Pioneering electricity reform in South America

In July, Spectrum opened a series on the power industry with articles an utility deregulation in the United States, plus a commentary on energy research [pp. 20-331. This issue completes the series with articles on the restructuring of power sectors in South America and Eur~pe, plus a viewpoint on the computerized grid-control systems needed in the new regime.

HE SWEEPING TRANSFORMATION OF THE electric energy sector in South America hard- ly matches the continent's image as a dull place for electrical engineers to work in. The upheavals began in 1982, when Chile formal-

ized an electric power reorganization. Argentina followed suit in 1992, then Peni in 1993, Bolivia and Colombia in 1994, and finally-this year-Brazil and Venezuela.

For decades, electric power development in many South American countries had been hamstrung by the inefficien- cy of state-owned, vertically integrated monopolies. Problems were endemic.

tribution chain dropped from $6000/kw of installed cap- acity to approximately $2000/kW, indicating a tripling of the productivity of money put into the system.

At the same time, very strict electric quality standards have been set in Argentina, Bolivia, and Peni, with penal- ties for not complying, without (so far) any apparent prej- udice to the development of new energy resources.

Although the power sectors are small in most South American countries by comparison with the larger ad- vanced industrial economies [see table, p. 4 11, demand for electricity has begun to grow a healthy 4 or 5 percent per annum in countries like Argentina and Brazil. In Chile.

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In Buenos Aires, the maintenance of thermal plants was so lax that regular repairs of steam boilers were taking over 90 days, finally precipitating an energy crisis in 1988-89. Yet from 1970 to 1990 there also was a significant overinvest- ment in the Argentinian electricity system-at more than US $25 000 million, it was larger than half the country's bloated external debt. In Colombia, prolonged power rationing had to be decreed in

where electricity demand grew 10 percent last year, private groups are competing to bring natural gas from Argentina to combined cycle plants in different parts of the country.

The countries that have restructured and privatized their electric power sectors are starting to attract invest-

ments from numerous North American and European companies, including Houston Power, Ontario Hydro, Britain's National Grid, and

i992-93 because of a severe drought that the sys- tem could not handle in view of its limited thermal genera- tion development. Meanwhile, in Bolivia and Peni, govern- ments were failing to raise enough funds for the electricity sectors, yet at the same time subsidizing rates for poor users. Similar problems are only now being confronted in Brazil, where a dire financial shortage halted public investment in the power system and is one of the main reasons for privati- zation [see IEEE Spectrum, June, "Catching up with modern times," pp. 22-28, and "Utilities for sale," pp. 29-33].

The reforms have had radical results in several countries. In Chile, two power suppliers have given place to five gen- erating companies competing in the main grid. In neigh- boring Argentina, still more strikingly, two state-owned companies have been replaced by over 30 competing pri- vate generators. In Buenos Aires and Lima, two distribution companies compete not only against each other but also against an ideal model.

The impact of the changes on the quality of service has been n o less remarkable. In Argentina, availability of ther- mal generation plant has increased from a historic low of 47 percent in 1992 to an anticipated 75 percent for 1996, while average monthly electricity prices in the wholesale market dropped from US $50-$60/MWh to $3O/MWh after deregulation and privatization. In Chile, average re- sponse time to electrical outages has shortened markedly, and dramatic growth in electricity production has been accompanied by improved productivity [Fig. 11. Distrib- ution losses have shrunk in several countries where dereg- ulation has taken place [Fig. 21: losses in Chile, energy theft included, were halved in seven years and in Argen- tina, in just three years. During roughly the same period in Argentina, investment in the generation-transmission-dis-

Electricit6 de France. In addition, South Amer- ican companies-among them Chile's Endesa, Chilgener, and Chilquinta-have made investments across national boundaries.

A new engineering world A new conceptual understanding of the electric energy

sector has fundamentally reshaped the engineer's world. The electric power system is now thought of as the elec- tricity market, and the consumer as the customer. The basic regulatory philosophy no longer is "protection for public utilities that provide an electric service with deter- mined costs," but rather, "competition among firms that offer a commodity with resultant prices." In short, eco- nomic and business matters can take priority over techni- cal ones. So career prospects may well be brighter for engi- neers dealing with economic matters, tariffs, contracts, and least-cost dispatch rather than with hardware alone.

Employment opportunities have undergone a metamor- phosis. Downsizing and outsourcing have brought new jobs into being and made old ones disappear. Productivity of the labor force has increased in all the countries where restruc- turing and privatization have taken place. In Chile, for example, the number of customers per distribution worker more than doubled in 10 years.

The changes have been bound up with a redefinition of the role of the state in societies whose economic develop- ment used to be led by their governments. Now, as the Chilean reformers stated early in the process, it is thought that the government should play only a subsidiary role in the ener- HUGH RUDNICK gy sector. In other words, it Catholic University should perform entrepreneurial of Chile

RUDNICK ~ PIONEERING ELECTRICITY REFORM IN SOUTH AMERICA 39

[I] Between 1989 and 1995, productivity at Chile's largest electricity company, Endesa, more than doubled in terms of gigawatthours generated per employee [above]. During the same period the average response time for providing distribution emergency service was cut by more than half at Chilectra, another of the coun- try's top electric companies [right].

activities only when such activities cannot or will not be carried out by the private sector, and its main job should be to regulate activities that are monopolistic

Everywhere in the reforming countries, market forces are rec- ognized as a basic mechanism in the correct allocation of resources in the electricity sector, with competition being wel- come wherever it can take place. Deconcentrating, decentralizing, and finally privatizing the activities and property of the electrici- ty companies has been recognized as necessary for the efficiency and stability of the system.

Divided into three parts The basic economic characteristics of the electricity chain

have been reconceptualized, with differing implications for gen- eration, transmission, and distribution.

Generation is recognized as the one part of the chain where there are no economies of scale: since small power plants can pro- duce energy at about the same costs as large ones, competition can be introduced. But the need to produce electric energy on demand entails a form of coordination of the physical operation. Hence the idea that coordination pools be created in competitive, unre- stricted generation markets.

Transmission activity, both because of lump investments and the need for redundancies to meet security requirements, is rec- ognized as the part of the chain where economies of scale are vital. To illustrate, as nominal voltage is increased along with transmission capacity, power lines and related equipment have a lower average cost per unit of power and per kilometer trans- mitted. Such economies tend to produce a natural monopoly in

transmission, which must be regulated to prevent the grid own- ers from overcharging for the service.

The need for regulation is all the more acute when the trans- mission grid is the kingpin of competition among geographi- cally dispersed generators. The universal trend therefore has been to establish unique transmission organizations in each market, with the mission to provide third parties with access to the use of the wires.

In distribution, finally, there are clear economies of scope or density. Obviously, one distribution network can provide a cheap- er sewice than two or more networks serving a single area, and regulators usually have given geographical concessions to distri- bution companies. In principle, however, local utilities can be required to supply their customers with cheaper electricity from third parties.

Common regulatory features In sum, an electricity system can be unbundled to make room

for competition in major components of the chain. Equipped with this understanding, a number of South American countries have developed new legal and regulatory frameworks for the electric energy sector, in which the main common elements are: 0 Explicit separation of the three businesses (generation, trans- mission, and distribution) and definition of these vertically dis- integrated companies, along with large customers, as the main market players. 0 Competition at the power generation level, but with all gen- erating companies agreeing to be centrally dispatched by an independent operator.

40 IEEE SPECTRUM AUGUST 1996

Source: OLADEICE, Sistema de lnformacion Economica-Enerqetica (SIEE), 1996 (except GDP)

Licensed operation of transmission and distribution companies. No licensing of thermal plants, but licensed construction of hydro-

electric plants, which entail the exploitation of natural resources. Open-access schemes, where transport concessionaires must per-

mit open and nondiscriminatory use of their transmission systems. The assignment to distribution concessionaires of the right

and obligation to supply electricity locally in the present and in the future.

A pricing system in which both generation and transmission business have operational or capacity expansion marginal prices or both. Distribution service is priced on the basis of the marginal cost of expanding capacity, which is evaluated using model distribution companies or price cap schemes (both corre- sponding to yardstick regulation schemes).

Penalties applied to stimulate better service: distribution com- panies are subject to fines for not serving customers, and in some countries transmission companies also face penalties for not pro- viding service.

As this summary suggests, reform has followed similar paths in all the countries involved. But "similar" does not mean "iden- tical." There are restrictions on cross ownership among different categories of companies (that is, generation versus transmission versus distribution) in most countries (Argentina, Bolivia, and Peni), but they are not defined in the Chilean law. Argentina and Bolivia further bar any generating company from holding more than 10 percent or 30 percent of the market, respectively.

While Colombia uses capital expansion marginal costs to fix a tariff for transmission services, the rest favor the use of short- term marginal costs coupled to tolls on the transport of power. Peni, Colombia, and Bolivia have left the transmission system under the control of a single nationally owned company, but Argentina and Chile have favored the development of several private transmission operators.

Argentina, Chile, and Peni have chosen the concept of mod- el distribution companies to set distribution rates, Bolivia has opted for the British price cap scheme, where rates are adjusted with inflation plus a yearly efficiency reduction.

The system operator in charge of coordinating grid opera- tions is run only by generators in Chile. In P e d the operator also includes transmitters, and in Argentina and Bolivia distributors,

large consumers, and the regulator. While in Chile, Peni, and Bolivia generation is dispatched on the basis of audited costs, bid prices are used in Argentina and Colombia.

These differences stem from independent assessments by each country as to the advantages of one model over the other. Solid applied knowledge, worldwide, as to the best industrial organization and regulation for this new electricity sector has after all been absent. So a distinctly experimental flavor has per- vaded the whole course of events.

Technology riot prime mover n the case o'f telecommunications, technological innovation was what transmogrified the organization of the industrial sector. In fact, the rapid transformation of telecommunica-

tions equipment is still turning the industry upside down, play- ing a key role in the sector's evolving regulatory practices.

In the electricity industry, in contrast, there has been no great technical innovation or technological breakthrough, in the sense of modifying the very principles of the industry's organization. The reasons for deregulation in South America varied from country to country, but most have been essentially economic or political.

Electric power got off to a fast start in South America. Soon after Thomas A. Edison demonstrated the electric light in 1879 in New York City, Rio de Janeiro, at that time the capital of Brazil, installed electric lighting in its main railroad station. In 1883, pub- lic lighting was inaugurated in the main square of the Chilean cap- ital, Santiago, one year after it was introduced in London. Hydro plants in the region started operating soon after.

In 1883 a dialmond field in Minas Gerais, Brazil, was using two 6-kW hydro generators and a 2-km-long dc line. In 1897, Chivi- lingo, a 500-kVA hydro plant designed by Edison, was supplying coal mines in 'Chile.

Public servic:e soon started in many municipalities in South America, and electricity companies were formed. Initially the power sector developed on the basis of private investment, with no special regulation. But during the Great Depression of the OS, private investment dried up throughout the region, to the detriment of electricity supply to cities, industry, and mining.

In most countries, the governments seized the initiative and

RUDNICK - PIONEERING ELECTRICITY REFORM IN SOUTH AMERICA 41

from the '40s to the end of the '70s put aggressive electrification programs into effect. Eletrobris in Brazil, Endesa in Chile, Electropeni in Peni, ISA in Colombia, and Ende in Bolivia were among the national electricity companies that were created. In general, power system development was concentrated in their hands, and they built hydroelectric plants and transmission lines tying previously isolated networks into interconnected systems. Private firms still existed, but mostly at the electricity distribu- tion level in the main metropolitan areas.

In some countries, however, the public authorities failed in the long run to adequately manage electricity companies. And then, with renewed economic difficulties in the '70s and OS, some gov- ernments lacked the resources to finance power-system develop- ment. Soon, foreign banks started making loans conditional on the initiation of privatization or deregulation processes. Concurrently, free-market ideas gained currency, starting in Chile, and gave rise to the notion that government control over the economy should be reduced and the role of the private sector enhanced.

Although technological innovation was not at the root of these changes, technical developments did indeed produce smaller economies of scale in generation, and that in tum bol- stered the case for introducing competition at that level. O n the other hand, technical developments that have increased trans- mission-line voltage levels have implied greater economies of scale in that activity and so strengthened the case for maintain- ing national grids as natural monopolies.

Not to be forgotten is the role of technological change in industries external to power, particularly in telecommunications and computers. New communications equipment and computer systems are providing vital tools for the restructuring of the elec- tricity sector and in the future will have an even larger impact on the organization of distribution.

Chilean case history hile shows how the process of electricity deregulation can get started, not so much out of a desire to reshape the electric sector as such, but because of broader economic

and political aims. For all practical purposes, the story begins in 1977, when Bruno Philippi, an engineering professor at Catholic University of Chile and a Stanford Ph.D. in engineering took over as executive director of the newly created National Energy Commission. At that point the main objective of the govem- ment was to rationalize and bring order to the chaotic price sys- tem prevailing in the energy sector as a whole.

At the same time, the government believed that the state elec- tric company exercised more influence than the regulating agen- cies charged with its oversight, so that it had become an entity that went its own way, irrespective of the public interest. It was also felt that the government's regulatory and business roles, quite generally, were in conflict.

Oil, coal, gas, and electricity prices, mostly set by large state companies, were completely distorted. Cross subsidies produced an inefficient use of resources, unnecessary investments were made, and capital was being diverted from other social needs.

Under Philippi's leadership, a nationwide energy strategy was formulated. A key element was that decentralized decisions by energy consumers and producers had to be bound to yield eco- nomic efficiencies. The implication was that prices of the differ- ent energy products had to reflect their true economic value, so that individual decisions coincided with the least cost for the country. That understanding led first to legal and institutional changes to deregulate prices of liquid and solid fuels.

The question immediately arose as to what to do with electric- ity. The glaring problem here was that electricity competed with liquid and solid fuels as an alternative energy source, but-unlike coal and oil-had no international reference price. Moreover, the system was primarily hydroelectric, making the determination of market prices all the murkier.

Chile's solution was formulated by Sebastiin Berstein, an engineer with the state company who joined Philippi at the National Energy Commission. Berstein was influenced by the French economic school of thought, which stresses use of mar- ket prices in regulated sectors. He considered that an efficient and coherent electricity price policy could be based on the use of marginal supply costs. Thus was born the idea of a competi- tive electricity market at the generation level, and actions were taken to facilitate the development of such a market.

Even with a strong military government in charge, it was not easy for Philippi and Berstein to bring forward their proposals. Criticism arose not only in the powerful, vertically integrated state monopolies, but also within the military hierarchy. The country had long been accustomed to believe that energy was a strategic resource and had to be handled by the state so as to guarantee independence from abroad. Price subsidies were con- sidered justified because electricity was an "essential" living ex- pense for the population.

In the beginning, too, international funding agencies were not supportive. The World Bank still made loans conditional on

[2] Greater operational rigor has been one result of the introduction of competitive pressures to the electric power industries in Chile, Argentina, and Peru. Witness the decline in electrical losses, as a percentage of the electricity distributed, caused by, among other things, theft.

4 2 IEEE SPECTRUM AUGUST 1996

the use of prices based on rate of return on net fixed assets, rather than on market prices.

But engineers with the state-owned electricity companies were soon convinced of the benefits of the new model and start- ed helping to further develop the proposals. Different problems had to be solved along the way, among them a winter with brown-outs. Decisions often were influenced by specific events and difficulties. It was not a process where a policy was first set and then implemented. Often, uncoordinated solutions had to be chosen, but always within an overall philosophy that gave them coherence. The adjustment of prices for final end-users took time, as simulations showed that price would rise a lot for some customers, while dropping for others. The upshot was the cumulative introduction of price increases to customers over periods of one to two years.

As in any pioneering effort, there was no one to learn from. The changes in the United Kingdom [see following article] were to start several years after, while the academic proposals on deregulation and spot pricing were to come much later in the United States. But isolated ideas from electric sectors from oth- er countries were adopted-for example, the incorporation of an independent system operator to plan operations for several pri- vate generators was founded on Belgian experiments.

In 1982, culminating a difficult process, an important electricity law was issued, though it still remained within the framework of a largely state-owned system. Today all transmission and distribution i s privately held, while the small fraction of generation still in the hands of the state will soon be privatized, too. Yet not so long ago the Chilean government controlled 90 percent of generation, all transmission, and 80 percent of distribution.

Regional changes in ownership Throughout the reforming countries of South America a long

history of strong state control has yielded to the view that the private sector should be enlisted to help with public problems. Different privatization schemes have been used, depending on the strength of local capital markets.

Whereas in Chile private pension funds provided financing for the privatized electrical system, in Argentina, Bolivia, and Per&, foreign investment was required. Ownership started to be widely shared, with company workers also invited to become shareholders in the business. Bolivia has developed a new priva- tization program called "capitalization": the shares of the electric

companies are not sold but rather are transferred to the popula- tion of the country through private pension funds; foreign investors finance a company's expansion, controlling the com- pany as shareholders that contribute a predefined amount to finance further investment.

But privatization has historically encountered opposition in South America, in relation both to the processes and to the prices. The arrival of foreign investment has at times been unwelcome, too, particularly when the issue of the "strategic importance of energy" has been raised.

This time around, stranded assets, attributable to past decisions, have generally been absorbed by the state. In Chile, stocks of state companies were allowed to float in the market before privatiza- tion, with much political discussion about the impact on society. That is, the values paid to the government were criticized as too low, and it was argued that private interests were reaping windfall gains. In Argentina, federally owned companies were privatized on the basis of bids, irrespective of their book-value.

Business andl engineers The deregulation process has posed diverse challenges to reg-

ulators, engineters, managers, and businessmen. As indicated., competition at the production level has been a

crucial free-market element. Private electric utilities bid publicly against one another for the opportunity to siupply large industri- al and mining complexes with electricity. Generators also com- pete to supply price-regulated distributors. The utilities, while competing, must take action to increase their returns and respond to their stock owners. Besides strengthening their com- mercial departments, utilities have had to incorporate technolo- gy in all those areas that noticeably affect income.

More efficient maintenance, the upgrading or replacement of existing equipment, and more sophisticated control systems for a tighter use of installations-all have been used to increase reli- ability and postpone further capital investment. Development has been stimulated by the search for more efficient technolo- gies in generation equipment, as well as cheaper energy re- sources. Many investors have sought to build combined-cycle gas units, with related investments in transporting natural gas across international frontiers. Consequently, South America will soon have an international network of natural-gas pipelines.

A chronic problem in Latin America has been the illegal use of electricity, which usually imposed severe burdens on the utilities.

43 RUDNICK ~ PlONEERlNC ELECTRICITY REFORM IN S O U T H AMERICA

Losses over 20 percent were not uncommon, and even now, some utilities in Venezuela lose more than 50 percent of the energy bought. A political solution chosen by some countries had been to share this burden among all paying consumers, assuming elec- tricity theft was a social problem. But in the new regulatory schemes, where distribution companies are asked to compete with a model or a price cap, control over these strictly nontech- nical losses is a must if company revenues are to be increased.

When deregulation was started, creative solutions were worked out jointly by public authorities and private companies to confront this problem. Governments have provided financial facilities to cover unpaid electricity bills, while firms affected by the problem, besides taking managerial actions, have had to develop new distribution technology and hardware.

Companies in Chile have designed and installed distribution lines that are protected through the use of low-voltage braided conductors, concentric conductors for hook-up points, and high-voltage power lines with small distribution transformers. Meter protection schemes as well as common feeders for shanty towns were also developed.

Power system expansion he rise in competition and its related uncertainties in what was before a stable business asks more of the com- panies and engineers involved. Centrally determined

plans for the expansion of generation and transmission facilities are a thing of the past. Nowadays, private investors are making independent decisions in line with their own assessments, and new generating plants and transmission lines are being built on that basis, rather than on the basis of assessments by government bodies. This environment is rife with challenge and poses many questions as to how to reconcile the private and the public inter- ests in the expansion of the electric power installations.

The new ideas underlying Bolivian, Chilean, and Peruvian electric regulations have much in common.

Every six months, the regulatory agency in each country for- mulates a reference plan for generation and transmission expan- sion, taking into account all feasible investment possibilities and assessing what would be best for the country as a whole. This plan is used in controlling generation-transmission tariffs for small retail consumers. In practice, regulators have provided optimal plans only for generation investments, with only the principal transmission lines included, indicating how they expect the pow- er sector to evolve. Alternative expansion plans are studied, among them proposals by private investors for future-generation units. The plan that results is not binding on the private sector.

Second, the regulator determines an "economically adapted" transmission system. The Chilean electricity law provides a gen- eral definition: "an installation is economically adapted when it allows a given quantity to be produced at the lowest cost." The Peruvian and Bolivian legislation restrict that definition, indicat- ing that "an economically adapted system is that electrical sys- tem where there is an equilibrium between energy supply and demand, aiming for reduced costs and maintaining quality of service.'' The regulators in these last two countries must not only determine what the adapted transmission system is to be, but may also restrict the transmission owner's income on the basis of that adapted system. The aim is to stimulate efficient invest- ment, maintenance, and operation.

A similar concept is used in the three countries for the reg- ulation of distribution. An economically adapted model sys- tem is determined by the regulator every four years and used to derive a distribution value-added term used for the calcula- tion of tariffs.

Worth emulating T h e reorganization and privatization is an ongoing process.

Both Brazil and Venezuela, significant markets in the region, are actively seeking to change their regulations in order to attract the private investment they need and encourage an efficient electric sector. Brazil, the lead market with 35 million consumers and 59 000 MW of installed capacity, recently started privatiz- ing its utilities and reshaping its electricity regulations. Venezuela, with a 19 Ooo-MW installed capacity, is proceeding at a slower pace. Just 1 3 percent of the power sector is privately held, and the achievability of full competition in generation is under debate, because of the large economies of scale of hydro- electricity production at the 10 Ooo-MW Rad Leoni-Guri plant.

The entry of multinational companies into the South American electricity market has been an interesting byproduct of deregula- tion and privatization. U.S., Canadian, French, and Spanish utili- ties now have a sizable share in the region's electric power. Still more significant has been the rise of Chilean multinationals, with Chilean companies Chilgener and Endesa owning more installed generation capacity outside the country than inside. In addition to Santiago, two other capital cities, Buenos Aires and Lima, are now supplied by Chilectra, which thus serves 39 percent, 17 percent, and 17 percent of the Chilean, Argentinian, and Peruvian popula- tions respectively. Other Chilean companies also have started investing abroad, and all are interested in buying Brazilian gener- ation and distribution businesses.

The course of the South American revolution in electric energy has mn deep. The successes have been great, but so have the diffi- culties in what has been a pioneering excursion into unknown terri- tory Restructuring is still far from settling into a satisfactow steady state. However, the new industry model is rising above its historical origins and, despite certain chance elements in its development, it is proving a solid achievement worthy of wide emulation. +

To probe further: The /€€E Power Engineering Review has been publishing articles and

panel reports on changes taking place in Latin America. The Latin America and the Caribbean Technical Department at the

World Bank in Washington, D.C., regularly publishes regional reports on the power sector. For further information, contact Rafael A. Moscote, Energy and Regulatory Adviser, Advisory Group, Technical Department, The World Bank, 1818 H St., N.W., Washington, DC 20433; 202-473-8633; fax, 202-676-0239.

The Latin American Energy Organization, located in Quito, Ecuador, publishes regional reports on the energy sector. Contact executive director Francisco J. Gutierrez for further information, (593+2) 598 280; fax, (593+2) 539 684.

See especially the Proceedings of the 1995 /E€€ lnternational Forum on Deregulation and Restructuring in the Electrical Power Sector, held in December 1995 in Belo Horizonte, Brazil. Contact Carlos August0 Brandao for copies at [email protected]

About the author Hugh Rudnick (SM) was born in Santiago, Chile, and graduated as a civ-

i l electrical engineer from the University of Chile, later obtaining his MSc. and Ph.D. from Victoria University, in Manchester, United Kingdom. He is a professor of electrical engineering at t h e Catholic University of Chile. HIS research activities focus on the economic oper- ation, planning, and regulation of power systems. He has served as a consultant for utilities and regulators in Argentina, Bolivia, Chile, and Colombia, and he has written and lectured at length on South American deregulation. His e-mail is h.rudnickQieee.org.

Spectrum editor: William Sweet

IEEE SPECTRUM AUGUST 1996 44