editorial boardbookstore.teri.res.in/docs/journals/ijrg 1-1(all).pdf · 2015-07-29 · assistant...

Assistant EditorK P EashwarTERINew Delhi, India

EditorLeena SrivastavaTERINew Delhi, India

Editorial board

Associate EditorMeeta MehraTERINew Delhi, India

Mr Ian AlexanderRegional Coordinator, East and

South AsiaPublic–Private Infrastructure

Advisory FacilityProgram Management UnitThe World Bank, Singapore

Mr Ashley C BrownExecutive DirectorHarvard Electricity Policy GroupKennedy School of GovernmentHarvard UniversityUSA

Prof Anton EberhardInfrastructure Industries Reform

and Regulation ProgrammeGraduate School of BusinessUniversity of Cape TownPrivate Bag Rondebosch 7701South Africa

Dr Michelle Michot FossDirector, Energy InstituteC T Bauer College of BusinessUniversity of HoustonUSA

Prof. M Nurul IslamProfessorBangladesh University of

Engineering and TechnologyInstitute of Appropriate TechnologyBangladesh

Dr Raymond LawtonDirectorThe National Regulatory Research

InstituteThe Ohio State University, OhioUSA

Prof. Mohan MunasingheDistinguished Visiting Professor of

Environmental ManagementUniversity of Colombo, Sri Lanka

Dr R K PachauriDirector-GeneralTERI, India

Prof. S L RaoChairmanForum of Indian RegulatorsIndia

Prof. Dr Lineu Belico dos ReisEscola Politécnica da Universidade

de São Paulo - PEA USPAv. Prof. Luciano GualbertoBrazil

Prof. Rohan SamarajivaVisiting Professor of Economics of

InfrastructuresFaculteit TBM, TechnischeUniversiteit Delft, The Netherlands

Dr E A S SarmaPrincipalAdministrative Staff College of IndiaIndia

Mr S SundarDistinguished FellowTERI, India

Mr Steve ThomasSenior FellowPublic Service International

Research UnitSchool of Computing and

Mathematical SciencesUniversity of Greenwich, UK

Theory and practice of governance of the British electricityindustrySteve Thomas . . . 1

Incentive regulation and multi-year price controls: anapplication to the regulation of power distribution in IndiaIan Alexander and Clive Harris . . . 25

Energy industry restructuring in Brazil: a critical visionLineu Belico dos Reis, James Silva S Correia, and Renato CâmaraMendonça . . . 47

Transforming the energy sector: towards new governancestructuresR K Pachauri . . . 69

Effectiveness and negotiability of environmental regulationAtle Midttun and Anne Louise Koefoed . . . 79

International Journal of Regulation and Governance 1(1) June 2001

Contents

Foreword . . . v

From the editor . . . vii

Theory and practice of governance of the British electricityindustrySteve Thomas . . . 1

Incentive regulation and multi-year price controls: anapplication to the regulation of power distribution in IndiaIan Alexander and Clive Harris . . . 25

Energy industry restructuring in Brazil: a critical visionLineu Belico dos Reis, James Silva S Correia, and Renato CâmaraMendonça . . . 47

Transforming the energy sector: towards new governancestructuresR K Pachauri . . . 69

Effectiveness and negotiability of environmental regulationAtle Midttun and Anne Louise Koefoed . . . 79

I am extremely happy that my colleagues, with the initiative and lead-ership of Dr Leena Srivastava, have launched this new journal, whichwill obviously fill up an important gap in the literature dealing withindependent regulation and its practice. It is not that knowledge inthis subject has not been built up intensively over the years in manyparts of the world, but new thinking and directions in this field areevolving rapidly. This is as true in the case of developing countries,which are grappling with the establishment of new structures andsystems for independent regulation of the infrastructure sectors, as itis in the case, for instance, in countries like the US. In the US, whichhas clearly contributed more to the understanding of regulatory eco-nomics and institutions than, perhaps, any other nation in the world,deep soul-searching and analysis is now in hand resulting from theCalifornia experience. Not only are the limits of market solutionsbeing questioned, but questions of jurisdiction between federal regu-latory bodies and units at the state level are being examined in depth.

This inaugural issue of the journal is a rich blend of experiencesfrom different parts of the world and perspectives, which will providea comprehensive view of developments worldwide. The journal hasdeveloped a personality with this very first issue, which will certainlyget enriched over time as expectedly not only will papers of academicrigour and in-depth research get published, but also as the perspec-tives of decision-makers find adequate representation and reflection.Such an effort will require not only an enlightened editorial policybut considerable outreach and solicitation for appropriate contribu-tions from the right quarters. I have no doubt that this will be thecase, and that this journal will soon establish a strong and visibleniche for itself in the literature dealing with the important subject ofregulation.

Foreword

From the editorvi

Indeed, it was only after a vacuum was noticed that this journalwas given tentative contours to fill the gap. But as is the case withsuch publications, this one too will gradually evolve in keeping withthe priorities that those working in the field progressively define.And, in turn, these priorities will emerge from the problems and chal-lenges thrown up in the course of efforts made in the implementationof reforms in the field of regulation and the interface that links regu-latory bodies with governments, consumers, and society at large. Inthe case of developing countries, this interface will vary substantiallyfrom the milieu that has emerged in different parts of the developedworld. The effectiveness and direction of regulatory practice willdepend greatly on how regulatory structures relate to the politicalstructure in a particular society. Hence, what we see before us in theagenda to be addressed by this journal is a complex web of subjectsand disciplines, which ultimately go to the heart of efficiency andequity in the provision of services by infrastructure in an economicsystem. I have no doubt that the International Journal of Regulationand Governance will not only be able to effectively define the agenda setbefore it but address it in full measure and at a high level of excellence.

R K PachauriDirector-General

TERI

Foreword

International Journal of Regulation and Governance 1(1): v�vi

From the editor vii

From the editor

The International Journal of Regulation and Governance has beenlaunched to bring upfront the issues of regulatory reform and gov-ernance by widening the opportunity to publish analytical researchand practical knowledge associated with new forms of governanceand regulation. Most countries around the world, including the de-veloped nations, are experimenting with new market structures andgovernance mechanisms in the hope of improving efficiencies andquality of service while reducing the costs of delivering the same.However, the starting points for these experiments, as also the socio-cultural contexts, are quite different across countries, thereby provid-ing the opportunity for a panoramic display of challenges andachievements, which this journal hopes to capture.

The structural transformations and independent regulatory re-gimes, which form the basis of the reforms process, started in severaldeveloping countries were modelled after those that existed in the de-veloped world, typically in the United Kingdom and the UnitedStates of America. Reform consultants were flown into the countrieswith standard prescriptions for the way the economy should function,with little deliberation on the special requirements of these countries.In retrospect, it seems that decision-makers in the developing coun-tries were not fully aware of the experimental nature of developmentsin the developed countries nor were they sufficiently exposed to thekinds of objective analyses that can be put forward by academic andresearch communities. This does not mean to say that all that hashappened in the reforming developing countries thus far is wrong orsurreptitious. Knowledge of the transitionary status of developmentsand the uncertainty of outcomes, however, could have stimulated agreater analysis and consultation possibly leading to reform modelsbetter tailored to the contexts of these countries.

From the editorviii

This journal is fortunate to have a distinguished board of editorsrepresenting a diverse range of interests and geographical expertise.This first issue of the journal has five interesting papers – two of themcovering electricity sector issues from India and the United King-dom, two addressing developments in the broader area of energy, andone dealing with environmental issues.

The paper by Steve Thomas provides an interesting documenta-tion of the institutional and regulatory processes that the British elec-tricity sector has been subjected to since 1990. He has alsochallenged the basic premises of the reforms process and its achieve-ments as they relate to the creation of competition, the efficacy of thefamous RPI−X formula, and the degree of regulatory interventionrequired. The paper does not provide any solutions or directions, butattempts to expose what the author sees as some of the myths aboutthe success of the British electricity reform model.

The paper by Alexander and Harris attempts to address the vexedproblems of tariff rationalization and the encouragement of T&D(transmission and distribution) efficiency improvements. The elec-tricity reforms process in India, on hindsight, started at the wrongend with private participation in generation being encouraged first.There are now serious efforts on to improve the distribution end ofthe business, with the recognition that unless revenue flows increase– with an increase in T&D efficiencies and better metering and billingprocesses – the sector cannot become financially viable. The authorsexplore the parameters, in the Indian context, that would make theRPI−X formula relevant for the country. In arriving at this proposedapproach, the authors hope that Indian regulatory commissions maybe able to move towards a multi-year tariff setting. This approach canserve the dual purpose of freeing up some time to devote to non-tariffissues and easing the pressure arising from political processes associ-ated with tariff setting.

The paper by dos Reis and others provides a critical analysis of therestructuring of the energy industry in Brazil. They present the legalprovisions that have led to a restructuring of the energy industry inBrazil and describe the resultant market and regulatory structure andchallenges. The authors also clearly highlight the gaps and uncertain-ties that remain to be addressed while emphasizing the need to havecomplete stakeholder participation in the further developments inthis vital sector of the economy.

Earlier this year, India recognized the contributions of TERI’sDirector-General, Dr R K Pachauri, to the cause of resource effi-ciency and environmental amelioration in India by awarding him thePadma Bhushan – one of the highest civilian awards in the country.

International Journal of Regulation and Governance 1(1): vii�ix

From the editor ix

True to his sensibilities, his paper, addressing the issue of energy sec-tor transformations, brings out the special challenges of attractingprivate participation in this sector in developing countries such asIndia. Independent regulatory processes in developing countries, al-though deriving from the experience of the developed countries,would necessarily have to model their functioning and relationshipsuniquely to their socio-cultural contexts. The focus of such a model,he says, should be on reaching desired outcomes rather than onmethods or processes.

Midttun and Koefoed address the effectiveness of environmentalregulation as it applies to the rapidly transforming energy industry—set as it is in a situation of international competitiveness. Highlight-ing the challenges of international environmental negotiations in aglobalizing world, the authors argue that weaker regulatory regimes –that allow national governments greater flexibility in determiningmechanisms to comply with international agreements – may providea better balance between meeting competitive economic challengesand environmental responsibility. In doing so, the authors seem torecommend a gradualistic approach to a ‘greening’ of the economy—both locally and globally. The case of the European Union providesan excellent example of such an interplay between competitive mar-ket forces and environmental pressures even when there is a conver-gence of interests at the political level!

This inaugural issue of the journal hopes to set a trend for openand enlightened discussions on regulatory developments and associ-ated changes in governance structures. We welcome any feedbackfrom you on the scope and content of the journal as well as any view-points that you may have on articles published in the journal or at ageneral level. I hope, with your active participation, we will succeedin making this journal a product that will guide and inform reformsprocesses around the world and definitely in the developing countries.

Leena SrivastavaDirector

Regulatory Studies and Governance DivisionTERI

International Journal of Regulation and Governance 1(1): vii�ix

Why is I J R G published? How is its purpose being fulfilled?A biannual publication, I J R G (International Journal of Regulation and Govern-ance) is aimed at decision-makers, planners, consultants, corporate executives, andresearchers. The journal provides a forum for detailed and comprehensive investiga-tion, analysis, and review of such sectors as energy, telecommunications, water, en-vironment, and transport. The papers in this journal will address regulatory andgovernance issues related to tariff, demand forecasting, competition, institutionaland transitional market structure, etc. Only original articles will be published.

How often is I J R G published?I J R G is published twice a year, in June and December. The two issues make up avolume.

How to subscribe and how much does it cost?A year’s subscription to I J R G costs Rs 1000 within India and $30 overseas at cur-rent rates. Payment can be made by demand draft or local cheque drawn in favour ofthe Tata Energy Research Institute, payable at New Delhi. We also accept paymentby MasterCard, Visa, American Express, and Diners Club cards.

Whom to contact for more information?For information on editorial content, please contact

The Editor <[email protected]>, I J R G

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Information for authors

An international biannual journal, the International Journal of Regulation and Gov-ernance has been published by the Tata Energy Research Institute, New Delhi.

SubmissionsThree good-quality hard copies of the manuscripts have to be submitted to the Edi-tor. Manuscripts can be submitted electronically also.

Presentation of manuscriptsManuscripts must be in English and the length of original articles should not exceed6000 words. They must be typed on one side, only on international standard A4 sizepaper, with a left-hand margin of 40 mm. The main text should be double-spacedwith headings and sub-headings clearly indicated and placed on the left-hand side ofthe text. All tables, figures, and equations should be numbered with Arabic numeralsand the measurements should be given in metric (SI) units. The manuscript shouldbe arranged in the order given below.1 Short title (10 words is the desired maximum length), subtitle (if desired)2 Author’s name, affiliation, full postal address, and e-mail, telephone, and fax

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For journals: Davis G R. 1990. Energy for planet earth. Scientific American 263(3):55–62.For books: Carmichael J B and Strzepek K M. 1987. Industrial Water Use and Treat-ment Practices. London: Cassell Tycooly.For chapters of edited books: Sintak Y. 1992. Models and projections of energy use inthe Soviet Union. pp. 1–53. In International Energy Economics, edited by T Steiner.

From the editorxii

London: Chapman and Hall.For grey literature: Togeby M and Jacobsen U. 1996. How conflicting goals concerningenvironment and transport influence the policy process? Paper presented at the Confer-ence on Transport, Energy and Environment, 3–4 October, Helsingor, Denmark.

FootnotesFootnotes should be minimized, and where unavoidable, should be indicated in thetext by superior Arabic numerals, which run consecutively through the paper. Theyshould be grouped in order of appearance at the bottom of the concerned page innumerical order and must be double-spaced.

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From the editor xiii

The SAFIR workshop onregulatory strategy, held on 12and 13 September 2000, inDhaka, Bangladesh, took stockof developments ininfrastructure regulation inSouth Asia and discussedvarious strategies forintroducing and deepeningregulatory reforms in thisregion. The proceedings of theworkshop cover its fivesessions; it details the differentissues and the various pointsthat emerged in thediscussions. This volume hopesto serve as a ready reference toissues in regulation ininfrastructure sector,particularly in South Asia.

Book your copy of the

Proceedings of the SAFIR workshopon regulatory strategy

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Course outlineThis two-week course is designed to provide participants with a strongunderstanding of the theory and the practice of infrastructure regula-tion and reform. An attractive feature of the course is the presentationof detailed international and South Asian case studies, during sectoralbreakout sessions, which will enable participants to understand theintricacies of sector restructuring and price reviews.

A worked price control case study offers an opportunity for a hands-on application of what has been learnt. This will cover the main build-ing blocks of price regulation, including asset valuation, cost of capital,the incorporation of measures of efficiency, and the incentive proper-ties of different techniques of price regulation. There will also be opportu-nities to interact with other participants—regulators, government officials,and executives of regulated companies from the region.

The course will cover the following themes.n Reforming the infrastructure sectors and introducing competitionn Techniques of price regulationn Financial aspects of regulationn Non-price aspects of infrastructure regulationn Design and management of regulatory agencies and the regulatory

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The faculty for the course is drawn from ex-regulators, or those currentlyin the profession, who can speak from their own personal experiences.

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Theory and practice of governance of theBritish electricity industry

Steve ThomasSenior Fellow, Public Service International Research Unit, School of Computing andMathematical Sciences, University of Greenwich, 30 Park Row, London SE10 9LS, UK


AbstractThis paper reviews the theory and practice of governance of the Britishelectricity industry since its reform in 1990. It shows that the promisethat regulation would be �light� has not been fulfilled and regulation isnow a dominant influence on the policies of the electricity companies. Akey element of the new system was the use of incentive regulation to setthe prices for monopoly activities. This was meant to be cheaper andsimpler than rate-of-return regulation, providing stronger incentives forthe companies to reduce their costs. However, incentive regulationmethodology has evolved and now differs little from rate-of-return regu-lation. Regulatory interventions have frequently been necessary in thegeneration market to prevent abuse of market power. The structure ofthe generation market is now highly competitive and the market mecha-nisms have been reformed, but it remains to be seen whether this will besufficient to make generation truly competitive. The regulator has beensuccessful in completing the corporate separation of monopoly activi-ties from competitive activities, but it now seems likely that generationand retail supply will be allowed to integrate. This will provide a moresecure environment for new investment, but at the expense of competi-tion in generation.

Steve Thomas2


IntroductionIn 1990, the British government reformed the British electricity sup-ply industry adopting a structure that has come to be known as the‘British Model’.1 One element of the British Model was the establish-ment of new regulatory bodies and mechanisms to replace the lessformal governance arrangements. This paper examines how the gov-ernance of the reformed British electricity industry has developed.

There are now seven main areas of governance for the electricityindustry in Britain.1 Prices for monopoly services2 Markets3 Industry structure, including mergers and take-overs4 Reliability standards5 Representation of consumers and consumer complaints6 Environmental impacts7 Strategic national decisions.

This paper concentrates on the first three areas. As the referencepoint, we use papers by Littlechild written before the reforms tookplace. He was one of the architects of the regulatory system for Brit-ish privatized utilities, and served as the electricity industry regulatorfrom 1990 to 1999. We examine his views when the regulatory systemwas designed (Beesley and Littlechild 1983) and shortly before hewas appointed regulator (Beesley and Littlechild 1989).2 The paperalso reviews the changes to the regulatory system introduced by theLabour government after its election in 1997. These are enshrined intwo pieces of legislation: the Competition Act of 1998, which cameinto force in March 2000, and the Utilities Bill, which was passed inJuly 2000.

The 1990 reforms and the current status of the industryWe define first what the reforms included and how they were imple-mented. Five major changes, most of which were implemented on1 April 1990, were made.1 Privatization The nationally owned industry was sold to private

investors.

1 There are three electricity systems in the United Kingdom. The system described is the larg-est covering England and Wales. The Scottish system is connected to England and Wales andwas privatized in 1992, also with little scope for competition. The Regulator for England andWales also covers Scotland, while Ofreg regulates the electricity and gas industries in North-ern Ireland.2 For an account of his current views on regulation, see Littlechild (2000).

Theory and practice of governance of the British electricity industry 3


2 De-integration The industry was divided into four activities: gen-eration, high-voltage transmission, low-voltage distribution, andsupply to final consumers.3

3 Introduction of competition to supply All final consumers were to beallowed to choose their electricity supplier.

4 Introduction of competition to generation Central planning of thegeneration sector was abandoned, barriers to entry for new gen-eration companies removed, and plant dispatching was to be setby competitive means, the Power Pool.

5 Re-regulation Prices for activities categorized as monopolies wereto be set by a regulator using a ‘price cap’ formula. Prices for com-petitive activities were to be set by the market, but under the scru-tiny of the regulator.

However, these changes could not all be fully implemented immedi-ately and the system has continued to develop, not always in the di-rection originally intended.

PrivatizationMost of the industry was privatized in 1990/91. The main problemwas the attempt to privatize the nuclear power plants (MacKerron1996). It was hoped this could be accomplished by splitting the gen-eration assets between only two companies (National Power andPowerGen), the larger of which (National Power, with 70% of theassets) would have the economic and technical strength to meet thespecial demands that nuclear power plants impose. This plan provedinfeasible, the nuclear plants were withdrawn and placed in a newstate-owned company (Nuclear Electric). The performance of thenuclear power plants improved markedly after 1990 and it was possi-ble to privatize 70% of the nuclear capacity (British Energy) in 1996,leaving the oldest plants in public ownership (Magnox Electric). Thishad important consequences for the reforms. A consumer subsidy,the fossil fuel levy, 10% of consumer bills, was introduced to keepNuclear Electric solvent, initially accounting for about half its in-come.4 Only two competing generation companies were set up (thenuclear company was a price-taker), and, since 1990, there has been

3 Generation and transmission are familiar as separate activities, but defining distribution andsupply as separate activities was novel. Distribution covers the operation of the local low-volt-age network and is regarded as a monopoly. A supply company purchases electricity from thewholesale market and retails it to final consumers. The supply activity is potentially competitive.4 The fossil fuel levy was judged a state aid by the European Commission. Permission wasgranted only till 1998 to levy a charge on consumers for generation sources that did not usefossil fuels (Mitchell 1995).

Steve Thomas4


considerable regulatory activity to make the generation market morecompetitive.

RestructuringThe main existing company, the Central Electricity GeneratingBoard, was split into three generation companies and a transmissioncompany, the NGC (National Grid Company). The 12 existing dis-tribution companies were privatized intact as REC (regional electric-ity companies) and given a single licence: the Public ElectricitySupply licence to cover both distribution and supply. Only an ac-counting separation between their distribution and supply businesseswas required. Since then, there has been a continual restructuring ofthe sector.

Competition in generationTransitional arrangements including those to protect the British coaland nuclear industries meant that the Pool did not play a significantrole in setting the wholesale electricity price from 1990 to 1998. Itwas found to be unreliable in operation, and, in 1997, it was decidedit should be replaced even before the transitional arrangements ex-pired. The new market design, the NETA (New Electricity TradingArrangements) was introduced in March 2001.

Competition in supplyConsumer competition was phased in over a decade. The 5000 larg-est consumers (30% of the market) were given choice in 1990, a fur-ther 45 000 consumers (20%) were given choice in 1994, and, from1999, all consumers could choose their supplier.

Re-regulationGovernment claimed the new regulatory system would be cheap andwould not be a strong influence on decision-making in the industry.It would be very different from rate-of-return regulation as practisedin the US, which was presented as expensive, time-consuming, andinterfering too much in commercial decisions. These predictions haveproved wrong, and managing relations with the regulator is now thekey strategic concern for regulated companies.

Reliability, consumer representation, environmentalregulation, and national strategy

Before describing in detail regulation of monopolies, markets, and in-dustry structure, it is useful to comment briefly on the other four ar-eas of governance.



Reliability standardsWhen electricity was privatized, there was concern that system reli-ability should not be jeopardized. Performance standards for theoverall reliability of the system were set for the companies. Consum-ers who receive poor service, such as failure to meet an appointment,receive compensation. These measures seem to have been successfulin maintaining or improving the high standards in the industry.5

Consumer representationUnlike gas, for which the pre-existing Gas Consumer Council under-took consumer representation, organizations appointed by Offer (Of-fice of Electricity Regulation) were introduced. In the government’s1997 review of regulation, it was decided that the independent con-sumer council system was more effective and a new GECC (Gas andElectricity Consumer Council) independent of the regulatory bodieswas set up in December 1999, although by early 2001, it was still notfully operational.

Environmental regulationThe Environment Agency carries out environmental regulation, and,since privatization, the environmental impact of the industry has gen-erally been reduced. However, this has come about because of thesubstitution of gas for coal as a generation fuel, a switch drivenlargely by market forces and requiring no intervention in the market.It remains to be seen what will happen if achieving environmental ob-jectives conflicts with minimizing generation costs.

Strategic decisionsOne of the objectives of privatization was to avoid political interven-tion in the commercial decisions of the electricity industry. For thefirst 6 years, the belief that political interference could be avoidedseemed to be borne out. The political interventions that did occurresulted mainly from attempts to protect the British coal and nuclearindustries. However, since the election of the Labour government in1997, energy policy with its traditional agenda balancing economicefficiency with social equity, security of supply, and environmentalprotection seems to be re-emerging. For example, a review of powerstation fuel sources was carried out and restrictions on building newgas-fired power plants were imposed. Some (Newbery 1998) viewthis as the Labour party exhibiting its interventionist tendencies,

5 For a review of the performance of the network companies, see Ofgem (2000a).

Steve Thomas6


while others (Helm 1999) regard it as inevitable, especially given thegrowing importance of the environmental agenda.

The regulatory bodiesThe key institutions in the economic regulation of the electricity in-dustry have been the DGES (Director General of Electricity Supply),assisted by Offer and the relevant government minister, from 1992onwards, the minister for the DTI (Department of Trade and Indus-try). Two other regulatory bodies, the Competition Commission andthe DGFT (Director General of Fair Trading), assisted by the OFT(Office of Fair Trading) have an important role.

Director General of Electricity SupplyThe example set by the privatization of telecoms and gas was fol-lowed. Regulatory responsibility was given to one person, the DGES,with the assistance of Offer. By 1998/99, Offer employed 250 peopleand had a budget of 24 million pounds funded by the licensed elec-tricity companies. The staffing level increased only marginally overthe 10 years following privatization. As a result of the government’sregulatory review of 1997, there were changes to the regulatory sys-tem, under new legislation, the Utilities Bill, passed in July 2000. Thegas and electricity industries were converging at all points in the valuechain and it was believed that effective regulation would be facilitatedby creating a body that regulated both industries. The gas and elec-tricity regulatory staffs were combined to form the Ofgem (Office ofGas and Electricity Markets) and the DGGS (Director General ofGas Supply), appointed in September 1998, was appointed DGES inJanuary 1999. The budget for Ofgem was about 50 million pounds in2000, although this figure was inflated by the costs of the introduc-tion of NETA and of merging Offer with the Ofgas (Office of GasSupply).

The government believed that a single regulator was not appropri-ate and that a primary duty to promote competition did not put suf-ficient emphasis on the interests of consumers. The Gas andElectricity Markets Authority (hereafter, the Authority), comprisingfive executive and five non-executive directors, was set up in Decem-ber 2000 to replace the Director Generals. The Authority inheritedthe powers of the DGES and the DGGS, and has responsibility forstrategy and policy. Ofgem is responsible for day-to-day decisions.The DGES and the DGGS became the chief executive of Ofgem andthe managing director of the Authority. The primary duty of the Au-thority is to protect the interests of consumers. The creation of theGECC will result in a transfer of about 120 staff from Ofgem to theGECC, leaving Ofgem with a staff of about 300.



The Secretary of StateThe DGES shares his duties with the government minister. The min-ister appoints him and can dismiss him in certain circumstances.There is no evidence that ministers have intervened to any significantextent in the DGES’s decision-making. However, the minister hasnot always followed advice given by the regulator, for example, ontake-overs. The DTI has played a more strategic role since the elec-tion of the Labour government in 1997 through an Energy UtilitiesDirectorate. This body (or predecessors) led a number of electricityindustry reviews, including those on regulation, power station fuels,and renewables (Department of Trade and Industry 1998a, 1998b,and 1999).

The Competition CommissionThe Competition Commission (formerly Monopolies and MergersCommission or MMC) is a long established body that investigatesmergers and examines the competitiveness of markets. In August2000, there were 39 commissioners and from these a panel, typicallyof 5, is set up for each investigation. It operates in response to a re-quest by the relevant government minister and produces a report thatdetermines whether the merger or the market reviewed operates‘against the public interest’. If it produces such a finding, it has widediscretion about the remedies it can suggest. Its report is submittedto the minister, who may choose not to follow its recommendations.In such cases a justification must be provided. The privatization ofthe utilities saw an expansion of the MMC’s role. If a company doesnot agree to an ‘X’ factor proposed by a regulator, it can ask theMMC to carry out an investigation and make recommendationsabout the value of ‘X’. Even in these cases, the final arbiter is notclear. A dispute between the DGGS and British Gas about how therecommendations of an MMC inquiry would be implemented wassettled by negotiation.6 The Northern Ireland Regulator refused toimplement one of the findings of an MMC inquiry, but was overruledin the Court of Appeal (Ofreg 1997; Power UK 1998). In 1999, theMMC was renamed the Competition Commission, and an AppealsTribunal was set up to deal with appeals against the decisions of regu-latory bodies.

Director General of Fair Trading and Office of Fair TraningThe OFT’s duty is to guard the interest of consumers in competitivemarkets. It has not often been active with the utilities but it carried

6 See Utility Week Ofgas price cap move sidesteps MMC report 25 July 1997, p. 5 andUtility Week Agreement reached on revenue cap row 17 October 1997, p. 6.

Steve Thomas8


out investigations that led to the decision to restructure the privatizedBritish gas industry (Office of Fair Trading 1991). The CompetitionAct of 1998 gives new concurrent powers to Ofgem and the OFT,which Ofgem will apply. The main provisions prohibit the operationof cartels and the abuse of dominant market positions (OFT 2001).The Act gives Ofgem powers to levy fines of up to 10% of 3 years’turnover on companies found in breach of the Act.

To see how these bodies interact, it is useful to see how take-overbids for RECs have been handled. In September 1995, PowerGenplaced a bid for Midlands Electricity followed within a week by a bidby National Power for Southern Electric. These bids raised issuesabout the extent to which integration of generation and supplyshould be allowed. There was an expectation that the bids would beallowed because earlier decisions had implied integration was accept-able. Scottish Power had been allowed to take over an REC in Sep-tember 1995 and another REC was buying a large volume of powerplant from National Power and PowerGen at the time. However, theminister, following advice from the DGES and the DGFT, referredthe bids to the MMC in November 1995. The MMC’s reports, sub-mitted in April 1996, concluded that the take-overs would be againstthe public interest but would be acceptable provided conditions (notexpected to have proved onerous) were met. The MMC verdict, madeby a five-member panel, was not unanimous, and a report by the dis-senter was published along the majority reports (MMC 1996a,1996b). Another member of the MMC, not on this board, resignedfrom the MMC in protest at its conclusions. The minister decidednot to allow the take-overs (Bailey 1996). His grounds were that ver-tical integration was not wrong, but that until markets were morefully developed, the take-overs would harm competition. The minis-ter has not always followed advice from regulators on referrals to theMMC. In November 1995, the minister chose not to refer a bid byNorth West Water for an REC to the MMC, counter to the advicegiven by the DGFT (Financial Times Power in Europe 1995).

Regulation of monopoly servicesResults of regulation

Since 1990, there have been five elements to electricity bills in Brit-ain. The market sets the price for the largest element of the bill—gen-eration. The regulator sets the charges for use of the transmission anddistribution networks, while government sets the nuclear subsidy,which is now very small and is only used to subsidize renewables. Theregulator also sets the charge for supply to small consumers until



1999 when small consumers were allowed to choose. There are somerestrictions on the prices the incumbent suppliers (but not new en-trants) can charge, expected to be removed in 2002, after which themarket will set this charge.

Two main features emerge from an analysis of prices for small con-sumers (Table 1). First, the government’s regulatory settlement in1990 resulted in the price of the monopoly services increasing mar-ginally over the first 5 years. Since then, the regulator has clawedback the lost ground with large, one-off reductions 1995–98. Second,the effective removal of the nuclear subsidy in 1997 was the mainfactor behind the reduction in prices since 1990. Overall, real pricesset by the regulatory authorities fell by about 40% in the 8 years afterprivatization.

The methodology in theory and practiceThe system for setting prices of monopoly services in the British elec-tricity sector is known as incentive regulation, or ‘RPI−X’. Under thissystem, the price of a monopoly service is allowed to increase by therate of inflation (RPI is the retail price index) minus ‘X’.7 This wasproposed by Littlechild and adopted by the government of theUnited Kingdom as the way to regulate prices in the privatizedtelecoms industry (Littlechild 1983). Beesley and Littlechild (1983,p.20) claimed

7 There are various ways the ‘X’ factor can be applied, for example, to the prices charged or tothe income per unit of output. These differences can have significant implications for compa-nies, but for these purposes, it can be assumed that the ‘X’ factor determines the movement ofprices.

Table 1 Movement in small consumer bills: 1990�98

1990/91 1991/92 1992/93 1993/94 1994/95 1995/96 1996/97 1997/98

Typical bill (1990=100) 100.0 107.0 105.0 103.5 97.7 89.5 87.2 81.8

Distribution 25.0 25.2 25.4 25.6 25.8 22.2 19.3 18.7

Supply 6.0 6.0 6.0 6.0 5.9 5.8 5.6 5.5

Transmission 5.0 5.0 5.0 4.8 4.7 4.6 4.4 3.5

Total monopoly charges 36.0 36.2 36.4 36.4 36.4 32.6 29.3 27.7

Fossil fuel levy 10.6 11.8 11.6 10.3 9.8 8.9 8.7 1.8

Total regulated charge 46.6 48.0 48.0 46.7 46.2 41.5 38.0 29.5

Generation 53.4 59.0 57.0 56.8 51.5 48.0 49.2 52.3

(Typical bill − regulated charge)

Note The figures shown are index numbers set so that the total bill in 1990/91 is 100. The distribution charges apply to the

Seeboard area of England. Charges for distribution in other areas vary somewhat.

Source Author�s calculations

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The level of X would, in practice, be the outcome of bargainingbetween [the utility] and the Government; an exhaustive cost-ing exercise is not called for. The purpose of the constraint is toreassure customers of monopoly services that their situation willnot get worse under privatisation. It ‘holds the fort’ until compe-tition arrives, and is inappropriate if competition is not expectedto emerge. It is a temporary safeguard, not a permanent methodof control. The one-off nature of the restriction is precisely whatpreserves the firm’s incentive to be efficient, because the firmkeeps any gains beyond the specified level. Repeated cost-plusaudits would destroy this incentive and moreover encourage‘nannyish’ attitudes towards the industry.8

Companies would be able to find their own way to achieve the per-formance standards that were required of them. If they could meetthem more cheaply than was implied by the ‘X’ factor, they couldkeep the savings, if not, any extra costs would come out of profits.The implication appears to be that either all activities could becomecompetitive and that the ‘X’ factor should not be adjusted once set.There is no mention of any role for a sector regulator in setting prices,indeed, they advocate strong pro-competition policy and use of thecourts as a more efficient way of solving disputes. They criticize theprocedures involving the MMC, the OFT, and the Secretary of Stateas not being strong enough or speedy enough.

By 1989, practice with RPI−X was significantly different to thisearly vision. The ‘X’ factor was set for about 5 years, initially by thegovernment but subsequently by a sector regulator, allowing firms tomake long-term investment plans, but allowing the sector regulatorto tune the ‘X’ factors to maintain tough but fair pressure on theregulated companies. Beesley and Littlechild (1989, p.471) stillseemed to believe that regulation need only be temporary (they re-peat that ‘the aim is “to hold the fort” until competition arrives’). De-spite this divergence from his vision of regulation of privatizedindustries, Littlechild seemed to have no problem in accepting a rolethat he had earlier appeared to dismiss as that of a government‘nanny’ (Beesley and Littlechild 1983, p.20). In the decade after pri-vatization, there was no sign that distribution and transmission couldbe treated as anything other than a monopoly, yet he did not act onhis earlier suggestion that ‘RPI−X’ was inappropriate if competitionwas not expected to emerge.

8 It is not clear from the text whether Beesley and Littlechild then assumed that all activitiescould become competitive or that for activities for which competition was not feasible, anotherform of regulation should be chosen.



The government set the initial ‘X’ factors for the electricity indus-try, and the distribution companies were allowed to increase theirreal prices for the 5 years after 1990 by up to 10%. The governmentexplained that these price increases were needed to clear a backlog ofinvestment needs. The high profits made by the RECs in this periodsuggest this need did not exist. Beesley and Littlechild (1989, p.457)recognized that wider considerations were at work in setting the ini-tial ‘X’ factors. For example, the generous initial ‘X’ factors were astrong influence in increasing the sale price of the companies.

To see how ‘X’ factors are set, we examine the electricity distribu-tion price review, which will apply from 2000 to 2005. The consulta-tion process started in February 1998 with a paper reviewing theregulatory work programme, including the distribution price review,for the following two years (Offer 1998a). This was followed in Julyby a more detailed review of the considerations that would be in-cluded in the price review (Offer 1998b). In December, the regulatorissued a paper reviewing the business plans of the distribution com-panies (Offer 1998c). In May 1999, the regulator published anotherpaper setting out much of the data on which the price control wouldbe determined (Ofgem 1999a), and, in August, he published draftproposals (Ofgem 1999b). After consultations, the proposals wereupdated in October (Ofgem 1999c) and final proposals published inDecember (Ofgem 1999d). The companies accepted them and theywere implemented in April 2000.

The main determinants of ‘X’ are operating expenditure, capitalexpenditure, value of the asset base, and allowed rate of return on as-sets. The review of transmission prices (Ofgem 1999e, p.23) states

NGC’s present price control was set so that the net presentvalue of its allowed revenues over the period of the price controlis equal to the net present value of three elements: forecast effi-cient operating expenditure; depreciation; and a reasonable re-turn on NGC’s regulatory value.

Depreciation is a function of: the opening regulatory value;the remaining asset lives of the assets which comprise this regu-latory value; and efficient levels of capital expenditure whichNGC is expected to incur during the price control period.

These are the constituents of rate-of-return regulation. The maindifference is how capital expenditure is treated. British incentiveregulation approves capital investment in advance, while rate-of-re-turn regulation of the US approves it retrospectively. In the US, utili-ties invest in assets and when they are complete, the regulatorassesses whether they are ‘used and useful’ and the investment

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‘prudently incurred’. Rate-of-return regulation is criticized becauseit can lead to ‘gold-plating’. Utilities undertake too much capital ex-penditure because increasing the value of the asset base increases thelevel of profit it is allowed to make. However, this appears to be amatter of practice rather than methodology. If utilities invest toomuch, rate-of-return regulation allows regulators to prevent themfrom adding the excess expenditure to their rate base, effectively de-ducting excess expenditure from profits.

Under British regulation, utilities present 5- and 10-year invest-ment programmes to the regulator. The regulator agrees a total in-vestment need over the period. This is used in the calculation of the‘X’ factor. The risk of gold-plating is still there. Far from allowingcompanies to determine independently what investments they shouldmake, the British system requires them to negotiate with the regula-tor to get de facto prior approval for investments. There have been nodetailed procedures to monitor whether the investments take placeand to assess whether they were really worthwhile. Regulated compa-nies have always invested less than they projected to the regulatorarguing that the investments made had been rendered unnecessaryby efficiency improvements. Some of the investments made havebeen of dubious value. It seems likely that as experience of utilitiesinflating their investment needs grows, British regulators are increas-ingly adopting more formal means to monitor investment pro-grammes. Indeed, in 1999, Ofgem carried out an investigation intowhy the gas distribution company had invested significantly less thanit forecast (Ofgem 1999f).

The DGES has criticized the interval between determinations ofthe ‘X’ factor, suggesting that the 5-year interval puts too much em-phasis on a single process (Ofgem 1999a, p.19). The regulator for gasand electricity for Northern Ireland, Douglas McIldoon, was criticalof the RPI−X methodology. He described the RPI−X mechanism as‘exceptionally crude’ and suggested that ‘As the scope for efficiencygains in the company’s operating costs declines, Capex will becomethe key factor in shaping the next Transmission and Distributionprice control’ (Ofreg 1998, p.4).

Examination of the transmission review shows that regulatorymethods are getting more complex. There is no longer a single ‘X’factor to cover all NGC’s activities; some of its activities are regulatedexplicitly by rate-of-return regulation. There is a different rate of re-turn allowed for investments made before and after privatization,and, for some of its activities, there are incentive schemes in whichsavings made by bettering the target performance level are sharedbetween consumers and the NGC.



Overall, RPI−X regulation is still evolving in Britain, but it seemsunlikely that it will fulfil the promise that it would provide strongerincentives for efficiency improvements than rate-of-return regula-tion, while still being cheaper and simpler.

Regulation of marketsThe real departure in regulation with the British Model was that theregulator did not set prices for generation and retail supply to finalconsumers. Beesley and Littlechild were sceptical about the need forextensive regulation of competitive markets. Nevertheless, they rec-ommended that a highly fragmented market be created rather thanwaiting for the market to develop by itself. There was little suggestionthat once established, markets would need regulatory oversight. Theystated (Beesley and Littlechild 1983, p.19)

Competition is the most important mechanism for maximisingconsumer benefits, and for limiting monopoly power. Its essenceis rivalry and the freedom to enter a market. What counts is theexistence of competitive threats, from potential as well as exist-ing competitors. The aim is not so-called ‘perfect’ competition. . . Where there are very few existing outside competitors, ornone at all, the starting structure should be designed to createeffective competition. When in doubt, smaller rather than largersuccessor companies should be created.

The wholesale marketDespite his belief that regulation of markets was not needed,Littlechild intervened frequently in the wholesale market. The gov-ernment split generation among only two privatized companies. Con-tracts and conditions imposed by the government in 1990 to givetransitional protection to the British coal and nuclear industriesmeant that for the first 3 years, the conditions for more than 90% ofthe RECs’ wholesale purchases were pre-set by government-imposedcontracts. The transitional measures for coal were re-negotiated in1993 for a further 5 years at about half the volume of coal previouslycontracted, and the nuclear protection continued until 1997. Theoutput of new plant ordered by the RECs was fully contracted to theowners, so, from 1993 to 1998, about 90% of the market was notopen to competition.

It is not surprising that with little liquidity in the Pool and only twocompanies bidding seriously, prices showed signs of being manipu-lated by the two dominant generators. The regulator required the twolarge companies to bid their plant such that the average Pool price

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was below a specified level over the period 1994–96 and he forcedthem to sell about 15% of their capacity to new entrants in 1996.

In 1997, the regulator was still not satisfied, still blaming the largegenerators despite their market share being half what it was in 1990.He required them to sell about a third of their remaining capacity tonew entrants. He conducted a review of the Pool, the result of whichwas that a new design of market, the New Electricity Trading Ar-rangements, was implemented in March 2001. Littlechild’s replace-ment, Callum McCarthy, was not satisfied that Pool prices werebeing set fairly, and, in January 2000, he proposed an new licencecondition for generators that would require them to undertake not toindulge in ‘abuse of substantial market power in the setting of whole-sale prices for electricity’ (Ofgem 2000b). Two of the seven compa-nies to which the condition would apply refused to accept it, andMcCarthy referred the matter to the Competition Commission. InDecember, the Competition Commission ruled against the regulatorand the condition was withdrawn. It is not clear why McCarthy feltthis clause was necessary. Under the 1998 Competition Act, he hadpowers to impose heavy fines on companies indulging in such prac-tices. It also showed a lack of faith that NETA would overcome thedeficiencies of the Pool. It remains to be seen whether NETA and themore fragmented generation market will mean that regulatory inter-vention in the generation market will die away.

The retail marketThe main activity for the regulator in the retail market has been coor-dinating its phased opening. In both 1994 and 1998, things did notgo smoothly. In 1994, when 45 000 additional large consumers weregiven choice of supplier, the systems were in chaos for about 18months after the opening of the market. However, medium and largeconsumers are now using the market effectively to shop for cheaperpower.

The systems necessary to allow competition for small consumersproved complex and expensive and delayed market opening by a year.Consumers will have to pay an additional 30 pounds in the first 5years for these systems whether or not they switch supplier.9 How-ever, the much bigger issues concern the consequences on industrystructure of liberalization and the apparent reluctance of small con-sumers to treat electricity as a normal purchase.

9 This figure is based on total costs of building and operating the IT systems over 5 years thatwill be passed on to consumers of 726 million pounds divided between about 25 million con-sumers (see House of Commons Trade and Industry Committee 1998).



In 1997, the regulator published data showing that supply compa-nies were allocating their cheapest power purchases to large consum-ers (Table 2). It is not clear how he reconciled this with the licencerequirement that suppliers should not to discriminate or show unduepreference between consumers or classes of consumer. He apparentlybelieved that allowing small consumers to choose would solve thisproblem—companies that charged too much would lose their marketshare. However, if residential consumers do not change frequently tothe cheapest supplier, the suppliers will treat them as captive andcontinue to discriminate against them. So far, the main beneficiary ofconsumer switching has been the main gas supply company, BritishGas, even though in most areas, it is one of the most expensive of theavailable suppliers. The other companies that are trying to build mar-ket share in supply have done so by acquiring existing supply busi-nesses. This mirrors experience in gas where the only companies tohave significant success in winning residential gas consumers fromBritish Gas were the local electricity companies. It seems consumersare only comfortable buying such an important service from a sup-plier they know and trust.

An important issue is how to ensure that new entrants do not targetthe most attractive consumers, rich households with high bills, leav-ing poor consumers with an expensive service. The better the marketworks (as measured by switching rates), the more this issue will ariseas companies will have a stronger incentive to cherry-pick. There areno systematic checks in place to ensure companies are behaving equi-tably. The regulator has proposed that the ‘non-discrimination’clauses in supply licences be scrapped and that reliance be placed onthe 1998 Competition Act (Ofgem 2000c).

Table 2 Regional Electricity Company purchase costs: 1996/97

Average price Quantity

(p/kWh) (TWh)

Franchise consumers

Coal contracts 3.92 71.7

Independent power producer contracts 3.84 28.9

Other contracts 3.71 34.3

Average franchise purchase costs 3.85 134.9

Non-franchise purchase costs 3.00 80.4

Average total purchase costs 3.54 215.2

Source Offer (1997)

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It may be that, if it is perceived that small consumers in generaland the poorest consumers in particular are doing poorly from theopening of the market, the pressure for regulatory oversight of theretail market will increase rather than decrease.

Industry structure and take-oversThe implication of Beesley and Littlechild’s statements on competi-tion was that the priority was to provide a structure that allowed freeentry to the market. Take-overs and mergers in the competitive partsof the market were a healthy sign of market disciplines being exertedand were of little concern as long the entry barriers were low enoughto maintain a realistic threat of competition.

StructureThe ideal structure given the existence of two monopolies and twoareas where competition could occur is an industry with four sets ofcompanies, each set operating in only one sector of the market. Forcompetitive activities, there should be a large enough field of compa-nies to give confidence of competitive behaviour. Competitive activi-ties should be separated from monopoly activities to ensure thataccess to the network is provided on non-discriminatory terms. Thecreation of separate wholesale and retail markets was to reduce barri-ers to entry for new generation and supply companies. If generationand supply were largely integrated, it would be difficult for new gen-eration or supply companies to enter.

This ideal could not be met in 1990, mainly because of practicaldifficulties, such as establishing a large number of new companieswith strong enough credentials for investors to be willing to buythem. The grid was seen as a key resource to ensure security of supplyand that competition between generators was fair. The governmentgave the grid to the RECs, but with limits on the extent to which theycould influence its policies. This seemed to offer the prospect of non-discriminatory access, while also giving the NGC some financialbacking to ensure that its investment needs could be met. In 1995,the regulator required the RECs to sell their shares in the NGC. Thiswas primarily to give the NGC greater financial autonomy. There wasno suggestion that the RECs could have used their ownership of thegrid to any unfair competitive advantage. The distribution and supplybusinesses were both owned by the RECs. The conflict between acompany owning a monopoly network and supplying competitiveservices using this network was handled by requiring the RECs togive non-discriminatory access to their networks and to keep separateaccounts for distribution and supply.



In 1997, as the opening of the retail market for small consumersneared, the regulator became concerned that the overlap betweendistribution and supply was allowing the RECs to cross-subsidizetheir supply businesses from distribution. As a result, the RECs nowhave separate distribution and supply licences and Ofgem has re-quired that there be a full managerial and operational separation be-tween distribution and supply, although they may still be undercommon ownership. The separation of the monopoly networks fromthe competitive businesses is now, therefore, largely complete.

The issue of how far ownership of generation and supply shouldoverlap is complex. The creation of a wholesale market implied thereshould be some separation between generation and supply to allownew generation companies into the market. If vertically integratedcompanies dominated, little power would be traded in the Pool. Newentrants would not only have to generate at competitive prices, theywould also have to find final consumers to buy their power, a daunt-ing requirement. However, the required separation was not complete.Generators were able to compete in the supply market for large finalconsumers up to a specified market share (7% in any REC territory,later increased to 16%). The RECs were allowed to obtain the equiva-lent of up to 15% of their peak demand from plants they owned.

The position on vertical integration of generation and supply wasclouded further in 1996 when bids by the two large generation com-panies for RECs were blocked (see section on the regulated bodies).In 1998, there was renewed pressure to allow vertical integration. Theprospect of a very tough regulatory settlement for the distributionbusiness in 2000 meant that most of the American owners were keento sell their RECs. The decision to enforce a split between the RECs’distribution and supply businesses meant other RECs were open tooffers for their supply businesses. With no scope for cross-subsidiesbetween distribution and supply, and the loss of their monopoly insupply to the residential sector, RECs no longer had any incentive toretain distribution and supply in the same business. The end of themonopoly on supply to residential consumers also meant that supplycompanies were reluctant to sign power purchase deals of more thana year, making generation an even more risky business. Generatorswere, therefore, prepared to pay a high price for a supply business,typically 150–200 pounds per consumer acquired, to give them moremarket assurance. This time the pressure was not resisted, and, in1998, PowerGen took over an REC while National Power bought asupply business. The ‘price’ for government allowing this was thatNational Power and PowerGen would sell some of their generationplant to new entrants. By spring 2001, companies that had large

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generation businesses owned 12 out of 14 of the privatized supplybusinesses in Britain.10

The main problem in retaining a separation between generationand supply is the fragility of a supply business. A supply businesshas few tangible assets other than the loyalty of its consumers. It is avery small business, five per cent or less of a typical bill and it is dif-ficult to build customer loyalty by product differentiation. Supplyonly makes business sense if integrated with generation or with abasket of other network-delivered services such as gas, water, andtelecoms—so-called multi-utilities. Two attempts to build a multi-utility around an REC have failed. British Gas, taking advantage ofits powerful brand name, may prove more successful selling electric-ity, gas, and telecoms, but this may be the exception, if consumers areonly prepared to switch if it is to a trusted company they have dealtwith before.

Mergers and take-oversThe logic of privatization and liberalization was to minimize govern-ment involvement in electricity. The threat of take-over would be animportant discipline on companies. However, the public was con-cerned that key public services would be taken over by foreign com-panies with no commitment to provide reliable services. Theelectricity companies were, therefore, privatized with Golden Sharesgiving the government right of veto over any proposed take-overs. Asa result, there was an expectation that the privatized companieswould continue to be independent. However, the Golden Shares inthe RECs expired in March 1995. All were soon subject to take-overbids, the main bidders being British generation companies, electricutilities from the United States, and privatized British water compa-nies (see Table 3). The government intervened to block the bidsplaced by PowerGen and National Power. American utilities tookover seven of the RECs with little public concern. There were, per-haps, two main factors behind this indifference to foreign ownership.First, the British public was resigned to key industries being takenover by foreign companies; for example, all large-scale car manufac-ture was by then in foreign ownership. Second, experience with pri-vate ownership had made it clear that the first priority of theprivatized companies was profits, not public service, and it made lit-tle difference whether the shareholders were British or foreign.

10 By 2000, it was clear that the Scottish market will be integrated into that of England andWales so it makes sense to see Great Britain as one market with 14 territories, including 2from Scotland.



Table 3 Take-overs and mergers for the REC (Regional Electricity Company)

REC Take-overs

Eastern Distribution Hanson 7/95 Energy Gr 1/97 TXU 2/98 London 12/99Multinational (D) US utility (MM)

Eastern Supply Hanson 7/95 Energy Gr 1/97 TXU 2/98Multinational (D) US utility

E Midlands Dominion 11/96 PowerGen 6/98US utility UK generator

London Dist Entergy 12/96 EDF 12/98 Eastern12/99US utility French utility (MM)

London Supply Entergy 12/96 EDF 12/98US utility French utility

Manweb Scot. Power 7/95UK generator

Midlands Dist Avon En 5/96US utilities

Midlands Supply Avon En 5/96 Nat Power 11/98US utilities UK generator

Northern CalEnergy, 12/96US utility

Norweb Dist NW Water 9/95UK water co

Norweb Supply NW Water 9/95 TXU, 7/98UK water co US utility

Seeboard Cen & SW 11/95US utility

Southern Scottish Hydro 9/98UK generator (M)

Swalec Dist Welsh W 12/95 Western PowerUK water co Dist 8/00

US utilitySwalec Supply Welsh W 12/95 British Energy Scottish and

6/99 Southern 7/00UK water co UK generator UK integrated

Sweb Dist Southern Co 7/95US utility

Sweb Supply Southern Co 7/95 EDF 6/99US utility French utility

Yorkshire Yorkshire Holdings Innogy 3/01US utilities UK generator

Notes1 Changes marked �M� are mergers, �MM� management mergers, and �D� de-mergers.2 Avon Energy was a consortium of two US utilities, GPU and Cinergy, but in 1999, GPU bought

out Cinergy. The Midland distribution business is now branded GPU Power UK.3 The Southern Co sold 51% of its holding in Sweb to Pennsylvania Power and Light. The SWEB

distribution business trades as Western Power Distributor.4 The jointly managed London and Eastern distribution networks trade as 24seven.5 Yorkshire Holdings is a consortium of American Electric Power and Public Service of Colorado.6 Central and South West Corporation has been taken over by American Electric Power.7 The merged Scottish Hydroelectric and Southern Electric trades as Scottish and Southern Electric.8 Innogy is the de-merged UK business of National Power.

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By 1996, the role of Golden Shares was unclear. An indefiniteGolden Share was taken in NGC in 1995 when it was sold by theRECs, and the government invoked the Golden Share in 1996 whena United States’ utility tried to buy National Power. However, theprivatized nuclear company, British Energy, arguably a more strate-gic asset than a fossil fuel generator, was only given 10-year GoldenShare protection when sold in 1996. It may be that the use of GoldenShares will be ruled in contravention of the European Union Treatyof Rome, and there is little sign that the government now has anyappetite to use them to protect privately owned companies.

An important current issue is the fate of the distribution businessesand the pressure for mergers. London and Eastern have set up a jointmanagement structure for their adjoining regions, although owner-ship will remain separate and the owner of the South West region haspurchased the adjoining South Wales region. It might be expectedthat economies of scales could be achieved by such mergers, but atthe cost of loss of regulatory comparators. The ability to compare theperformance of a number of companies carrying out the same task,distribution, was claimed by Beesley and Littlechild (1989, p.471) asan important tool for the regulatory authorities.

ConclusionsThe provisions of the 1990 reforms to the British electricity industrytook a decade to implement and the industry is still changing rapidlyand unpredictably. One of the main elements of the reforms was amore formal system of regulation, the heart of which was the ap-pointment of one person with responsibilities to regulate economicaspects of the industry. His tasks included setting monopoly prices,monitoring the competitive markets and commenting on industrystructure issues. A key promise was that the regulator’s influence onthe industry would be ‘light’ and that as competition took hold, the needfor a regulator would disappear altogether. This forecast has been provedwrong and the workload of the regulator appears to be increasing.

The forecast that regulation would be simple was based on the useof the RPI−X formula to set monopoly prices. Under this method,the real price paid for monopoly services would fall by ‘X’ per cent ayear. It seemed that the regulator merely had to choose a value of ‘X’that would put strong, but reasonable, pressure on companies to in-crease their efficiency. In practice, the elements required to deter-mine ‘X’ are the same as are required for rate-of-return regulation, aform of regulation previously scorned by the government andLittlechild. These elements are the operating costs, the value of the



assets owned, new investment needs, and a fair rate of return on in-vestment. The main difference is that RPI−X requires the regulator topre-approve investment programmes and, far from allowing the com-panies to make independent decisions, it forces the regulator effec-tively to pre-approve investment decisions.

Littlechild did not act in accord with his stated belief that, pro-vided markets were ‘contestable’, a ‘perfect’ market structure marketwas not required. He intervened continually in the wholesale electric-ity market, capping prices and forcing asset sales. Indeed, at his insti-gation, the wholesale electricity market is currently being totallyredesigned. In the retail market, now that competition has been ex-tended to all consumers, it may be that there will be more rather thanless need for regulatory intervention. The political reality may bethat, whether or not the market would, left to itself, resolve marketimperfections, the time needed for this to occur is too long.

The ideal industry structure, a fully de-integrated structure withseparate sets of companies operating in the four component parts ofthe industry has only been partially achieved. The monopolies arenow separate from competitive activities and fair access to the infra-structure has been achieved. However, generation and supply are in-tegrating and it seems that the market will become dominated by asmall number of companies, primarily supplying their consumersfrom their own power stations. This is a logical way for companies todeal with the high risk that the generation and supply businesses bothinvolve, but it means that competition in generation is much less in-tense and barriers to entry in generation are high. If the number ofcompanies is allowed to get too small the electricity market couldbecome an oligopoly.

The hope among some politicians that the reforms would createstrong companies to compete for Britain in world markets has notbeen fulfilled. A major factor behind this failure has been the regula-tor’s policies to reduce the market power of the two large generationcompanies by forcing them to sell a large proportion of their powerplants to new entrants. The market share of National Power andPowerGen is now little more than a quarter of what it was 10 yearsago and National Power has had to split itself into two parts, a UnitedKingdom business and a foreign business, to survive.

ReferencesBailey K. 1996A bid too far?Utilities Law Review 7(4): 134–136

Steve Thomas22


Beesley M and Littlechild S. 1983Privatisation: principles, problems and prioritiesLloyds Bank Review 149: 1–20[Reprinted in Bishop M, et al. 1994. Privatisation and economic performance,Oxford: Oxford University Press. pp. 15–31]

Beesley M and Littlechild S. 1989The regulation of privatized monopolies in the United KingdomRand Journal of Economics 20(3): 454–472

Department of Trade and Industry. 1998aA Fair Deal for Consumers: modernising the framework for utility regulationLondon: Department of Trade and Industry.

Department of Trade and Industry. 1998bThe Review of Energy Sources for Power Generation and Government Re-sponse to Fourth and Fifth Reports of Trade and Industry CommitteeLondon: Department of Trade and Industry.

Department of Trade and Industry. 1999New and Renewable Energy: prospects for the 21st CenturyLondon: Department of Trade and Industry.

Financial Times Power in Europe. 1995Water bid clearedPower in Europe 211: 25–26

Helm D. 1999Energy policy since 1979: from Lawson to MandelsonPaper presented at the BIEE Annual Conference, St John’s College, Oxford, 20–21September 1999. 17 pp.

House of Commons Trade and Industry Committee. 1998Developments in the liberalisation of the domestic electricity marketSelect Committee on Trade and Industry Tenth ReportLondon: House of Commons [HC871]

Littlechild S. 1983Regulation of British Telecommunications’ profitabilityLondon: Department of Trade and Industry.

Littlechild S. 2000Privatisation, competition and regulation in the British electricity industry,with implications for developing countries.Washington, DC: The World Bank. [Joint UNDP/ESMAP Report]

MacKerron G. 1996Nuclear power under reviewIn: The British Electricity Experiment, pp. 138–163, edited by J SurreyLondon: Earthscan.



MMC. 1996aNational Power plc and Southern Electricity plc, cm 3230London: HMSO

MMC. 1996bPowerGen plc and Midlands Electricity plc, cm 3231London: HMSO.

Mitchell C. 1995The renewables NFFOEnergy Policy 23(12): 1077–1091

Newbery D. 1998The international energy experience: markets, regulation and environment– a summing upIn The International Energy Experience: markets, regulation and the environment,pp. 361–371 edited by G MacKerron and P PearsonLondon: Imperial College Press.

Offer. 1997The competitive electricity market from 1998: price restraint proposalsBirmingham: Offer.

Offer. 1998aReviews of public electricity suppliers 1998 to 2000: consultation paperBirmingham: Offer.

Offer. 1998bPrice controls and competition: consultation paperBirmingham: Offer.

Offer. 1998cReviews of public electricity suppliers 1998 to 2000: PES business plans –consultation paperBirmingham: Offer.

Ofgem. 1999aReviews of public electricity suppliers 1998 to 2000: distribution price controlreview consultation paperLondon: Ofgem.

Ofgem. 1999bReviews of public electricity suppliers 1998 to 2000: distribution price controlreview draft proposalsLondon: Ofgem.

Ofgem. 1999cReviews of public electricity suppliers 1998 to 2000: distribution price controlreview – updateLondon: Ofgem.

Steve Thomas24


Ofgem. 1999d.Reviews of public electricity suppliers 1998 to 2000: distribution price con-trol review – final proposalsLondon: Ofgem.

Ofgem. 1999eThe transmission price control review of the National Grid Company from2001 [Initial consultation document]London: Ofgem.

Ofgem. 1999fMonitoring Transco’s capital expenditure [A Report and Consultation Docu-ment]London: Ofgem.

Ofgem. 2000aReport on distribution and transmission system performance 1998/99London: Ofgem.

Ofgem. 2000bThe prevention of wholesale market abuse: guidelines for generatorsLondon: Ofgem.

Ofgem. 2000cGas and electricity supply licences: proposals for standard non-discrimina-tion licence conditionsLondon: Ofgem.

Office of Fair Trading. 1991The gas competition reviewLondon: HMSO.

Ofreg. 1997NIE price control announcementPress release, 6 August 1997

Ofreg. 1998Forward work plan and topics for consultation: October 1998Belfast: Ofreg.

OFT. 2001The Competition Act 1998: the application in the energy sectorLondon: Office of Fair Trading. [OFT 428]

Power UK. 1998McIldoon loses NIE appealPower UK 57: 13

Incentive regulation and multi-year price controls:an application to the regulation of powerdistribution in India*

Ian Alexander and Clive Harris**Regional Coordinator, East and South Asia, PPIAF (Public�Private InfrastructureAdvisory Facility), Singapore


AbstractThere is a perception among potential investors in electricity distribu-tion projects in India that the price-setting methodologies employed byregulatory agencies are not conducive to long-term investments. Al-though regulators acknowledge the problem that present approacheslead to, they believe that the available information base does not sup-port the development of credible multi-year tariffs. This paper evaluateswhether this constraint is a barrier to the implementation of an incen-tive-based methodology and shows that this need not be the case. AnIBRC (incentive-based revenue and cost pass-through) hybrid methodol-ogy that rewards companies for improvements in efficiency for costitems under their control is developed. The robustness of this approachis evaluated given the database of information available to regulators inIndia. These results are more generally applicable across other sectorsand in other countries.

* The work is that of the authors and does not necessarily reflect the views of their respectiveinstitutions. This paper draws on work previously published as a mimeo Setting multi-year tar-iffs in India: an assessment of some options in October 2000 by Alexander and Harris. Alexan-der’s work on this project commenced while employed by the Private Participation inInfrastructure Group within the World Bank.** Senior Private Sector Development Specialist, Private Sector Advisory Services Depart-ment, The World Bank, Washington, DC, USA

Ian Alexander and Clive Harris26


IntroductionIn 1999, the Government of Orissa privatized the distribution assetsof GRIDCO (Grid Corporation of Orissa) selling a controlling equityshare in four companies. Three of these were sold to the BombaySuburban Electricity Supply Co. Ltd and the fourth to a consortiumlead by the AES Corporation. A number of other states, includingAndhra Pradesh, Karnataka, and Uttar Pradesh, have announcedtheir intentions to privatize parts of their distribution systems. ThePrime Minister’s Economic Council has also recommended that theprivatization of distribution be implemented by state governments toreduce the high levels of theft and other non-technical losses seentoday in India.

However, potential operators of these distribution assets have ex-pressed concern at the lack of clearly defined paths for the prices thatthey will be allowed to charge to customers. SERCs (state electricityregulatory commissions) in India have thus far set prices on an an-nual basis, although some performance-based incentives have beenintroduced. This reflects their concern that the existing informationbase does not support the development of sufficiently accurate multi-year tariffs, making it likely that either excess profits would be madeor companies would make high losses and ask the regulator to re-open the price control. Either of these outcomes could damage thecredibility of the regulatory process.

In the next section, we review the present legal framework and theexisting approaches to price setting by SERCs. Thereafter, the mainapproaches to providing multi-year price paths are reviewed. Follow-ing this, their applicability to conditions prevailing in India is re-viewed. A methodology is developed around an IRBC (incentive-based revenue and cost pass-through) concept, which provides com-panies with incentives to reduce costs under their control and whichpasses on to consumers increases or decreases in costs outside of theircontrol. Finally, the robustness of this approach under Indian condi-tions is evaluated. It should be noted that this paper concerns itselfwith the issue of creating incentives within a pricing regime, it doesnot tackle the following important issues.n The cost-reflective nature of existing and future tariff levelsn The structure of tariffs.

Both of these are important issues that must be addressed but whichdo not directly impact on the overall design of the incentive regime asdiscussed here.

Incentive regulation and multi-year price controls 27


Price regulation of distribution in India: legal andregulatory framework and approaches adopted to date

Prior to the privatization in Orissa, India had substantial experiencewith private ownership and operation of distribution systems, withprivate electricity companies1 regulated as licensees under the SixthSchedule of the Electricity (Supply) Act, 1948. In essence, thisschedule sets out that on a year-to-year basis, the profit earned by anoperator should not, as far as possible, exceed the amount of reason-able return. The definition of a reasonable return is set in relation toprevailing government interest rates and the asset base.2

Reform legislation from the 1990s has allowed regulators to incor-porate other factors into pricing decisions to provide these incentives.The Orissa Electricity Reform Act, 1995, specifies the existing legis-lation as one factor to be considered by the OERC (Orissa ElectricityRegulatory Commission), but also includes the interest of consumersand other factors related, inter alia, to efficiency and good perform-ance. The Act also requires the OERC to record its reasons for devi-ating from the Sixth Schedule in writing. The Andhra PradeshElectricity Reform Act, 1998, adopts similar wording. The ElectricityRegulatory Commissions Act, 1998, of the Government of India alsoallows deviation from existing legislation to promote efficiency, re-flect the cost of service, and safeguard consumers. The new legisla-tion, therefore, explicitly allows regulators to deviate from the SixthSchedule. In practice, SERCs have followed the format of the SixthSchedule closely,3 but have deviated substantially in that the fullcosts of supply are not reflected in tariff orders (Table 1).4

There are variations in the level of revenue reduction, sometimesexplained by commitments to improve efficiency or by governmentsubsidies. There are also differences in the approaches taken bySERCs to adjust the revenue sought by utilities. However, the patternof substantial adjustments is consistent, as is the reliance on annualtariff reviews. SERCs have not yet adopted multi-year tariff orders,although these have been discussed in recent tariff orders andthe UPERC (Uttar Pradesh Electricity Regulatory Commission)

1 These are located in Ahmedabad, Kolkata, Mumbai, and Surat.2 See Ahluwalia (1999) for a fuller explanation of the application of the Sixth Schedule.3 This includes the details of the calculation of the asset base and the rate of return.4 It could well be argued that Table 1 underestimates the scale of the problem. State-ownedcompanies may well be influenced to ask for inadequate revenues to avoid the need for tariffincreases, and the lack of auditing means that the out-turn is not well known.



provided incentives based on sharing of revenues if the company wereto beat a set of pre-defined loss targets. With the exceptions of theDelhi Vidyut Board and the Kanpur Electricity Supply Board, noregulated entities have asked an SERC for anything resembling amulti-year price control.

The proposed Electricity Bill 2001 may well give regulatory com-missions greater freedom to develop different principles for pricing.However, SERCs will remain concerned about inadequate data caus-ing multi-year price controls that will damage the credibility of theregulator. Present approaches, however, do not provide a clear pic-ture of how regulators are going to set prices, and consequently in-crease perceptions of regulatory risk. Finally, the lack of a clearerpath for both prices or revenues means that efficiency improvementsthat require investments that have a payoff period of more than oneyear might be deterred.5

In the remainder of this section, we review two key issues relatingto this: the quality of the information base used by SERCs in theirprice reviews, in particular loss levels (both commercial and techni-cal) and the efficiency improvements generated by private distribu-tion companies. The latter is of particular interest given concerns thata multi-year price control may prove too lax for a company and thatexcess profit will be made. For this, we draw largely on experience

5 What is evident is that any incentive created through these PBR (performance-based regime)schemes may well be of a limited duration. At the most, annual price reviews mean that anybenefits of beating the incentives are quickly lost to consumers—forcing PBR to become moreof a stick than a carrot since the benefits of the carrot only last for a year. This is true, forexample, for schemes proposed by SERCs in India, which propose sharing of revenues frombeating a loss reduction target, but do not provide price or revenue projections to provide alikely monetary value for these benefits.

Table 1 Reductions in revenue (billion rupees) imposed by state electricityregulatory commissions

Orissa Orissa Andhra Uttar

1998/99 1999/2000 Pradesh Maharashtra Pradesh

Revenue requested by utility 21.68 23.59 96.81 131.55 86.87

Revenue allowed by regulator 17.84 18.43 90.39 119.46 75.41

Total reduction in revenue 3.84 5.16 6.42 12.09 11.46Total revenue reduction as

percentage of revenue requested 17.7% 21.9% 6.6% 9.2% 13.2%

Note Revenue does not include an adjustment for non-tariff income.

Source Ahluwalia (2000)



from Orissa, which has a history of regulatory reviews of prices datingto 1997 and experience since 1999 of private management and own-ership of distribution.

In their analysis of tariff filings, SERCs have focused on the diffi-culty of getting good estimates of the total losses of the regulated util-ity. Most states see metered sales at less than 50% of total sales. In itstariff order of May 2000, the APERC (Andhra Pradesh ElectricityRegulatory Commission) said it was not possible to estimate the levelof losses and to fix an appropriate loss target, and that the only reli-able target to use was the level of billing (APERC 2000). The mostrecent OERC tariff filings, which were completed in January 2001,still exhibit a considerable amount of uncertainty over the loss levelsreported by the four distribution companies.6 This suggests that itwill be difficult in practice to use loss levels to precisely target a rateof return, particularly on a relatively low asset base.

Evidence submitted by the licensees to the OERC suggests a rela-tively slow decline in the level of losses, due to the poor initial state ofthe state electricity board (and successor company) grids, difficultiesin instilling a commercial culture in staff, and the initial low levels ofmetering. The Central Electricity Supply Company of Orissa, one ofthe distribution companies, has reported a reduction of losses ofaround 3% a year, to a present level of around 43%. The other licen-sees have been reducing losses at a slower rate. However, billings and,in particular, collections have increased substantially faster, on aver-age by nearly 20% over the period 1999/2000. Despite this, none ofthe companies have been able to reach cash break-even as of this date.

This suggests that profits in excess of those forecast are unlikely inthe initial years of privatization in India and that the difficulty in ac-curately measuring key parameters such as losses needs to be takeninto account in designing an appropriate regulatory approach.7

OptionsWhile there is a continuum of price methodology options, they areusually simply classified under the following two broad headings(covering the extremes of the options).1 Cost-plus (or rate of return), where the allowed costs are calcu-

lated on the basis of costs actually borne by the operator.

6 The OERC comments that ‘The authenticity of the loss level projected by the licensee hasnot been supported with verifiable data.’ (OERC 2001, paragraph 7.3.2). The OERC thenrequested the licensee to perform surveys on feeders with metering of all consumers.7 Lack of information about losses is not unique to India. Many countries face similar prob-lems. One example of a regulator trying to tackle this problem is provided in Regulation andSupervision Board (2001).



2 Incentive-based (price caps, revenue caps, etc.), where theallowed costs are calculated, at least partly, on the basis of externalinformation.

These basic options have been discussed in detail in many otherplaces (for example, Armstrong, Cowan, and Vickers [1994]; Alexan-der, Mayer, and Weeds [1997]). So this section will focus on some ofthe other factors that can be included within the basic price control.These can be split into two separate areas.1 The allocation of costs between controllable and uncontrollable

elements, and the use of a pass-through mechanism for the latter.2 Variants on the basic incentive mechanism through sliding scale

(profit-sharing) and revenue controls.

Controllable costsWhen considering a regulated company, it is useful to consider thesplit of costs into those that the management of the company cancontrol and those it cannot. A regulatory commission should be seek-ing to provide the owners and management of a company with incen-tives to cut costs that are under their control and to insulate them fromabnormal profits and losses arising from costs that are outside their con-trol. For an electricity distribution company, costs are likely to be splitalong the lines shown in Table 2. Table 3 shows the relative importance ofeach type of cost element data using data from Andhra Pradesh.

As Table 2 shows, the degree of controllability is often far from asimple statement of being fully controllable or fully uncontrollable.Rather, two situations can arise.1 Some elements of a cost may be controllable; for example, the ba-

sic wage rate may be set by general macro-economic conditionsbut the rate of wage inflation may be partly under the control ofmanagement.

2 The degree of controllability may depend on the timeframe in-volved. For example, rates associated with buildings may be seenas a fixed uncontrollable element since changing them would in-volve moving the office. This may not be possible in the next year,but could be possible over a 5-year period.

Determining how to allocate costs between controllable and uncon-trollable is not straightforward. However, it is possible to do,and, as Table 3 shows, over 30% of the costs of an illustrative Indiandistribution company can be considered as controllable. As such,providing incentives to reduce these costs can have a significantimpact on prices.



Table 2 Initial thoughts on the degree of controllability

Variable Degree of control Comment

Demand Limited Clearly the company can at the margin affect demand, but(see comment on much will depend on general economic conditions, etc. In thelosses below) Indian context, the interaction with loss levels has to be

considered.Generation and Very limited Depends on the market model adopted. However, under thetransmission costs existing conditions in India any distribution company is

dependent on a single buyer achieving efficiency in powerpurchase. If a multi-buyer model is adopted, greater power ispassed to the company, but this may be initially limiteddepending on whether vesting contracts are put in place andover what period they cover.

Losses Substantial Assuming that the company can exercise control overemployees, they should have control over this variable. Asnoted in the introduction, the high level of losses in the Indianpower sector has led to their special treatment by regulators.

Labour costs Some As noted above, this cost category can be split into severalaspects. The company clearly has control over some of theseaspects. Exactly how much control will depend on theconditions set at the time of �privatization� covering issuessuch as staffing and pay bargaining.

Material costs Some While material costs will be partly determined by the state ofthe existing assets (something outside the company�s control),the company controls the processes by which it purchasesspare parts and is able to control some of the substitutabilitybetween investment and repairs.

Rent and rates Very limited In the short term, it is difficult for a company to change therent and rates bill. However, in the longer term, it is possible toshift towards low-cost buildings, etc.

Depreciation Limited Although much of the depreciation bill depends on the age ofthe assets and their costs, a company has the opportunity toargue that its assets should be revalued or asset lives altered.While these issues are then controlled by accountants, etc.,outside the direct influence of the company, experience hasshown that companies can have an influence on this.

Required profit Some If an optimum cost of capital (or even cost of equity) position isadopted by the regulator, companies have an opportunity tobeat this target by finding cheaper sources of funding, possiblythrough manipulation of the tax position.

Investment costs Some Investment can be split into several aspects. The quantity ofinvestment will depend on several factors including demand,quality, service expansion, and environmental obligations.Most of these are outside a company�s control. However, thecost of investment may be partly affected by a company�sdecisions, as may the timing�there may be a trade-offbetween some repairs and investments or some demand-related investments may have some flexibility as to when theyhave to occur.



Refinements to the incentive regimeThe regulatory system can be designed such that excessive profits arenot earned. This is unlikely to be an issue in India in the short term.Significant debate was sparked in the United Kingdom when it cameto light that companies were earning excess profits, which in manycases reflected in large pay increases and bonuses to management..

One explanation was that initial price controls were lax, including anunderestimation of demand that subsequently benefited the compa-nies. Another cause was a series of events outside the control of thecompanies leading to significant cost savings that were captured byinvestors rather than consumers. The lessons from this experiencewere that regulators had to focus more on getting the controls rightand ensuring investors only benefit from actions under the control ofthe managers of the company. Probability of excess profits can becontrolled byn ensuring companies only benefit from controllable cost savings—

so making uncontrollable cost movements a pass-through itemn limiting the profits of the company through a profit-sharing/slid-

ing scale regimen focusing on controllable total revenue rather than on controllable

cost for a unitn placing limitations on revenue through a sliding scale regimen re-basing an element of the control to capture costs diverging

from levels forecast in the review.

The first of these steps builds on the earlier discussion on controlla-ble costs. The others are described below.

Table 3 Allocation between controllable and uncontrollable costs for anillustrative Indian distribution company

Initial cost % ofElement Controllable (Rs million) total costs

Controllable opex Yes 9901.3 9.6Uncontrollable opex No 6044.1 5.9Investment Yes 7150.7 6.9Required profit (based on 16% return) Yes 1003.5 1.0Generation and transmission charges No 79249.9 76.7Electricity distribution lossesa Yes 20605.0 19.9

a Losses are part of the overall generation and transmission charge, but the company has somecontrol over it.Note These costs are an amalgamation of individual cost items.



Sharing of profitThis limits the profitability of a company once it moves above or be-low an acceptable range. For example, the acceptable range may be15%–17% and then anything outside that range is ‘shared’ with con-sumers on an agreed basis. Here, if the sharing rate was 50% and thecompany earned 10%, then a mechanism would be needed to allowprofits to increase to 12.5%. If profits were 20%, a mechanism to re-duce profits to 18.5% would likewise be needed. These mechanismscan be a correction factor applied to the following year’s prices asutilized in the classic profit-sharing example of New York Telephone,or a stabilization fund, as used in Hong Kong. The properties ofprofit-sharing have been studied in papers such as Mayer and Vickers(1996) and the case for using this approach is far from proven, and isdiscussed in the following section.

Revenue caps An approach that has gained support in the United Kingdom is thatof focusing on the total required revenue for a business, based ondemand assumptions, and then setting this on a CPI−X (consumerprice index – x) based approach. This still provides incentives for cut-ting costs but limits the upside for management to those factors notunder their control, such as unanticipated demand increases. It is stillpossible for a company to earn excess profits as a result of an unan-ticipated demand increase, but this is limited because any over- orunder-recovery of revenue is corrected for the following year nor-mally with financing of costs or interests included.

Sharing of revenueThis approach captures the revenue focus from revenue caps but thentreats revenue like profits. Thus, if revenue is above a certain pointsome of the revenue is returned, and if below, higher revenues arethen allowed for.

Rebasing the controlOne suggestion that has recently been put forward in the UnitedKingdom as a solution to information problems is that annualmechanistic rebasing should occur (Mayer 2001). Uncertainty re-garding assumptions about the future means that even well-proc-essed regulatory decisions can lead to significant excess profits. As analternative to reopening the whole regulatory decision, Mayer pro-poses a mechanical solution that maintains incentives for outper-forming other companies in the sector while correcting for genericmisassumptions. This solution depends on ensuring that the average



industry market value is equal to the average industry regulatory as-set base—a semi-replacement cost valuation of the assets. This en-sures that the average return earned is equal to the industry cost ofcapital, but divergences between companies within the industry arestill possible.

Choosing between these variations of the basic incentive approachdepends on having a framework for trading off the advantages anddisadvantages of each refinement, especially since many of the refine-ments are not mutually exclusive.

Framework for choosing the appropriate approachWhen assessing the options and their applicability in any specificcase, it is important to consider the following criteria.n Incentives for efficiency savings What are the management re-

warded for and what perverse impacts might incentives for effi-ciency savings have? This is also linked to the allocation of riskbetween the various stakeholders, in turn partly dependent on thecost structure of the company and the controllability question.

n Incentives for regulatory gaming Regulatory gaming is the situa-tion whereby withholding information, or presenting informationin a specific way, will be advantageous to the company and lead toit receiving a more favourable outcome. For example, under aprice cap any growth in demand beyond that originally forecastincreases profits for the company, giving it an incentive to under-estimate demand growth at the time of the regulatory review (for adiscussion of the various ‘gaming’ incentives, see Alexander andShugart 2000) (Risk, volatility and smoothing: regulatory options forcontrolling prices).

n Political acceptability Although regulation is often independent ofpolitics, the reality is that politicians may become involved if ex-cess profits (losses) occur.

n Ease of implementation Ease of implementation takes two forms.• Whether the regulatory body has the skills, information, and

resources to calculate and monitor the application of a regime.• Whether the costs of an option are greater than the benefits. If

a refinement will lead to only a small improvement in incen-tives yet is costly in terms of information and monitoring, thenit is likely that the refinement should not be applied. Regula-tion should only be undertaken when the benefits are greaterthan the costs.

n What new information is required each year Price and revenue capsrequire less information within a price review, being restricted tothat required to check where average prices and total revenues



Table 4 Assessment of options against the criteria

Criteria Comment Viable options

Cost allocation The majority of the controllable costs is Focus on revenue-basedfixed once the demand forecast for approaches rather than price-the coming period is known. When based ones.losses are considered a controllablecost, these should not be consideredas a fixed cost.

Efficiency savings Possible for the majority of direct Incentive-based systems aredistribution costs�about 50% of appropriate.the total electricity cost (oncedistribution losses are includedas a distribution cost)

Potential for gaming Significant potential, especially Focus on revenue-based approaches.in relation to losses and demand.

Political acceptability Need to ensure that significant Focus on profit-sharing andexcess profits are not earned. revenue-based approaches.

Shorter periods e.g. 3 rather than5 years to control an option.

Implementation Information availability is a Find systems that are mechanicalproblem. Existing resource base once the initial multi-year tariff isfor regulators is limited, making set. Concern about applyingmonitoring difficult. profit-sharing owing to the

subjective nature of profits.New information issues Expectation that new information Ability to improve estimation of

will become available over the future costs, especially in relationnext 3�5 years. to losses, suggests a shorter period

might be appropriate. Profit- orrevenue-sharing mechanisms couldalso be used to deal with extremeoutcomes. Mechanisms for re-basing by independent review of keyvariables could also provide someopportunity for adjusting the valuesof certain parameters, e.g. losses.

Impact of additional Given the nature of the state of Provided that the shocks are on theexternal factors reform in the sector it is possible uncontrollable costs this will not be an

that future shocks will occur. issue if cost pass-through is adopted.

(respectively) are relative to the annual level specified in the cap.Profit-sharing requires the annual calculation of returns and in-creases the level of regulatory risk because more variables can be re-viewed with the possibility of investments or costs being disallowed.

n Extent to which the control formula can incorporate new data onfactors outside the control of the company.

Having established a set of criteria by which any proposal can bemeasured, it is now possible to determine what, in our opinion, is theappropriate solution for electricity distribution in India. Clearly, anyspecific case should be considered on its own merits, but our overallview of the sector is given in Table 4.



Although profit-sharing meets some of the requirements of the cri-teria, it does not meet all. This is especially true with respect to po-tential for gaming, implementation, and low asset base.n Potential for gaming Profit-sharing may lead to companies having

incentives to (1) manage accounting numbers to lower profits(lower profits are preferable in all cases except inasmuch as inves-tors may downgrade a company owing to low reported profits)and (2) delay efficiency savings if by smoothing gains less, ornone, of the gains have to be immediately shared with consumers.

n Implementation The need to directly establish profitability, theimpact of uncontrollable costs on profitability, and the amount tobe shared will ensure that intrusive annual regulation will be re-quired—something that will place undue pressures on the devel-oping regulatory commissions in India and increase the amount ofregulatory uncertainty in the system

n Low asset base Most distribution companies in India have low as-set bases compared to revenues and costs, given present valuationapproaches and historically low levels of investment. As an exam-ple, a one per cent reduction in losses (translated fully into in-creased revenue) could lead to a near-doubling of the rate ofreturn. A profit-sharing scheme will have presentational difficul-ties since the bands may appear very large on paper when ex-pressed as a percentage of assets. Reducing the band woulddampen incentives to reduce losses.

A system based on a revenue cap with cost pass-through for non-con-trollable costs would seem most appropriate given its stronger abilityto allow real incentives for the company while controlling for politicalacceptability. It would also appear to be more easily implemented—the only annual adjustment should be mechanical.

A partial solution: an incentive-based revenue and costpass-through methodology

Given the discussion in the previous section, our preferred approachwill be one that focuses on revenue but allows uncontrollable costs tobe passed through. Consequently, if revenues were forecast for 5years, the only annual adjustments would be to incorporaten inflationn efficiency savings (the ‘X’ value)n over- or under-recovery of revenue compared to the controln mechanical correction for out-turn uncontrollable costs being dif-

ferent from forecast.



The control could look something like

R R CPI X C At t t t+ = × + − − −1 1( )

R is the level of revenue,8 CPI is the level of inflation, X is the ex-pected efficiency gain in controllable costs (corrected for the fact thatcontrollable costs are only one element of the required revenue), C isthe standard revenue-cap correction for over- or under-recovery ofrevenue (for example, if demand, or the composition of demand, wasdifferent from that forecast), and A is the adjustment for uncontrolla-ble cost elements, the elements of which are defined upfront at thestart of the price control.9 The distinction between C and A is rela-tively arbitrary. A simpler model could be proposed where those twoelements were combined. However, for the sake of clarity in the argu-ment the model has been specified with the two separate elements.

Building on Table 3, the items that would be treated as uncontrol-lable, and hence subject to a pass-through, would be generation costsand part of the operating costs, which account for over 80% of totalcosts in this example (with generation costs by far the dominant ele-ment).10 These would be forecast forward for the length of the pricecontrol period, but changes in these costs relative to forecast valueswould be reflected annually through the formula given above. Itshould be noted that this does not assume an immediate transition tofull cost recovery, which would be unrealistic given the present situa-tion in India. An increase in revenues towards full cost recovery,based on assumptions about improvement in efficiency, would needto be incorporated in the model.

To illustrate how the model would work, we consider three sce-narios.11

1 Out-turn demand diverges from forecast demand.

8 In the context of India, where billed and collected revenue are quite different, it is worthemphasizing that the target should be set on billed revenues.9 Both C and A should be corrected for the level of interest so that the company is no better orworse off in real terms.10 The tariff being considered here is the final retail tariff, which comprises generation, trans-mission, distribution, and supply costs. If we were to just focus on the distribution and supplyelements, then the vast majority of costs would be controllable. However, in the Indian con-text it seems most appropriate to consider the final total retail tariff. Our arguments would notbe changed if we just focused on the distribution and supply costs of the final tariff: all thatwould happen is that the equation would be written slightly differently.11 These and other scenarios are ‘quantified’ through simple financial modelling in Alexanderand Harris (2000) (Setting multi-year tariffs in India: an assessment of some options).



2 Planned investment announced at the price review is not under-taken.

3 Losses prove easier to deal with than anticipated by the regulator.

The first of these is the classic situation that revenue caps were de-signed to address. In the following year, the C term adjusts revenuesso that the over- or under-recovery of revenue is corrected for. So,while the company may appear to make exceptional gains or losses inthe year of the divergence, the following year, ceterus paribus, a com-pensating level of return will be made. Thus, if demand wasunderforecast and actual revenues were 100 million dollars morethan expected, although the company reports an additional 100 mil-lion dollars of profit in this year, the following year will see a declineof 100 million dollars (plus an imputed return) in profits, making theaverage return equal to that forecast.12 The company will have boughtmore energy in bulk but will not be penalized since this is treated asuncontrollable and hence subject to an automatic pass-through.

While determining the price control, it will be necessary for theregulator to determine, with inputs from the companies and otherstakeholders, what an appropriate level of investment should be. Thisinvestment should be clearly linked to levels of quality of service. Thecompany then has an incentive to deliver the quality of service at alower than forecast level of investment, so that it is able to earn higherprofits. If it is able to do so, revenue is unchanged but profits arehigher. Equally, if delivering the agreed levels of service costs morethan forecast, the company will suffer lower levels of profits. Diver-gences in investment from that forecast are an issue that has causedsignificant concern to regulators. One notable case was the‘clawback’ of investment undertaken by the Office of Regulation ofElectricity and Gas (Northern Ireland) in the late 1990s, which wassubsequently supported by the appeals body in the United Kingdom,the Monopolies and Mergers Commission (Monopolies and MergersCommission 1997). While the circumstances behind this action mayhave been unique, it does illustrate that investment must be consid-ered carefully.

What happens if losses are reduced faster than forecast? In the sim-ple model of the IBRC detailed above, the following outcome wouldoccur. Since losses are lower than forecast, revenues will be higher—either because less electricity is required to meet the existing demand

12 Of course, the reality would be a little more complex. There would be additional uncontrol-lable costs that would be incurred in the first year and then corrected in the following year thatwill mitigate to some extent the positive impact of unanticipated demand.



or because more units are now being collected. Under the revenuecap, this increase in revenue will be corrected for in the following yearthrough a lower allowed level of revenue. Consequently, it would ap-pear that there is no incentive to reduce losses beyond that forecastby the regulator, placing pressure on the regulator to provide credibleestimates of what is possible in what is an informationally demandingsituation. This is discussed in more detail below.

Implementation issues: is the IBRC approach toosimple?

One of the problems with regulatory regimes is that the devil is in thedetail. While it is possible to establish what, on the surface, appears tobe simple controls to ensure appropriate incentive properties, often awhole raft of additional elements of the regime are grafted on to thesimple equation. While this may be appropriate in some cases, allregulators should investigate whether the refinements provide moreof an addition than the costs that they impose on the regulator andthe company. This sort of cost-benefit analysis of regulation is regu-larly undertaken in countries like Australia and provides a usefultouchstone for regulators and ensures that ‘regulatory creep’ does notoccur.

Two areas of concern regarding the incentives inherent within theIBRC approach arose when considering the scenarios illustrating theoperation of the system. This section of the paper considers the pos-sible solutions to these concerns and sets out the pros and cons ofmaking the IBRC approach more complex to overcome these con-cerns. Any specific application of this type of model should addresseach of these concerns in the context of the state or country to whichthe model is being applied. We outline here the options that can befollowed if the issue is felt to be significant enough to require correction.

InvestmentFinding an approach that adequately incentivizes investment is theHoly Grail of regulation. No regulator has yet achieved this situation,although some have moved closer than others to achieving this. Re-finements to the simple IBRC approach to improve the positive in-centives for investment without creating perverse incentives forunder- or over-investment must be measured against the ‘deepening’of regulation that is required to establish whether investments havebeen delayed for appropriate reasons, etc.13 Increased intrusion

13 Here, deepening should be translated as greater intrusion by the regulator on an ongoingbasis requiring enhanced regulatory resources and greater reporting costs to the company.



would not be necessary if it was possible to determine an appropriateset of service indicators that could be accurately measured. A focuson outcomes would allow the regulator and company to agree on anappropriate investment programme that would deliver the desiredoutcomes and then give the regulator a measure of whether the com-pany was failing to deliver its part of the bargain. Sadly, this clear linkbetween investment and outcomes is not possible.

Some of the other approaches to dealing with divergences in in-vestment are as follows.1 Annual reporting of investment including an explanation of any

divergence.2 Detailed investigations of any divergence over the life of the price

control period at the end of the price control period, with acorrection to ensure that any unacceptable divergence is revenueneutral.

3 Shortening the price control period—making it easier to forecastthe investment requirements over the period and so limit the op-portunities for exploitation.

4 Excluding investment from the initial price control but then roll-ing-up actual investment and including it with an ex post adjust-ment at the end of the period to allow the recovery of prudentlyundertaken investment.14

It should be noted that these approaches are not necessarily mutuallyexclusive and may even have complementary effects.

The first approach requires greatly enhanced regulatory auditingresources. However, even this would be less intensive than presentpractices in India of reviewing annual investments before they areadded to the rate base (along the lines of the ‘used and useful’ con-cept). Similar issues arise with the fourth approach. Rolling-up in-vestment at the end of the period also raises questions about theability of companies to meet the financing costs of the investmentprior to the recovery of costs at a later date. It also introduces anotherpotential source of regulatory discretion.15 Overall, the second

14 This approach has been adopted in Abu Dhabi and a variant, focusing only on unanticipatedinvestment, has been utilized by OFWAT, the water regulator in England and Wales.15 In Abu Dhabi, the approach of setting the price controls without regard to capital expendi-ture forecasts was discussed in a series of consultation papers and was applied with the agree-ment of the companies concerned. The process of consultation also identified the criteria to beused by the regulator when deciding whether actual expenditures should be included in theregulatory asset base. The ex ante publication of such criteria limits regulatory discretion. Theregulator also satisfied itself that the approach to capital expenditure would not result in un-due price volatility between price control periods.



approach is more appropriate—reviewing the last price control period asan input to the determination of the forecasts for the next price controlperiod is a key element of the price determination process.

Given the relative importance of investment, especially when com-pared to the desire to create incentives and the significance of losses,it is probably not appropriate to limit the price control period to, say3 years rather than 5. However, given that most distribution compa-nies will need substantial investments, this might be an appropriaterefinement of the IBRC in some circumstances.

LossesThe losses scenario showed that the IBRC provides no incentive toreduce losses beyond those forecast by the regulator. This raises someconcerns in thatn information on losses is limited (as discussed earlier) and conse-

quently regulators may find establishing credible and testing fore-casts of losses difficult

n the lack of incentives means that improving the information databasethrough companies striving to outperform the target will not occur.

Given the quantitative importance of losses within the financialframework of the distribution companies, the question of whethergreater incentives for loss reduction should be incorporated into theformula must be addressed.

Several options are available for increasing the incentive for lossreduction. We consider two here—many others may exist, but thesetwo serve to illustrate the approach to refining the model. These op-tions are1 any increases in revenue that are not associated with an increase in

electricity purchases by the distributor can be kept by the com-pany as higher profits and

2 a separate item relating to measured losses is introduced into theformula whereby losses are directly calculated and incorporatedinto the model.

Although both options provide incentives, they do this in differentways and have different information needs.

With an approach based around the level of revenue and electricitysales rather than having to directly measure the level of losses, thefocus is on the impact. This approach tries to separate the two ele-ments of movements in revenue, namely1 increases or decreases in the level of demand and2 improved collection of bills or reduction in technical losses.



To distinguish between the two revenue drivers, the level of electricitypurchases is used. If demand is increasing and the level of losses isunchanged, then more electricity will have to be purchased. How-ever, if for the same level of electricity purchases greater revenue canbe recovered, this must be through a reduction in losses. As such, thecompany can be incentivized to reduce losses by applying this correc-tion factor.16

Establishing the form of such a control is relatively straightfor-ward. Revenue can be split into four elements.1 The number of units of electricity purchased by the distribution

company2 The generation and transmission price per unit of electricity pur-

chased3 Distribution costs4 Losses (comprising technical and commercial).

By considering the calculation of forecast and actual revenue usingthese elements, it is possible to get an estimate of the change in lossesfrom those forecast. It is this impact that you would want to allow thecompany to retain. This estimate has to be derived from the total gen-eration purchased information, owing to the lack of reliable meteringdata. Something like the following could be employed.

TG N G ltf

tf

tf

tf= × × +d i d i1

where TG is the total generation cost, N is the kWh collected fromconsumers as estimated by the company,17 G is the generation andtransmission price per billed kWh, and l is the proportion of losses.The superscript f denotes a forecast figure and there is a time sub-script t.

Any divergence in actual TG not explained by a divergence in oneof these elements must be due to a change in losses, the element thatwe wish to isolate and incentivize the company to control.

It is possible to estimate the losses that actually occur by solvingthe equation

16 Some issues relating to the practical application of this methodology may arise if individualtariff levels are not established by the regulator. These implementation issues are not insur-mountable and interact with the general revenue-cap elements of the control.17 Ideally one would use actual sales but these are not readily verifiable in most states in Indiagiven low levels of metering.



lTG

N Gta t

a

ta

ta

=×

L

NMM

O

QPP

−d i

1

where a denotes an actual figure. The impact of the change in losses(L) can then be estimated and the company rewarded accordingly.

L l l N Gt tf

ta

tf

tf= − × ×d i d i

This approach relies on information reported by the company. Incen-tives for loss reduction are high, since the company effectively keepsthe generation cost per unit of electricity—consequently, it may beappropriate to share the impact, although this does raise issues aboutincentives as noted above with other sharing systems. Since it is notpossible to distinguish between reducing losses and selling more, thecompany may also get rewarded for demand increases.

The second approach would be to measure the losses directly.This would then allow a simple correction factor to be introduced,which captured the exact change in losses. This type of approach wasmodelled in Alexander and Harris (2000) (Setting multi-year tariffs inIndia: an assessment of some options), where losses were included ana-lytically as a controllable cost, with reductions in losses over andabove that forecast being kept by the company, and excesses abovethose forecast being borne by the company. This requires reasonablyaccurate measures of losses, arguably something that the companieshave failed to provide, including those that have been privatized.

Losses are by far the most important of the controllable costs andconsequently whatever incentives possible should be provided fortheir reduction. Correspondingly, we would recommend that theIBRC formula be recast as

R R CPI X C A Lt t t t t+ = × + − − − +1 1[ ]

Lt is a measure of the impact of changes in losses relative to the levelof losses forecast. Initially we would recommend that the simple rev-enue-based calculation be used. This is limited in terms of the incen-tives it provides but is easy to implement. If the companies can startto provide improved information on losses then we would recom-mend moving to a more direct measure of the change in losses whichprovides greater incentives for the companies—if anything, this is a



good way of determining whether the investment in improved meter-ing is worthwhile.

A third modification would be to move towards a price-cap regime,where a price per unit sold is established (with adjustments forchanges in the per unit costs of uncontrollable cost inputs such asbulk power purchase costs). This would have the advantage that anyincrease in sales would be retained by the company, providing clearerincentives for loss reduction. This would, of course, suffer from thesame deficiencies that were noted for price caps in the section on‘Framework for choosing the appropriate approach’. It could be ar-gued, however, that in the short term, it would be a possible transi-tional option and that as long as companies were investing to meetdemand and increase sales, they should not face an incentive regimethat blunts their interest to do this.

Which of the options described above is suitable could be exam-ined by modelling the impact of the different controls under variousassumptions, including the accuracy of loss estimates.

ConclusionsThis paper has attempted to show that it is possible to construct amulti-year price control formula for the Indian power sector whichcreates incentives for companies to operate efficiently, limit the ben-efits enjoyed by companies to controllable cost items, so keeping thereturn ‘fair’, provide forward-looking price paths that will help pro-vide certainty to investors,18 and is relatively administratively light-handed. This can be done within the informational constraints thatpresently exist in the Indian power sector by focusing on informationthat is available and can be audited and by incorporating new informa-tion on parameters in the control formula as they become available.

Our initial IBRC model, however, is probably too simplistic.Losses are clearly an important issue and, as such, a correction forthese should be introduced to provide enhanced incentives for lossreduction. This is one area where information is a constraint. Ourproposal to overcome this is simple and consequently does not createas high a degree of incentive as would be achieved with good infor-mation on losses. However, the focus on a simple model makes im-plementation possible and also creates an incentive for the companiesto improve their measurement of losses if this will be advantageous tothe companies. As such it is a good model to determine the appropriate

18 Consumers also appreciate certainty about the price path since it allows them to plan futureexpenditure. Having prices that move significantly from year-to-year may make some budget-ing decisions difficult for both industry and households. Providing certainty to consumersthrough a multi-year price path helps overcome this.



level of investment in metering that is required for each distributioncompany. There is no ‘one size fits all’ answer to the problems facedby SERCs. The solution developed in this paper is an illustration ofthe way in which some aspects of the problem can be considered andovercome.

At present, in India, high transmission and distribution losses andlow levels of collection efficiency mean that present tariff levels donot provide a base for covering costs. Evidence to date suggests thatreductions in losses and improvements in collections will not berapid. There will be a need to introduce price increases while makingrealistic assumptions about efficiency improvements if private man-agement and capital is to be introduced. It is important to note thatthere is no regulatory approach that can get around this difficulty.Whichever approach is adopted will need to deal with these funda-mentals. The advantage of the proposed approach is that it sets outmore clearly the revenue path for the company and provides incen-tives for improved efficiency.

There are a large number of issues associated with setting multi-year tariffs that this paper does not touch on and, clearly, a great dealof work is required to make this operational. However, one advantageof the proposed approach, as compared to present approaches, is thatit frees up more time for SERCs to focus on issues such as the qualityof service provided by the companies and their responsiveness toconsumers.

AcknowledgementsThe authors are grateful to Aftab Raza (Regulation and SupervisionBureau, Abu Dhabi), Alan Townsend (The World Bank), SanjeevAhluwalia (formerly Secretary to Central Electricity RegulatoryCommission, India), and William Derbyshire (Frontier Economics).The authors are also grateful to the participants in the infrastructuresession at the International Conference on Industrialization in a Reform-ing Economy, organized by the Delhi School of Economics, 20–22 De-cember 2000, and to an anonymous referee for comments on this andearlier drafts of the paper. This work also benefited from practical ap-plication on behalf of the Kazakhstan electricity regulator in 2000.

ReferencesAhluwalia S S. 1999Tariff reform in India: a review of directions and issuesIn Transition to a Liberalized Environment: experiences and issues in regulation, pp. 198–214, edited by L Srivastava and S K Sarkar.New Delhi: Tata Energy Research Institute. 595 pp.



Ahluwalia S S. 2000Developments in price regulation: approaches adopted in the Indian powersectorPaper presented at the 2nd South Asia Forum for Infrastructure Regulation Core Train-ing Course on Infrastructure Regulation and Reform, 4–15 December 2000, Dambulla,Sri Lanka.

Alexander I, Mayer C, and Weeds H. 1997Regulatory Structure and Risk and Infrastructure FirmsWashington, DC: The World Bank.

APERC. 2000Order for the revision of tariffs of Transmission Corporation of AndhraPradesh Limited for Financial Year 2000–01Hyderabad: Andhra Pradesh Electricity Regulatory Commission [May 2000]

Armstrong, Cowan, and Vickers. 1994Regulatory Reform: economic analysis and British experienceCambridge, Massachusetts, USA: MIT Press.

Mayer C. 2001Water: the 1999 price reviewIn Regulating Utilities: new issues, new solutions, pp. 1–16, edited by C RobinsonCheltenham: Edward Elgar.

Mayer C and Vickers J. 1996Profit-Sharing Regulation: an economic appraisalLondon: Institute for Fiscal Studies.

Monopolies and Mergers Commission. 1997Northern Ireland Electricity Plc: a report on a reference under Article 15 ofthe Electricity (Northern Ireland) Order 1992UK: HMSO.

OERC. 2001Revenue requirement and determination of tariff for retail supply for M/sCentral Electricity Supply Company of Orissa Ltd (paragraph 7.3.2)Bhubaneswar: Orissa Electricity Regulatory Commission [January 2001]

Regulation and Supervision Board. 2001Initial consultation on the review of price controls for the Al Ain and AbuDhabi distribution companies, TransCo and ADWECAbu Dhabi: Regulation and Supervision Board.

Energy industry restructuring in Brazil:a critical vision

Lineu Belico dos Reis,* James Silva S Correia,** and RenatoCâmara Mendonça***Escola Politécnica da Universidade de São Paulo - PEA USP, Av. Prof. LucianoGualberto, Trav. 3, 158, CEP: 05508-900, São Paulo � SP, Brasil


**Universidade Salvador – UNIFACS, Av. Cardeal da Silva, 132, Federação, CEP: 40220-141, Salvador – BA, Brasil

AbstractThis article presents a critical analysis of the restructuring process in theenergy industry in Brazil, emphasizing the influence of the country�s pe-culiarities. The analysis focuses initially on the general energy scenario,especially the main problems that led to reform in the energy sector.Then the two main energy sectors � petroleum/gas and electricity � arereviewed, with an emphasis on the basis and construction of the newmodels; principles and objectives of the models; and the role of the in-stitutional participants. Reference is also made to problems associatedwith the period of transition to the new models.

Present difficulties such as the lack of investments, necessity of elec-tricity rationing, and political pressures, are finally introduced into thescenario, allowing a critical vision of the situation, in which the mainaccomplishments and challenges are emphasized.

This summarized view of the recent changes in the Brazilian energyindustry may be the basis for further work and discussions on the sub-ject, and represents an experience that can be helpful for other coun-tries or regions going through structural changes.

Lineu Belico dos Reis, James Silva S Correia, and Renato Câmara Mendonça48


Brazilian energy scenarioBrazil is the largest country in Latin America as regards its economy,population, and territorial extent. The country is going through aprocess of economic growth, which depends strongly on the use ofenergy. Energy will also be needed to provide better infrastructuredistribution across the country (about 15% of the population is stillnot supplied with electricity) and to guarantee the basic needs for agreat part of the population (that forms part of the repressed energydemand). An efficient and environmentally integrated use of naturalresources should also be envisaged, considering a sustainable devel-opment pattern.

The Brazilian energy matrix can be considered very ‘clean’ with re-gard to the environmental questions related to global warming. Table 1shows the energy consumption structure in Brazil during the last twodecades.

Brazil has been going through a series of structural changes in itsevolutionary process. Intense debates during the last decade on thegovernment’s role in the Brazilian society resulted in the decision tochange to a regulatory state rather than an entrepreneur state. Thischoice had a significant impact on the national energy industry, lead-ing to privatization of most of the energy companies. As a conse-quence, new investments are held by private capital, leaving to thestate regulatory agencies the task of regulating the industry. The insti-tutional role of the regulatory agent, as one responsible for acting ina constant search for the balance among the several participants inthe market, has been consolidated within this period.

The strategic role of electricity in the country’s economic growthresulted in this industry going through a deep restructuring process,which was designed considering its peculiar characteristics and thedecisive role of the regulatory agents in promoting the adequate andbalanced development of the free and competitive market. An elec-tricity regulator, ANEEL (National Agency of Electric Power), wascreated and has been playing an outstanding role in the new model ofa free and competitive market. Besides the energy generated fromlarge hydroelectric power stations (around 92% of the present elec-tricity supply) and the thermal generation envisaged in the shortterm (using natural gas, mainly from Bolivia), generation from re-newable energy sources (biomass, solar energy, wind energy, smallhydro plants, and cogeneration plants) is also included and would getincentives in this new scenario. Experts in Brazil generally supportthe idea that the ideal energy matrix should be one that minimizes thecurrent and future costs for society, considering the economic, tech-nological, social, and environmental aspects. This needs to be kept in

Energy industry restructuring in Brazil: a critical vision 49


mind by the regulatory agents in their efforts to balance the interestsof all the actors in the sector.

The path taken by the state in the electric power restructuringprocess was followed in the petroleum and natural gas sectors; that is,the competition among the participants in these markets would beregulated by an agency linked to the public sector. Therefore, theANP (National Agency of Petroleum) was created to look at the con-tinuous development of the petroleum and gas industries in Brazil.

Energy industry�s restructuring processThe energy industry as a whole: basic and integrationaspects

The energy industry structure is related to the global economic sce-nario. The following structural transformations occurred and sus-tained this industry’s growth.n Mechanical uses of energy grew quicker than the thermal uses that

prevailed in the pre-industrial societies.n New energy sources (coal, petroleum, hydroelectricity, natural

gas, nuclear) have been inducted into the scenario along the years.n The world regions now denominated as ‘developing countries’

(mainly in Asia) consumed more than half of the world energyproduction until Europe and North America overtook them dur-ing the first half of the 19th century. By the beginning of the 20thcentury, Europe and North America together consumed 75% ofthe world energy production.

Table 1 Energy consumption structure in Brazil (share in %)

Year

Fuel 1970 1980 1990 1999

Diesel 7.6 12.1 12.0 12.3Fuel oil 9.4 12.5 5.6 4.5Gasoline 10.5 6.8 4.3 6.0Natural gas 0.1 0.7 1.8 2.4Electricity 16.6 27.9 37.3 39.5Mineral coal 2.4 3.7 4.5 4.1Firewood 42.7 20.2 12.6 7.5Alcohol 0.4 1.3 3.6 3.1Others 10.3 14.8 18.3 20.6

Source Ministry of Mines and Energy (2000)



These structural changes cannot be dissociated from the world de-mographic growth, and more importantly, from the revolutions andtransformations that resulted from them. Both economic growth andenergy growth are mutually connected and influence each other de-pending on the time and the agreements between the involved nations.

The current energy industry increasingly demands efficient pat-terns of competitiveness to reach larger market shares. From thispoint of view, the verticalization process of these industries becomesmore and more important to achieve cost reductions and increase op-erational efficiencies. This process shows the need for a constant con-textual understanding of the transformation that society has gonethrough in the past few years.

The petroleum companies, which are strongly represented in theglobal energy market, have been trying to optimize their operationaland managerial resources. The petroleum industry has gone throughseveral changes, with strong investments from major companies tokeep up its continuous growth. This has led to the following majorstructural changes.n Verticalization The trend to form a single energy market and the

implementation of e-commerce in the near future (which can im-prove activities and businesses in the whole chain and create newbusinesses for companies in the industry, besides enabling the en-trance of new participants from other economical segments).

n Great partnerships and alliances.

With the evolution of a highly competitive market, there is a greaterstruggle for a larger market share and, as a consequence, for companygrowth. Major companies attempted to capture a larger number ofconsumers in their home markets. This trend, which started at theend of the 19th century and the beginning of the 20th century, accel-erated in the second half of the 20th century.

Another approach to develop the industry was through a diversifi-cation of products. The peculiar characteristics of the energy industryusually makes investment in multiple lucrative projects more feasible(less costly) than investment in separate projects. Therefore, petro-leum companies became energy companies, taking advantage of theseveral vertical and integrated processes in the petroleum, gas, andelectric power segments. This leads to the so-called convergence,which is one of the most important issues presently in the regulatoryscenario due to its link with different regulatory agencies and its im-pact on the consumers’ perception and treatment.

This general view of the energy industry as a whole and its interna-tional trend stresses clearly one basic responsibility of the regulatory



agencies, which is rather difficult to accomplish: to maintain the mar-ket free and competitive, in spite of economic trends, and one thatguards consumers’ interests. This conflict is, in essence, the raisond’etre of regulation.

Petroleum and natural gas industriesThe first Brazilian regulation for the petroleum industry appeared on29 April 1938 in Law No. 395 through which the government createdthe CNP (National Council of Petroleum), directly subordinate tothe president. The mission of the CNP was to make the decisions re-garding development of the Brazilian petroleum industry.

On 10 March 1953, after many public and political debates, thepetroleum monopoly was established through Federal Law No. 2004.It constituted the PETROBRAS, the Brazilian Petroleum Corpora-tion, linked to the Ministry of Mines and Energy, and defined its role.The main functions of PETROBRAS included research, drilling, re-fining, processing, trading, and transportation (along with other as-sociated activities) of petroleum obtained from various sources(wells, schist, and other rocks), petroleum products, natural gas, fluidhydrocarbons, etc.

The same law that authorized the creation of PETROBRAS alsodefined its performance conditions, specifying details regardingshareholders, management, and fiscal board. It also included thecreation of subsidiaries, albeit with the approval of the CNP.

Later, the procedure adopted in the relationship between the CNPand PETROBRAS was established through a federal ordinance. TheCNP holds orientation and monitoring duties and PETROBRASholds the federal monopoly, including its subsidiaries. The monopolyextended from the exploration to the distribution, not including thecommercialization of petroleum and its derived products. Even withthe PETROBRAS monopoly, there were already several foreign com-panies in Brazil operating under the so-called ‘risk contracts’. There-fore, the scenario and history of the Brazilian petroleum industry aredirectly related to the performance of PETROBRAS, which held a mo-nopoly over most of the activities related to the processes of this industry

Until the mid-1970s, PETROBRAS was not very active in the ex-ploration field, focusing more on terrestrial basin research. Sincethen, it gradually started to focus on ocean basin research, and, afterthe confirmation of the great potential of petroleum reserves in theCampos Basin in the state of Rio de Janeiro, PETROBRAS signifi-cantly increased oil production and improved its profits.

The industry restructuring began in 1997, with the passing of theLaw of Petroleum, which determined the end of the PETROBRAS



monopoly. The process of opening the market is increasing rapidlybecause PETROBRAS now shares the market with 34 other compa-nies operating in the country, with 22 of them focusing on both ex-ploratory blocks and production.

This scenario has come about mainly because PETROBRAS in-creased its partnership portfolio in 1998, and also because the ANP(National Agency of Petroleum), created under the above law, startedthe period of area concession auctions in 1999. Significantly, 44 ofthe 119 existent exploratory concession areas are not explored byPETROBRAS.

Another important factor is the strategic importance given to de-velopment of activities in foreign territories by PETROBRAS. This, itwas felt, would consolidate its position as a competitive company inthe global scenario. This strategy is yielding results today, exemplifiedin the following: exploration of wells in Nigeria and EquatorialGuinea, production of 20 000 barrels a day in Colombia and 19 000barrels a day in Angola, export of crude petroleum to China, theUnited States, and France, besides partnerships with French andJapanese companies and with the Ukraine to explore gas and petro-leum in the Black Sea. PETROBRAS has thus become a global com-pany acting in a strategic manner, with partnerships with othercompanies, and diversifying its activities.

Today, Brazil has the second largest oil reserve in South America(Venezuela has the largest), and it is predicted that the country willbecome self-sufficient in petroleum production in just a few years.

Like in the petroleum industry, the natural gas market used to beregulated such that the exploration, production, processing, import,export, and transport activities were under federal monopoly and thedistribution, storage, and commercialization activities were under thecontrol of the federation states.

Exploration and production structures in Brazil are also similarand related to the petroleum market. The processing units are similarto the petroleum refineries. Afterwards, the industry started to oper-ate as a network, showing similarities to the electric power industry.

After the Law of Petroleum, the natural gas industry has evolvedsignificantly, going from a monopoly in the exploration and produc-tion activities and a few state agents holding the commercializationactivities to a competitive market situation.

Natural gas has a share of only 2.4% of the Brazilian energy matrixtoday, with about 4820 km of distribution pipelines and 4240 km oftransport pipelines (excluding the Brazil–Bolivia gas pipeline). Theprospect of increasing its share in the energy matrix and building onthe gas pipelines acted as the drivers for reform. The government



hopes to attract international capital by providing the necessary in-centives for the market to be competitive, thereby bringing both fi-nancial and quality benefits for both investors and consumers.

Summarizing, it is possible to state that the petroleum and thenatural gas industries have gone through several structural changes inthe last few years. In 1997, as mentioned earlier, ANP was createdthrough the Law of Petroleum. As stated in this law, ANP is responsi-ble for regulating the industry opening process for both local and for-eign companies. Today, PETROBRAS no longer holds theexploration, production, distribution, refining, and importation mo-nopoly in Brazil. With the reality of a competitive market, there is theexpectation of market growth and, therefore, the necessity for theregulating agency to establish the rules to support it.

The new model: principles and objectivesIn this period of transition from a monopolistic to a free market,based on partnerships, alliances, and new contracts that regulate thepetroleum and natural gas activities, Brazil needs a new regulatorymodel. This model should facilitate a competitive market and pro-vide, as a consequence, technical–scientific development.

The regulatory agency ANP must establish uniform criteria to befollowed within the whole national territory; compare the quality in-dicators of several participants at the national level; settle technical,economical, and juridical conflicts between state and municipalagents; regulate the Federal Ordinary Law and, most important,regulate its performance in agreement with the Consumer DefenseCode issues.

The public services that are regulated by the state must follow fivebasic principles.1 Permanence Imposes the continuity of the service2 Generality Imposes the same level of service for all consumers3 Efficiency Demands constant service updating4 Reasonable costs Demands reasonable tariffs5 Courtesy Good performance for benefit of the public.

The regulatory agency must re-establish appropriate market opera-tion in the case of lack of any of these requirements.

The Federal Law No. 9478 of 6 August 1997 in the ConstitutionalAmendment No. 5/95 denominated the Law of Petroleum discussedearlier. The Law of Petroleum deals with the basic rules to be fol-lowed in the formulation of national energy policies – including elec-tric power, petroleum, and natural gas – and not merely with thepetroleum-related subjects. Therefore, it demands special attention



in its interpretation and applicability. It is a legislative matter exclu-sively related to the Federal Union, as established in Article 22 of theFederal Constitution of 1988.

With the end of the Federal Union monopoly and the participationof the private initiative in field exploration with all its risks, the statefocused its attention towards promoting competition.

Juridical questionings and interest conflicts exist now, as severalagents now participate in economic activities that were once mo-nopolistic. Just the petroleum and natural gas exploration, develop-ment, and production are based on concession contracts, once theyinvolve exclusive Union’s exploratory rights. Within the presentframework, the utility has the obligation of exploring the field orgroup concession contracts, but it will only pay the government’sshare if the production is successful.

The objectives initially planned for restructuring the petroleumand natural gas industries in Brazil can be summarized as newincentives for the economy, promotion of national development,greater social justice, market expansion, increase of technologicalknowledge, and protection of the citizen/consumer interests and theenvironment.

Role of institutional participants: government(CNPE) and regulatory agencies

The government is mainly responsible for the energy developmentprocess in a country. Even if it does not act as an investor, it mustcreate mechanisms to promote the sustainable growth of that seg-ment. Recognizing this concept, the CNPE was created to advise thepresident and to formulate policies and strategic guidelines for theenergy industry.

The CNPE was created by the Law No. 9478 (Law of Petroleum),regulated by the Ordinance No. 2457 of 14 January 1998, and itsoperation is authorized by the Resolution No. 1 of 7 November 2000.

The CNPE has the following goals.n Promote the rational use of energy resourcesn Expand the country’s competitiveness in the international marketn Assure, based on regional characteristics, energy supply to the

most remote or inaccessible areas in the countryn Periodically review the energy matrix in different areas of the

country, considering the conventional and the alternative sourcesand also the available technologies

n Establish guidelines for specific alternative sources such as naturalgas, alcohol, other biomass, coal, and thermonuclear energy usageprogrammes



n Establish the guidelines for import and export, to fit the internalconsumption needs, for petroleum and its derived products, natu-ral and condensed gas

n Assure the appropriate operation of the National System of FuelsInventory

n Guarantee the execution of the Annual Plan of Strategic FuelsInventory.

The CNPE is formed by the Minister of State of Mines and En-ergy; the Minister of State of Science and Technology; the Minister ofState of Planning and Budgeting; the Minister of State of Finance;the Minister of State of the Environment; the Minister of State of theIndustry, Trade and Tourism; the Secretary of Strategic Subjects ofthe Presidency; a representative of federal states and districts; and aBrazilian citizen who is a specialist in energy issues.

The government, represented by the CNPE, must interact perma-nently with the regulatory agencies to assure an integrated processthat will get the results initially set.

The ANP, which is regulated by the president through Ordinance No.2455 of 14 January 1998, was established as an autarchy under specialregime, with patrimonial, administrative, and financial autonomy.

Although ANP is linked to the Ministry of Mines and Energy, itmust act as an autonomous agency for the petroleum and natural gasindustries, preserving the interests of the Brazilian society. Therefore,the directors chosen to run the agency must go through an approvalprocess of the Congress before assuming their positions.

The law stipulates regulatory and monitoring (with penalization, ifneeded) functions besides the task of promoting concession auctions.The ANP is supposed to undertake only those studies and researchleading to political decisions that will result in industrial, technical,and economic development of the country.

The ANP has the following principles and objectives.n Supervise the operators’ market powern Organize the entrance of new operatorsn Care for the implementation of a new organizational modeln Arbitrate conflicts between the participantsn Complete the regulation processn Stimulate both efficiency and innovation.

Therefore, the ANP acts in practically all stages of the petroleum andgas industries, excluding the piped gas services.

To establish its credibility, ANP had to overcome several chal-lenges. These included the provision of regulations still missing,



PETROBRAS’s transition to the new model, the market openingprocess, and the temporal asymmetry between the regulator and themarket.

The ANP must communicate to CADE (Administrative Councilof Economic Defense) in case of any irregularity or infraction. Thecouncil will adopt reasonable procedures based on the pertinent leg-islation. The functions of CADE are to monitor the market practicesand to promote the competent administrative process to investigateany infraction of economic order, acting both preventively and re-pressively.

The main objective of the ANP, together with CADE, is to assurecompetition to protect consumer rights. It protects the marketdynamics – free competition – a general principle of any economicactivity.

An innovation that occurred not only with the ANP but also withother regulatory agencies was their economic and financial inde-pendence, obtained through endowments consigned at the UnionGeneral Budget, government stakes, donations, etc.

Along with the ANP, the following characterize the post-monopolyperiod.n The change of the state’s role from entrepreneur activities to regu-

latory tasksn A larger regulation of the industry through the ANPn The implementation of the exploration area auctionsn Increasing investments from both national and international com-

paniesn The Brazil–Bolivia pipeline, the largest investment for the natural

gas market, with the possibility of a second gas pipeline to assist inthe growing demand of natural gas in Brazil.

Electric power industryThe new model: principles and objectives

Due to its enormous territorial extent and its heterogeneous social,political, and economical characteristics, Brazil had to modify thebases of its electric power structure model to keep pace with the de-velopment of other nations.

Problems related to the old structural model, such as high levels ofdebt, bad management, and lack of control, resulted in redirectingthe focus of the state’s actions mainly to promote the social develop-ment of the country. This new definition included the redirection ofits operations such that it would focus, at least ideologically, on theactions related to social issues and also to the progressive expansionof the private sector in the infrastructure sectors. So it has been



possible to identify the intention of the state in acting as a regulatoryentity in several public sectors and services, leaving business per-formance to private companies.

In that context, a programme to decrease the state presence in theBrazilian economy, the Programa Nacional de Desestatização, wasstarted in the early 1990s through the privatization of metallurgicalparks and petrochemical plants. This programme was strengthened in1995 with the promulgation of the Law of Public Services Conces-sions, analysing the privatization of the public utilities, and it becamea landmark in the identification of a new political strategy for thecountry.

The creation of regulatory agencies of public services wasprioritized. These agencies should establish minimum conditions forthe development of the respective markets and also prioritize socialachievements.

ANEEL, the National Agency of Electric Power, was created in1996 to regulate the electric power market and to reach a balanceamong its participants.

The restructuring process, which started with the redefinition ofstate strategies and was strengthened by the Law of Concessions, isnow facing decisive questions, ranging from the implementation ofthe chosen model to the statement of policies to consolidate thechanges required to achieve a competitive market, capable of bring-ing significant improvements to the country’s energy development.

The principles of the electric power industry restructuring werebased on (1) competitiveness and efficiency, (2) supply to serve thedemand, (3) stability of rules, (4) rationalization of both supply anddemand, (5) industry’s investment capability, (6) respect for the envi-ronment, (7) the regulatory and monitoring state, (8) private partici-pation through investments, and (9) quality and fair price to theconsumers.

Several important factors motivated the restructuring process inBrazil: the reinvestment needed because of the interruption of con-struction of the facilities, lack of government resources, obsoletetechnologies in use, and the growing consumer consciousness regard-ing its rights.

The basic conceptual modelThe idea of restructuring the Brazilian electric power sector was notnew. The RE-SEB (Restructuring the Brazilian Electrical Sector)project was planned with the objective of formatting a new structurefor energy, one that would allow the continuous development of thatmarket.



Defining the project’s basic guidelines was held by the governmentthrough the Ministry of Mines and Energy. Some relevant points thatwould direct the whole process were identified, and, with the ap-proval of the Conselho Nacional de Desestatização, the project wasbegun. After that, the Reference Term, a document that establishedsome criteria to be followed, was considered. This document in-cluded 34 items that were considered by the participants involved inthe restructuring process.

The RE-SEB project was effectively started on 1 August 1996,with a very short deadline, due to the high priority assigned by thegovernment at that moment to solve the probable supply problems.These deadlines were taken into account, and in August 1998 theproject was, at least preliminarily, finished.

The new model was based on the fundamental concept of a freeand competitive market, to be regulated by a federal regulatoryagency.

The first step for the establishment of this model was taken withthe de-verticalization, or segmentation by activities, of the electricutility to achieve a more competitive environment and to avoid theformation of monopolies. Three segments were defined: generation,distribution, and transmission. Table 2 shows how these three seg-ments would be regulated by the regulatory agency.

Several other characteristics regarding the new model can belisted.n The fundamental participation of private participants in the new

market composition.n Entry into the sector regulated by the Law of Concessions.n Free access to monopolistic facilities to avoid imbalance in the

industry.

Table 2 The new electric power industry structure in Brazil

Regulation Segment Situation Types of enterprises

Deregulation Generation Competition Small hydro plants / hydro thermal /wind / other sources

Regulation Transmission Natural monopoly n Lines of the �basic network�Regulation Distribution Natural monopoly n Lines � generation of restricted interest

n Lines � distributionn Distribution installation

Deregulation Trading Competition Does not have electrical systems

Source ANEEL (2001)



n Freedom to choose the supplier, starting in 2005.n An indicative planner that would act together with the develop-

ment policies of the country.

The National Congress determined the creation of the ONS (Na-tional System Operator) and the MAE (Electrical Energy WholesaleMarket) in 1998.

The ONS is a private entity responsible for coordinating and con-trolling the operation of the generation and transmission facilitiesthrough the Brazilian interconnected network. It is a civil associationthat includes generation, transmission, and distribution companies,energy importers and exporters, and free consumers. The Ministry ofMines and Energy is also a member, with the power to block the de-cisions that might not be in accordance with the government policiesestablished for the sector.

The ONS is responsible for assuring the quality and the best eco-nomic performance of the energy supply and for assuring free accessto the basic network.

The MAE is considered as a virtual environment, where energy-trading activities are held through bilateral contracts and short-termnegotiations.

The MAE has the following objectives and responsibilities.n Establish and conduct the market efficientlyn Promote continuous market developmentn Take co-responsibility for the Brazilian electric industry’s opera-

tion and development.

The implementation of this new model has the following objectives:to assure expansion, increase operational efficiency, supply the en-ergy at a fair price, and offer supply quality and continuity. Table 3shows a comparison between the old and the new models.

Role of the institutional participants: government(CNPE) and regulatory agencies

The CNPE, the agent responsible for determining the energy policiesin Brazil, defines the objectives and actions to be taken to achievecontinuous development of the energy sector. It interacts with otheragencies of the sector to achieve satisfactory development in the elec-trical power industry.

Despite adversities faced since its creation, it has executed its regu-latory tasks in an autonomous and efficient way. It has accomplishedseveral goals while conducting the regulatory process, with a positivebalance overall.



Some of the positions and actions taken by ANEEL are as follows.n Regarding regulation, ANEEL has focused its actions on the es-

tablishment of rules that result in market development. It inter-acts with society through public audiences, in which proposalsand new ideas are taken for the solution of specific problem. Reso-lution Minute for the Universalizing of Electrical Power Public Serv-ices, published recently by ANEEL, has contributed to the actionsaimed at serving the population that has no access to electricalpower.

n ANEEL prioritizes the entrance of new participants with provencapacity to supply electrical power and quality services. It has fre-quently held public bids for transmission lines and hydroelectricplants, with great success.

n ANEEL has monitored 100% of the public utilities, resulting inseveral recommendations that have been accepted or are underthe implementation process. It has also applied several penalties tothe utilities that had not covered all the contractual requirements.The quality and continuity indicators have improved after the in-tervention in some utilities. There has also been a process of del-egating and decentralizing its structure through integration withthe federation states agencies to expand the area to be monitored.

n ANEEL has set up a centre of ‘ouvidoria’ (hearing) to keep a di-rect and active relationship with the several participants in themarket. It also seeks to assist their demands of complaints, cri-tiques, opinions, and praises, and to keep an interactive connec-tion with society.

n The agency has been involved in R&D, and it has been seeking toreach knowledge niches to help solve the needs that arise fromconstant technological innovations in the energy field.

Table 3 Comparison of the old and new electrical power industry models

Old model New model

Financing through public entities Financing through public (BNDES)a and private entitiesVertical state-owned companies Utilities divided by activities: generation, transmission,

distribution, and tradingMonopolies with no competition Free competition � competition in both generation and

tradingCaptive consumers Free consumersPrices regulated by the DNAEEb Prices defined by the market

a BNDES � National Bank of Economic and Social Development; b DNAEE � National Departmentof Water and Electrical EnergySource Ministry of Mines and Energy (2001)



n It has shown good ability to mediate the divergent interests and tosolve several conflicts in the market.

With regard to its autonomy, in spite of the normal difficulties facedas a function of political actions of the National Congress and othergovernment members, it has been trying to act in an exemplary way,searching for alternative solutions for problems and acting in the in-terests of society.

But there is some dissatisfaction regarding its performance in someof its activities, especially the definition of the tariffs for the con-sumer. The society questions the profits made by the utilities (distri-bution), which have obtained very good financial results due to thetariff-updating mechanisms. There are also a great number of uncer-tainties regarding the rules and the operation of the energy wholesalemarket. ANEEL also lacks synergy with the CNPE, which is respon-sible for defining the energy policies for the country.

ANEEL has been contributing to the balanced development of theelectric power market. However, only through an integration of theseveral participants, with each one playing its role, will the energyindustry develop. Thus, collective integration has been one of themain issues during the transition to the new model.

Critical vision of the current scenarioPetroleum and natural gas industriesUncertainties and issues regarding transition andinstitutional role: accomplishments and challenges

The history of the petroleum industry has been one of great profitsand great losses. There is no guarantee given to the explorer/producerin either the national or the foreign legislation. The only certainty forthe explorer/producer in the concession contract is that, for a certainperiod of time, it will have the exploration and production exclusive-ness in the area granted by the Union, represented by the ANP.

The ANP is now developing the third ‘big round’ of new areas to beauctioned for exploration—much smaller areas than the first two.

In addition, the ANP has several challenges to be faced in theshort term, namely to promote technological development andrational use of energy, to collaborate in the promotion of the naturalgas development, and to consolidate the monitoring of the new auc-tion rounds. In spite of the challenges faced up to now, Brazil is onthe road to improved development and self-sufficiency in petroleumproduction.

Regarding natural gas, PETROBRAS has a strategic plan for tri-pling the gas pipelines before 2005, thereby increasing the transport



capacity to 95 million cubic metres and also indicating a share of10% of this fuel in the national energy matrix.

The Brazilian natural gas market is based on the expansion of itsuse in the industry and in electric power generation, which is a grow-ing international reference. Logically, that will not be easy since theregulatory picture of the natural gas market is complex due to theexistence of correlated problems, such as free access, price of thetransport, and the imbalance of powers among the states.

The important issues are the introduction of competition and theenlargement of the investments with clear rules, since natural gas willreplace petroleum in several of its uses, mainly due to environmentalreasons.

Natural gas is gradually occupying a larger slice of the nationalenergy matrix. This growth is because of (1) the discovery of new re-serves, (2) the development of new technologies associated with therational use of the gas, (3) the specific characteristics of the naturalgas (less pollutants, more abundant, etc.), (4) the restriction to theuse of pollutant sources by society, and (5) the substantial increase ofnew investments by private agents after the Law of Concessions.

The ANP, which is responsible for the regulation of the natural gasmarket, has always tried to act in a positive way. Through new regula-tions, the resolution of conflicts, the search for the balance among theagents, and through the creation of a structure capable of spurringthe growth of the intensive use of this source, the agency has shownits ability to promote the development of this market.

The electric power industryUncertainties and issues regarding the transition andthe institutional role: accomplishments and challenges

The changes accomplished until now delineate a new model for theBrazilian electric industry, focusing on efficiency. The model allows,through the creation of a strong and active regulatory agent, societyto act as an important participant in the maintenance of quality andreliability in energy supply. That model was based on the creation ofa competitive market, with the regulatory agent acting to maintain abalance, providing adjustments to any signs of imbalance.

The restructuring model adopted for the Brazilian electric indus-try has been greatly discussed due to the recent energy crisis in Cali-fornia, United States, due to its similarities. This situation, however,should not be seen solely as negative. It is necessary to make a criticalevaluation of the operation of that market, taking into account spe-cific Brazilian characteristics, and create the mechanisms capable ofavoiding any disorder in the national energy industry.



Additionally, the present real perspectives of rationing (due to thelack/delay of investments in generation and transmission and in-crease in demand, aggravated by the impact of a poor monsoon) havesensitised society to the energy policies defined by the government.The BNDES (National Bank of Economic and Social Development)has pointed out the following as major causes that led the country tothis situation: (1) lack of investments through the 1990s; (2) thevague stance on the privatization model of energy companies that arestill under state control; (3) the uncertainties regarding the regula-tion of the system; and (4) the lack of coordination among electricpower, petroleum, and natural gas policies.

In this context, during the period of transition to the new model,and challenges for all the participants, the performance of the regula-tory agent will be crucial. Many discussions and suggestions are be-ing put on the table now, the pace and model of privatization is beingre-evaluated, emergency solutions are being addressed to avoid theimminent possibility of rationing, political issues are being over-stressed, society is reacting for being called to pay a non-taken debt.The regulatory agency is an active and main player in this scenario,taking on its shoulders a great part of the responsibility to ensure thatthe appropriate measures are taken in time. In this sense, this crisiscan be a good opportunity for strengthening the regulatory agent sothat a better scenario may arise when the clouds are dispersed.

Another important regulatory issue, not only during emergencyconditions, is related to Brazil’s continental dimensions and regionaldifferences, which reinforce the importance and necessity of the part-nerships of the federal agency with the state regulatory agencies,seeking not just to overcome the problems related to geographicaldistances but also to strengthen the relationship with the consumersthrough local public power. The focus of ANEEL must always be thesatisfaction of the needs of the majority, considering, evidently, thedivergent interests of the market. Therefore, it is important to inter-act continuously with the society.

The main aspects and facts presented in this work show the im-provement achieved in the construction of the new Brazilian electric-ity sector model over time. There is still much work to be done. In thiscontext, it is important to emphasize that the implementation of afree and competitive electric power market demands constant atten-tion by society. Society should act as the promoter and also the maininterested party in the creation of an atmosphere that makes possiblecontinuous development of the nation. The link of the regulatoryagency to the society is then an important foundation for the successof the envisaged model.



The following observations from people living under the transitionprocess can be useful for countries that will restructure their energyindustries.n The state is the entity responsible for supplying quality energy at

fair prices; it does not matter if it acts as a regulator entity or aninvestor.

n The best restructuring model is one that considers all the cultural,political, economical, social, and geographical peculiarities of thecountry.

Energy industry and the country scenarioFor a better and broader understanding of the present Brazilian en-ergy scenario and its trends, it is important to consider other generalaspects, some of which are directly connected to the energy industryand some are from the energy sector interrelations with the wholecountry scenario.

The most important of these aspects involving social, political,environmental, and economic issues are listed below with brief com-ments. It is only a general and simplified view of the questions, sincetheir full treatment is complex and beyond this paper’s objective.n The question of privatization There are still many groups arguing

against privatization, which creates the risk of going to a final hy-brid (part-privatized and part-government participation) model,different from the one initially envisaged. This would require sig-nificant adjustments and changes of routes. Any difficulty thatoccurs in this transition period is used as an argument against pri-vatization, which makes the question complicated. It can broadlybe considered a political issue that involves not only Brazil’s inter-nal situation, but also its external relations, since the initial aim ofthe privatization process was to get money to decrease the countrydebts.

n Other strong pressures against the changes Different groups, somewith a social agenda and others due to the risk of losing the rela-tive advantages they enjoy in the present status quo, put pressureagainst the changes. These pressures come from practically all theactors in the scenario: consumers, politicians, investors, technicalpeople, and so on. Thus, a political decision may be needed tosolve the problems.

n Lack of complete, structured, and clear rules Investors blame thelack of clear-cut rules for the paucity of investments. This againraises the question: should all the rules be determined beforestarting the changing process? There is a feeling that if this hadhappened, the process would still have been under debate and the



present situation would have been worse. The need now is for astronger effort to establish, as soon as possible, the major part ofthe rules. For this, the present questions and pressures should befaced more quickly. The rules in the energy market too are notfully set: there are many points still under discussion, which in-volve the regulatory agency also, even though the market is alreadyworking. This ‘delay’ in establishing the rules has led to much de-bate on to the penalty for the delay in starting operations at thenuclear plant Angra 2. Perhaps, the present crisis can force aquicker solution to these problems.

n Environmental questions Although Brazil’s environmental legisla-tion is considered to be very advanced, there are important ques-tions to be considered such as the different views of society andinvestors, the weak effort to promote ‘real and consistent’ environ-mental education, the pressure of economically and politically ori-ented groups, and the lack of people in the environmentalagencies to deal, in due time, with the large number of processesthat are under way.

n Economical and financial aspects The so-called ‘Brazil’s risk’makes it difficult for the investors to find the guarantees requiredfor structuring a ‘project finance’ process. The rate of return is lowwhen compared to other countries and other investments such astelecommunications. The government tried to solve part of theseproblems by using state institutions as long-term energy buyers toguarantee the contracts and for creating some special financingschemes. But these are only limited solutions and do not structur-ally solve the problem.

n Lack of a country industrial policy Lack of an industrial policy forBrazil, associated with the lack of an energy development strategicplan, was also a factor that negatively influenced the energy sce-nario. This seems to have been addressed with the recent estab-lishment of the CNPE, but it is too early to determine if it has hada positive impact.

n There are other important questions too that are specific to thepetroleum and natural gas sectors, which are under the regulatoryframework of the ANP. The main difficulties are in dealing withPETROBRAS, which is still a politically powerful company; thenecessity of implementing a gas distribution network, which is to-day limited within the country; implementing the free access togas ducts, after dealing with the initial reaction of PETROBRASto open the access to the Bolivia–Brazil gas duct; dealing with thegas price, already addressed in this paper, which resulted in thedelay of the gas-based electricity generation programme and is



still subject of discussions, which, in the Brazilian model, involveharmonic actions of two regulatory agencies, ANP and ANEEL.

The Brazilian electricity and petroleum/gas sectors presented, sincethe beginning, different contexts and challenges. Thus, it is difficultto directly compare both processes, but some comments can be made,taking into consideration the interrelation of those sectors throughnatural gas and the objectives of increasing efficiency and quality.

With regard to natural gas, the two regulatory agencies usuallywork harmonically. Despite this, there are some issues that remainunsolved for a while, since they depend on government policies. Oneexample is the delay in the emergency plan on thermal generationdue to the risk associated with the unstable money exchange rate,since natural gas is bought from Bolivia in US dollars and the elec-tricity tariff is in Reais, and adjusted yearly.

With regard to efficiency and quality in both sectors, improve-ments are taking place and actions are being taken to speed up theprocess. The barriers that still exist should be addressed.

The present improvement is associated with the indexes and re-quirements placed in the contracts and monitored each year by theregulatory agencies.

The actions to speed up the process result from the projects, pres-ently going on, developed by the companies under the obligation ofapplying a percentage of their gross sales in efficiency and R&D.These projects also involve Brazilian universities and research insti-tutes and are approved and monitored by the agencies.

The main barriers to the efficiency and quality questions areeconomic, cultural, and legal. On the part of the consumers, theyare not fully informed of their rights, although the agencies andcompanies have provided facilities to connect to the consumers.In general, people are not educated and conscious of the importanceof the efficiency actions and energy-related issues in their presentand future life, and a majority of them cannot afford to shift toefficient technologies. As for investors, there are many legal proce-dures that still allow them to ‘run away’ from some regulatoryrequirements and go to the court to continue their non-proactive ac-tions or to gain time to implement the changes required to cope withthese requirements.

AcknowledgementThe authors thank the post-graduation student Flavio Falcone dosReis, who helped with the organization and translation of the text.



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Transforming the energy sector: towards newgovernance structures

R K PachauriDirector-General, TERI, New Delhi, India


AbstractGovernance issues related to the energy sector are complex and are as-suming increasing importance with respect to sustainability of naturalresources. This paper discusses the birth of the concept of independentregulation in the US, the two streams of regulation � rate of return regu-lation and price cap regulation � in the developed world, and the differ-ences in their approach. It then covers independent regulation andgovernance of the energy sector in developing countries, focusing on India.

Though the approach to independent regulation and changes in gov-ernance of the energy sector in the developing countries have drawn onthe record and performance of entities in the developed world, the chal-lenges faced are greater and more complex given the differences in classstructure and social forces in the two societies. Heavy subsidies presentone such complication. Independent regulation can, however, becomean important factor in maximizing the welfare of the people and in si-multaneously bringing about improvements in the efficiency of an en-ergy enterprise. Tackling the problem of fuel poverty in the developingworld would dictate a move towards local governance in energy decision-making.

Attaining sustainable development is another important challenge. Inthis respect, the developing countries have to guard against rigid actionsor narrowly prescribed regulations that create actions that could harmthe public. Effective regulation requires rigorous analysis. Good govern-ance of public goods and services should be such that it effectively usesmarket-based instruments and prescribes desirable outcomes ratherthan methods or actions.

Given the differences in problems faced by, and the social milieu of,the developed and the developing countries, rigorous and capable intel-lectual efforts are required that could result in a new paradigm of regu-lation and the rise of governance structures that should be rooted in thephilosophy and tenets of sustainable development, unique and differentfrom those in the developed countries.

R K Pachauri70


IntroductionGovernance issues related to the energy sector are complex and ofsignificance to the welfare of human society. They are also becomingincreasingly important for the sustainability of the earth’s natural re-sources. Historically, the exploitation of natural resources on whichenergy supplies have been based has generally been treated as the re-sponsibility of the state and has, therefore, been managed by publicenterprise. Even in the US, as far back as a hundred years ago, Presi-dent Theodore Roosevelt was responsible for government invest-ments in electricity projects that produced hydroelectric power.However, growth of the electric utility industry in the US took placelargely through the efforts of investor-owned public utilities. Since, inthe case of electricity, these were enterprises functioning withinclearly defined geographical boundaries, they were seen to assumemonopoly powers that raised questions about the regulation of theirprofits and the equitable supply of electricity to the consumers in aparticular region they serviced. Thus was born the concept of inde-pendent regulation, which resulted in a fairly neat separation ofpower and a clear definition of governance systems.

Concept of independent regulationThe power to legislate and lay down rules for the operation of theelectric utilities remained in the hands of the elected representativesof the people. The power to produce and supply electricity within thelegislated objectives for a particular region remained with the pri-vately owned utility. The power to regulate the investment, pricing,and operational decisions by these utilities was assumed by inde-pendent regulatory bodies. But the regulators were required to func-tion in the interest of the people of a particular region served by theutility. They, at all times, had to function within the laws applicable tothe states where they were the empowered regulators. Within theframework of regulatory provisions, the regulator was required toensure that consumers were charged an equitable and fair tariff andthat producers received a fair and adequate return on investments.The discipline of regulatory economics progressed steadily in the USand the knowledge base of the regulator, the regulated, and the pub-lic at large increased significantly during the 20th century.

Different regulatory approachesSeveral other parts of the world, most notably the UK and other partsof Europe, established independent regulation of the energy sectormuch later than the US. Several of them, such as the UK, had to estab-lish regulatory bodies and their practices even while the government

Transforming the energy sector: towards new governance structures 71


privatized utilities that had existed as public sector units for well overa century. The challenge in such cases was substantial, and requiredpolitical enlightenment and determination at a high level to be ableto move ahead. It is a tribute to the system in these countries that, byand large, this major change in governance structures in energy en-terprises has been achieved smoothly and successfully. But the his-torical distance in time between the two streams of regulation thatnow dominate the developed world has led to differences in ap-proach. For instance, the US emphasis on rate of return regulationhas been substituted in several countries with price cap regulation orthe so-called RPI−X approach, which brings in strong but subtle dif-ferences in the governance structures associated with both.

The price cap regulatory practice generally requires greater sanc-tion by the public and, therefore, is a subject of much greater disputeand discussion within the public domain than is the case with the rateof return method. The latter is seen more as a technical issue, themethodology for which is determined by the regulatory commissionconcerned, without much comment or discussion by the customersserved by the system. Issues that question the methodology followedare generally those related to the impacts of regulatory decisions on oneor the other group of customers or on rate increases demanded for vari-ous reasons from time to time. When the protective cover of the regula-tory body is intended to be removed by opening up the retail end tocompetition, as in the case of the recent California experience, there isclearly a redefinition of governance structures and procedures with eco-nomic implications, which may be totally unanticipated.

Independent regulators and governance of the energysector in developing countries: challenges

In the developing countries, the approach to independent regulationand changes in governance of the energy sector have generally drawnon the record and performance of entities in the developed world. Yet,some of the challenges existing in the countries of the South aremuch bigger and far more complex, in a sense, than those that werefaced by the countries of the North. For instance, several countries inthe South have emerged from colonial rule. Even in countries wherethis was not the case, the structure of society has often been charac-terized by major divisions, largely feudal in character. The class struc-ture and the social forces that exist are, therefore, different fromthose that have been seen in the countries of the North, which havepractised democracy for several decades.

In India, for instance, the inheritance of a centralized bureaucraticstructure at the centre and in the states gave rise to electricity boards

R K Pachauri72


in the states, which essentially functioned and were treated as arms ofthe government. The oil industry, which after independence was con-trolled by a group of multinationals, in contrast, was nationalized bythe Government of India some decades later, and while the compa-nies thus formed have managed to retain part of the commercial cul-ture of the oil majors, they have been subjected to governmentcontrols. It would be interesting to see how they emerge after the dis-mantling of the administered pricing mechanism by 1 April 2002 andthe consequent increase in competition.

The coal industry, which was fragmented during British rule,was nationalized in the early 1970s, and while it has shown someminor changes in its functioning, it vastly remains an industry domi-nated by government decision-making, with almost total exclusion ofthe private sector. Naturally, therefore, the challenges of governancein this industry, as also in other segments of the energy sector inIndia, remain different from those in the developed countries. Itcould be argued that the UK, which at least in the coal and powersupply industries had problems similar to those that we see in Indiatoday, was able to privatize these industries in a reasonably smoothmanner and bring about changes in the governance structure quiteeffectively.

What complicates the situation in India, as in other developingcountries, is the fact that there is a large number of poor consumerswho have received protection from the market through a price struc-ture that carried heavy subsidies. This also provides a political basefor the continuation of leftist policies and excessive faith in govern-ment control of the energy sector. The subsidies, of course, have notalways been confined to benefiting only those who were targeted forthe purpose but have often been cornered by other influential andrelatively affluent groups. The result is that any change in status quoencounters massive resistance by powerful groups and vested inter-ests. Hence, changes in the governance structure require a carefulassessment of the political and social realities inherent in the socialstructure that exists in a particular country. Changes need to be evo-lutionary in nature and have to be pursued with some deliberationaccording to a carefully prepared road map.

Governance issues in most developing countries would, therefore,invariably lead to a tussle wherever change is contemplated. Theforces that should attain primacy in setting the agenda and directionof change become critical. The question then arises as to who deter-mines the welfare of the people. In the ultimate analysis, it is theelected legislators and the representatives of the people who enactlaws and define the boundaries of policy. However, once a legal structure



and a policy framework have been developed, should the action ofenergy sector entities be controlled by the elected representatives andthe executive arm of a democratic government or should there beanother body that interprets laws of the country professionally andoversees the operations of an energy enterprise? This is where inde-pendent regulation steps in because, if effectively practised, an em-powered process of independent regulation would provide muchgreater transparency and ensure professionalism in the functioning ofan energy enterprise. The rules of the game are then respected andtheir observance ensured by an entity that is outside the governmentand that theoretically can confront the government where actions falloutside the existence or fair interpretation of specific laws. Independ-ent regulation can, therefore, become an important factor in maxi-mizing the welfare of the people and, at the same time, in bringingabout improvements in the efficiency of an energy enterprise. Boththese objectives are in some sense identical and certainly not mutu-ally exclusive. Inefficient functioning of the energy sector hits all sec-tions of society wherever it exists, but the worst sufferers are alwaysthe poorest of the poor. It is the poor who have no recourse to optionsand whose lives are affected disproportionately by decisions that en-ergy enterprises take.

Another important challenge that exists in the developing coun-tries in the governance of the energy sector is in respect of attainingsustainable development. Energy use in the developed world has notonly led to depletion of natural resources worldwide but has also cre-ated serious environmental damage at the local, regional, and globallevels. It would be in the interests of the developing countries to keepthe objective of sustainable development clearly in focus when de-signing governance structures for the energy sector. Often, these is-sues will go beyond decision-making applicable to the energy sectoralone. For instance, if air pollution emanating from transport in alarge city in a developing country has to be reduced, the requiredaction to be taken does not lie only with authorities in the energy sec-tor; the problem has to be essentially solved through the design ofsustainable transport systems. The biggest challenge in such cases liesin internalizing externalities such as the cost of air pollution in theprice of activities that create the problem in the first place. Rigid ac-tions or narrowly prescribed regulations to create such actions mayhave the best intentions, but may actually overprescribe regulatorycompliance, which could ultimately harm the public. Good governanceof public goods and services should be such that it effectively uses mar-ket-based instruments and prescribes desirable outcomes rather thanmethods or actions.

R K Pachauri74


A pertinent example is the recent decision to convert 10 000 busesin the city of Delhi to the use of CNG (compressed natural gas). Thisdecision appears to have ignored completely the cost of infrastruc-ture to be established for retail supply of CNG, the existence ofcheaper and cleaner options like ultra low sulphur diesel, and thetechnical deficiencies of converting diesel buses to the use of CNG.While firmly defining the direction of change, regulatory decisions ofthis nature must allow enough freedom of choice to ensure that thecosts and feasibility of actions taken lead to the best results. Unfortu-nately, not only is the larger issue of total costs of change often ig-nored in regulatory decisions, but the time horizon of decisions andtheir impacts is often short and myopic.

Clearly, the most desirable solution for achieving sustainable de-velopment would have to come from legislation, which lays down aframework for decision-making that targets objectives beyond theimmediate. After all, the basic definition of sustainable developmentis that of a process which ensures that the development needs of thepresent generation are met without compromising on the ability offuture generations to meet their own needs. Ensuring the properhealth of natural resources, such as air, water, soil, flora, and fauna,therefore, becomes an important objective for every society not onlypertaining to its own territorial boundaries but also in terms of im-pacts likely to be created through regional cross-boundary effectsand at the global level. As yet, governance at the global level on criti-cal environmental matters is weak and ineffective. This requires theestablishment of global institutions that are seen to be effective andequitable in their actions. A dialogue is currently under way to bringabout necessary changes in global environmental governance, butprogress is understandably slow in this regard.

In a publication titled ‘Regulation, Deregulation, or Reregulation:what is needed in the LDCs power sector?’, the World Bank Industryand Energy Department had discussed the theory and practice ofregulation of the power sector and had arrived at some directions fordeveloping countries. At that stage, widespread competition was notprevalent in the power sector (The World Bank Industry and EnergyDepartment 1990). Hence, while the authors discussed free entryand competition as a means to create a beneficial impact on the inter-nal efficiency of a natural monopoly, they also stated that potential oractual entrance may in fact fail to discipline a natural monopoly. Thiswas brought out and explained in a figure provided by the authors(Figure 1).

What was indicated is that if the competitive marginal cost curve isMCc1, while the monopolist’s marginal costs are given by MCm,



consumers would be better off under monopoly pricing Pm than theywould be with the competitive supply price of P

c1. The point put forth

was that while entry controls may help establish and retain an effi-cient industry structure, they can also have diametrical effects on themonopolist formations.

It needs to be emphasized that effective regulation requires rigor-ous analysis, and a mere political philosophy of increased competi-tion may not yield desirable results. In some sense that has beenproved by the recent experience in California, where a misplacedfaith in competition at the retail end completely ignored the eco-nomic signals that this would provide to those in the business of gen-eration leading to major imbalance between supply and demand.

The OECD Report on Regulatory Reform, compiled by the Inter-national Energy Agency (1998), deals with the electricity sector andother infrastructure sectors in the OECD (Organization for Eco-nomic Co-operation and Development) countries. It traces the his-tory of the power sector in the OECD countries, going back over ahundred years. As mentioned earlier, the evolution of the electricityindustry followed different paths in Europe and in the US. Early inthe 20th century, many European governments had decided that thepower sector, with all its components, was a natural monopoly and,therefore, the multitude of small producers had to be merged intoone nationwide or many large regional monopolies. It was felt thatthe best way to prevent monopolistic behaviour was to create public

MR � marginal revenues; MC � marginal costs; AC � average costs; D � demand; P � priceFigure 1 Benefits inherent to an unregulated natural monopoly outweigh thepotential gains associated with a competitive market structureSource The World Bank Industry and Energy Department (1990)

MCC1

PC1

Pm

PC2 MC

C2

MCm

AC

Y (output)MR D

D

R K Pachauri76


ownership of all the smaller entities. In many countries, regulationexplicitly forbade new entry into the power sector. In the US, a differ-ent approach was followed. The private monopoly was regulated byan independent regulatory commission, but a large number of federalor municipality-owned power companies remained and continue toremain in business. The federal or locally-owned power companiescame into existence during the period of public-funded hydroprojects and other electrification programmes. During the energy cri-sis of the mid-1970s, independent power producers were encouragedthrough federal regulation based on the belief, which was not mis-placed, that independent generators can operate in a manner thatdoes not destroy the stability of the grid. This brought into being amajor philosophical change, namely that organizational structuresother than a vertically integrated monopoly could function effi-ciently. This provided the beginning of what might be called the Cali-fornia experiment. We, therefore, have governance structures that aremixed and diverse. This makes independent regulation necessary andcomplex. To some extent, in the developing world too, a movementtowards similar structures seems likely, and hence regulatory practicewould have to evolve in consonance.

One major issue of governance that is relevant for the developingcountries is the extent to which the voices of the poor need to be re-flected in decision-making within the energy sector. The rationale forsubsidies for agriculture in India, for instance, has been to ensure theprotection of poor farmers. This is also part of the country’s agricul-ture strategy, which aimed to make the exploitation of groundwaterviable by provision of low-cost electricity through subsidies. Govern-ments in the states and at the centre have practised this philosophy,which has resulted in major financial losses for the state electricityboards. With independent regulation, there would be a trend towardsreversal of this practice. While it is a matter of record, borne out by anumber of surveys and studies, that the major beneficiaries of thesesubsidies have been the rich farmers in the rural areas rather than thepoor, there are some poor farmers who do benefit from subsidizedelectricity prices.

There is little formal treatment of this issue in the literature. Onemajor policy document that deals with the problems of the poor inthe context of energy supply and consumption is the UK govern-ment’s Fuel Poverty Strategy (Department of the Environment,Transport and the Regions 2001). This strategy, which was developedby the Department of the Environment, Transport and the Regionsof the UK government, targets those households, estimated around



5.5 million in 1996, who struggled to keep warm in winter. The strat-egy means to address the vulnerability of many in these households tocold-related ill health and commits the government to ending fuelpoverty by 2010 for vulnerable households. Fuel poverty in otherhouseholds will also be tackled once progress is made on the priorityvulnerable groups. However, the UK’s Fuel Poverty Strategy does nothave much value for developing countries. Basically, programmes to beimplemented targetn improvements in energy efficiency for fuel-poor householdsn action to maintain downward pressure on fuel bills, ensuring fair

treatment of the less well-off and supporting the development ofenergy industry initiatives to combat fuel poverty

n action to tackle poverty and social exclusion, recognizing theirmulti-dimensional problems.

The strategy also aims to work with industry, charities, and non-gov-ernmental organizations to combat the problem of fuel poverty. Inthe case of developing countries, where the proportion of the poor ismuch larger than that in developed countries, it would be far moredifficult to solve the problem of fuel poverty, since income levels areso much lower and commercial energy prices higher than in the de-veloped world. Particularly for the rural poor, there are no significanteconomies of scale in centralized supply of energy, and, therefore,tackling the problem of fuel poverty would also dictate a move to-wards local governance in energy decision-making. Independentregulation would, therefore, have to lay down some framework bywhich local generators and providers of electricity can function effi-ciently and with a sense of fairness. Undoubtedly, monitoring thefunctioning of such local entities would be a difficult task. But if theframework and rules guiding regulation are developed carefully, itshould be possible for local bodies themselves, through the involve-ment of the community, to sort out problems and discrepancies thatcrop up.

In the developing world, a much greater role will have to be playedby the government to provide significant levels of subsidies to helpthe poor. This necessarily would reduce the power and strength ofregulatory organizations, and the government, already in control ofregulatory activities, may not vacate its place to independent regula-tors easily. In any case, in countries like India, independent regula-tion can still not be called truly independent. The constraints – political,economic, and social – in pricing of services for the poor only limit theextent to which regulatory decisions can be truly independent.

R K Pachauri78


ConclusionDeveloping countries are confronted with a complex set of chal-lenges. While on the one hand the theory and experience of regula-tion comes largely from the developed world, the problems and socialmilieu defining the challenge in developing countries stand outstarkly in contrast. It is for this reason that new structures and proc-esses in developing countries would have to be supported by rigorousand capable intellectual efforts. What would evolve, therefore, is anew paradigm of regulation and the rise of governance structures thatwould be unique and different from those in the developed countries.It should be our endeavour to make these structures, approaches, andmethodologies efficient, equitable, and deeply rooted in the philoso-phy and tenets of sustainable development.

ReferencesDepartment of the Environment, Transport and the Regions. 2001The UK Fuel Poverty StrategyConsultation paperLondon: Government of UK.

International Energy Agency. 1998The OECD Report on Regulatory Reform: Volume I—Sectoral StudiesParis: International Energy Agency. 328 pp.

The World Bank Industry and Energy Department. 1990Regulation, Deregulation, or Reregulation: what is needed in the LDCspower sector?Washington, DC: The World Bank Industry and Energy Department. 97 pp.[Industry and Energy Department Working Paper Energy Series Paper No. 30]

Effectiveness and negotiability of environmentalregulation

Atle Midttun and Anne Louise KoefoedThe Norwegian School of Management, Department of Innovation and EconomicOrganization, Centre for Energy and Environment, PO Box 580, 1302 Sandvika,Norway


AbstractThis paper investigates the limitations and possibilities of various regula-tory strategies with respect to meeting the joint challenge of ecologicaland commercial modernization, in a context of loosely integrated poli-ties. The major focus is on the trade-off between (1) regulatory effec-tiveness, (2) competitiveness and distributive effects across andbetween national energy industries, and (3) the political legitimationchallenges that this poses at the national and international policy level.

The paper concludes that focusing on negotiability and choosing se-quential �soft� regulation does not necessarily imply weak environmen-tal standards in the long run. Rather, the softly initiated evolutionarystrategy represents a realistic appreciation of the fragility of global andfederal institutions in issues of major industrial concern, and develops apath towards sustainable governance that takes this into consideration.

Atle Midttun and Anne Louise Koefoed80


IntroductionEnergy industry in both the EU (European Union) and other ad-vanced industrial countries is currently facing two major challengessimultaneously, namely that of commercial and environmental mod-ernization. By commercial modernization we refer to the process ofderegulation and integration of both electricity and gas markets andthe challenges this poses to companies and to regulatory authorities.By ecological modernization we refer to the process of finding na-tional and international governance mechanisms that may supportenvironmental management of energy industry, taking into consid-eration human effects on climate change and strong demands on gov-ernment to secure low levels of local pollution.

Handling these two challenges simultaneously is a formidable task,particularly as this takes place under weakly coordinated interna-tional governance.n On the one hand, the exposure of energy industry to international

market competition implies that national governments may nolonger intervene to regulate energy industry on a unilateral basis,without setting the competitiveness of national industry at risk. Ifone nation sets considerably higher environmental standards forits industry than its industrial competitors, this may underminethe industrial profitability of the avant-garde nation’s industryand transfer energy production to less strictly regulated nations.

n On the other hand, even relatively loose political cooperation toovercome the fallacy of unilateral governance under internationalmarket competition is hard to achieve. Differences in resourcebases apparently imply that most common environmental policieswould have distributive effects that prevent certain nations fromaccepting them.

Thus, in the context of the fairly loosely integrated EU, and evenmore, of course, in the context of the international climate negotia-tions regime, there appears to be strong forces, both at the commer-cial and at the political levels, that oppose strong environmentalregulation of the energy industry. Politically negotiated top–downenvironmental policies are clearly running into trouble. New andmore flexible regulatory mechanisms are, therefore, being created toenable environmental regulation without too strong negative effectson the competitiveness of the energy industry. These new mecha-nisms rely strongly on bottom–up and/or subsidiarity (national orregional autonomy in implementation). In some cases, environmen-tal regulation may also offer unique opportunities for industrial inno-vation so that optimal coordination between industrial development

Effectiveness and negotiability of environmental regulation 81


and regulatory intervention may potentially take place in a win–winatmosphere. There are, in other words, options that, if explored crea-tively, might take us out of the present non-decision dilemma.

To further the search for constructive options in this situation,this paper investigates the limitations and possibilities of variousregulatory strategies with respect to meeting the joint challenge ofecological and commercial modernization in a context of loosely in-tegrated polities. A major focus is on the trade-off between (1) regu-latory effectiveness, (2) competitiveness and distributive effectsacross and between national energy industries, and (3) the politicallegitimation challenges that this poses at the national and interna-tional policy level.

The following section outlines an analytical framework, phrased instrategic game-theoretical terms. Then follow three sections focusingon strategic aspects of three distinct regulatory strategies. The firstconcentrates on government-initiated flexible mechanisms such asquotas and tradable permits; the second on market-based instru-ments such as green electricity markets and consumer initiatives; andthe third on negotiated regulation, where industry agrees to self-regulation in a dialogue with the state.

Our analysis indicates that the attempt to simultaneously modern-ize both in commercial and in ecological terms is difficult. Interna-tionalization and commercialization of energy markets under weakinternational governance, such as the EU, easily fails in developingcollective solutions such as strong ‘polluter pays’ regulation. Thismay subsequently lead to a retreat to national protectionist environ-mental strategies at a minimum common denominator level.

The paper argues that the emergence of new, alternative forms of‘softer’, non-authoritarian regulation points at possible ways out ofthe deadlock as they allow us to strike new and better balances be-tween effectiveness and negotiability. The way this balance is struck isidiosyncratic to each regulatory strategy and is dependent on distinctcharacteristics such as their facilitation of negotiation and effect ondistribution among the participants in the regulatory game.

One of the ways to do this can be to develop general agreements onemission targets between nations and to then delegate to each nation,in dialogue with national industry, to find the mechanisms by whichthese targets can be met. In this way, the paper argues, internationalenvironmental policy makers may push for fairly ambitious goal-set-ting, while appeasing corporate interests by leaving room for them inthe implementation phase.

Finally, the paper argues that, in an evolutionary perspective,environmental regulation and the normative pressure that it entails



may shift consumer preferences in a green direction. If adequatelychannelled into the market context, this might move the bottom-lineeconomics in a green direction, from where new environmental regu-lation would take it further. Furthermore, when companies see theirinterests served by strategic and economic opportunities offered bygreen products and green technologies, they may come to supportfurther green regulation and also pursue greening policies at the busi-ness level, e.g. by profiling greenness as part of their competitivestrategy. This dynamics potentially also pushes competitors in thesame direction.

Strategic aspects of environmental regulation underweakly coordinated governance

Commercial modernization and the move from planned to marketeconomy entails a parallel need for reforming environmental govern-ance towards market-oriented environmental policy instruments.Taxation according to the ‘polluter pays’ principle, which adds a costto polluting energy production proportionate to its negative exter-nalities, is a classic first-best solution. The problem is that this policyinstrument requires strong and coordinated governance throughoutthe whole market system. When an integrated energy market is im-posed under a weak environmental governance structure, first-bestenvironmental regulation, such as the ‘polluter pays’ principle, ishighly difficult to achieve.

Core elements of the problem of environmental regulation of en-ergy industry under international competition may be formulated interms of a simple strategic game where the parties have two options.They may choose between a first-best principle for environmentalregulation applied to the whole market area (we shall here assume auniform tax based on the ‘polluter pays’ principle) or they may pur-sue nationalistically defined environmental policies. Applied to acompetitive international energy market, such protectionist environ-mental policies are likely to lead to sub-optimal solutions for themarket system as a whole, as they will tend to maintain inefficientforms of energy production and environmental governance will bemanaged locally, in each national market segment according to dif-ferent standards, leading to complex interaction effects between envi-ronmental regimes in different regions.

To start out with, we shall assume identical interests between thestate and dominant parts of its energy industry and analyse the stra-tegic interplay under assumptions of equal distribution of energy re-sources and technologies across nations throughout the wholemarket area. We will subsequently modify these assumptions in two



steps. First, we shall discuss the strategic interplay under unequaldistribution of energy resources. Second, we shall also leave the as-sumption of identity between state and industrial interests and elabo-rate on the strategic consequences of a two-level analysis ofnegotiation – an international and a domestic level – which recog-nizes the possibility of domestic conflict about what the ‘national’interest requires. We are here following the tradition of Putnam(1988), Scharpf (1997), and others.

Coordination under equal resource distributionThe implementation of ‘polluter-pays’-based environmental regula-tion of the energy system, under symmetric resource endowmentsbetween weakly integrated nations, is foremost a question of coordi-nation. The assumption that systems are similarly fuelled implies thatcompetition takes place on an equal basis and that general first-bestenvironmental regulation, according to the ‘polluter pays’ principle,will have the same implication for all parties concerned.

The plusses and minuses in Table 1 presents the welfare gains foreach strategy combination seen from the side of both parties. As illus-trated in Table 1, gains and losses are similar and symmetric. Bothparties have incentives to cooperate to develop a system of environ-mental regulation, according to the ‘polluter pays’ principle, fromwhich they both individually profit (+/+ in square 1). Given the as-sumption that the ‘polluter pays’ principle is applied systematicallythroughout the whole market area, this would also constitute themost effective solution from the point of view of the integrated mar-ket system as a whole.

However, without coordination, both parties have incentives to fallback to nationalistically defined environmental policies that lead to a

Table 1 Environmental regulation in a two-party game with equal endowments

Part 2 Part 2�Polluter pays� regulation, calibrated Nationalistically orientatedto the international market environmental policies

Part 1�Polluter pays� regulation, 1 2calibrated to the +/+ −−/++international market

Part 1Nationalistically orientated 3 4environmental policies ++/− −/−



far less preferable solution (−/− in square 4) when both parties’ strat-egies are combined. In this case, both parties would end up with lessattractive policies, out of fear that one-sided general application ofthe ‘polluter pays’ principle would lead to exploitation from the otherparty. This could, for example, take place through environmentalpolicies that would allow environmental dumping from less strictlyenvironmentally regulated countries. Such exploitation might, forexample, result from nationalistically defined environmental policiesthat would distort competition. The example of Finnish–Danishtrade relations under one-sided application of Finnish ‘polluter-pays’-based CO

2 taxation is a case in point. Danish coal-fired genera-

tion without a CO2 tax could easily underbid similar Finnishelectricity generation that suffered a substantive CO

2 tax and which

thereby came under threat.The example illustrates the worst case scenarios (−/++ and ++/− in

squares 2 and 3) for part 1 and 2 respectively, resulting in Finland aban-doning the one-sided application of the ‘polluter pays’ principle, therebybringing the game back to the square 4 suboptimal equilibrium.

In this case – where one can identify an equilibrium in joint appli-cation of the ‘polluter pays’ principle calibrated to the integratedmarket – we are facing a simple coordination game, which may besolved through mutual trust and cooperation and where centralizedintervention is only needed for credible coordination. Under thesestrategic conditions, responsible collective governance may, there-fore, be reached under voluntary convention without strong authori-tative pressure applied by super-national organization.

Zero-sum conflicts under unequal resource distributionThe large difference in the fuelling of European energy systems, how-ever, moves the challenge of consistent, market-oriented environ-mental regulation beyond the simple coordination problem. Underunequal resource distribution, the parties enter into a strategic situa-tion where even collectively oriented strategies are clearly suboptimalto some actors, at least in the short run. We are here maintaining ourassumption of symmetry between state and industrial interests.

There is extensive variation in the composition of EU electricitygeneration in terms of fuel sources (Figure 1). In Germany, UK, andthe southern European states of Spain, Portugal, Greece, and Italy,thermal generation is predominant with generation based on fossilfuels. This stands in contrast to France, Belgium, and Sweden whereelectricity generation is predominantly nuclear based. In countriessuch as Denmark, Austria, the Netherlands, and Finland, a mix ex-ists, yet with strong reliance on fossil fuels and thermal generation.



With this diverse composition, the ensuing emissions and environ-mental impacts of electricity generation varies extensively among Eu-ropean countries. For example, CO2 emissions per capita (Figure 2)vary by a factor of 1 to 4, with Luxembourg as the most polluting andPortugal as the least polluting country per capita (Figure 2).

Given the large differences in resource endowments, the burdensof collective environmental regulation for some national energy sys-tems may prevent common solutions. While the parties in a coordina-tion game – where the gains are equally distributed – have incentivesto end up in an equilibrium of the ‘polluter pays’ regulation cali-brated to the international market, there is no such equilibrium un-der large inequalities in resource endowments and followinginequalities in technological systems and environmental emissions.Given the unequal resource endowments1 in fuel base and generationtechnology, the commercial effects of the strategy combinations thatwe discussed in the previous section will, therefore, affect the partiesin a different manner from that in the previous coordination situation

Figure 1 EU (European Union) sources in electricity generation: 1996Source EU (1998)

1 Our distinction between weak and well endowed refers to the fuel base and generation tech-nology: well-endowed nations have ‘green’ production facilities at low cost, while weakly en-dowed have polluting fuel bases and technology at medium or high costs.

Thermal Nuclear

Hydro and wind

400

360

320

280

240

200

160

120

80

40

0

Share (TWh)G

erm

any

UK

Italy

The

Net

herla

nds

Spa

inD

enm

ark

Fran

ce

Finl

and

Gre

ece

Belg

ium

Port

ugal

Aust

ria

Irela

nd

Swed

enLu

xem

bour

g



Table 2 Environmental regulation in a two-party game with unequal endowments

Part 2 Part 2Weakly endowed Weakly endowed�polluter pays� regulation, regulation oriented atcalibrated to the protecting nationalinternational market actors and resources

Part 1 1 2Well endowed + +/−− −/+�polluter pays� regulation,calibrated to theinternational market

Part 1 3 4Well endowed ++/−−(−) 0/0regulation oriented atprotecting nationalactors and resources

(Table 2). The commercial effects presented in the table may besummed up as follows, listed square by square.

The square 1 combination of joint ‘polluter pays’ strategies cali-brated to the integrated market from both parts suffers from highlybiased commercial effects, providing the less-endowed party with

Figure 2 EU (European Union) CO2 emissions per capita: 1997

Source EU (1999)

25000

20000

15000

10000

5000

0

Ger

man

y

UK

Italy

The

Net

herla

nds

Spa

in

Den

mar

k

Fran

ce

Finl

and

Gre

ece

Bel

gium

Port

ugal

Aust

ria

Irela

nd

Sw

eden

Luxe

mbo

urg

kg of CO /inhabitant2



clear disincentives to enter into this position. While the better en-dowed party will harvest extensive gains from price increases and anincreased market share (++), the less-endowed party may stand tolose large market shares (−−) due to prohibitive tax burdens. In spiteof its distributive effects, this is clearly the most beneficial strategycombination seen from an environmental point of view, for the mar-ket system as a whole.

The square 3 combination of an open, ‘polluter-pays’-orientedstrategy calibrated to the entire market system from the less-endowedparty and protective nationalist strategy from the well-endowed ishighly unlikely, because the interest to open up markets and go forcollectively oriented regulation is likely to come from the better en-dowed party. For the weaker party this is a worst case, althoughhardly much worse than in square 1 (therefore [−1]), since the well-endowed actor would anyhow be in a strong competitive position.The stronger party will, therefore, not have strong needs for protec-tion, and therefore have little gains from its protective strategy.

The square 2 combination of ‘polluter pays’ orientation from thewell-endowed party and protective, nationalistic environmental regu-lation from the less-endowed party allows the weaker party to maxi-mize its commercial interests by protecting its home market,therefore +, while the stronger party, with an open ‘polluter-pays’-oriented strategy calibrated to the international market, will exposeitself to environmental dumping from the weaker actor, therefore −.

Finally, the square 4 combination of mutual nationalistic protec-tive environmental regulation strategies represent the equilibriumposition in which both parties will end without authoritative pres-sure. This is a closed and protective economy position, which isclearly sub-optimal to both parties (0/0), but where they have no betteralternative combination of strategies that is acceptable to both sides.

Even with credible coordination, therefore, the parties cannotreach common collectively orientated regulatory solutions becausethe country that harvests gains when commercial considerations arealso taken into account seeks such solutions only one-sidedly. Undersuch conditions, and under the assumption of symmetry betweenstate and industrial interests, distributive effects of ‘polluter pays’regulation undermine collective action and countries find themselveslocked into nationally protected strategies.

International coordination under competing subnationaldecision-making

The previous discussion in both the positive sum coordination andthe zero sum cases has been based on the concept of single-level



negotiation, where each state represents its unitary vested interests atthe international negotiation table. However, as widely recognized inthe international negotiations literature (Putnam 1988 and Scharpf1997, among others), the national positions at the international bar-gaining table are frequently shaped by domestic coalitions and thepressure they exert on national government. We may, therefore, speakof a two-level game, where the national game shapes the positionstaken in the international game, but where the latter may, undergiven circumstances, also influence the other.

In environmental politics, two important domestic fractions aretraditionally industrial and environmental interests. The former aretypically well organized for political lobbying and command largeresources to protect their vested interests. The latter may also havefairly well-organized front-runners, but usually acquire much of theirinfluence only when able to mobilize broad popular support. The twodomestic fractions, therefore, have rather different cost-payoff struc-tures, as illustrated in Figure 3.

Given the way the two fractions are constituted, their relativestrength is likely to vary with the mode of policy-making. Industrialinterests are likely to dominate under routine politics or so-called‘low policy mode’ because of their organizational capabilities and re-sources. However, as governments in political democracies are re-sponsible to parliament, the decisions of the corporate channel may,

Figure 3 Payoffs in the national game over environmental policy under routine sectoralpolicy-making

Environmental and

general interestsHigh

Low

Low Payoff from

influencing policy

High

Costs of

organization

Industrial

interests



in principle, always be challenged in the democratic arena. This mayhappen if the environmental fraction is capable of mobilizing thegeneral public to give the issue high attention on the political agendaas a matter of general public debate. Under democratic decision-making, and most prominently in the form of a referendum, the gen-eral interests, because of their numerical weight, have a dominant say.

To translate sub-national strategic configuration into positions ininternational negotiations, we shall refer back on the matrix of strate-gic choice in Table 2, with the inclusion of environmental and generalinterests. For the sake of analytical clarity, we have included environ-mental interests as a separate category. As was the case of Table 2, weare assuming unequal resource endowments among the participatingparties.

A deeper analysis of democratic and corporate decision-makingwould require the study of strategic options for subnational interests.Given our focus on decision-making between national interests, weare here limiting ourselves to noting the likely national outcomes ofrespective routine politics and highly mobilized political decision-making. This rather complex table may perhaps be best summarizedsquare-by-square and line-by-line. The commercial aspects de-scribed in line 1 are identical with Table 2 and will not be elaboratedon here. Focusing on environmental interests (line 2), therefore, wefind the following pattern.

Table 3 Environmental regulation in a two-party game with unequal endowments

Part 2 (weakly endowed) Part 2 (weakly endowed)�Polluter pays� regulation, Regulation oriented atcalibrated to the protecting nationalinternational market actors and resources

Part 1 (well endowed) 1 2�Polluter pays� regulation,calibrated to theinternational marketn Industrial interests ++/−− −/(+)n Environmental interests +/+(+) −−/−−

Part 1 (well endowed) 3 4Regulation oriented at protectingnational actors and resourcesn Industrial interests ++/−− 0/0n Environmental interests 0/0 −/−(−)



The strategic combination in square 1 of the ‘polluter pays’ regula-tion calibrated to the international market, we will assume, providesenvironmental effects that are beneficial to both parties as far as CO2

is concerned (+/+). In addition comes the abatement of local pollut-ants that are most beneficial to the weakly endowed part (part 2),marked by an extra (+).

The strategic combination in square 4 of mutually protective strat-egies, we assume, will entail suboptimal environmental regulation forboth parties as it implies weak policy coordination and higher CO2

emissions than necessary under an integrated energy market regime(−/−). The weak regulation of local pollutants is obviously most nega-tive to the weakly endowed part (part 2), marked by (−).

The strategic combination in square 2 of the ‘polluter pays’ regula-tion calibrated to the international market from the well-endowedparty and nationalist protective environmental policy from the lessendowed may, under certain conditions, entail environmental effectsthat are more negative than the mutual protective strategy combina-tion in square 4. This is because the regulatory openness of the lesspolluting party invites dumping strategies from the more pollutingparty 2 system. We have, therefore, scored this combination with anegative ranking −/−(−).

Finally, the strategic combination in square 3 of the ‘polluter pays’regulation calibrated to the international market from the less-en-dowed party and protective from the well-endowed implies environ-mental effects that are less detrimental than in square 2 becausemuch of the assumed environmental benefit will accrue from exportof cleaner energy from the well-endowed party into lesser endowedparties’ markets. However, the square 3 strategy combination will un-dermine synergies from operating the two systems in conjunctionand, therefore, scores lower than in the square 1 situation with thejoint ‘polluter pays’ regulation, thus 0/0.

It may be argued that the general interests are more oriented to en-vironmental policy than to industrial policy, in which case the bal-ance in favour of a collective strategy even for less-endowed countrieswould occur under environmental mobilization. The dominant strat-egy of the well-endowed party is anyhow collective. Thus, democraticdecision-making will tend to reproduce collective strategies underthe above conditions.

Routine ‘low politics’ decision-making may, to simplify, be seen assolely based on the industrial aspects above. We may, therefore,as already argued in the previous section, conclude that with theabove evaluation of commercial strategies, the dominant strategy forthe weakly endowed country is the protectionist strategy, which



entails a less effective environmental policy seen from the market sys-tem as a whole.

The choice of arena, high policy/democratic or low policy/lobbypolitics may, in other words, be decisive for the outcome of nationalpositioning in international negotiations.

Regulatory models and mechanismsThe preceding discussion basically assumed the use of one regulatoryinstrument as the first-best choice, namely the ‘polluter pays’ taxa-tion calibrated to the international market. We then discussed thepreconditions for using this instrument against regulation oriented atprotecting national actors and resources.

Slacking our rather strong assumptions about the instrumentationopens up an array of new possible trade-offs between national indus-trial vested interests and effective environmental regulation. We shallhere explore some of the ‘new’ regulatory mechanisms that carry withthem an expectation of a better trade-off between regulatory effec-tiveness and negotiability of environmental regulation under marketcompetition and weak governance.

We have elsewhere (Midttun 1999) presented a typology of ap-proaches to environmental regulation that may also serve as the basisfor this enlarged discussion of policy instruments. This typology di-vides the instruments into well-known hierarchic and market-basedapproaches along the horizontal dimension. Along the vertical di-mension we have added an authoritative and non-authoritative di-chotomy, which, together with the traditional market-hierarchydichotomy, generates a two-dimensional matrix with four polar val-ues (Figure 4). In this figure, the squares I and II of public serviceand government-imposed regulation belong to the traditional regula-tion debate over market versus hierarchy. The two squares III and IVof non-governmental hierarchic governance and market-endogenousregulation represent ‘new’ alternatives that deserve closer inspectionin the light of the above discussion of state failure. A fifth form, V,negotiated regulation, represents an intermediary position.

Squares I and II represent traditional types of regulation that havebeen discussed in the previous section. Public service (I) implies amode of governance where environmental concerns are directly em-bedded in the service management through instruction. The publicowner may, in other words, impose a complex goal function with bothenvironmental and wider welfare elements as a mandate on theadministrative management of the firm. The administrative manage-ment is then, in turn, authorized to specify operative procedures tofulfil the mandate within the framework of a monopoly right to



supply the service. Given the current re-orientation of energy indus-try towards market economy, this form of governance is abandonedand will not concern us much in this paper.

Under competitive organization of the service (II), non-commer-cial goals are externalized to a regulatory agency outside the bounda-ries of the firm. The agency must then set explicit and general rulesthat provide incentives to the parties to fulfil non-commercial publicgoals under competitive firm behaviour. This square represents theconventional first-best approach to market-oriented environmentalgovernance of the energy system, which has also been assumed in theprevious section.

The first of the ‘new alternative’, expanded menu of environmentalgovernance, square III: private hierarchy, implies that non-public or-ganization with influence and authority to govern take regulatory ini-tiatives to further collective goals. This may, for example, occur astrade associations are concerned with industry’s reputation and takeaction to improve it. In such cases, trade associations may sponsor

Figure 4 Dimensions of regulation

I

Public service Competition under

government-imposed

regulation

III

Private hierarchy

II

IV

Market-endogenous

regulation

Not authorized

by public authority

Authorized

by public authority

Hierarchic Competitive

market based

V Negotiated regulation



and administer environmental codes of practice. Nash (1998)presents the US Chemical Manufacturer’s Responsible Care Initia-tive, the American Petroleum Institute’s programme, Strategies forToday’s Environmental Partnership, and the American Forest andPaper Association’s Sustainable Forestry Initiative as examples.

In principle, private organizations, such as industrial organiza-tions, if dominated by an industrial coalition, which sees its interestsserved by strong environmental policies, might substitute govern-ment regulation by undertaking sanctions against excessively pollut-ing members of the industrial community. This could be doneirrespective of public authorities in the polluting industry’s homecountry. However, such negative sanctions are perhaps unlikely ex-cept in extreme cases. The basis for acceptance of strong policies atthe industrial association level is not likely to be stronger/better thanat the government level.

However, industrial organizations are more likely to be involved incoordinating positive environmental governance measures. Attempts todevelop industrially coordinated environmental certificates trading is arecent example where avant-garde industrial firms with the industrialassociation seek to establish markets and trading instruments, for exam-ple, the RECS (Renewable Energy Certificate System) initiative,2 inspite of failure to establish such instruments at the government level.

The second of the new squares, IV: market-endogenous regulation,highlights the existence of a self-regulatory potential in industrialdevelopment. Consumers may voice concerns that – communicatedthrough mass media – may trigger self-reinforcing regulatory actionby producers. Sometimes, the process may be more complex and alsoinvolve NGOs (non-governmental organizations) as mediating actors.

Analytically, Hayek (1948) has eminently discussed this mode ofregulation. Expanding on Von Mises’ critique of planned economyand using the Mengerian concept of spontaneous order, Hayek fo-cused on the self-regulatory character of market systems. Rejectingthe option of a rational and comprehensive state regulation as unreal-istic, he placed himself within an evolutionary tradition, viewingregulation as emergent rules and developments.

Endogenous market regulation may potentially support strong en-vironmental policies against the interests of both energy industry andnational government. When, for example, consumer interest ismobilized against polluting practices, industry may find itself in a

2 The RECS is a private industrial initiative to promote trade in renewable energy certificatesand to stimulate (internationally harmonized) national markets for renewable energy certifi-cates (see www.recs.org).



squeeze, where the threat of customer boycott may override indus-trial policy interests.

Facing the increased complexity of environmental regulation, ne-gotiated regulation (V) has become a popular mode of regulatory in-tervention. This is regulation at the interface between centralauthority and non-authority-driven regulation. This mode of regula-tion allows industrial interests to accommodate regulation to specificcharacteristics of their production system, to meet environmentaltargets flexibly, with minimal pain (Arentsen 1996). However, on thedomestic scene, these negotiations have often been conducted in ‘theshadow of hierarchy’ (Scharpf 1989), that is, under threat of authori-tative regulation if negotiations fail.

Several of the new post-Kyoto mechanisms have strong elementsof negotiated, market-endogenous and/or private hierarchy govern-ance. By use of ‘softer’ and more flexible mechanisms, the interna-tional climate policy negotiations seek to find ways out of thelegitimation crisis for strong authoritative environmental regulationof the energy system under market competition with only weak re-gimes in place to handle coordination of international governance.

In the following sections, we shall explore these new alternativeregulatory strategies in more detail with reference to the strategic di-lemmas spelled out in the previous sections.

Flexible use of market mechanisms in environmentalgovernance

Internationally, both at the level of the EU and at the level of thewider climate negotiations, participating parties have recognized thestrategic problems associated with the ‘polluter pays’ taxation cali-brated to the whole market economy under weakly coordinatedmulti-state decision-making contexts. This has triggered a search forregulatory mechanisms that can strike a better balance between ef-fectiveness and legitimacy.

By allowing each state to formulate its own distribution of environ-mental obligations under a common agreement that sets nationalemission targets/quotas, each state is allowed to solve its environmen-tal obligations through domestically targeted instruments. Thismodel does, to some extent, also compromise between environmentaland industrial interests. The environmental interests are importantsupporters of the global framework conditions, while the industry-dominated domestic decision-making takes over the design of na-tional mechanisms for implementation.

In terms of our analytical scheme (Figure 4), flexible mechanismswork in an interface between square II competition under govern-ment-imposed regulation, squares III and IV market-endogenous



regulation, and square V negotiated regulation. The overall goals andthe overall system/mechanism design are set by international agree-ments based on government authority. Then distribution and burdensharing is, to a large extent, negotiated at the national level, and, fi-nally the price setting is market endogenous.

In terms of effectiveness, the flexible mechanism construct willhardly reach the standards of general ‘polluter pays’ taxation if thelatter is applied consistently throughout the whole market area andacross borders. First, the distribution of general initial obligations isprobably not symmetric with the emission levels and environmentalimpacts of energy industries. Second, the distribution of the initialportfolio of permits within each country may be skewed and maydepend dominantly on industrial negotiating power and not on allo-cation following efficiency criteria. Nevertheless, the result is prob-ably better than square 4 solutions in the Table 3 matrix (mutualnationally protective strategies) as the collective environmental targetis set via the design at the international level. This implies a collectivewelfare advantage compared to a business-as-usual development.

Another example of a mixed, complex form of regulation is thetradable pollution scheme. One precondition for using a tradablepermit system is, however, that the pollution category is administra-tively feasible to control. It is primarily larger stationary sources(e.g. industries and utilities) that are of interest, as the tradablepermit system needs a control system that relies on precise monitor-ing of pollution quantities.3 The household and transportation sec-tors with numerous small sources are less suitable targets for tradablepermit systems.

Another precondition for a system of tradable permits to beeffective is that firms or countries must have distinct marginal pollu-tion abatement cost curves for there to be an incentive to trade. Firmsor countries that have low abatement costs and are able to reducetheir pollution levels below their permitted levels will be allowed totrade the permit/their excess amounts (referred to as a trade of cred-its). Conversely, firms or countries with high pollution abatementcosts will have an incentive to buy permits if their pollution abate-ment cost curves are higher than the cost of permits.4 Given a biased

3 Quantity monitoring is a further precondition for the establishment of a well-functioningsanction mechanism. The latter is typically based on economic fines, which to be effectivemust be set higher than the permit price (Svendsen 1998).4 The key difference between centrally authorized taxation and trade schemes is the propertyright aspect of tradable permits in which there is transferability of permits, credits, or quotas.The trade aspect is what makes it an economic instrument since a non-tradable quantity re-striction would be an example of ‘command-and-control’, the regulatory procedure wherebyan environmental quality standard is set and is to be obeyed.



initial distribution of permits, therefore, the trading across nationalborders serves to increase the efficiency and effectiveness of environ-mental policy.

Regardless of whether a maximum level of pollution, a targetedlevel of green energy, or CO

2 emissions reduction are used as exam-

ples, the basic logic of the policy instrument is the same. The target ofgreen energy/total allowable emissions is first defined by some regu-latory authority either at the national or international levels. Then,permits/quotas are allocated to countries, which in turn redistributethese at the national level to relevant industrial actors. Trade in per-mits/quotas may occur at the national and the international levelsafter a marketplace and verification and clearing systems have beenestablished.

Using the example of renewable energy and electricity, percentagequotas would initially be distributed to participating countries by in-ternational negotiations. These would then be redistributed to thenational electricity and energy sector as supply or consumption quo-tas through national negotiation processes. This leaves the sector withseveral options for compliance: first, through physical installation ofgreen energy and renewable capacity; second, through financialtransactions and the purchasing of ‘green’ certificates from a greenmarket pool/independent renewable generators with certification ofgreen kilowatt hours; or, third, through purchase of credits from suppli-ers with surplus credits.

All these mechanisms serve to increase the overall efficiency andeffectiveness compared to nationalistic protective policies, driven bydifferences in the marginal costs of ‘greening’ diverse energy systems.By creating a market that balances permits and abatement costs, thetrading mechanism is supposed to equate the marginal cost of greenenergy development across firms or countries or both. Assuming thatthe market for permits is competitive, this should lead to selection ofthe most cost-efficient green energy development.

Cost-efficiency and flexibility were issues raised in the instrumentdebate in climate change negotiations. Flexible mechanisms as out-lined in the Kyoto Protocol (clean development mechanism orCDM), joint implementation or JI, and target-based emissions trad-ing systems5) were advanced to provide participating countries with

5 The Kyoto Protocol incorporated four distinct mechanisms for the achievement of individualand differentiated emission reduction targets for the first commitment period from 2008 to2012. These measures include (1) a CDM for project-based cooperation with developingcountries (article 12 and accounted for in article 3.12) in which Parties not included amongthe Annex I countries will benefit from project activities that at the same time results in certi-fied emissions reduction; (2) a project-based transfer of credits or JI (article 4) among Annex I



greater flexibility in the achievement of their obligations or QELROs(quantified emissions limitation and reduction objectives). By allow-ing the Parties to undertake, finance, or purchase emissions reduc-tions outside their individual national territory, one increases thecost-efficiency of greenhouse gas reduction.

Although tradable permit schemes tend to ease distributive con-flicts that arise in negotiations due to diverse resource endowments,they do not altogether do away with them. The challenges listed be-low highlight issues that potentially bring us to the same dilemmas.n Maximum levels of pollution, CO

2 reduction, or mandatory re-

newable energy levels need to be negotiated.n Distribution of quotas/permits needs to be determined first

through international negotiation, then at the national levelamong sectors and industries.

n Trade rules and compliance and monitoring systems need to bedeveloped and implemented across borders.

n Green/renewable energy definitions need to be negotiated.n New versus existing levels of green energy production need to be

negotiated.

Nevertheless, under the assumption that some regulatory initiative isunavoidable given internationally stated commitments, tradeschemes seem to offer advantages to industrial interests as comparedto alternative regulatory strategies. This is because of the flexibilitygiven to firms in their methods of compliance with more stringentenvironmental regulation. Furthermore, contrasted with the ‘polluterpays’ taxation, which levies a tax on all emissions, the cost imposedon the industrial sector through a trade scheme concerns only thecost of the actual targeted emissions reduction and does not involveextra costs on all emissions (Svendsen 1998).

Hence, the flexible mechanisms may attract the support from in-dustrial interests and thereby facilitate agreement on environmentalregulation. Finally, the flexible mechanisms have international trans-ferability, which makes them more compatible with the trend towardsde-regulation and competitive international energy markets.

countries (authorized by article 6 and accounted for in articles 3.10 and 3.11); (3) a target-based emissions trading system as a supplement to domestic actions (article 17), asking theParties to define relevant principles, rules, and guidelines, as well as for verification, reporting,and accountability for emissions trading; and (4) burden-sharing arrangement or a so-calledoption of ‘bubbling’, i.e. meeting the commitments individually or jointly, for example, withina framework of a regional economic integration organization (article 4).

(footnote 5 continued)



Endogenous market regulationMarket-endogenous regulation, squares III and IV in the matrix, isdefined as non-governmentally initiated regulation and may takemany forms. It may result from industrial initiatives at self-regula-tion, consumer initiatives triggering industrial change, and NGO-mediated consumer–industry interaction. This mode of regulationdiffers from the previous, which although may include market ele-ments, typically takes as a point of departure international agree-ments that specify national targets and national governmental designof domestically targeted instruments.

As far as consumer-triggered industrial change and NGO-medi-ated self-regulation are concerned, technologies and channels ofcommunication typical of the industrial information society facilitateself-regulation. Media may act as catalysts of collective interests bygiving them symbolic manifestation and thereby improving the vis-ibility of green issues. However, the media may also act as an arenafor reputation building, which is of industrial concern in a competi-tive economy with multiple suppliers of rival products and services.

Non-authorized self-regulation intrinsically relies on voluntarymarket-based interaction and does not recur upon the monopoly oflegal and coercive power that resides with the state or supra-stateentities. However, political or private institutions, or both, may havea catalytic role by designing certification procedures for products,spreading information about them, and exerting normative pressureon the population to make use of them.

As far as the electricity sector is concerned, competition and mar-ket orientation increasingly leave the consumers free to change sup-pliers and to specify conditions for their electricity supply. The supplyof green electricity on the market now allows consumers to voice per-sonal preferences as far as environmental performance is concerned.In this context, electricity has become a commodity, which can bedifferentiated and sold for its merits and benefits like other com-modities on the market, and green marketing takes advantage of thisby appealing to people’s environmental awareness.

To create a customer-driven market for renewable energy throughvoluntary green electricity purchases, however, there are strong infor-mational requirements. Even though green marketing approaches donot warrant any direct government involvement, public policy maynevertheless facilitate and stimulate this development through infor-mation and certification procedures (Wiser, Pickle, and Goldman1998). Policy measures that may stimulate consumer-driven greenelectricity are (1) fuel source disclosure requirements, (2) greenpower certification, (3) customer education of green power options,



(4) government purchases of renewable energy, and (5) customer in-centives to purchase renewable energy. Common to all these policiesis that they predominantly seek to enhance information and facilitatecustomer choice.

Disclosure of objective and verifiable standards on alternativeproducts seems to be highly relevant if a market is to regulate itself.Greening electricity in Sweden may serve as an example of NGO-mediated consumer–industry interaction. The SNF (Swedish Asso-ciation for Nature Conservation) was central to the process ofdeveloping green electricity standards and green electricity certifica-tion procedures and served as a third-party endorsement. This en-dorsement from an NGO adds not only credibility but alsostandardization in a market where consumers are increasingly bom-barded with environmental claims on products, in addition to beingbaffled by the complexity of environmental issues.

Motivations that drive industrial initiatives for self-regulation arenumerous. For one, neglecting environmental and social costs ofproducts and processes is a potential liability.6 The legal proceedingsagainst Exxon ensuing the Exxon Valdez oil spill (1989) exemplify themagnitude of environmental liabilities and potential payments toremedy environmental damages. The bill confronting Exxon is ap-proaching 20 billion dollars and a decade after the accident, the legalclaims for damages/compensation have still not been finalized.7

Other motivations for industrial self-regulation, e.g. green energy,include improvement of commercial image, maintenance ofstakeholder goodwill, and differentiation of products so as to accom-modate consumer preferences for environmentally sound productsand processes. Expanding on this, self-regulation may from a com-petitive perspective be analysed and interpreted as a strategy driving

6 An environmental liability is an obligation to pay future expenditures to remedy environmen-tal damage that has occurred because of past events or transactions, or to compensate a thirdparty that has suffered from the damage (Schaltegger, Müller, and Hindrichsen 1996, p. 88).7 See Schaltegger, Müller, and Hindrichsen (1996, p. 87) and www.exxonvaldez.org/index.html, the official web site of Exxon Valdez victims. During the first three stages of courtproceedings the bill confronting Exxon totalled 16.5 billion dollars: 3.5 billion dollars forclean-up, 1.5 billion dollars in compensation, and the rest as punishment. Further, during thefourth phase of proceedings, a unanimous federal jury found Exxon Corporation liable for theExxon Valdez oil spill and awarded damages of 5.3 billion dollars to 40 000 people injured bythe spill, including Alaskan native people, commercial fishermen, small business people, andland owners, as well as local governments and other entities injured by the spill (September1994). These numbers do not include the amount spent on litigation, which are surely notinsignificant considering a decade of proceedings. Exxon has so far appealed the damage ver-dicts and the case concerning the 5.3 billion dollars was heard in the US Court of Appeals inMay 1999 and was without a final decision as of March 2000.



market growth and as a means of differentiation, thereby reducingthe threat from substitute products. From a business perspective,being an early mover with an appeal to thoughtful customers with asocial outlook may, therefore, be a viable strategy to gain an upperhand in a growing market.

Corporate self-regulation, however, may also be a strategy for en-hancing internal management control of environmental factors andthus be interpreted as an indicator of proactive management. Self-regulating initiatives have resulted in increased operational effi-ciency, improvement of production processes, waste and emissionsreduction, and hence reduced relative costs. In general, this has re-sulted in a better understanding of the processes where value is addedand value is lost (Schaltegger, Müller, and Hindrichsen 1996). Porter(1996, pp. 63–66) similarly perceives pollution as a form of economicwaste, such as when scrap, harmful substances, or energy forms aredischarged into the environment as pollution. It is a sign that re-sources have been used incompletely, inefficiently, or ineffectively.Hence, environmental efforts may lead to higher productivity frominnovation and as a result of enhanced resource productivity throughprocess or product improvements, or both.

Self-regulating initiatives started at the level of a trade or industryassociation (square III) potentially have significant effects on actorsbelonging to the association. Schmidheiny (1992) cited peer pressurefelt by members of an industry association as a driving force behindindustry self-regulation. One example includes the internal target setby BP Amoco to reduce CO

2 emissions to 10% below 1990 levels by

2010. The Royal Dutch/Shell Group followed suit, pledging to makea 10% reduction of greenhouse gases by 2002 compared with its1990 levels. Another example is the previously mentioned chemicalproduction industry’s initiative in Canada, known as ResponsibleCare, launched in 1985.8 Illustrating peer influence/pressure, theCanadian Chemical Producers’ Association has made subscription tothe codes and guiding principles of Responsible Care a condition ofmembership in the association (Labatt and Maclaren 1998). The in-dustry association has here, in a sense, taken an authoritative role inregulating its members.

A current example of self-regulation in the energy sector is theRECS initiative.9 This initiative was taken in early 1999 by energy

8 This programme comprises codes for management practices along with guiding principlesfor issue areas such as community awareness and emergency response, R&D, manufacturing,transportation, distribution, and hazardous waste management.9 See www.recs.org/.



sector representatives in the Netherlands (EnergieNed), Denmark(Association of Danish Energy Utilities), and several smaller organi-zations in England, which were occasional contacts of EnergieNed.In brief, the initiative seeks to develop a platform for informationexchange and collective action leading to an international harmoni-zation of trade in renewable energy certificates. The support of theinitiative has been growing. Participants for Medio 2001 are fromAustria, Belgium, Denmark, Finland, France, Germany, Greece,Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, andSweden. Hence, where government negotiations at the EU level sofar have failed at harmonizing renewable energy policies, private en-ergy sector actors attempt to design a system that facilitates certifica-tion, trade, and administration of green energy certificates throughprivate negotiations coordinated through industrial associations.

To sum up, self-regulation potentially solves the negotiation anddistributive dilemmas as they by definition may be initiated with orwithout state/regulatory involvement. The previously mentionedgreen electricity support policies partly move this regulatory strategyback into the formal policy arena, although in a far less imposing waythan through taxation and permits. Since the support policies (fueldisclosure, certification, education) that may advance the success ofvoluntary consumer-driven self-regulation in the electricity sectorappear to impose a lesser financial burden on commercial interestscompared to, say, a fuel tax, one would not expect strong oppositionfrom corporate interests in the negotiation of such types of energy-related regulatory initiatives.

However, there are limits to self-regulation. First, self-regulationappears to demand publicity and media focus to mediate a pressureon firms to self-regulate, as well as to provide incentives in the formof rewards from self-regulation. Second, many forms of self-regula-tion assume that we are dealing with companies with a reputation tolose and companies of considerable size that already are closelymonitored by consumer organizations or NGOs, or both. One reser-vation is, therefore, that smaller peripheral firms under low publicscrutiny may be too small to attract media focus and may hence bewithout strong motivation to voluntarily impose restrictions on theirbusiness practices.

On the other hand, whereas self-regulation through industrial ini-tiative is likely to be biased to industrial interests, self-regulationdriven by consumer initiatives and supported by activist NGOs maybe merciless and may reach smaller market players along an entiresupply chain. Hence, an industrial sector and its sub-suppliers mayget caught between strong possible market reactions and ambitious



policy goals advanced internationally. Especially when market-endogenous regulatory pressure is imposed by consumers and NGOsoutside an industry’s national territory, the bargaining power of in-dustrial interests at the national level may be significantly under-mined, as illustrated by Luukkanen (2000) in the case of the Nordicpaper industry, which was virtually obliged by its German customersto make strong environmental adaptations in its production process.

Negotiated regulationFacing the complexity of environmental regulation in terms of policyjurisdiction and policy coordination across borders, negotiated regu-lation has emerged as a new mode of regulatory intervention. In ourtypology of regulatory approaches (Figure 4), negotiated regulationis placed in the centre of the matrix (V) between public authoritydriven and not public authority driven regulation and, as the wordsimply, this type of strategy emphasizes negotiation, dialogue, and in-formation exchange between economic actors and public authorities.

On the one hand, negotiated regulation is distinguished from uni-lateral government regulation by the fact that industry and not thestate conceptualizes and implements regulatory measures and instru-ments. On the other hand, negotiated regulation is distinguishedfrom self-regulation by the fact that government takes part in the goalsetting and may also act as a partner in the implementation process.

More specifically, negotiated regulation10 refers to (1) an environ-mental agreement between public authorities and an individual in-dustry/firm or (2) an environmental agreement between publicauthorities and an industry association, where a collective target is setfor the entire sector.11 Negotiated regulation has gained increasedpopularity, and, as pointed out in a report from the EU, there arethree main advantages of negotiated environmental agreements(Commission of the European Communities 1996).1 They can promote a proactive and cooperative approach from in-

dustry.2 Flexibility exists as to compliance and achievement of the environ-

mental objective, allowing for tailor-made solutions in a specificproduction system and for technical innovation that reduces com-pliance costs.

10 Negotiated regulation is referred to as voluntary, negotiated environmental agreements or,as in the Netherlands, long-term agreements/environmental covenants.11 Practice in different countries with negotiated agreements differs with respect to the follow-ing: the degree of volunteerism, participants in the negotiation process in which targets areset, and the degree of formality as far as the implementation of tasks, responsibilities, and timeschedules to reach the environmental objectives (Sunnevåg 1999).



3 An environmental objective may be met more quickly than whenactions are instigated through formal legislation at the national orinternational level.

As argued by Segerson and Miceli (1998), voluntary agreements fallinto two categories: those that induce participation by threatening aharsher outcome, i.e. formal legislation and threat of mandatory re-strictions (the stick approach), and those that induce participation byproviding positive incentives such as cost sharing or other subsidies(the carrot approach).

With the stick approach, credibility in compliance is achieved bythe central authority threatening to revert to an authoritative rolewith threats of new regulation in the area covered by the agreement.This is what the German political scientist Fritz Scharpf (1989)called ‘negotiations in the shadow of hierarchy’ or under threat ofauthoritative regulation if negotiations fail.

With the carrot approach, compliance may be stimulated by theuse of economic incentives or cost-sharing arrangements. An addi-tional incentive to commit to an agreement may also be possiblegains in goodwill either from authorities or consumer markets and toregain public trust and recognition if already suffering from low pub-lic credibility.

Analysing the Dutch use of environmental agreements in the en-ergy sector, Arentsen (1996) points out that negotiated regulationunderlines the idea of common responsibility and joint private andpublic action. He finds the strength of public authorities in the abilityto analyse problems and to translate this into policy goals and indi-cate the course of action to be taken. Arentsen finds the strength ofthe private sector in its ability to translate goals and action into cost-effective measures and technologies.12

The same study points out how the negotiated style of regulationmay also serve to bring issues onto the political agenda and to formulate

12 In more detail, Arentsen (1996) described the Dutch process of negotiated regulation asconsisting of four steps: (1) investigation in consultation with the target group, what should bedone and how it should be done; (2) signing of an agreement on energy-saving efforts, andhow these measures are to be implemented; (3) extensive communication of the agreement tothe members of the target group and to regional and local authorities; and (4) monitoring theimplementation of the agreement. Arentsen also pointed out certain societal prerequisites onwhich negotiated regulation must rest: that all economic and social interests that participateare well organized; that the interests accept their representatives in the negotiating commit-tees; that there is a minimum level of mutual confidence; that there is a shared perception ofenvironmental and energy problems; that public authorities are willing to take a certain risk ofnot achieving their goals.



programmes to combat problems. Arentsen also argues that the nego-tiated regulatory style may have a constructive impact on the regula-tory environment in the sense that it enhances information flowbetween the regulator and the regulated and that it allows a mixtureof policy instruments, which together can be effective in attainingpolicy goals.

Overall, negotiated agreements and their associated advantagesappear to have a facilitating effect on negotiations at the nationallevel. Negotiated agreements restructure the regulatory environmentin which environmental goals and policies are formulated by involv-ing parties from government agencies and firms/industries. Hence,by allowing industrial initiatives in formulating mechanisms and ap-plication, concessions are given to the industrial interests.

With a trade or interest association as a liaison to the regulator, im-plementation responsibility and follow-up work with geographicallydiffused member firms may be transferred to the agreeing firm orindustrial association, or both. Public implementation and enforce-ment costs are, therefore, also likely to be reduced. Nevertheless, thecomplexity of negotiation and implementation may imply consider-able monitoring costs. Furthermore, failure of compliance withagreements may necessitate the development of a supplementary au-thoritative regulatory regime.

Concluding remarksThe point of departure for our discussion on environmental regula-tion of energy industry under commercial exposure has been the fail-ure to agree on first-best regulatory solutions, here defined as‘polluter pays’ taxation. Under commercial exposure in a competitiveinternational market and with diverse national resource endowments,we have argued that radical ‘polluter pays’ taxation will redistributeresources so unequally between nations and companies that commonagreement is highly unlikely.

Therefore, the attempt to simultaneously modernize both in com-mercial terms and in ecological terms is an extremely challengingtask. Internationalization and commercialization of energy marketsunder weak international governance such as the EU easily fail in de-veloping sufficiently effective environmental governance, such asstrong ‘polluter pays’ regulation, and easily lead to a retreat to na-tional protectionist environmental strategies at a minimum commondenominator level. This deadlock is outlined in Figure 5 as the dis-crepancy between the two points A (unattainable collective tax opti-mum) and B (lowest common denominator solution undernegotiation of general taxation, when national interests are based onhighly diverse resource bases).



Figure 5 Regulatory mechanisms and trade-offs in environmental policy

The emergence of new, alternative forms of ‘softer’ regulationpoints at possible ways out of the deadlock as they allow us to strikenew and better balances between effectiveness and negotiability(illustrated by the point C in Figure 5). The way this balance is struckis idiosyncratic to each regulatory strategy and dependent on distinctcharacteristics of the regulatory approach. Particular characteristicsthat appear to enhance acceptability of environmental regulationat the national level are flexibility in compliance; adaptation oftechnological solutions to unique production systems and industrialstructures; industrial participation in goal-setting; and development ofpolicy instruments that allow participation in implementation strategies.

A decoupling of policy implementation from the authoritativepublic agency domain, while still maintaining overall environmentalgoal setting coordinated by international forums, is, for example, in-tended through the tradable permits approach to international cli-mate change mitigation. This seems to enable consensus aroundmore ambitious environmental governance than the lowest commondenominator in negotiations of general taxation (the point B solu-tion). Further, this dual approach of establishing agreement of gen-eral emissions limitation at the international level and leaving thecompliance mechanisms up to national design seems well suited toaccommodate both environmental and industrial interests in the do-mestic policy game. While environmental interests may mobilizearound the general compliance levels, the industrial interests get theirsay at the implementation level.

A Unattainable

collective

optimum based

on polluter pays

principle

C

Solution under

new mechanisms

B Solution under

unnegotiability of

polluter pays

regulation

Low High

High

Low

Environmental

welfare

Negotiability with industrial interests and

perceived competitiveness for industry



Hence, it appears that a more flexible design of the implementa-tion process contributes to regulatory agreement and may, therefore,also facilitate agreement in international environmental negotiationsbetween states with different resource endowments. As already men-tioned, negotiations at the national level seem to be facilitated if in-dustrial interests are integrated in decision-making on issues likenational distribution of environmental targets and decisions on bur-den-sharing arrangements. At the international level, it may, there-fore, be argued that focus should be on contextual matters of coreinterest to economic agents and environmentalists such as the gen-eral target setting, initial international distribution of targets, harmo-nization of framework conditions, and agreement on priorities andtime frames for achieving environmental obligations.

The regulatory strategies discussed in this paper are not mutuallyexclusive but should rather be seen as complementary. Some of thestrategies discussed are clearly most negotiable and viable at the na-tional level, for example, negotiated agreements between governmentauthorities and industrial firms/associations. However, negotiatedagreements may function well as part of a national compliance strat-egy to fulfil international environmental commitments. Further-more, the involvement of national interests in decision-making mustbe supplementary to the international agreements when handling envi-ronmental problems with global impacts. National and local decision-making must necessarily be central when introducing environmentalregulation for more site-specific and local or regional issues.

Dynamic aspects of environmental regulationExperiences from the dynamic process initiated by ‘soft’ negotiatedderegulation of European electricity industry show that the interplaybetween initial negotiated agreements and subsequent market dy-namics may take the reform far beyond the initial requirements.When companies see their interests served by fully taking part in thenew commercial economy, they may come to take the reform furtherby themselves and thereby push others in the same direction. Extend-ing this experience by analogy to the environmental field would meanconsidering soft negotiated regulation as only a first step. In thelonger run, one would hope that this will trigger spin-off effects thatwould push for environmental performance far beyond the originalminimum requirements.

More systematically, the sequential impact of even soft environ-mental regulatory intervention can be schematically presented in agame tree, where the implications of regulatory choices and theirconsequences are displayed in a sequential order (Figure 6). The



Figure 6 Dynamic aspects of regulation

13 We assume here that nature moves twice by determining the success or failure of soft regu-lation in C and by determining the preference shift / technological shift in D.

game tree has two kinds of nodes: nodes where choices are beingmade (represented by a star) and nodes where nature chooses itsmoves (consequences of regulatory choices), designated by circles.

Assuming that strong regulation is highly improbable in the shortrun, insistence on direct strong regulatory action is likely to lead tofailure (b1), which means that we forsake the high positive effectsthat such a strategy might have if successful (b2). Choice of softernegotiated regulation might be more likely to succeed (c2), butwould in turn yield smaller yet considerable positive effects (d1).However, in the next round, the soft regulatory intervention mighttrigger preference shifts or technological shifts, or both, and therebycreate a new basis for the next round regulation.13 At the next decisionpoint (E), strong regulation has a far larger chance being implemented F

A

Soft, negotiated

regulation

e1

Soft, negotiated

regulation

e2

Strong regulation

c2

Success

(rather likely)

f2

Success

(rather likely)

d2

Preference and

commercial shift and/

technological development

(rather likely)

d1

No preference and

commercial shift and/

technological development

(less likely)

c1

Failure

(unlikely)

f1

Failure

(rather unlikely)

No positive effects

Fallback on e1 Very high positive effects

No positive effects High positive effects

High positive effects

Considerable

positive effects

b1

Failure

(highly likely)

b2

Success

(highly unlikely)

Strong regulation

C B

D

F

E



(f2), as industrial interests might have prepared themselves already, ormay be compelled by the market forces to adjust their policies.

Furthermore, leading firms that have already ‘greened’ might wel-come strong regulation at this point to secure compliance fromsmaller firms. It is, therefore, possible that we might end up withstrong regulation (f2) but only through the initial soft regulation path(C–D–E–F).

As shown in the game tree exposition, temporary suboptimal envi-ronmental policy solutions may, in a long-term perspective, contrib-ute to moving primary commercial interests in a green direction. Wemay thereby come to see a shift in direction of the trade-off from thetraditional zero sum to possibly a positive sum situation.

This shift may also be facilitated by consumers, who in response toenvironmental issues increasingly demand green policies and come tochange their expectations in a green direction. Primary commercialconcerns of energy industry may change accordingly, as greeningimplies economic gains and pays off as a commercial strategy. Thuswhen consumers demand and expect green energy, the environmentaldimension increasingly becomes internalized in the economy throughconsumer demand. We may then come to see the energy and environ-mental policy fields moving hand in hand, rather than pulling in oppo-site directions. Going back to our earlier trade-off diagram (Figure 5),this would imply moving up from C to a C* position (Figure 7).

Figure 7 Trade-offs under dynamic considerations

Low High

Negotiability with industrial interests and

perceived competitiveness for industry

Solution under

unnegotiability of

polluter pays

regulation

B

CSolution under

new mechanisms

AUnattainable

collective

optimum based

on polluter pays

principle

High

Low

Environmental

welfare

C*New positive

sum relation



A similar transformation from a zero to a positive sum situationmay take place if environmental regulation includes positive stimulifor technology development. If greening policy supports and bringsabout technological breakthroughs where companies are able to in-crease their competitiveness, then greening policies may also givethem technological and commercial advantages. Eventually, such de-velopment may approach a first-best ‘A’ level of environmental wel-fare at a much higher level of negotiability and competitiveness. Atthis point industrial interests might even accept a polluter-pays-based taxation, which leading industrial interests may already haveprepared for, but where they, as already mentioned, might want to seesimilar standards imposed on marginal competitors.

Focusing on negotiability and sequential ‘soft’ regulation doestherefore not necessarily imply weak environmental standards in thelong run. Rather, the softly initiated evolutionary strategy representsa realistic appreciation of the fragility of global and federal institu-tions in issues of major industrial concern and develops a path to-wards sustainable governance that takes this into consideration.Furthermore, many of the soft regulatory mechanisms explicitly incor-porate the technological and commercial skills embodied at the firmlevel, which the bottom–up environmental strategies seek to unleash.

AcknowledgementsThe authors wish to express their gratitude to the Joint Committee ofthe Nordic Social Science Research Councils (NOS-S project #131108), the Norwegian Electricity Association, and the NorwegianResearch Council (project # 138970/212), which have contributed tothe financing of this paper.

The authors have also benefited from open information sharingfrom industry associations and government agencies and from closecollaboration with colleagues: Maarten Arentsen and ValentinaDinica, University of Twente; Niels I Meyer, Danish Technical Uni-versity; Roland Menges and Holger Krawinkel, EnergiestiftungSchleswig-Holstein, Tomas Kåberger, Chalmers Technical Univer-sity; Jyrki Luukkanen, University of Tampere; and Lutz Mez, Univer-sity of Berlin.

The authors also wish to extend their thanks to Per Schreiner andKnut Arild Larsen, ECON, Øystein Guldbrandsen, the NorwegianInstitute for Social Research; Geir Høgsnes, at the University of Oslo;and Kjell Hjerto for valuable comments.



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