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p. 8 of 21 BACK | NEXT Introduction: Looking ahead Past policies and operations Changing context of the policy review Poverty reduction Private sector participation and sector restructuring Regional and global environmental impacts Regional cooperation Impact of the financial crisis Future assistance in the changing context Conclusions

Energy 2000: Review of the Energy Policy of the Asian Development Bank : Changing context of the policy review

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Private sector participation and sector restructuring

34. Experience has shown that when properly regulated and operating under competitive market conditions, the private sector can generally use resources more efficiently than the public sector. Vertically integrated monopolies in the energy sector are being unbundled to facilitate establishment of a competitive framework for greater private sector participation. Further, there is a need to address issues related to energy pricing and governance to maximize the efficiency gains of energy companies managed by the private sector.

Public sector monopoly

35. For a very long time the energy sector in most countries was dominated by public sector monopolies. Financial performance in the energy sector tended to be of little relevance, particularly in the centrally planned economies, when all commercial forms of energy were treated as merit goods,¹³ and the development and provision of energy services were considered to be welfare functions of the state. During the oil crisis in the 1970s, it was recognized that this was not sustainable, and organizations in the energy sector were pressured to recover the full cost of providing the service and generate some surplus for expansion. This change from energy as a public service to a commercial product has a major impact on the price paid by consumers, even though there is no obvious change in the product that the consumers in DMCs receive. When considered a commercial product, the energy business must explicitly recognize all costs including hidden subsidies and implicit guarantees, like opportunity cost of equity investment, risk-adjusted cost of debt, depreciation, open market cost of the effort utilized in developing a project proposal, risk-adjusted project implementation cost, insurance, and costs related to other provisions that become necessary to continue business in adverse conditions.

36. It was often difficult to measure these risk-related costs and distinguish them from operational inefficiencies in each system, particularly in the power subsector, because they had unique characteristics. Regulators or government officials responsible for setting tariff levels had limited access to operational data, and the use of nontransparent reports with aggregate figures by utilities operating as a monopoly was not conducive to a wellinformed analysis of costs and efficiency of services. Further, technical factors such as the direct link between power generation and its utilization, the perceived necessity of unified control, and efficiency gains through economies of scale, promoted large, vertically integrated utilities. Proper governance of such utilities required setting transparent financial targets and the performance measured over both medium and long term, which became possible only under a commercial framework applicable to corporate entities. With the development of the energy sector, the power utilities also grew to have greater influence on the economy, but it was often difficult to assess their efficiency in view of their monopolistic character. However, starting with initiatives taken by some countries in the hydrocarbon subsector, monopolies are no longer considered essential for ensuring supplies, and energy sector restructuring to establish competition has become a reality. Competition in a well-structured market is a forceful means to achieve higher efficiencies and, in turn, lower supply costs.

Hydrocarbon subsector restructuring

37. The hydrocarbon subsector started to attract private investments much earlier than the power subsector¹⁴. Except for kerosene, which was an energy source that the poor could readily use, the subsector products had a weaker recognition as merit goods. During the history of their development, several arguments were used to bring the coal and oil subsectors under government control, like strategic control over natural mineral resources; to balance the power of the private international oil companies; as a means of providing employment in economically backward regions (particularly coal mining); and public control of diesel because it is extensively used in the transport sector and by rural population in agriculture and fishery. Over time, however, government involvement as a producer was found to be very cumbersome for exploration, development of new production and processing facilities, and generation of foreign exchange to import oil. At the same time, the attitude toward, and the framework for, private sector participation improved and the capabilities of the private sector in terms of efficiency and technological innovation became well recognized. A gradual withdrawal of the public sector from most of the activities in the hydrocarbon subsector has already been accomplished in some DMCs. However, the establishment of a comprehensive, fair, and transparent framework remains on the agenda of many DMCs and is the main prerequisite for public sector withdrawal through commercialization, corporatization, and privatization of national oil and gas companies, as well as for the transfer of regulatory and policy functions to the government. The main focus of the regulation should be to ensure that the government, not private entities, realize the natural resource rents as royalty. Further elaboration about establishing competition in the natural gas subsector is provided in Appendix 3.

Power subsector restructuring

38. The power subsector has evolved through several stages. As the value of electricity as an input to economic growth became evident (for manufacturing and irrigation), large investments were made, mostly from public sources, for expanding the service coverage. By the middle of the twentieth century, the responsibility for the development and management of the power subsector was vested with government departments or state-owned companies in most countries. As coverage became universal, which happened first in the industrialized economies, less investment was needed for new power generation capacities and extension of the transmission systems. It became possible to generate adequate resources within the sector, commercialization was possible, and the private sector took a large share of the business in countries such as Japan and the United States. Most DMCs, however, have not come close to full electrification and public investment continues to be needed. When the first ADB energy sector policy was prepared in 1981, the thrust was on commercialization of the power subsector. With growth and improved managerial capability, many DMCs have by now created corporations with considerable autonomy to manage the power subsector. To bring additionality of resources, encouragement has been given to private sector participation, and most countries have changed the legal framework to permit implementation of private sector and joint venture power plants. The 1995 Energy Policy gave particular emphasis to this change.

39. The past decade has brought about a worldwide paradigm change in the power subsector. Based on the experience of successful operation in a number of developed economies, vertical unbundling (separating generation, transmission, distribution, and supply)¹⁵ without any drop in reliability of supply is considered technically feasible. The transmission and distribution networks tend to be natural monopolies since declining average costs resulting from significant long-run fixed costs enable incumbent service providers to pre-empt entry of new suppliers. Such monopolies need to be regulated to deny sub-marginal service providers their monopoly rents and allow new investments. The transmission and distribution networks are separated from the other components, i.e., generation and supply, that are required to function in a competitive market. The private sector has taken advantage of the opportunities offered by unbundling and deregulation of power generation to install new power plants, and demonstrated its ability to use resources more efficiently. There are a number of countries where the power generation and supply components have now been made competitive with prices being determined by supply and demand, while power transmission and distribution have been retained as regulated monopolies with open access to all participants. Merchant power plants, which do not have exclusive long term take-or-pay contracts and hence bear market risks, are being implemented when the regulatory framework becomes clear and project developers can reasonably forecast the sales revenue over the life of the project. Several market models and instruments for private participation have been developed and tried and as more is understood about the behavior of market participants, further improvements will be made. Appendix 4 outlines the experience with private sector investments in the context of a changing energy sector structure. It also explains the roadmap to competitive markets, which could be the ultimate goal or the ideal conditions to aim for, from a sector efficiency point of view. The impact of restructuring on demand-side management and energy use efficiency is also discussed in Appendix 4.

40. Many countries, both industrialized and developing, are now unbundling the power subsector and moving to competitive electricity markets to maximize the economic efficiency and minimize the impact of “regulator capture” wherein the regulator is suborned by the regulatee, and to avoid the “public choice” conundrum, i.e., the risk that the regulator may pursue its own interest, rather than that of the public. With the establishment of competition, many state-owned power utilities are being privatized (or have been privatized), with the notable exception of France. In Asia, countries like Indonesia; Republic of Korea; Malaysia; Philippines; Singapore; Taipei,China; and Thailand have decided to move to competitive markets. Through program loans and TA, ADB is supporting these restructuring efforts in Indonesia and the Philippines. ADB is also assisting in unbundling in Pakistan and India. The power subsector in these and a few other DMCs is relatively large, with well-diversified generation sources to make competition feasible. Where this is not the case, restructuring will not be an option as the cost of unbundling the subsector would be high without commensurate gain in efficiency. Private sector participation in such countries may still be possible through contract arrangements and competition at the entry stage.

41. Restructuring brings about a change in the role of the government, from that of a service provider to that of a policymaker and facilitator. New investments and the responsibility for efficient operations will gradually shift to the private sector, and the government will continue to be responsible for long-term planning, policy formulation and legislation, collection of rents and taxes, and evaluation of sector performance. The unbundling and emphasis on decentralization may require these activities to be carried out at different levels of government, i.e., municipal, provincial, and national. The other major change will be in the regulatory structure: it has to be viewed as being distinct and independent from the government in a competitive environment, and it has to have transparent and predictable oversight processes that safeguard the interests of the consumers, and at the same time provide incentives for private sector investments to meet the growth in demand.

42. In this move to competitive markets, DMCs face various constraints. Governance of a market requires that the judiciary has adequate resources and capacity to safeguard property rights. The regulator responsible for the sector oversight should be able to analyze the economic impact of its actions and detect any anticompetitive behavior in the market that compromises efficiency. In most DMCs, building public acceptance and obtaining legislative support for making the necessary policy changes may take considerable time. Restructuring is a logical step in the privatization of state-owned power companies but would require that the domestic financial markets have considerable depth and maturity to enforce corporate governance. Evidently, these changes are outside the power subsector and the pace with which they can be introduced depends on macroeconomic factors, political stability, and level of economic development in a country. Therefore, even in DMCs that opt to restructure, the process of change will take time and there could be a prolonged period of overlap when both public and private sector funds will be needed to sustain the power development.

43. Summarizing the approach to power subsector restructuring, the specific changes in each DMC need to be considered and designed based on the stage of its economic development and the constraints in the subsector. In the Pacific DMCs and countries where competitive electricity markets will need a long time to evolve, private sector participation in both generation and distribution will be encouraged through other competitive processes. Public sector investments will be supported in areas that fail to meet investment criteria for private sector funds, such as construction of hydropower plants and rural electrification. Public-private partnerships will be encouraged to take advantage of the higher operational efficiencies that can be achieved by private operators while mitigating the long-term investment risks of the private sector. Support will also be extended for improving the governance of public sector organizations. In countries where competition is possible, ADB will support restructuring and the creation of an enabling environment for the transfer of commercial activities to the private sector. During the period of transition from public to private management and ownership, ADB will assist further growth of the power subsector, including the addition of generation capacity, strengthening of the transmission network (particularly to facilitate competition when needed), and increasing access to electricity.

Energy pricing

44. Energy pricing policies have a direct impact on opportunities for restructuring the energy sector, making it financially robust and increasing private sector participation. ADB’s approach to energy pricing evolved in the context of the energy supply entities being in the public sector, organized as vertically integrated utilities and subjected to administered pricing regimes. Broadly, the approach was that, in respect of traded commodities such as coal and oil, the product prices should approach border prices suitably adjusted for taxes, handling, and transportation. At the same time, there was a concern that the entities producing such commodities should be allowed a producer price adequate to recover the cost of production, including the cost of capital. In respect of nontraded commodities such as electricity and natural gas, the approach was different. In the private sector environment, the producer price for natural gas was usually indexed to that of crude oil, since during exploration it was not known whether oil or gas, or both, would be found, and the terms of the production-sharing contract, which governed exploration, linked the two. The producer price for natural gas in state-owned companies was expected to be somewhere between (i) the long-run marginal cost of production plus allowance for depletion premium, and (ii) the traded price of an alternate fuel such as low-sulfur fuel oil adjusted suitably for handling and transportation. The consumer price for natural gas was driven by the economic prices of appropriate traded substitute fuels, like liquefied petroleum gas or kerosene for households, and fuel oil or diesel for industries.

45. The international energy trade is of equal importance to economies that export crude oil and petroleum products and those that need to import them. For most DMCs, the trade of petroleum products involves a considerable portion of their foreign exchange reserves and therefore becomes an important factor in maintaining macroeconomic stability. Proper energy management involves (i) optimizing the tradable value through prudent transactions using supply contracts, and spot and future markets; (ii) minimizing the domestic consumption of energy by improving energy efficiencies in supply and use; and (iii) adopting appropriate cost-recovery strategies in the domestic energy market. International oil prices have demonstrated considerable volatility. The first oil crisis of 1973 raised average crude oil prices to $35 per barrel (in 1998 dollars), then gradually the average prices sank below $10 per barrel in late 1998; again by mid-2000 the spot prices rose to the $35 per barrel level. High international prices adversely affect oil-importing countries, but at the same time encourage investments in exploration, production, and refinery capacities. A number of hedging instruments provide the means for relative stability in domestic prices. However, when the oil subsector is not fully deregulated, cross-subsidies in pricing are seen to occur. Domestic pricing strategies for various products like fuel oil, automotive and aviation fuels, and kerosene tend to take into account the end use. Some are consumptive uses wherein affordability and willingness to pay considerations play an important part; others are productive uses wherein the impact on the cost of the produced goods are considered. Kerosene is used by the poor in DMCs for cooking and lighting. Diesel is used for transport and irrigation, and its price hence gets linked to food prices. Therefore, the pricing of these fuels become a matter of public debate. When the oil subsector is fully restructured, economic pricing through efficient markets is possible with due regard to affordability of the poor. The volatility of the international oil prices makes this task even more challenging.

46. In the case of electricity, the approach was that the average tariff should provide adequate revenue for the power utility to be in sound financial health, and the tariff structure should follow the following principles: (i) capacity cost (per kW) should reflect long-run marginal cost; (ii) energy cost (per kilowatt-hour [kWh]) should reflect short-run marginal cost; (iii) tariffs for different classes of customers should be based on the cost of supply to them, rather than on the use to which the electricity is put; (iv) tariffs should vary as a function of factors like voltage of supply, quantity of kWh consumed, time-of-the-day or the season of consumption, load and power factors¹⁶ of consumption, and reliability or interruptibility of the required supply; and (v) internal cross-subsidies and external subsidies to the power subsector should be avoided to send correct price signals to the consumer. From the financial point of view, the objective was to enable the utility to charge tariffs adequate to cover fuel and operating costs—including depreciation—service its debts, and earn a reasonable return on its investments. Internal cash generation of the utility was expected to finance a reasonable proportion of the utility’s investment needs for system expansion. To the extent energy supply remains in the public sector and continues to be organized in the vertically integrated fashion, and prices continue to be administered, these considerations remain valid. However, in the context of possible unbundling of the sector and privatization of electricity generation and supply in the future, a closer look has become necessary at the rate of return to be achieved by the utilities that now operate as monopolies.

47. Since the mid-1980s, multilateral lending to power projects has often been linked to a pre-set level of rate of return on investment, but frequently that level has not been achieved. The power subsector in most DMCs is in the rapid growth phase, which suggests that a uniform return is not possible on all elements of the investment. The demand growth results from two distinct sources, existing consumers who increase their consumption as they grow with the economy, and new consumers who start using electricity from the grid. Incremental investments necessary to satisfy the former source of demand growth should result in immediate returns, as this market is mature. It is comparable to the situation in more developed economies, and utilities can be rightly expected to increase their productivity and hence their operating margins. However, the case is different when new consumers are being connected. Generation capacities, and new transmission and distribution networks are added, but the lumpy investments are larger than what would be necessary to satisfy the immediate demand. Prudent planning practices require the investments to be adequate for demand growth over the medium term, which is often as high as 10-12 percent per annum. Understandably, initial returns from such investments related to the asset base would be under par as long as the demand is lower than the capacity of the project. In DMCs that add significant new assets every year, thus continuously increasing their rate base, there will be an inherent lag in the increase of the operating margin. There is little evidence that during the period when today’s more developed economies were in a similar stage of rapid expansion (early twentieth century in the United States and Europe, or post-Second World War reconstruction in Europe), energy sector investments were driven exclusively by rate of return considerations.

48. In the context of power subsector restructuring involving unbundling and creating a competitive market in activities hitherto regarded as natural monopolies, the approach to tariff setting needs to be different. In such an environment, the electricity price would be a sum of (i) the commodity price of electricity generated as determined in the competitive market with many sellers and buyers; (ii) the regulated price of transmission services (including the grid access costs, etc.); (iii) the regulated price of distribution (“wires”) services; and (iv) the cost of supply services availed by customers. The charges for (ii) and (iii) will have to be regulated, because transmission and distribution will continue to be natural monopolies.

49. A similar approach holds good for the pricing of natural gas. When unbundling takes place, and several producers and buyers trade in a market, the consumer price will comprise the regulated transmission and distribution charges and the price of gas at the production point determined through a process of negotiation between the producers and buyers in a competitive environment. However, unbundling of the gas subsector can be done in a meaningful manner only if a basic backbone gas transmission system is in place and a regulatory agency is established. In many DMCs, the share of natural gas in the energy mix still lags far behind the corresponding share in more developed countries despite the DMCs’ gas potential. This disparity can only be corrected through the relative pricing of natural gas and other fuels used for power generation, considering that a significant portion of domestic natural gas can be used for this purpose.

50. In respect of traded commodities such as coal and oil, deregulation of prices and demonopolization of marketing arrangements and liberalized trading regimes should result in national market prices reflecting the world market prices of these commodities. Domestic producers will have to improve their productivity and efficiency to survive such market competition.

Governance

51. Good governance in the energy sector has the potential to yield significant benefits because of large resources invested in the sector. Operational issues such as financial control systems, procurement of goods and services, and improvements in productivity and efficiency have been commonly discussed and considerable resources are deployed to address them. High electricity losses is another acute problem in some DMCs. Some of the electricity generated in a power plant is consumed by auxiliary equipment, and part of it is lost in transmission and distribution¹⁷. Utility managements in some DMCs have reported losses as high as 45 percent, only part of which is technical loss; the rest is theft. From the utility’s viewpoint, a reduction in losses would increase operating income, as the operating expenses remain unchanged. From the economy’s viewpoint, as the unaccounted electricity is in fact used (other than the amount attributed to metering errors), its welfare impact is shared between consumers and agents that participate in the theft. However, stolen power generally yields lower efficiency as it is seldom allocated to the most efficient use. As long as this theft has not become endemic, investments in power system improvement (particularly metering), and the use of procedures and punishments that deter corrupt practices (both within the utility and in society) will be helpful. The introduction of competitive markets and profit considerations under which the private sector companies operate will have a beneficial effect, because competition among service providers promotes the use of innovative methods to increase revenue and provides a natural incentive to curtail corrupt practices. The introduction of competition has also confirmed that markets enforce governance in capacity additions. This frees up considerable resources from deferred projects as operators increase the utilization of existing power-generation capacities and improve grid management, which obviates the need for new investments for capacity additions and yields significant economic benefits.

52. As governments distance themselves from management of the energy sector by opening it up for private sector initiatives, the importance of the regulator’s role increases. Companies, whether in the private or public sector, are accountable to lenders and shareholders through the financial markets; to the regulators with respect to the rules and codes that are propagated to ensure competition and security of electricity supply; and to several other authorities for environmental, labor, and legal matters. Regulators in liberalized energy markets need to be capable, vigilant, and empowered to prevent, detect, and punish unscrupulous behavior and safeguard the interest of small consumers.

53. Power has the characteristics of a perishable good, which means that electricity has to be generated as and when it is used. This is not unlike many other goods and services. However, in the case of electricity, if a provider interrupts the delivery of power, relatively large disturbances can occur in other production processes and services with consequent economic losses. Until recently, this “perishability” was used as an argument to justify the government’s role in the provision of power supply in many countries. The liberalization of the power subsector will not change electricity’s attribute, but shift the burden of enforcing governance to the regulator. This aspect will need to be reflected in the terms of license that will be held by all electricity businesses. While rights will be given, license holders will also be obliged to remain in business and follow instructions for ensuring the integrity of the supply system. Conditions that could cause the exit of companies, such as bankruptcy, will need to be monitored by the regulator so that timely responses can be initiated to avoid the interruption of services, without prejudicing the rights of the creditors.

54. In ADB’s policy on the subject, governance has been defined as “the manner in which power is exercised in the management of a country’s economic and social resources for development.” For promoting accountability, emphasis has been given to, inter alia, public sector management and public enterprise reforms. Together with participation and transparency, all these are especially relevant during energy sector restructuring. The need for regulators to be predictable rounds off how the four elements of good governance fit into the energy sector.

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