Implementation of Energy MarketsImplementation of Energy MarketsLessons learned from Lessons learned from Argentina and BrazilArgentina and Brazil

Luiz T. A. MaurerBangkok, ThailandOctober 14, 1999

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AGENDAAGENDA

INTRODUCTION

OVERVIEW - ARGENTINA AND BRAZIL

MOTIVATION FOR CREATING AN ENERGY MARKET

OBJECTIVES AND CONSTRAINTS

BASIC CHARACTERISTICS

STATUS OF IMPLEMENTATION

TRANSITIONAL MEASURES

BENEFITS SO FAR

LESSONS LEARNED

NATURAL GAS CHALLENGES

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Despite the unique characteristics of each sector, we think that

international experiences can provide meaningful lessons to

other countries embarking on similar ventures

INTRODUCTIONINTRODUCTION

We will talk about Argentina and Brazil cases Two success stories in transforming their energy sectors Focus of the presentation: electric sectors Particularly in the establishment of competition ... And the creation of energy markets In both countries, markets already in operation But in different stages of development Many points in common and lessons to be learned

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OVERVIEW OVERVIEW

ARGENTINA AND BRAZIL ARGENTINA AND BRAZILORDEMEPROGRESSO

165 62 340 7 130

35 20 72 39 683

Population Installed Electric Natural Gas Natural Gas (million Capacity Energy Production Reserves inhabitants) (G W) Production (b c m / y r.) (b c m)

ORDEMEPROGRESSO

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MOTIVATION FOR CREATING MOTIVATION FOR CREATING AN ENERGY MARKETAN ENERGY MARKET

Part of an overall process of reform of the public sector Introduce workable competition on the supply and demand sides Attract private capital to support expansion and help mitigate impending

energy crisis Pave the road for privatization of G and D assets

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

existed

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OBJECTIVES AND CONSTRAINTSOBJECTIVES AND CONSTRAINTS

Preserve the benefits of system optimization No additional risks of supply disruption Create a competitive market where agents can settle

contracts, buy or sell differences, hedge against price fluctuations

With transparent rules and no barriers for new players To enable competition at the contract and spot levels Where contract prices, volumes and terms can be freely

negotiated Transitional phase - as smooth as possible, to avoid tariff

shocks

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BASIC CHARACTERISTICSBASIC CHARACTERISTICS

Overall reform - driven by highest government levels, with legislative support

Central optimization system with no relation to contracts

– In Brazil, very tight pool, virtually no bidding

– In Argentina, more flexibility for power plants to bid A lot of emphasis on long term bilateral contracts

– To reduce spot price volatility for Gs and D/Rs

– To facilitate privatization of generation

– Regulatory mandates for minimum contracting requirements Active spot market for uncontracted demand

– All energies are taken into account to form the spot price

– Price as an economic signal for expansion/contracting

– Spot price to settle uncontracted generation/demand

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BASIC CHARACTERISTICS (Continued)BASIC CHARACTERISTICS (Continued)

New private agencies created for operational and commercial purposes

– In Brazil - separate WEM (MAE) and ISO (ONS)

– In Argentina - combined (CAMMESA) Central planning roles limited in scope

– In Argentina - no planning for G or T

– In Brazil - ISO plans T, Government produces indicative planning for G

New, independent, regulatory agencies as part of sector reform - ENRE in Argentina, ANEEL in Brazil

Simultaneous, gradual deregulation of the demand side - open access and retail choice for larger customers

Transitional measures to move to a competitive market

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BASIC CHARACTERISTICS (Continued)BASIC CHARACTERISTICS (Continued)

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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STATUS OF IMPLEMENTATIONSTATUS OF IMPLEMENTATION In both cases, markets up and running - but at different

stages of development Argentina started first, in 1991 - about 2 years to make market

operational, in a kind of “big bang” approach Brazil started later, in 1996 and is taking longer

– 2 years to design and approve the new model – 1 year to implement MAE and Market Rules (ongoing)– 1-2 years yet to build the infrastructure - metering, systems

Horizontal separation concluded in Argentina and only partial in Brazil, as privatization takes place

In both cases, regulations lag behind in creating the trading function (separate from wire business) and in enforcing non discriminatory, open access rules

Financial risk management tools at early stages

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STATUS OF IMPLEMENTATION (Continued)STATUS OF IMPLEMENTATION (Continued)Why things move at different speeds ?Why things move at different speeds ?

Different perceptions of crisis - Argentina was in the middle of a major, national blackout when reforms initiated

Argentina started at the beginning of a Presidential term - and had Government support across the entire process

Technical complexities also matter

– Brazil is basically hydro based - cascade and multiple ownership effects

– Contrary to Argentina, where thermal x hydro competition existed from the start

Political complexity is also important - balance of power between Federal and State Governments in Brazil

Brazil had to “pass the baton” very early to the private agents - conflicts between Gs and D/Rs drag the process

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TRANSITIONAL MEASURESTRANSITIONAL MEASURES Competition in the generation business is desirable - but it can not

be achieved overnight Moving from a regulated to a free market pricing system entails two

challenges (see chart):

– Windfall profits - accounting costs below [expected] market prices

– Stranded costs - accounting costs above [expected] market prices How to handle those problems on the supply side?

– Long term contracts, to smooth transition and reduce risk to G buyers (see graph)

• Initial Contracts in Brazil - 8 years, declining 25% p.a

• Long term contracts for large privatized plants in Argentina

– Set bulk prices at politically acceptable levels

– Mix “old” and expensive energies in a single portfolio

– Net effect = still some costs to be absorbed by the taxpayer – Stranded costs solved via write-off on reduced privatization proceeds

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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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CONTRACTS ARE KEY TO TRANSITIONCONTRACTS ARE KEY TO TRANSITION

Spot Market

Cu

rren

t S

itu

atio

n Competitive Market(Bilateral Contracts)

Transition period

(Initial Contracts)

Year

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BENEFITS SO FAR - BENEFITS OF BENEFITS SO FAR - BENEFITS OF DEREGULATION ARE CLEARDEREGULATION ARE CLEAR

Source: Brookings Institution/George Mason University

Price Decline (%) 2 years

5 years

Transport. Roads Airlines Long DistanceCalls

Natural Gas

50

40

30

20

10

0

40%

10 years

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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

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The UK example showed the world that generationThe UK example showed the world that generationhorizontal separation is a structural pre-requisite horizontal separation is a structural pre-requisite

to create a competitive marketto create a competitive market

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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LESSONS LEARNEDLESSONS LEARNED Creating a market is not an isolated action - major, concerted piece of a sector

reform - institutional, regulatory, commercial, technical Not an easy task either

– Very important sectors - changes have strong economic and political dimensions– Cultural changes, as it challenges old established monopolies– Government has to refrain from temptation to control prices– Competition not ingrained in culture/institutions– Deregulation per se creates winners and losers

It required strong, constant government support at all levels– Executive and Legislative branches– Regulatory and Funding Agencies– Privatization Cabinets

It also requires initial investments - advisors, metering, revised optimization systems, accounting and settlement, new agencies, etc.- but it certainly pays off

1a Comercialização de Energia/Livre Acesso/Livre Escolha– Enron Comercializadora de Energia

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NATURAL GAS CHALLENGESNATURAL GAS CHALLENGES

Very different stories - despite a common backdrop of opening up the industry and fostering private capital participation

In Argentina natural gas is the “fuel of choice”

– Large reserves and production (up to 107 MM cu.meters/day)

– Large participation in energy matrix - more than 40%

– Well developed infrastructure

– Prior to privatization, large company in place (Gas del Estado)

In Brazil, situation was the opposite

– Limited reserves and production, with no imports – Negligible participation in the energy matrix (2%)– Small LDCs, in a few, limited geographical areas

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NATURAL GAS - Argentina was poised NATURAL GAS - Argentina was poised for industry deregulationfor industry deregulation

Major deregulation/privatization effort developed in 1992 Lessons learned from previous industry restructuring efforts -

airlines, telecommunications, electricity Government had a clear objective of creating a competitive

market, fostering private capital participation and solving supply problems

Gas del Estado, a large national company, was split and sold in 10 parts - two transcos and 8 LDC´s

Many benefits achieved - privatization was a success, new investments, more production, T bottlenecks solved

Challenge is to create a real market, with support from regulator - customer choice not a clear reality yet

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NATURAL GAS - Brazil faces the challenge to NATURAL GAS - Brazil faces the challenge to build the infrastructurebuild the infrastructure

A major gas pipeline, connecting Bolivia to Brazil, was a significant effort to increase supply sources - others to follow

Market pressure has been intense to have access to gas– Industrial users - key to competitiveness– Power generation - only solution to imminent crisis

Petrobrás more interested in increasing gas penetration– Respond to market needs– Contestability - other potential suppliers, after end of monopoly

Brazil is still a long way to go to build the required infrastructure - supply, transportation and distribution

Still far away from establishing a competitive industry

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Enron: Commitment in the Southern ConeEnron: Commitment in the Southern Cone

Cuiabá

0 350 700

MATO GROSSODO SUL

B R A Z I L

SANTA CRUZ

B O L I V I A

P A R A G U A Y

A R G E N T I N A

MATO GROSSO

Kilometers

BeloHorizonte

Vitória

Rio deJaneiro

Curitiba

BrasíliaGOIÁS

MINAS GERAIS

ESPÍRITOSANTO

RIO DEJANEIRO

BAHIA

PARANÁ

RIO GRANDE DO SUL

A T L A N T I C O C E A N

Porto Alegre

SANTA CATARINA

U R U G U A Y

Santa Cruzde La Sierra

P A C I F I C O C E A N

SERGIPE

ALAGOAS

PERNAMBUCO

La Paz

Asunción

MontevideoBuenos Aires

Santiago

C H I L E

P E R U

RONDÔNIA

Porto Velho

TOCANTINSCuiabá 480 MW

and 390 mi Pipeline

TransredesPipeline

3,093 Miles

TGS4,104 Miles

Gas/PowerTrading

Projects/Businesses Under Construction

Existing Assets and Operations

PARAÍBA

Emsergás0.1 MMcm/d18 Customers

Algás0.3 MMcm/d5 Customers

PBGás0.1 MMcm/d18 Customers

Compagás

CEG/Riogás LDCs3.3 MMcm/d

551,000 Customers

Elektro1.6 Million customers

10,500 GWh

Enron Southern Cone

• Participation in 15,206 km of oil and gas pipelines, representing over 75% of regional gas pipeline capacity

• Participation in 9 gas LDCs and 1 electric LDC with over 2 million customers and exclusive franchises for over 60 million people

• First IPP and first private gas pipeline in Brazil

• First gas/power trading deals in Argentina and Brazil

• Several other investments under consideration

Enron Southern Cone

• Participation in 15,206 km of oil and gas pipelines, representing over 75% of regional gas pipeline capacity

• Participation in 9 gas LDCs and 1 electric LDC with over 2 million customers and exclusive franchises for over 60 million people

• First IPP and first private gas pipeline in Brazil

• First gas/power trading deals in Argentina and Brazil

• Several other investments under consideration

Campo Grande

São Paulo

SCGás

Bahiagás1.6 MMcm/d21 Customers

Copergás0.5 MMcm/d37 Customers

SÃO PAULO

Florianópolis

Bolivia-Brazil Pipeline1,864 Miles