Japan's Electricity System Restructuring: Review and Points for Discussion (No.3) Assessment of Power Transmission and Distribution Unbundling (1): Utilizing the ITO Model

in Japanese

(originally published in Japanese on 1 November 2024)

In meetings of the Electricity System Reform Expert Subcommittee (Agency of Natural Resources and Energy) held in 2012 and 2013, the biggest point of contention was the pros and cons of power sector unbundling, i.e., separating the transmission and distribution (T&D) sectors from the generation sector. Although power sector unbundling is a necessary requirement for liberalizing the electric power industry, such a change would dramatically change the organizational structure of Japan’s major electric power companies, which is why they strongly opposed the idea in discussions of the Electricity Industry Committee in the early 2000s. Consequently, the decision was taken not to separate T&D from generation in Japan. After the issue was debated again, the decision was made in 2013 to legally unbundle the T&D sectors. Now that four years have passed since the legal unbundling was officially implemented in 2020 (2016 in the case of TEPCO), how do things stand?

The Importance of Unbundling Power Transmission and Distribution

To recap, let’s review the reasons why unbundling T&D is so important. During the era of regulated monopolies, electricity businesses were operated under integrated systems of power generation, transmission, distribution, and retail. However, even after liberalization, T&D networks continue to function as natural monopolies without effective competition. This presents a bottleneck that needs to be opened up so that new entrants in the power generation and retail markets can use these infrastructure services equitably. On the other hand, it is unreasonable to expect that major electric power companies with vertically integrated systems (former general electric utilities) would readily unbundle these services. Thus, the power sector unbundling serves as a means of regulatory reform to structurally separate competitive sectors from the monopoly sector (i.e., T&D).

The important thing to note here is that the power sector unbundling is intended not only to promote competition, but also to help ensure a stable supply of electricity. For example, as stated in the 2013 Report of the Electricity System Reform Expert Subcommittee, if the pricing mechanism operates properly, “supply-demand regulation through price will work flexibly,” e.g., by means of demand response. The report also states that independent transmission companies will actively invest in cross-regional interconnection lines as a means of “expanding areas of power grid interoperability,” making it easier to “balance supply and demand on nationwide scale.”

Supporting these claims is the fact that although 30 years have passed since separation of ownership was implemented in a number of European countries, power outages have not become more frequent, and none of the countries has reverted to a vertically integrated power system. While proportionally deploying around twice as much renewable energy as Japan, they have maintained stable supplies of power through market mechanisms. The leading role in this success has been played by independent transmission system operators (TSOs).

Having operated integrated power systems for more than 50 years, the main players involved in Japan seem to have difficulty in accepting the idea of splitting up their major sectors into separate companies. In Europe, there were similar objections in the 1990s. However, both theoretically and empirically, there is no doubt that adjusting supply and demand through market mechanisms based on independent T&D businesses contributes to power supply stability. While this needs no explanation in Europe, in Japan there is still a misconception that separating T&D from generation of electricity will have an adverse impact on power supply stability, so this point needs to be emphasized.

Legal Unbundling or Ownership Unbundling?

The 2013 Report of the Electricity System Reform Expert Subcommittee explains the reasons behind the choice of legal unbundling across nine pages, under the title “Ensuring the impartiality of the transmission and distribution sectors,” with comparisons to the approach of functional unbundling which requires separation between ownership and operation of network businesses. While pointing out that “the need for adequate regulation of conduct” is a disadvantage, due to the remaining “capital ties within the corporate group,” legal unbundling was favored due to the advantages of “integrated development, maintenance, and operation of T&D facilities” and the fact that “factors in the power generation sector do not directly impact the finances of the T&D company.”

The report makes very little mention of ownership unbundling because Japan’s major electric power companies are privately owned, making it difficult for the government to order the sale of assets. It still states that “the most obvious way of achieving neutrality may be separation of ownership, but this option will be left for future consideration if reforms are determined to be insufficiently effective.” Therefore, this approach of ownership unbundling shares the advantages of legal unbundling mentioned above, but not its disadvantage. Its only disadvantage is the issue of property rights, but, from the standpoint of regulatory reform, ownership unbundling is the most desirable form.

I share the view that the choice of legal unbundling in 2013 was appropriate. Legal unbundling is a compromise measure, but it is likely to be reasonably effective provided that there is “adequate regulation of conduct.” However, in early 2023, incidents of unlawful data leakage involving seven general electrical T&D operators came to light¹. In these violations of the Electricity Business Act, customer information about new retail companies held by T&D subsidiaries, which were supposed to be independent, was illegally viewed by the retail arm of the same corporate group. Since information isolation, the supposed basis of conduct regulation under legal unbundling, was disregarded continually and in a wholesale fashion, it is reasonable to conclude that legal unbundling has been inadequate.

Accordingly, the extent to which ownership unbundling is taken up as a question for consideration in any subsequent verification of the independence of T&D businesses should be a point of contention. However, in the briefing document submitted by the secretariat to a meeting of the Electricity and Gas Strategic Policy Subcommittee on 8 May 2024, which examined grid expansion and T&D independence, only 10 pages out of 77 related to unbundling, of which only two touched on separation of ownership. In the actual debate, the pros and cons of separation of ownership were barely discussed at all. This is likely due to the cautious attitude of the secretariat of the Agency for Natural Resources and Energy to the issue of ownership unbundling, presumably shared by many members of the Electricity and Gas Strategic Policy Subcommittee.

The “Issues” with Ownership Unbundling

We know then that there is no issue of power supply stability with ownership unbundling, but property rights are a contentious question. However, the briefing document submitted by the secretariat at the May meeting points to two other issues.

The first one is the risk that the rapid disaster response capabilities established by the corporate group may be degraded. This presumably refers to the inability of employees in the retail operation of a major electric power company to support the T&D operations in the event of a power outage resulting from a typhoon or other natural disaster. In Europe, on the fundamental principle of transmission independence, this kind of support is not permitted. As a rule, power transmission companies should use their own maintenance personnel to restore the power grid, covering the cost of such maintenance from wheeling charges. If needed, support can be provided by other transmission companies². Thus, disaster response cannot be a reason for a retail arm of the same corporate group to access information about the customers of a competitor.

The second issue is the risk that unbundling will make it hard for the corporate group to secure financing. This probably relates to the fact that splitting off T&D will reduce the total stable income of a corporation, thereby making it harder for the group to make large investments in nuclear power generation or other costly projects. Under legal unbundling, a group may expect to receive dividends from its T&D subsidiaries. However, since T&D are essentially a regulated monopoly, it is virtually impossible to earn large profits in the sector. If a generation business requires large profit from T&D operation for new investment, it would not be viable to begin with. Furthermore, if a group sells off its T&D operations (ownership unbundling), it will earn a sizable profit from the sale. This money can then be invested to expand its power generation business. For example, E.ON and Vattenfall Europe in Europe have reorganized their business portfolios through ownership unbundling.

To sum up, neither of these two “issues” is a valid reason to reject ownership unbundling. Although the claim is made that this approach to ownership unbundling “will be carefully considered, weighing up purpose and effectiveness,” there are no indications that the merits of ownership unbundling have been positively examined. Rather, it seems that it has been “considered carefully” from the beginning.

Implementing ITO Instead of Legal Unbundling

From the above, it’s fair to conclude that the reason that the relevant players in Japan are opposed to ownership unbundling on the pretext of property rights. Property rights need to be respected. On this question, the case of Germany can serve as a useful reference, since its major electric power companies are privately owned, like those of Japan.

Germany’s major electric power companies, which were vertically integrated and privately owned, were first legally unbundled around 2000 as part of industry liberalization. The four major companies set up transmission companies under the same corporate name, but this alone did not lead to a sufficiently independent power grid³. In 2009, after the European Commission pushed for further unbundling of the transmission sector, two of the four major power companies (E.ON and Vattenfall Europe) opted for ownership unbundling. The other two companies (RWE and EnBW) opted instead for the ITO (Independent Transmission Operator) model.

The ITO model is a form of separating power transmission from generation that is superficially similar to legal unbundling, in that it allows major power companies to retain ownership of their transmission facilities. However, it seeks to ensure a level of impartiality comparable to ownership unbundling by strictly regulating conduct. Take, for example, RWE Transportnetz Strom, the former transmission subsidiary of RWE. In 2009, the company’s name was changed to Amprion, and its head office relocated from Essen, where RWE is headquartered, to Dortmund. Although RWE owns only 25.1% of Amprion stock (as of August 2024), it is required to station an executive internally at Amprion to work full-time on ensuring the subsidiary’s independence from its parent company (RWE). The companies are also subjected to strict regulations on conduct, including information isolation. (For details, see the column “Assessment of Power Transmission and Distribution Unbundling (2): A Look at the European ITO Model.”) As a result of these arrangements, employees of ITOs such as Amprion have little sense of belonging to the parent company. In short, independence of the power transmission sector must be sufficiently ensured while respecting property rights.

According to German regulators we have communicated with, there is little difference between ownership unbundling and the ITO model in terms of both network independence and power supply stability. Of the three methods, we could say that legal unbundling is the least effective, while the ITO model and ownership unbundling are almost equally effective. Essentially, a TSO (Transmission System Operator) license would not be granted under the condition of general electricity T&D operators of Japan at the level of legal unbundling. The big German power companies such as E.ON and RWE were not necessarily in favor of the unbundling, but for business reasons they chose between ownership unbundling and the ITO model. It should be noted that there is no evidence that the disaster response capabilities of German power companies have declined or that the companies have struggled to procure financing following the separation of power generation and transmission.

In the light of all this, the current examination of the independence of the T&D sector in Japan cannot be considered adequate. I get the impression that the important options of ownership unbundling and ITO model were kept off the table from the very beginning. The Agency for Natural Resources and Energy may have judged that physically separating information systems and enhancing internal controls would be enough to ensure information isolation, but given the current competitive environment in Japan, as seen in the case of “electricity cartel,” electric power system reform seems fundamentally shaky. If ownership unbundling is too difficult, at the very least the ITO model should be adopted. The fact that it has not even been discussed is of serious concern, even in the context of ensuring a stable supply of electricity.