Paths to deregulation



For Asia’s power markets, 2003 promises to be a seminal year. With little fanfare, several countries have been preparing the ground for deregulated electricity markets, as well as the systems for managing the greatly increased risks that will inevitably follow.

This comes in the wake of the power market deregulation in North America, Europe, Australia and New Zealand, and Asian reformers are determined not to make the mistakes experienced elsewhere. The California power deregulation debacle and high-profile bankruptcy of Houston energy giant Enron have not, however, deterred Asian countries from cautiously pushing ahead with the creation of their own competitive electricity markets.

Within the Asia-Pacific region, Australia and New Zealand have largely achieved this goal. Singapore and South Korea, meanwhile, have embarked on a phased opening up of their power industries that involves (in the earlier phases) the creation of wholesale pool markets, supplier choice for big consumers and privatisation of generators. But the lesson that Asia’s deregulating governments have learned is that the design of competitive new markets has to be got right. “Deregulating power supply introduces a lot of new risks for many of the market participants. Putting in place the right risk management framework is critical to avoid a disaster like California,” says an energy market consultant in Singapore.

Among those countries where the pace of market deregulation is picking up is South Korea, which will introduce two-way bidding in the wholesale electricity market in 2003, as part of the second five-year phase of its electricity market restructuring. Some large industrial power consumers will also be allowed to negotiate supply contracts directly with one of the six newly created generating companies (gencos). South Korea’s three-phase plan was announced in January 1999. Under the first phase, Korea Electric Power Company (Kepco), which then produced 92% of the country’s electricity, was split up into six separate gencos – five thermal companies, and a hydro-nuclear genco. The five thermal gencos are to be privatised, probably starting with South East Power or South West Power in early 2003. Around 2004, the distribution and sales segments will also be split from Kepco, which will keep the transmission business, as well as the hydro-nuclear genco. Competition for power in the wholesale market will be followed by retail competition from 2009.

The Korea Power Exchange (KPX) was set up last year to operate the wholesale pool, along with the Korea Energy Commission (Korec) to regulate the industry. As in Australia, vesting contracts are being introduced to smooth the transition from regulated prices to free market prices. These contracts will probably be introduced later this year, initially between the gencos and Kepco, as the main purchaser. But the contracts will later be transferred to the independent distributors and sales companies, according to Cecilia Ho, a Seoul-based Kepco assistant manager.

The vesting contracts, which may run for five years, are similar to the contracts for differences (CFDs) – essentially swaps – widely negotiated between generators and supply companies in the electricity industry. When the spot price for power exceeds the contract strike price, the generator pays the buyer the difference. When the spot price is below the strike price, the buyer pays the generator the difference. This will essentially set the price range over the next five years, an approach that is criticised by some commodity brokers for limiting the free operation of the market. However, such criticism fundamentally misunderstands the purpose of the spot market, says Harry Koller, a power reform specialist at consultants PricewaterhouseCoopers in Seoul, one of the firms advising the South Korean government on deregulation.

The contract market is the most critical part of the wholesale electricity pool, with the spot market typically accounting for only about 5-7% of wholesale electricity pool trading, says Koller. The rest is traded through contracts, which can be bilateral, or traded on the over-the-counter (OTC) market, or on an exchange.

“As California demonstrated, you can’t run a spot market without a contract market, otherwise the retailers will go broke, particularly if they are selling electricity to customers at a regulated tariff,” he says. “The only difference between the normal contract market and vesting contracts is that the latter are put in place by governments to manage the transition. So the idea that the establishment of vesting contracts means that there is not a real spot market is not true.”

Anyway, retailers are still exposed to variations in actual demand versus the quantities specified in the vesting contracts, as would be the case with normal bilateral contracts, so they will still undertake short-term bilateral trades to adjust to their vesting positions, Koller adds. In time, the vesting contracts will be wound down in line with the introduction of full customer contestability and replaced with bilateral contracts.

South Korea, Koller says, will not make California’s mistake, and fail to ensure that there is some sort of risk management framework in place to address the risk faced by retailers selling to customers at a regulated price. In California, retailers were obliged to purchase all their requirements on the spot market, and were restricted from entering into bilateral contracts. When several adverse events coincided, including forced outages, higher natural gas prices and drought, retailers were caught between rising spot prices and fixed consumer prices. Some companies have filed for bankruptcy as a result.

Electricity futures contracts are under active consideration in South Korea, but there is some dispute over where they should be traded, according to Cho Kang-Wook, the KPX manager helping to design the operating rules for the wholesale market. Korec wants electricity futures contracts to be traded on the KPX, but South Korean financial exchanges are also eager to list futures contracts, he says. “We know we must introduce a financial market, alongside the spot market, to allow participants to hedge their risks,” says Dong Sup-Shim, in the Korec project research team. But no launch date has been set.

Korec officials are aware, however, that exchange-traded futures contracts have had mixed success in Australia and the US. The Sydney Futures Exchange’s electricity contracts were delisted in July following criticism from market participants that their design did not reflect the needs of operators in the physical market. Redesigned contracts are being launched by the exchange in September, with its rival, the Australian Stock Exchange, also adding a futures contract to its arsenal. However, at the moment, most of the hedging in Australia – seen as a model by other reforming countries such as South Korea – is chiefly OTC.

In Singapore, which is following a broadly similar power market restructuring to that of South Korea, a key stage comes next year when three gencos are put on the block for privatisation. The Singapore government corporatised the electricity industry as early as 1995, when the various power supply functions of the Public Utilities Board were separated into three generating companies (Tuas Power, Senoko Power and PowerSeraya), one transmission and distribution company (PowerGrid) and one electricity power retailer (Power Supply).

The gencos, currently under the umbrella of Temasek, the government investment holding agency, will be privatised through trade sales in 2003, says Lorenz Chenaux-Repond, head of the Asia power group at UBS Warburg corporate finance, in Hong Kong. Singapore Power, which is now responsible for the monopoly businesses, such as transmission and distribution, will be partially privatised through an initial public offering (for which UBS Warburg has the mandate), possibly within the next 12 months, he says. A number of retail companies have also been set up, both by the generators and by groups previously outside the power industry.

At the same time, the Singapore Electricity Pool, set up in 1998, is being revamped to increase competition. Under the New Electricity Market, which is expected to start operating later this year, big consumers will be allowed to buy directly from the pool, and nodal pricing will be introduced, allowing prices to vary at different locations on the network. And full contestability may not be too far behind. “By the end of 2003, every consumer in Singapore, from large industrial companies to small households, will be able to choose its own electricity supplier,” explains Chenaux-Repond.

In a similar vein to South Korea, the Energy Markets Authority (EMA) of Singapore, set up in 2001 to regulate the market, will impose vesting contracts in the early years of deregulation. And brokers predict that an OTC market will start to develop along with the full opening up of electricity trading next year. Although there are no official plans to set up an electricity futures market, the EMA will support any private initiative to introduce listed contracts, says Yeo Yek Seng, the authority’s deputy manager for market governance.

If South Korea and Singapore are in the vanguard of Asian power deregulation, Japan’s market reforms have been glacial. But fresh developments are under way even there. The second phase of the country’s electricity market deregulation is likely to start next year, possibly March, according to Tokyo-based Yoshitaka Makimoto, head of the energy division at money brokers Yamane Prebon.

Under the first phase, which began in March 2000, some 30% of the market, representing the largest consumers, was notionally deregulated. However, little actually changed for the 10 major, vertically integrated private utilities that each dominate the generation, transmission and sale of electricity in their own district. As one specialist says: “Japan does not have a power market. It has a club of utilities.”

Some nine or 10 private power suppliers (PPS) have been set up to compete for business, including eRex (a joint venture between money brokers Nittan Capital and Ueda Tanshi, the trading house Mitsui Corporation, Mizuho Bank and Taisei Construction) and Ennat (a joint venture between telecoms company NTT, Tokyo Gas and Osaka Gas). These PPS have, however, so far captured only about 0.6% of the ‘contestable’ market, according to official figures.

Yet, with the highest power prices in Asia, and possibly the world, pressure for more extensive reform is building up in Japan. Under the wing of the Ministry of Economy, Trade and Industry, a key 26-member council, representing the power sector, industry, consumers and academia, has been meeting regularly since late last year to determine how to proceed with electricity deregulation. It is expected to decide before the end of this year the structure of the power exchange market and transmission network; and also raise the contestable portion of the market to 63% of total consumption. Some voices from industry and the independent power trading sector are calling for 100% deregulation of the market, the establishment of a wholesale pool and the unbundling of the big 10 utility companies, such as Tokyo Electric Company (Tepco), into generators, transmission and sales businesses. Until recently, the utility companies were resisting change, citing the bankruptcy of Enron (which entered the Japanese market with big ambitions), as a reason for caution.

However, the resistance is weakening. Nobuya Minami, Tepco’s president, is now backing full deregulation by 2007, although opposing unbundling. Some observers expect a power exchange market to be set up within one or two years. A financial market, including forwards, swaps and options, would have to start at the same time, to allow electricity operators to hedge, says Makimoto, who is planning to set up a joint venture between money brokers Central Tanshi and Prebon Energy that will specialise in energy broking. The joint venture, called Central Prebon Energy, is expected to start operating next year.

Several banks, both foreign and local, are poised to enter the OTC market when it starts. Mizuho Bank is one that would be keen to enter that market, says Hiroshi Matsui, Tokyo-based head of its derivatives development team. The bank is waiting for permission to undertake such business. Matsui predicts it could happen within two years. Meanwhile, the Tokyo commodities exchange, which already trades oil futures, is believed to be looking at possibilities for launching electricity futures contracts, suggesting that Japan’s energy market could be on the verge of taking off at last.

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