electricity system reform: world bank approach and latin american reality

Electricity system reform: World Bankapproach and Latin American reality

Adilson de OliveiraGrupo de Economia da Energia, Instituto de Economia Industrial, Universidade Federal do Rio de Janeiro,

Av. Pasteur, 250, sala 11, Rio de Janeiro - RJ 22295-900, Brazil

1. IntroductionThe World Bank recently produced apaper reviewing its policy guidelineson the electricity systems of develop-ing countries (DCs) [World Bank,1993]. After 40 years of strong finan-cial and technical support to the de-velopment of the electricity supplyindustry (ESI), the Bank considersthat it is time for a drastic change ofits policy. Its assessment is that theindustry performance started deterio-rating soon after the oil crisis andthere are no signs that this trend islikely to be reversed within the cur-rent ESI institutional arrangement.From its point of view, external fac-tors can partially explain the trend forperformance deterioration[1] but thebulk of the problem is of domesticorigin: government policies that areharmful to utilities’ economic and fi-nancial performance are readily ac-cepted by utility managementsbecause they are ‘‘monolithic state-owned monopolies’’ that pass over toconsumers any additional cost thatgovernment policies impose on utili-ties. The Bank’s new approach to theindustry has decentralisation, deverti-calisation, competition and privatisa-tion as cornerstones of its futureaction concerning the ESIs of DCs.

For those familiar with the past ac-tivities of the Bank in this area, it israther surprising to hear that the Bankno longer believes that governmentshould play a central role in the ESIand that competition and decentrali-sation instead of monopoly and cen-tralisation are sources of economicimprovements in this industry. In-deed, for too many years Bank staffhave been travelling across the devel-oping world suggesting that the ESIshould look for economies of scalethat could only be achieved by large

projects executed by monopoliesowned by the government. At thattime, the Bank was prepared to offersoft loans for government-ownedutilities in order to support them togradually develop an interconnectednational electricity grid that wouldmake room for large power plants. Itis not a surprise therefore that theBank’s policy paper was receivedwith scepticism among DC policy-makers.

This radical change in the Bank’sapproach to the ESI of DCs waslargely driven by a new set of ideasthat emerged in industrialised coun-tries (ICs) in the 1980s. The Ameri-cans were the first to explore theconcept of decentralisation, introduc-ing the obligation for utilities to buyelectricity from qualifying facilities(PURPA legislation). At the begin-ning of the 1990s, the British wentfurther, transforming their ESI in or-der to give competition instead ofmonopolies a central place in theelectricity system. This is obviouslya very controversial idea that mostoften finds no great acceptanceamong utilities [Bouttes and Lederer,1991] but was wholeheartedly en-dorsed by the Bank despite the factthat it is unclear to what extent com-petition suits the current situation ofDCs.

Sponsors of competition argue thatit plays a crucial role in economicperformance: it forces producers tokeep prices in line with marginalcosts and it induces an efficient allo-cation of scarce economic resources.However, no economist claims thatelectricity supply is an industrywhere competition can be easily in-troduced. Indeed, economists tend toagree generally that electricity trans-portation (transmission and distribu-

tion) is still a natural monopoly andelectricity generation can at best bestructured like a strong oligopoly. Itmay even be argued that monopolyrather than competition can guaranteebetter economic performance for theESI. Moreover, the electricity systemis a physically integrated co-operativenetwork of suppliers and consumers;it means that the quality of electricitysupply is largely determined by activeco-ordination among suppliers andconsumers. Such circumstances limitthe scope for competition.

This paper explores the recommen-dations of the World Bank for reform-ing the ESI of DCs, intending toassess the suitability of the Bank’srecipe to Latin America. First, it re-views the development of the ESI andanalyses the nature of the ESI crisisin both ICs and DCs. The second sec-tion summarises the new approach ofthe Bank towards the electricity sys-tem of DCs. The third section pre-sents the British experiment ofradical use of competition in the ESIand the Chilean experience of man-aged competition. The conclusionuses the lessons of these two casestudies to inquire whether the Bank’srecommendations are suitable forLatin American countries.

2. A brief historical review

The ESI was born at the end of the19th century as a private enterprise.The rapid growth of electricity con-sumption for lighting and power ledto the development of several compa-nies oriented to supply the main ur-ban centres with this source ofenergy. At its beginning, electricitycompanies had no technical standardsto comply with and their economicperformance was largely determinedby the development of their local

Energy for Sustainable Development l Volume III No. 6 l March 1997

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market. This historical process pro-duced an ESI that was a collection of‘‘electric islands’’ with large differ-ences among the various companiesas far as both technical standards andeconomic performance are concerned.

In the second quarter of this cen-tury, the shortcomings of this essen-tially local, non-integrated marketorganisation became apparent. Tech-nological innovations both in genera-tion and in transportation ofelectricity offered very substantialopportunities for economies of scaleand scope but local markets neededto be interconnected in a large, singleintegrated electricity system in orderto reap these opportunities. Indeed,pooling different ‘‘electric islands’’ inone single system would reduce ag-gregate peak demand and would offerroom for larger power plants. Lessgenerating capacity would be neededand larger power plants, with smallercapital costs and lower heat rate,could be introduced into the grid. Insimple words, the interconnection oflocal markets into a single grid wouldsubstantially diminish supply costsand would improve reliability andstability of the electricity system aswell.

Although it was possible to obtainbig economic benefits by intercon-necting local markets, these benefitswere difficult to exploit within the in-dustrial organisation of the ESI at thattime. Indeed, the interconnection ofdifferent markets required that elec-tricity companies accept a single setof technical standards[2], centralisethe decision-making process, concen-trate financial flows in order to investin large power plants and long trans-portation lines, and co-ordinate ex-pansion plans. Eventually, it becameclear that a profound reform of theESI was needed.

The USA pioneered the reformsduring this period, introducing thePublic Utility Holding Company Act(PUHCA) legislation that still largelygoverns the ESI in that country. InEurope, the reform process acquiredmomentum soon after the war whenElectricité de France (EdF) and theCentral Electricity Generating Board(CEGB) were created in France andBritain. Different institutional

arrangements were adopted by thesethree countries but they all had oneobjective in mind: to develop an in-terconnected grid that would makeroom for large power plants. Thistechnological trajectory producedconcentration, centralisation andlarge monopolies but it offered plentyof reliable, high-quality electricityservices at stable if not decreasingtariffs. Many industrial consumers,who usually generated their own elec-tricity, decided to close down theirpower plants, preferring to buy elec-tricity from utilities.

This period was the golden age ofthe ESI. Electricity consumption wasincreasing rapidly (roughly at 7% ayear) while the grid was extensivelycovering new geographical areas,spreading the economic benefits ofthe use of electricity through society.To increase social and regional cohe-sion, cross-subsidies were offered tounderdeveloped regions and/or poorersocial groups. The ESI was then per-ceived by both governments and con-sumers as a source of economic andsocial development.

In Latin America, the pattern of de-velopment of the ESI was similar tothat described so far. Electricity com-panies, most often controlled by for-eign investors, developed the ESI asa collection of ‘‘electric islands’’from the beginning of the 19th cen-tury. Just before the Second WorldWar, these companies started beingcriticised for their inability to keepsupply matching a rapidly increasingdemand. Lack of investment wascausing deterioration of the quality ofservices utilities provided and thiswas perceived by Latin Americanpolicy-makers as a major constraintto the import substitution industriali-sation process. Foreign investorscomplained that electricity tariffswere not high enough to offer theright incentives to raise financial re-sources needed to supply a fast-grow-ing demand[3]. A substantial increasein electricity tariffs was requested byutilities in order to attract private in-vestments. However, Latin Americangovernments opposed such a policy,preventing access to electricity tomany potential consumers. Moreover,large periods of electricity rationing

were frequent. In such a precarioussituation, the ESI was acting not as asource of economic development butas a constraining factor instead.

The post-war period created thepolitical climate for reform of the ESIof Latin America. Indeed, the sameeconomic benefits of concentration,centralisation and large monopolieswere potentially available and emerg-ing theories of economic develop-ment suggested that investments ininfrastructure should precede invest-ments in other sectors of the econ-omy. The ESI was listed as a priorityfor government financial support, aview that was shared by multilateralfinancial organisations. Indeed, about15% of total cumulative lending ofthe World Bank was oriented to theESI of DCs [World Bank, 1993]. Itssupport was not limited to providingfinancial resources: technical exper-tise offered by the Bank played animportant role in the industrial reor-ganisation of the ESI of Latin Amer-ica during the 1960s and 1970s.Eventually, large interconnected mo-nopolies emerged in the 1980s [Col-lier, 1984].

The industrial organisation of theESI as a large interconnected monop-oly opened a window of opportunitiesfor technological innovations, en-hancing the quality of service pro-vided and reducing electricity supplycosts. Consumers took advantage ofthese benefits, rapidly increasingtheir consumption from the grid,opening new opportunities for inno-vation that reduced costs and en-hanced services further. A virtuouscircle of increasing consumption, in-terconnection, opportunities for re-ducing costs, lower tariffs and higherconsumption was built in. Concentra-tion, centralisation and monopolywere key factors in this virtuous cir-cle. Although public ownership wasnot essential, it facilitated the processof interconnection, concentration andcentralisation, and it offered politicallegitimacy for monopoly. Consumersand government both shared the viewthat the ESI was a major source ofeconomic and social development.

Unfortunately, good things do notlast forever. In the middle of the1970s, the first signs emerged that the


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golden age of the ESI was coming toan end. The performance of the elec-tricity system started to deteriorate inboth ICs and Latin America.2.1. The nature of the crisis inindustrialised countriesIn ICs, interconnection was com-pleted and economies of scale ofpower plants disappeared. Progres-sively, it became clear that the virtu-ous circle has been replaced by avicious circle of increasing costs, di-minishing productivity and deterio-rating performance. The first signsemerged on the supply side but theycould rapidly be seen on the demandside as well.

The oil crisis reversed the long-lasting trend for lower fuel prices,substantially increasing utilities’ op-eration costs. The adoption of rigidmonetary policies by ICs increasedinterest rates to very high levels,never before reached, augmentingutilities’ financial costs substantially,especially for those that had bor-rowed heavily to adjust their fuelstrategy to the new context created bythe oil crisis. Material and construc-tion costs escalated as well, as a re-sult of the changes in economicenvironment brought about by the oilcrisis, increasing utilities’ capitalcosts. These pressures diminished inthe 1990s but new pressures on utili-ties’ costs emerged. Public concernwith the environmental impact of thegeneration and supply of electricity isincreasingly forcing utilities to inter-nalise environmental costs that wereusually passed on to society. More-over, risks and uncertainties concern-ing fuel costs and technology haveincreased substantially, increasing fi-nancial costs.

From the demand side emergedeconomic forces that reduced sub-stantially the rate of growth of elec-tricity consumption. Electricityconservation policies and the revivalof cogeneration by manufacturers re-duced the need of electricity supplyfrom the grid. In ICs, underlyingthese changes is the end of the so-calledbaby-boom reconstruction period; asaturation of electricity-intensive ap-pliances among domestic consumersand relocation of electricity-intensiveindustries towards DCs. The combi-

nation of these economic forces in-hibited electricity consumption inICs, drastically reducing its growthrate. In Britain, for instance, electric-ity consumption is currently growingat roughly 0.5% a year.

The vicious circle was built up.Cost pressures were pushing pricesup while consumption was slowingdown. Utilities had already startedprojects assuming that electricity con-sumption growth would remain at therate of the 1960s but consumptionwas growing at a much lower rate.Overcapacity emerged, putting strongcost pressures on utilities’ balance-sheets. Consumers, especially in theUSA, reacted negatively to the usualmechanism of utilities passing on mo-nopoly costs. Environmentalists re-acted as well, criticising utilities forpassing on to society its environ-mental costs. Moreover, new tech-nologies emerged on both the supply(e.g., combined-cycle gas turbines)and demand sides (e.g., cogenerationand conservation) which offered bothconsumers (especially large industrialconsumers) and environmentalists anew role in the electricity system.These new technologies and newplayers, combined with radical inno-vation in information technology,have eroded the monopoly of the de-cision-making process that used tovest in utilities: decisions have, po-tentially, moved closer to consumers.The climate for a profound review ofthe institutional organisation of theESI was created.

In ICs a view began to emerge thatthe ESI was no longer a source ofeconomic development but a con-straining factor. The economic andenvironmental costs of electricitywere increasing but utilities paid noattention to their controllable costsbecause they were used to passingtheir costs on to society. Moreover,although new technologies wereavailable that could abate costs, utili-ties were conservative in their tech-nological choice, preferring to usetheir tested technologies. New play-ers were prepared to invest in thesenew technologies but the existingones used their monopoly power tomake their entry difficult. Centralisa-tion, concentration and monopoly that

for so long have been sources of eco-nomic efficiency started to be blamedfor the deteriorating performance ofthe ESI in ICs.

In ICs, the ESI is considered a ma-ture industry. The necessary transpor-tation (transmission and distribution)infrastructure is already in place butis not used to its full capacity andelectricity consumption can only in-crease slowly for the reasons pointedout earlier. In these circumstances,the ESI should focus its efforts on theoptimisation of its existing installedcapacity and on mitigating the envi-ronmental impact of electricity gen-eration and use. It is expected that thediversification of players in the elec-tricity system, the introduction of dif-ferent forms of competition and theseparation of the generation, trans-mission and distribution of electricitywill reintroduce a trend towards costreduction in the ESI in ICs. Can asimilar result be expected in DCs?2.2. The nature of the crisis in LatinAmericaThe ESI of Latin America stronglybenefited from the virtuous circle de-scribed earlier. Until the 1970s, thequality of the service provided byLatin American utilities was improv-ing continuously and their tariffsmost often were diminishing in actualterms [Mason et al., 1988]. Despitethe substantial growth rate of theirelectricity supply, Latin Americanutilities were able to find financial re-sources in order to develop their pro-jects of rapid expansion. Multilateralfinancial organisations such as theWorld Bank played a crucial role inthis process. They offered core re-sources that facilitated the assemblyof financial packages that enabledLatin American utilities to keep to thepath of growth of their electricitysupply. Bank staff actively supportedinterconnection, centralisation andconcentration to build up large elec-tricity supply monopolies in the re-gion, assuming that the opportunitiesfor economies of scale and scope ofthe technological trajectory of the ESIwould be available for Latin Americaas well. Large state-owned monolithicmonopolies emerged from this proc-ess.

The underlying situation of Latin


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American utilities also changed in the1970s but this was hardly perceivedby consumers or even, to a substan-tial extent, by the utilities. Costs es-calated but actual electricity pricesdid not increase accordingly becauseof social considerations. Facing rap-idly increasing consumption and a re-ducing cash flow, utilities werepersuaded to borrow heavily in inter-national financial markets, wherepetro-dollars were available, at lowinterest rates. However, Latin Ameri-can countries undertook huge cur-rency devaluations in the 1980s tocope with macroeconomic problemsresulting from the interruption of theinternational flow of capital and thedramatic increase in interest ratescaused by IC monetary policies. Suchdevaluation enormously increasedLatin American utilities’ debts andrendered most of them financially in-solvent [OLADE, 1988].

Although the ESI of DCs still hadopportunities for economies of scaleand scope for improving perform-ance, these opportunities were muchmore difficult to exploit in the con-text of the economic crisis. Unable toinvest properly, utilities tended toconcentrate their financial resourceson generation, aiming to keep supplyand demand in balance. Investmentsin both transmission and distribution(T&D) were postponed and expendi-ture on maintenance was reduced.This approach has had a profound im-pact on utilities’ technical perform-ance: fuel consumption and T&Dlosses are greater than what is reason-able to expect, availability of powerplants is much too low and powerplant construction periods are toolong. Latin American utilities werethus caught in another sort of viciouscircle of increasing costs and deterio-rating performance.

Still, it can hardly be assumed thatthe opportunities for economies ofscale and scope have disappeared inLatin America. Indeed, there are ele-ments that suggest that electricityconsumption should continue to in-crease relatively rapidly in the region.Although population growth is dimin-ishing, it remains quite high still(around 2% a year). Moreover, themarket for electricity-intensive appli-

ances is far from saturation levels asyet and large proportions of the popu-lation and of the land still have noaccess to electricity supply. There isa strong need for the development oftransportation infrastructure. Thesefactors explain why Latin Americanelectricity consumption continues togrow at relatively high rates still(over 5%). Indeed, it can hardly beargued that the electricity system ofthe region is mature.

Electricity infrastructure still needsto be developed but this developmentis constrained by lack of financial re-sources. The debt crisis destroyed thefinancial equilibrium of public ac-counts; therefore, governments canno longer provide financing at low in-terest rates. Moreover, multilateral fi-nancial organisations decided thatfunds available for publicly-ownedutilities are very scarce [World Bank,1993]. The challenge facing the LatinAmerican ESI is to re-establish finan-cial flows in order to invest in meet-ing a still rapidly increasingconsumption demand, and simultane-ously improve its economic and en-vironmental performance. The Bankclaims that this challenge can only befaced through a radical change in theinstitutional arrangement that wouldgive a much larger role to competi-tion and private investors in the in-dustry. A growing number of LatinAmerican governments share thisview, although there is no modelemerging from their attempt to re-form the ESI.

3. The World Bank reformapproach

The deterioration in DC utilities’ fi-nancial performance prompted a pro-found review of the Bank’s lendingpolicy for the ESI of DCs [WorldBank, 1993]. To provide a rationalefor its policy reorientation, a reassess-ment of 300 power projects financedby the Bank between 1965 and 1983was carried out by Mason Gilling andMunasinghe [Mason et al., 1988].The conclusion of their study wasthat it is questionable whether thepursuit of expansion of the ESI ofDCs is ‘‘possible or even desirable’’.They recommended that the Bank’srole should emphasise ‘‘efficiency

and restructuring issues’’, although itrecognised that such a strategy leadsto lower level of access to electricitysupply for the DC population.

The policy review considers thatDC utilities put too much emphasison expansion, neglecting the eco-nomic benefits of an efficient opera-tion of the existing installed capacity.High consumption of fuel per kWh,high T&D losses and lack of conser-vation policies are pointed out by theBank as clear signs of this neglect[4].From the Bank’s point of view, gov-ernment ownership is at the core ofthis situation: investments and pric-ing are politically driven; utilities’billing and purchasing powers areboth decided using administrative in-stead of economic criteria; and man-agers are not accountable for theirmismanagement because they are po-litically appointed. Moreover, mono-lithic state-owned utilities preferlarge projects and they are far too op-timistic about both electricity demandand power construction costs. Theseutilities are quite often over-capital-ised in order to compensate for theirinefficiencies, thereby increasing op-erational and investment costs. Theoutcome is high operational and in-vestment costs, leading to high elec-tricity tariffs and massive demand forfinancial resources. Latin Americanutilities are asking for US$ 210 bil-lion in the 1990s to finance their ex-pansion plans, a figure that Bankofficials consider difficult to achieve.

It is obvious that there was a verysubstantial change in the Bank’s per-ception of the role of electricity ineconomic development. While in thepost-war period, electricity supplywas perceived as a developmentalfactor, this is no longer the Bank’sperception. The Bank policy reviewpaper argues that electricity supplyshould be handled as a service likeany other, being offered only to thosewho have the ability to pay for its fullcosts. Moreover, the ESI should beregulated as a market-oriented activ-ity. Not surprisingly, the Bank (andother multilateral financial organisa-tions as well) has substantially re-duced its investment share in the ESI,leaving space for private investors tofill the gap. In Latin America, for


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instance, the share of private banksin the energy sector was over 70% in1988 [OLADE, 1988].

In its new approach to the ESI, theBank regards concentration, centrali-sation, monopoly and public owner-ship as no longer being sources ofeconomic efficiency. The lack ofcompetition is blamed for cost esca-lation above what was reasonable toexpect and government ownership isreproached for obstructing the neces-sary increase in tariffs. From theBank point of view, these elementsare at the core of the process that ledDC utilities to a poor economic andfinancial situation. Institutional, fi-nancial and managerial reforms aresuggested by the Bank in order to re-vive the past trend of continuous per-formance improvements.

From the institutional point ofview, the policy paper suggests that anew industrial organisation should bebuilt up that will largely rely on com-petition. Decentralisation, devertical-isation and open access to the gridshould be promoted, in order to fa-cilitate competition. Independentpower producers and cogeneratorsshould be encouraged to providepower to the grid, receiving economicincentives if necessary. A new regu-latory regime must be introduced thatmust drastically reduce governmentinterference in utilities’ decisions, es-pecially in all aspects concerningutilities’ day-to-day management.However, management accountabilitymust be strongly reinforced in orderto guarantee a much greater transpar-ency in the ESI, particularly with re-gard to utilities’ relationships withsuppliers and big electricity consum-ers. It is suggested that the regulatormust have considerable power to re-duce barriers to entry into the ESIand should establish performancestandards to force utilities to quicklyimprove their economic and environ-mental performance.

From the financial point of view, itis suggested that electricity tariffsmust increase substantially in order toaugment self-financing by utilitiesand reduce investment needs aswell[5]. More important, it is pro-posed that a much larger role must beoffered to private investors in the

ESI. The menu of suggested changesis indeed long: out-sourcing servicessuch as billing, maintenance, and dataprocessing from specialised compa-nies; build-operate-transfer (BOT)-type projects; partnership of privateinvestors in state-owned utility man-agement; and privatisation of publicutilities. In all circumstances, incen-tives[6] must be offered to encourageprivate capital to invest in the ESI.Particularly important are mecha-nisms that can substantially reducethe very high risks of electricity pro-jects. Special contracts should be de-signed to attract private investors,especially foreign investors.

From the managerial point of view,it is proposed that efficiency im-provements must be the driving forceof the industry. In order to achievethis goal, it is suggested that compe-tition should be introduced whereverfeasible and monopoly power drasti-cally diminished. It is stressed thatstate-owned utilities should be sub-ject to the same economic regime asprivate companies[7]. It means publicutilities should be free: (1) to managetheir manpower, including wages andemployee benefits; (2) to buy equip-ment and contract out services, in-cluding from international suppliers;and (3) to fix tariffs on economicgrounds. The Bank gives great impor-tance to energy conservation policiesto curb electricity demand.

The Bank’s policy paper states thatits future action in the ESI of DCswill be based on five principles.

Principle 1: The establishment ofa legal and regulatory process satis-factory to the Bank. It expects trans-parency and consistency ofdecision-making, environmental safe-guards, clear pricing guidelines anddemand-side management policies.

Principle 2: In the least developedcountries, to bring in developed coun-try or more advanced developingcountry electric power services. Thiscan be done through twinning ar-rangements or contracting out se-lected sectors services to foreigncompanies.

Principle 3: The Bank will aggres-sively pursue the commercialisationand corporatisation of, and privatesector participation in, DC power sec-

tors. It means that the Bank will en-courage private participation in theESI, in some countries channellingsome portion of its lending throughcommercial banks.

Principle 4: The Bank will focusits lending on those countries that fallin line with the above principles.

Principle 5: To encourage privateinvestment in the power sector, theBank will use some of its financialresources to support programmes thatfacilitate the involvement of the pri-vate sector.

It is clear that the Bank’s new ap-proach towards the ESI is oriented to-wards breaking up the state-ownedmonopoly industrial organisation thatstill governs the ESI of DCs, in orderto create room for private investmentsand, possibly, competition. What isunclear as yet is to what extent thesemovements will contribute to DCeconomic development.

4. Reforming the ESI

4.1. England and Wales: radicalcompetitionUntil privatisation, the British ESIwas organised in such a way that theelectricity generation and transmis-sion was centralised in the CEGB andthere were 12 regional electricityboards (REBs) that had a monopolyfor selling electricity services in theirgeographical areas. The CEGB usedto sell electricity at a wholesale priceto the REBs which added on their dis-tribution costs to make up electricitytariffs to their consumers. From thefinancial point of view, the BritishESI was successful. Indeed, for someyears the electricity companies wereable to finance all their investmentsand, in addition, to pay back most oftheir long-term debt. At the time ofprivatisation the industry was close tobeing debt-free.

Despite this healthy financial situ-ation, the ESI was criticised for lackof cost discipline, technological con-servatism and neglect of consumersneeds. In 1987, the Conservative gov-ernment decided to radically changethe organisation of the industry tosolve these problems. The British si-multaneously promoted decentralisa-tion and privatisation, giving tocompetition instead of monopoly a


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central role in the reorganised ESI.The CEGB was split into three dif-

ferent generation companies[8] andone transmission company. The trans-mission company[9] was initiallyowned by the 12 distribution compa-nies that emerged from the REBs andit must offer open access to the gridto generators, distributors and con-sumers. A new regulatory agency wascreated, Office of Electricity Regula-tion (OFFER), to oversee the indus-try, promote competition andguarantee that all players would playby the rules of the Electricity Act. Allcompanies, except the nuclear com-pany, were privatised. A transitionalperiod was established to protect nu-clear power, domestic coal suppliersand regional distribution companies,at least partially[10], from competitionbut it is expected that competitionwill gradually increase as both newgenerators[11] find their way to con-sumers and limits for consumers tobuy electricity directly from gener-ators are lowered.

The regulator plays a crucial rolein the new British ESI. She/he fixesthe price cap indexes, therefore set-tling tariff adjustments for regulatedmarkets (transmission, distributionand captive consumers); fixes thevalue of the loss of load (VOLL) thatis the market inducement for capacityincrease; and monitors the competi-tive behaviour of generators, a taskthat in reality has proven very diffi-cult to carry out. The designers of thenew British ESI imagined that therole of the regulator should progres-sively be reduced as competition de-veloped. The experience so far ispointing in the other direction, therole of the regulator becoming moreand more important to guarantee thatmarket players do not use their mar-ket power to gain extra benefits. In-deed, there are clear signs that thetwo large generators have been ma-nipulating the price of electricity inthe pool in order to maximise theirprofits [MacKerron, 1995].

The pool plays a vital role in thenew British ESI. Consumers and sup-pliers of electricity are competing forthe electricity offered to the pool bygenerators at a previously fixed pricefor each half-hour of the day. The

price of electricity is determined bythe quantity of electricity that con-sumers decide to use at each half-hour and generators are paid at themarginal price of the system. Itmeans that all generators are paid thesame price asked for the last powerplant that had to be dispatched tomatch consumers’ demand[12]. How-ever, most of the electricity used(sold) by consumers and distributors(generators) is not paid (received) atthe pool price since generators havefinancial contracts with consumersand distributors that compensate forany difference between their contrac-tual price and the pool price. Thepool price acts as a signal for gener-ators, distributors and consumers ofthe likely price they should be payingat that particular half-hour. It is ex-pected that progressively contract andpool prices will become closer.

In the beginning, the British priva-tisation experiment produced limitedbenefits for consumers although costswere drastically reduced for severalreasons: job cuts (roughly 37,000 andstill more expected); lower coal costs(substitution of costly domestic coalby imported coal); lower investmentcosts (development of combined-cy-cle gas-fuelled power plants). Obvi-ously, there was a dramatic increasein electricity companies’ profits: theyhave doubled since privatisation, to-talling £3.55 billion in 1994 [MacK-erron, 1995]. More recently, theregulator’s effort to improve compe-tition has forced the industry to passon to consumers a substantial shareof its profit.

The British reform has drasticallychanged the ESI managerial ap-proach. Electricity companies havebeen much more careful in their fore-cast of future electricity consumptionand have worked hard to intensify theuse of their installed capacity. Riskassessment has become a crucial as-pect of electricity companies’ activity.The strategic role of the industry hasmoved rapidly from generators to thedistribution companies.4.2. Chile: guided competitionChile was the first Latin Americancountry to reform the ESI. The Chil-ean electricity system has two maininterconnected grids and two large

isolated electric sub-systems. Thelargest interconnected grid covers thecentral area of the country (4120MW) and the other grid covers theNorth (876 MW); the two sub-sys-tems are located in the South (98 MWand 19 MW).

In contrast to most other countriesin the region, the role of private in-vestors in the Chilean ESI was veryimportant before President SalvadorAllende assumed power and national-ised Chilectra in 1970. Thus, whenGeneral Augusto Pinochet’s regimedecided to privatise the ESI there wasno great political opposition to thismove.

The first step of the Chilean reformwas to address the financial situationof utilities which had deterioratedduring the long period of political tur-moil. This step was necessary in or-der to prepare public utilities for laterprivatisation. The ENDESA, SAESAand FRONTEL distribution compa-nies were the first utilities to be pri-vatised. However, the reform gainedmomentum only after the governmentpromulgated the Electricity Act in1982[13].

The Electricity Act promoted a par-tial deverticalisation of the industry,splitting generation and transmissionfrom distribution. Utilities wereforced to open access to their grid[14]

for other generators, self-gener-ators[15] and large consumers (over2MW) that have to pay a toll to usethe grid. These measures set up theconditions for the development ofcompetition among electricity gener-ators. Moreover, the Electricity Actintroduced a new pricing regime nolonger based on balance-sheet costsbut on economic costs. This repre-sented an enormous stimulus for newinvestments in the industry. In orderto attract private investors to the ESI,the large electricity consumers wereinduced to buy financial instrumentsthat are reimbursed in kind (electric-ity)[16]. Most utilities were privatised,only three utilities remaining in pub-lic hands: EDELNOR, COLBUN andEDYLAYSEN.

In 1985, the regulatory regime wasfurther changed. Centres for dispatch-ing the four main sub-systems (Cen-tros de Despacho Economico de


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Cargas, CDEC) were created in orderto guarantee minimum economiccosts[17] and an agency for monitor-ing the electricity system (Superin-tendencia de Electricidad yCombustible) was introduced as well.The National Energy Commission(NEC) was given the responsibility ofregulating the industry. The NEC es-tablished the tariffs for regulated mar-kets and, very important, it producedan indicative plan that establishes fu-ture investment[18] and operationalcosts, and estimates the cost of lossof load. Electricity projects envisagedin the indicative plan have easiest ac-cess to financial resources endorsedby the government.

A relevant aspect of the new roundof reforms is the pricing system. Itcombines a regulated tariff regimeand a free pricing system. Generatingcompanies can either contract theirpower freely with consumers (over2MW) or sell it to the distributionutilities at tariffs fixed for each barof the system for six months by theNEC. The generators can alterna-tively sell electricity to other gener-ators at their marginal cost, this pricebeing established by the generatorsthat are active in the CDCE, but thisis obviously just an adjusting mecha-nism. NEC tariffs are based on themarginal costs: short-run for opera-tional costs and long-run for invest-ment costs [CNE, 1993]. Here theindicative plan plays a crucial role. Itis important to remark that it is for-bidden to sell electricity at pricesmore than 10% above the respectivebar tariffs. Moreover, tariffs are in-dexed to take into account possiblefluctuations in the exchange rate, fuelprices, wages and general prices.

Distribution companies sell theirelectricity adding their costs[19] to thebar tariff and this price is fixed everyfour years by NEC. Tariffs for con-sumers vary, depending on the den-sity of each market. There are threemain situations: urban areas withhigh density, urban areas with me-dium density and rural areas with lowdensity. The NEC and utilities havestudies conducted for each one ofthese three main situation to fix tar-iffs. Tariffs are calculated using 2/3of costs calculated by NEC studies

and 1/3 of costs calculated by utili-ties.

The Chilean reform is widely per-ceived as being successful. Over 40%of the electricity is sold directly toconsumers, electricity prices remainstable and private capital has been at-tracted to the ESI. It is clear, how-ever, that in contrast to the Britishcase, the Chilean government stillrules substantial aspects of the indus-try. Prices are closely monitored andthe long-term planning for the indus-try is largely conducted by govern-ment authorities.

5. Conclusion

Electricity supply is an infrastructuralundertaking that plays an essential,pervasive role in any modern society.As such, the relationship between theESI and government has been, and islikely to remain in the foreseeable fu-ture, strong. After World War II, mostgovernments opted for public owner-ship to govern the industry, promot-ing the construction of nationalmonopolies that are now stronglycriticised by the World Bank.

At the end of the 1970s, it was pos-sible to identify both advantages andshortcomings of the ‘‘monolithicstate-owned monopolies’’. The big-gest advantage is the centralisation ofoperating and planning activities thatpermitted economic dispatching andoptimisation of investment costs.Public ownership has the additionaladvantage of facilitating coherencebetween energy policy and social, re-gional and industrial policy. This isparticularly important during the pe-riod of construction of the nationalgrid. The biggest shortcoming is thelack of competition that allowed utili-ties to take a soft view of costs, sincethey are automatically passed on toconsumers. From the governancepoint of view, public ownership hasthe disadvantage of government inter-ference in utility management, givingrise to avoidable extra costs.

As soon as the opportunities foreconomies of scale and scope disap-peared, the shortcomings started tooutweigh the advantages. At the sametime, criticism of utilities’ behaviouremerged in ICs and reforms were in-troduced to offer more room for pri-

vate investors and competition in theESI. It is too early to fully evaluatethese reforms. The good news is thatthe trend towards cost escalation wasreversed; the bad news is that con-sumers have hardly profited from thisnew trend. In the long run, the suc-cess of these reforms will be largelydetermined by their ability to com-bine coordination and competition.

Despite the lack of a consistentevaluation of these reforms, theWorld Bank took the view that DCsmust reform their ESI using compe-tition and privatisation as main re-form guidelines. The government rolein the industry should be restricted tosetting policy guidelines and regula-tion. Private investors should be wel-comed into the industry: they willavoid government interference andwill reduce government financing ofthe ESI as well. These are two im-portant outcomes from the point ofview of the Bank. The fiscal situationof DCs is such that any reduction ingovernment expenditures is largelyappreciated by the international fi-nancial community.

Can competition and privatisationhelp to improve the performance ofthe ESI in DCs? This is not an easyquestion to answer. Reform in ICshas proved that it is hard to introducecompetition in the ESI if the benefitsof coordination are to be preserved.Indeed, if competition means morethan privatisation, then the British ex-perience is showing that electricitycompanies have a great deal of powerto induce prices to behave to theirbenefit [de Oliveira and MacKerron,1992]. In this circumstance, the roleof the regulator is far from fading outas initially expected; indeed, theregulator is likely to play a larger andmore consistent role in the govern-ance of the industry. Moreover, to en-force energy policy guidelines,government interference was stillnecessary although the use of subsi-dies[20] made its interference moretransparent.

Reform in England and Wales wasmade easier greatly by the fact thatutilities were financially healthy andthere was no need for substantial in-crease of installed capacity. More-over, there was abundance of natural


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gas that could feed combined-cyclenatural gas-fuelled power plants,which are highly attractive for privateinvestors[21]. This is not the contextof the Latin American ESI. This canlargely explain why the Chilean re-form took another approach: it in-tended to introduce competition andattract private investors to the ESI aswell.

Indeed, electrification is still a keyissue for most Latin American coun-tries. The electricity system is stillbeing developed in most countries ofthe region and there is under-con-sumption of electricity as well.Therefore, it is expected that installedcapacity for generation, transmissionand distribution of electricity willrapidly increase for many years more.Economies of scope and scale are stillrelevant but government and multilat-eral funds that in the past had sup-ported investments in the industry areno longer available. Moreover, elec-tricity in the region is largely basedon hydropower which still has a greatpotential to be exploited. The chal-lenge the region has to face is to at-tract private capital to the industrywithout losing the benefits of econo-mies of scale and scope that plannedcoordination of expansion can pro-vide. From the energy policy point ofview, mechanisms have to be put inplace that will induce generators todevelop the hydro potential in orderto minimise the long-term cost ofelectricity supply.

Chile opted for a pragmatic reformthat combined both competition andmonopoly, private and public invest-ments, centralisation and decentrali-sation of decisions, short-term marketand long-term planned signals. Its re-form was progressive (financial re-form, Electricity Act and furtherregulation controls) and maintainedthe clear objective of avoiding therisk that the benefits of coordinationwere jeopardised by too strong a biastowards private investment and com-petition. It is important to remember:the financial reform intends to im-prove efficiency.

It is patent that the centralised,concentrated, monopoly industrial or-ganisation of the ESI need to be re-formed. A combination of changes in

the supply and demand side of the in-dustry is inducing ICs to reform theirESI. In the case of Latin Americancountries, reform is more urgentlyneeded because utilities are facinggreat difficulties in financing expan-sion plans. Private investors and com-petition will certainly play asubstantial role in the new institu-tional arrangement of the industry butthe reality is proving that it is mis-taken to suggest that the industry willbe governed only by market forces.

Competition will most certainly belimited, possibly aiming to supply bigconsumers and, therefore, access tothe grid is an important policy issue.Although the efficient use of installedcapacity will become increasingly im-portant, Latin American electricitysystems will continue to grow strongfor many years yet. Hence, the bene-fits of a coordinated expansion planare very great still, suggesting that acertain level of centralisation of deci-sion-making must be preserved. Hy-dropower is a central piece in theenergy policy of most countries of theregion but hydropower plants are notattractive to private investors[22].Therefore, policy instruments must beestablished to induce technologicalchoice in accordance with energy pol-icy. It is clear that utilities, eitherpublic or private, can no longer as-sume, as they did in the past, the fullrange of risks associated with elec-tricity projects[23]. Electricity compa-nies, consumers, investors,contractors, energy and equipmentsuppliers will have to share theserisks, using the wide range of instru-ments recently developed by financialmarkets to find the best economicpath for the ESI. In any circum-stances, the industry will increasinglybe governed by contractual arrange-ments and the regulatory regime willplay a crucial role in the new ESIsince it will conduct competition andwill organise the entry of privatecapital in the industry.

Notes1. External factors have been particularly relevant in the

1970s when fuel prices, interest rates, and inflation rateswent up.

2. It is important to note that the use of different standardswas a significant obstacle to the mass production ofelectric equipment, therefore causing greater equipmentcosts as well.

3. It is interesting to remark that this same complaint ismade by public utilities nowadays.

4. More often the Bank staff tends to produce a caricatureof the situation of the ESI of DCs, using data from dif-ferent countries to paint a dark picture of DC utilities’performance. Obviously, this does not contribute to cre-ating a climate of trust among DC policy-makers withregard to the Bank policy guidelines for reforming theESI.

5. It is assumed that higher electricity tariffs will induce therational use of electricity.

6. For instance, tax incentives, exemption from import du-ties, security of profitable tariffs, and guarantee that prof-its can be repatriated.

7. It is interesting to remark that the Bank does not believethat the French formula of ‘‘contract plan’’ can work inDCs.

8. Originally, the nuclear power plants were to be includedwithin two generating companies but there was strongaversion among private investors to owning nuclearpower plants.

9. The transmission company inherited the responsibility ofguaranteeing the stability of the electrical system andordering the dispatching of the power plants.

10. Consumers below 1000 kW were not allowed to buyfrom generators until 1994 and consumers below 100kW will be allowed to buy from generators from 1998.

11. Since privatisation smaller generators have started of-fering electricity to consumers. The substantial expan-sion of co-generation is worth remarking.

12. If the load of the system is over 80% of installed capac-ity, dispatched generators earn a capacity charge to in-duce the construction of additional capacity. Thiscapacity charge depends on the value of loss of load(VOLL) and of the loss of load probability.

13. At that time there was no parliamentary debate in Chile.14. It is important to remark that distribution utilities had not

been relieved of the obligation to supply consumers intheir franchised area.

15. Self-generators play a substantial role in the Chileanelectricity system. For instance, CODELCO (ChileanCopper Company) is a large power producer (464 MW),representing around 64% of the installed capacity of thegrid in the northern part of the country.

16. Aportes Financieros Rembolsables.17. Generators that want to be dispatched need to offer at

least 9MW of power. Initially, this limit was fixed at 62MW.

18. Investments are planned using 10% as discount rate.19. Distribution companies’ investments can yield between

6% and 14% a year.20. In order to improve competitiveness of nuclear power

and renewable energy sources, consumers pay a levyon their electricity bill that is used to subsidise theseenergy sources.

21. Relatively low capital intensity; short construction peri-ods and highly competitive electricity prices.

22. They take time to build up, are capital-intensive and,usually, the use of water for electricity generation isregulated.

23. Environmental, financial, technological, fuel, future con-sumption, etc.

ReferencesBouttes, J.P., and Lederer, P., 1991. ‘‘Electricity: monopolyvs competition?’’, Utilities Policy, Butterworth-Heinemann,April.Collier, H., 1984. Developing Electric Power Systems: ThirtyYears of World Bank Experience, John Hopkins UniversityPress, Baltimore.Commission Nacional de Energia (CNE), 1993. El Sectorde Energia en Chile, Commission Nacional de Energia,Santiago.

De Oliveira, A., and Mackerron, G., 1992. ‘‘Is the WorldBank approach to structural reform supported by the expe-rience of electricity privatisation in the UK?’’, Energy Policy,Butterworth-Heinemann, February.


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De Oliveira, A., and Pinto Jr., H.Q., 1995. ‘‘La restructura-tion des industries electriques d’Amerique Latine: vers unnouveau mode d’organisation?’’, Revue de l’Energie, Edi-tions Techniques et Economiques, Janvier-Fevrier.Mackerron, G., 1995. ‘‘Regulation and the economic out-comes of electricity privatisation in England and Wales’’, Re-

vue de l’Energie, Editions Techniques et Economiques, Jan-vier-Fevrier.Mason, M., GIlling, J., and Munasinghe, M., 1988. A Reviewof World Bank Lending for Electric Power, World Bank,Washington.Organizacíon Latino-Americana de Energia (OLADE), 1988.

The Foreign Debt of the Energy Sector of Latin Americaand the Caribbean, Quito.World Bank, 1993. The World Bank’s Role in the ElectricPower Sector: Policies for Effective Institutional, Regulatoryand Financial Reform, World Bank Policy Paper, Washing-ton.

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electricity system reform: world bank approach and latin american reality

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