Friday, March 20, 2009

Electricity de-regulation parable!

As the summer and agriculture harvest season approaches, the demand for electricity is shooting through the roof. Expectedly, the prices of electricity traded in the spot markets and the newly created power exchanges have sky-rocketed to the ranges of Rs 11-14 per unit (the maximum charged price on the end-user is only in the range of Rs 5-7). There is nothing to be surprised if prices go over the roof in the coming days and months, as this parable illustrates.

Once upon a time there was a fast growing country called Emergonia, whose people consumed widgets for their survival. It had a population of 10000 and there were ten widget makers who competed to supply widgets to their customers. Widgets, being an essential commodity, its market was tightly regulated by a Widget Regulatory Commission (WRC) of Emergonia. Widget makers had to enter into widget purchase agreements (WPAs), containing supply price details, with consumer associations (and buyers are all organized into such associations) so as to obtain permits to start business.

The demand for widgets suddenly increases and the ten widget makers, for various reasons (both natural and artificial entry-barriers), are unable to meet the demand. The shortage of as essential a commodity as widgets leads to a crisis, forcing the rulers of Emergonia to look outside for solutions.

They hear about the apparent success of Marketonia in increasing the production of widgets by de-regulation of the industry. Marketonia had set up trading exchanges, where people could enter into short-term, day-ahead, contracts to buy widgets from licensed traders, who in turn had contracts to take supply from widget makers.

So one fine day, Emergonia decided to set up a trading exchange, the Widget Trading Exchange (WTX) of Emergonia, and all new widget makers (and some older ones) were granted permission to sell varying shares of their produce in WTX. It also de-regulated the process of obtaining licenses to set up widget factories. However, the stiff qualification norms meant that only ten traders got licenses for widget trading. Further, since the construction and commissioning of a widget factory takes a few years, there was limited actual addition of widgets into the market in the short and even medium-term.

In the meantime, as Emergonia strived to catch up with other developed economies like Marketonia, the demand for widgets kept increasing exponentially. With an eye on the forthcoming elections, the new government of Emergonia gave a big filip to widget demand by providing widgets for free to the poorest 30% of the population of Emergonia! On an estimated total demand for widgets of about 1 million, the actual supply was only 0.8 million, of which 0.7 million was being supplied through the old-fashioned bi-lateral contracts and the remaining traded in the WTX.

The results were a fait accompli. The ten traders and their suppliers (some of the existing and a few new producers) had a field day making spectacular profits out of the demand-supply gap. Worse still, four of the ten traders entered into an informal understanding to fix trading prices. Further, since many of those issued permits to set up new widget factories were already owners of older plants which had also obtained permission to sell a share of their production in WTX (and they were profitting handsomely from the scarcity induced high prices), they were in no hurry to commission their new plants. The market collapsed in the face of the huge demand-supply gaps and sky-rocketing prices and left the residents (and government) of Emergonia fighting for survival. And the election results were predictable...

Then came the post-mortem. It revealed that the apparent success of Marketonia with de-regulation and trading was just that - apparent! Thanks to the time-warp in which the rulers (and more importantly the other stakeholders) of Emergonia had wrapped themselves in, they were unaware of the ultimate results of the Marketonian experiment!

Now replace Marketonia with California, Emergonia with India, widgets with electricity and we have the story (including the not-so-far future) of electricity de-regulation in India!

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