The effects of corruption and counter-measures in the energy market on a regional, national and supranational level

Table of Contents

Memorandum

Table of Figures

Table of Tables

1. Introduction
1.1 Foreword
1.2 Side Remark on Deregulation and Corruption
1.3 Regulatory Agencies – under constant pressure
1.4 When Structures are reshaped

2. The Effects of Corruption.
2.1 Definition Area of Corruption
2.2 Measurement of Corruption
2.3 Area of Impact

3. Role of Regulation and its Methods
3.1 Rate of Return Regulation – ROR.
3.2 Revenue Cap
3.3 Incentive Regulation
3.3.1 Price Cap
3.3.2 Yardstick Regulation – Benchmarking
3.3.3 Earnings Sharing

4. General Structure of Energy Markets
4.1 Outline of the U.S Market
4.2 Outline of the EU Market

5. Geographical Analysis of Significant Factors
5.1 Analysis of the Corruption Perception Index (CPI)
5.2 Correlation of the CPI and the respective Energy Sector Performance
5.3 Bribe Payer’s Index 2011

6. Case Studies of Corruption and Counter-Measures
6.1 Speculation and Artificial Shortages – Case of California
6.1.1 History in a nutshell
6.1.2 Enron – ask why
6.2 Theft of Power – Case of Turkey
6.3 Integrity loss by Alienation – Case of Argentina, Nigeria etc
6.4 Cash Flow Redirection – Case of Ukraine

7. Extracted Key Factors
7.1 Subsidies and Social Welfare
7.2 Financial Innovations
7.2.1 Market Trade
7.2.2 Mark to Market – Accounting Methods
7.2.3 Advancement into New Sectors
7.3 The Finiteness of Resources
7.4 Misinformation - Corruption of data
7.5 Lobbying as a Destabilizer

8. Application of Counter-Measures
8.1 The U.K. Bribery Act as a showcase model
8.2 Code of Conduct – Lessons (to be) Learned

9. Recap

Abstract

Zusammenfassung

List of Literature

Internet Sources

Appendices

Table of Figures

Figure 1: U.S Energy Spectrum

Figure 2: U.S Electricity Sector

Figure 3: U.S. Total Used Energy

Figure 4: U.S. Use of Energy in Transport

Figure 5: Europe Energy Efficiency Part I

Figure 6: Europe Energy Efficiency Part II

Figure 7: Europe´s Power Shift

Figure 8: Percentage Change in Renewables

Figure 9: Europe´s energy mix (1999-2009)

Figure 10: Europe´s energy mix Austria to Estonia (1999-2009)

Figure 11: Europe´s energy mix Finland to Latvia (1999-2009)

Figure 12: Europe´s energy mix Lithuania to Portugal (1999-2009)

Figure 13: Europe´s energy mix Romania to U.K. (1999-2009)

Figure 14: Global Map of the CPI

Figure 15: The Cost of Corruption in India – KPMG Part I

Figure 16: The Cost of Corruption in India – KPMG Part II

Figure 17: Turkish Electricity Tariff Schemata

Figure 18: Turkish Electricity Theft Graph

Figure 19: Graph of an energy-subsidy impact on social welfare

Figure 20: World crude-oil production estimation

Figure 21: Energy Comparison

Figure 22: Energy Comparison Finite Resources

Figure 23: Energy Comparison Renewables

Figure 24: U.S. Consumer Perception of PV Rankings

Figure 25: Global Energy Mix Transition Prognosis of the University of Toronto.

Table of Tables

Table 1: Comparison of the prices between deregulated and rate-regulated states

Table 2: Perceptions of foreign bribery by sector

Table 3: Lobby Spending in U.S. in 2012

1. Introduction

1.1 Foreword

The energy sector is figuratively seen the motor of not only (real-) economy, technology, machinery, but life itself depending of the definition of standards of society. In such an important field corruption leads to multiple negative results such as a decreased speed in technology research, health issues, decreased life standards, monetary losses, (partially permanent) damages to the environment and also spreads out to other sectors (as higher prices for energy may enforce less competition in various business areas, which is less beneficial from the point of view of total social welfare).

The incentive to use corruption methods is rather high reasoned by (mostly) ineffective counter-measures, powerless regulation agencies, inadequate penalties (or even immunity), a history of “corruption culture” and mostly a disrupted government.

The objective of this master thesis is to depict the energy sector environment regarding the various sources of energy, the correlation of energy mixes, various trends of transition and mainly corruption of these preceding aspects. A view of successful probable and failing counter-measures will also be provided.

The introduction enables a broad outline of deregulation, regulatory agencies and the process of restructuring in aspect to corruption.

A unique part will be the comparison of the general corruption in the public sector of various countries and the perceived corruptive behavior in the energy sector. Considering the setting of the energy sector, namely the attribute of supra-nationality and its cross-linking to the financial sector, the greater cases cannot be limited to countries (or even small time frame).

The definition of corruption will be discussed as well and is absolutely crucial to fully acknowledge results of various methods which cannot always be accredited directly as the main nature of corruption is secrecy.

The probably most interesting part is the collection of extracted key factors where “entry points” of corruption are indicated, analyzed and referenced. A focus on clarification of misinformation is emphasized as well.

“Those who corrupt the public mind are just as evil as those who steal from the public purse.”

- Adlai Stevenson II, UN Ambassador (1900-1965)

This master thesis should provide a solid overview of the relation between corruption and the energy sector, numerous cases or certain methods and a few focused and further discussed details.

illustration not visible in this excerpt

^[1]

1.2 Side Remark on Deregulation and Corruption

In the last decades the energy sector has endured vast regulation changes concerning deregulation, liability adaptions and structure – even if most of the parts (inventions like electricity for instance) are, historically seen, quite new like the theory of economic regulation which dates back to the nineteenth century. The main goal of an efficient regulation nowadays is to adapt to the global requirements of a responsive and flexible system.

A regulatory board should not only monitor the regulation methods and their respective usage, but also the environment of the firm, its respective operating sectors, its investments and its long-term strategic planning.

Various examples indicate that deregulation in general may cause different problems, instabilities and even breakdowns. One reason for that is the definition of deregulation, namely, simply put a reduction in monitoring and therefore authority. This results mostly in a tendency to exploit the absence of a certain control level, which enables an entry point for corruption.^[2] (Proven by the California case)

“California's deregulated power industry, in which producers can sell electricity for whatever the traffic will bear, was supposed to deliver cheaper, cleaner power. But instead the state faces an electricity shortage so severe that the governor has turned off the lights on the official Christmas tree — a shortage that has proved highly profitable to power companies, and raised suspicions of market manipulation. The experience raises questions about deregulation. And more broadly, it is a warning about the dangers of placing blind faith in markets.”

- Paul Krugman (Nobel laureate in economics and Princeton University Professor)

Some of these examples and their underlying principles will be analyzed in later chapters. A broad overview of the difficulties that a regulatory institution may encounter should be achieved. The cases of California, Turkey, Ukraine and South America will show that the problems of regulation in fact do not rely upon the simple application of methods and monitoring. The system of an energy market has to be stabilized on all of the different parts of the distribution chain.

When the financial market intersects with the energy market the nature of its fluctuations logically produces instabilities such as abundance, which results in profit loss of a firm and shortage which affects the consumer negatively either in a higher price or life standards perceptible, like the oil speculation for instance. There is an academic discordance on this topic.^[3]

It has to be mentioned, that energy regardless of its forms should be seen as a “necessity” and not a mere commodity. When compared to a normal product (even if produced by a monopoly) the dependence by society is limited. Therefore the impact of failure is huge and affects in different levels on a global scale the world economy.^[4][5]

1.3 Regulatory Agencies – under constant pressure

The tasks of these institutions are numerous and sophisticated. An absence of influence cannot be guaranteed regardless of the political system, the degree of technological advancement or the level of bureaucracy. The negative side of such an influence is not always “classic” corruption but a circumvention of the regulatory framework. Hence, the regulatory lag must be as little as possible to minimize losses either of the firm or the society. Usually the utility firms are in favor.^[6]

The main goal of a regulatory agency is to find a regulation that exceeds its costs of appliance by the benefit. Naturally, the costs are two-sided, whereas the direct costs are minuscule and the indirect costs can be extremely high.

The other question is if without regulation the prices would be too high overall and/or the situation would be anti-competitive by meaning of an artificial monopoly, which is rather complicated in a sector of natural monopolies, a strict regulation is necessary in the first place as various scientists favor deregulation.

When an energy sector is privatized, its firms can be bought by private companies usually via a monopoly concession. The decision of which is the most suitable operator is heavily influenced by the rating system (factors are weighted) and the bid sum.^[7]

A misdetermination may result in an impossible situation for re-regulation and adaption to an efficient system. There are various instances of regulatory boards which can be directly linked to a ministry of energy, nature and environment, or rather independent. The controlling areas comprise the direct or indirect setting of the price, the revenues and operating areas of the firm, the investments, quality reassurance and sustainability. The financial market to that extent is far more difficult to control where the major tradeoffs are done by middlemen and not by both ends of the chain.^[8]

“A McClatchy review of the latest Commitment of Traders report from the Commodity Futures Trading Commission (regulates oil trading) shows that producers and merchants made up just 36 percent of all contracts traded in the week ending Feb. 14 while speculators (who will never take delivery of the oil) made up 64 percent.”^[9]

1.4 When Structures are reshaped

Without going into too many details, the history of regulation in electricity is relatively brief. In the U.S. the first regulatory agency was already founded in the 1900s and was called Federal Energy Regulatory Commission (FERC) - the definition of an overall energy sector and its regulation followed decades after.

The creation was also based on the necessity of a stable procurement, which was not possible with the occurring franchise system that prevailed the first decades. The FERC´s are different institutions in different states with different rules such as the conduction of transactions regarding electricity and natural gas.

Natural monopolies existed due to the nature of the sector. These resources were considered to be too important to not be regulated. This has changed with the commonly split of the unified monopoly in three subsectors (generation, transmission and distribution) in the 1990´s and tested the strength and authority of the regulation boards.

The European Market has its European Regulators´ Group for Electricity and Gas (ERGEG) and its respective state related regulatory boards like E-Control in Austria and the “Bundesnetzagentur” in Germany. Deregulation or privatization have been controlled by the EU government more or less carefully and as unified as possible – adapted to the market situation and stability.

When compared to the U.S. market privatization it seems private firms have not succeed in having more efficiency and lower prices than state owned utility companies.

“By 2000, 24 states and the District of Columbia had passed laws ordering or allowing their monopoly utilities to sell their power plants to other companies or to transfer them to their own unregulated affiliates. But eight years later ten states had repealed or delayed their deregulation laws in response to the California energy crisis of 2000-01 and other problems associated with deregulation.”^[10]

illustration not visible in this excerpt

Table 1: Comparison of the prices between deregulated and rate-regulated states^[11]

Privatization has a tendency to be corrupted in the process, especially if the regulatory boards do not have enough political power and independence. Resulting from the calculations of this table, it can be stated that the prices of deregulated states are significantly higher and thus consumers are far worse off.

There are many examples where the privatization did not work as intended, but also numerous where the liberalization process was successful. With this example only a tendency can be perceived but not the general probabilistic outcome as too many factors of the environment and the circumstances have to be (re)considered.^[12]

Summarized however it can be definitely emphasized that privatization processes are entry points of corruption, inefficiencies and exploitation.

2. The Effects of Corruption

Before an analysis of the topic’s combination of corruption and the energy sector may be performed, it is absolutely crucial to first examine each of those individually. Examples though include the “cohesive partner” as well.

2.1 Definition Area of Corruption

The term corruption in an economic environment is defined as fraud, bribery, immorality and misuse of power. An example for a definition is the following of the business dictionary:

“Wrongdoing on the part of an authority or powerful party through means that are illegitimate, immoral, or incompatible with ethical standards. Corruption often results from patronage and is associated with bribery. ^[13]

Various similar descriptions are used when outlining corruption often without considering the echoes and different ways of impact - the incentive of corruptive behavior on the side of the authorities are on the one hand assurance of maintaining that position and on the other hand gaining benefits for “distributing” this power. Generally speaking, the first result of such actions is a reduction of the (total) social welfare. However, this is not a short term and not even necessarily a monetary problem as such patterns are highly likely to induce a spiral. As a matter of fact, sufficient and preferably adaptive counter-measures are necessary to intervene and limit such actions.

The exact classification of the area of corruption is rather difficult as such arrangements may occur randomly in different sectors and transits may occur to the energy sector indirectly and become unidentifiable. Cases where bribery was involved in a monopoly concession auction are quite common, nevertheless mostly unknown to the public.^[14]

The probability that the corruptive behavior of only one local politician affects the energy sector on a huge scale is quite low but surprisingly possible (examples in the cases later on).

In this sector disruptive patterns are generated by conglomerates’ lobbies, collusive partners in industries and politics, councils and greater political institutions (like the European Parliament or the House of Senate).

Another more deceiving part of manipulation is the desire to misinform and misinterpret “data”. Not every technology reaches its predicted heights or wasn’t even able to, in the first place in its current state of evolution (for instance debates about potential of wind farms).^[15]

In the following chapters examples will determine how corruption shatters technology capabilities, waste energy, gamble in the financial markets etc.

2.2 Measurement of Corruption

The determination of corruption levels will be expressed and explained in the chapter of “The geographical Analysis” via the Corruption Perception Index (CPI).

The organization of “transparency” explored and researched the corruption of public sectors worldwide since 1996 while at the same time providing not only the results of their data but the process of collecting data, the weighing methods and the interpretation of this data as well.

As the characteristic of corruption is to deceive and hide its true nature this logically results in difficulties to measure it.^[16]

As an example the inflation of potatoes in Central Europe originated in Germany from the three biggest “competitors”. In collusion they achieved a price increase of over 40%.

Interestingly, this was the second highest price increase and has been proven to be corrupted while the number one good (onions) seems not to have been discovered or researched.^[17] In this case, measuring corruption would be either an estimation based on statistics (similar to a statistic correlated to drug use of professional athletes) or an investigation where in- and outputs have to be recalculated which is a difficult and, depending on the scale and frequency, very costly method.^[18]

Summarized, it can be said that statistical data indicates possible corruption and with sufficient data, may even define a more refined area of corruption.

2.3 Area of Impact

The effects of corruption are wide spread in the energy sector due to various factors. Not only is this sector (disputable) the most important economic base factor but also paradoxically a technology based “technology enabler”.

Therefore irregularities produce technology setbacks (decrease of research speed), a reduction of businesses’ growth (California case closure), carbon footprint (comparable to future costs that are shared globally) and also global turbulences of financial markets.^[19]

As there are numerous scientific specializations of economics (for instance lean management, sustainability, cost-benefit analysis etc.) corruption itself is not in-between.

Because it is mostly hidden and not/or difficult to measure, depict and express even if there is a hub of research for corruption (transparency.org) a specialization has not been established in the studies of economics resulting in a “lack of” research compared to other topics.

Inevitably, the area of effect is indirectly noticeable in every technologically driven village, city or society as there are no “substitutes” for energy (compared to food). As a matter of fact, the area of impact is global.

3. Role of Regulation and its Methods

The most prominent factor of the theory of regulation is the choice and adaption of a suitable method. While each of these methods have their strengths and weaknesses their correct and persistent implementation is the key to success in creating the most beneficial outcome for the social welfare.

This however will be just a short review of some of the methods as the more problematic part of corruption is the environment, the circumstances, the risks and the opportunities of regulation methods. Often the strict observance of efficient methods is already the first obstacle and/or collapse of the system.

When a firm naturally aims for profit maximization a control board has to be set against an unfavorable position of the consumers/ society. The task of setting an optimal regulation which leaves the financial capabilities and flexibility intact, while at the same time ensuring quality and a “fair” price, is comparable to Sisyphos, due its nature of the persistent struggle of enforcing a continuous work.^[20]

3.1 Rate of Return Regulation – ROR

This type of regulation focuses on maintaining the characteristics and especially the advantages of a competitive market in a monopolistic one. The goal is that firms are allowed to make profits, but only up to a certain rate.

They can manage their input into the company on their own, the resulting output or the price to which they want to sell, as long as the revenues do not exceed the pre-established level of return.^[21]

This is a much-criticized model. The first ones that put this under scrutiny were Harvey Averch and Leland Johnson who declared in 1962 that a company trying to maximize its profits under these conditions would fail to minimize its costs.

In contract to an unregulated company, that would strive to use both capital and labor efficiently, a firm conducted under the rate-of-return restriction would employ too much capital at the expense of labor.

This is called the “Averch Johnson Effect”.^[22][23]

3.2 Revenue Cap

The choice of the revenue cap over the price cap normally induces a fixed or known quantity.

The limitation of the total revenue received by the firm to a certain sum in a time frame can be circumvented through implicit decisions on the actual rates or return on capital that is in employed with the intention to reach for the price limit edge. As a result it is often indistinctive to the ROR.^[24][25]

3.3 Incentive Regulation

As different regulation methods were implemented, that were not always advantageous for the companies’ financial developments, an urge arose to create something that would bring gains.

The following three types of governance were specifically designed to motivate firms in introducing efficient cost – benefit processes, to be innovative and to improve quality.^[26][27]

3.3.1 Price Cap

As the name states, this type of regulation implies setting an upper limit for the prices firms are allowed to charge. It is a formula that subtracts the expected efficiency savings (X – average value based on the past performance of companies of the same sector) from the Consumer Price Index (CPI) thus attempting to reach the level of the overall rate of inflation of the economy.

As the savings are fixed, this method is supposed to create an opportunity for companies to maximize their revenues and pass the surplus to their shareholders.^[28]

3.3.2 Yardstick Regulation – Benchmarking

Historical data has always proven to be very significant for studying purposes in any business sector. Naturally, this is also used as a method of regulation. Statistical, past information is gathered and with the support of specific mathematical models, the data can be analyzed and structured in such a manner that benchmarks can be set and even future events predicted.

The selection of the appropriate data and the underlying model is of utmost importance because misinterpretation can lead to significant losses.

For regulating purposes, five types of metrics are differentiated and put in practice. The Core Overall Performance Indicators relate on information available to the general public, such as output per employee, usual key performance indicators as ROACE, ROI, revenues.

These financial criteria fail to identify relations between the different factors, reason why regulators often chose to ground their studies on Performance Scores based on Production and Cost Estimates that highlight the best and worst performers out of a group.

The Virtual Company Approach tries to set a baseline for measuring performance, but it faces the challenge of distorted company information and the Process Benchmarking Concept that focuses more on management concerns rather than economic outcome.^[29]

The last one is the Customer Survey Benchmarking that is on the one hand constructive, because it depictures the current view of the customers, but is highly inconclusive because the consumers can be easily manipulated and therefore little concrete payoff can be gathered.^[30]

3.3.3 Earnings Sharing

Also called profit sharing or sliding scale regulation, this is another form of government that involves, as the name states, sharing of gains between the company and its consumers.

Of course, the regulated firm is allowed to keep its earnings as long as they do not exceed a pre-established rate of return.

Should this happen, the excess revenue will be returned to the customers, either through the means of direct payments or by lowering the prices. Nevertheless, should the firm generate much too low profits; these losses will also be shared with the consumers, generally by increasing the prices of the products.^[31]

[...]

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^[4] Kilian, Lutz: “The Economic Effects of Energy Price Shocks” University of Michigan (2007), Pg.40

^[5] Fortelny, Marc-Joël: “When and how is regulation circumvented in the energy market?”, University of Vienna (2013), Pg. 2

^[6] http://www.valueline.com/Stocks/Commentary.aspx?id=13098 (last accessed on 22.02.2013)

^[7] can be too high or too low depending on estimations/ expectations that may vary greatly

^[8] Fortelny, Marc-Joël: “When and how is regulation circumvented in the energy market?”, University of Vienna (2013), Pg. 3-4

^[9] http://www.mcclatchydc.com/2012/02/21/139521/once-again-speculators-behind.html (last accessed on 22.02.2013)

^[10] Slocum, Tyson: “The Failure of Electricity Deregulation: History, Status and Needed Reforms”, Public Citizen´s Energy Program (2007), Pg. 6

^[11] Source: Slocum, Tyson: “The Failure of Electricity Deregulation: History, Status and Needed Reforms”, Public Citizen´s Energy Program (2007) Pg. 7

^[12] Fortelny, Marc-Joël: “When and how is regulation circumvented in the energy market?”, University of Vienna (2013), Pg. 4-5

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^[14] http://www.europarl.europa.eu/document/activities/cont/201206/20120626ATT47717/

20120626ATT47717EN.pdf (last accessed on 16.06.2013)

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^[20] Fortelny, Marc-Joël: “When and how is regulation circumvented in the energy market?”, University of Vienna (2013), Pg. 6

^[21] Brauetigam, Roland; Panzar, John: „Effects of the Change from Rate-of-Return to Price-Cap Regulation“ American Economic Association (1993) The American Economic Review Vol. 83, No. 2, Papers and Proceedings of the Hundred and Fifth Annual Meeting of the American Economic Association, Pg. 191

^[22] Viscusi, W. Kip; Harrington, Joseph E. Jr; Vernon, John M.: „Economics of Regulation and Antitrust“, MIT Press (1995) Fourth Edition, Pg.433-436

^[23] Fortelny, Marc-Joël: “When and how is regulation circumvented in the energy market?”, University of Vienna (2013), Pg. 6-7

^[24] http://regulationbodyofknowledge.org/price-level-regulation/features-of-price-cap-and-revenue-cap-regulation/ (last accessed on 22.02.2013)

^[25] Fortelny, Marc-Joël: “When and how is regulation circumvented in the energy market?”, University of Vienna (2013), Pg. 7

^[26] Viscusi, W. Kip; Harrington, Joseph E. Jr; Vernon, John M.: „Economics of Regulation and Antitrust“, Fourth Edition, Pg. 436

^[27] Fortelny, Marc-Joël: “When and how is regulation circumvented in the energy market?”, University of Vienna (2013), Pg. 7

^[28] Fortelny, Marc-Joël: “When and how is regulation circumvented in the energy market?”, University of Vienna (2013), Pg. 8

^[29] Fortelny, Marc-Joël: “When and how is regulation circumvented in the energy market?”, University of Vienna (2013), Pg. 8

^[30] http://regulationbodyofknowledge.org/price-level-regulation/properties-of-benchmarking-and-yardstick-regulation/ (last accessed on 22.02.2013)

^[31] http://warrington.ufl.edu/centers/purc/purcdocs/papers/0213_sappington_price_regulation_and.pdf (last accessed on 22.02.2013) , Pg. 3-4