Not to be quoted without permission

In this paper we describe the Spanish electricity industry and its current regulatory regime. Special emphasis is given to the description and discussion of market design issues (including stranded cost recovery), the evolution of market structure, investment in generation capacity and network activities. We also provide a critical assessment of the 1997 regulatory reform, which did not succeed in introducing effective competition, but retained an opaque regulation which has been subject to continuous governmental interventionism. Furthermore, the implementation of the Kyoto agreement could show the lack of robustness of the regulatory regime. Competition is good for society because it increases efficiency and it is good for consumers because they benefit from efficiency gains through price cuts. This general principle could well have applied to the Spanish electricity industry, if only effective competition had been introduced. In 1997, the Spanish regulatory authorities reached an agreement with the electricity companies to reform the industry, starting on 1 January 1998. The main innovation introduced by the new regulatory regime was the reliance on a spot market (dominated by two large producers) as a way to allocate production and determine wholesale prices. Nevertheless, the industry remained heavily regulated in ways that made the wholesale market unable to transmit efficiency signals. Regardless of market prices, what consumers end up paying and firms receiving is ultimately determined by regulated tariffs, set by the government on a multi-year basis. Hence, contrary to the authorities’ claims, the reduction in retail prices since the 1997 reform (a 16.6% in nominal terms, and a 35.6 % in real terms) does not prove its success. Rather, we argue that the retail price decrease hides the lack of a real reform. 1 Protocolo para el Establecimiento de una Nueva Regulación del Sistema Eléctrico Nacional, December 1996; (text, in Spanish, available at http://www.unesa.es/documentos_regulacion/Pro11-12.zip ). 2 These price-cuts have been possible thanks to factors such as the reduction in interest rates over the period 1998-2003, a more intensive use of the existing capacity (to the extent that the system has been operating at weak reserve margins), a strong decrease in the costs of the regulated activities, and administrative decisions unrelated to any cost considerations (capacity payments