Beyond LUMA: Some Lessons from the International Experience Restructuring Electricity Markets

Beyond LUMA: Some Lessons from the International Experience Restructuring Electricity Markets

Published on April 22, 2021 / Leer en español

The agreement between the Puerto Rico Electric Power Authority (“PREPA”) and LUMA Energy for the operation and management of Puerto Rico’s electric grid has been in the public spotlight recently. Many private sector organizations, as well as multiple NGOs, have pointed out the deficiencies of that agreement. Yet, canceling or terminating the agreement with LUMA, by itself, will not solve Puerto Rico’s electricity problems. The fact is that PREPA is a highly inefficient electricity company and its operations have a material adverse effect on the Puerto Rican economy. Therefore, the restructuring of Puerto Rico’s electricity market is inevitable to jumpstart endogenous economic growth.

Yet, the final decision as to how to restructure Puerto Rico’s electricity market will be a function of the interplay among and between different economic and political interests. There is no single, one-size-fits-all, solution for every jurisdiction. Indeed, economies with different institutional endowments have developed different solutions, notably when it comes to the forms of asset ownership in the electric industry, and some have been considerably more successful than others. What, then, are some of the lessons we can draw from the international experience with the restructuring of electricity markets?

First, a little bit of background. During most of the 20th century, customers had no choice with regard to their electricity provider. Customers had to purchase electricity from the utility that held the monopoly, either private or public, for its supply in the area where these customers were located. In most cases, these utilities were vertically integrated and controlled the entire infrastructure for generating, transmitting, and distributing electric energy to these captive consumers.

This business model traditionally known as “build and grow”, based on (1) the construction of increasingly large and efficient centralized generation plants using cheap fossil fuels and (2) a continuous increase in the consumption of electricity, began to fail in the 1970s due to limitations in the achievable efficiency in the generation of electricity, the increase in the price of fossil fuels, new environmental regulations, the reduction in the demand for electricity, and the introduction of new generation technologies using renewable sources.

These structural changes converged with technological advances that for the first time allowed the separation of the production and trading of electricity from the operation and ownership of the utility network. In fact, some economists have argued that the analytical separation of ownership of the utility network from the provision of supplies over that network was “the great innovation of the post-oil shock period” (Newberry, 2001)

Restructuring Electricity Markets

Delivered electric power is a bundle of many services. These include transmission, distribution, frequency control, and voltage support, as well as generation. The first two deliver the power while the second two maintain power quality, other services provide reliability.  Each service requires a separate market and some may require several markets. This raises many questions about which services should be privatized and which should not.

In general, the restructuring of electricity markets involves three inter-related processes. First, restructuring requires the partial deregulation of the electric power market to allow new producers to enter the generation market and to permit them to sell that power over the regulated network.

Second, restructuring entails the opening of the electricity market to competition, at a minimum, in the power generation sector for sale in a deregulated wholesale market. Transmission and distribution services, in certain circumstances, can also be opened to private management.

Third, restructuring could involve, but does not require, the privatization of government-owned electricity assets. In fact, research indicates that countries that have enacted proper regulatory regimes and introduced competition in the electricity sector have experienced greater efficiency gains than countries where only privatization has been undertaken.

Finally, approaches to reform have varied across countries. Therefore, it is quite difficult to compare the restructuring experience across countries, which exhibit different legal frameworks, diverse political and policy preferences, and great variation in economic and institutional endowments.

A team of UK economists (Zhang, Parker, and Kirkpatrick, 2002), however, was able to examine the effects of privatization, competition, and regulation in the electricity sector, using a panel data set covering 51 developing countries, for the period from 1985 to 2000. The performance indicators they used were net electricity generation per capita, installed generation capacity per capita, net electricity generation per employee, capacity utilization, and electricity prices. Their principal findings were as follows:

  • Competition appears to bring about favorable effects in terms of service penetration, capacity expansion, labor efficiency, and prices charged to industrial users.
  • The effects of privatization or having an independent regulator, by themselves, were, however, inconclusive, except for capacity utilization, which appears to be improved by privatization.
  • By contrast, the co-existence of the two reform measures (privatization and having an independent regulator) did seem to be correlated with greater electricity availability, more generation capacity, and higher labor efficiency.

The authors, in short, found significant benefits to be associated with the introduction of competition, privatization, and regulatory reform in the electric power market. However, they did not address the critical policy question of whether there is an optimal sequencing of the reforms. After all, while it may be the case that each of the reforms—privatization, regulation, and competition—is desirable, there is rarely a country that has felt able to introduce all three measures simultaneously.

In a later study, the same authors (Zhang, Parker, and Kirkpatrick, 2004) studied the effects of the sequencing of reforms using a panel dataset of 25 developing countries that had privatized electricity generation in the period from 1985 to 2001. The primary performance indicators used in the study as dependent variables were net electricity generation per capita, installed generation capacity per capita, electricity generation to average capacity, and net generation per employee. Their principal findings were as follows:

  • The results suggest that subjecting generators to competition ahead of privatization reduces and may even remove monopoly incentives to restrict output.
  • The study also found that the establishment of an independent regulator ahead of privatization reduces monopoly effects on output.
  • Supporting evidence was also found with regard to the beneficial effects of reform sequencing on capacity expansion. Specifically, the regression results suggest that putting a regulator in place, in advance of privatization, provides private investors with more confidence to invest and expand capacity.
  • In terms of capacity utilization, the study found that having an independent regulator and introducing competition before privatization brings about increases in capacity utilization.
  • With regards to labor productivity, the results of the study were inconclusive due to data limitations.

In short, this study found that having an independent regulator before privatizing electricity generation is associated with higher electricity availability and more generating capacity; while introducing competition before undertaking privatization in electricity generation appears to bring about favorable effects in terms of service penetration, capacity expansion, capacity utilization, and capital productivity.

In end, however, the decision to restructure electricity markets will inevitably reflect the deeper political and social characteristics of any given society, as will the institutions that evolve in response to those characteristics. Economies with different institutional endowments have evolved different solutions, notably in the forms of ownership, and some have been considerably more successful than others. Therein, perhaps, lie some lessons for Puerto Rico from the international experience of restructuring electricity markets.