Why electricity deregulation is likely to fail: An explanation with an application to Israel

In this paper we contend that electricity deregulation likely fails because of a fundamental, but so far ignored, reason. In particular, a deregulated electricity market cannot have too many producers because they will not be able to recover their investment costs. Nor can it have too few producers because the resulting market price will likely exceed the regulated rate. If constrained by the financial viability of privately owned generators and an overarching goal of unregulated market price not exceeding the regulated rate, the set of feasible numbers of producers in the competitive market can be very small, and at times empty. Our theoretical prediction applies to deregulation of other industries with large fixed and sunk costs (e.g., gas transportation, electricity transmission and distribution, local telecom networks, ports, railways, etc.). We show that a large improvement in the operational efficiency of the deregulated industry is a necessary condition for a successful deregulation of the industry. Unfortunately, operation improvement in electricity generation is limited because fuel (e.g., coal, oil, natural gas, and liquefied natural gas) and generation equipment (e.g., turbines, transformers, and cables), which constitute about 80% of the total cost of electricity generation, are commodities traded in a competitive world market. Thus, cost savings due to deregulation in the electricity generation market mainly come from efficiency improvement in capacity investment and variable input use of labor and O and M. Unless the regulated integrated utility has been investing inefficiently in surplus capacity, such savings, mainly in labor and O and M, are unlikely to produce more than a 10% reduction in total generation cost. For this reason and based on the experience to date, we caution against deregulation in regions that currently have a regulated electricity sector (e.g., China, India, Hong Kong, Israel, Africa, and many parts of North America). Our theoretical model focuses on the connection between the number of producers (firms) and market structure. We compare an electricity market with two (or more) technologies (e.g., coal-fired generators, combined cycle gas turbine (CCGT)) and, possibly, time-of-use pricing, under regulation and under deregulation. Production of electricity entails high fixed cost (mostly, the initial investment in the generator and its regular maintenance). Thus, 'perfect' competition with a large number of producers can be financially unsustainable because the firms cannot recover and make a return on their investments. To be sure, exit by unprofitable firms may lead to an oligopoly market with price above marginal cost, thus providing sufficient operating margin (electricity price minus average variable cost) to the remaining firms to cover their fixed costs. We explore the market equilibrium under regulation and under deregulation, so as to determine whether deregulation will likely succeed in reducing the electricity price below the regulated rate. Using real-world data for Israel, we verify that indeed, a workably competitive electricity market, in which the competitive rate is not higher than the regulated rate, may not exist. (Author)