Monday, June 28, 2004

A Matter of Trust

Last Sunday a researchers group of the IIT-UPCo published in EL PAIS, Madrid newspaper, a leading article entitled "Una Cuestión de Confianza" on the Spanish Electricity Market performance. The article can be read in the EL PAIS web, but it requires subscription. My own translation into English of that article can be read below. In short, they suggested two things to improve the performance of the market: (1) an increasing of trust in the market, and (2) an updating of the regulatory model.

After reading this article come to my memory the Op-Ed that Paul Krugman wrote in the New York Times on August 19, 2003; only five days later of the New York Blackout:

“The Road to Ruin”
in New York Times, August 18, 2003

In that Op-Ed Paul Krugman wrote in the beginning: "…politicians and deregulation enthusiasts simply had faith that somehow "the market" would take care of the problem". And further along: "…the power industry hasn't spent enough on the control systems and safeguards that are supposed to prevent such things. And the cause of that neglect is faith-based deregulation."

By the way, many Spaniards will be very glad to see how Paul Krugman receive the Prince of Asturias Prize next October in Oviedo.

Certainly trust is the "main food" for the good performance of any market. Even there is a famous book of Fukuyama about this subject: "Trust. The Social Virtues and the Creation of Prosperity". The Free Press 1995. In page 7 of this book we can read; “ of the most important lessons we can learn from an examination of economic life is that a nation’s well-being, as well as its ability to compete, is conditioned by a single, pervasive characteristic: the level of trust inherent in the society.” And in page 26: “Trust is the expectation that arises within a community of regular, honest, and cooperative behaviour, based on commonly shared norms, on the part of other members of the community”.

Blackouts have shown that trust, or faith, is not enough by itself to improve the performance of the electricity market. This is one of the reasons why I have created this blog. The governance structures available at present are based on the heritage of the Frederick W. Taylor and Henri Fayol, whose theories were elaborated at the start of century XX. The electricity companies faced the industry reform with this kind of governance structures.

There has been done much work to create a new governance structure of the power utilities to create the electricity market, and improve its efficiency as well. This work has been based on the unbundling. However, tt could be that what is being gained in allocative efficiency (market), and static efficiency (regulation) do not balance what is being lost in dynamic efficiency (technology), because the blackouts are losses.

Few attention has been paid to study how Information Technologies will shape the governance structures of the firm of the century XXI, and how new power applications will shape the grid of the future. In other words, it could be the approach applied up to know is not sound enough. In the end, the focus of the electricity industry reform, instead of being in the regulation and reliability, it could be in the Organization Theory and the Technology.

A Matter of Trust
Ignacio Pérez-Arriaga, Carlos Batllé, Álvaro Baíllo, y Carlos Vázquez - Reserachers of the Instituto de Investigación Tecnológica of the Universidad Pontificia Comillas. Madrid.
EL PAÍS - Negocios - Sunday, June 27th, 2004. Page 4.

Since 1998 a wholesale market of electricity works in Spain. In it there is negotiated most of the electricity that we consume and there is fixed an hourly price that depends on uncertain factors as the hydraulic contributions that receive the reservoirs or the fuels cost the power plants utilize. The role this price plays is key, since is the one that the companies of generation get for its production, with an important exception: the energy produced in the power plants built before 1998 remunerates to an essentially fixed price due to the recovery mechanism of the so called transition costs to competition (CTC). Another exception is the special regime generation, renewable and cogeneration, hold to a remunerative specific regime.

In the retail segment, all the consumers can choose the company to buy electricity. However, great part of the consumers remain sheltered to an integral tariff, that of the lifelong, which the Government set annually. A great part of the income of the sector is fixed a priori, opposite to a few costs that change due to external uncertain factors.

Rate setting in these conditions is a forecasting task. The possibility of arising a scene of deficit, in which the income turns out to be insufficient to cover the costs, is evident. How are these imbalances solved?. In most countries, simply shifting the mismatch to the next year rate. Other solutions fit, as in the Argentine case, by means of the creation of a stabilization fund that absorbs the differences between the foreseen prices and the real ones.

And in Spain, how has this problem been approached?. Attending to the statement of the former Secretary of State of Energy, " doing bobbin lace with the electricity rates" (sic). The fact of the matter is that the Government does not need to be very accurate in its estimation of the wholesale price, nor the special regime production, neither the demand, provided that it can use the CTC recovery mechanism like a buffer: the years in which the costs turn out to be greater of the foreseen, the assigned amount to CTC recovery diminishes. The actual conflict arises when the costs increase turns out to be greater than CTC's buffer and the incomes do not reach to pay the incurred costs. This is what in the sector is known as rate deficit.

A questioned model

A situation of this kind took place from 2000 to 2002, what stirred up an intense polemics that finally the Government closed in 2002 by accepting to compensate the mismatch of those years in the rates of the future years. However, it opened at time a new controversy by limiting with a Royal Decree the annual increase of the rate until year 2010, and defining the ratio of potential imbalances that each of the utilities would assume with right to CTC. Thus, the rate become a cap, not so much at the cost of the market, as to the income of the agents subject to the CTC recovery mechanism.

With this decision, besides making possible the annual rate adjustment, the Government reserved a mechanism that allows it to exercise a certain control on the price of the wholesale market, in which does not seem to trust in excess.

This distrust, not completely open to criticism, keeping in mind the composition and the geographical isolation of our market, is behind the deficit problem and of great part of the flaws of the regulatory design. The upcoming events - the Iberian Market of Electricity, the European directive of emissions trading and the transposition of the new European directive on the internal market of electricity - are presented as stupendous excuses to undertake a good face washing of the regulatory model.

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