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Reforming Japan's Electricity Sector

Abe's Push for Deregulation

An Interview with Koichiro Ito

By Jennifer Steffensen
October 23, 2013

Japan is one of the few industrialized nations that have not fully deregulated their electricity sector. Ten regional electricity monopolies control most power generation, transmission, and distribution networks, and only large-scale consumers can choose their electricity provider. As Japan grapples with soaring electricity prices and reduced power-generation capacity in the aftermath of the Fukushima crisis, Prime Minister Shinzo Abe has advocated for deregulation of the electricity sector as a way to bring in new market players, reduce energy costs, and promote clean and renewable energy innovation. Yet the prospects for achieving meaningful reform remain uncertain: Japan’s regional utilities wield significant political power, and skeptics question whether deregulation will actually result in lower electricity prices.

In this policy Q&A, Koichiro Ito (Boston University School of Management) discusses the political challenges of deregulation and explains what is at stake for Japan’s economic and energy future.

What is the history behind Japan’s regional monopoly system? How has this arrangement shaped the country’s current energy landscape?

The regional monopoly system began in 1951 during the American occupation. Since then, nine regional power companies (and Okinawa Electric Power Company since 1972) have monopolistically controlled power generation, transmission, and distribution for their territories. In the 1990s, following the deregulation of electricity industries in other countries, the Japanese government made a few attempts at deregulation. However, all these efforts did not result in a comprehensive overhaul because of strong opposition and political pressure from the regional power companies. As a result, the current Japanese electricity industry is “partially” deregulated. For example, while the wholesale electricity market (the power-generation sector) is open for new entrants, the regional monopolies still supply 96% to 98% of electricity.

There are various barriers for new entrants in the market. For instance, they have to meet strict terms of access to the transmission lines and pay high user fees because the lines are owned and managed by the regional monopolies. These barriers make it difficult for Japan’s energy market to be competitive, which eventually hurts consumers because they must bear the burden of uncompetitive energy prices.

What steps have been taken toward energy deregulation? What reform scenarios are on the table?

Prime Minister Abe’s cabinet submitted a bill to the Diet, which was supposed to be passed in June 2013. Unfortunately, deliberation on the bill was postponed for an unrelated political reason, but the bill was resubmitted to the Diet on October 15, 2013 and will most likely be passed this fall.

Abe’s bill calls for three steps toward the deregulation of Japan’s electricity industry. First, the government plans to establish an independent system operator (ISO) by 2015. The ISO controls the flow of electricity in the entire national grid and plays an important role for deregulation. Second, the government aims to deregulate the retail electricity market, including the retail market for residential customers, by 2018. This step would allow consumers to freely choose their retail electricity providers. Third, the government plans to unbundle transmission from the regional monopolies by 2020 in order to improve access to transmission lines.

The bill sent to the Diet this year concerns the first step of the plan. The cabinet has to submit and pass two more bills in the next few years to implement the second and third steps.

Abe is not the first Japanese politician to call for breaking up Japan’s utility giants. Why have past attempts failed? Have these dynamics changed?

Since the 1990s, there have been three major attempts by the Japanese government to deregulate the electricity market. In each attempt, however, a complete overhaul did not happen because of strong opposition and political pressure from the power companies.

Yet the current situation is different from the past attempts for two reasons. First, the power companies lost public support after the Fukushima nuclear disaster. Politicians now have strong support to overhaul the electricity industry. Second, compared with the previous attempts at deregulation, the current plan was initiated by stronger political leadership, specifically Prime Minister Abe and Toshimitsu Motegi, the minister of economy, trade and industry. Such leadership was facilitated by the high levels of public support for deregulation after the Fukushima nuclear disaster.

However, there is still uncertainty about both of the above two points. Although the regional power companies lost public support, they still have very strong connections with politicians, including politicians in Prime Minister Abe’s Liberal Democratic Party (LDP). Power companies have been among the largest monetary contributors to political parties in Japan, and their labor unions have been playing an important role in political discussions. In fact, an explicit goal for unbundling transmission lines, found in the original bill, was replaced with a weak statement because of pressure from politicians who have connections with the regional monopolies.

Another concern is that there will be political uncertainty in the next few years before deregulation is completed. It is well known that Japanese prime ministers and their cabinet members are replaced very frequently. Abe’s plan will not be completed until 2020, and no one knows who will take over his position after he leaves the cabinet. If someone who favors the existing system of the energy industry takes over, the subsequent plans could be fully changed. Political uncertainty is thus a real obstacle to completing this overhaul.

In the aftermath of the Fukushima crisis, Japan has turned to imported liquefied natural gas (LNG) and coal to make up for its reduced nuclear capacity. With most of the country’s nuclear reactors still offline, electricity prices remain very high. How will reform of the power sector affect Japan’s energy prices?

In theory, deregulation can stimulate competition and cause prices to decline. Empirically, economists have found that the deregulation of electricity industries generally makes power generation more efficient and lowers operation costs. Previous research, however, also emphasized that it is very important to establish a mechanism that guarantees fair competition and prevents the exercise of market power. This is one of the lessons from the California electricity crisis in 2000–2001.

Compared with electricity markets in other countries, new entrants in the Japanese wholesale electricity market face a few additional challenges. First, most of them are midsized thermal power plants that burn imported oil. This is because these power plants require lower upfront capital investment than other types of power plants. Unfortunately, oil has been relatively expensive in recent years. In the United States new entrants can benefit from cheap natural gas, but the situation is quite different for new entrants in Japan because the price of imported LNG is currently expensive.

There is a possibility that the price of natural gas in Japan will fall after Canada and the United States start exporting their natural gas to Japan in 2013 and 2014. However, if North American exports do not lower the natural gas price considerably, Japan might have to generate more electricity from oil-based thermal plants. In terms of pollution, natural gas is cleaner than oil- or coal-based thermal plants. But given the high price that Japanese consumers are paying, it is unrealistic to entirely rely on natural gas to fuel thermal plants unless the price of natural gas falls significantly.

Second, according to Abe’s plan, the unbundling of the transmission lines will not happen until 2020. New entrants might have to keep paying a high user fee for the transmission lines, unless the Japanese government can guarantee fair access. If these concerns prevent new entrants from joining the market, deregulation may not be able to lower electricity prices in Japan.

Abe has suggested that deregulation would encourage growth and innovation in Japan’s renewable energy sector. What do you think?

If the Japanese government can make sure that deregulation leads to fair access to the transmission lines and also fair competition in the wholesale and retail electricity markets, I can agree with the assessment. However, we have to remember that currently Japan’s available capacity from renewable energy is not large enough to consistently cover all electricity demand.

One more reality is that most renewable energy is still quite expensive and not economical without substantial subsidies from the government, which eventually result in increases in electricity prices. For example, the Japanese government is providing a generous feed-in tariff for solar panels on residential roofs. Although these tariffs will be phased out, they guarantee generous prices for renewable energy for the next ten years, which will be passed on to consumers through the price of electricity. Innovation in the renewable energy sector is key to making renewable energy economical and scalable in practice.

Who would be the winners and losers in deregulation? What would be the overall economic impact?

I believe that there would be a large economic benefit from deregulating the wholesale electricity sector (the power generation sector). A variety of companies have already started or plan to start new businesses in the electricity industry. By bringing new ideas and competition, they could entirely change the Japanese electricity market. The market has been dominated by the regional power companies under rate-of-return regulation, in which power companies can pass on any costs to consumers without competition. In the near future, the electricity market will be further integrated with other markets such as the automobile, electric appliance, and information technology markets. For example, when electric vehicles and plug-in hybrid vehicles are available to many consumers, their gas and electricity consumption will be integrated in their home grid system. Therefore, automakers could be an important new player in electricity markets. Allowing open access to these markets is the key to stimulate this transition and encourage the participation of automakers, electric appliance makers, IT ventures, and other companies.

Likewise, deregulating the retail electricity sector is also likely to benefit consumers, although it requires careful consideration for universal (fair) access to electricity services. Such deregulation would allow consumers to freely choose their provider and tariff. However, if electricity providers focus on consumers who are most profitable to their businesses, some consumers might be worse off, unless the government provides a safety net. I believe that this point will be one of the most important topics of discussion in the second step of deregulation, which will be completed by 2018.

Jennifer Steffensen is an Intern at NBR.

Koichiro Ito is an Assistant Professor at Boston University School of Management and a Faculty Research Fellow of the National Bureau of Economic Research. He received his PhD from the University of California–Berkeley. Before joining Boston University, he was a Postdoctoral Fellow at the Stanford Institute for Economic Policy Research. His research interests include environmental and energy economics, industrial organization, and public economics.