Resource Endowment and Electricity Sector Reform

Jens Weinmann and Derek Bunn1

2004

Abstract This paper analyses how the structure of the electricity supply industry and the resource endowment of a country have an impact on the feasibility of reform in that sector. Firstly, research suggests that the indivisibility of capital-intensive assets, such as nuclear energy or hydropower, may hamper the implementation of competition in a wholesale market for electricity. For the case of 26 Latin American countries we find that countries with important fossil reserves or a weak segmentation of hydropower plants tend to relatively delay electricity sector reforms after more general market liberalisation reforms. Secondly, we find that the absolute size of the electricity sector also determines the time interval between a general reform and an electricity sector reform. Smaller countries tend to liberalise their electricity sectors later, if at all. The paper concludes that structural characteristics of the supply side and its physical and technical features do have an impact on the timing and existence of reform in the electricity sector.

JEL: L51, L94, N76, P16,

1 Jens Weinmann is a researcher, and Derek Bunn, Professor, at London Business School, Energy Markets Group, Sussex Place, Regents Park, London NW1 4SA, UK. Emails: (jweinmann, dbunn@london.edu). Earlier versions of this paper have been presented at the 6th Annual Conference of the International Society for New Institutional Economics and the 22nd North American Conference of the United States Association for Energy Economics.

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1. Introduction Over the last two decades the electricity sector in many industrialised and developing countries has been moved from public ownership and government control to private ownership and market liberalisation. This change of government policy not only induces important modifications in the sector’s institutional and regulatory framework, but also affects the industry structure and the allocation of property rights. Mainly during the second half of the 90s, a widespread enthusiasm about the expected benefits of liberalisation, such as the prospect of lower prices and a more efficient use of resources, led many countries in the developing and in the industrialised world adopt electricity sector reforms. However, a number of countries, such as France and Mexico, and many states in the US remained reluctant to restructure and liberalise their electricity supply. One explanation may be found in the prolonged opposition of domestic pressure groups. Another possibility may be that governments remain sceptical about the long-term viability of competition in the electricity sector as a basic infrastructure service, particularly after the failure of the initial Californian deregulation. We investigate the proposition that one important but under-researched reason could be that specific features of the energy supply side – physical constraints or resource endowment – make it more difficult if not impossible to implement a fully competitive market regulation in some countries. 2. Background Privatisation and liberalisation have been the subject of intense research activity, theoretically as well as empirically, from a number of perspectives. The external policy changes and the diffusion of privatisation and liberalisation policies are, for example, viewed in Eggertsson [1997] from an institutional perspective within political economy, whereas Peltzman [1989] and Becker [1983] focus on shifts of power among competing interest groups. Ikenberry [1990] explores different kinds of policy “bandwagoning” and diffusion processes. A game-theoretic approach is suggested by Shapiro and Willig [1990], who see the differences between public-sector regulation and private ownership mainly through diverging information flows. Their paper concludes that private ownership is more favourable if the institutional framework to limit the bureaucrat’s or politician’s personal agenda is weak. On the other hand, public ownership has advantages if the externalities are large or uncontrollable, which is a position close to that of Vickers and Yarrow [1991]. Other models describe the interaction between utilities and regulator (Newbery [1999]), ownership and vertical integration (Grossmann and Hart [1986]), and intervention rights in private and public ownership (Sappington and Stiglitz [1987]). Case histories are only now becoming sufficient to analyse empirically the various factors influencing the results of these market reforms. Thus, Pollitt [1997] and Bortolotti et al. [1998] estimate the impact of regulatory interventions on the success of re-structuring, whilst Bergara et al. [1997] and Zelner and Henisz [2000] discover links between the quality of institutions and the political system on the amount of investment in the power sector. Zhang and Kirkpatrick [2002] identify the effect of privatisation, competition and regulation on the performance of the supply side in 51 developing countries, concluding that privatisation on its own does not necessarily lead to gains in economic performance in the sector, whereas liberalisation and the introduction of competition stimulates performance even with only partial privatisations.

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The major focus of these empirical studies is the causality induced by political reforms on agents in the market and their conduct in network industries, either at a public or private-ownership level. The usual methodology follows an econometric analysis that uses political and institutional indicators as the explanatory variables and seeks to establish a relation to efficiency, quality of supply, or investment as the dependent variable (see e.g. Wallsten [2001] for the case of liberalisation in telecommunication in Africa and Latin America). The results for the electricity sector confirm that autonomous regulation (Zhang and Kirkpatrick [2002]), credible democratic institutions (Zelner and Henisz [2000]), or vertical unbundling of the utilities (Steiner [2000]) leads to a better performance in terms of consumer prices, investment and capacity utilisation. In this paper, the causal link between government policy, industry structure and business performance is explored in the opposite direction, to the extent that specific features of the electricity sector and the resource endowment of the country may influence the reform process and its outcome. In particular, the effect of the supply structure on government policy and sector regulation is the focus of our analysis. As such, the proposition is a generalisation of the usual structural paradigm (Mason [1939, 1957], Bain [1956, 1968]), which starts from the basic conditions of the sector, such as available technologies and associated costs, and tries to explain patterns of behaviour of the players, as well as features such as the allocative efficiency of the market (Clarke [1985], p. 3). The causality from structure towards performance has indeed been a recurrent theme of the analysis of electricity markets, mainly because of its network characteristics and non-storability (Millan, Lora and Micco [2001]), the inelastic demand curve and the sunk costs of assets (Henisz and Zelner [2001]). The electricity industry also serves as a good example of complex institutional arrangements and asset specificity (Williamson [1975], Finon [2001], Knittel [2003]). Especially in evaluations of different spot market systems in liberalised markets the supply side structure determines how firms behave and what forms of strategic behaviour they can adopt (for the England & Wales market see Bunn [1999] and Green [1999], for California see Borenstein and Bushnell [1999]). Moreover, Glachant and Finon [1998] observe that each market is determined by a unique set of constraints, and that there is no single optimal way of regulation; an approach that contrasts sharply with the view that all liberalised national or regional electricity markets will sooner or later converge to one “superior” market model2. For conceptual purposes, the impact of the supply side on sector regulation can roughly be divided into economic and technical / physical features. Economic reasons for changes in the regulation of the electricity sector have been widely discussed (e.g. see Joskow [1996], Newbery [2001]), and they range from the inherent institutional inefficiencies of public utilities, over-investment in assets and in the working force, to the lack of fiscal discipline due to soft budget constraints. They also capture questions of ownership in generation, transmission and distribution, including market power due to the concentration of property rights (Borenstein [2000], Larsen and Bunn [1999], Bunn and Oliveira [2001], Newbery [1999], Joskow [1996]). However, the technical / physical reasons have not been the subject of as much explicit research. Apart from the animated debate on transmission congestion (e.g. Glachant and Pignon [2002]), involving questions of ownership, technical constraints and spatial characteristics of the system, there are some studies on how to deal with small electricity markets and competition (e.g., Millan and Vives [2001]) and how to implement competition in markets with a large proportion of hydropower in supply (Fischer and Serra [1999]). In the following sections of the paper we will seek to analyse more fully the effects of several technical characteristics on the organisation and regulation of the electricity supply 2 See e.g. Ruff [1999, p. 20]: “... One size of market model really does fit all – or at least one size should fit all if the objective is to create effective and efficient competition for the benefit of the consumers.”

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industry. We start with a general analysis and then focus on Latin America as an empirical case study. 3. Resource Endowment and Industrial Organisation If the electricity supply structure is concentrated in a few power plants that show a significant degree of interdependence, as is often the case in hydro-dominated domestic generation, the “indivisibility of capital-intensive assets” may hamper the implementation of effective competition. It has been observed that one of the major reasons why the “competitive paradigm” (Ghamarian [2002]: 15) emerged was the development of a new generation of technologies, which allowed for higher efficiency of small power plants, mostly equipped with combined-cycle gas turbines (CCGT). Those smaller-scale power plants involve less financial risk and greater flexibility for private investors to participate in electricity generation, either by having the status of an independent power producer (IPP), which delivers electricity to a single buyer on a long-term contractual basis, or as a merchant participant in a wholesale electricity market. The low capital and construction costs of CCGTs accelerated the complete dismantling or sale of marginally profitable plants. As the preferred technology in liberalised electricity systems they contrast sharply with hydropower: The co-ordination of outflows of interconnected water basins is often subject to complex multiobjective optimisation schemes, while seasonal variations of precipitation and drought pose problems of substantial price fluctuations that may deter potential investors, especially when regulatory intervention induces price caps. Borenstein and Bushnell [1999, p. 299] predicted, before the Californian crash, that “the amount of available hydro power in the Pacific Northwest and California plays a large role in determining the extent and severity of market power.” Newbery [2002, p.16] even doubts whether private ownership of generation in a hydro-dominated system yields any advantages at all: “Private involvement in generation has a comparative advantage where timely construction and maintenance are required to deliver possible efficiency benefits, but is least likely to work in dominantly hydro systems.” Similarly, if generation is mainly based on nuclear power plants, privatisation and divestment pose severe obstacles. Finon [2001, p. 766] comments that “the financial community or the industrial candidates for repurchase have misgivings about an economic risk that is difficult to define, as the problems of privatising British Energy in 1995-1996 and those of Ontario Hydro in 1998 have shown”. Public opinion about nuclear assets may hamper a reform even more substantially, as the author claims for the case of France: “The presence of some 60 reactors whose operation is subject to rigorous safety requirements and seasonal co-ordination for maintenance and reloading of fuel is not amendable to the idea of dispersing a fleet of nuclear reactors amongst several private and public producers all in competition.” (ibid.), but the option of leaving nuclear assets under public ownership “would create an irreducible dominant position situation on the electricity market” (ibid.). Experience with privatising the nuclear assets in England & Wales shows that nuclear power plants retain a special status in generation due to their performance risks of serious faults, and “back end” risks of waste management. As a consequence, they have received preferential treatment from government aid even under competitive market frameworks (eg, with the low wholesale prices in 2003, when several thermal IPP companies in the UK were allowed to go bankrupt, inc AES and TXU, British Energy received state aid and ultimately recovered). A further reason for a government’s hesitation to implement competitive elements in the electricity sector is the size of the potential market. Again, a major obstacle may be found in the “indivisibility of capital-intensive assets”: If a country’s electricity demand can be met by

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a small number of power plants, no matter what primary energy resource they are based upon, the ownership structure after the reform may show signs of an oligopoly, because international investors tend to prefer a large presence in a given country (Millan and Vives [2001, p. 5]), especially in developing countries with significant institutional uncertainties. Rufin [2002] comments that the “political transaction costs [for electricity sector reform] are more severe in small countries” and that “with a smaller market size, collusion is a priori likelier”, which subsequently requires greater market monitoring in order to prevent market power abuse and vertical re-integration. Small countries (in terms of power generation) represent a significant proportion of the developing world: approximately 60 developing countries have a system peak load below 150 MW, another 30 between a 150 and 500, and another 20 between 500 and 1,000 MW (IADB [2001, p.7]), whereas the efficient size of a CCGT is about 400 MW (Jamasb [2002, p. 45]). Jamasb questions “whether the efficiency gains from competing small or sub-optimal units outweighs diseconomies of scale and increased transaction costs of an unbundled system.” (ibid.). The problem is more pronounced in developing countries, but even industrialised countries may face difficulties in the implementation of a competitive wholesale market. Woo [2002, p. 13] states that a liberalisation of the electricity supply industry in Israel may suffer from too few units and a market that is simply is too small: “Market reform is unlikely to succeed in a small market without interconnection.” (ibid.). He is equally sceptical about Hongkong and states that a sector reform “along the lines of the models adopted in California, Norway, Alberta, or the UK is almost certain to fail in a country with rapid growth [of electricity consumption], limited generation sites, and no indigenous fuel” (Woo et al. [2003, p. 1114]). Similar doubts are expressed by the president of the Icelandic Stock Exchange considering competition in the Icelandic electricity sector, which is a small, isolated system of 1500 MW dominated by hydropower (80 %) and geothermal energy (10%) and has one incumbent company with a share of 85 % in generation: “Regulatory reform alone will not guarantee the realisation of the hope for benefits from competition, adjustments to the organisation structure are also needed.” (Fridjonsson [2003, p.10]) These examples suggest that the resource endowment and the technical characteristics of the electricity supply industry may have a substantial impact on the success of a sector reform, more perhaps than was conventionally assumed during the early years of global liberalisation efforts, especially in the developing world. We therefore focus on a region that was among the first where countries started to implement reforms of the electricity sector, and analyse in a detailed way whether those characteristics had significant effects on the evolution of reforms. 4. Latin America Among the developing regions, Latin America offers the best conditions for a cross-country, comparative study for two reasons. First, from the practical perspective of an adequate amount of reasonably comparable data, this region is attractive because it has been the first in the developing world to start with far-reaching electricity sector reforms. More than US-$ 230 billion have been invested in the sector between 1990 and 1998 (Estache [2000, p. 1]), nearly half of the total investment in developing countries over that period. Reforms in the electricity sector started as early as 1982 in Chile and spread across the hemisphere from the early 90s onwards. Second, whilst Latin American countries exhibit a great diversity in the structure of their power supplies, they share a collective history of institutional developments. The “most similar cases” selection criterion can therefore be applied, subject to the constraint of minimising selection bias (Rufin [1999, p.7]). Despite the variations in objectives, attitudes to

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their relative importance and the processes of change in each country, there are common bureaucratic, legal and political features in all Latin American countries. North [1990, p. 103] states that “the persistence of the institutional pattern that had been imposed by Spain and Portugal continued to play a fundamental role in the evolution of Latin American policies and perceptions and to distinguish that continent’s history, despite the imposition after independence of a set of rules similar to the British institutional tradition that shaped the path of North Americ.” Due to its relatively long experience with reforms, data availability on the impact of Latin America’s changes in the electricity sector is uniquely suitable for this research task, and a substantial literature already offers scope for theoretical elaboration. For example, Rufin [1999] provides an analysis of institutional changes in Bolivia, Argentina, Brazil and Chile; Fischer and Serra [2000] suggest a categorisation of electricity sector reforms across Latin America, which is complemented by Joskow’s [2000] and Hogan’s [2000] insightful comments; Rudnick [1998] summarises the successes and failures of market design in the Latin American electricity sector, whilst Levy and Spiller [1996] provide comments on regulation with regard to the institutional environment in several countries of this region. 5. Working Hypotheses Latin America experienced a decade of far-reaching economic reforms from the late 1980s to the present (see IADB [1997] for a detailed review), and there is not a single country in this region, apart from Cuba, that did not undergo a phase of deep economic and financial crisis and a subsequent programme of structural adjustment. Lora [2000] develops an ordinal measure for general reforms (ranging from 0 to 1) as an indicator of the increasing implementation of reforms. He observes that “for an average of 19 Latin American countries, the total index shows steady improvement, from 0.35 in 1985 to 0.60 ten years later.” [2000,p. 12], and that “the most outstanding advances have been in the areas of trade and financial reform (the corresponding indices approach average values of 0.9 and 0.8, respectively).” The IADB [1997, p. 34] comments that “equally profound [like the combat of inflation] were some structural reforms intended to enable markets to operate freely and to avoid state interference in economic decisions. In the mid-eighties, on average every import made in Latin America had to pay tariffs of 40 percent; by 1996 this extra cost had been cut to around 10 percent.” The IADB [1997, p. 46] furthermore presents statistics that show that “forty-three percent of the value of privatisations in the region has taken place in utilities, which were traditionally closed to private participation and where the potential to obtain gains from productivity and efficiency is greater.” Both IADB and Lora observe, however, that privatisation and liberalisation of network industries did not advance with the same pace: “The average index of privatisation reached an average level of only 0.26, with very large differences among countries” (Lora [2000, p. 12]), and despite the fact that “Latin America has been the world leader in power sector reform… the process of electricity sector reform has occurred in waves, and so far has not reached all countries in the region” (IADB [2001, p. 165]). Latin American countries indeed exhibit a great diversity in their current regulation of the electricity sector: Some countries have fully liberalised, with price-based competition emerging in the wholesale and parts of the retail market, others have established a bilateral trading system with a power dispatch based on regulated costs and optimisation schemes, whereas many countries have not yet implemented any reform and remain in the traditional framework of public-sector regulation. We propose that this observed heterogeneity within

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the region is, among other factors, causally linked to structural phenomena of the electricity supply industry. Assuming that structural reforms in trade and financial markets generally extend to the liberalisation of infrastructure services like telecommunication and energy, we formulate the following general proposition: If a country has undergone a general macroeconomic reform or a structural adjustment programme, its tendency to extend market liberalisation into a substantial reform of its electricity sector will depend upon the industrial organisation of its sector, characterised by a number of technical and infrastructure variables. Such variables would be significant for either a delay or a complete absence of liberalisation, and we postulate and empirically examine three of them in this paper: the concentration of hydro power plants and their share in electricity supply, the energy autarky of a country, and the size of the electricity sector.

In the following sections these variables are reviewed in detail. We then carry out an event history analysis to test the impact of the factors on whether a substantial reform is carried out and when it is carried out, i.e. how many years after a general macroeconomic reform or structural adjustment programme. Our analysis simplifies the regulatory spectrum into two possibilities: either a substantial reform has taken place or not. We specify “substantial” as being characterised by cost-based or price-based competition in the wholesale electricity market. 6. Hydropower Plant Concentration Latin America’s electricity supply structure is composed of 64% hydroelectric and 33% thermal production, 2% nuclear and 1% others (eg geothermal and the “new” renewables: solar and wind). The thermal power production includes oil, which still accounts for roughly 50% of the thermal power production but is declining in importance, gas with an annually rising share (currently around 35%), and coal which contributes15% of thermal power. The most striking feature of the Latin American electricity sector is the large potential and use of hydropower, especially when it is compared to the world’s total hydro generation of below 18% (all data from Olade [2001] and IEA [2001]). In general, hydropower is not necessarily an obstacle to competition, as can easily be seen in the success of the Nordpool, which is substantially based on Norway’s hydropower plants. As long as the allocation of property rights is well-balanced and the size of the individual hydro plants is reasonably small not to dominate the market, an effective and competitive market structure can be introduced. However, if one or two big hydro plants account for the bulk of the electricity supply, the introduction of competition in generation will be difficult and, at least, oligopolistic behaviour of the agents can be expected. As a quantitative measure of plant concentration an index is introduced: the Hydropower Concentration Index. It follows the same approach as the Herfindahl-Hirshman Index (HHI)3. For our purpose it is calculated by using the installed capacity of each hydropower plant in a given country. The indicator is based on individual plant data provided by OLADE [2002].

3 HHI is the usual measure of market concentration and equals the sum of each firm’s squared percentage share of the total market

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Figure 1: Hydropower plant concentration and hydropower share in generation Source: OLADE Database 2002, EIA Database Figure 1 combines the Hydropower Concentration Index with the share of hydropower in generation. Countries that have a high degree of concentration but whose share of hydro is fairly limited are not in danger of strategic market behaviour of hydropower participants. The same can be assumed for markets with a high share of hydropower, but a low degree of concentration. However, if both factors coincide, a closer look on the country has to be undertaken. One striking example of technical obstacles is Paraguay in the top right corner of the graph. Paraguay produces most of its electricity in one single power plant, the Itaipu plant at the Parana river. It is the largest operational hydroelectric dam in the world with a capacity of 6300 MW. However, 97 % of its produced electricity is sold to Brazilian electricity companies. Apart from Itaipu, two other dams of nominal capacities of 1750 MW and 200 MW provide additional power. The capacity of thermal plants lies below 40 MW, leaving the implementation of effective competition in the near future very questionable. Uruguay is another country with a big share of hydropower in generation and a certain amount of market concentration. Its dams have nominal capacities of 148 MW, 108 MW, 333 MW and 945 MW for the Uruguayan part of the Salto Grande dam, which is shared with Argentina. The Uruguayan government introduced a law in 1997 that allows for independent power producers and subsequently for a liberalisation of generation. However, doubts remain about the feasibility of a liberalised market. Suriname’s electricity provider EBS buys three quarters of its electricity from a large aluminium company that runs the only hydropower plant, Afobaka with a nominal capacity of 1050 MW, in the country. Venezuela, one of Latin America’s more populous countries, generates the bulk of its electricity in one single dam, Guri, which is the world’s second biggest dam in terms of nominal capacity. None of the countries

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mentioned has implemented any substantial reform up to now. Our first working hypothesis is therefore: HW1: A country will delay or not undertake a substantial reform in its electricity sector if the hydropower capacity is strongly concentrated and represents a significant proportion of all the electricity generated. But even in countries that have a low degree of market concentration in terms of installed capacity, a danger of market manipulation occurs due to the physical structure of the system (Bunn [1999, p. 3]). For example, in Brazil the interdependence of hydro basins could lead to a co-ordinated operation of companies. Therefore the Brazilian government has now adopted a system where power is dispatched in a way that “hydro and thermal generators submit [to the Pool] only technical data on their plant, such as water levels in the reservoirs, rate of inflow, technical availability of the turbines, thermal efficiency, fuel and operating cost data, etc.” (Melo [1999, p. 13]). A further obstacle to the introduction of competition in generation in countries with large hydro resources is the trade-off between the usage for electricity production and other tasks, such as irrigation or flood control. According to the ICOLD World Register of Dams [1998], only 26 % of all Latin American dams are exclusively designed for electricity production, and a quarter of all dams have multiple purposes. Of those multi-purpose dams, 51 % are used for generation, 47 % for flood control, 68 % for irrigation and 42 % for water supply. It is difficult to find a balance between mutually exclusive goals in the use of dams, which is mainly a question of optimisation in a regulated, state-controlled environment, but becomes problematic in competitive markets when the main objective of the firms is the maximisation of monetary profits. Newbery states that “the most favourable circumstances [for private investment in hydro assets] would be for dams whose sole use is for hydro-electricity, and where the price of electricity is set by thermal plants, as in Chile and Argentina.” [2002, p. 16] 7. Energy Resource Endowment and Distributional Conflict In order to understand the structure of the electricity supply industry in Latin America, one has to bear in mind that many countries in the region are net energy exporters. In terms of fossil fuel reserves, Latin America is second after the Middle East for petroleum, with an estimated 13.4 % of the global reserves – mainly because of the reserves in Mexico and Venezuela, which account for 35 % and 53 %, respectively, within Latin America. The subcontinent furthermore keeps 5.3 % of the global gas reserves. The energy resource endowment of a country plays an important role in considerations of equity and welfare. Traditionally, Latin American governments used to subsidise all sorts of energy, such as LPG, kerosene and electricity, because energy services were considered a basic need and vital for human development. Governments that envisage privatisation and liberalisation have to cope with domestic opposition, because “the perception that privatisation policies hurt the poor is widespread in the popular press and is an important factor in determining the political sensitivity of the reform agenda” (Estache et al. [2000, p. 1]). This consideration is particularly relevant in countries with an abundance of energy resources. For example, in Venezuela the government “heavily subsidises most energy sources and fuels, reflecting the historical significance of petroleum production and exports to the economy. In most cases, price controls hold prices down below true supply costs...

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Political instability and the likelihood of social unrest that would result from raising energy prices, notably gasoline and electricity, make the process of subsidy removal difficult” (IEA [1999, p. 179]). The IEA estimates that household electricity tariffs, “which are held low for social policy reasons, average only 16 % of full costs. Industry pays a little under half of full supply costs” (ibid.). Energy subsidies may also have a fiscal effect. In Mexico, for example, “limited efforts have been realised to liberate [the electricity utilities] from acting as an instrument of industrial and social policies since recurrent macroeconomic crises have impeded the elimination of subsidies. Specially after the financial crisis of 1994 until when electricity tariffs have been used to stop inflation” (Serrato Angeles [1999, p. 137]) A closer look on Peru shows that in the late 80s, the revenues from the electricity sales did no longer match the expenses of the utilities. The electricity tariffs were set politically, actually below operational costs, leaving the electricity companies without the necessary financial resources to effectively maintain or even extend the system substantially. In 1989, electricity rates covered only 39 % of average operational costs in the sector. In the same year 1989, the companies had to cope with an operational deficit of US-$ 426 million, roughly three times the money that they earned with their electricity sales (CONITE [2000]). However, since the utilities were publicly owned, the fear of bankruptcy was shifted towards the government and the utilities operated only under soft budget constraints. While governments in Peru and Argentina privatised the bulk of their energy companies and subsequently tolerated higher prices for energy services, the main oil-exporting countries left the major energy companies in state ownership. Mexico, Venezuela and Ecuador have all less than 20% private ownership in electricity generation and less than 10% private ownership in transmission. In distribution, private companies own 0%, 40% and 30% respectively. Figure 2 combines information on the average residential electricity price with the energy autarky of a country. The energy autarky is measured by the energy exports minus the energy imports, divided by the total energy consumption of the country. For example, Venezuela exports more than double of its domestic consumption, whereas Grenada imports almost all of the energy in the form of primary or secondary energy resources (this plotted data only takes into account the commercial energy). Net energy exporters have thus positive values, whilst importers have negative values. The residential electricity prices are the average of the 90s, measured in 1990 US-$. The figure shows a strong negative linear correlation (-0.72) between the energy resource endowment of a country and its residential electricity prices, no matter what type of resources is concerned. For example, a country could be a net electricity importer, but exports the bulk of its petrol reserves, and would still have a positive energy balance. The negative correlation between the inverse residential prices and the autarky is even stronger at -0.87, the nonlinearity of which is better specified in that the curve converges to a limit of –1 for countries that import 100% of their energy needs. The correlation between industrial electricity prices and the autarky of a country (–0.60) does not reach the level of residential electricity prices, possibly because the pressure that is exerted by their lobbying groups depends more on the state of industrialisation of a country than on its fossil resources.

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Energy Resource Endowment and Residential Electricity Prices

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Figure 2: Energy Resource Endowment and Residential Electricity Prices Source: OLADE Database 2001 Concerning the electricity industry structure of a Latin American country, these results suggest that countries with a high degree of energy autarky face more severe obstacles to restructuring and privatising the assets of the energy sector, because the political viability of the move is substantially hampered by the prospect of significant increases in tariffs. Our second working hypothesis is therefore: HW2: A country will delay or not undertake a substantial reform in its electricity sector if the energy autarky of that country is high. 8. The Size of the Electricity Market In Latin America, and especially in the Caribbean, a number of small countries with small electricity sectors face great difficulties in implementing competition. Apart from the lack of institutional stability in terms of rule of law, an independent judiciary and accepted property rights (Millan and Vives [2001, p. 4]), those countries suffer from a deficit in the economic viability of liberalisation: “It may just be impossible to have the structure required for competition in the market not only because economies of scale limits the number of players but because competitive markets are highly demanding on technical skills and institutional capability”(ibid.). Carrying out a substantial reform and introducing effective competition with, at least in generation, a sufficiently large diversity in ownership reduces the chances of attracting foreign investors to participate in the market, since they expect to be compensated for the high institutional risk by a low market risk. This risk-averse investment policy is most easily satisfied in an oligopolistic or monopolistic market that is conducive to high returns. Energy analysts from international lending agencies such as the Inter-American Development

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Bank (IADB) therefore suggest that small electricity markets rather substitute “wholesale competitive markets by medium-term contracts competitively procured and a cost-based spot market” (Millan and Vives [2001, p. 5]) and gradually create the institutional capabilities to later become integrated into a regional market, for example across the Central American countries. The opinion of international lending agencies on policy formation is particularly influential in small developing countries, since they often provide the financial resources and professional advice to implement those policies. Millan and Vives [2001, p. 5] state that “competition is not an end but a means to obtain lower prices for consumers. One may relinquish competition temporarily if there are assurances that consumers may get a reasonable deal by industry standards, properly regulated and controlled and audited by independent organisations”. This highly pragmatic approach contrasts with earlier policies, commonly reassembled under the terminology of the “Washington Consensus”, that considered markets to be in most respects superior to traditional regulation, since they foster efficiency, reduce prices and create optimal allocation of resources. For the electricity sector in developing countries, though, the effect of price reductions for consumers has usually been limited to industrial consumers, because (as we have observed in the previous section) residential consumers have generally had the advantage of cross-subsidies to their favour. In more populous developing countries, the focus has tended to be not so much on the introduction of competition, but rather the revenues of privatisation. For example, Brown states that in Brazil “privatisation was first and foremost, and sector reform was a secondary matter, put into effect as an after-the-fact justification” (2002: 10). In addition to fears of oligopolistic supply structures in small countries, public opinion is not necessarily positively biased towards privatisation and liberalisation. In Honduras, for example, the government has tried to introduce competition in the electricity sector, but “surveys show that a substantial share of the Honduran population does not see privatisation warmly... This is partly explained by previous experience with privatisation in other sectors, which was surrounded by the suspicion that questionable deals were entered into” (Walker and Benavides [2002, p. 2]). Hence, countries with a small electricity sector suffer from a number of factors apparently inhibiting its liberalisation. Figure 3 provides an overview of the Latin American countries. The vertical axis indicates the total electricity production of the country on a logarithmic scale, whilst horizontal axis measures the time gap (in years) between a general reform or the launch of a structural adjustment programme and the year in which a substantial electricity sector reform took place, which is indicated by the country abbreviation being highlighted in white colour. All countries that have not yet liberalised their electricity sector are kept in black letters. The horizontal axis counts the years from the year of the major macroeconomic reform until 2002.

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Electricity Production and the Pace of Electricity Sector Reform

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0 5 10 15Time Gap in Years between Major Economic Reform and

Substantial Power Sector Reform (white) or Year 2002 (black)

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Figure 3: Electricity Production and the Pace of Electricity Sector Reform Source: OLADE Database 2001, IADB ([1996]/[1997]), SDS/ENV [1999] and own calculations We can identify three main clusters of countries. First, the group of Latin American countries with a small to medium market size in the bottom right corner, which mostly had not liberalised their markets or had just started by 2002. The exceptions in this cluster, as indicated by white letters, are El Salvador and Bolivia. El Salvador pursued a fundamental free market policy carried out in the aftermath of the civil war by the Cristiani and Calderon Sol governments. It included the privatisation of the banking system, telecommunications, public pensions, electricity distribution and generation. Bolivia liberalised its electricity sector simultaneously to Peru and Argentina and provides an excellent example of spatial policy diffusion. The second cluster contains the medium-sized markets of Argentina, Colombia, Chile and Peru, all of which have liberalised their electricity sectors within a short period of time after their general reforms. A third cluster contains Mexico and Venezuela with medium to large markets and a significant amount of energy reserves, which, by 2004 had not yet liberalised their markets. Paraguay and Brazil are special cases. Paraguay’s electricity production is mainly exported to Brazil, and the problems of introducing competition in Paraguay’s electricity sector have already been discussed. Brazil is quite special. Although it is a net energy importer, its electricity sector is highly autonomous and dominated by hydro. We consider the country to have undertaken a substantial reform with the implementation of a wholesale market for electricity, the MAE (Mercado Atacadista de Energia), which was created in 1998 and contains a long-term bilateral market and a spot market. The spot market is based on costs and does not exceed 10 to 15 percent of the total market, whereas the bilateral market is the main trading instrument (Zilber [2001, p. 8]). Whether Brazil has indeed liberalised its market is a question of definition, but despite the fact that there are numerous opinions that would reject that view (e.g. Brown [2002]), in our opinion the

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creation of a wholesale market with bilateral contracts is already a signal of substantial liberalisation within the restrictions of a hydro-dominated supply structure. Figure 3 therefore suggests the third working hypothesis: HW3: A country will delay or not undertake a substantial reform in its electricity sector if the electricity sector is small. The research issue that now arises is therefore whether these three working hypotheses provide statistically significant explanations for the delay or the absence of reforms in individual countries. We use some event history analysis in order to model these. 9. Event History Analysis of Electricity Sector Reforms in Latin America Event history analysis is a statistical method “used to analyse time intervals between successive state transitions or events” (Blossfeld [1989, p. 11]). In the field of organisation and management research, event history analysis has been applied to examine the survival time of political regimes, firms, or working groups. In evolutionary economics the method is used to explain the “births” and “deaths” of firms (e.g. Carroll and Delacroix [1982]). For our purpose event history analysis seems to be the appropriate tool, because it describes a process of change from one state of the system to another, and uses independent variables, similar to a regression, in order to explain the shift. The model is constructed in the way that the time span between the occurrence of the general reform and the electricity sector reform is taken as the dependent variable, and a dummy is introduced that symbolises whether the country has undertaken an electricity sector reform or not. Countries that have not yet liberalised are included, but the time span lasts from the point of general reform to 2002. As explanatory variables, we use autarky, the product between the HydroIndex and the share of hydropower in generation, and the logarithm of the electricity sector size. For Cuba, which has neither undertaken a general reform nor an electricity sector reform, we count the years from the first observation of the dataset (1985) until 2002. The data comes from the Latin American Energy Organisation (OLADE), the Inter-American Development Bank (IADB), the Energy Information Administration (EIA) and is publicly available. We tried to compare different studies on the actual years of the major structural reform, but relied most heavily on judgements of the IADB. For the year of the electricity sector reform, we evaluated Millan [1999] and the country sheets of the EIA. The event history analysis is carried out using a Weibull distribution of rare events, which is the most adequate substitute for a non-normal distribution of that size and the very few events (corresponding to reforms) that have occurred. The results show that all variables are indeed significant for the time delay between general reform and electricity sector reform. The HydroIndex is significant at p=1.48 %, and autarky is significant at p=2.49 %. The most significant variable is the logarithm of size, which is significant at a level below 1%. .

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Estimated Regression Model - Weibull ----------------------------------------------------------------------------------------------------------------------------------------

Standard Lower 95.0% Upper 95.0% Parameter Estimate Error Conf. Limit Conf. Limit ---------------------------------------------------------------------------------------------------------------------------------------- CONSTANT 1.28292 0.177329 0.935362 1.63048 HydroCombined -0.0000448505 0.0000154368 -0.0000751061 -0.0000145948 Log_Generation 0.342079 0.0484384 0.247141 0.437017 Autarky -0.107861 0.0383044 -0.182937 -0.0327859 SIGMA 0.109298 0.0204603 0.0757306 0.157745 ---------------------------------------------------------------------------------------------------------------------------------------- Log likelihood = -35.379 Likelihood Ratio Tests ------------------------------------------------------------------------ Factor Chi-Square Df P-Value ------------------------------------------------------------------------ HydroCombined 5.93749 1 0.0148** Log_Generation 20.9835 1 0.0000*** Autarky 5.03233 1 0.0249** ------------------------------------------------------------------------ ** and *** indicate that the coefficient is significant to 5% and 1% levels, respectively The results of the event history analysis confirm that the supply structure and size of the electricity sector as well as the resource endowment of a country do indeed have an impact on the pace and existence of electricity sector reforms in Latin America. All three working hypotheses have to be considered relevant in this regional context. 10. Conclusions and Implications for Electricity Sector Reforms The quantitative results of our analysis do not imply that it is infeasible to implement a successful reform of the electricity sector if one or more of the variables under consideration – segmentation and share of hydropower, energy autarky, or size of the electricity sector – reveals an underlying structural inhibitor in a specific country. They, rather, imply that governments in Latin America have experienced obstacles or delays in the reform process which may be related to these variables. Other countries with comparable patterns in their electricity supply structure and resource endowment may therefore face a similar challenge in restructuring and liberalisation. However, the global learning process of introducing competition in the electricity sector now shows a more differentiated and industry-specific set of solutions. The doctrine that competition is always the first-best option appears to have been abandoned, and a more pragmatic approach is appearing, which explicitly integrates the institutional environment and the technical conditions into the shape of the regulatory framework. Government policy and international lending organisations agree that the imperative of electricity sector reform has to be to “keep the lights on” and provide a reliable, cost-reflective service. However, propositions vary considerably. For hydro-dominated systems a market design integrating cost-based bidding and long-term bilateral contracts seems to be the most viable option, even though an indispensable prerequisite for establishing a competitive market is an optimisation of the multi-purpose character of dams (which may not be politically and socially acceptable) and a substantial degree of segmentation of the hydro plants. If segmentation is weak, incentive-based regulation with auctioned contracts and penalising systems may create quasi-competitive conditions.

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The best option for introducing competition in small electricity markets is regional integration, as it is envisaged for the Central American countries. This helps to prevent an oligopolistic situation in one country, eases the burden of the national regulatory agency and increases the security of supply. If a small country is isolated, diversification and decentralised generation may be the answer, especially with renewable energy sources like micro hydro, geothermal or wind farms – but only as long as the regulatory transaction costs do not exceed the benefits of competition. If a country, like many of the oil-exporting countries in Latin America, has a tradition of subsidising electricity, but its government intends to establish a regulation based on the true costs of service, including the long-run marginal costs of adding new capacity, price adjustments have to be made. Jamasb [2002, p. 26] suggests that “the important issue is to design subsidy schemes that address undesirable social impacts while limiting price distortions and adverse impacts on the economic efficiency of reforms” in order to prevent that subsidies only benefit wealthier parts of the population. He recommends that tariff adjustments should be introduced in steps. A certain degree of government intervention is needed, though, if electrification is low and general access to electricity part of the government’s objectives. In that case, a one-off subsidy to the lowest-bidding private sector actor providing the connection and a mobilisation of the local communities may ease the government’s burden and introduce competitive elements in the process (Tomkins [2001]). These particular cases and circumstances indicate that the implementation and the success of reforms is not only a matter of the institutional environment of the country and the institutional arrangements within the sector, including the allocation of property rights, but also depend on a careful selection of the regulatory framework. Of course, other factors may contribute to the approval and implementation of reforms, such as policy diffusion, imitation or coercion within the political system. But the importance of individual characteristics of a country’s energy supply structure questions the view that all electricity markets are likely to converge to one standard model of regulation, because the technical and physical reality and the complexity of each power sector’s individual features require a specific solution for every country. In respect to the research methodology, the significance of the variables implies that the conventional one-way analysis that uses indicators of modifications of regulation, namely the shift from public control to competition, in order to explain changes in the performance and market structure clearly has to be complemented by an appreciation of the opposite influence of structure and basic conditions on regulation. Due to the structure and distribution of its energy resources, the case of Latin America provided a particularly striking example of causality from structure to regulation, and we believe that further research on the supply side in both developing as well as industrialised countries can reveal important insights into the complex issues shaping the success of electricity sector reforms.

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Jens Weinmann and Derek BunnAbstract

Figure 1: Hydropower plant concentration and hydropower share in generationFigure 2: Energy Resource Endowment and Residential Electricity PricesFigure 3: Electricity Production and the Pace of Electricity Sector Reform

10. Conclusions and Implications for Electricity Sector Reforms