changing canadian el market and future role of goverment

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Energy Studies Review

| Issue 2Volume 6 Article 3

11-10-1994

Changing Canadian Electricity Markets and theFuture Role of Government

Mark Jaccard

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Recommended CitationJaccard, Mark (1994) "Changing Canadian Electricity Markets and the Future Role of Government,"Energy Studies Review: Vol. 6: Iss.2, Article 3.

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Changing Canadian Electricity Markets and the Future Role ofGovernment

Abstract

The roles of two arguments from neoclassical economics for government intervention in the electricityindustry, based on the existence of natural monopoly and public goods, have been diminishing, while theneed to deal with negative environmental externalities has been given increasing attention. In recent debatesover appropriate policy responses, these rationales have frequently been treated in a confusing manner andone encounters policy proposals that focus on one of the arguments while ignoring the others. The evolutionof these rationales is described and its implications for policy formation are considered. The paper concludeswith an illustration of how this analysis suggests a certain range of policy solutions, combined with substantialroom for distinct choices within that range.

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The roles of two arguments from neoclassical economicsfor government intervention in the electricity industry,based on the existence of natural monopoly and publicgoods, have been diminishing, while the need to deal withnegative environmental externalities has been given in-creasing attention. In recent debates over appropriate pol-icy responses, these rationales have frequently been treatedin a confusing manner and one encounters policy pro-posals that focus on one of the arguments while ignoringthe others. The evolution of these rationales is describedand its implications for policy formation are considered.The paper concludes UJith -an illustration of how this anal-ysis suggests a certain range of policy solutions, combinedwith substantial room for distinct choices within thatrange.Deux argumentations d'inspiration economique neoclas-sique, en faveur d'une intervention gouvernementale dansIe secteur de l'energie eIectrique, qui s'appuient surl'existence d'un nwnopole nature! et sur la notion de bienspublics jouent un role de moins en moins important alorsqu'on prete de plus en plus attention au besoin de traiterles problemes extemes lies aux consequences negatives del'industrie sur l'environnement. Au cours des recentsdebats sur l' elaboration de politiques appropriees enriponse aces problemes, ces arguments ont souvent efeabordes de maniere confuse et on rencontre des pro-positions de politique qui se focalisent sur un des argu-ments et ignorent les autres. L'article expose 1'evolutionde ces logiques d'argumentation et fraite de leurs impli-cations en matiere d'elaboration des politiques. En con-clusion, il ilIustre la maniere dont une teIle analysesuggere qu 'il existe un certain eventail de solutions enmatiere de politiques et en mOOe temps qu'une marge demanoeuvre substantielle pennet d'effectuer des choixdistincts.

Mark Jaccard is Chairperson and CEO of the BritishColumbia UtilitiesCommission and Associate Professor in the School of Resource and EnvironmentalManagement, Simon Fraser University, Vancouver.An earlier version of this paper was presented at theInternational Seminar on Regulation: Energy, Environ-ment and Finance at the University ofMexico, August16-18,1994.

Changing CanadianElectricity Marketsand the Future Roleof GovernmentMARK JACCARD

The appropriate role for government in theelectricity market has recently emerged as ahighly contentious issue. Although argumentsfor government intervention have existed sincethe electricity industry's beginning a centuryago, in recent decades two notable rationalesthat have dominated for most of the centuryare diminishing in importance, while a newrationale is emerging. In t he t erms of neoclassical economics, the first two rationalescentre around the concepts of natural monopolyand public goods; the more recent rationale isbased on negative environmental externalities. Thefirst objective of this paper is to step back fromthe day-ta-day debate in order to discern thesebroader trends in the rationales for governmentintervention in electricity markets, and to assessthe ir separate an d combined implicationsIHowever, whi le the analysis of interventionrationales is generic to the electricity industrythroughout the world, the appropriate policyresponse depends on the specific characteristicsof each region or country. Thus, the secondobjective is to assess the implications of theseindustry-wide trends for government intervention in Canadian electricity markets. Ofparticular concern is the extent to which the1/ Note that the issue addressed in thi s paper isnot simply one of public versus private ownership.The concern here is with the broad question of theappropriate degree of government intervention inall its forms.

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Jaccard: Changing Canadian Electricity Markets and the Future Role of Gove

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current trends will either force convergencetoward a single industry model or continue toallow for the regional diversity that hashistorically characterized the Canadianelectricity industry. Analysis suggests that thereare both forces for convergence and possibilitiesfor divergence, implying that some changes willbe similar, bu t t ha t t he level of governmentownership and regulat ion can still vary considerably. In particular, private competitiveelectricity generat ion markets will emergethroughout the industry, as will more stringentenvironmental regulation, bu t the degree ofgovernment ownership and the form of environmental regulation may differ significantly.1. Past Rationales for GovernmentIntervention in Electricity MarketsThe approach in this paper is to explaingovernment intervention in capitalist marketeconomies in terms of standard concepts ofneoclassical economics. This approach offerscertain advantages in terms of clarifying theunderlying fundamental issues in public debate.But i t should not be assumed that politiciansexplicitly carry ou t this type of analysis whenmaking policies. The approach here is interpretive rather than descriptive.

Neoclassical economics defines conditionsunder which markets are unlikely to maximizesocial welfare.2 These conditions are generallydef ined as market failures, and they providea rationale for government intervention in agiven market.3 Two market failure rationalesfor government intervention in electricity2/ According to economists, social well-being (orwelfare) is maximized if consumers can freelydetermine their consumption and if productiveresources are allocated to satisfy these consumptiondemands in the most economically efficient mannerpossible. Economists specify several conditions, including perfectly competitive markets, that willlead to welfare maximization.3/ There is no guarantee that government intervention will bring society closer to the social optimum, which is why some argue against government intervention even where market failure is obvious.

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marke ts have existed since that industryemerged at the beginning of the century. Thefirst is based on the concept of naturalmonopoly, the second on the a rgument tha telectricity exhibits some of the characteristicsof public goods. A third argument, not discussed in as much detail here, does not relate tothe market's failure to be efficient, but to asocial equity goal: the belief that the almostuniversal provision of electricity at a cornmonprice is socially desirable.1.1 Natural MonopolyIn some industries, the lowest possibleproduction costs can be achieved only if thereis one firm in the market. This type of marketis cal led a natural monopoly in order to distinguish it from markets in which an 'artificial'monopoly exists, in that, if it were to be replaced by several competing firms, priceswouldfall4 In the electricity market, a capital intensivedistribution system is required and i t is readilyapparent that redundant distribution systemsowned by competing firms would entail muchhigher costs. Also, until recently itwas assumedthat economies of scale in generating tmitsmeant that one large unit would have a lowercost of production than two or more smallerunits.

For society to capture the benefits of naturalmonopoly, the general assumption is thatgovernment intervention is required in orderto ensure that the monopolist operates efficiently and does not gamer excess profits.5Governments have generally opted for one oftwo major forms of intervention in electricitymarkets. One is to countenance a privatemonopoly, bu t to regulate i t with a publicutility commission. The other is to establish apublicly owned monopoly - in Canada acrown corporation - overseen by one or moreof direct ministerial control, cabinet appoint-4/ See Berg and Tschirhart (1988) for a formaldefinition.S/ Excess profitS are here distinguished from normal profits, the latter being a return to capital commensurate with the investment risk.

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ment of the utility's board of directors, or a parliamentary review committee.

The dominant approach in Canada has beento create crown corporations. Over 80% ofelectricity generated in Canada is by verticallyintegrated crown corporations owned by provincial governments (Table 1). However, theCanadian model varies from province toprovince, with only Alberta, Nova Scotia andPrince Edward Island dominated by privateownership, and with many provinces and territories having special characteristics, such assmall privately owned utilities or rnlU1icipalutilities. Ontario Hydro, for example, deliverspower to over 300 municipal utilities (NaturalResources Canada, 1993).

In its emphasis on public ownership, thedominant Canadian model is similar to that ofEurope. In contrast, in the US, as in Alberta,most major generating utilities are investorowned, regulated by public utility commissions.Neither the regulation of private monopoliesnor the creation of crown corporation mono-polies have been free of criticism as solutionsto the natural monopoly problem. In the caseof regulated , privately-owned utilities, twocriticisms have been particularly salient.

One criticism is that there is a tendency inregulation to award excessive returns to capital,thereby providing an incentive for utilities toover-invest and to bias their investments towardcapital and away from labour and otherproductive inputs (Averch and Johnson, 1962).The second criticism emphasizes the differencebetween regulatory theory and practice. I t issuggested that regulatory agencies are at riskof "capture," such that they eventually confusethe objectives of the regulated entitywith thoseof society (Stigler, 1971; Posner, 1974). Both ofthese theories are difficult to prove or refute,and efforts at empirical analysis have tendedto show t ha t t he regulatory process is muchmore complex than either critical model wouldsuggest Uoskow, 1974)6

Over the years numerous reforms have been6/ Kahn, A., (1988) and most other texts on electricutility regulation review the inconclusive researchresults.

suggested and implemented. These tend eithertoward more careful scrutiny of utility management decisions or toward efforts to better integrate market mechanisms into the regulatoryprocess. The latter approach includes price caps,which encourage greater efficiency effort by theutili ty because cost decreases allow higherprofits in the period between cap reviews, andfranchise bidding, in which the monopoly franchise is open to competi tive bid at regularintervals.7

As for the public ownership model , twocriticisms stand ou t (Vickers and Yarrow, 1988;Laffont and Tirole, 1993). The first relates to theeconomic inefficiency that may result whenpolitical concerns and the self-interest of utilitymanagers interfere in investment and operatingdecisions. The second relates to the problemsfor democratic societies due to the concentrationof power in the hands of managers of largepublicly owned corporations. Positions i n thedebate about public ownership are, however,often determined by broader ideologicalperspectives. Those with a propensity to favourmarket intervention will tend to be more opento public ownership, and the converse, thoughthis dichotomy does not always ho ld withrespect to electricity, as shall be seen below inthe discussion of public good.

The debate about investment efficiency isalmost impossible to resolve empirically (Bergand Tschirhart, 1988). Even if the publiclyowned monopoly were shown to have lowerprices, a non-interventionist would likely beable to cite evidence of public subsidy, as thesefrequently exist in the form of public debtguarantees or low returns to public equity. Conversely, if a private regulated monopoly wereshown to set lower prices than a publiclyowned monopoly, an interventionist mightargue that the publicly owned monopoly hadsimply done a better job of incorporating other

7/ See Joskow and Schmalensee (1983) and Moorhouse (1986) for detailed analysis of the options forreforming utility regulation. Demsetz (1968) presents the case for franchise bidding and Shepherd(1984) provides a counter argument to this approach.

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Table 1: Electricity Supply and Mode of Government InterventionElectricity Demand(Twh) Electricity SupplySource Ownership ofGeneration Rate Regulation

hydro 95%

Manitoba 18.4Saskatchewan 14.6

Alberta 45.9British 57.3Columbia

94% predominantly utility commissionprivate

95% predominantly utility commissionpublic

NewfoundlandPEl

Nova ScotiaNew Brunswick

QuebecOntario

10.70.89.913.9

164.6139.4

fossilfuelfossilfuelfossilfuelnuclearhydrohydrofossilfuelnuclearhydrohydrofossilfuelhydrofossilfuelhydro

100%

89%

49%30%19%

96%22%48%29%

99%77%22%

predominantlypublicprivateprivatepublic

publicpublic

publicpublic

provincial cabinetutility commissionutility commissionprovincial cabinet

provincial cabinetprovincial cabinet

provincial cabinetprovincial cabinet

relevant cost or equity considerations into itsdecision making, suggesting that social welfarewas optimized even if commodity prices werehigher. Moreover, it can be argued that sinceneither private no r public monopolies face thediscipline of the competitive market, the keydeterminant of efficiency performance is to se teffective management incentives.1.2 Public Good and Social Equity ConcernsThe natural monopoly rationale alone is acompelling reason for government interventionin electricity markets. However, the specificcharacter of that intervention is influenced byother factors. First, the propensity to favourpublic or private ownership will differ. Second,electricity is also seen as having other specialproperties that invite government intervention.Notably electricity is sometimes treated as if it

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were a public good and as a necessi ty thatshould be provided to all as a principle of socialequity.

A public good is defined as a good characterized by non-exclusivity and non-rivalry. Nonexclusivity means that the benefits of the goodcannot be withheld from anyone. Non-rivalrymeans that use of the good or service by somedoes no t diminish its benefit to others. Thus,for example, a lighthouse is a public good. I tis difficult or impOSSible to prevent particularships from benefiting from the services of alighthouse (non-exclusivity), yet their use of thatservice in no way diminishes the benefits re-ceived by others (non-rivalry). Because privateeconomic agents cannot capture in markettransactions all of the benefits of public goods,public goods will generally be under-prOVided




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by markets8While it is difficult to describe any good asa perfect public good, goods can be rankedalong a continuum with pure public goods atone end and pure private goods at the other.Electricity, the argument goes, is somewherea lo ng this c on tinu um, c lo se r to a p ur e p riva tegood bu t nonetheless sharing some of theatt ributes of public goods. These attributesespecially relate t o the strategic importance ofthe choice of resources and technologies usedin producing electricity, in that they influencethe general character of the economy. Pro-ponents of intervention have apparently per-ceived a jointly-


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nologies, electricity generation investments canrepresent a significant portion of total invest-ment and increments in the debt of a countryor region. The timing and magnitude of suchdecisions may have implications for countercyclical macroeconomic policies, as well as fortrade and debt balances. This too can be viewedas involving a pub lic good and it inv it esgovernment involvement; that is, by influencingthese financing decisions the government cancreate ne t benefit that would no t be created byl eaving the decisions totally to the privatesector.

Governments have also been influenced bythe argument that electricity is an essentialcomponent of modem society and t hat , a s amatter of social equity, the electricity gridshould be extended to all regions and pricesshould be the same (within broadly definedcustomer classes) regardless of differences inthe costs of proViding service. Such a policyrequires either subsidies across customers orsubsidies from taxpayers. Satisfying a socialgoal in this way produces an outcome that canbe far from economically efficient and thisargument is thus generally at odds with theother two rationales.1.3 Intervention in the Canadian ElectricitySectorGiven the diversity and complexity of factorsmotivating government intervention, it is notsurprising that the outcomes have var iedsignificantly, even within a single country. Thus,whil e natu ral monopo ly inevitably invitespublic intervention, it is the public goodrationale and the propensity for marketintervention within a particular national orregional society tha t t ends to determine thechoice between public and private ownershipin the electricity sector. Canadian historyillustrates this point. Public ownership is usuallyassociated with the principal electricityproduction technology (notably nuclear orhydro power) and w ith the effort to frovideelectricity service to hinterland areas.9/ For further background see Vining (1981).

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British Columbia is one example. Prior to1960, Vancouver was served by the privatelyowned BC Electric, while hinterland areas ofthe province were served by the publicly ownedBC Power Commission. Although the SocialCredit government of the 1950s and 60s wouldqualify as a non-interventionist government, itperceived large-scale hydropower developmentas a precursor to economic development in theprovince's hinterland regions. To realize thisobjective, the government nationalized BCElectric, creating BC Hydro in 1962, withmonopoly starus over most of the province, andproceeded with simultaneous development ofthe Peace and Columbia Rivers.

In Quebec, the motivating factors fornationalization also had public good overtones,although the specific issues were quite different.The nationalization and consolidation of theelectricity sector was perceived by the reformistLiberal government of the 1960s as a keycomponent in Quebec's effort to mas te r itseconomic destiny. In recent decades, HydroQuebec served this objective by undertakingmajor hydro-electric development in the JamesBay area.

Alberta provides a third variation. Thehistorical preference for non-interventionistgovernment in that province, and the key roleof thermal resources, have together contributedto the development of an Albertan model thatclosely resembles that of the US, a predominantly private utility sector with regulation by autilities commission.

In contrast, Saskatchewan has traditionallybeen noted for interventionist politics. Thus,even though its electricity generation resourcesare also predominantly thermal, its electricitysector is publicly owned.

As examples in the US and elsewhere haveshown, government objectives can be realizedalmost as easily with private ownership as withpublic ownership. Thus, government efforts inresearch and development, in addition to othersupport, can influence private sector choices,as has occurred in support of nuclear devel-opment in the US, Germany and Japan. Utilitycommissions also prOVide an opportunity forthe inclusion of various public values related




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to electricity's public good attributes and tobroader social equity concerns. Thus, uti li tycommissions throughout the US, and in Canadawhere applicable, have been supportive in thepast of utility rates and policies that, amongother things, (1) applied uniform tariffs withincustomer classes regardless of cost of servicedifferences, (2) subsidized uneconomic extensions of service, (3) provided special tariffs andservices for low income customers or troubledindustries in regions suffering from economicrecession, and (4) explicitly favoured the development of particular generation technologiesover others.2. Emerging Forces of ChangeSeen from the perspective of the 1990s, the threedecades followingWorld War 11 were relativelystable, at least in te rms of the fundamentalcharacteristics of the electricity industry andconsequently with respect to the rationales forgovernment intervention. However, by the1980s the cumulative effect of technologicalevolution and changing public and politicalconcerns began to shift the debate about therationale for intervention in the electrici tyindus try. Whi le the convent ional rationalefocused on natural monopoly and public goods,an emerging rationale relates to another formof market failure - environmental externalities.In addition, the strength of the two traditionalrationales have been eroded by developmentsand changing public perceptions about thedesirability of market intervention. These changes have set off a broad ranging debate aboutthe appropriate roles for government andindustry in the electricity market, and have ledto substan tial uncer ta in ty about the futurecharacter of that industry.2.1 Environmental Concerns: the ExternalityRationaleEconomists refer to most environmental impactsas external ities - a negative or posit ive effectof some activity that is experienced by a thirdparty but is no t accounted for in an associatedpurchase transaction or payment for damage.

The above discussion of public goods dealt withposit ive externalities; the focus here is onnegative environmental extemalitiesr whichhave been a key concern in the electricity sector. lO Because negative externalities are coststhat are not incorporated in final product prices,the private market will produce more of the externality-causing good or service than is optimalfor society.

Rising environmental awareness in the late1960s and early 1970s had important implicat ions for the electricity industry. Indeed,virtually every major electricity generationtechnology has been under an environmentalchallenge since the 19705, with new concernsemerging as earlier ones have been partlyaddressed.n

Since the 1970s, the safety aspects of nuclearpower have been aggressively questioned, inparticular fuel transportation, plant operationand waste disposal. This ha s become a politicalissue in many countries, and Canada is noexception.Major hydro-e lect ric projects are nowexamined more rigorously and critically fortheir environmental and social impacts and forthe non-market values of the land lost toreservoirs. Recent hydro projects in Alberta, BCand Quebec have all been associated with majorcontroversy because of their potential environmental and social impacts.Combustion of fossil fuels in the generationof electricity is now recognized as a significantcontributor to regional and local air pollution.Acid rain, partly caused by electricity generationhas been a regional problem in eastern Canadaand the northeast US.

Depending on plant sitings, the n it rousoxide emissions from fossil fuel-based electricity10 / Negative social externalities have in some casesalso been very important. An example would beuncompensated social impacts suffered by CreeIndians from Hydro-Quebec's James Bay projects,or the negative effects suffered by British Columbiaaboriginals and non-aboriginals due to the development of the first Kemano project in northwest BCin the 19505.II/For details on the period prior to 1980, seeRoberts and Bluhm (1981).

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production can also contribute to urban airpollution. Nitrous oxide is a precursor to lowlevel ozone, a critical air pollutant in theWindsor to Quebec City corridor and in metropolitan Vancouver.The most recent environmental concern fromelectricity generation is the risk of global climatechange associated with greenhouse gas emissions. Fossil fuel-based electricity generationteclmologies are again at issue, in this caseprimarily because of their CO2 emissions.Governments have responded to theseenvironmental concerns in various ways. In partthis divers ity is a result of differences in technology, bu t it is also explained by differencesin public perceptions and differences in pre-ferred regulatory mechanisms.

In response to the concerns about nuclearpower, governments and regulatory agencieshave increased safety measures and conducteddetailed public reviews, resulting in substantialcost increases for nuclear power in manyjurisdictions. In the US, these cost increaseshave seriously undermined nuclear power'sability to compete for new capacity requirements. In Europe there have also been intensepublic debates about nuclear power, withseveral countries, such as Denmark andSweden, ruling ou t future use of that technology. Less anti-nuclear sentiment has beenevident incountries such as France and Belgium. Ontario Hydro ha s no active plans toconstruct another nuclear plant, although it isdifficult to separate public policy intent fromthe consequences of an economic downturn.

With few exceptions, most industrializedcountries are no longer willing to further exploittheir remaining large-scale hydropower potential.12 Moreover, the full costs of past projectsare being re-assessed, notably because of corrective expenditures and foregone generationbenefits (spilling water) required to mitigatelosses to other economic sectors, such as thefishery. The most striking example is the major12 / Quebec is an exception, but this policy isseriously challenged by environmentalists andsome of the aboriginal peoples living in the area ofgreatest hydropower potential, James Bay.

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action taken to correct losses to fish resourcescaused by earlier hydropower projects of theBPA along the Columbia River system13

Growing concerns for acid rain in easternNorth America and central and northern Europealso led to regulatory responses that increasedthe cost of electricity from fossil fuels, especiallycoal. In the US, this concern culminated in thefederal government's Clean Air Act of 1990,which set targets for total ac id gas emissionfrom electricity generation and established atradeable permit system in an effort to achievethe reduction targets at lowest total cost. InEurope, the EC has set new emission standardsfor generating plants, and is currently attempting to encourage or subsidize similartechnological developments in eastern Europe.The Canadian federal government and pro-vincial governments have also tightened theiremission standards.

In terms of the local a ir quali ty impacts ofelectricity generation from fossil fuels, regionalauthorities in the Los Angeles basin are playinga leading role, setting targets and devisingimplementation mechanisms to reduce local airemissions. This strategy has implications for thechoice of electricity supply technologies, thesiting of new generation plants, the retrofit ofexisting plants, and dispatch decisions fromexisting plants. Standards throughout the USare set by the Environmental Protection Agency.Similar efforts are underway or contemplatedin southern Ontario and the Vancouver region.The climate change issue has only recentlybecome a serious concern of governments. Mostcountries have now made general commihnentswith respect to stabilizing or reducing CO2emissions, but only a few specific policies haveso far been enacted. In addition to these policiesfocused directly on the externality problem, therecent shift in electric utility regulation toward13/ The concern to correct damages to fisheryresources, combined with major misinvestrnents innuclear plants, provided a dual impetus for thecreation of the Northwest Power Planning Councilby the US government in 1980. Its general mandateis to promote conservation in the planning processes of the BPA and the region's utilities, and to findoptions for the recovery of fish stocks.




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encouraging energy efficiency is also seen asa key policy response. While many would arguethat the energy efficiency initiatives amongutilities in the US in the 1980s were not initiatedfor environmental reasons, these actions havenonetheless had profound implications in thedebate about the appropriate government response to the externality issue.

During the 1980s, US utility commissionsbegan to shift their focus from the least-costprovision of electricity, the commodity, to theleast-cost provision of the services provided byelectricity, such as lighting, heating, motiveforce, refrigeration, etc. Least-cost analysis ofelectricity service provision frequently leads tothe conclusion that inveshnents in efficiencywould be more profitable than investments innew supply. Programs to incite such investments are referred to as demand-side management (DSM). The process to ensure faircomparison of supply and DSM options isreferred to as integrated resource plarming(IRP). Utilities in most states in the US are nowmandated to conduct IRP and to implementthose DSM measures that are least-cost relativeto supply alternatives. Increasingly, the IRPprocess includes public involvement via interestgroup participation.

The causal factors for the regulatory shiftin the US are complex. First, many utilities hadover-invested in new capacity in the late 1970sand early 1980s, and in some cases significantshareholder losses were incurred when utilitycommissions refused to allow complete recoveryof these inveshnents through rate increases.Utility managers were, as a consequence, morereceptive to planning approaches that reducedthe r isk of unrecoverable investments. Publicinterest groups that had resisted major supplyinvestments, and subsequent price increases,were generally enthusiastic in their support ofefforts to find alternatives to such investments.Secondly, an underlying current in the debatearound these phenomena was the recognitionby many that there could be significantenvironmental benefits from an emphasis onenergy efficiency1414 / Lovins (1976) played a critical role in the

A third important factor was that manyutility commissions and participants in theregulatory process became convinced of theexistence of several additional market failures(or market impeifections) affecting energymarkets15 Independent engineering andeconomic analysis suggest that some consumers'decisions about electricity consuming equipmentare non-optimal from the consumers' ownperspectives, and certainly non-optimal froma social perspective. Several market imperfections have been suggested as the cause of thisapparent non-optimal behaviour. They includelack of information, high transaction costs,unnecessary risk aversion and imperfect capitalmarkets, among others.16 This third factor market imperfections in consumer choices provided the rationale for greater interventionin electricity markets, in this case to influenceconsumer behaviour instead of the behaviourof the utility.Although the indirect environmental benefitsof DSM are frequently recognized - lessgeneration means less pollution - many utilitycommissions in the US have also focuseddirectly on environmental externalities throughtheir ability to regulate the choice of electricitygeneration technologies. In this sense, they havetaken over much of the market intervention rolethat in other countries might be performed bynational and regional governments. Throughthe IRP process, utility commissions are experimenting with various mechanisms to influencethe choice of generation technology, including(1) applying percentage adders to the cost ofdevelopment and popularization of the argumentthat promoting energy efficiency is a key component of a sustainable energy future. See E. Kahn(1988) for a review of the development ot lRP inthe US utility regulation process.15 / While some have used the term market failurein this context, others have preferred marketimperfection, so as to make a distinction betweenthese problems and the more conventional cases ofmarket failure involving externalities.16 / There is an extensive literature on marketimperfections. See, for example, Fisher and Rothkopt (1989) and Krause et al (1993).

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environmentally damaging supply technologies,(2) estimating monetary values for negativeexternalities and internalizing these into the costof supply technologies when deciding betweentechnologies, and (3) establishing renewable set-asides, to ensure that a certain percentage ofincremental supply will be from renewable,environmentally benign, electricity generatingtechnologies, regardless of their cost (Rose,Centolella and Hobbs, 1994).

There have been several criticisms of theefforts of government and regulatory agenciesto deal with externalities in the electricitymarket.A general criticism, leveled by many eco-nomists, is that governments have tended tooverlook the possible economic efficiencybenefits of using market instruments to achieveenvironmental objectives. Ideally, the economistwould like to see envirorunental outcomes resultfrom the internalization into market prices ofexternality costs. However, most economistsadmit that it will be a long time, if ever, beforemarket values for all externality costs can bedetermined and effectively internalized, andeven if that were to be achieved there isuncertainty as to whether individual consumption behaviour would lead to environmental outcomes that are considered optimalby most members of society. However, even ifsociety instead chooses to determine the desiredlevel of pollution (or pollution reduction) bysome other means, economists argue that itshould still rely on economic instruments toachieve that desired level at minimal costs.Pollution taxes and tradeable pollution permitsare frequently cited as examples of sucheconomic instruments.

But economists have not been the onlygroup disenchanted with government responsesto environmental externalities. Ecologists andepidemiologists, in particular, have noted thatmany of the effects of pollutants may no t bestatistically detectable or may only emerge yearslater. Moreoverf non-linearities and criticalthresholds in ecosystems can make it extremelydifficult to develop reliable estimates of therelationship between different levels of apollutant and the associated incremental

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changes in environmental damage. As aconsequencef these scientistsf and environmentalists in general, argue that the governmentresponse to the externality market failure shouldbe guided by the precautionary principle. Ac-cording to this principle, the burden of proofshifts so that actions possibly affecting theenvironment are disallowed unless it can bedemonstrated with reasonable confidence thatno negative externality is likely. This argumentcalls for a much greater government intervention in the economy, in this case in apreemptive manner. It would support, forexample, policies to favour specific technologies(e.g., certain types of renewable electricity gen-eration technologies) simply because these poseless risk to the environment.

The rationale for DSM has come undercriticismf especially from economists. Some havequestioned the market imperfections listed insupport of DSM activity, arguing that estimatesof economic energy efficiency potential will tendto overstate the achievable potential to theextent that they ignore important intangiblecosts and consumer surplus differences betweenproducts (Sutherland, 1991)17 Othe rs haveargued that estimates of economic efficiencypotential are exaggerated because of a failureto account for th e full costs of utili ty imple-mentation of DSM and because, in estimatingsavings, real world results should be usedinstead of best practice engineering simulations(Joskow and Marron, 1992). Economists aremore supportive of DSM if i t is offered as one17! This large debate can only be treatedsuperficially here. The argument is that estimates ofeconomic efficiency potential generally fail toaccount for (1) differences in consumer surplusbetween products that ostensibly provide the sameservice and (2) intangible costs of more efficienttechnologies. If the light of an incandescent bulb ispreferred to that of a compact fluorescent bulb,there is a difference in consumer surplUS betweenthese two goods. Intangible costs relate to additional perceived risk and/or transaction costsbecause the more efficient product is general lynewer, less well known, less tested for reliability,and therefore likely to be more troublesome (hencecostly) to find, shipf installf operate and maintain.




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of the means of responding to environmentalexternalities or to correct the tendency of regulators to set electricity prices at average costinstead of marginal cost (assuming the latterexceeds the former).Finally, a key criticism o f u ti li ty led IRPprocesses as a response to environmentalexternalities is that they may inadvertentlyresult in a worse outcome. The argument is thatactions at the state or provincial uti li ty com-mission level may actually decrease socialwelfare because utility commissions only havejurisdiction over certain energy forms andcertain energy companies. For example, aneffort to favour renewable, environmentallybenign, electricity generation technologiesmaydrive up th e price of electricity such thatconsumers switch to an alternative for aparticular end-use (say oil for space heating)that happens to have an externality impact overit s life cycle even greater than th e life cycleimpact of electricity as currently generated.182.2 Erosion of the Natural Monopoly RationaleThe second force for change in recent times hasbeen an outcome of both technological evolutionand regulatory changes. As noted above, thecosts of conventional, large scale, electricitysupply technologies increased as a consequenceof regulatory responses to environmentalconcerns, especially for nuclear and fossil fuelbased technologies. In many jurisdictions, thecosts of nuclear also increased because ofunforeseen operating problems. Finally, thesetechnologies also experienced a general decreasein the rate of advances in technical efficiencyGoskow, 1987; Hirsh, 1989). At the same time,advances with other technologies have shiftedthe cost advantage from large-scale back towardsmall-scale technologies. This holds true espec ia lly for natural gas-based generationtechnologies, the least pol lu ting of th e fossilfuels, bu t it is also increasingly true foralternative, renewable technologies, notably18 / Life cycle costing is a methodology that incorporates all costs from production through to wastedisposal of a particular commodity or service.

wind, biomass, small hydro, geothermal and,in some cases, solar. Among thermal technologies, there has been a dramatic improvementin relative unit costs for smaller scale units thatuse a combined cycle for electricity generationand/or cogenerate steam for industrial or domestic uses.

Taken together, these technological developments imply that past assumptions abouteconomies of scale in electricity generation areless and less valid. Considerably smaller unitsare now economically viable. This is especiallythe case in private electricity markets, such asthe US, where the long amortization periods required by large scale technologies, such asnuclear, are seen as more risky by privateinvestors. The full implications of this economicshift are the subject of lively debate in th e USand now increasingly throughout the world.

The electricity supply industry consists ofthree components: generation, transmission anddistribution. The broadest possible implicationof lost economies of scale in electricity generation is the elimination of the natural mono-poly rationale for electric utilities, at least forgeneration.19 As a consequence, it. is nowincreasingly argued that private competition atthe generation level is the market structure thatbest maximizes social welfare. This wouldreplace the vertical integration model of theelectricitymarket structure with the model thatis emerging in th e North American gas industry, one in which transmission and d i ~ t r i bution utilities are separate from commoditysupply companies.

However, this argument for privatecompetitive markets in generation is not universally accepted. Positions in the debate depend on how one trades off the decline in thenatural monopoly rationale against the otherrationales for intervention in electric markets.19/ Ruff (1994) argues that the vertically integratedelectricity firm includes an additional naturalmonopoly function, that of coordinating short-runsupply dispatch in order to ensure instantaneousmarket clearing at all times; this is of particularconcern because of unique properties of electricitytransmission and because electricity cannot bestored.

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In particular, even if the natural monopolyargument for a m on op ol y i n generation ha sdiminished, this ma y be offset by a continuationof the public good rationale, or b y the emergingenvironmental externality rationale. Accordingto some analysts, these latter may be sufficientrat ionales for continued public monopolyownership of Eledricite de France (nuclear) orth e Bonneville Power Authority (hydro)20

An additional issue is whether the technological trends that have undermined the naturalmonopoly rationale in generation will eventually have similar effects for the remaining majorcomponents of the electricity industry, transmission and distribution. Some analysts speculate that the improving economics o f s m alleran d smaller generation units, notably combinedcycle turbines, fuel cells an d solar-based technologies, m ay i n future favour on-site electricitygeneration ("distributed generation") such thatt he m on op ol y p os it io n o f t r an sm is si on an ddistribution monopolies will also b e r ed uc ed(Flavin an d Lenssen, 1994).

Developments in the US have played a keyrole in this erosion of the natural monopolyrationale, although more radical market experiments are now being conducted in othercountries, notably th e UK, Norway, Ne wZealand an d Chile. In 1978, the US federa lgovemment passed the Public Utility RegulatoryPol icy Act (PURPA), forcing elect ric utilitymonopolies to take supply from non-utilitygenerators if these were at lower cost than theutilities' ow n pl anned s upply units. While th ePURPA initiative wa s moti vat ed i n large partby concern in the US about the use of importedoil for electricity generation, the implicationsfor the natural monopoly rationale h av e b ee nconsiderable. The experience of th e followingdecade demonstrated a clear shift in the econo-20 / In France one still hears the argument that thetime horizon of private investors i s too short toarrive at socially optimal electricity generationinvestments. Nuclear investments, even if optimalfrom a holistic social perspective, will tend to beoverlooked by the private sector on its ownbecause the investments are so capital intensiveand require such a long time for recovery of theinitial investment (Bouttes and Lederer, 1991).

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mics of electricity generation, with smaller scaletechnologies proving to be competitive withconventional large utility supply projects.

Although PURPA initially required utilitiesto pa y private generators a price that reflectedth e cost of electricity from the utili ty 's next,proposed generation project (its avoided cost),it soon became apparent that non-utility supplyexceeded demand at this price. Uti li ty commissions began to recognize the benefits tocustomers of establishing bidding mechanismsto ensur e s upply at th e lowest possible price,adjusted for various non-priced factors such asrisk and in some cases externalities. Competingsuppliers included il1depel1del1t power producers(IFPs) an d other utilities w i th s urpl us capacity.Under this wholesale electricity competitiol1, theutility functions as th e monops ony purchaserof electricity on behalf of its customers, bu t theutility must accept the best bi d for incrementalelectricity supply, subject to various constraintsor other regulatory objectives. Because thei ndus tr y has gr ow n l it tle in the last decade, thewholesale competition m o de l h as only experienced limited testing thus far. However, wholesale competition ha s no w been accepted by theUS federal govemment as at least a minimumrequirement in the evolution of the electricityin du s try , a s o u tline d in th e Energy Policy Actof 1992.

In th e las t few years, the debate about theimplications of lost scale economies has beencarried further, leading some to criticize eventhe wholesale competition model an d advocatea retail competition model in its place. Accordin g to this argument, the wholesale competitionmodel still fails t o m ax im iz e social welfarebecause it substitutes the preferences emergingfrom the utility commission regulatory processfor the preferences of individual consumers. Ifthe electricity market is no w truly a competitivemarket like any other, the argument goes, thenconsumers s hould be allowed to make utilitymaximizing decisions just as they would in anyother market (Galloway, 1994). We return to thisdebate in Section 3.




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2.3 Erosion of the Public Good RationaleThe third force for change in recent t imes is theerosion of the public good rationale for government intervention in electricity markets. Thishas been driven by mishaps with publiclyowned electric utilities, technological andeconomic changes, and shifting political values.

A fai rly extreme position is that governments and regulatory bodies a re virtuallyineffective in directing investments in electricand other markets to best satisfy the long-runpublic interest. Thus, the argwnent goes, privateownership is almost always preferred to publicownership. Even in natural monopoly markets,private ownership is preferred and regulationshould be min imized by the use of incentivemechanisms such as price caps. As one mightexpect, the rise to power of non-interventionistpolitical parties in some industrialized countries,has been accompanied by various privatizationinitiatives. The UK is the quintessential case,where the privatization campaign touched manysector s of the economy, including ports andairports, aerospace, airlines, oil and gas, telecommunications, automotive, and electricity.

The argument against government ownershi p and other forms of intervention can beexplained in terms of the principal-agent problem(Vickers and Yarrow, 1988). According to thisconcept, the publicly owned corporation is anagent of goverrunent ass igned to meet thegovernment's objectives. However , the agentmay have different objectives than goverrunentand as a result may frustrate or at least fail toachieve the latter's objectives.21 Thus, even withacceptance of the view that governments aregenerally motivated to maximize social welfare,and also that certain sectors of the economyexhibit significant market failures, concern overthe principal-agent problem may still lead oneto conclude that public ownership is an ineffective tool for addressing most legitimate argu-21 / One can take the concept back one step further,with the populace as the principal and governmentas the agent, arguing that here too there will be adiscrepancy in terms of the inconsistencies betweenthe agent's and the principal's interests, and hencethe desirability of as little government as possible.

ments for market intervention.While one's sense of the costs and benefitsof public ownership will undoubtedly be influ

enced by ideological predispositions, there has,in addition, been a general decline in enthusiasm for public ownership in recent years inmost industrialized countrie's. One argumentis that public ownership has no t succeeded aswell as open regulatory processes in involvingthe public in the major critical decisions aboutelectricity investment. Substantial debates onthis i ssue have occurred in recent years inFrance, the UK, Canada, and several otherwestern countries. In publicly owned electricutilities, key decisions are frequently made bytechnocrats or political adv isors withoutmeaningful opportunities for publ ic part ic ipation. Major projects may be favoured becauseof their political or technological attractiveness,not because they maximize social welfare whentes ted aga inst the full range of legit imatealternatives, with estimated public values onexternal costs and benefits incorporated.

The experiences of the three largest Canadian utilities are noteworthy. In the late 1970s,British Columbia Hydro was increaSingly criticized for planning large hydro-electric projectsthroughout the province without fairly evaluating financial and environmental risks, smallerscale supply opporturrities, and energy efficiency alternatives. The largest and most criticalinvestment decisions in the province were beingmade by a group of technicians and bureaucrats, with virtually no opportunity for publicinput or review. Mounting public concern thatthe agent was no t at all serving the interests ofthe principal convinced the goverrunent to placeits publicly owned utility under the regulatorycontrol of the provincial public utili ty commission. This created the somewhat uniquesituation in which a publicly owned utility isregulated by a public agency. In effect, onecould say that the publicly owned utility wascreated to address the natural monopoly andpublic good market failures, while the layer ofutility commission regulatory controlwas addedto address the principal-agent problems ofpublicly owned corporations. In spite of itsunconventional design, this institutional model

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has proven to be very successful compared toother Canadian jurisdictions. BC Hydro hasbeen generally ahead of its Ontario and Quebeccounterparts in being responsive to publicconcerns and in adjusting to new technologicaland market developments of the kind outlinedin this paper. In particular, BC Hydro has beenan innovator i n Canada in exploring demandside management options and incorporating riskand other environmental and social factors intoits electricity planning framework.

In Quebec and Ontario, the legitimacy ofdecisions by publicly owned utilities has beenespecially challenged in the last few years.22 Asrecently as the late 1980s, both of these utilitieswere still following th e large project, supplyfocused path of the 1960s and 1970s. This isexemplified by planning decisions in the late1980s (1) to continue with an electricity supplyvision dominated by large scale nuclear powerprojects in Ontario and (2) to continue withmassive hydropower projects in Quebec. In-deed, by the late 1980s, these two Canadianutilities were virtually the only large utilitiesin the US and Canada whose plans were stilldominated by electricity supply megaprojects.For many, it is no coincidence that these remainthe only two large, vertically integrated utilitiesin the US and Canada that are no t openli, andfully regulated by a utilities commission. Notsurprisingly, both provincial governments haverecently initiated review processes that examineoptions for addressing the principal-agentconcern, with the options ranging from shiftingto the British Columbia model to full privatization.

In addition to the principal-agent concern,there is another reason for the erosion of thepublic good rationale. It is increasingly suggested that the public good attributes of electricityhave diminished in recent years. In particular,the percept ion of electricity's public good22/ See McKay (1983) for a review of interestgroup mistrust of Ontario Hydro up to the 19805,23 / Ontario Hydro's rates are reviewed in publichearings by the Ontario Energy Board, but theBoard has no ratemaking authority and simplymakes recommendations to cabinet.

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character has diminished in part because of thechanging assumptions about economies of scalein generation; the same factors that underminethe natural monopoly rationale can alsoundermine the public good rationale.First, it appears that the electric industrymay be less critical in the future in determiningth e pace of economic development, at least inindustrialized countries. Once the electric gridcovers most of the country, the issue shifts fromaccess to electricity to the l inkage betweenelectricity and economic growth. While electricity consumption and economic growth willremain correlated, past assumptions about anextremely tight causal relationship have beenundermined by evidence since the 1970s(National Research Council - US, 1986).

Second, as the scale economies of generationtechnologies shift in favour of smaller units (andperhaps DSM), electricity generation investments wil l have less impact on the economy.The slow-down and reduction in total industryinvestment has allayed past concerns about theeffects of utility debt and utility technologychoices on the aggregate cost of capital, th etechnological options for the rest of th e economy, and the consequences for counter-cyclicalmacroeconomic objectives.

Third, there is unlikely to be any significantdevelopment of large scale hydropower resources in industrialized countries in the future,while nuclear remains important in only a fewcountries. This reduces the rationale for publicintervention in new electricity generationdevelopment, although there remains the dilemma of whether or not existing hydropowerfacilities are best managed by the private orpublic sector. Thus far, it appears that thegeneral preference in the US will be to retainpublic ownership of the major hydropowerentities, BPA and TVA.

Fourth, since the mid-1980s oil independenceha s declined in importance as a nationalsecurity issue. While governments in th e 1970sand 1980s intervened in electricity markets inorder to influence th e fuel choice away fromoil, changing economics have since favourednatural gas and, in any case, the oil market is




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less vulnerable to political manipulation. 24Fifth, in developed countries the electricity

grid has now been widely extended such thataccess to electricity is no longer the social equityissue it once was. However, the appropriatepricing strategy for electricity remains a keyissue, with much of the public sti ll supportinguniform prices within each customer class,regardless of location and the cost of providingservice. In developing countries, in contrast,both grid extension and electricity pricing arestill critical issues relating to government inter-vention in electricity markets. The issue hingeson the trade-off between the benefits that apublicly owned utility can provide by subsidizing the nascent stages of economic devel-opment, and the potential drain on the economythat such utilities c an b ec o me if they are ex -tremely inefficient and make decisions for shortterm political expediency with no clear socialwelfare maximizing objective. This issue ha sbecome more pressing as the World Bank hasbegun to demand refonn of the electricity sectorin developing cOW1tries as a precondition tocontinued financial support253. Th e Future: Convergence orFlexibility?The thesis presented in Section 2 can besummarized with the help of Figure 1. On eachaxis the diagram shows one of the three majorrationales for public intervention in electricitymarkets: natural monopoly, public good andenvironmental externality. The other end ofeach axis represents the absence of such arationale. The thesis of this paper is that thereha s been a shift from the lower right to theupper left of Figure 1 as a result of changingtechnological conditions and public perceptions.While these perceptions vary between countries2 4 / The issue of fuel choice and politicalindependence has not completely disappeared. InEurope there is a concern that competi tive elec-tricity markets would favour natural gas whichincreasingly must be imported into Europe fromunstable countries like Russia and Algeria.25/ See, for example, World Bank (1993).

and individuals, a general shift has occurredbecause of the widespread emergence of theexternality rationale and the erosion of thenatural monopoly and the public good rationales.3.1 Conflicting Models of the FutureThis evolution is creating fundamental challenges to current institutions and policies, bu t thereis no consensus on the appropriate govemmentresponse to these challenges. l ndeed, verydifferent positions are being advocated.26 Hereare four distinct positions.1) Competitive generation markets are no tdesirable because of the continued importanceof the public good rationale and the emergingexternality rationale2 ?2) While the demise of the natural monopolyrationale implies the need for competition ingeneration, this should be wholesale competition regulated by utility commissions, in orderfor the electricity sector to be able to effective]?'address the emerging externality rationale23) The demise of the natural monopoly rationaleimplies the need for break-up of the verticallyintegrated monopoly, introducing retail competition in generation because this has the greatestpotential to fully meet consumers' needs.Moreover, because externality issues are en-demic to the entire economy they should beaddressed by different means, not by misusingmarket intervention mechanisms that weredeveloped more appropriately to address na-2 6 / For a detailed analysis of some specific modelsof industry structure, see Tenenbaum et al (1992).27 / This argument still dominates in France, whereit i s bel ieved that only this model can assure thelong run benefits of a technology as complex andsignificant as nuclear power (Bouttes and Lederer,1991). This type of argument is still vigorouslyadvocated throughout other industrialized anddeveloping countries as support for the continua-tion of publicly owned utilities.2 8 / This argument is currently associated withRalph Cavanagh of the Natural Resources DefenceCouncil in the US. See, for example, Flavin andLenssen (1994) and Gegax and Nowotny (1993).

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29 / This is the argument expressed in support ofthe California Public Utility Commission's recentdecision to implement retail competition in electricity. See, for example, Galloway (1994).30 / This was a common sentiment in the U.K.privatization initiativer and in part explains theminimalist approach to regulating the transmissionand distribution segments of the U.K. electricityindustry. In Canada, the argument is associatedwith Energy Probe, a non-governmental interestgroup organization in Ontario.

tural monopoly294) The demise of both th e natural monopolyrationale and the public good rationale impliesthe need for both privatization and deregulationof the entire electricity sector. Environmentalproblems should be taken care of separately.3o

I t is the thesis of this paper that these wideranging positions on the appropriate responseto the evolving rationales for market intervention are explained in large part by the ideological predispositions of the advocates of eachposition. In particular, many of these advocatesseem to develop arguments that focus especiallyon change that has occurred with just one ofthe rationales for interventionr while ignoringor down-playing what is happening withrespect to the other rationales. Thus, for example, the a rgument that t he decline of thenatural monopoly rationale in electricity generation must imply privatization assumes awaythe potential importance of the other two rationales for intervention. Similarly, the argument

Competition

PrivateGood

Figure 1

Externalities

No Externalities

PublicGood

NaturalMonopoly

that retail electricity competition must bestopped under all circumstances, implies thatit is not possible to develop alternative meansof dealing with externalities or other aspects ofthe long-run public interest. Finally, the argument that the erosion of the natural monopolyrationale in electricity generation eliminates theability to mandate IRP neglects the crucial factthat a natural monopoly will still exist intransmission and distribution, and that DSMand IRP remain desirable as part of the packageof cost-effective policies for addressing envi-ronmental externalities.

The goal for this final section of the paperis to speculate on what these developmentsshould imply for the future character of govenunent intervention in electricity markets. Thespeculations are broad because each society willweigh and trade-off the issues according to itsown values and priorities. But hopefully thepublic policy decisions that shape electricitymarkets in the future will be well informedones, mindful of the full se t of rationales forgovernment intervention and of the evolVingjustification in support of each rationale. Thecritical question, therefore, is whether thechanges in rationales for intervention describedin this paper imp ly tha t only one model isappropriate for future government regulation- regardless of differences in each society'sinstitutions r technologiesr resources, economicsystemr political concerns, or interventionistpredisposition - or if several alternativemodels may be appropriate.

The answer is both yes and no. Yes, theshifts in intervention rationales imply forces ofchange that will impact everywhere. These arereferred to below as forces of convergence.However, the forces of convergence will not bes trong enough to require every country orregion to follow an identical model of government intervention. There is flexibility that willallow each country or reg ion to significantlyshape the overall character of its electricitymarket interventions. These are referred tobelow as margins of flexibility.

Figure 2 portrays on a continuum somepossible outcomes of these converg ing anddifferentiating trends. The left end of the

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N o n ~Interventionist HighlyInterventionist

1--------+---------1 verlicallydiflerentia1ed priva1e ownerShip competition ingeneration lrarK:hisebidding lorconlinued natural mOl1


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FREE TRADE AGREEMENTS WILL HINDER THEABILITY TO PREVENT PRIVATE GENERATIONCOMPETITION

Countries with a predisposition to retainpublicly owned monopolies in generation willbe under pressure to adjust their posit ion atleast somewhat by free trade protocols. Thus,for example, Electricite de France will be underpressure from the organizations of the Europeancommunity to allow some form of competitionin its generat ion market. Examples of othercountries that will also experience this kind ofpressure are Mexico and Canada.INTERNATIONAL ENVIRONMENTAL AGREEMENTSAND DOMESTIC PUBLIC PRESSURE WILL REQUIRECON"TINUED ELECTRICITY MARKETINTERVENTIONGovernments will be under domestic and/orinternational pressure to address the environmental externalities of electricity generation.33Intervention policies may focus on severalobjectives, including energy efficiency, fuelSWitching, emission reductions, lifestyle chan-ges, and infrastructure design. Categories ofpolicy instruments include regulations, taxation,subsidies and information campaigns. All ofthese will undoubtedly be used in one manneror another. Pressure for cost-effectiveness inpolicy will continue to push governments toseek synergies among intervention mechanisms.The abil ity to find synergies will depend,however, on the relative importance eachgovernment places on each of the threerationales for intervention.

brium.33 / This obligation may seem the least obvioustoday in the U.K., where electricity generationcompetition has coincided with environmentalbenefits as natural gas substitutes for coal. How-ever, there is no reason why this convenient coincidence will continue indefinitely; even natural gaselectricity generation has environmental costs.

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CONTINUED NATURAL MONOPOLY INTRANSMISSION AND DISTRIBUTION WILLREQUIRE CONTINUED IJ\JTERVENTION

A strong rationale for intervention in electricitymarkets exists as long as there is naturalmonopoly in transmission and distribution.While approaches to intervention can be minimalist (e.g., a price cap), there will be pressureto ensure long run economic efficiency and toprevent high monopoly profits by private electric utilities.34 Also, even with a minimalistapproach there will be pressure to require IRPprocesses and develop DSM programs at thetransmission and distribution level in order toaddress environmental objectives. Programsmay be restricted to those that do not affect therates of non-participating customers. But evenif the programs did increase the transmission(and/or dis tr ibut ion) service rates of nonparticipating customers, such expenditureswould be possible even under a scenario of fullretail competition. Only in extremely rare caseswould the slightly higher transmission servicecharges of a utili ty engaged in prudent DSMprograms be sufficient to be the determiningcause in the decision of large industrialcustomers to self-generate or build transmissionbypass.ENERGY EFFICIENCY WILL REMAIN A USEFULTOOL FOR ADDRESSING ENVIRONMENTALEXTERNALITIESGovernments will continue to recognize that34/ Woolf (1994) describes some of these pressureson the recently established regulatory agency in theUK. The extreme contrast betvveen micro-management and incentive approaches to regulation isfrequently over-emphasized. It is possible to develop hybrid regulatory approaches that award specific returns on equity but that use various adjustment formulas and other incentives to keep de-tai led regulatory hearings down to about onceevery three years, thereby giving the regulatedcompany t ime to pocket some of the profits fromlegit imate efficiency efforts. Innovations in thisdirection are currently under development in theUS and Canada.




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energy efficiency will playa critical role i n thepublic policy response to concerns over environmental externality. In some cases, governmentswill establish separate energy efficiency agenciesor funds, as has occurred in New Zealand,France, the UK and other countries. However,in many cases governments will also follow themodel developed in the US, in which regulatedutilities implement IRP processes that includecost-effective DSM targets and implementationmechanisms. The lesson from the US experienceis that a utility-led marketing focus on energyservices can reveal significant opportunities forrelatively low-cost environmental benefits, andthat increasingly DSM programs can beimplemented in ways that inform rather thanbribe or otherwise manipulate consumer choice.Moreover, as noted in (4) above, IRP processesand DSM programs can be implemented byutilities even when the industry is no longervertically integrated, with the regulatedtransmission and/or distribution utility responsible for IRP.35MAJOR WORLD LENDING INSTITUTIONS WILLINFLUENCE MARRETS IN DEVELOPlJ'iGCOUNTRIESDependence on foreign capital will intensify thepressure on developing countries to allowprivate generation competition and will restricttheir freedom to override economic efficiencyobjectives using the public good rationale. Thus,previous assumptions that grid and distributionexpansion increased social welfare, regardlessof cost, will be restrained by more rigorouslending criteria. In addition, the constructionand operating costs of electric utilities wil l bemore tightly controlled, in part by exposingpublicly owned monopolies to competitive forces. This could have many variations, including(a) subcontracted private construction andoperation with public ownership retained, (b)35 / While some analysts suggest that the US 1992Energy Policy Act was inconsistent in encouraginggeneration competition along with greater utilitydirected IRP, that policy is consistent with theapproach described here.

private construct ion and regulated privateownership, and (c) franchise bidding for privateoperation and ownership with negligibleregulation, and (d) independent regulation ofpublicly owned utilities.3.3 Margins of FlexibilityThese are some of the key margins of flexibilitythat will allow governments to vary their response to electricity market failures in accordance with their country or region's specificinstitutions, technologies, resources, economicsystem, political concerns, and predispositionsregarding intervention.PREDISPOSITIONS TOWARD MARRETINTERVENTION WILL VARYThe political predisposition to intervene inmarkets will vary in time and space. Forexample, if the Conservative party had notretained power after 1988, the UK electricitymarket would probably be very different today.In contrast, there is sti ll a consensus amongmajor political parties in France that a publiclyowned, vertically integrated natural monopolyis in the long-run public interest. To the extentthat other market attributes allow for flexibilityin the choice or degree of market intervention,this predisposition factor will playa role.TECHNOLOGIES AND RESOURCES HAVE SPECIALATTRIBUTESNuclear power is a technology that tends torequire state intervention. There is a reciprocalaspect. Jurisdictions that have a propensity forelectricity market intervention, like France, willbe more willing therefore to op t for nuclearpower. Jurisdictions that now have nuclearpower may be requi red to retain governmentintervention even if they would rather not, asis the case in the 13K. Hydropower is anexample of a special resource. The US federalgovernment retains ownership of BPA and TVAeven though it general ly pre fe rs privateowner sh ip in electricity generation. Publicownership is much more significant in Canada

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where hydro-electricity predominates, eventhough the Canadian natural gas industry isalmost completely privately owned and publiclyregulated like it s counterpart in th e US.ALTERNATIVES FOR DEALING WITH THETRANSMISSION AND DISTRIBUTION NATURALMONOPOLYIn spi te of the emphatic arguments on bothsides, there is not a strong argument todayfavouring either private or public ownership ofelectricity transmission and distribution. Thenatural monopoly rationale for intervention stillexists, and there is no compelling evidence thatprivate, but regulated, systems are more or lessefficient than public systems. Thus, govern-ments are unconstrained in their decision to optfor one or the other form of intervention, whichwill therefore probably be determined by someother factor, notably the government's generalpredisposition toward public or privateownership.OPTIONS FOR DEALING WITH EXTERNALITlESAND FOR FOSTERING ENERGY EFFICIENCYAs noted in the previous section, there aremany options available to government fordealing with externalities and for fosteringenergy efficiency. Governments can pursuepolicies that require direct participation by finnsin the electricity sector, an example being theapproach advocated in the US Energy PolicyAct of 1992, involVing IRP, DSM and resourcebidding for electric utilities. Or, governmentscan develop separate agencies, funds and policyinstruments, an example being the US Clean AirAct of 1990. Again this means that other factorswill determine the outcome in each country orregion.DEVELOPING COUNTRIES HAVE SPECIAL NEEDSFinally, in spite of the increased influence frominternational finance agencies, the needs in theelectricity sector of each developing country willbe different, perhaps even of each region withina developing country . For example , in th e

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eastern regions of China a significant privatesector role may now be appropria te . Thetransmission grid has been extended to manyregions and, with the recent dramatic economicgrowth, there are opportunities for profitableprivate investment in generation, with appropriate government regulation, including thepursuit of environmental objectives. In moreisolated regions of China, as in many developing countries, grid extension and even gen-eration resources may still require a significantrole for the public sector, or at least privatesector initiatives that are subsidized and/orclosely regulated in order to coordinate themwith government economic development plans.3.4 Reconciling Environmental, Public Good andCompetition Imperatives in the CanadianContextDecisions about public intervention in electricitymarkets will depend on how each societyweighs the three main rationales for intervention outlined in this paper. This can lead tovery different models depending on the uniquecircumstances facing each country or region. Noone model should be presumed to beuniversally applicable; each society will makeits own choice.

In making that choice, it is important thata focus on one rationale not lead to muddledthinking about th e other rationales. Manyquestions therefore need to be addressed ineach jurisdiction and the responses may differsubstantially from one region/country to anoth-er. Here are some of the key questions. What other intervention mechanisms exist orwill be created to address environmental externalities? What other intervention mechanisms exist orwill be created to encourage cost-effectiveenergy efficiency? How important is consumer choice formaximizing social welfare in the case ofelectricity? What are the most favorable supplytechnologies, and what are their optimal invest-ment and operating requirements? What are the technical and economic




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advantages of centralized monopoly control ofelectricity supply in each jurisdiction? What are the options for competitive elec-tricity supply? What institutional arrangements are requiredfor competitive electricity supply, and how ef-fective can they be? What is th e likelihood of failures or abusesof various types of public intervention mechanisms? What is the current level of economicdevelopment of the country or region, and whatis required for future economic development?

As a conclusion to this paper, the reviewexercise suggested by the above questions isconducted for the electricity sector in BritishColumbia. This provides a concrete example ofwhat the approach advocated in this papermight lead to in terms of scanning policyrecommendations for a specific jurisdiction.

The model depicted in Figure 3 representsan attempt to balance the current and likelyfuture reali ties of the three rat ionales forgovernment intervention in the electricity sector.In particular, it is based on the following conclusions.1) PRIVATE MARKET COMPETITION FORINCREMENTAL GROWm IN GENERATION ISDESIRABLE.In BC, the generation assets of BC Hydro couldbe separated from transmission and distribution(T&D), with the existing assets competing withIPPs for either wholesale sales to the T&Dutility or retail sales to customers, if allowed. Inone scenario, all increases in generation assetscould be restricted to the p rivate market in acompeti tive process regulated by the BCUtilities Commission an d managed by BCHydro, in the case of wholesale competition, ordecided by consumers, in the case of retailcompetition. In another scenariol Be Hydrowould be allowed to compete with IFPs for newgeneration, bu t in this case the regulation of thisprocess and of BC Hydro must ensure that thereare no cross subsidies from existing assets andthat resource selection is unbiased. In addition,BC Hydro's power in the generation market for

the foreseeable future would require continuedrate regulation.

If retail commodity competition werepermitted, effective means must be in place todeal with the externality issue. Environmentalcontrols on IPPsr via the environmental reviewprocess and the energy project certificaterequirements (or any other comparable govern-ment policies analogous to the US Clean AirAct), should be designed to ensure that no IFPis initiated or captures market share solelybecause of externality costs that have bee nignored.2) HYDRO AND NUCLEAR GENERATION ASSETSCOULD BE PRIVATIZED, BUT mERE ARE PUBLICGOOD ARGUMENTS AGAINST THIS.The opera tion and maintenance of existinghydro and nuclear power generation assetsretains public good attributes (or public liabilityattributes in the case of most UK, US andOntario nuclear facilities), suggesting that th erationale for public ownership is still fairlystrong. Since most of BC Hydro's generationassets are hydropower facilities, there is a casefor retaining public ownership, provided thatthe cabinet ha s an effective external controlsystem to ensure efficient management. In BCthis is provided by th e regulatory overview ofthe BC Utilities Commission and by the CrownCorporatiOns Secretariat, an advisory oversightagency of cabinet.3) T&D REMAINS A NATURAL MONOPOLY, ANDCOULD BE PUBLICLY OR PRIVATELY OWNED.The T&D assets and the short -run marketcoordination filltction remain natural mono-polies. Whether private or public, the T&Dutility should be regulated by th e BC UtilitiesCommission in order to prevent the capture ofmonopoly rents (in the public ownership case,regulation is also intended to address th eprincipal-agent problem). The T&D utilitywould fW1ction as a common carrier (retailcompetition) or as a purchasing agent (whole-sale competition), in either case with publishedand regulated transmission and distribution

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ND

DiSlribUled Gellenlliollelf-Cenerationor IPP Bypass

!PI'si

i jIMPORT B.C. HYDRO

~ ; ~ ; [ill [j BCn EXISTING,', ', ' ,' , , ', ' Nw GENERATIONASSETS. , I. IrS.C. HYDROTRANSMISSION &DISTRIBUTION(/RP/DSM)

'---.. ---------------.1: ~ N ~ 0 S ! ~ ~ A L ~ : 1 I . : G q ! > . 1 ~ ~ q ! \ ~ : & : ~ ~ ! Q ~ 1 A L : : :.: : I. LEGERetail Co- - "

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EndUse

DistributedGeneration!SelfGeneralion

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Transmission

Figure 3: A Sustainable Model for BCs Electricity Industrytariffs. The T&D component could be either as ingle entity or divided into a transmissioncompany and a distribution company. Thislatter option may be desirable especially if thereare perceived public good and/or environmental benefits to greater regional control ofdistribution systems. This split was carried ou tin England as part of the privatization initiative,while in Norway and Denmark, for example,the regional/ local utilities remain publiclyowned, generally at the local level.4) THE T&D UTILITY CAN BE RESPONSIBLE FORIRP/DSM.The assessment of energy service cost-effectiveness from the customers' perspectives neednot be conducted by a regulated utility becausethe issues of IRP extend beyond the regulatedutility sector to include consumption of otherenergy forms (oil, coal, biomass , etc.) andconsumers who are not served by the utility(isolated regions or communities). However,

there is a counter-argument that utilities arebest placed to assist customers in assessing theirenergy service options, and that governmentsinterested in the environmental benefits ofenergy efficiency would want to continue toencourage utility-led IRP105M. Thus, IRPIDSMactivity could remain the domain of the T&Dutility, including, however, coordination andcollaboration with more broadly applicableinitiatives of the energy and environmentministries. Costs of IRPIDSM can be recoveredfrom a levy on T&D service charges. However,DSM initiatives should probably avoid crosssubsidies between customer classes and attemptto minimize cross-subsidies between participants and non-participants within customerclasses in order to reduce the risks of l oaddisplacement inveshnents that are triggeredsimply to avoid IRP IDSM costs.

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5) REGULATION, WHETHER OF PUBLIC ORPRIVATE T&D ENTITIES, SHOULD SEEK TO ENSURETHAT INCENTIVES FACED BY UTILITYMANAGEMENT ARE CONSISTENT WITH SOCIALWELFARE OBJECTIVES.All regulation is incentive regulation in that itcreates a framework of incentives for utilitymanagement. Regulation of the T&D utilitycould provide incentives for operating efficiency. One mechanism is to establish price adjustment formulas, tied to inflation and productivity factors, that reduce the need for frequent,detailed regulatory review, and allow utilitiesto keep short-term profits garnered f rom accelerated productivity gains. Regulation of theT&D utility cou ld also remove incentives tobuild the rate base where that is not the optimalutility action. One mechanism is to decoupleutility short-run profits from commodity sales.A complementary mechanism is to provideadditional rewards for desired activities, suchas assisting customers with least-cost energyservice evaluations and measures.

This ske tch of pol icy options in Br it ishColumbia has some elements that applyspecifically to that province, bu t it also hasmany generic elements that could be appliedto other Canadian provinces. For example, inOntario the assets that are likely to remain inpublic ownership are hydro and nuclear generation, while in Quebec they would be hydrogeneration. Also, in both Ontario and Quebec,.the principal-agent problem with publiclyowned corporations suggests the need forregulatory control by an independent agencywith a responsibil ity for public involvement.Ontario would also be faced with additionaltransitional challenges in moving to this proposed model. Presumably, the governmentwould want to protect current high cost generation assets from full IFP competition. In theUK, nuclear assets have been protected by aspecial levy on all electricity consumption,although this is slated to decrease or disappearover time.

In Alberta and some other provinces, thesame extent of public ownership either does no texist or is no t necessary. In any case, the T&D

utility must still be regulated. However, Albertamay pre fe r that all energy efficiency andenvironmental externality issues be dealt withoutside of the utility commission regulatoryprocess. This may work as long as there areeffective mechanisms using other governmentinstruments.

In summary, while this concluding sectionobviously does not purport to resolve the issuesof future government intervention in Canadianelectricity markets, i t sketches some of thesalient features of l ikely models based on anassessment of the interplay of the forces ofconvergence, the margins of flexibility, andsome of the unique characteristics of Canada'sregions.

Rationales for government intervention inelectricity markets have evolved substantiallyin recent times, and this has engendered aperiod of debate, experimentation and considerable confusion. Sorting through the issues inorder to arrive at good public policies will notbe easy. But the outcome is especially in doubtif the issues and rationales are not clearly un-derstood. The goal of this paper is to contributeto tha t understanding so as to facilitate betterpublic policies.ReferencesAverch, H. and L. Johnson (1962) 'Behavior of

the Firm Under Regulatory Constraint, 'American Economic Review, 52:1052-69.Berg, S. and J. Tschirhart (1988) Natural Monopoly Regulation (Cambridge University Press).

Bouttes, J. and P. Lederer (1991) 'ElectricityMonopoly versus Competition,' Utilities Policy,19:3:212-27.

Demsetz, H. (1968) 'Why Regulate Utilities?,'Journal of Law and Economics, XI:55-65.

De Paoli, L. and D. Finon (1993) 'Implicationsof Community Policy for the Electr

changing canadian el market and future role of goverment

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