Reforming the Indian Electricity Supply Industry Frank A. Wolak Department of Economics Stanford University Chairman, Market Surveillance Committee of California Independent System Operator (ISO)
Outline of Presentation Summarize current conditions in Indian electricity supply industry Provide cost-benefit analysis of further re-structuring given these initial conditions Recommend course of action given initial conditions based on experience of other countries around the world Effective and credible regulatory oversight essential to address current challenges Conditions needed for effective regulation Establishing credible regulatory process Initial conditions for further re-structuring in India Current state of progress towards this goal Low risk strategy for further re-structuring in India
Current Conditions in Indian Electricity Supply Industry Subsidies to electricity consumption are currently estimated to be slightly less than 1 percent of GDP Close to $6 billion at current exchange rate Enormous subsidies to agricultural users of electricity Many farmers pay fixed connect charge and zero marginal price Significant subsidies to residential consumers Industrial and commercial users pay highest average prices Exact opposite from developed country experience Current price can explain apparent electricity shortages At existing prices demand is much greater supply
Current Conditions in Indian Electricity Supply Industry Enormous average technical and commercial transmission and distribution losses Theft is major source of commercial losses Current average technical and commercial losses for India are approximately 40 percent % AT&C Losses = [(Units Input Units Paid for)/(units Input)]*100 Comparable developed country figure less than 10 percent All State Electricity Boards (SEBs) are effectively financially insolvent Many have been unable to make contractual payments to independent power producers Enron Dabhol Project best example Private new generation investment to sell to SEBs has declined to close zero in recent years Captive generation is major user of private investment
Cost Benefit Analysis of Further Re-structuring The major source of benefits to re-structuring arise from more efficient new capacity investment decision-making relative to former regime Investment decisions based on desire to minimize cost of meeting increase in demand because sales for new capacity typically made at fixed price Under former regime, political and other non-economic factors were important determinants of new capacity investment mix International experience with re-structuring has shown that short-term benefits of a bid-based wholesale market are small Give up on economies to scope between transmission and generation, but provide strong incentives for suppliers to minimize costs of producing electricity Suppliers may not sell at price that only recover these costs Significant downside associated with bid-based wholesale market due to exercise of unilateral market power California, New Zealand, Colombia, Spain, England and Wales Pool, PJM, New England, Texas, New York, Alberta, Ontario, El Salvador, Panama have all experienced periods of substantial unilateral market power in bid-based short-term energy market
Cost Benefit Analysis of Further Re-structuring Optimistic estimate of long-run benefits of re-structuring is a 5% reduction in retail price of electricity Roughly half of retail price is composed of wholesale price Ten percent reduction in average wholesale price very optimistic A few markets have achieved this savings over long-term Australia, UK Eliminating subsidies that are 1 percent of GDP has far greater expected benefits to Indian economy than further re-structuring to create a bid-based wholesale market that could yield 5% retail price reduction Two years of Indian subsidies Total cost of California electricity crisis Decision is made even easier by the fact that Further private sector participation in electricity supply industry very unlikely without change in financial condition of SEBs Bid-based wholesale market has significant potential downside California, New Zealand, UK Pool Bid-based markets are extremely expensive to set up and operate California $250 million start-up costs, eastern US markets in PJM, NY, and NE not as high because of their history as power pools Lower risk and higher return short and medium term strategy is to create initial conditions for a successful wholesale electricity market in India Can proceed to introduce wholesale market tailored to India after this step completed
Effective and Credible Regulatory Process Effective and credible regulatory oversight essential part of successful wholesale market regime Wolak (2003), Diagnosing California Electricity Crisis finds that ineffective regulation by Federal Energy Regulatory Commission (FERC) allowed a solvable regulatory intervention to become a financial disaster New Zealand twice had price runs ups very similar to California in June to September 2001 and 2003, which caused government to abandon light-handed approach to regulation Currently Commerce Commission undertaking study of competitiveness of electricity supply industry in New Zealand Co-ordinated national and state-level regulatory process necessary to solve India s problems and establish initial conditions necessary for a successful restructuring process SERC = State Electricity Regulatory Commission CERC = Central Electricity Regulatory Commission
First New Zealand Meltdown Average Daily Wholesale Price $350 $300 $250 2001 $/MWh $200 $150 $100 2000 $50 $0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Effective and Credible Regulatory Process Regulatory process must Protect investors from expropriation of their assets Dahbol Power problem common to history of US regulatory process Ensure that consumers pay average prices that recover going forward cost of producing electricity, including a return on capital invested Ensure that all electricity consumed is paid for Eliminate cross-subsidies across four components of electricity supply industry generation, transmission, distribution and retailing Eliminate all but need-based cross-subsidies across customer classes
Conditions Needed for Effective Regulatory Process Ability of regulator to receive information on firm-level financial and technological characteristics Regulator must have the ability to ask for and receive all data necessary to do job Regulator should oversee financial separation of four stages of production process Generation, transmission, distribution and retailing Set separate prices for each service Establish common accounting standards for all entities in electricity supply industry Set procedures for determining rate base (regulatory capital stock) of SEB Rate base provides commitment mechanism to regulatory process Commits future regulators to pay for assets previous ones approved Regulated firm provided with opportunity to earn regulated rate of return on any investment put into rate base for life of the asset
Conditions Needed for Effective Regulatory Process Regulatory commission much have economic, technical, and legal expertise Regulatory staff provides institutional memory for regulatory mechanism International and national training programs for staff of state and central government regulatory commissions Establish common sets of administrative procedures for regulatory rate-making National guidelines for operation of state-level regulatory processes can help to maintain independence of state-level regulatory process Similar to function of National Association of Regulatory Utility Commissioners (NARUC) in the United States
Establishing a Credible Regulatory Process Most difficult task of regulation is establishing credibility Credibility is double-edge sword Politicians must delegate substantial authority to independent regulatory process Regulator must be willing to be subject to judicial review of decisions Judicial review to ensure compliance with regulatory mandate Review establishes that due process was followed to reach decision Was decision made based on evidence presented to regulatory commission Credibility comes from having decisions survive judicial review During early years, regulatory process must pick battles with firms and other stakeholders In US, FERC has had over 70 years to establish credibility Consequently, US Courts give FERC tremendous deference because it had credibility established expertise Part of what allowed California crisis to occur FERC used its credibility to delay acting until their failure became to large to ignore and then took action that made matters worse Now FERC has lost a substantial amount of credibility because of California crisis, Enron revelations, and fraud in natural gas markets
Initial Conditions for Further Re-structuring Willingness to pay surveys for electricity seem to indicate some farmers are willing to pay more for reliable electricity (Dosani and Raganathan, 2003) Dimensions for increasing quality of electricity which can allow supplier to increase amount of electricity sold and paid for Rostering of power implies farmers receive power for only portions of the day May need power for longer sustained period for irrigation and are willing to pay for it Pump burnout due to power quality problem Pump burnout implies more frequent purchase of pumps and increases production costs Customers appear to be willing to pay to avoid pump burnout If give subsides, then given them on average price, but not on marginal price Give farmer right to by 100 KWh per month at 1 cent/kwh, but pay for additional consumption at 10 cents/kwh and receive payment of 10 cents/kwh if total purchases are below 100 KWh
Initial Conditions for Further Re-structuring Most important pre-market goal is making SEBs financially solvent Customers must pay for what they consume SEBs must pay for what they buy SEBs must be able to charge average prices that cover these costs plus a return to capital A price that does not cover return to capital will not allow new investment Regulatory process must establish consistent set of standards for determining retail prices that offer SEBs the opportunity to recover their costs Including return to capital invested Provide procedures for undertaking accounting separation to set individual prices for generation, transmission, distribution and retailing services Necessary to have these prices available for subsequent steps of restructuring process
Initial Conditions for Further Re-structuring Establish national regulatory standards that no unmetered power can be sold after a fixed date in future Customers without meters are disconnected from system Customers that do not pay are disconnected from system Very important that these policies are nationwide Credibility of policies requires end date and consequences for failing to meet them Establish national standards for means-tested access to subsidized electricity rates All subsidized rates should have hourly, daily and monthly maximum consumption bounds Means-tested subsidized rates exist in all US states California Alternative Rates for Energy (CARE) program Pre-payment meters for popular low-income consumers in Europe
Progress Toward Necessary Initial Conditions Securitization of outstanding debts of SEBs to Central Power Supply Utilities (CPSUs) through bonds issued by state governments Waiver of ~25% delayed payment surcharge to SEBs Electricity Act of 2003 resulted in the implementation of a number programs that are positive steps towards achieving initial conditions Mandatory formation of SERCs All 28 states have established SERCs Mandatory metering Significant progress on installing minimal amounts of metering Accelerated Power Development Reform Program (APDRP) Subsidies for infrastructure investment Transmission and distribution network, substation and metering Incentives to reduce average technical and commercial losses to 10 percent level Progress in some states, not in others Substantial improvement in data collection and public data release on details of industry performance
Progress Toward Necessary Initial Conditions Some provisions of Electricity Act of 2003 could make situation worse Reduced barriers to construction of captive generation units Current high price for industrial and commercial customers could cause inefficient bypass of national grid Large customers that pay their bills leave state/national network because they are charged high prices Reduced financial health of SEBs because they are left to serve small customers that may not pay New generation capacity constructed in inefficient manner to serve national load, which increases average cost of electricity Units built primarily to serve captive customers Inefficient location and mix of new capacity Reduced incentive to build out transmission network Large customers served from captive facilities
Strategy for Further Re-structuring Once SEBs are financially viable focus on development of active forward financial market for electricity Attaining financial viability of SEBs could take a number of years Major market design error in developed world, particularly US, is excessive focus on design of short-term energy market, ignoring long-term market Without substantial fixed-price forward contract coverage of final demand, a bid-based short-term energy market cannot be workably competitive the vast majority of hours of the year California, New Zealand, UK, Spain, Australia Ten equal sized large suppliers in California, yet severe market power problems arose because of inadequate fixed-price forward contract coverage of final demand Run a cost-based imbalance market based on filed heat rates and input prices Suppliers must participate in real-time market as pre-condition to sell forward contracts Avoids significant market power problems with short-term energy market
Cost-Based Dispatch Market Lesson from Latin America Cost-based system provides more certainty on imbalance charges loads and generators will be liable for relative to their forward contracts Can reduce cost of new investment Makes it easier to sell standardized forward contracts for energy Costs Increase incentive to put fixed costs into variable costs Limited incentive to reduce input fuel purchase costs Limited incentive for suppliers to invest to reduce production costs Greater incentives for inefficient dispatch Withhold lower cost units to allow high cost units to set market price Benefits Limit number of ways suppliers can exercise market power Can only bid higher if can cost justify higher bid Reduce volatility of wholesale prices and congestion prices Can limit incentives for demand-side involvement in market Can reduce economic justification for transmission upgrades Both of which limit ability of suppliers to exercise market power in bid-based market Summary Potential for increased average cost of real-time system operation to limit risk of enormous market power in spot market
Strategy for Further Re-structuring Core versus Non-Core retail model Those non-core loads willing to be negawatt suppliers connect to network and sell negawatts under same terms and conditions as generators Once you are non-core you can never come back to being core Required to have interval meter to measure consumption for all negawatt suppliers For remaining core customers, SEBs purchase all energy sold to noncore customers to manage electricity price risk Non-core customers can have monthly meter reads SEBs buy forward contracts on behalf of non-core customers SEBs has opportunity at cost recovery for all prices set by regulatory process generation, transmission, distribution and retailing
Increasing Competitiveness of Forward Market State regulators must impose restrictions on minimum forward contract coverage of core load To procure this coverage, must run periodic anonymous wholesale procurement auctions Use these market clearing auction prices to set regulated wholesale price contained in retail price New Jersey Basic Generation Service (BGS) Auctions To encourage new entry, must set forward contract coverage as percentage of forecast demand for far into the future Latin American country experience At some time before delivery, forward contract seller must demonstrate physical deliverability through construction of new facility 3 years before must post earnest money to show ability to deliver For Non-Core customers they face outage risk and should therefore have a strong incentive to find best way to hedge exposure to outage risk
Concluding Comments Re-structuring for wholesale competition at this time should be low priority Limiting entry of captive capacity may even make sense Focus on eliminating subsidies and restore financial health of SEBs National policy to make all subsidies mean-tested Effective and credible regulatory process necessary for this to occur Increase staffing level, training of staff, establish administrative procedures for regulatory decision-making Must have universal metering for all customers and bill according to these meters Metering must extend to customer premises with some entity responsible for payment Enforce customers paying for power by nationwide standards non-payment penalties and service terminations Once SEBs are financially solvent re-structuring can move forward Focus re-structuring process on development of active forward market Involve demand side only to the extent that it is willing to be treated as symmetric to generation core versus non-core model low-cost way to do this If investors are confident contracts will be honored, private investment in generation will come
For more information on electricity industry re-structuring and regulatory process design around the world http://www.stanford.edu/~wolak