Why do new players hesitate to enter reforming energy markets?

When energy markets open, new entrants rush in. That’s the theory, or at least the hope of governments as they embark upon energy market reform. But in almost every case we’ve seen, including the UK and the reforms currently underway in Mexico, new entrants are hesitating rather than hurrying to enter. Why do they wait – and what can governments do about it?

It helps to first understand how reforms change the market and how these changes impact investment.

• Before reform, an energy market includes a small, closed pool of market participants doing business with each other.
• After reform, an energy market includes a large, open pool of market participants trading either bi-laterally within a tightly controlled legislative regime, or through an intermediary (e.g., a market or system operator).

The prospect of moving from a closed to an open market can introduce uncertainty. Uncertainty is almost always a disincentive to invest.

Before reform, the purpose of the vertically integrated monopoly is clear – to provide safe, reliable, reasonably priced power to customers. This rationale tends to create a disconnect between the physical aspects of dispatch (i.e., which set/station turns on when), and the commercial aspects (which set/station would be the most cost-effective to dispatch at this particular time in the system load profile). Little priority is given to maximizing shareholder returns – there is no need. There is an acknowledgement of the need to balance price, efficiency, employment, cost and reliability. It is acceptable that dividends may be traded for lower prices to customers.

Despite the rigidity of the system, it does allow for new generation entrants, provided they work within the existing framework. The use of long-term power purchase agreements (PPAs) is a known, bankable formula within the industry and allows new wholesale entrants to raise finance against supply to a credit-worthy counterparty.

Reform disrupts investment certainty

So when reform announcements are made, despite the promise and potential of any future, free energy market, the immediate impact on investment is disruptive in two main ways:

1. Stability of returns is threatened: Announcements of reform are usually accompanied by government statements that aim to weaken the hold and market power of the incumbent utility derived from its control over the offer of long-term PPAs. Governments believe these statements will be welcomed by potential new market entrants but sometimes overlook how threats to undermine the current market framework can destroy the promise of reliable returns sought by private investors.
2. The evolution of reform takes several years: Despite all the reassurances of government, the announcement, design and even creation of a merchant market does not provide the certainty that new generation entrants require.  Indeed, in most cases it can be many years until the market evolves enough for generation companies to have the certainty they need to forecast the success of a bidding merchant.

The result is apathetic and disengaged incumbent utilities and hesitant new entrants. Government is faced with the challenge of trying to design a new energy market without the participation and views of a range of market participants, many of which will not fully engage until they are convinced that a future market will emerge. 

How to overcome the apathy

So how can governments deal with these issues and drive the interest and investment from new market entrants that will ultimately deliver the objectives of reform?

• Understand the motivation of incumbents and new players: This is the heart of the answer. As I’ve said in previous blogs, governments must put themselves in the shoes of market participants and understand what drives them. For incumbents, the focus is on grappling with fundamental cultural change brought by reform. New, private investors, meanwhile are looking for certainty regarding market conditions before making a commitment.
• Create an attractive investment environment: Awareness of these key drivers will allow governments to plan for a successful new market. Creating an attractive investment environment requires governments to be alert to the potential of incumbents engaging in problematic behaviours, including obstruction of retail markets, unreflective cost allocation and informational ring-fencing, as market opening draws nearer. Regulatory measures designed to target such conduct need to be put in place and, often, legal or ownership unbundling of the incumbent is required to address potential conflicts.  It is also important that transmission system operators send clear signals regarding where new capacity in needed and that generators can feel confident about the stability of future returns. Strong regulators and committed policy makers are necessary here. 
• Leverage existing market power and experience: Many governments, while planning a new, competitive generation market, miss the opportunity to leverage the power and experience of the incumbent utility. Many mechanisms that worked well in the old market can be adapted for the new one. For example, modified versions of IPP arrangements could allow developments already in progress to proceed with certainty, while also sowing the seeds for the merchant plants of tomorrow and allowing wholesale markets to develop slowly and sustainably.  Contrary to the views of most policy makers, new entrants see an important perpetual place for the stabilizing presence and influence of the incumbent, and an environment where a diversity of companies brings benefits that go beyond lower spot prices to include increased efficiency, innovation and employment opportunities.

Keep in mind the ultimate targets of reform

The biggest message for governments seeking to attract new investment in generation is to think long-term and big picture. Keep in mind the ultimate targets of reform. Diversity of generation and fuel mix, even if capacity is fully contracted, brings new plants, new companies, new employment possibilities and new relationships to a market which may have been historically closed. These are benefits in themselves.

Over time, if governments consider the drivers of all players when making decisions, the market will fulfil the potential of reform as players move in tune with their own incentives. For monopoly utilities, these include understanding their role in a competitive market, reshaping their identity and focusing on their strengths. New retail entrants will seek to make a place for themselves in the market over the 1-10 years following reform, while bringing innovation and choice. New generation companies, once they see signals of certainty within the market, will deliver much-needed privately funded plants and commit to becoming a long-term partner in a reformed electricity system that delivers a range of economic and social benefits.

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