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1 Introduction
This paper demonstrates that the market reform proposal for the Israeli electricity sector, announced by the government in June 2003 and reaffirmed in mid-2006[1] , will likely fail because of the proposal's virtual impossibility of achieving the substantial cost savings necessary to yield the required price decline for welfare improvement. Operational improvement in electricity generation is limited because fuel (e.g. coal, oil, natural gas, and liquefied natural gas) and generation equipment, which constitute about 80 percent of the total cost of electricity generation, are commodities traded in a competitive world market. As a result, significant cost savings due to deregulation can only come from variable inputs like operations and maintenance (O&M)[2], [3] and unless the pre-reform industry has large surplus capacity, which is not the case in Israel, such savings are unlikely to exceed 50 percent of the pre-reform O&M costs (i.e. 10 percent of the pre reform generation cost). For this reason and based on reform experience to date, we caution against deregulation in Israel and other regions that currently have a regulated electricity sector (e.g. Hong Kong, Africa, and many parts of North America).
To explore the likelihood of a reform success (or failure), this paper models the connection between the number of producers (firms) and equilibrium market price. To capture the reality of heterogeneous generation units and time-varying demands, it considers two technologies - coal-fired generators (CFGs) and combined cycle gas turbines (CCGTs), and two time-of-day prices - peak and off-peak[4] . It analyzes the electricity market equilibrium in two regimes: the existing cost-of-service regulation vis-a-vis the government's reform proposal. Because electricity generation entails high-fixed cost, "perfect" competition with numerous producers is not always financially sustainable, as firms may not make a return on their investments ([35] Tishler and Woo, 2006)[5] . To be sure, the exit of unprofitable firms may, at least in theory, lead to an oligopoly market with price above marginal cost, providing a sufficient gross margin (electricity price minus average variable cost) for the remaining firms to be financially viable.
A substantive policy question thus arises: is the post-reform price likely to be less than the pre-reform regulated rate? If the answer is "no" the reform has failed to deliver consumer benefits[6] . To be...