As the generation sector is the sector capable of delivering the biggest efficiency gains in the electricity industry, the regulatory variables used by the OECD focus on the key economic regulations needed to establish a competitive generation sector — structural separation of generation from transmission, whether third parties can access the transmission grid and whether a wholesale pool (electricity market) exists. The modelling did not look at other forms of regulation in the generation sector, nor at regulation in the transmission,14 distribution or retail sectors, despite the potential for the transmission and distribution sectors to expropriate efficiency gains derived elsewhere in the system (King 2000) and the fact that some economies have delivered full or partial retail competition. The regulatory variables did not cover regulation addressing non-economic objectives, such as environmental or social policies.
Dummy variables were used to indicate the three key economic regulations needed to establish a competitive generation sector.
The unbundling of generation from transmission variable takes on a value of 1 if separate companies control the generation and transmission sectors, or if both sectors are controlled by a single entity keeping separate accounts for each sector (accounting separation); otherwise it takes on a value of 0. Having separate companies reduces the likelihood that any gains arising in the generation sector will be expropriated by the company controlling the transmission sector. Yet physical separation need not translate into economic separation, if it is accompanied by cross-ownership between the companies concerned or if one of the companies exercises any monopoly power. Accounting separation is a considerably weaker proposition than having separate companies, as it gives the single entity considerably more scope to engage in strategic behaviour and to maximise its joint profits to the detriment of society. Accounting separation is also weaker than the notion of ‘ring-fencing’ that is sometimes used in Australia and other economies, as the ring-fenced activities operate with greater autonomy from the rest of the organisation than do business units.
The third party access variable takes on a value of 1 if generators have a legal right to access the transmission grid on certain pre-specified terms and conditions (regulated third party access) or can negotiate the terms and conditions under which
14 Some of the regulatory variables for the generation sector — unbundling of generation from
transmission and third party access — carry implications about the structure and regulation of
grid access can occur directly with the operator of the transmission grid (negotiated third party access); otherwise it takes on a value of 0. New generators need to be able to access the transmission grid on similar terms and conditions to existing generators to ensure effective and ongoing competition in the generation sector. However, the variable does not capture important differences in the way the third party access arrangements operate across economies.
The wholesale pool variable takes on a value of 1 if generators can voluntarily sell, or are obliged to sell, their electricity into a wholesale electricity market; otherwise it takes on a value of 0.15 The pool is designed to overcome limitations associated with the use of long-term bilateral contracts that may stifle competition. However, the variable does not capture whether the pool is mandatory or optional and the rules governing how it operates. An optional wholesale pool that allows participants to voluntarily bypass the pool and negotiate their own bilateral contracts should lead to lower electricity prices than a mandatory pool in which all electricity must be sold, as bilateral contracts can be used to deliver mutually beneficial outcomes that would not be available under a mandatory pool.
Competitive electricity markets would generally be expected to lead to lower industrial electricity prices, so that the unbundling of generation from transmission, third party access and wholesale pool variables would be expected to be negatively related to industrial electricity prices.16
In addition to the three regulatory variables needed to establish a competitive generation sector, the OECD included three market structure variables in their model — ownership, the time to liberalisation and the time to privatisation — as they may also account for price differences across economies.
Ownership of the generation sector varies widely across economies, ranging from full public ownership all the way through to full private ownership. To
15 The variable does not, however, differentiate between the different price setting arrangements that may occur in the absence of a wholesale pool (eg bilateral contracts and price controls). 16 Where insufficient competition exists, generators may be able to manipulate a wholesale pool
by exercising their market power. The rules governing the operation of the market and the behaviour of the regulator will affect the extent to which this occurs. Insufficient competition can arise, for example, where the pre-reform generating capacity was divided into too few generators prior to establishing a wholesale market (insufficient horizontal separation) or where new generators find it excessively difficult to enter the market (eg if the third party access arrangements are too stringent). The recent UK decision to replace its wholesale pool with bilateral contracts was based on concerns about insufficient competition in the generation sector. However, it is not at all clear whether alternative price setting arrangements, such as the use of bilateral contracts, will necessarily deliver lower prices than a wholesale pool, as the underlying problem is the same under both regimes — the market power of the generators.