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Power sector: Next generation reforms - Views on News from Equitymaster
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  • Nov 8, 2000

    Power sector: Next generation reforms

    This article attempts to clarify issues on electricity supply reforms faced by the country. It also looks into the regulatory and institutional structural issues that affect power pricing.

    In virtually every country the power sector (generation, transmission and distribution) was under the centre's administration. The rationale behind this was the understanding that electricity is a public good and that it formed a natural monopoly.

    However, there has now been a shift in Government thinking across the globe. It is now believed that electricity generation is not a natural monopoly and can be separated from transmission and distribution. Therefore, while considering electricity reforms, one aspect is the de-integration of the industry into generation, transmission and distribution companies.

    With evidence from United States, Chile, Argentina and several other countries, there is also consensus being built that the private sector in the power industry is more efficient than their public sector counterparts. Thus, privatisation is another aspect of power sector reforms.

    Effective regulation of the sector will continue to be imperative despite the de-integration and privatisation of the industry. An independent regulatory body will ensure prevention of politicization of electricity pricing and consequently subsidization. Further, some aspects of electricity supply, in particular, the “last-mile” as well as high-voltage transmission lines, will continue to be a natural monopoly, and, therefore, need regulation.

    Power was amongst the first sectors to undergo reforms in India. The reform process initiated in 1991 was in response to the economic crisis in general and the rapidly deteriorating health of the power sector. The SEBs were incapable of balancing their books and consequently added to the burden of State Government finances. Further, being an emerging economy the demand for power was ever increasing, however, facing a cash crunch the SEBs could not undertake capacity expansion. This aggravated the demand-supply position resulting in chronic shortages that threatened the pace of economic development.

    In light of this the power reform process was initiated. It was expected that the reforms would attract foreign capital in the sector. The power policy of 1991 focused primarily on augmenting the generating capacity in the country. The policy hoped to attract foreign investments in generation by offering a slew of incentives.

    The policy was a landmark in the reform process as the there was conceptual acceptance of unbundling of the electricity sector amongst the policymakers. The utilities were to be de-integrated into generation, transmission and distribution. However, distribution was not be privatised due to several political, regulatory, and financial roadblocks. Further, the financial weakness of the SEBs deterred private capital from setting up generation plants.

    Consequently, the policy did not meet its objective, as it failed to address certain issues. The reforms did not address the issue of off-takers risk. It was more concerned with how much the generators earned rather than the price-value equation they offered. More importantly, it did not address the issue of an independent regulator considering the politicization of the sector.

    With failure of the '91 policy the Government initiated fresh discussion on the subject. Subsequently, a new document emerged termed the 'Common Minimum National Action Plan for Power' (CMNAP). The document recognized that the problem was not the incentives provided to the private sector but the financial weakness of the SEBs. Therefore, the reforms should be targeted at restructuring the SEB's. Accordingly, the document recommended the following:

    • Corporatisation of the SEBs.
    • The creation of an independent regulatory commission in each state. The regulator will fix the tariffs and later look over licensing, planning and other such functions.
    • The gradual privatisation of electricity distribution.
    • The tariffs should be set by the SERC's such that the SEB earns at least the minimum return on capital (3%).
    • Shift from negotiation based to competitive bidding for power generation.
    Based on the recommendations of CMNAP several legislations were passed:
    • Electricity Regulatory Commission Act '98
    • Electricity Amendment Act '98, which separated transmission and distribution. It also created the Power Grid Corporation of India Ltd. (PGCIL).

    Despite this the reforms continued to move at snail's pace. Consequently, a ministerial meeting was summoned in Dec '98 to speed up the power sector reform process. It was agreed that all states would set up SERC's by March '99. Efforts have to be made towards the corporatisation and unbundling of SEBs. Further, the transmission sector is to be opened up to the private sector. The reforms of '97 were important as they recognized that distribution is critical to the successful development of the power sector and consequently, awarded it due weightage. However, the current industry structure continues to be dominated by integrated utilities.

    As mentioned earlier de-integration of utilities is considered to be a more efficient structure. But there are different levels of integration that have been attempted, each with their own effects on efficiency and prices. The article attempts to identify the most optimal institutional structure (ensures least energy costs to the end user) assuming no regulation.

    Integrated Utility: In the absence of regulation the integrated utility will operate as a profit-maximising monopolist. The utility has greater bargaining power, as the price elasticity of electricity demand is low.

    Single generator and distributor: Here too the outcome will be the same, the only difference being that the generator and distributor will share the monopoly profits.

    Many generators and single distributor: Under this case the bargaining power shifts to the distributor. Consequently, the distributor captures the entire monopoly profits. It is important to note that several countries, including India, are structuring de-integration on this model. However, this will not lead to the optimal solution unless distribution is regulated. A stakeholder controlled distribution with the aim of maximizing throughput and not profits can be a more efficient structure.

    Many generators and distributors: Against popular belief this structure too does not result in the optimal solution. This is because the distribution jurisdiction is broken into independent customer categories resulting in the distributor being the sole agency catering to a particular class of consumers. This structure only results in breaking up a monopoly into several monopolies.

    Single generator and multiple distributors: This is the opposite of many generators and a single distributor. Under this case the monopoly profits will be captured entirely by the generator. Therefore, it does not result in an optimal solution.

    The above alternative structures show that de-integration by itself does not result in an optimal solution for the end user. Regulation will be needed irrespective of the industry structure. Consequently, deregulation of the industry is a delusion if monopolistic practices are to be avoided.

    Tariff Regulation
    When monopoly is unavoidable regulation is inevitable. The regulator will have to identify the most efficient tariff regulatory structure, which maximizes the benefits for the end user. The alternative structure for determining efficient tariffs are:

    • Cost plus: Under this mechanism the distributor has an incentive to overstate costs so as to earn higher profits. If compensation is linked to assets, the asset base can be overstated or the distributor can incur excess capital expenditure. Under a competitive scenario the distributor will sell power to customers who are above a certain threshold default-risk level. However, if compensation is based on cost-plus approach there is no incentive for the distributor to regulate the customer risk profile.
    • Yardstick Regulation: Under this method the price to be charged by the distributor should equal the average cost / mega watt (MW) of all homogeneous distribution companies. There by, each firm will have an incentive to control costs. However, the system does not prevent the company from overstating costs at the time of tendering.
    • Vickery's Auction: The regulator invites closed bids from a group of homogeneous distributors. The lowest bidder is awarded a price equal to that of the second lowest bidder plus a bonus. While all others are awarded a price equal to the second lowest bidder. However, the homogeneous grouping of distributors could be a serious challenge for the regulator, as distributors could overstate costs to be placed in a fovourable group.

    Although the reforms of '91, '97 and '98 laid down the foundation to a more modern electricity sector, there is still much to be done. A strong regulatory structure is necessary irrespective of the de-integration and privatisation of the sector, as shown above. The elements of a successful reform process demand an independent regulator and de-integration of the industry followed by privatisation. Appointing a regulator should be the first step of the reform process. The regulator should lay down the institutional (industry) and contractual (tariff) structure of the industry. It can then guide the de-integration and privatisation of the industry.

    Power Generation Reforms
    The generation segment was the first to be liberalized due to the huge demand supply mismatch in the industry. Further, it was realized that generation is not a natural monopoly. However, subsequent generation reforms should have the following elements:

    • New generation and existing generation should be transferred to the private sector since; the private sector is known to be more efficient.
    • The reform process should allow for power trading.
    • Stipulation granting minimum 16% rate of return should be dropped, as once the minimum return is achieved there is no incentive for the generator to increase efficiency.
    • Cross holding between the generator and distributor for the same area should not be permitted.
    • If the currency is not convertible the Government should provide for sovereign cover on repatriable earnings.

    Power Distribution Reforms
    Reforms in the distribution sector will be critical, as successful development of the power sector will hinge on the financial soundness of distribution companies. Therefore distribution reforms should have the following elements:

    • Unified distribution zones should be broken up into smaller zones based on customer class and financial feasibility of the circle.
    • The distribution zones should then be privatized. Tariffs for homogeneous zones should be based on mechanisms other than cost-plus approach.
    • Distribution licenses should be awarded to the lowest cost supplier. Licenses should not be granted for fixed or revenue sharing fee unless the proceeds are to be utilised outside the power industry.
    • Regulation should provide for legal enforcement against power theft and non-payment of dues.
    • T&D lines above the small distribution zones should continue to remain under state control. At a later date it can be transferred to a non-profit autonomous transmission company.

    The reforms will not result in redundancy of the regulator. In fact, the regulator will need to keep strict vigil on power prices. It will have to manage the rise in prices from their initial artificially low levels today. But, once prices reach competitive levels, the regulator will have to control any further increases.

    Thus, this paper illustrates that the successful, long-term development of the power sector will depend on the institutional, regulatory and contractual reforms that result in competitive outcomes.

    This article is based on a paper, Regulating the Electricity Power Sector in India: Alternative Institutional Structures and Mechanisms, written by Dr. Rafiq Dossani and Mr. Robert Thomas Crow, Asia Pacific Research Centre, Stanford University. The paper was presented at the India Energy Conference, Centre for International development, Harvard University. Dr. Dossani is also consulting professor, Stanford University.



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