GOVERNMENTS AND INDEPENDENT POWER SECTOR REGULATORS: WHO DOES WHAT AND WHEN? 2007 Annual Convention of the Society of Electronic and Electric Engineers in Israel Eilat, Israel November 15, 2007 Ashley C. Brown Executive Director, Harvard Electricity Policy Group John F. Kennedy School of Government Harvard University Of Counsel, Dewey & LeBoeuf, LLP

2 Historical Roles of Governments in Power Sector Policy Maker Investor /Proprietor Regulator

3 Rationales for Establishment of Independent Regulation Relieve Government's Inherent Conflicts of Interest Investor – Competitor Policy Maker – Adjudicator Proprietor – Regulator Reduce Politicization in Power Sector Enable / Facilitate Longer Term Perspective Professionalize Regulatory Activity Enhance Transparency Deter Corruption Provide Comfort Level for Private Investment in Sector

4 Three Basic Areas of Regulatory Responsibility 1. Formulating and Articulation of Basic Policy Governmental Functions ― Basic Policy Definition: Whatever Government Says It Is Government Policy is Established Ex Ante Policy: Embodied in Law

5 Three Basic Areas of Regulatory Responsibility – cont’d 2. Implement, Clarify, and Detail Policy Independent Regulatory Agency Functions ― Must Adhere to Articulated Government Policy (i.e. Law) ― Implement Policy Through Administrative, Legislative, and Adjudicatory Means ― Make Subsidiary Policy To Clarify, Detail, and Effectuate Basic Policy

6 Three Basic Areas of Regulatory Responsibility – cont’d 3. Assuring Regulatory Accountability and Compliance Appellate (e,g, Judicial Review) ― ExPost Only ― Assuring Legality, Fairness, and Reasonableness of Decsions Government ― Reviewing and Revising Institutions, Law and/or Policy On a Prospective Basis Only

7 Recurrent Theme: Balancing Independence and Accountability Independence Short term Political Insulation Ability to make Decisions Without Approval from Elsewhere Transparency Accountability Appellate (Judicial) Review Government (Legislative) Oversight and Prospective Change of Law Public Criticism

8 Typical Sources of Conflict Between Government and Regulators Failure to Fully and Clearly Articulate Policy Overly Detailed/Rigid Government Policy Political Interference (Often at behest of Interest Groups) Overreaching by Regulators Appellate Review Focused on Substance not Law, Process, and Reasonableness Change in Government/Old Regulator Carry Forward

9 Two Case Studies of Government/Regulator Conflicts I. Brazil: Retail Tariff Formulation/Asset Valuation II. United Sates: Transmission Pricing

10 First Case Study: Brazil: Retail Tariff Formulation/Asset Valuation Background Distribution Companies Privatized With 5-7 Year Indexed Tariffs In Licenses Privatization Preceded Formation of Market Rules and Regulatory Regime No Articulated Methodology for Tariff Formation or Asset Valuation ― Neither in Law nor License Initial Concession Period Ends With No Further Clarification

11 First Case Study: cont’d Brazil: Retail Tariff Formulation/Asset Valuation Controversy Regulator Must Set New Tariffs ― No Policy Guidance on Methodology for Setting Tariffs or Asset Valuation Companies Believe Asset Value is Based on Purchase Price ANEEL (Regulator) Does Not Use Purchase Price for Asset Valuation ― Employs Methodology Producing Lower Tariffs Than Companies Expect Distribution Companies are Generally in Poor Financial Condition as a Result of Rationing

12 First Case Study: cont’d Brazil: Retail Tariff Formulation/Asset Valuation Course of Controversy Companies Appeal to Ministry of Finance for recourse Minister of Finance Convenes CNPE (National Council on Energy Policy) to Review the Matter Ministry of Finance Conflicted Between Need for Independent Regulation and Not Wanting to Discourage Foreign Investment Matter is Unresolved Before new Government Takes Power Regulator Reconsiders Decision and Employs New Methodology, Which Produces Higher Tariffs Than Originally Proposed, but Still Less Than Companies Sought New Government Implements New Market Model Which Did Not Affect the Asset Valuation Methodology Adopted by ANEEL, but did Reduce Overall Risks on Distribution Companies

13 First Case Study: cont’d Brazil: Retail Tariff Formulation/Asset Valuation Outcome Regulator was Subjected to Enormous Political Pressures, But Did Retain Discretion to do Asset Valuation and Tariff Formulation Government Prospectively Changed the Market Model and Risk Allocation

14 First Case Study: cont’d Brazil: Retail Tariff Formulation/Asset Valuation Lessons Basic Policy Needs to Be Formally Articulated Ex Ante Regulator Must Fill In Gaps When Policy is not Fully Articulated

15 Second Case Study: United States: Transmission Pricing Background Transition from Vertically Integrated Monopolies to Open Access Congressional Consideration of Who Pays for Transmission Upgrades LMP Pricing Being Implemented FERC Proposes Standard Market Design With RTO’s

16 Second Case Study: United States: Transmission Pricing Controversy Many Utilities Want IPP’s to Pay for Transmission Upgrades What Distinction, If Any, Is There Between Reliability and Economic Upgrades? Role and Rights of “Native Load” Customers Terms of Competitive Access to Grid

17 Conclusions Key Criteria for Policy Making Essential Policies Should be Fully Articulated by Government ― Where it is Essential ― Where Predictability is Most Desirable ― Where the Public Interest So Requires Policy Should Be delegated to Regulator ― Where Technical Capability is Essential ― Where Politicization Might Be Most Detrimental

18 Conclusions Course of Controversy Many Monopoly Utilities Demand “Participant Funding” for Transmission Upgrades Proponents of Competition Oppose “Participant Funding Debate Overshadowed by Stark Differences Between Various Regions

19 Conclusions Outcome Congress Mandates “Participant Funding” Regulators Find “Participant” Very Difficult to Define ― Meaningful Implementation Almost Impossible

20 Conclusions Lessons Delegation of Policy Making to Regulators Can Be More Prudent Course ― Competent Policy Making Often Requires Technical Expertise