A new currency is emerging in world markets. Unlike the dollars, ruros and yen that trade for tangible goods and human services, money exchanges hands for pollution - particularly emissions of carbon dioxide, which are caused by burning fossil fuels and are the leading cause of global climate change. Carbon credits, as they are called, are poised to transform the world energy system and thus the world economy.

Starting in the late 1980s many nations began to reform their electric power markets away from state-dominated systems to those with a greater role for market forces. In developing countries, especially, these reforms have proved challenging. Successful reform requires a complex set of institutions and complementary reforms, such as in public finance and corporate governance. State-dominated systems typically create their own powerful constituencies that block or redirect the reform process. In an earlier detailed study of reform in five key developing countries, the Program on Energy and Sustainable Development (PESD) found that the result of these pressures, in most cases, is a “hybrid” outcome—an electric power system that is partly reformed and partly dominated by the state 2. Almost always the first step in hybrid reform is the encouragement of private investors to build independent power projects (IPPs)—generators that are hooked to the main power system and, typically, supply electricity according to long-term power purchase agreements (PPAs).

When the People's Republic was founded in 1949, the Chinese electricity industry, with only 1.85 GW installed capacity, was primitive. It has since grown into the second largest in the world, with installed capacity rising to 353 GW in 2002. The number of people who have no access to electricity has been reduced to less than 2 percent of a population of 1.26 billion. On a per capita basis, installed capacity has edged up to one half of the world's average. Development has been particularly impressive since the 1980s thanks to increased investment in the sector. According to industry accounts, an estimated RMB 1,107 billion ($US 134 billion) was invested between 1981 and 2001 in new generation and delivery capacity. Additional investment was also made in retrofitting and upgrading the system, reaching over RMB 100 billion ($12 - 15 billion) per annum in the past seven years. Three quarters of this sectoral capital came from domestic sources, with foreign investment making up the rest. This remarkable power sector growth and financing have been achieved through an ongoing, unsystematic process of electricity industry reforms initiated in the mid 1980s. Further system expansion, projected at about 25 GW per year for the next two decades, challenges the Chinese government to continue and deepen this reform process.

This chapter, by PESD fellow Thomas Heller and PESD affiliate P.R. Shukla, was published by the Pew Center on Global Climate Change in 2003 as part of their "Beyond Kyoto" series.

This chapter aims to explain the motivations and strategies for reform in the Mexican electricity sector. Our focus is on the effects of politically organized interests, such as unions and parties, on the process of reform. We show how particular forms of institutions-notably, the state-owned enterprises (SOEs) within the power sector as well as the state firm that supplies most fuels for electricity generation-shape the possibilities and pace of reform. The tight integration of these SOEs with the political elite, opaque systems for cost accounting, and various schemes for siphoning state resources explain why these institutions have survived and the actual progress of reform has been so slow. Where private investors have been allowed into the market it has been only at the margin through the "independent power producer (IPP)" scheme, an oxymoron since the purchase agreements and dispatch rules that determine payment to these IPPs are dominated by the State.

Executive Summary

The purpose of this paper is to present a general framework for electricity market design in Latin American Countries (LACs) that addresses the current problems facing electricity supply industries (ESIs) in this region. The major issue addressed is what market rules, market structures, and legal and regulatory institutions are necessary to establish a competitive wholesale market that provides the maximum possible benefits to consumers consistent with the long-term financial viability of the ESI.

The paper first presents a theoretical foundation for analyzing the electricity market design problem. A generic principal-agent model is presented and its applicability to the electricity market design problem explained. It is then applied to illustrate the incentives for firm behavior under regulation versus market environments. The impact of government versus private ownership on firm behavior in both market and regulated environments is also addressed using this model. This discussion is used to guide our choices for the important lessons for electricity market design in developed countries and LACs.  Using the experiences from ESI reform in developed countries, the paper presents five essential features of a successful wholesale electricity market. The first is the need for a sufficient number of independent suppliers for a competitive market to be possible. Merely declaring the market open to competition will not result in new entry unless no single supplier is able to dominate the market. Second is a forward market for electricity where privately-owned firms are able to sell long-term commitments to supply lectricity. This report argues that the conventional wisdom of establishing a competitive spot market first leading to a competitive forward market is an extremely expensive process in developed countries and is prohibitively expensive in developing countries. Third is the need for the active involvement of as many consumers of electricity as is economically feasible in the operation of the wholesale market.  This involvement should occur both in the long-term and short-term market. In the short-term market, there must be a number of buyers willing to alter their consumption of electricity in response to short-term price signals. Fourth is the importance of a transmission network to facilitate commerce, meaning that the transmission network must have sufficient capacity so that all suppliers face significant competition. This implies a dramatically different approach to determining the quantity and magnitude of transmission network expansions in a market regime.  The final lesson is the need to establish a credible regulatory mechanism as early as possible in the restructuring process. An important lesson from developed countries around the world is that the initial market design will have flaws. This implies the need for ongoing market monitoring to correct these flaws before they develop into disasters.

The paper then takes on the issue of the specific challenges to LAC restructuring. Rather than focus on the details of specific markets, the paper instead identifies a number of problems common to LACs and provides recommended solutions to each of these problems. A major theme of this section is a warning that short-term solutions to market design flaws can have longterm market efficiency costs. The paper identifies seven major challenges to Latin American ESI restructuring. The first is related to the problem of introducing wholesale markets in systems dominated by hydroelectric capacity. This section also deals with the related issue of using cheap hydroelectric power as a way to keep electricity prices low and the risk of electricity shortages high. The second issue is concerned with the difficulties of establishing an active forward market for electricity in LACs. The third relates to the LAC-specific challenges associated with establishing an independent and regulatory body. The fourth addresses the advisability of cost-based versus bid-based dispatch of generation units in LAC wholesale markets. The fifth is how to regulate the default provider retail electricity price in LACs. Sixth concerns the advisability of capacity payments mechanism for ensuring energy adequacy in markets where demand is expected to grow rapidly. The final issue is the role for government versus private ownership in LACs.

The report then discusses specific market design challenges in five LACs. These countries are Brazil, Chile, Colombia, Honduras, and Mexico. A number of these challenges are specific examples of the general challenges discussed earlier in the paper, whereas others are unique to the geography, natural resource base or legal environment in the country.

The report closes with a proposed market design that should serve as a baseline market design for all LACs. Deviations from this basic design could be substantial depending on initial conditions in the industry and the country, but the ideal behind proposing this design is to have a useful starting point for all LAC restructuring processes.

The study of regimes has focused on the negotiation of rules that, in practice, have been codified into single agreements. Scholars have generally assumed that individual regimes are decomposable from others. Given the rising density of international institutions, we suggest that an increasingly common phenomenon is the "regime complex"-a collective of partially-overlapping regimes. We suggest that regime complexes evolve in special ways. They are laden with legal inconsistencies because the rules in one regime are rarely negotiated in the same fora and with the same interest groups as rules in other regimes. These inconsistencies, which occur at the joints between regimes, focus a process of problem-solving as actors attempt to resolve inconsistencies through the process of implementation; in turn, viable solutions focus later rounds of formal rule-making and legalization. We illustrate the concept of regime complexes using the rarely studied issue of property rights in plant genetic resources (PGR). Over the last century governments have created property rights in these resources in a Demsetzian process: as new technologies and ideas have made PGR more valuable, property rights have allowed firms and governments to appropriate that value. We explore our conjectures about the development of rules in a regime complex through the PGR case.