Electricity market structure matters, says Prof. Anton Eberhard

CESP NEWS

September 27, 2004

Originally appeared in Business Day in South Africa, September 23, 2004

SA's looming power shortages will probably be averted, but at what cost to the economy? Eskom is starting to recommission old mothballed coal-fired power stations. It now appears that government will authorise Eskom to procure further power-generation capacity to meet peak electricity demand in 2006-07. Meanwhile, the minerals and energy department has initiated a private sector tender to procure new capacity in 2008.

SA's growing electricity demand will require capacity additions each year. Due to the long lead times many of the investment decisions need to be made soon. In 10 years about R100bn will have to be committed to new power generation projects. The magnitude of these new investments creates both opportunity and risk. If capital is allocated efficiently then the electricity industry will contribute to increased economic growth and competitiveness.

If poor decisions are made on market structure, technology and timing of investments, cost increases will be passed to consumers with negative consequences for economic performance and social welfare. An analysis of the performance of Eskom over the past 50 years indicates this is exactly what happened during the last investment cycle.

Electricity consumers faced a real increase of 70% between 1974 and 1978, and high prices continued through the 1980s because Eskom ordered power stations that were not needed. Electricity prices are no cheaper today in real terms than in the early 1950s or mid-1970s. This implies that despite massive new investment Eskom has not achieved lasting or dramatic efficiency improvements. And prices are again increasing.

One could argue that Eskom today is a different organisation. Its commercial management has improved since the 1980s. It operates as a company with a (government) shareholder agreement specifying performance expectations. The National Electricity Regulator is progressively imposing a more rigorous cost-of-service regulatory regime.

The institutional model of a publicly owned monopoly industry means risks are shifted disproportionately to consumers or taxpayers. Because of information asymmetries, the regulator will never have a perfect picture of costs and potential efficiency gains.

What are the alternatives? Two broad electricity market models have emerged over the past two decades. The first is competition for access to the electricity market. The private sector is encouraged to invest in new power-generation capacity through tenders or auctions.

If well managed, competition can result in improved efficiencies in technology and investment choices.

The second electricity market model involves competition between electricity generators and suppliers to dispatch and sell electricity to consumers. Competition is managed through a power exchange or bilateral markets or both, and risks managed through derivative financial markets. What is emerging is a hybrid model. Eskom, which generates 96% of our electricity, has been given responsibility for immediate new investment.

Eskom is also exploring new options, including joint-venture investments. At the same time, government is proceeding with a tender for new private independent power producers (IPPs). Meanwhile, cabinet decisions in 2001, and subsequent design work on a power exchange and bilateral contract electricity market, appear to be on hold.

Ministers now indicate competition is not a priority and Eskom's unbundling or privatisation in the short term is unlikely. But no new or comprehensive electricity policy has been announced. The situation creates a lot of uncertainty for private investment. Uncertainty means higher risks and costs.

What is the sensible way forward? Clearly the first step is for government to spell out the institutional and market structure within which new power investments will be made. If the preferred model for the next few years is for IPPs to come into the market then the procurement of these multibillion-rand investments will need to be managed by an institution with robust financial, technical and contracting capability. Government departments and the regulator are not well positioned to fulfil this function.

This leaves Eskom as a possible candidate, but it cannot be both player and referee. An obvious solution is for Eskom's transmission division and system operator to be unbundled into a separate company (still state-owned). A new, single-buyer office could be established within this company to be responsible for system planning and capacity procurement. This is a relatively uncomplicated, no-regrets option that could be accomplished within 18-months.

In the medium to long term, it makes sense to separate potentially competitive elements of the industry (generation and supply) from noncompetitive, natural monopoly components (transmission).

The cabinet agreed to this is 2001. There is every reason now to proceed. It solves the immediate need for creating a robust, transparent and fair process for new generation procurement, while establishing a platform for possible competition in the future.

It is equally clear what not to do. It would be disastrous to privatise Eskom or sell a strategic equity stake without first unbundling Eskom and creating conditions for competition. Privatisation in the existing industry would restrict government options for creating a more competitive structure in the future.

The above approach has many advantages for Eskom. Its business model could shift from defensive to being a forward-looking company, confident it can succeed in competitive markets, in SA, and internationally.

Government is turning its attention to large-infrastructure industries. It is committed to ensuring these industries receive substantial new investment and that efficiencies are improved. Getting the structure of the electricity market right will be an important first step.

Eberhard is a professor at the Graduate School of Business at the University of Cape Town.