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VOICE OF ELECTRICITY WORKERS
Electricity Sector Reform in Developing Countries:
A Survey
of Empirical Evidence on Determinants and Performance
The Policy Research
Working Paper Series disseminates the findings of work in progress to encourage
the exchange of ideas about development issues. An objective of the series is to
get the findings out quickly, even if the presentations are less than fully
polished.
This paper was prepared as part of the research program on Industrial
Organization Policy for Development at the Development Research Group of the
World Bank.
Driven by ideology, economic reasoning, and early success stories, vast amounts
of financial resources and effort have been spent on reforming infrastructure
industries in developing countries. It is, therefore, important to examine
whether evidence supports the logic of reforms. This paper reviews the empirical
evidence on electricity reform in developing countries.
Until we know more, implementation of reforms will be more based on ideology and
economic theory rather than solid economic evidence.
Introduction
Since the early 1990s, a large number of developed, transition and developing
countries around the world have embarked on electricity sector reform. The pace
and the extent of the trend has been remarkable and, by the end of 1990s, the
majority of OECD countries and over 70 developing and transition countries had
taken some steps toward reforming their electricity sector (Bacon, 1999;
Steiner, 2001). This has occurred under a broad paradigm shift from state
ownership and centralized organization of infrastructure industries to private
ownership, public regulation and market-oriented structures (OECD, 2000). The
technological progress and reform pioneered in some countries has encouraged
others to follow suit.
This trend primarily reflects dissatisfaction with the performance of
traditional forms of organisation and a desire to improve efficiency and reduce
fiscal drain in the public sector. Added to this is a growing questioning of the
theoretical and empirical justification for state-owned enterprise, the
development of models of competition within network utilities and theories of
incentive regulation of private natural monopolies (see Newbery, 1999).
The model adopted for the electricity supply industry (ESI) since the Second
World War resulted in the use of costly generation technologies, neglect of
customer services and economic inefficiency. Combined with the interruption of
demand growth after the oil crisis of the 1970s, the traditional approach to the
industry resulted in excess capacity. In addition, the perverse incentives of
cost-of-service regulation had received serious criticism (Averch and Johnson,
1962). However, measuring inefficiencies and the effect of regulation has proven
to be very difficult (Joskow and Rose, 1989; Joskow and Noll, 1981). Later, much
of the debate on problems of regulation of monopoly firms has been focused on
the issues of information asymmetry and incentives.
The argument for integration of generation and transmission systems was further
undermined by the emergence of new technologies: combined-cycle gas turbines
reduced the importance of economies of scale, information technology
significantly improved remote monitoring and control of electricity flows (e.g.
dynamic thermal circuit ratings (DTCR) and the Wide Area Measurement System (WAMS)).
However, the driving forces behind electricity sector reform differ considerably
between developed and developing countries. In developed countries the principle
aim has been to improve the economic and financial performance of technically
reliable systems. A conjunction of circumstances also contributed to increase
the pressure for reform.
In developing and transition countries the burden of subsidies, low service
quality, non-collection rates, high network losses and poor service coverage
have meant that many governments are no longer willing or able to support the
existing arrangements
Macroeconomic conditions played a rather more fundamental role in developing
economies. For example, in Latin America the debt crisis of the 1980s
interrupted capital flows into the region and it became increasingly difficult
for the public sector to maintain the required financing for infrastructure
investment. Private ownership imposes hard budget constraints, ensures that
bills are collected and increases revenue. Governments should note that, to
privatize successfully, regulation needs to be improved. The regulation needed
to support privatization should ensure that prices are set at cost-reflecting
levels which should, in turn, solve the twin problems of financing investment
and reducing fiscal drain.
Privatization proceeds can also be used to alleviate the fiscal crisis by
amortizing debt and restructuring public sector liabilities.
International finance and development agencies were advocates of market-oriented
reform in developing and transition economies. This background explains the
appeal of privatisation and market-oriented reform in developing economies
which, at times,preceded other necessary reform measures. Thus privatisation in
Central and Eastern Europe preceded the establishment of effective regulatory
institutions, and privatization in many Latin American countries clearly
sacrificed competitive market structure to the need to raise extra privatisation
revenue (e.g. in Chile).
While many OECD countries, transition economies and a significant number of
developing economies have taken concrete steps toward liberalisation, reform is
only in its early stages in the majority of developing countries. In South Asia
and Sub-Saharan Africa, less than 20% of countries have taken key reform steps.
China and India, in particular, are both in the early stages of their
electricity reform.
There are differing views and a degree of theoretical ambiguity in the economic
literature on the effectiveness of privatisation and competition in network
industries on issues such as the relative efficiency of privately vs. publicly
owned natural monopolies,and gains from competition vs. economies of
co-ordination in vertically integrated systems. In practice, the benefits of
each reform and restructuring must more than compensate for the increase in
transaction costs of unbundling vertically integrated systems. The pre-reform
literature suggests that publicly owned and privately owned firms were equally
efficient and that there were substantial vertical economies associated with
electricity generation and downstream wire networks. The legacy of this
literature still colors the debate in spite of post-reform evidence to the
contrary, most powerfully demonstrated in the experience of the UK, Argentina
and Chile.
In many countries, reforms have encountered significant difficulties and policy
makers have found the reform path considerably more complex than anticipated.
This is partly because electricity markets are characterized by the need for
real time balancing of supply and demand (due to a lack of storage) and hence
are required to be better designed and regulated than most other deregulated
sectors. It is also clear that reformers underestimated the political difficulty
in moving tariffs to cost-recovering levels, and the problems of corruption,
patronage, labor opposition to reducing waste, poor collection and other fiscal
leakage. Simpler reforms, such as encouraging independent power producers to
enter into long-term power purchase agreements with financially fragile
counterparts, stored up difficulties that were revealed by devaluation and other
macro shocks. Serious reform of the price setting mechanism for residential
tariffs, combined with economically rational regulation, both central for
revenue adequacy, were delayed or not recognised as important, or were derailed
by intransigent price regulation.
At the same time, countries interested in reform, as well as international
development and finance organizations, have to evaluate their options and
policies toward the electricity sector in the light of recent blackouts in
leading reform-countries such as Italy 2003, California 2001, Auckland, New
Zealand 1998, and Chile 1998-99. As shown by the case of California's
electricity crisis, the financial and political costs of flawed reforms can be
unacceptably high.
Within this context and in the light of accumulated experience from countries
around the world since the 1990s, the empirical literature on reform can make an
important contribution to the debate and, more importantly, inform policy-making
decisions.
Organization of the study: In this study, we present a critical review of the
empirical literature on the determinants and performance of electricity sector
reform in developing and developed countries. More specifically, the aim is to
establish the extent to which the literature has: (i) resolved the theoretical
ambiguities involved in the reforms, (ii) enhanced our understanding of the
determinants of reform, (iii) contributed to the design of better reform models,
and (iv) measured reform performance. We outline a conceptual model of
electricity reform for the review that is largely based on the established
structure-conduct-performance paradigm of industrial organisation. The study
reviews the main research questions and hypotheses tested in the studies,
assesses the methodologies and performance measures used, and evaluates the
robustness of the findings. We then identify some additional hypotheses and
issues that need to be addressed in order to improve the theoretical and
empirical basis of policy debates on electricity sector reform in developing
countries.
Theoretical basis:
In principle, a reform should be undertaken if it will have a positive welfare
economic impact. However, governments do not necessarily perform social
cost-benefit analysis prior to reform and instead they tend to rely on less
formal types of assessment (UNESCAP, 2001).
One of the main policy objectives of reform in developed market economies was to
promote efficiency. There are different theoretical arguments on why private
ownership and market-oriented reforms might lead to greater efficiency.
In developing countries, the main policy objective is more likely to be a rise
in the rate of investment and a reduction in the cost to the public budget.
Increases in efficiency that reduce costs certainly help, but if prices are not
able to cover both running and capital costs, investment will be either
curtailed or financed at the expense of increasing public deficits. Private
ownership offers the prospect of imposing hard budget constraints and the need
for sustainable (full) cost-reflective pricing. Seen in this light, successful
privatisation is a test of public commitment to address these fundamental
problems.
The counter argument is that such privatisation requires the government to
create credible regulatory institutions and to restore prices to cost-reflective
levels, and if it were able to do that, then the sector's problems would have
been solved. Much, then, depends on whether public sector regulatory prudence is
better sustained with private ownership, or whether any government sufficiently
capable of successful restructuring, regulation and privatisation would also be
able to manage a publicly owned electricity industry competently.
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