Why is it difficult for markets to work in the electricity sector ?

Our core arguments

  1. Reliable and affordable electricity is key to development. Citizens cannot go about their daily lives without transportation, refrigeration and many other products and services which depend significantly on electricity. Modern businesses cannot survive without reliable and affordable electricity. Income levels and quality of life of Indians cannot be improved without reliable and affordable electricity. Hence, decarbonisation of electricity cannot be the only objective of the electricity sector policy. Any sector reform program (including reliance on competition and market forces) has to be tested on its ability to provide cheap and reliable electricity.
  2. Most of the challenges of the electricity sector in India are in distribution. Most distribution companies have high transmission and commercial losses. It is extremely difficult to create competition in distribution. Privatization with enlightened and strong political and bureaucratic support is what has worked.
  3. Market means producers and consumers being free to choose each other. This is difficult to do in the electricity sector because demand and supply is bid for and matched days in advance and this makes it easier to manipulate the market. More importantly, in India cross subsidy makes creation of markets almost impossible. Finally, to create meaningful markets, supply from existing producers would need to be allotted to new players. All these make the electricity markets synthetic and unlike most other markets.
  4. If somehow a market for electricity were to be created, the price signals would have no influence on most electricity suppliers. The dominant coal producer in the country, Coal India Limited (CIL), does not respond to price signals. India has a high share of hydroelectricity and many dams have dual objectives of irrigation and electricity generation with the former taking priority. It is impossible to set up nuclear power generation plants based purely on market signals without any government involvement. Renewable energy has thrived because it was kept outside the power market, and was required to be dispatched whenever available.
  5. Leaving fuel choice and capacity addition to market forces can be disastrous for India. If private investors do not invest in fossil fuels, and electricity storage solutions do not become cost-competitive at large scale, India could fall foul of its objective of reliable and cheap energy. Achieving the objectives of cheap & reliable power and decarbonisation will need a calibrated, dynamic balance; the Government will necessarily need to be actively involved in this.

Our argument in detail

Before we begin, it is important to state what this article is not about. This article is not about maintaining the status quo. This is not an argument for continuing with public sector dominance of the power sector, and the regular bail outs of Distribution Companies (discoms). We very much welcome private sector investment and associated efficiencies; but want to caveat the challenges in harnessing those efficiencies, and point out why “let Govt get out of the way” is neither feasible nor consistent with the energy sector goals of the country.

Cheap and reliable energy is critical for development

a. India needs affordable energy to increase income levels

Affordable energy is critical for development. History shows that economic growth accompanies periods when energy is available cheaply. As Vacalav Smil points out in his book “How the world really works” while talking about the oil crisis of 70s,

b. Reliable electricity is critical to modern life

Energy should not only be cheap but also reliable, i.e. available on demand. Modern life is not possible if energy is not available reliably. We would not be able to perform basic functions like cooking at home and commuting to our work place. Logistics chains would not be able to supply all the goods that we consume.

c. Governments will intervene if the market makes electricity prices go high

If electricity is not cheap and reliable the society suffers. If ice cream or ball bearing supplies are not cheap and reliable, it is a minor inconvenience. In that sense, electricity is similar to any other infrastructure sector like roads, telecom and ports. Like any other infrastructure industry, society should be investing for the demand we would see tomorrow and not today but markets may not always ensure that. This is because, for producers, the benefits of shortages and the costs of over capacity may be symmetrical but for a society the cost of shortages may be much more than the cost of overcapacity. We will look at this issue in detail in our section on markets.

Power sector cannot have “all players as creatures of the market”

The electricity sector can be understood as three broad segments. a. The transmission and distribution wires (along with the transformers, capacitors, meters, etc); b. the power plants that generate the electricity that flows over these wires and into our homes, malls, farms and factories and c. customers.

a. Viable discoms are prerequisite to creating a market

The wires business (transmission and distribution) is a natural monopoly. It does not make sense to have multiple grids in a region. For example, anyone setting up a second transmission wire from a distant power plant to the grid would always be outcompeted by the existing player.

  • Accurately measuring the electricity consumption for the customer categories that are subsidized.
  • Raising tariffs for the subsidized customer categories.
  • In case, the state decides to subsidize a certain category of customers, making sure that it pays the subsidy to the distribution company in time and in full.
  • Stopping theft of power.
  • Reducing technical losses.

c. Discom viability depends on regulation, political will, fiscal space, and perhaps privatisation

The first thing to note is that these improvements, if they happen, will not be driven by competition but by the regulator and by the distribution company operator. More importantly, all the above require a tremendous amount of political will. A big risk for any private entity is whether the political will to support such reforms will continue in face of protests, electoral reverses and change in government. Added to the risks is the challenge that the return of the distribution company is capped by regulation. This incentivises private operators to indulge in illegal practices such as gold plating investments (that is inflating the cost of equipment to get a higher return) potentially negating the benefits of increased efficiency.

Electricity markets are synthetic; need careful monitoring

There are two levels at which competition works in the power sector (not mutually exclusive). One is known as Bulk Supply competition, where generators and large purchasers (primarily Discoms), transact in a Power Market. The other is known as Retail Supply competition, where multiple suppliers compete to supply to end consumers, using the wires of the discom.

a. Competition cannot be effective if price regulation prevents cost-reflective tariffs

Let us talk about Retail Supply competition. This is the ideal world that is imagined by those in favor of unleashing market forces. Monopoly distribution companies that are regulated (and contribute a very small proportion of the overall cost); and several suppliers (generators and traders), providing tailored packages to different types of consumers. Customer choice, as in case of telecom and direct-to-home entertainment, is expected to be replicated in the power sector. Setting up customer choice is extraordinarily difficult. Let us discuss some of the difficulties.

b. State Governments do not have the fiscal space to allow prices to reflect costs

How difficult is it to eliminate Cross Subsidies? It is so difficult that State Governments insisted on the Electricity Act to be amended, so that the provision to eliminate cross subsidies can be deleted. On all India average basis, industrial and commercial consumers pay Rs 7.4 per unit and Rs 8.1 per unit, while domestic and agricultural consumers are charged Rs Rs 4.5 per unit and Rs 0.75 per unit. The difference is wider in several States.

c. Consumers cannot respond to price signals if prices are not deregulated

Finally, we note that if customers are subsidized, then those customers would not respond to price signals. A farmer that is getting free power has very little incentive to not waste it by leaving the water-pump on all night, for example. Additionally, the cost of power varies by time of the day and time of the year. For a power market to function, this will need to reflect in consumer end tariffs. Implementing Time of Use tariffs requires advanced meters to be installed at the consumer end. While a program to do so is underway, it will take a long time. Considering the large population of consumers that have not paid flat meter based tariffs, implementing time-of-use based pricing poses a challenge for regulators and discoms.

d. Even in developed countries, power markets have been gamed

If governments were persuaded to remove cross subsidies and provide timely subsidies, we would face another set of difficulties in creating markets in electricity. Electricity markets are synthetic, and prone to gaming; so difficult to set up and regulate. Why is this?

e. Reallocation of contracts, to reduce market dominance, will be complex and long drawn, to avoid charges of favoritism

This is not all. If markets have to be set up for electricity, existing depreciated assets have to be allocated to all suppliers of electricity fairly. If, as an incumbent, I own generation assets that have been paid for, and have contracts with power producers who run depreciated plants, then I would have an advantage over any new comers. These assets have to be distributed over all newcomers for any competition to be meaningful. However, this redistribution would be done in a process designed in the backrooms of government and corporations. Hardly a description of competitive markets.

Most power producers in India cannot respond to price signals

Most of the generation capacity in the country cannot respond effectively to price signals. Coal fuelled thermal power plants are responsible for approximately three fourths of electricity generated in the country. For the older depreciated plants, fuel costs constitute most of the costs. More than half of these plants get coal from Coal India Limited (CIL). CIL is almost a monopoly and does not respond to price signals. If it did, it would have produced much more coal and not forced users in the country to import more than 200 MT every year.

Markets cannot deliver the balance between energy security and decarbonisation requirements of the country

Energy prices have shot up across Europe and the world since the beginning of the Russia Ukraine war. Energy bills for households have gone up many fold across Europe and businesses are in trouble even in industrial power houses like Germany.

Summary

We have discussed that ‘markets can take care of our problems in the electricity sector’ is a very misleading statement.

  • The objective of reliable and cheap energy should be at the heart of any reform and markets, left to themselves, do not deliver on this objective.
  • The biggest reform is needed in distribution, and competition is not possible there.
  • Making distribution viable would require the political will and fiscal capacity to address subsidies and cross subsidies, and institutional strengthening regulatory authorities and discoms to deliver efficiency improvement. None of these are outcomes of a market; these are prerequisites
  • If these are done, creating a functional electricity market will still be a formidable challenge. It would require allocating existing generation assets (or privatising them), and strong institutional mechanisms to enforce rules and prevent gaming. By nature, electricity markets are ‘constructed markets’. Very different from markets in most other products and services.
  • Even if somehow an electricity market were to be created, most generators would not be able to respond to price signals. Coal supply is a monopoly, hydroelectric plants run according to irrigation needs and not power needs, and renewable energy plants need to be dispatched whenever they are running.
  • Similarly, at the consumer end. If the market leads to shortage and/or price increases, Governments will intervene. The cost of energy shortage to the economy is very high; unlike ball bearings.
  • Finally, capacity addition (in terms of choice of fuel, location, size) cannot be left to market forces. Synthetic markets are not good at delivering reliability, nor in discovering the appropriate cost of reliability. That private investors do not want to invest in fossil fuels (which are the cheapest source of reliable power at present) only compounds this challenge. Considering that the cost of energy shortage is significantly higher than the cost of under-utilisation of assets, Governments will need to remain actively involved in the balance between energy security and decarbonisation.

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Yogesh Upadhyaya

Yogesh Upadhyaya

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Entrepreneur. Economist. Investor. Actor. Technophile. Policy wonk. Comedian. I love to explore places where these worlds intersect.