Governance of competitive transmission investment in weak institutional systems

Available online at www.sciencedirect.com

Energy Economics 30 (2008) 1306 – 1320 www.elsevier.com/locate/eneco

Governance of competitive transmission investment in weak institutional systems ☆ Manuel A. Abdala LECG, LLC, 1725 Eye St NW – Suite 800, Washington, DC 20006, United States Received 11 November 2006; received in revised form 5 August 2007; accepted 27 December 2007 Available online 9 January 2008

Abstract Despite progress in economic analysis in recent years, transmission investment governance still poses policy design challenges in competitive electricity systems. The degree of regulatory intervention in allocating investment costs is a central issue. Scholars tend to agree that centralized solutions are almost inevitable, mainly due to free riding and coordination problems. In systems with weak institutional endowments and pressures of distributive politics, however, there is an increased likelihood of regulators acting opportunistically or imposing arbitrary changes to the cost allocation rules, which makes centralized solutions less desirable. We provide some examples from Argentina, El Salvador and Peru and suggest that a two-tier governance scheme composed of a self-governing Forum of transmission stakeholders, with regulation as a subsidiary measure, may be a more adequate design to restraint undue government interference. The expected outcome is twofold: a better match with users' preferences and a restraint to government opportunism and arbitrariness. Measuring the robustness of this scheme in minimizing the risks for either too much or too little investment will certainly require further research. © 2008 Elsevier B.V. All rights reserved. JEL: L51; D71; L94 Keywords: Transmission governance; Clubs; Electricity institutions; Transmission investment; Electricity pool

☆ This paper is based on a prior version presented at the International Society for New Institutional Economics (ISNIE) 8th Annual Conference, Tucson, AZ, September 2004. I am grateful for the useful comments and remarks from Stephen Littlechild, Paul Joskow, and Diego Bondorevsky. E-mail address: [email protected].

0140-9883/$ - see front matter © 2008 Elsevier B.V. All rights reserved. doi:10.1016/j.eneco.2007.12.009

M.A. Abdala / Energy Economics 30 (2008) 1306–1320

1307

1. Why weak institutional systems are different It should be of no surprise that a sector riddled by property right problems, free riding issues, externalities, 1 reliability and network coordination conditions has deserved substantive academic and practical attention in the last decade, as these issues raise barriers to optimal investment decisions.2 The setup of proper competitive transmission investment3 arrangements and the degree of centralized regulatory intervention involving cost allocation rules among private parties has been quite a challenging assignment.4 Policy recommendations have often ended up advocating centralized regulatory solutions.5 Centralized or administrative solutions have two principal attractions: first, they save on transaction costs that multiple agents would have to incur to get organized; and second, they allow a more direct regulatory control over activities that typically require government intervention because of all the riddles mentioned above. Centralized solutions, however, have potential disadvantages. Regulatory decisions, when not well designed and implemented, can lead to solutions that deviate from network users' preferences, and thus may create inefficient outcomes.6 In systems with weak institutional endowments, characterized by deficient checks and balances between the different powers of government; insufficient judiciary restraint of administrative decisions; fragile regulatory procedures; and inadequate conflict resolution mechanisms, the disadvantages related to centralized solutions are exacerbated. In weak systems there is a higher exposure to government's arbitrariness,7 opportunism leading to administrative expropriation,8 and redistributive policies9 that turn the allocation of investment costs in unfair outcomes,10 or 1

Transmission investment decisions may cause positive or negative externalities to electricity agents. These agents can be competitors, providers or customers of those who would like to undertake a new investment project. In electricity networks, externalities arise when, for example, the existing capacity of a line diminishes/expands due to a new project. Also, externalities take the form of quality aspects of the network, through changes in system reliability. See Hogan (1999), and Joskow (2003). 2 See Hogan (1999). 3 Transmission investment refers not only to the construction of new lines, but also to the upgrades of network components (i.e. reliability breakers), compensators, capacitors, re-conduction of existing lines, substations, as well as enhancement of communication, control and monitoring capabilities. 4 See, among others, Hogan (1992), Chao and Peck (1996), Hogan (1999), Littlechild (2004), Kristiansen and Rosellón (2003), and Joskow (2003). 5 When organizing network activities with multiple agents such as the operation and expansion of an electricity grid, countries have often resorted to centralized solutions. See Joskow and Tirole (2003), Hogan (2003), and Joskow (2003). 6 See, among others, Demsetz (1969), and Littlechild (2004), and the public choice literature generally. 7 See Levy and Spiller (1996), who argue that regulatory problems are less severe and utility regulation far more credible in countries that restrain discretion from the executive and legislative branches. Weingast (1995), in turn, argues that discretionary powers and centralization of decision-making are behind the lack of economic development of many countries. 8 For general literature on opportunism and risks of administrative expropriation, see, among others, Goldberg (1976), Williamson (1976), McCubbins, Noll and Weingast (1987), McCubbins, Noll and Weingast (1989). For references on how the risk of opportunism is greater in weak institutional systems, see Levy and Spiller (1996), and Spiller (1996). 9 Redistributive politics influencing the rules for cost allocation in transmission investment is present in all countries. However, this problem is exacerbated in weak institutional systems because of politically unstable governments. Political instability triggers more frequent episodes of government interference with pricing and investment policies of utilities, driven ultimately by distributional and macroeconomic concerns. See Spiller (1993), pages 393−394, Heller and McCubbins (1997), and also Levy and Spiller (1996), page 6, who also state that distributive politics can interfere with the allocation efficiency that can be achieved by regulatory incentives. 10 By unfair we mean an allocation of costs that departs significantly from the individual benefits and corresponding willingness to pay of each stakeholder of the project.

1308

M.A. Abdala / Energy Economics 30 (2008) 1306–1320

even worse, in projects that are totally unfeasible for private parties to undertake. The policy recommendation, thus, may well be in the opposite direction to a centralized solution. Several authors have remarked on the importance of regulatory policies that restrain governments from political opportunism in facilitating private sector development (McCubbins et al. 1987, 1989; Levy and Spiller, 1996; Spiller, 1996). For private investment transactions to prosper in electricity transmission, then, not only free riding, network coordination and externalities issues must be dealt with, but also political opportunism must be restrained, and politicization and arbitrariness minimized. Weak institutional systems share the following characteristics. First, arbitrariness may often substitute regulatory discretion.11 In transmission investment, it is common to observe, regardless of the degree of institutional strength or weakness, that the regulator has a critical amount of discretion in determining the rules for the allocation of investment costs. That is, who should pay and how much is often determined by ex-ante rules set by the regulator. Also, regulators typically decide the amount of transmission investment costs that electricity providers can pass-through to end-user tariffs. This kind of regulatory discretion, when adequately exercised, poses normal regulatory risks that are bearable to investors. Discretion, however, may easily be turned into arbitrariness when regulatory decisions are contrary to the prescribed rules or do not follow established regulatory procedures, or when they are politically motivated. In weak systems, then arbitrariness often substitutes objective regulatory discretion.12 The arbitrary setting of investment levels and changes in investment allocation rules is therefore an important concern for private investors in weak systems.13 Second, weak systems are more exposed to Government opportunism that may expropriate (partially or totally) private investor's assets. Expropriation of transmission assets does not normally take the form of nationalization. Rather, it takes more subtle forms of setting usage and access fees low for political and other reasons. Expropriation can also be related to the removal or lack of enforcement of vested transmission rights, or to the mandatory requirement of transmission enhancements and expansions that cannot be recovered through fees. Finally, weak institutional systems are more vulnerable to distributive politics. In electricity transmission, distributive politics may not be very noticeable, but it can take the form of manipulation or appropriation of congestion rents to favor certain expansion projects at the expense of others (including competing projects such as natural gas pipelines and generation plants located at consumption centers) thus altering the market conditions for competitive investments. The underlying reasons for redistributive pressures can be diverse, and may be related to populist governments, political favoritism, discrimination among users, regional distribution of rents, geopolitical considerations, and others. The implications of a larger exposure to government's arbitrariness, opportunism and redistributive policies are twofold. First, and most obvious, it exacerbates the perception of regulatory 11 Whereas regulatory discretion requires the regulator to judge wisely, objectively, and according to the established regulatory norms and procedures, arbitrariness refers to regulatory decisions that are either not objective, contrary to the prescribed rules of the regulatory framework, or falling outside the established regulatory procedures. Often, we observe that arbitrariness is the direct result of politically motivated regulatory decisions. Levy and Spiller (1996), page 6, noted that: “In some countries the only way to curb administrative arbitrariness may be to withdraw almost all administrative discretion.” 12 See North (1990) as well as Levy and Spiller (1996). 13 Notice that arbitrariness not only causes additional risks to private investors but also may result in governments pushing for investment projects that the market would otherwise not undertake, with consumers or taxpayers paying the higher costs. See Littlechild (2004), for instances in which the regulator may end up imposing or accepting investment requirements which may result in over investment, suboptimal location decisions, or both.

M.A. Abdala / Energy Economics 30 (2008) 1306–1320

1309

risks and thus may trigger underinvestment by the private sector, or no investment at all. Second, if any private investment decisions are made at all, they will be distorted by the nature of the government's intervention, which will likely result in a further departure from grid users' preferences, thus implying allocation as well as location distortions.14 While most transmission systems involve centralized regulatory solutions, a few have attempted to provide a role for private investment driven by grid users or by investment allocation rules among users (i.e. based on private initiatives as in Peru and El Salvador, or by incremental physical flows as in Chile or Argentina) rather than centralized regulation or regulation of a monopoly transmission company. Hence, we examine examples at transmission investment in systems where the decision to expand or upgrade the grid does not depend directly on a decision by either the monopoly or the regulator, but rather by the grid users, or by pre-existing rules that determine the allocation of investment costs among grid users. The focus of this examination is in countries with weak institutional endowments. The paper is organized as follows. In Section 2 we present a brief illustration of actual transmission experiences in weak systems, with examples of Argentina, Peru and El Salvador. In Section 3 we make a policy proposition based on a two-tier governance scheme that draws on a self-governance mechanism with a subsidiary regulatory rule. The first tier governance scheme is presented in this section. Section 4 develops the ideas underlying the second tier of governance. Finally, Section 5 presents some conclusions and suggests areas for further research. 2. Brief illustration of transmission investment experience in weak systems 2.1. Argentina The Argentine transmission arrangements have received some attention in the literature given its good performance records in terms of increased reliability and its high degree of ex-ante competition at the construction phase of the projects. How these arrangements work can be found elsewhere in the literature.15 Argentina has experienced the three types of exposure to government intervention that we deal with. First, arbitrariness was manifested in the way the Government recently decided on the reallocation of congested rents.16 Congestion rents were regularly allocated exclusively to support the financing of new transmission projects in the zones where congestion occurred. During 2002–2003, contrary to the rules prevailing for almost a decade, the use of congestions' rents was ”socialized” across regions and also used for other purposes unrelated to transmission investment.17 This move distorted the signals for private investment, as congestion rents not only 14 Unlike allocation distortions that could eventually be resolved through pricing changes, location distortions may have long-lasting effects. 15 See, for example, Abdala (1994), Bastos and Abdala (1993), Abdala and Chambouleyron (1999), Chisari et al. (2001), Galetovic and Inostroza (2004), Littlechild and Skerk (2004a,b). 16 The investment allocation rule in Argentina had been relatively stable for a decade and was recently praised by Littlechild and Skerk (2004a,b) as a rule that, among other features, prevented overinvestment induced by too much state involvement. Other authors have been more critical about the features of the original rule. See, for instance, Abdala (1994), Chisari et al. (2001), Chisari and Romero (2004), or Abdala and Chambouleyron (1999), who noted that “…physical flows are an imperfect measure of benefits because benefits have price and quality dimensions.” Abdala and Spiller (2000), in discussing the transmission investment allocation rule in Argentina, also point out that: “Veto safeguards to protect those receiving negative externalities or those who had to bear a share of investment costs larger than their willingness to pay are insufficient, and there are no provisions for compensation mechanisms.” 17 For more details, see Littlechild and Skerk (2004b).

1310

M.A. Abdala / Energy Economics 30 (2008) 1306–1320

would not longer be consider as a complementary source of private project financing, but also could be diverted to competing (and perhaps even inefficient) projects.18 Second, there was Government opportunism. In early 2002, the Government decided to freeze all tariffs in the public utilities, including electricity transmission. It also ordered the mandatory conversion of public and private contracts in foreign currency to domestic currency at belowmarket parity.19 Both measures ultimately altered the ability of private transmission investors to recover their expected returns, and consequently, send wrong signals for future private investment for both incumbents and newcomers. Finally, there was the issue of distributive politics. As explained in Littlechild and Skerk (2004b), the Government took steps to promote a more active role of the state in the location, size and drafting of 500 kV transmission lines since late 1999.20 It then fostered a “Federal Plan” to boost further interconnection among regions, including areas with no major consumption centers in the present or in the foreseeable future.21 The Federal Plan was to be financed by mixed private–public participation. Public funding was to be levied through a nationwide surcharge fee payable by electricity consumers. Since inception, so far, only one out of five major projects had started under this scheme.22 The Federal Plan represents an example of redistributive politics playing at hand, interfering with private investment decisions; as the specific projects fueled by the government ultimately will crowd out alternative private initiatives. The Government further distorted market signals when in 2003 decided to fund a public– private natural gas pipeline project, linking the northwest region (interconnected with Bolivia) with the northeast regions. The decision was nurtured by redistributive purposes, as the Government was pursuing lower future tariffs for natural gas and electricity users, via subsidization of the natural gas pipeline.23 Since in Argentina natural gas pipelines are in many cases direct competitors of transmission lines, the decision by the government to subsidize pipelines broke its “hands off” policy in place for almost a decade. Argentina then offers a very good example at hand of a weak system whose original design was particularly tailored to foster decentralized private transmission investment, but nonetheless had been already exposed to arbitrariness, opportunism, and redistributive politics. 2.2. Peru The electricity law in Peru generally provides the conditions for decentralized private investment decisions, driven mainly by the interests of grid users. Although the two main transmission companies were not privatized at the time of the reform, the initial regulatory design tried to create conditions to foster private investment related to new expansion projects. 18 We do not discuss here the efficiency features of the established rule for allocating congestion rents to finance new projects. 19 See Law 25,156. 20 See Littlechild and Skerk (2004b), pages 31−43. 21 The Federal Plan had the natural support of some stakeholders, like constructors as well as incumbent transmission companies. 22 This is the interconnection of the system with the southernmost part of Patagonia, a 345 km line. Other projects yet to be undertaken are a 660 km line between Comahue-Cuyo; a 1045 km link between the northwest and northeast regions; a 165 to 215 km line between Cuyo and mining regions in the northwest; and a 500 kV line joining the Abastos node with the city of Mar del Plata, within the Buenos Aires province. 23 The Government picked up the private partner for the construction and operation of the pipeline in a non-competitive process. For more on the effects of regulatory rules and decisions on the competition between natural gas pipelines and electricity transmission in Argentina, see Chisari and Romero (2004).

M.A. Abdala / Energy Economics 30 (2008) 1306–1320

1311

Transmission investment in Peru was originally intended to develop under the assumption that transmission tariffs should allow private investors to recover its operating costs, amortization and a normal return on investment. In practice, however, the setting of tariffs in the transmission sector has not only been complex, but also subject to the discretion and judgments of the regulator, in particular in the identification of potential beneficiaries and thus on who would eventually be allocated the burden of the investment costs. Indeed, in a 2003 consulting report prepared to the Peruvian authorities, it is stated that those interested in transmission investment had the feeling that the regulator “…was not doing enough to define objective, transparent criteria and processes for determining tariffs.” It is also said that: “…market agents can find that their transmission tariffs change significantly from year to year for reasons that they cannot predict, control, or even understand after the fact”.24 Other authors share the view that the lack of clarity in the initial rules, plus the fear of arbitrary decisions by the regulator led, as a consequence, to very few projects maturing under the initial scheme.25 This perception led the government to start granting special guarantee arrangements under BOOT26 contract arrangements to enhance private investment.27 As explained in the 2003 consulting report: “…the most significant transmission investments in Peru (e.g. a major line to the south of the country) have been built only when the Government entered into BOOT contracts that guarantee the transmission owners an attractive rate of return, with the contract's costs recovered from consumers as a whole, independent of the “normal” tariff-setting process outlined below breferring to the lawN” As a consequence, in Peru we observe two types of exposures to Government interference. First, in an environment where the initial rules of the games are too complex and unclear, the fear of arbitrariness seemed to have prevented any meaningful private investment in the first stages after electricity reform. Second, the government-backed system of guarantees on BOOT projects opened the window for other type of arbitrariness (i.e., what type of project to support, at what price, etc.) and eventually redistributive politics,28 which, contrary to the effects of the fears of government interference in the first phase, may result in overinvestment. 2.3. El Salvador In El Salvador, the electricity law provides some freedom for stakeholders to engage in transmission investment activities under private arrangements. When projects are supposed to have joint benefits to existing grid users, however, the project plan must be determined by the 24

See Ruff (2003), pages 18 and 24. According to Ruff (2003) only small projects related to reactive compensation near Lima which directly benefited one or two parties have prospered within the original scheme. According to Gallardo et al. (2003) the initial regulatory incentives for transmission investment were not too clear in identifying the allocation of costs among beneficiaries. Campodónico (1999) identifies similar problems. 26 BOOT stands for build, own, operate and transfer. For more details on how BOOT transmission contracts operate in Peru see De la Cruz and García (2003), page 41. 27 For example, the transmission line Mantaro-Socabaya (in Arequipa), which links the network systems between the north and the south was granted under a BOOT arrangement to a consortium led by Hydro-Québec, for US$ 179 millions. See Campodónico (1999). 28 Redistributive politics in this case takes the form of competition for the guarantees among politicians from different regions, which want to see BOOT projects developed in locations that benefit their constituencies. 25

1312

M.A. Abdala / Energy Economics 30 (2008) 1306–1320

pool company and administrator, the UT, (or Unidad de Transacciones), whereas the final decisions on how to allocate the project investment costs must be taken by the regulator, SIGET. Dussan (2003) believes that the fact that no transmission project of joint benefits have ever prospered since the liberalization of the sector in 1997, the procedure has not worked well given that some expansions are apparently needed.29 In his view, one bottleneck to the current mechanism is that the UT does not have a long-term view to plan projects. The apparent shortfall of transmission expansion, however, maybe the consequence of the initial conditions, given that El Salvador's system started off operations with transmission excess capacity, and given that to date there are no signs of major transmission constraints. If the latter is the case, then one may conclude the opposite of Dussan's opinion, as the observed lack of investment may be a reflection of efficient market-driven decisions. Despite a successful story of privatization coupled with full liberalization of the electricity market (taking place since 1996), the implementation of the rules of the games (which are neither too detailed, nor too specific) and the setting of prices in El Salvador has been vulnerable to government interference, both through regulation and through the action of the state-owned CEL, which is the dominant generator in the market.30 There is indeed evidence that CEL has been able to influence outcomes in the electricity market in recent years. In a newspaper article, CEL's admitted that in January 2003 it manipulated down spot market prices when they exceeded US $130 per MWh.31 Similarly, in late March 2003, CEL forced prices down from the historic US $50–80 per MWh band to less than US$5 per MWh. In this case, the apparent purpose of this price reduction was to avoid an increase in retail prices prior to an election date. The implementation of the rules of the game for private transmission investment, thus, is perceived by private parties as riddled with uncertainties, inasmuch as it is unclear to what extent UT, SIGET, and CEL may influence the outcome of private transmission initiatives by decisions that can be considered arbitrary. The practical results of this potential problem are yet to be commensurate. 3. Policy proposition: the forum as the first tier of the governance scheme Given the problems of undue government interference that weak systems are so much exposed to, we look for a governance scheme with basic properties to attempt to isolate these problems. A general property to avoid undue government interference is to have users as primary decision makers. A system that places the investment initiatives and closing decisions in the hands of the private sector would be better prepared to resist undue government interference than a system in which the government has ultimate control of the investment decision process. As a consequence, users will be better suited to determine what they want, to start with, without the government trying to impose its own investment agenda, which may not only deviate from market preferences, but also be driven by redistributive politics to begin with. 29 According to Millán (1999),“There are still considerable improvements to be made in transmission and distribution facilities, damaged during the war and deteriorated further due to low levels of investment in maintenance and expansion programs. It has already caused major problems in the reliability of the operating system.” 30 A high level of concentration characterizes the wholesale electricity market in El Salvador. CEL controls more than half of total installed capacity. By December 2003, CEL held 53% of installed capacity and generated 59% of total injections to the national system. In addition, CEL's planned investments mean an expansion of El Salvador’s capacity at a 6.5% per year, twice the 3.3% rate of expansion of the demand over the 1999−2004 period. 31 See La Prensa Gráfica, “Presidente de CEL admite manipulación de Precios” (CEL's President admits price manipulation), April 9, 2003.

M.A. Abdala / Energy Economics 30 (2008) 1306–1320

1313

Second, the governance scheme has to be more resistant to government interference. The higher the degree of consensus and acceptability of its outcomes, the higher will be the level of resistance. This is because interference becomes more costly for the government when all (or at least the strong majority) transmission stakeholders32 have consensus on what projects to undertake, and how much to pay for them. Attempts to impose arbitrary, opportunistic or redistributive decisions would be harder for the government than in the absence of stakeholders' consensus. We suggest that weak systems can benefit from a two-tier governance scheme that relies primarily on a self-governing forum of transmission stakeholders (henceforth the “Forum”), with minimum regulatory oversight. We propose that this may turn out to be a more adequate governance scheme than centralized regulatory solutions or than ex-ante, centrally designed investment allocation rules. The inherent problem with centralized regulatory decisions, which is applicable to either weak or strong systems, is that it is difficult for a centralized agent to assess the preferences of investors when considering the addition of a new transmission line.33 Beneficiaries of new transmission investment belong to different classes of stakeholders (ISO,34 transmission firms, generators, distributors, electricity traders, industrial users, etc.) who are likely to benefit in different ways,35 have different risk profiles, sector-specific risk premium (and hence discount rates), and therefore distinctive willingness to pay. In addition, transmission stakeholders are likely to have different views on the expected utilization rate of the new transmission asset and the stream of economic benefits associated with any particular investment project.36 Finally, new transmission projects have an impact on electricity prices, which are likely to vary through time. The dynamics of allocating investment costs then becomes very complex.37 All the problems mentioned above are exacerbated in weak systems, as private investment becomes more exposed to undue government interference. Let us then analyze the first tier of the proposed mechanism, which hinges heavily on selfgovernance. The mechanism works under the following premises: 1. Open eligibility: The Forum is open to all qualified transmission stakeholders, seriously interested in transmission investment, with the only exception of small end-users whose direct representation is indeed cumbersome. Forum membership does not need to be restricted to existing grid users, that is those with a facility (demand or supply side) connected to the 32 A transmission “stakeholder” is any private party interested in the outcome of transmission investment projects. Natural stakeholders are grid users that buy and sell electricity, but there could also be other stakeholders from complementary activities, such as natural gas producers, constructors, suppliers, as well as parties just interested in the financing of new projects. 33 Similarly, it is cumbersome for the regulator to disentangle grid users' preferences on quality standards, a typical feature of common-pool resources. See, for example, Ostrom (1990). 34 ISO refers to the independent system operator. On the ISO as a relevant stakeholder, Hogan (1999) argues that one of the main challenges for competitive systems is the analysis if grid expansion opportunities will at some stage involve the ISO. Hogan believes that “The timing, degree of participation, and incentives for the ISO are subjects of controversy.” 35 For example, a trader may benefit from an increase in its volume of sales; a generator may benefit because of the relief of a transmission constraint, which was previously restraining its dispatch capabilities; an industrial user may benefit because of lower electricity prices due to cheaper energy from remote locations, etc. It is very difficult for a centralized agency to know the magnitude of these benefits (and thus the willingness to pay of each stakeholder). 36 For instance, the centralized solution has to deal with questions such as: how does the centralized decision (or ex-ante rule) take into account what the market wants in terms of location, size and timing of new transmission projects? How does it allocate investment costs among stakeholders? Are all stakeholders properly identified? Who is the ultimate bearer of the risks for the potential underutilization of transmission lines? 37 Hogan (1999) recalls that whenever the investment significantly changes prices, this could lead to a continuing role for regulation to approve expansions with associated allocations of the cost and benefits.

1314

2.

3.

4.

5.

38

M.A. Abdala / Energy Economics 30 (2008) 1306–1320

network, as policy makers do not want to promote a closed club that may prevent entry of new stakeholders.38 Consensus and revelation of preferences: Self-governance relies on voting rules and enforcement.39 As a general principle, for a voting mechanism to be successful in creating consensus, it has to promote self-revelation of preferences among members. Each investment project requires to be approved based on a system of votes, vetoes, compensation arrangements, and a multiple-round English-type auction40 of financial commitments. Votes are essential to get a majority consensus about project seeking special considerations for objections or for compensation arrangements.41 The auction mechanism, in turn, must be designed so as to induce parties to gradually reveal their preferences as to how much they are willing to pay for any particular project (see Phases IV and V below).42 Compensation arrangements: Forum members expecting to receive negative externalities from a particular project, (due to changes in expected utilization, loop flows or potential overriding of pre-existing transmission investments) can request compensation. Compensation mechanisms are important because, unlike other market arrangements, common-pool networks may generate negative externalities that if not dealt with, can result in investment deadlocks. Requests for compensations have to be approved by strong Forum majorities and, to avoid room for exaggerated demands, petitions are subject to eligibility rules and caps set by the Forum itself. The compensation mechanism has the purpose to avoid majority stakeholders impose negative effects on minorities that can be negatively affected by projects.43 Vetoes: The voting rules to determine project approval and compensation schemes can be complemented with veto arrangements, to deal with special situations that may create internal deadlocks in the process of project approval. Enforcement: Without enforcement, the mechanism is certainly not sustainable.44 Enforcement of fulfillment of financial commitments is a critical aspect. This can be dealt appropriately through financial guarantees at the time of the auction, and through the use of binding legal provisions.

Membership provides the basis for enforcement of Forum rules (i.e., like a stock or commodity exchange association). Ideally, interested parties become members of the Forum only voluntarily. However, one could imagine arrangements in which membership is a requirement, at least for grid users. 39 See, for example, Ayres and Braithwaite (1992), Steins and Edwards (1999), and Loehman and Kilgour (1998). 40 A so-called “English” auction is an ascending-type auction in which the price is successively raised until there is a winner bid or until there is a full allocation of the goods being auctioned off. 41 See the parallelism of voting rules for governance of electricity transmission organizations and network coordinators in Barker et al. (1997). See also Abdala and Spiller (2000) on examples of voting rules in the regional forum FREBA, in Argentina and MACS in New Zealand. 42 There are many features that must be taken into account in the design of a multiple round English auction with binding activity rules, in which each stakeholder has an independent assessment of the value it attaches to each particular investment project. First, activity rules that mandates interested stakeholders to bid (or be active) in all rounds must be in place so as to avoid “wait and see” bidding strategies. Second, bidding will stop only when the sum of the individual bids reach the value of the estimated project cost. Thus, this estimate acts not only as a natural ceiling on the sum of all bids but also as an incentive to reveal true willingness to pay. Third, the auction must be progressive, in multiple-rounds, so as to allow bidders to gradually learn about the valuation preferences of other bidders. This, combined with the activity rules and the ex-ante knowledge of the estimated cost of the project, generates an incentive to bid up to maximum willingness to pay. Fourth, giving the requirement of the estimated budget, there should not be any bid ringing concerns. For more on auction properties, see Vickrey (1961, 1976), and Klemperer (1999), among others. 43 There is always the possibility that the compensation sought by stakeholders that are negatively affected may exceed the amount of oversubscription. This can be dealt with additional auctioning rounds to begin with, and with supplementary voting and veto arrangements, so as to avoid internal deadlocks. 44 See Menard (2000).

M.A. Abdala / Energy Economics 30 (2008) 1306–1320

1315

6. Competitive tenders for construction stage: An important ingredient to keep final construction cost as low as feasible is to allow competition for the construction stage of the project. Projects selected by the Forum are approved on the basis of estimated construction costs. Actual construction costs, however, may differ from the estimates. Third-parties (others than the ones helping in the project design) must then be allowed to bid for the construction stage. Cost wise, the benefits of introducing competitive tenders at this stage can be significant.45 The mechanism works as follows, with the following phases: Phase I: Forum members present initiatives on transmission projects. Each project initiative is listed and tagged with its location, technical specifications and estimated investment cost. Phase II: A time is allowed for Forum members to evaluate each initiative, and to allow the regulator to express concerns on technical and location specifications, as well as eventual approvals for end-users' tariff pass-through for Load Serving Entities (LSEs) that may also be Forum members.46 Informal and tentative arrangements for a voluntary allocation of costs for each project are dealt with at this phase. Phase III: After evaluation, Forum members can present objections and/or petitions for compensation (due to negative externalities) to any particular project. A technical committee within the Forum evaluates the ground for these requests, and may deny them due to lack of merit. For compensation requests that are deemed commendable, project initiators are asked to accept the amounts of compensation as an item to be added into the estimated project costs. If project initiators do not agree with the size of the compensation, the final amount is determined by majority of Forum member votes in Phase IV. Phase IV: The Forum calls for a general assembly in which the final allocation of costs for each project is made through a multiple-round auction process. Prior to the first round, all pending issues regarding compensation requests and objections are settled under strong majority assembly's votes.47 In the first auction round, each stakeholder reveals the amount of money that he is willing to commit in the financing of any listed and pre-approved project. Projects that get fully subscribed (that is, that generates financial commitments at least equal to the estimated investment costs) receive a stage approval, showing success and consensus in the critical test of financial commitment. Projects that are undersubscribed in the first auction round pass to the second round. The subscriptions are incremental like in most multiple-round ascending auctions, with minimal amounts and activity rules required in each round.48 This subscription mechanism allows stakeholders to reveal preferences among competing investment projects at a very low 45

See Galetovic and Inostroza (2004). See Section IV. 47 Each Forum should decide how to best deal with voting arrangements. For some cases, the rule of one vote per member may be suitable, whereas in others it might be best to have a voting system leaned towards parties that have a larger stake on the transmission network. 48 Notice that positive externalities are internalized throughout the coalition formation process, which finally ends up in Forum members revealing its preferences through the auction process. As with most self-governance arrangements in common-pool networks, however, there is no assurance that free riding will be eliminated completely, as stakeholders that benefit only in a small proportion of a particular project may decide not to subscribe at all speculating that others (those apparently benefiting the most) may fully subscribe up to the estimated investment cost. Notice also that some level of free riding may be tolerable to the stakeholders that co-pay for a certain transmission project. This is a feature that is not different from what can actually be observed in associations that share common facilities such as homeowner associations, fisheries, groundwater basins, irrigation systems, forests, grazing, etc. In the Forum, auctions that allow various rounds will tend to ameliorate this free-riding problem. 46

1316

M.A. Abdala / Energy Economics 30 (2008) 1306–1320

transaction cost, as well as to turn down projects that do not generate enough consensus on its realization and/or on the degree of financial commitment.49 Phase V: Auction rounds end when there is no more bidding activity or when the sum of all bids reach the estimated project cost. Projects that get full subscription are approved and will be called for competition in the construction costs. Projects that did not get full support, on the other hand, are turned down, until the next time the Forum open up the process for new initiatives. The organization of the Forum must be such that transaction costs are minimized, so that in principle members can reach satisfactory outcomes for all its relevant projects. Investment projects that are approved within the Forum mechanism will have the main advantage of being best aligned with users' preferences, as compared to centralized decisions. Since the decision to subscribe financial funding to a particular project involves some risk (i.e. the risk of not fully recovering the investment), the mechanism also has the advantage of being best aligned with the proper allocation of ex-ante risks, as compared to centralized solutions in which the central agency mainly decides who bears the risks of the investment. The timing, location and size of the projects should also be better aligned with market-driven outcomes, as opposed to centralized solutions. A mechanism based exclusively on this first tier, nevertheless, has some potential drawbacks. First, there might be high transaction costs in setting up the new institution and in getting agreements among stakeholders with divergent interests. Second, although closer in conception to a market solution, the mechanism provides no guarantee that an efficient outcome will be achieved. Third, free riding may not be fully eliminated.50 Fourth, there is the risk that Forum members perceive themselves as a “club” and act accordingly to exclude competitors and new entrants to their industries.51 Finally, there is the issue of the representation of end-users in the Forum. End-users (with the exception of large customers) are certainly not Forum members because of representation problems, and neither is the regulator that may act on their behalf. In most places, retail tariffs are regulated, and therefore the extent of transmission investment costs pass-through depends on the regulatory rules at place. LSEs will need prior permission from the regulators to know in advance the extent of the pass-through, and therefore, they will find that their financial capability to commit support to their relevant projects in the Forum will be conditioned upon the extent of regulatory approval.52 The last two limitations of the first tier level (end-user representation and the antitrust considerations) require the involvement of the regulator. We thus discuss next the second tier of the governance mechanism, in which there is a role for the regulator.

49 The great advantage of this mechanism as opposed to direct negotiations among Forum members is that bidders can learn, in real time and at almost no cost, about the values of other bidders through the progressive open bidding process. Thus, the auction minimizes the transaction costs related to direct-party negotiations, in which stakeholders spend time and effort in trying to identify who the other stakeholders are, and, once identified (if at all) to assess their willingness to pay. The proposed auction provides free real-time information as to the stakeholders’ willingness to pay, as opposed to direct negotiations, which can eventually turn into deadlocks. 50 See footnote 30. 51 Inefficient investment in the transmission grid could be used to create market power in generation by imposing new bottlenecks. See Hogan (1999). 52 Other regulatory restrictions on investment transmission cost pass-through may also affect power purchase arrangements (PPAs) that have reliability guarantees at point of deliveries, as this can be a way for generators subscribing voting rights at the Forum to pass-through costs to end-users. If regulators put constraints on the extent of PPAs passthrough, which is often the case, these generators will face similar uncertainties in “voting capabilities” as they LSEs peers.

M.A. Abdala / Energy Economics 30 (2008) 1306–1320

1317

4. Second tier of the governance scheme: the subsidiary regulatory rule The regulator has at least two roles (potentially three) in this governance scheme. First, the regulator must determine pass-through rules to end-users prior to Forum members deciding on the allocation of investment costs for each project. Second, the regulator can certainly object a project based on a number of technical issues of the project (i.e. environmental, rights of way, inadequate location, etc.). Third, the regulator can eventually act as the institution of last resort to solve Forum deadlocks. This is an optional route and will depend on the institutional characteristics of each country. 4.1. Pass-through rules for transmission investment costs Deciding the extent of pass-through the regulator is a difficult task. A low pass-through rate may make the participation of the LSEs unfeasible or insufficient, whereas a full pass-through scheme will prevent the LSEs from bearing any risks related to the investment decision (i.e. under utilization of the line). To allow LSEs participation in the Forum as an active stakeholder, with a sort of “limited” representation of end-users money, the regulator needs to set up an appropriate pass-through rule which will of course depend on the regulatory framework and the tariff regime in place, and in some cases, on special features of the proposed projects.53 4.2. Technical approval A second need for regulatory intervention is related to the technical, location and environmental specifications of the project. In the Forum mechanism, before projects get to the auction stage, they should have at least a pre-approval from the regulator on all technical matters, that is, site studies, environmental impact on urban and rural areas, network compatibility, etc. 4.3. The regulator as an arbitrator of last resort? Finally, there is a third aspect in which the regulator could intervene. The Forum may not be completely free of deadlocks due to lack of agreement among members. Since in most if not all competitive systems there is open access to the network, Forum members undertaking a particular investment project will not be able to prevent access from other future users who, for example, may decide not to finance the project. Thus, those members committing resources to investment costs need a certain degree of protection from free riding coming from future grid users. In some systems, partial protection against inter-temporal free riding may already be in place through a combination of access fees, congestion charges and other charges.54 These existing mechanisms, however, may turn out insufficient or incomplete. Hence, there is a room for the regulator to provide a last-tier resort to ensure protection when voluntary agreements are not possible, or when outcomes are perceived to be unfair.

53 Depending on the regulatory regime in place, there might be certain projects that require special pass-through rules. This is often the case of large projects, as opposed to upgrades or marginal incremental capacity. Notice that a lack of definition of the pass-through rule may impede the participation of the LSEs as an effective stakeholder in the Forum. 54 For some interesting ideas on market-driven transmission expansion based on transmission rights, see Kristiansen and Rosellón (2003).

1318

M.A. Abdala / Energy Economics 30 (2008) 1306–1320

Notice that the sector regulator however, may not be the only institution able to play this role. Although technically the most knowledgeable, in some countries private arbitration or mediation courts may play a role, as well as eventually the judiciary. 5. Conclusions The main thrust of this paper is that in weak institutional systems, the exposure to government opportunism, arbitrariness and redistributive politics may seriously undermine the incentives for private transmission investment. Examples from some countries reflect these problems. In Argentina, we observed the three types of problems, all of them resulting in distortions to private investment decisions. Either too much or too little investment can result in Argentina under the existing rules, which are far more centralized than when they were originally put in place, in 1992. In Peru, the fear of arbitrariness in the implementation transmission tariff rules, which form the basis for cost recovery in new transmission projects, led to an apparent lack of private investment in the first stages after reform. Later on, the decision by the Peruvian Government to provide guarantees to support targeted BOOT projects opened room for redistributive politics to develop. Finally, in El Salvador, the regulatory design opens the door for arbitrariness in the implementation of transmission investment allocation rules, either via the pool company, the regulator or the main electricity provider, all of them under state-owned control, which is seen as a potential deterrent to private investment. We propose that a two-tier transmission investment governance scheme based on self-governance with a subsidiary regulatory rule works better than centralized regulatory solutions in weak institutional systems. The first tier of the governance scheme serves two main purposes. First, it puts a natural restraint on the temptation by government to exercise arbitrariness, opportunism and redistributive policies when dealing with transmission line projects. This is because private parties as opposed to government actions ignite the main investment decisions and because it becomes more costly for the government to interfere with agreements that enjoy high consensus from transmission stakeholders. Second, it better aligns the outcomes on the allocation of investment costs with those of network customers' preferences. These two features have its advantages. Investment outcomes that are better aligned with users' preferences, with the proper allocation of ex-ante risks, will promote a better outcome on the timing, location and size of the projects, and thus the risk for allocative and location distortions are minimized. In addition, the mechanism should be more attractive for private investment, as the risks of arbitrary or opportunistic governmental behavior are diminished. The two-tier mechanism proposed in this paper draws heavily in the practical experience of the FREBA forum, developed and created in Argentina in 2001. To date, investment arrangements in this forum have been undertaken relatively smoothly, and there were no major conflicts among stakeholders. In one perspective, this can be viewed as a positive aspect. On the other hand, we can also say that the institution is still too young, and that its robustness has not been fully tested yet. Certainly, many more practical experiences would need to be evaluated for more comprehensive assessments from case-study analysis. The experiences of two-tier governance mechanisms in non-weak systems also provide useful information. In Victoria (Australia), in New Zealand and in some regions of the United States at the pool coordinator level there are experiences that are worth exploring to assess how governance issues have been functioning, and to learn lessons that can be extracted to transmission investment forums in weak institutional systems.

M.A. Abdala / Energy Economics 30 (2008) 1306–1320

1319

Given that a natural consequence of self-governance in the use of a common-pool network is the internalization of externalities, one of its crucial features for the Forum to be effective is the provision of incentives that lead to self-revelation of preferences, and the efficient resolution of conflicts among grid users. We proposed a voting system based on strong majorities to decide on potential objections and compensations, as well as a multiple-round English auction to allow stakeholders to reveal willingness to pay and allocate the financial support that each of them can commit to any specific investment project. The mechanics can surely be fine-tuned to further minimize transaction costs of self-governance. The role of the regulator or other enforcers providing a second-tier protection level is important to complement this proposition, as regulators have a role in deciding how much of the transmission investment costs can be allocated to end-users. Furthermore, the regulator has to make sure that the Forum does not transform into a closed “club” that may hinder entry of new competitors, either at the transmission or the generation level. Finally, in our proposition we do not discuss how governments reach a decision of self-restraint like the one involved in this proposal. This would indeed be a research topic in itself. We know, however, that for governments to be able to self-restrain interference has to be costly. We argue that when there is ample consensus among grid users and other stakeholders, interference is more costly for the government. The proposed two-tier governance mechanism is thus a procedure that attempts to minimize transaction costs so as to get ample consensus through self-governance with minimum regulatory oversight, which in turn will make it less vulnerable to government intervention. Further research and empirical evidence is needed to test the robustness of decentralized investment initiatives in weak systems. References Abdala, M.A., 1994. Transmission pricing in private-owned electricity grids: an illustration from the Argentine electricity pool. XXIX Annual Meeting of Asociación Argentina de Economía Política. Abdala, M.A., Chambouleyron, A., 1999. Transmission investment in competitive power systems. decentralizing decisions in Argentina. Public Policy for the Private Sector 192. Abdala, M.A., Spiller, P.T., 2000. Decentralized investment and quality decisions in common pool networks. XXXV Annual Meeting of Asociación Argentina de Economía Política. Ayres, I., Braithwaite, J., 1992. Responsive regulation: transcending the deregulation debate. Oxford Socio-legal Studies. Oxford University Press, New York. Barker, J., Tenenbaum, B., Woolf, F., 1997. Governance and regulation of power pools and system operators: an international comparison. World Bank Technical Paper 382. Bastos, C.M., Abdala, M.A., 1993. Reform of the Electric Power Sector in Argentina. Buenos Aires. Campodónico, H., 1999. Las Reformas Estructurales del Sector Eléctrico Peruano y las Características de la Inversión 1992–2000. CEPAL Serie Reformas Económicas, p. 25. Chao, H., Peck, S., 1996. A market mechanism for electric power transmission. Journal of Regulatory Economics 10 (1), 25–59. Chisari, O., Romero, C.A., 2004. Transmission investment decisions in a club with imperfect representation: the case of Argentina in the nineties. International Society for New Institutional Economics (ISNIE) 8th Annual Conference. Chisari, O., Dal-Bó, P., Romero, C.A., 2001. High-tension electricity network expansion in Argentina: decision mechanisms and willingness-to-pay revelation. Energy Economics 23, 697–715. De la Cruz, R., García, R., 2003. La Problemática de la Actividad de Transmisión Eléctrica en el Perú. Algunas Opciones de Política. Report prepared for Consorcio de Investigación Económica y Social. Demsetz, H., 1969. Information and efficiency: another viewpoint. Journal of Law and Economics 1–22. Dussan, M.I., 2003. Diagnóstico Preliminar del Mercado Mayorista. Paper prepared for MINEC. Gallardo, J., García, R., Pérez-Reyes, R., 2003. Determinantes de la Inversión Eléctrica. OSINERG Working Paper, p. 12. Goldberg, V., 1976. Regulation and administered contracts. Bell Journal of Economics 7 (2), 426–448. Galetovic, A., Inostroza, J.R., 2004. Transmisión Eléctrica y la ‘Ley Corta’: Por Qué Licitar es (mucho) Mejor que Regular. Documentos de Trabajo Serie Economía Centro de Economía Aplicada Universidad de Chile, p. 177.

1320

M.A. Abdala / Energy Economics 30 (2008) 1306–1320

Heller, W., McCubbins, M., 1997. Political institutions, utility regulation, and economic development in Argentina and Chile: the case of electricity. Journal of Policy Reform 1 (4), 357–387. Hogan, W., 1992. Contract networks for electric power transmission. Journal of Regulatory Economics 4, 211–242. Hogan, W. Electric Transmission Adequacies and Market Institutions. Mimeo presented at the Meeting of the NARUC Committee on Electricity 1999. Hogan, W., 2003. Electricity deregulation: where to from here? Paper presented at Bush Presidential Conference Center Texas A&M University. Joskow, P., 2003. The difficult transition to competitive electricity markets in the US. The Cambridge–MIT Institute Electricity Project DAE Working Paper Series, p. 28. Joskow, P., Tirole, J.P., 2003. Merchant transmission investment. The Cambridge–MIT Institute CMI Working Paper, p. 24. Klemperer, P., 1999. Auction theory: a guide to the literature. Journal of Economic Surveys, Blackwell Publishing 13 (3), 227–286. Kristiansen, T. and Rosellón, J. A Merchant Mechanism for Electricity Transmission Expansion. Mimeo 2nd Workshop on Applied Infrastructure Research, TU Berlin / DIW Berlin 2003. La Prensa Gráfica, 2003. Newspaper. April 9. Littlechild, S., 2004. Transmission regulation, merchant investment, and the experience of SNI and Murraylink in the Australian national electricity market. The Cambridge–MIT Institute Electricity Project DAE Working Paper Series, p. 37. Littlechild, S.C., Skerk, C.J., 2004a. Regulation of transmission expansion in Argentina Part I: state ownership, reform and the fourth line. Cambridge Working Papers in Economics, p. 0464. Littlechild, S.C., Skerk, C.J., 2004b. Regulation of transmission expansion in Argentina Part II: developments since the fourth line. Cambridge Working Papers in Economics, p. 0465. Levy, B., Spiller, P.T., 1996. Regulations, Institutions, and Commitment: Comparative Studies in Telecommunications. Cambridge University Press, London. Loehman, E., Kilgour, D., 1998. Designing institutions for environmental and resource management. In: Loehman, E., Kilgour, D. (Eds.), New Horizons in Environmental Economics. Elgar, Cheltenham. McCubbins, M.D., Noll, R.G., Weingast, B.R., 1987. Administrative procedures as instruments of political control. Journal of Law, Economics, and Organization 3, 243–277. McCubbins, M.D., Noll, R.G., Weingast, B.R., 1989. Structure and process, politics and policy: administrative arrangements and the political control of agencies. Virginia Law Review 75, 431–482. Menard, C., 2000. Enforcement procedures and governance structures. In: Menard, C. (Ed.), Institutions, Contracts and Organizations. Perspectives from New Institutional Economics. Edward Elgar Publishing, Cheltenham. Millán, J., 1999. Profiles of power sector reform in selected Latin American and Caribbean countries. Environment and Natural Resources Division, IDB. North, D., 1990. Institutions, Institutional Change, and Economic Performance. Harvard University Press, Cambridge. Ostrom, E., 1990. Governing the Commons: The Evolution of Institutions for Collective Action. Cambridge University Press, Cambridge. Ruff, L., 2003. Transmission Pricing in Peru: Interim Report by PEPSA. (Unpublished mimeo). Spiller, P.T., 1993. Institutions and regulatory commitment in utilities' privatization. Industrial and Corporate Change 2 (5), 387–450. Spiller, P.T., 1996. Institutions and commitment. Industrial and Corporate Change 5 (2), 421–452. Steins, N., Edwards, V., 1999. Synthesis: platforms for collective action in multiple-use common-pool resources. Agriculture and Human Values 16 (3), 309–315. Vickrey, W., 1961. Counterspeculation, auctions and competitive sealed tenders. Journal of Finance 16, 8–37. Vickrey, W., 1976. Auction, markets, and optimal allocations. In: Amihud, Y. (Ed.), Bidding and Auctioning for Procurement and Allocation. New York University Press, New York. Weingast, B., 1995. The economic role of political institutions: market preserving federalism and economic development. Journal of Law, Economics, and Organization 11. Williamson, O., 1976. Franchise bidding for natural monopolies – in general and with respect to CATV. Bell Journal of Economics 73.