NOTE NUMBER 225 P U B L I C P O L I C Y F O R T H E privatesector DECEMBER 2000 The Single-Buyer Model Laszlo Lovei Laszlo Lovei is Lead A Dangerous Path toward Competitive Electricity Markets Specialist in the Energy Sector Unit of the World Many Asian, African, and Eastern European countries freeing up their Bank’s Europe and electricity markets are preser ving an ar tificial monopoly over the Central Asia Region. Before joining the Bank wholesale trading of electricity even after the ver tically integrated in 1986, he worked in national power company is unbundled. Evidence so far suggests that this THE WORLD BANK GROUP PRIVATE SECTOR AND INFRASTRUCTURE NETWORK the National Planning Office of Hungary. “single-buyer” model has major disadvantages in developing countries: it invites corruption, weakens payment discipline, and imposes large contingent liabilities on the government. These disadvantages in most cases overshadow the higher shor t-term costs of a “bilateral contracts model” where generators contract with customers. Why so popular? awarded exclusive rights to the newly formed The single-buyer model first appeared in devel- transmission and dispatch company—the single oping countries in the 1990s. To relieve capacity buyer—to purchase electricity from generators shortages while conserving scarce public and sell it to distributors (figure 1).1 resources, governments in several countries The legal separation of generation from authorized private investors to construct power transmission and distribution facilitates compe- plants—-independent power producers (IPPs) tition by allowing equal treatment of IPPs and —to generate electricity and sell it to the national the national utility’s power plants. The simplest power company. IPPs sold their output through way to ensure equal treatment is to require all long-term power purchase agreements that generators to sell their output to the transmis- included take-or-pay quotas or fixed capacity sion and dispatch entity, ruling out direct (bilat- charges to protect investors from market risks. eral) contracts with distributors, which may Some governments went further and split the unfairly favor some plants over others. national utility into generation, transmission, The popularity of the single-buyer model is and distribution companies, intending ulti- due to a number of technical, economic, and mately to turn over generation and distribution institutional factors: facilities to the private sector. Most decided to ▪ Electricity supply has to match demand sec- keep strategically important transmission and ond by second, requiring the balancing of dispatch facilities in state hands, however, and differences between the planned and actual T H E S I N G L E - B U Y E R M O D E L A DANGEROUS PATH TOWARD COMPETITIVE ELECTRICITY MARKETS Figure The single-buyer model for electricity trading 1 Generators Transmission and dispatch Distributors Consumers 2 Note: The red lines represent electricity trading. output of individual generators and between What’s the downside? the planned and actual loads of individual The single-buyer model can be seen as a transi- distributors. By giving the entity responsible tional arrangement before the conditions for a for real-time dispatch the exclusive right to competitive wholesale market are satisfied. But is buy electricity from generators and sell it to it better to skip this stage by adopting a market distributors, the single-buyer model greatly model with multiple buyers immediately after facilitates this balancing. unbundling? Evidence suggests that the answer is ▪ Network electricity flows follow the laws of yes. The single-buyer model has major disadvan- physics with no regard for contractual tages, particularly in countries with weak or cor- arrangements—a major problem for market rupt government and low payment discipline. models with multiple buyers and sellers. The First, decisions about adding generation single-buyer model solves this problem with- capacity are made by government officials who out requiring a regime for third-party access do not have to bear the financial consequences to transmission, which can be costly and insti- of their actions. In countries where investors tutionally demanding to establish. found government assurances attractive (such ▪ The single-buyer model preserves a key role as Hungary, Indonesia, Pakistan, and Thai- for the sector ministry in decisions on invest- land), there has been an upward bias in the gen- ments in generation capacity, and for the state- eration capacity procured under both the owned electricity company in the sector’s single-buyer and the IPP models. The apparent day-to-day financial affairs—and thus tends to reason: government officials found it difficult to be favored by these influential players. resist powerful interest groups pushing for state- ▪ The single-buyer model helps to maintain a guaranteed capacity expansion. unified wholesale electricity price, simplify- Second, power purchase agreements create ing price regulation. a contingent liability for the government, which ▪ The single-buyer model makes it possible to is expected to step in if the state-owned trans- shield financiers of generation projects from mission company (or, in the IPP model, the ver- market risk and retail-level regulatory risk, tically integrated utility) is unable to honor its reducing financing costs or making the obligation to the generator. This expectation is investment commercially bankable. often formalized in a guarantee agreement. ▪ The single-buyer model appeals to the pop- Unless managed carefully, these implicit or ulist instincts of politicians reluctant to sup- explicit contingent liabilities can undermine port the state’s complete withdrawal from the government’s creditworthiness and, ulti- wholesale electricity trading. mately, macroeconomic stability. The cash- based budgeting typically used in developing Some of these disadvantages disappear under countries hides the fiscal exposure associated a mandatory competitive pool, the most advanced with guarantees, creating perverse incentives form of the single-buyer model. The private sec- that distort the government’s decisionmaking. tor makes decisions about new generation Third, the single-buyer model responds capacity, and the pool agreement and market poorly when electricity demand falls short of rules replace power purchase agreements. projections (such as in a macroeconomic crisis). Generators are not shielded from market risks Ideally, electricity prices would fall, stimulating by government guarantees, and wholesale prices demand, and revenue losses would be allocated respond quickly to changes in demand and sup- 3 to private financiers, best equipped to manage ply. And it is relatively easy to allow generators market risks. Under the single-buyer model, and distributors in neighboring countries to sell however, wholesale electricity prices rise into and purchase from the pool. But in many because take-or-pay quotas (or fixed capacity developing countries the electricity system may charges) must be spread over a shrinking vol- be too small for a pool to function competitively. ume of electricity purchases. When these high Moreover, the lack of direct contracts between prices cannot be passed on to final consumers, generators and distributors still undermines pay- taxpayers must bear the losses. ment discipline,2 and the temptation for gov- Fourth, the single-buyer model hampers the ernments to intervene in dispatch and cash development of cross-border electricity trade by allocation remains as strong as under the basic leaving it to the single buyer, a state-owned com- single-buyer model. The Ukraine experience pany without a strong profit motive. This can with a mandatory pool—with the government become a major disadvantage when neighbor- intervening arbitrarily in the allocation of cash ing countries adopt a less restrictive market proceeds and generators unable to stop supply- model. ing electricity to delinquent distribution Fifth, the single-buyer model weakens the companies—shows that these disadvantages can incentives for distributors to collect payments have severe consequences. from customers. The state-owned single buyer is often reluctant to take politically unpopular Is there a better way? action against a delinquent distributor, and its Allowing generators to sell electricity directly to aggregation of cash proceeds from distributors distributors and large consumers eliminates allows it to spread the shortfall caused by a poorly most of the disadvantages of the single-buyer performing distributor among all generators. model (figure 2). Generators that fail to get When distributors see that paying and nonpaying paid by their contractual partners can reduce distributors are treated alike, their motivation for their output and look for more reliable buyers. cutting off nonpaying customers weakens. The ability of the government to intervene in Sixth, the single-buyer model makes it so easy the payment chain from consumers to genera- for governments to intervene in the dispatch of tors is greatly diminished. Decisions about con- generators and the allocation of cash proceeds structing new capacity—and the associated among them that few are able to resist the temp- market risk—can be left to private investors.3 tation. In Poland and Ukraine, for example, But this bilateral contracts model also poses pressure groups formed by coal miners have difficult challenges that must be tackled up front: obtained special treatment for coal-fired power ▪ The electricity production and consumption plants. In countries with high-level corruption of sellers and buyers seldom match the con- an equally important concern is the temptation tracted amounts. A balancing mechanism needs to divert cash to illegal purposes, such as fund- to be created that the system operator can ing political campaigns. rely on to maintain equilibrium in real time.4 Finally, the single-buyer model increases the ▪ Unless market participants receive the cor- likelihood that, under pressure from vested inter- rect signals and incentives relating to the ests, governments will indefinitely delay the next externalities created by their power flows, step toward fully liberalized electricity markets. even a well-informed system operator will be T H E S I N G L E - B U Y E R M O D E L A DANGEROUS PATH TOWARD COMPETITIVE ELECTRICITY MARKETS Figure The bilateral contracts model for electricity trading 2 Generators Transmission and dispatch Distributors Consumers viewpoint is an open forum to encourage dissemination of public policy innovations for private sector – led and market-based solutions for development. The views published are those of the authors and should not be Note: The red lines represent electricity trading. The transmission and dispatch entity may have contracts with market players, but these are not for the trading of electricity. An example is a attributed to the World contract with generators for ancillary services (such as frequency control, spinning reserve, and cold reserve). Bank or any other affiliated organizations. Nor do any of unable to implement the agreed transac- the conclusions represent tions. This requires development of a trans- official policy of the World mission access and pricing regime that reflects Bank or of its Executive capacity constraints and loss factors in the Notes Directors or the countries high-voltage network. 1. In theory, transmission and dispatch can be sep- they represent. ▪ Even with state-of-the-art technology and sig- arated from the wholesale electricity trading monopoly. naling mechanisms, parties entering into In practice, developing countries opting for the single- To order additional copies bilateral contracts sometimes forgo trades buyer model kept these functions together to reduce contact Suzanne Smith, beneficial to the system. And in most devel- transactions costs. managing editor, Room I9-017, oping countries, given their institutional and 2. Generators and distributors may enter into “con- The World Bank, technical constraints, direct contracting tracts for differences” to hedge the risks from volatile pool 1818 H Street, NW, between generators and distributors is likely prices. But these contracts do not reduce payment risks. Washington, DC 20433. to often lead to suboptimal dispatch schedules, 3. Investors may still ask for government assurances particularly just after the new market model on regulatory and market regimes, including the nature Telephone: is introduced. of government control over wholesale and retail prices ▪ The lack of a unified wholesale market price 001 202 458 7281 and the rules of access to the transmission network. In Fax: means that the electricity price for small con- contrast with the contingent liabilities from government- 001 202 522 3181 sumers depends on the power purchase con- backed power purchase agreements, these partial risk Email: tracts signed by their distributors. To protect guarantees limit the government’s exposure to risks fully ssmith7@worldbank.org the interests of these consumers, the regula- under its control and leave the market risk with the pri- tor needs to spell out procurement rules or vate sector. other criteria that distributors must meet 4. A net or residual pool may be an effective solu- Printed on recycled paper before they can pass through electricity pur- tion to the balancing problem in some countries. The chase costs to captive consumers. option to trade outside the pool through “bilateral phys- The short-term costs of developing solutions ical contracts” (as opposed to “contracts for differences”) to these challenges are worth the investment, differentiates this pool from the mandatory pool. given the compelling long-term benefits of the bilateral contracts model: reduced likelihood of Laszlo Lovei (llovei@worldbank.org), World Bank, Europe and government interference, incentives to improve Central Asia Region, Energy Sector Unit. payment collection, market-driven decisions on new capacity, and better opportunities for cross- border electricity trade. This Note is available online: www.worldbank.org/html/fpd/notes/