Brazil and Argentina - Ontario (Ca) S

Implementation of Energy MarketsImplementation of Energy MarketsLessons learned from BrazilLessons learned from Brazil

Luiz MaurerNiagara-on-the-Lake, Ontario, Canada

June 08, 2000

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AGENDAAGENDA

INTRODUCTION

OVERVIEW OF THE ENERGY SECTOR IN BRAZIL

HISTORY AND MOTIVATION FOR AN ENERGY MARKET

KEY ELEMENTS OF MARKET DESIGN

IMPLEMENTATION ISSUES

LESSONS LEARNED

APPENDICES

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INTRODUCTIONINTRODUCTION

We will talk about the restructuring of the energy markets in Brazil

Focusing on the establishment of competition in the electric sector

So far, a five-year effort to liberalize the market A mixture of a vision, politics, tension, conflicting objectives,

successes and procrastination In retrospect, we see progress - but still a lot to be done and

agreed upon Several lessons to be learned to other countries embarking on

similar ventures

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OVERVIEW OF THE ENERGY SECTOR IN BRAZILOVERVIEW OF THE ENERGY SECTOR IN BRAZILELECTRICITY - Sizable 65 GW of installed capacity, mostly hydro Total production of 350 TWh 45 million customers Market growth = 5.2% c.a.g.r last 5 years (4.3% onwards) 65% of D already privatized; only 18% of G in private hands Poised for liberalization

NATURAL GAS - To be developed Reserves of 160 Bcm Consumption of 5.6 Bcm/year (< 2% of energy matrix) Brazil-Bolivia Pipeline as a major breakthrough No gas fired power plants - Enron to be # 1 Infrastructure yet to be developed (1 MM customers) Petrobrás de facto monopoly No gas markets any time soon

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HISTORY AND MOTIVATION FOR AN ENERGY MARKETHISTORY AND MOTIVATION FOR AN ENERGY MARKETGeneral BackgroundGeneral Background

1995 - Two key legislative changes threw the “seeds of creative destruction” for sector reform (“Tropical PURPAs”)– Compulsory bidding for any new Concessions

– Private and public capital on an equal basis

– IPPs and Customer Choice [yet timid] 1996 till 1998 - RE-SEB Project by MME

– World Bank sponsored, with consulting support

– Work on design and coherent implementation details 1997 - ANEEL (FERC equivalent) was created At the same time, an ambitious privatization program was launched -

“changing tires on a moving vehicle”– Both at Federal and State levels– Initially distribution; generation to follow

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HISTORY AND MOTIVATION FOR AN ENERGY MARKETHISTORY AND MOTIVATION FOR AN ENERGY MARKETGeneral Background of ReformGeneral Background of Reform

Creation of an energy market was a seamless part of the overall process of reform of the public sector

Objective of introducing workable wholesale competition on the supply side and [some] retail choice

Without losing the benefits of central optimization (tight pool) and no tariff shock - “sacred cow”

Attract private capital to support expansion and help mitigate impending energy crisis

Pave the road for privatization of G and D assets

Before 1995, supply side was basically in the government hands, as a producer, seller, and agent in charge of operating the pool - no competition existed

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HISTORY AND MOTIVATION FOR AN ENERGY MARKETHISTORY AND MOTIVATION FOR AN ENERGY MARKET Basic characteristics of new power poolBasic characteristics of new power pool

Two separate agents - one to operate the system (ONS) the other to operate the market (MAE)

Central optimization system with no relation to contracts - a “super-tight pool”, with virtually no bidding for existing plants

Contracts financial by nature - grid is accountable for “physical delivery”

Hydro plants sharing dispatch risk via MAE rules Only new thermal plants and DSB allowed to bid Creation of an energy market (MAE) to allow competition on

contracts (mostly) and on a spot basis Spot price as a result of an optimization model - supply an

demand curves determined centrally Four sub-markets/prices - each representing SRMC + CF

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KEY ELEMENTS OF MARKET DESIGNKEY ELEMENTS OF MARKET DESIGN

SUPPLY SIDE

DEMAND SIDE

CREATION OF ONS (ISO) AND MAE (WEM)

REGULATORY FRAMEWORK

EACH ONE OF THOSE ELEMENTS WILL BE DISCUSSED IN TURN

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KEY ELEMENTS OF MARKET CREATIONKEY ELEMENTS OF MARKET CREATION

SUPPLY SIDE

– In principle, all MW should compete for [financial] contracts and on a spot basis - except Itaipu and Nuclear Plants

– However, immediate liberalization would entail tariff shocks

– Mechanism of “Initial Contracts” was devised (old energy), whereby wholesale energy price should gradually approach marginal costs (next page)

– Stranded costs and windfall profits offsetting each other (acceptable, as long as all G assets in public hands)

– Legislation enabled privatized MW to become IPPs

– Legislation also enabled the emergence of pure traders

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INITIAL CONTRACTS MECHANISMINITIAL CONTRACTS MECHANISM

Spot Market

Cu

rren

t S

itu

atio

n Competitive Market(Bilateral Contracts)

Transition period

(Initial Contracts)

Year

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WINDFALL PROFITS - STRANDED COSTSWINDFALL PROFITS - STRANDED COSTS

Cos

t (U

$/M

Wh

)ORDEMEPROGRESSO Rate of Return on Asset Base = 10 %

Cumulative Generation (TWh)

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KEY ELEMENTS OF MARKET CREATIONKEY ELEMENTS OF MARKET CREATION

DEMAND SIDE– Law 9.074 enacted in 1995 - established “customer choice”

• Qualified customers have the option to become free• By default, customer “belongs” to host D/R

– Initially, “free customers” as the ones > 10 MW, > 69 kV (or 3 MW if new ones)

– This year, 3 MW, > 69 kV for any customer not bound by contracts - very large ones allowed to participate in the MAE

– Recent proposal made by ANEEL (Public Hearing) reduces threshold level to 50 kW in 2003; all customers free in 2005

– Enron’s view• The sooner the better • However, a herculean implementation task• Ballpark - from 100 kW to 300 kW in 2003 would be viable proposition• We also advocate that customers should have obligation to choose

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COMPLEXITY GROWS EXPONENTIALLY COMPLEXITY GROWS EXPONENTIALLY WITH THE NUMBER OF CUSTOMERSWITH THE NUMBER OF CUSTOMERS

Number Number Cumulative Market ShareCumulative Market ShareThresholdThreshold ofof (TWh)(TWh)

CustomersCustomers HighHigh LowLow

----------------------------------------------------------------------------------------------------------------------------------------------------------300 kW300 kW 8.4008.400 41,241,2 27,027,0

100 kW100 kW 38.40038.400 44,444,4 30,030,0

50 kW 50 kW (*)(*) 61.40061.400 44,944,9 30,630,6

AllAll 37.500.00037.500.000 100,0100,0 100,0100,0

(*) Assumes for all voltage levels(*) Assumes for all voltage levels

SourceSource : Working Paper – Project RE-SEB, 1997 : Working Paper – Project RE-SEB, 1997

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CREATION OF MAE AND ONS WERE TWO [PRIVATE] CREATION OF MAE AND ONS WERE TWO [PRIVATE] PILLARS OF THE NEW SECTORPILLARS OF THE NEW SECTOR

MAE - WHOLESALE ENERGY MARKET (WEM)– Responsible for contract register, energy accounting and

financial settlement– At the outset, refine/implement MAE rules– As well as the detailed design of all processes and related

computer systems for metering and settlement (US$ 50 + 130MM)– Literally, work from a “blank sheet of paper”

ONS - (ISO)– Responsible for system operation and dispatch– Perform several roles related to system reliability– Transmission deterministic planning (< 3 years) – Close cooperation with MAE to make market work

BOTH ROLES WERE ORIGINALLY PLAYED BY ELETROBRAS

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ANEEL is “the regulator” for the electric sector in Brazil Technically, everything has to be approved by ANEEL

– Licensing MAE and ONS– All rules under which MAE and ONS should operate– Licensing new traders to operate in the MAE

Some are regulatory by nature (per se)– T and D wheeling rates (retail and wholesale)– Pass-through issues for energy purchased in the market– Market concentration (horizontal) and anti-trust issues– Requirements for de-verticalization– Technology transfer

Interfaces between ANEEL and hydrocarbons regulations are virtually non existent

ANEEL IS RESPONSIBLE FOR PUTTING ALL THE ANEEL IS RESPONSIBLE FOR PUTTING ALL THE REGULATORY PIECES TOGETHER - STATE OF FLUXREGULATORY PIECES TOGETHER - STATE OF FLUX

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IMPLEMENTATION ISSUESIMPLEMENTATION ISSUESLOOKING IN RETROSPECT, A LOT HAS BEEN DONE IN THE LAST

THREE YEARS A coherent, comprehensive blueprint for reform is available ONS (a private company) was created and is now fully operational -

separate from Eletrobrás MAE is being implemented - Market Agreement signed, ASMAE

operational, and definitive rules approved in February 00 Emergence of pure traders (10) and energy contracts in the free market

(involving traders, free customers, D/Cs and Gs) Initial Contracts and T contracts signed Planning functions moved from Eletrobrás to MME Most distribution companies privatized - at high premiums Some generation in private hands - almost 10,000 MW Multiple new players - domestic and international (30 in electricity and

gas) Modernization/completion of the regulatory framework

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IMPLEMENTATION ISSUESIMPLEMENTATION ISSUESHOWEVER, IMPLEMENTATION IS MOVING AT SLOW SPEED The overall sector reform was supposed to be a two year, intense

implementation effort, throughout 1998 and 1999 Taking into account the need of a transitional period, for both supply and

demand sides - “gradual by design” Privatization of federally owned G has virtually stopped - still 50,000 MW

in public hands MAE implementation - expected 3 year delay to have all rules,

procedures and metering devices in place Negligible energy volumes traded in the free market (1%)

– Large customers not willing to leave sheltered rates

– Lack of liquidity (partly by design) - everyone is contracted

– Rules for trading in the free market being fine tuned as we speak Therefore, opportunities for Enron’s trading are limited

– Arbitrage between free energy and regulated markets

– Uncertainties regarding a two-tiered price settlement system

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IMPLEMENTATION ISSUESIMPLEMENTATION ISSUESHOWEVER, IMPLEMENTATION IS MOVING AT SLOW SPEED

(Continued)

ANEEL is slow in drafting the regulations - e.g. wheeling– Did not participate in the creation of the blueprint for reform– Understaffed and overloaded– Conservative - Public Hearings for issues already agreed upon

New Government has focused primarily in the supply side– Put together an emergency package to deal with supply crisis– Consisting of 17,000 MW, 49 Power Projects, by 2003

Haphazard, ad hoc regulations challenging market principles - e.g. Project of Law 2905, strengthening roles of Eletrobrás

IN SUM, OVERALL SPEED OF CHANGE HAS BEEN BREATH-TAKING. BUT RECENTLY WE HAVE BEEN PARALYZED SEARCHING A WAY TO HARMONIZE [APPARENTLY] CONFLICTING POLICIES - MARKET OR EXPANSION? THIS CREATES ANXIETY AMONG INVESTORS - HAS THE PENDULUM SWUNG BACK?

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IMPLEMENTATION ISSUESIMPLEMENTATION ISSUESWHOSE TO BLAME? EASY ANSWER - ON THE GOVERNMENT Presidential election in late 1998 - caused implementation hiatus Lack of leadership to orchestrate multiple implementation efforts (ANEEL,

ONS, MAE) Lack of government trust in market forces - shifting gears, under the

[wrong] assumption that market implementation and system expansion are mutually exclusive objectives

Therefore, violating some of the pillars of sector reform– Trying in vain to circumvent realities - market, institutional, regulatory

– Increased role of Eletrobrás and Petrobrás as offtakers/owners

– Consolidating an obsolete natural gas regulatory framework

– At best, a benign neglect to the coherence of the overall reform Lack of political courage to continue privatization (G); alleged

difficulties/obstacles have always been present ANEEL has been extremely conservative to finalize regulations

– Not leveraging coherence of RE-SEB Project

– But at the end of the day following most recommendations

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IMPLEMENTATION ISSUESIMPLEMENTATION ISSUESUNFORTUNATELY, NOT THAT EASY - MAE IMPLEMENTATION

HAS ALSO BEEN PLAGUED BY PROCRASTINATION MAE is a private company, owned by generators and distributors

in equal proportions It was created in 1998 via a “Market Agreement” A Board of Directors, a Technical Committee, and an operating

arm (ASMAE) were created in late 1998 The agreed objective was to have the market up and running on

January 01, 2000 - further refinements on the metering program till 2003 MAE rules to be approved in 60 days (two months)

Resources were made available for investment and operations (ANEEL agreed on pass through issues !!)

Procrastination has been the name of the game - 3 year delay– Constant schedule slippages/revisions (see next page)

– MAE Rules will likely take 23 months to be finalized

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Evolução a Mercado

MAE IMPLEMENTATION - WHEN? YEAR 2000 ?MAE IMPLEMENTATION - WHEN? YEAR 2000 ?

(*) Assumes definitive metering

Intial Plan AprovedBy theCOEX

Revision duringMAE budget(February 99)

Absorption of GCOI by MAE

Provisional Rules(Revocation of MP1819)

Delays to adopt thedefinitive Rules

Forecast

Revised Estimates

(Abril 99)

(July 99)

(September 99)

(January 99)

1998 1999 2000

ASMAEDefinitive Market Rules

Accounting & Settlement Computer SystemsInterim Metering Systems/Devices

2001 2002

Fase I

Fase I

Fase I.0 + Fase I.1

Fase II

Fase II

Fase II

Final Approval of Core Rules(February 2000)

“ Pseudo Mercado ” Evolução a Mercado

Delays in Submission to Aneel AP 2/2000 da ANEEL

(April 2000)

“ Pseudo Mercado ” (*)

Resolution 222 to be revoked

(*)

(*)

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IMPLEMENTATION ISSUESIMPLEMENTATION ISSUES

MORE COMPLEX REASONS TO EXPLAIN DELAYS IN MAE IMPLEMENTATION - KEY TO ENRON’S OBJECTIVES

No doubts - it is a complex task, from a blank sheet of paper No incentive/penalty and governance mechanisms to have MAE

up and running within a certain timeframe A zero-sum-game - each player wants to benefit when designing

new rules (or at least breakeven) 20-60-20 rule (60 indifferent + 20 against as deadweight) Excuses [false] not to confront reality - “Brazil is the only country

where the industry players designed the market rules” Perfectionism in polishing the rules - root cause or consequence

of the above? (see next slide) Only recently, the emergency thermal program seems to be

pushing MAE implementation

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EVOLUTION OF MARKET RULES DESIGNEVOLUTION OF MARKET RULES DESIGN

Added

Value

1996 1997 1998 1999 2000

100 %

75 %

50 %

25 % Restructuring Starts

Old GCOI rulesSep. 96

MMEConsolidated

ReportJul. 97

MarketAgreement

Aug. 98

WEM Rules in

Algebraic FormatMME Product

Nov. 98

25 %25 %

60 %60 %

90 %90 %

95 %95 % 98 %98 % 99 %99 %

Revised Rules by MAE in

Algebraic FormatNov. 99

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LESSONS LEARNEDLESSONS LEARNED Creating a market is a seamless, major piece of a sector reform -

institutional, regulatory, commercial, technical

A complex task - energy is a very important sector - changes have strong economic and political implications

– Cultural changes, as it challenges old established monopolies

– Government has to refrain from temptation to control prices

– In Brazil, tension between Federal and State Governments

– Competition not ingrained in culture/institutions

– Deregulation per se creates winners and losers

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LESSONS LEARNED (Continued)LESSONS LEARNED (Continued)

A reform of that magnitude goes beyond the borders of the electric sector per se– Lack of convergence between gas and electricity impedes competition

– Obsolete tax system is hampering MAE implementation

Therefore, It requires strong, constant Government support [and coordination] at all levels

A transition time may be necessary; but delays kill any project– Momentum is lost

– Shifts in the balance of power - market vs. interventionism currents of thought

– Ad hoc changes entail lack of coherence

APPENDICESAPPENDICESBRAZIL AND ARGENTINA ELECTRIC BRAZIL AND ARGENTINA ELECTRIC

SECTORSSECTORS

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BASIC CHARACTERISTICSBASIC CHARACTERISTICS

ARGENTINA

* Tight Pool

* Thermal to Hydro Competition

* Pool price based on thermal bidding and “cost of water”

* Spot price smoothing for load ; also capacity fee

* Initially very contracted - today 42 % spot

* No hydro dispatch risk mechanism

* Some emerging merchant plants

* Multiple nodal prices, which include T short term costs

* One agent to operate the system and settle contracts

* Up and running

BRAZIL* Very tight pool

* Hydro - thermal still subsidized

* Pool price based on central cost calculation - no bidding for now

* No spot price smoothing, except capacity fee, to avoid spot price to reach VLL

* Fully contracted (ICs) - Expected 10 to 15% spot

* Hydros share dispatch risk

* No merchant plants - unlikely

* 4 Pool prices (sub-markets), adjusted for short term losses

* Two agents: one to operate the system, one to settle contracts

* Under implementation

ORDEMEPROGRESSO

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INDUSTRY STRUCTUREINDUSTRY STRUCTURE

ORDEMEPROGRESSOARGENTINA BRAZIL

REAL MARKET POWER HAS TO CONSIDER * Sub-markets, T constraints * Cross-ownership * “Behind-the-market” contracts * Single buyer model * Vertical desintegration requirements (T/G)

Isolated Systems(17 D/Rs)

72 % 40 GENERATORS

14% 14 %62 %

11 GENERATORS10% 28 %

76 % 40 DISTRIBUTORS

24 % 10 D/Rs

80 %16 DISTRIBUTORS

18 % 60 D/Rs

Bi-national Cos

State Owned

18 Other Gs

Itaipu share allocated to 20 D/Rs

2 %

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BENEFITS SO FAR - ELECTRIC SECTORSBENEFITS SO FAR - ELECTRIC SECTORS

In Argentina– Spot prices went down – Contract prices following similar paths– New investments– Increased availability of thermal plants– Increased operational efficiency– Dramatic reduction on energy not served (ENS) figures – No one talks about crisis any longer– Excess energy to be exported to Brazil

In Brazil - still early but:– Competition for new contracts (thermal and hydro)– New G being offered below marginal costs– Pressure to diversify energy mix and bring gas– First free trading transactions -- win-win situations

ORDEMEPROGRESSO