployable assets configured to match
traditional governance arrangements should be taken into account in the design of
market institutions and contractual arrangements at the time the sector is restructured. If
they are not, the resulting inefficiencies and consumer burdens may ultimately lead to a
second (or third) round of reforms.

A second set of problems arises with regard to the coordination of generation and
transmission operations and transmission investments. This coordination historically took
place within vertically integrated firms. Some of the coordination tasks that were handled
through internal protocols are simply very difficult to decentralize effectively with market
mechanisms. These coordination problems result from the difficulty of creating "enough"
markets to support all important resource-allocation decisions, designing them to clear
quickly enough to allocate fast-moving flows of electric power efficiently, temporary
market power problems that arise from network congestion and related operating
constraints, network externality problems, problems associated with lumpy transmission
investments, and the difficulty of defining meaningful property rights for using the
transmission network which do not degrade the efficiency of the system (Joskow and
Tirole 2000). The implementation of electricity sector restructuring has sometimes
ignored these problems, with unfortunate results.
A third related set of problems is associated with broader market power problems in
competitive electricity markets. The objective of restructuring is not simply to create

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