Restructuring the E'S'I' In Developing Countries: Risks and Investments

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Restructuring the E.S.I. In Developing Countries
Risks and Investments

• Professor Kumar David
• Hong Kong Polytechnic University
• eeakdavi_at_polyu.edu.hk

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The Fundamentals
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Statement of the Problem - IA

• Four levels of decision making involved
• What is the appropriate ESI Structure?
• Following on this What Architecture for market
  design?
• Investment decision making How?
• Competitive operating strategy How to design a
  market play strategy?

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Statement of the Problem - IB

• Structure ? Ownership
• Architecture ? Market structure
• Decision makers State and Policy Makers
• Investment ? Mainly generation, some distribution
• Competition ? Bids, prices, contracts
  energy/balancing power/reserves
• Decision makers Corporate or private
  stakeholders

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Statement of the Problem - IIA

• Decision Space Parameters
• STRUCTURE
• Prevailing social/political/technical reality
• National economic goals and policies
• Scope for development (transmission, SEB)
• Regulator is part of the Structure
• ARCHITECTURE
• Mainly a design issue
• Interactive with STRUCTURE
• Many global cock-ups to learn fromMathematical
  tools not of much use Scenario analysis and
  decision tree methods of some use

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Statement of the Problem - IIB

• Decision Space Parameters
• INVESTMENT
• Conventional tools are useable
• Investments are long-term
• Often has a foreign vs. local complexion
• Hence parameters to employ are very uncertain
• PLAYING WITH THE MARKET
• Lots of opportunities for profit making
• Plenty of scope for methodology research
• Reformed ESI is an oligopoly

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Specifics of Developing Countries- Generic risks
in imposing market economics

• The Role of Government and public policy in
  infrastructure development is dominant
• Absence of a developed Market Structures and
  independent regulatory frameworks
• Perennial shortage of power - What competition?
• Incomplete grid structure
• Inadequate distribution systems
• Large parts of the country not electrified

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The Role of Government

• The role of the state is of vital importance
• Economic development driven by policy
• Government The big spender and investor
• Singapore, South Korea, Thailand, Taiwan,
  Malaysia The follower geese
• China, India, Vietnam, Sri Lanka
• Avoid conflict between levels of govt.
• Critical infrastructure National security

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Absence of a market culture in developing
countries

• Stock, commodities and capital markets are only
  lightly developed
• Sophisticated market tools and financial
  instruments are not much used
• Regulatory experience is limited and independence
  of regulators is suspect
• Capitalism and non-capitalism co-exist in most
  developing countries
• Electricity supply in any case is an oligopoly
  because of barriers to entry

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STRUCTURE
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Structural Challenges Facing Asian ESI

• Grow a unified national grid and establish
  regional transmission networks
• Reinforce and expand distribution in cities
• Secure funding for new generating plant
• Construct special and mega projects
• Achieve ESI corporate independence
• remodel corporate functionality
• improve decision making and leadership
• inculcate an employee work ethic
• eliminate corruption
• end political meddling

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Structure Ownership Issues

• National Transmission Authority
• Major Hydro Projects Operating Corporation(s)
• Build Operate Transfer (BOT) or BOO private
  investment in thermal generating capacity
• Independent Power Producers
• Regional Authorities (India, China, Indonesia?)
• Unit of unbundling the Distribution Networks
• Municipal, Corporate, Franchised or Private
  ownership of the Distribution business

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Hierarchy of Decision Making Mechanisms
Decisions endorsement of the new ESI structure
Parliament Cabinet of Ministers Subject Ministry
Advice to decision makers drafting of reforms
legislation evaluation of inputs from lower
levels
Machinery of Subject Ministry Public
consultation Stakeholder power play
Economic Assessment National
benefits Stakeholder benefits Productivity
improvement Investment prospects
Socio-political Assmnt. Politically
acceptable? Electoral prospects What are the
objections? Will reform be rolled back in a few
years?
Technical Assmnt. Size (MW) Installed gener.
mix Transmission system status Distri.
problems Prospects of TD reinforcement Options
technically OK?
Stakeholders the public utilities management
civil society employees technical bureaucracy
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Interdependence in ESI Reform
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National Transmission Authority
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ARCHITECTURE
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ARCHITECTURE Critical Risk Issues

• Ensuring that investment in generating capacity
  and transmission expansion can be financed and
  costs recouped
• Dealing with tariff categories, subsidies and
  cross-subsidies, and theft of electricity
• Designing an investment and revenue structure to
  satisfy central and regional needs
• Ensuring cash flow to service BOT/BOO contracts
• Designing market rules for purchase of IPP power
• Designing distribution business rules
• Incorporating the Regulators powers and functions

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Market failure Risk Aggravators

• Electricity is not a commodity which is
  technically suitable for volatile markets
• It is a critical infrastructure government has
  to step in every time there is a crisis
• For a critical commodity, competition will be
  useful only if there is capacity surplus
• Marketisation, often based on false promises
  about consumer costs and the environment
• Bad market design can be corrected but the above
  fundamentals cannot be overcome

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Many avenues to failure(this slide by courtesy
of Dr C.K.Woo)
Market design
Design stage
Good design
Bad design
Implementation stage
Successful implementation
Unsuccessful implementation (e.g., few sellers)
Operation stage
Capacity shortage, slow market entry, and
inelastic demand
Capacity surplus, quick market entry, and
elastic demand
Higher and more volatile prices, capacity
shortages, lower reliability
Lower costs, lower prices, more choice, higher
reliability
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Architecture may fail to limit exercise of
Oligopoly power

• It is not a perfectly competitive market
• Main reason is the barrier to entry High
  investment requirement
• Second issue is nature of transmission
• Issues that need to be studied
• existence of market power
• identification of reasons for market imperfection
• how market power is being exercised
• how to limit abuses of market power

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Evidence of abuse of market power

• Evidence
• Price increase above competitive levels is a
  manifestation of market power
• Sharp price spikes during some periods are also
  the result of abuse of market power
• Widespread evidence EW, California and other
  examples also

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Cournot Oligopoly Model
Suppliers set production to maximise
profit Output quantities of all suppliers cleared
simultaneously by the market assumes that an
equilibrium solution (outputs) can be found.
Inverse overall demand function.
R price PL demand
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U1 to Un are profit maximising utilities
Cournot Oligopoly Market Structure
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INVESTOR DECISIONS
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Investment decision making

• The understanding of risk correspond to well
  established business risk analysis methods
• The investment side stakeholders are state
  electricity boards, public corporations,
  municipalities, and local and foreign investors
• The principal sources of risk are
• Incorrect estimation of future demand
• Incorrect appreciation of strategy of business
  rivals
• Investor corporate governance misdemeanour
• Corruption and host utility failure, future host
  system cash flow problems, and labour and
  political risk

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Net Present Value V
Constant return of A per annum from year t0 to
tn Annual interest rate i and annual inflation
rate f
When i and f vary from year to year
Similarly find
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If A varies from year to year
Say At in year t
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The Risk of Project Termination Catastrophic
Risk
If the probability that the project will be
terminated in year t is pt (usually political
instability, nationalisation or corporate
misdemeanour), then-
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Including RISK in Present Value Assessment
Where j , ( 1J), is an index of a probable
outcome At(j) in year t with probability pt(j)
Provided A1 , A2 . . . At . . . An are
independent random variables. But this is
unrealistic in the real world.
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Dependent random variables?
Use the convolution integral
If v (u w) and u and w are independent
random variables
Extremely computationally burdensome if the
number of dependent variables is large
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Internal Rate of Return r
Using interpolation methods or otherwise find an
interest rate r such that the costs and
benefits of the investment sum to exactly zero
If the market interest rate is lower than r
then it is worth doing the project
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OPERATIONS DECISION MAKING
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Operations Decision Making

• The issue is as simple as A player in the power
  market (eg. IPP) desires to maximise returns
• The business decisions to make are-
• Generators How much power to bid into the
  energy, balancing and reserve markets, and how
  much to with hold and game in the market
• Generators What price to bid for each of these
• Brokers, Generators, Buyers What contracts to
  enter into at what price and for how long
• Speculators Futures, forward and transmission
  rights contracts.

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An Illustrative Example

• n generator marginal price based power Pool
• Know and price elastic demand
• Generators bid a linear price function
• The problem What price function should some
  particular generator bid so as to maximise net
  returns?

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Model
R is the market clearing price, Q the demand and
K the price elasticity
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Omniscient Solution
Solution available only to the omniscient ones
who know all the ? and ? values
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If i was an omniscient supplier
The supplier could forecast R and then compute Pi
and then reap net return ?i
C is the production cost function
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Forecasting the strategy of rivals
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Including aversion to risk in the model
Maximise
Subject to
E and D are the expected value and standard
deviation of a variable l the degree of risk
aversion
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Summary

• The story in developing countries and fast
  expanding economies is different from NAC
  paradigms
• Political, economic and ideological factors
• Case for a publicly owned Transmission Entity to
  own, operate and develop the grid
• Transmission and Distribution investment are no
  less important than Generation
• There is a definite and well defined role for
  private capital in this structure

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Summary- continued

• Risk analysis moves at four separate levels
  STRUCTURE, ARCHITECTURE, INVESTMENT DECISION
  MAKING, OPERATING STRATEGY
• There is a hierarchical relationship among the
  levels in the given order. Furthermore, the first
  two determine the second two
• Mathematical techniques are of no value at the
  higher levels and in general formal techniques
  are of little use at the highest level
• Established risk analysis methods, decision
  making techniques and mathematical and
  computational methods are useful at the lowest
  level