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The Private Power Revolution

Issue 4 and Volume 102.

The Private Power Revolution

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Industry Restructuring

A Revolution is Taking Place in the Global Electric Power Industry. Until Recent Years, Moving Away From Government

ownership to private control of public utilities was, for all practical purposes, unthinkable. This was due in no small part to two presumptions about electric power: government control was essential to achieve key planning objectives as they related to the assets of public utilities, and electricity was a natural monopoly and as such should be under close government control.

However, a number of trends (such as the advent of Independent Power Producers) have served to overcome previous presumptions about electric utility systems. The precise factors that have led to the process of restructuring differ somewhat from country to country, but the result of these trends has been that the electric power industries are moving in three parallel directions:

from government to private ownership;

from monopoly market structures toward more open, competitive market structures;

and from jurisdictionally separate entities to global players.

Further, these trends affect how power infrastructure development is financed. In the past, most power assets were financed by budget allocations from either government or vertically integrated utilities, on a centrally planned, integrated-system basis. Today, the trend is toward private-sector financing of developments on a project-by-project basis. An important implication of this is that funding sources have been broadened; lenders, investors, and bond buyers have become a much more diverse and globally dispersed group. Capital financing is attracted to a project based on its economic viability, rather than on the balance sheet of the utility company.

Countries are taking different approaches to restructuring, however. For instance, some countries are choosing only to privatize certain functions of their electricity markets, such as the power generation sector, while others are choosing to privatize the overall market. Chile, Argentina and the United Kingdom have broken up their power industries into generation, transmission and distribution sectors, and privatized these segments. Other countries (including the United States) are beginning to follow this model. More nations, however, have decided to keep the transmission and distribution functions within government control (or within monopoly systems) while selling existing utility plants into private hands and encouraging competition among builders of new power capacity. Still other countries have maintained the status quo for existing plants, while allowing private companies to build IPPs to meet a share of their new power demands.

Privatization Rationale

Increased operating efficiency is one of the greatest motivating factors currently driving privatization. Privatization generally improves the economic viability of power companies because private companies, operating as commercial, for-profit ventures, are less likely to subsidize rates or to allow power theft and other operating inefficiencies. Private companies are more inclined to base their investment and operating decisions on economic drivers instead of social or political motivators.

Consider this simplified example: Historically, electricity tariffs in most countries have been set by politicians or regulators who answer to them; in either case, the process has been politically driven. Well-meaning politicians have endeavored to make electricity as affordable as possible for the greatest number of people. This makes excellent sense when one thinks of electric power as a public service and not an economic commodity. The problem is that rates have almost invariably been reduced below what it costs to produce the power.

For example, average power tariffs in developing Asian nations with state-run utility systems are far below those in the industrialized countries that comprise membership of the Organization for Economic Cooperation and Development (OECD), despite lower operating efficiencies and tighter reserve margins. Also, in virtually all of these countries, rates for industrial and commercial users are significantly higher than rates for residential customers. This is the reverse of most industrialized nations, where residential rates tend to subsidize industrial rates, and not the other way around.

As if below-cost tariffs were not enough of an economic hardship for state-owned utilities, their bill-collection rates tend to be very low compared to countries with privately owned utilities. This is generally because the enforcement of bill collection has been impeded by political considerations. Other state-owned entities are often the worst violators, with such electricity-intensive operations as public transportation systems often months in arrears on their utility bills. Because both are operations of the state, it seems logical to assume that this is mostly an accounting failure and not a true economic crisis. The result, however, is that the utility`s balance sheet suffers while the budgets of other departments appear artificially healthy.

Finally, with no financial incentive to improve efficiencies, state-owned utilities have tended to put little effort into improving their operations and procurement procedures. New plant construction decisions have been driven by cronyism and political expediency rather than sound engineering and economic thinking. Plus, because of the utility`s poor financial position and tight reserve margins, many existing power plants have deteriorated because of inadequate maintenance and use beyond their expected lifetime. This has led to lower operating efficiencies, more forced outages, and higher costs per kilowatt-hour of power generated.

These combined effects are disastrous for a utility system as well as a government`s budget. The utility becomes a serious liability for the state, rather than a “crown jewel” asset. Budget allocations for new power capacity seem like a poor investment, when the utility seems so incapable of managing its existing assets. As power demands rise with economic growth, reserve margins become tighter and then disappear altogether. Power shortfalls ensue, and the country begins to face a real power crisis.

On the other hand, privately owned and operated utilities (or those that conduct business like private companies) are much less likely to make ratemaking decisions based on political considerations (or at least to a degree less than typical state-owned utilities). As a profit-making entity, the utility will ensure that collected tariffs cover operating costs and sufficient profit to provide for and justify future investments. Commercial utilities have a much higher bill-collection rate, as well, because they have a powerful financial incentive to cut off power to non-paying customers, whether they be government organizations or private companies. In cases where power distributors have been privatized, bill collection rates have typically improved dramatically.

Finally, investment decisions can be made on a pure cost-competition basis within the parameters of environmental performance and other factors established by government regulators. Competitive bidding procedures ensure that least-cost solutions are chosen and economic system planning models help to ensure that all parts of the system operate as efficiently as possible.

With rational tariff-setting and bill-collection processes in place, and an efficient method of building and operating power plants, the utility can maintain a strong balance sheet. This helps attract investment capital to finance future system expansion efforts.

Despite strong arguments in favor of converting a utility system from government-operated model to commercial model, actually doing so is no easy task. No one wants to pay 10 cents a kilowatt hour for power when they previously paid 3 cents–or paid nothing at all. In addition, the will to change is a scarce commodity, while the political and institutional inertia against change are abundant.

In an effort to overcome these hurdles, multilateral development agencies are sponsoring restructuring efforts. The World Bank, which has provided billions in funding for development of power infrastructure in the world`s developing economies, is strongly recommending that their beneficiary nations restructure their utility systems along these lines: tariffs should reflect economic costs of supply, in terms of structure and levels; and tariff levels should be set so as to make power utilities financially viable. The crux of the matter, then, is rational pricing policies.