Module1: Introduction

The power industry across the globe is experiencing a radical change in its business as well as in an operational model where, the vertically integrated utilities are being unbundled and opened up for competition with private players. This enables an end to the era of monopoly. Right from its inception, running the power system was supposed to be a task of esoteric quality. The electric power was then looked upon as a service. Control consisting of planning and operational tasks was administered by a single entity or utility. The vertical integration of all tasks gave rise to the term vertically integrated utility. The arrangement of the earlier setup of the power sector was characterized by operation of a single utility generating, transmitting and distributing electrical energy in its area of operation. Thus, these utilities enjoyed monopoly in their area of operation. They were often termed as monopoly utilities. Why were earlier utilities the monopolies'? The reason for monopoly can be traced right back to the early days when electricity was comparatively a new technology. The skeptical attitude of the government towards electricity led to investment by private players into the power sector, who in turn, demanded for the monopoly in their area of operation. This created a win-win situation for bothgovernment and the electrical technology promoters. However, the government would not let the private players enjoy the monopoly and exploit the end consumer and hence introduced regulation in the business. Thus, the power industries of initial era became regulated monopoly utilities . The structure of a conventional vertically integrated utility is shown in Figure 1.1. As evident from the figure, there was only a single utility with whom the customer dealt with. Thus, only two entities existed in the power business: a monopolist utility and the customer.

Fig 1.1 What does regulation mean? The regulations are generally imposed by the government or the government authority. These essentially represent a set of rules or framework that the government has imposed so as to run the system smoothly and with discipline, without undue advantage to any particular entity at the cost of end consumer. All practical power systems of earlier days used to be regulated by the government. This was obviously so. The old era power industries were vertically integrated utilities and enjoyed monopoly in their area of operation. Whenever a monopoly is sensed in any sector, it is natural for the government to step in and set up a framework of way of doing business,

in order to protect end consumer interests. Some of the characteristics of monopoly utility are: 1. 2. 3. 4. Single utility in one area of operation enjoying monopoly. Regulated Framework: The utility should work under the business framework setup by the government. Universal Supply Obligation (USO): Utility should provide power to all those customers who demand for it. Regulated Costs: The return on the utility's investments is regulated by the government.

In a nutshell, regulation is about checking the prices of the monopolist in the absence of private players and market forces.

Reasons for restructuring / deregulation of power industry

The next obvious question is, what is deregulation or restructuring of an industry? From the name, one can sense discontinuation of the framework provided by the regulation. In other words, deregulation is about removing control over the prices with introduction of market players in the sector. However, this is not correct in a strict sense. An overnight change in the power business framework with provision of entry to competing suppliers and subjecting prices to market interaction, would not work successfully. There are certain conditions that create a conducive environment for the competition to work. These conditions need to be satisfied while deregulating or restructuring a system. Sometimes, the word deregulation may sound a misnomer. Deregulation does not mean that the rules wont exist. The rules will still be there, however, a new framework would be created to operate the power industry. That is why the word deregulation finds its substitutes like re-regulation, reforms, restructuring, etc. The commonly used word in Europe is liberalization of power industry; deregulation is a more popular phrase in US. If the power industries worked successfully with the regulated monopoly framework for over 100 years, what was the need for deregulating or changing the business framework of the system? There are many reasons that fuelled the concept of deregulation of the power industry. One major thought that prevailed during the early nineties raised questions about the performance of monopoly utilities. The takers of this thought advocated that monopoly status of the electric utilities did not provide any incentive for its efficient operation. In privately owned utilities, the costs incurred by the utility were directly imposed upon the consumers. In government linked public utilities, factors other than the economics, for example, treatment of all public utilities at par, overstaffing, etc. resulted in a sluggish performance of these utilities. The economists started promoting introduction of a competitive market for electrical energy as a means of benefit for the overall powerector. This argument was supported by the successful reform experiences of other sectors such as airlines, gas, telephone, etc. Another impetus for deregulation of power industry was provided by the change in power generation technology. In the earlier days, cost-effective power generation was possible only with the help of mammoth thermal (coal/nuclear) plants. However, during the mid eighties, the gas turbines started generating cost effective power with smaller plant size. It was then possible to build the power plants near the load centers and also, an opportunity was created for private players to generate power and sell the same to the existing utility. This technology change, supposed to have provided acceleration to the concept of independent power producers, supported the concept of deregulation further. This technology change is supposed to have provided acceleration to the concept of independent power producers. This further supported concept of deregulation. This was specifically true where the financial losses were apparently high which was prevalent in some of the developing countries. It should be noted that these are the indicative or major reasons for introducing the concept of deregulation in power industry. There are many other reasons as well. One of the important reasons is the condition under which power systems were regulated, did not exist any more. There was no wind of skepticism about the electrical technology and all the initial investments in infrastructure were already paid back. Further, the deregulation aims at introducing competition at various levels of power industry. The competition is likely to bring down the cost of electricity. Then, the activities of the power industry would become customer centric.

The competitive environment offers a good range of benefits for the customers as well as the private entities. It is claimed that some of the significant benefits of power industry deregulation would include: 1. 2. 3. 4. Electricity price will go down: It is a common understanding that the competitive prices are lesser than the monopolist prices. The producer will try to sell the power at its marginal cost, in a perfectly competitive environment. Choice for customers: The customer will have choice for its retailer. The retailers will compete not only on the price offered but also on the other facilities provided to the customers. These could include better plans, better reliability, better quality, etc. Customer-centric service: The retailers would provide better service than what the monopolist would do. Innovation: The regulatory process and lack of competition gave electric utilities no incentive to improve or to take risks on new ideas that might increase the customer value. Under deregulated environment, the electric utility will always try to innovate something for the betterment of service and in turn save costs and maximize the profit.

The deregulation of the industry has provided electrical energy with a new dimension where it is being considered as a commodity. The commodity status given to electrical power has attracted entry of private players in the sector. The private players make the whole business challenging from the system operators point of view, as it now starts dealing with many players which are not under its direct control. This calls for introduction of fair and transparent set of rules for running the power business. The market design structure plays an important role in successful deregulation of power industry.

Understanding the restructuring process

The process of deregulation has taken different formats in different parts of the world. Also, the reasons for power sector to adopt the reforms vary from country to country. For the developed countries, introduction of competition to achieve social welfare was probably the most important reason. On the other hand, the developing countries mainly banked on the capacity addition through entry of private players. It is observed that neither, there is lone reson for driving deregulation of power industry nor is there a single objective of the same. The restructuring process starts with the unbundling of the originally vertically integrated utility. This essentially leads to separate the activities involved in an integrated power system leading to creation of functional partition amongst them. For example, the unbundling of power industry involves separating transmission activity from the generation activity. Further, distribution can be separated from transmission. Thus, these three mutually exclusive functions are created and there are separate entities or companies that control these functions. Then, the competition can be introduced in the generation activity by allowing other private participants in this segment. In contrast to the vertically integrated case where all the generation is owned by the same utility, there is a scope for private players to sell their generation at competitive prices. The generators owned by the earlier vertically integrated utility will then compete with these private generators. The transmission sector being a natural monopoly is most unlikely to have competing players in the sector. This is because for natural monopolies like transmission companies, the business becomes profitable only when output is large enough. Figure 1.2 shows the representative structure of deregulated power system. In contrast to the vertically integrated utility structure, it can be seen that there are many alternative paths along which the money flows. It is evident that there are many more other entities present, apart from the vertically integrated utility and the customers. It should be noted that there can be many more versions of deregulated structure.

Various Entities Involved in Deregulation: The introduction of deregulation has introduced several new entities in the electricity market place and has simultaneously redefined the scope of activities of many of the existing players. Variations exist across market structures over how each entity is particularly defined and over what role it plays in the system. However, on a broad level, the following entities can be identified: 1. Genco (Generating Company): Genco is an owner-operator of one or more generators that runs them and bids the power into the competitive marketplace. Genco sells energy at its sites in the same manner that a coal mining company might sell coal in bulk at its mine. Transco (Transmission Company): Transco moves power in bulk quantities from where it is produced to where it is consumed. The Transco owns and maintains the transmission facilities, and may perform many of the management and engineering functions required to ensure the smooth running of the system. In some deregulated industries, the Transco owns and maintains the transmission lines under the monopoly, but does not operate them. That is done by Independent System Operator (ISO). The Transco is paid for the use of its lines. Discom (Distribution Company): It is the owner-operator of the local power delivery system, which delivers power to individual businesses and homeowners. In some places, the local distribution function is combined with retail function, i.e. to buy wholesale electricity either through the spot market or through direct contracts with Gencos and supply electricity to the end use customers. In many other cases, however, the Discom does not sell the power. It only owns and operates the local distribution system, and obtains its revenue by wheeling electric power through its network. Resco (Retail Energy Service Company): It is the retailer of electric power. Many of these will be the retail departments of the former vertically integrated utilities. A Resco buys power from Gencos and sells it directly to the consumers. Resco does not own any electricity network physical assets. Market Operator: Market operator provides a platform for the buyers and sellers to sell and buy the electricity. It runs a computer program that matches bids and offers of sellers and buyers. The market settlement process is the responsibility of the market operator. The market operator typically runs a day-ahead market. The near-real-time market, if any, is administered by the system operator. System Operator (SO): The SO is an entity entrusted with the responsibility of

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ensuring the reliability and security of the entire system. It is an independent authority and does not participate in the electricity market trades. It usually does not own generating resources, except for some reserve capacity in certain cases. In order to maintain the system security and reliability, the SO procures various services such as supply of emergency reserves, or reactive power from other entities in the system. In some countries, SO also owns the transmission network. The SO in these systems is generally called as Transmission System Operator (TSO). In the case of a SO being completely neutral of every other activity except coordinate, control and monitor the system, it is generally called as Independent System Operator (ISO). Customers: A customer is an entity, consuming electricity. In a completely deregulated market where retail sector is also open for competition, the end customer has several options for buying electricity. It may choose to buy electricity from the spot market by bidding for purchase, or may buy directly from a Genco or even from the local retailing service company. On the other hand, in the markets where competition exists only at the wholesale level, only the large customers have privilege of choosing their supplier.

Understanding the restructuring process

Electricity, as a commodity, can not be compared with any other commodity traded in the market. This is because it has some distinguishing characteristics of its own, which demand satisfaction of technical constraints before accomplishing the commercial trades. Two important features of electricity as a commodity are: need for real time balance and inability to wheel the commodity through desired path (in bulk). Hence, a set of principles laid down by standard micro-economic theory can not be mapped directly to the electricity commodity markets. Tackling network congestion is one of the challenging issues of the de-regulated era. Transmission network provides the path through which transactions are made in a power market. But each transmission network has its own physical and operating limits like line flow limits, bus voltage magnitude limits and more. The power injection and withdrawal configuration should be such that no limit gets violated. If the network is operated beyond these limits, it may, even, result in the entire system blackout. Therefore, any arbitrary set of transactions cant be organized on the power network. This has given rise to a new problem under the restructured power system environment, referred to as congestion management. There are many ways in which congestion is formally defined but to explain in simple words, when some components in a power network appear to be overloaded due to a trading arrangement, that particular arrangement is said to create congestion on the network. The purpose of congestion management is to make necessary corrections in order to relieve congestion. It can be easily appreciated that under the vertically integrated structure, network congestion, in fact, is not a challenging task. This is because all the resources in the system are under the direct control of the monopolist. Thus, this is the sole responsibility of the monopolist to maintain its transmission network. Provision of ancillary services is another tough task carried out by the system operator under the deregulated framework. Ancillary services are defined as all those activities on the interconnected grid that are necessary to support the transmission of power while maintaining reliable operation and ensuring the required degree of quality and safety. Under the deregulated power system environment, the system operator acquires a central coordination role and carries out the important responsibility of providing for system reliability and security. It manages system operations like scheduling and operating the transmission related services. The SO also has to ensure a required degree of quality and safety and provide corrective measures under contingent conditions. In this respect, certain services, such as scheduling and dispatch, frequency regulation, voltage control, generation reserves, etc. are required by the power system, apart from basic energy and power delivery services. Such services are commonly referred to as ancillary services. In deregulated power systems, transmission networks are available for third party access to allow power wheeling. In such an environment, the ancillary services are no longer treated as an integral part of the electric supply. They are unbundled and priced separately and system operators may have to purchase ancillary services from ancillary service providers.

Then, there are certain issues like market design and market power which need regulatory intervention. Issues pertaining to market design revolve around choice made in the selection of dispatch philosophies, choice of various pricing schemes, choice between number of markets with multiple gate closures, etc., from various alternatives. The market architecture, which maps various markets on timeline, is also an important sub-topic of market design process. Existence of market power shows the signs of deviation from the prefect competition. In general, market power is referred to as ability of market participants to profitably maintain the market price above or below the competitive level for a significant period of time. To tackle the situation, an indirect regulatory intervention in the form of market design rules is needed. Thus, as mentioned earlier, deregulation does not mean ceasing to have rules. It is the restructuring of the power business framework. More rigorous treatment to these issues is given in further chapters.

Reasons and objectives of deregulation of various power systems across the world Restructuring or deregulation is a broad term and can have different meanings in different countries. This is because the changes essential for betterment of power sector depend on the prevailing conditions in the power sector of respective countries. Further, the word betterment can be looked upon subjectively. For example, well developed, industrialized countries can expect price to go down and these countries can treat the change in the prices as betterment. On the other hand, the developing countries need to make radical changes in the policy and regulation such that barrier to entry for private players is removed. The effective betterment can be looked upon from this perspective for developing countries. In this section we will see, in brief, the issues that led to restructuring of the power industry for following regions / countries: US , UK , Nordic Pool and developing countries. The US The US electric utilities, from the very beginning were privately owned and worked in a vertically integrated fashion. The developed countries like US had well functioning and efficient electricity systems. However for some systems, so long as consumers were concerned, they were not satisfied with the rising costs of electricity. For some other systems, utility management found that running the system was not viable due to low tariff. In some systems, pressure from smaller players to open up the business for competition played a major role. By and large, deregulation took place in developed countries by pressure to reduce costs while simultaneously increasing competitiveness in the market. Existence of market power shows the signs of deviation from the prefect
competition. In general, market power is referred to as ability of market participants to profitably maintain the market price above or below the competitive level for a significant period of time. To tackle the situation, an the indirect regulatory intervention in the form of market design rules is needed. Thus, as mentioned earlier, deregulation does not mean ceasing to have rules. It is the restructuring of the power business framework. More rigorous treatment to these issues is given in further chapters.

The UK The transformation of the British power sector proceeded along three paths in 1990.

First, the traditional industry was unbundled both vertically and horizontally. Highvoltage transmission assets were transferred to a new National Grid Company (NGC). Coal and oil fired units were divided among two companies National Power and PowerGen. Nuclear Electric retained control of all nuclear units. At the outset, National Power had 52 percent of total generating capacity, PowerGen had 33 percent, and Nuclear Power had the remaining 15 percent. The second set of changes involved ownership. Both National Power and PowerGen became private companies in 1991, whereas the difficulties associated with nuclear power resulted in continued government ownership of all nuclear units. Approximately 30 percent of shares in National Power and PowerGen were sold to the public,an equal amount to foreign and institutional investors. The remaining 40 percent was held by the government until 1995. The third set of changes sought to open the system to competition, wherever possible, while continuing necessary regulations. Vertical and horizontal restructuring of power generation was based on the assumption that generation had become workably competitive and would become increasingly so with new market entrants. A report on reform process was floated by the regulator in 2001 which stated that wholesale electricity prices had not fallen in line with reductions in generators input costs and that a lack of supply side pressure and demand side participation; and inflexible governance arrangements had prevented reform of the arrangements. The Nordic Pool The reforms in Nordic countries were inspired by the electricity market reforms in England and Wales in 1989, as well as by widely held beliefs that increased competition would raise power industry efficiency to the benefit of consumers. Norway was first amongst the Nordic countries to liberalize its electricity market in 1991, but without privatization. The Norwegian electricity sector remains almost entirely in public hands. Rather than implement national reforms, the other Nordic countries chose to reform by merging with the existing Norwegian market, Sweden joining the expanded Nordic pool in 1996, Finland in 1998 and Denmark in 1999. The Developing Countries The case of developing countries is different from that of other countries. In these countries, the electricity supply is treated as a social service rather than a market commodity. The ownership of the power sector in these countries is directly under the governments of respective countries. These state owned-controlled systems have led to the promotion of inefficient practices over a period. The power sectors of these countries are marked by supply shortages. There has been an inability to add to the generating capacity. The subsidies and high transmission and distribution losses are the major concerns before these systems. Another consequence of state control over electric utilities was the high level of overstaffing. The inability to raise funds for capacity addition invited financial support from international financial institutions like World Bank. These institutions mandated opening of the power sector for private companies which were contracted under build, own, operate and transfer (BOOT) scheme.