The Electricity Reforms in Chile - Essay Example

The Electri Reforms in Chile Introduction Among all countries in the world, Chile has the most complete and longest running electri restructuring program in the world. Reforms were initially introduced in 1978 when the National Energy Commission was set up. The 1982 Electricity Act is up to now the most vital law regulating the present organization of the sector. Privatization on a massive scale started in 1986. Electricity reforms program in Chile has been recognized as a very productive instance of electricity reforms among all developing countries in the world and an example that other countries can take a cue from1. During the late 1970s and early 1980s most of the earlier nationalized firms were being given back to their earlier owners and massive government companies, for instance electricity firms were enticed to trade on a commercial basis. Government firms were breaking even and by the late 70s and early 80s there were indications that electricity firms specially showed improving rates of return on capital. The macro economy and most of the major economic indicators started to indicate substantial improvement. Inflation dropped and GDP started to grow at a considerable pace especially after 1985. This healthy economic trend grew further during the late 1980s and accelerated further to 6.2 p.a. during the early 1990s. The electricity reforms in Chile follow most of the features found in the electricity systems of developed nations. Since Chile has a small population (15.5m in 2002), thus the capability to take advantage of economies of scale, if at all is moderate2. Even though Chile's electricity consumption per person is low when compared to developed countries, it is increasing fast at (6% per annum). The electricity making system has a big installed hydro capacity base, however as demand rises fossil fuels have become more vital. Most probably there is a difference between Chile and other developing countries as the strength due to the fact that it was administered by military rule for a long time. 2. Analysis i. Reform in electricity - History The Electricity Act enacted in 1982 is up to now the most vital legislation in the sector. In January 2004 there were some significant changes to the regulations governing the sector after the passage of Lay Corta. The electricity sector inChilebasically depends on thermal and hydro power generation. Shortage of natural gas led the government to increase the supply by building a first liquefied gas terminal with more capacity of generation. The new project started in the year 2007. Re-gasification plant terminal near the capital city ofSantiagois intended to increase and stabilize power supply for its existing and projected gas-fired thermal plants. There was a consideration to further expand the constructions in various new hydropower and coal-fired thermal plants. Chile's electricity sector reform was very efficiently implemented by the authorities and because of the success of the reforms many other governments followed the same to improve power generation in their respective countries3. Figure 4: Chile's Natural Gas Total Consumption (2003) - Total Annual Demand 8.73 BCM Source: www.lyd.com/english/noticias/restructuring.ppt -Chile4 Adaptation of many initiatives like vertical and horizontal unbundling ofpower generation, regular transmissionanddistributionand large scale privatization brought billions of institutional investment to the electricity sector due to electricity shortage of the country5. The 1982 Electricity Act was amended three times in 1999, 2004 and 2005 respectively in Chile's parliament. Even though during the 1980s there weren't many markets from which Chileans could draw inspiration, the officials visited UK, France and Belgium. From the knowledge gained from these countries they came up with the idea of separate generation and distribution firms where payment was done in accordance with a formula based on cost. This apart they also came up with a dispatch system which is based on marginal cost pricing as completed by the French Company and a trading power system among the generators in order to fulfill customer contracts as existed in Belgium. Thus these adaptations increasingly supported in both the vertical integration of the electricity sector and trading mechanism of wholesale power. In fact vertical disintegration and power markets can be identified as the modern outcomes of the electricity reforms. Following the break-up of the serving integrated firms a large amount of regional power markets dependant on the notion of Independent System Operator (the CDEC) was set up in 1986. There are two major regional power markets: the SIC, encompassing such regions as Santiago and the SING, encompassing the northern region of the nation6. Among these markets generators were needed to declare availability of plants at affordable marginal operating cost each hour. These standards were utilized to set up power plants and to set the spot price7. This price has to be adopted by power generators to trade electricity between themselves to meet contractual obligations. The spot price is influenced to a greater extent by the opportunity cost of water in the SIC system and at all times it is equal to this price. The cost for water is calculated using a computer model (OMSIC) for the major Laja reservoir. Under normal circumstances the opportunity cost is the same as the operating cost of the most costly thermal plant in operation. When there is less water the spot price is equal to the outage cost. The outage cost is the same as an amount dependant on consumer consent to recognize compensation for an anticipated outage of a particular size. For fewer than 10% demand restriction it is about 4-5 times the normal spot price. Figure 2: Energy sources in Chile Energy Source SIC - Central Electricity Grid (MW) % of total SIC SING-Northern Electricity Grid (MW) % of total SING Total Installed power (MW) Renewable 312.7 3.43 12.8 0.36 325.5 Run of river hydro over 20MW 1377.3 15.1 0 0 1377.3 Dam 3393.4 37.22 0 0 3393.4 Coal 837.7 9.19 1205.6 33.47 2043.3 Oil/Diesel 75 0.82 271.8 7.55 346.8 Dual (Diesel gas/gas IFO180) 582.9 6.39 0 0 582.9 Natural gas 2539.3 27.85 2111.7 58.62 4651 Total Installed power 9118.3 100 3601.9 100 12720.2 Source: http://www.renewableenergyfocus.com/view/1802/renewable-energy-rising-in-chile/8 Starting from 1982 up until early 2004 the installed capacity in the major SIC system increased from 2713 MW to 6991 MW (4.15 p.a). In the mean time the installed capacity in the SING system increased from 428MW to 3634MW (10.2% p.a.). The reserve margin at the climax in 2003 was 26% in the SIC and 59 % in the SING. The mostly thermal SING system struggles form over load, while the SIC system which is mostly hydro based has been rationed in dry areas. Under the ownership of private firms they managed to expand the amount of electricity generated while maintaining low prices. Simultaneously the number of units delivered has risen by 6.2% p.a to approximately 42800 GWh in 2003. Endesa's household speculation between 1991 and 2000 totaled $2.3bn. The Chile government has expanded the transmission lines to 8555km in 2002. This was intended to provide maximum electricity supply to its existing customers and also to meet the growing demand of the supply. There were 4.177m electricity customers in 2001. There was a rise of 4.4% p.a. between 1999 and 2002. Electricity supply rose from 38% to 86% in rural areas between 1982 and 2002 and in urban areas the supply rose from 95% to 98% during the same time period. The investment that has occurred since 1982 is highly encouraging. When compared to most other countries, the cost of electricity in Chile is lower. In 2002 the cost for domestic consumption was around 8.25 US cents per kWh while in the case of industries it was around 5.51 US cents per KWh. In 2000 the costs of domestic electricity were about average for Latin America while it was among the lowest quartile of prices for industrial costs. These prices indicate the availability of more hydro-electric generation in some nations at a lower cost such as Venezuela and Paraguay. From 1992 to 2002 average electricity prices have dropped by about 30% in real terms indicating better performance to prices for water, gas and telecommunication9. This drop indicates falls in the regulated value added in distribution and a sharp drop in the changed node cost of energy (see appendix - Figure 1). The fact that electricity is cheap and high rates of investment in this area have gone together with good financial performance by the firms involved (see appendix - Figure 2). Financial performance which was fairly good prior to privatization saw a significant improvement afterwards10. Chilectra averaged a mere return on equity of32% p.a. during 1996-98, while Endesa's return on equity hit 15.7 % in 1994. The average real rate of return on capital of the replacement cost in the distribution center was 13.9% in the year 2002 and this is regarded as the highest range of rates of return which is permitted by the law, i.e. of 5-15%. In producing and transmission returns were high earlier after privatization. However since natural gas was brought from Argentina in 1997, which gave rise to many new gas fired plants, returns have not been so good. In the year 2003, historic cost rate of return on equity identified as 14.8% for Colbun while 6.6% for AES-Gener and 5.0% for Endesa. These were quite good returns given the high sunk costs which both Endesa and Colbun posses in hydro electric investments and the normally poor performance of investments outside Chile11. Figure 5: Chilean Energy Matrix (before NG shortage) 1998 2003 2008 Petroleum 40% 36% 39% Natural Gas 11% 24% 33% Coal 16% 8% 41% Hilo power 17% 18% 14% Others 16% 13% 10% Source: www.lyd.com/english/noticias/restructuring.ppt -Chile12 Another significant factor in Chile has been the access to electricity for rural customers. Even though urbanization in Chile is high, 62% of rural homes (about 269,841 homes) were not having electricity in 1982. By 2002 this figure had dropped to 14%. After the setting up of the national programme for rural electrification (REP), overlooked by the National Fund for Regional Development, a lot of inroads have been made in terms of providing electricity to the rural communities. Under this scheme there is a three part funding of capital costs to providing electricity to rural homes whereby 10% of the cost is borne by the users, companies bear 20% and the state bears the remaining 70%. Running costs have to be borne by the users however. There has been a marked rise in the quality of electricity supply in Chile since 1982. Technical and non-technical losses dropped significantly. Thus the technical energy losses of throughout the Chile reduced from 10.2% in 1982 to 6.2% in 2002. For instance it reduced it's both the technical and nontechnical energy from 19.8% in 1987 to 5.6% in 2003 of the main distribution centre of Chilectra, in Santiago. This indicates a marked improvement in the metering and collection of bills so as to lessen non-technical losses such as theft. It also indicates that making illegal connections to the national grid has become increasingly harder. Since privatization power failures arising as a result of transmission problems have reduced considerably13. In the Transelec transmission system there is a drop in the time of transmission failure from 9.60 minutes in 1997 to 2.10 in 2003. Argentina has had a similar program of reforms14. However though Argentina succeeded to a greater extent the country was not able to adopt an appropriate energy policy due to the fact that in 2002 the country's debt repayment obligations to the IMF (International Monetary Fund) and the World Bank triggered off one of the worst financial crises in the region15. ii. Reforms in the Chilean Electricity Sector The following can be identified as a list of reforms implemented by Chile16, a) Generators are well equipped in electricity markets to establish direct contacts with customers. Assuming that such markets develop non monopoly characteristics leading to perfectly competitive environments there is a possibility that transmission and distribution units would function with a greater degree of efficiency thus leading to less concentration in price determination process17. b) Transmission systems require suitable regulation of present to make sure fair process as well as a sufficient rate on investment. An establishment is required that overlooks system wide planning to make sure new transmission links are built at the right time. c) Distribution firms ought to be well regulated with in conformance with well defined efficiency targets as in the case of water and electricity in the UK. This kind of would enable efficiency related gains to be made available to the final customer. d) It is better to practice economic regulation of the electricity segment by a single independent regulatory agency with the least ministerial control. Any institutional duties to make sure sufficient planning of the future developments in this segment can be entrusted to this body. Output based regulation utilizing suitable quasi-market mechanisms could tackle issues such as quality of supply and network extension as these are areas most likely to be influenced by politics. e) Random government policy changes should not be allowed to affect the general background in which the electricity sector is placed. The electricity sector should be stable and promote long term investment. Rules and regulations regarding the electricity sector should be realistic and sustainable. The Chilean electricity system indicates that there is a possibility of competition and privatization in a comparatively small power market with substantial hydro generation18. Even though the SIC and SING markets were small at the beginning Chile's electricity market has been able to deliver low prices and reasonable returns on investment for investors. This has been due to the flexible environment that the chile government adopt to allow more private investments to electricity sector with a view of redusing the shortage of power supply in the country 19. Owing to free entry their market share of capacity has dropped from 79.7% in 1993 to 59.1% in 2003, while the share of Endesa (the largest company) has dropped from 47.7% to 27.6%. This is partly because of the lack of restrictions on new building and linear transmission system has ensured that upgrading the transmissions links is easier. iii. General institutional environment favorable to reform electricity sector When the governments are engaging to reform the electricity sector it should be carefully organized because electricity sector has a huge bearing on the economic developments thus it regarding as a necessary infrastructure of the economy20. Institutional environment has a greater impact on the reformation and it consists of laws and regulations, procedures and conventions, customs, socio economic activities and behaviors of the economy. There should be a sound political environment and a stable government to undertake such electricity reforms. Because there are legal procedures to follow in undertaking such reforms such as an amendment should be passed and should get the approval from the parliament to carry out the operations. So in order to carry out operations it is necessary to have a sound political environment for the success of the reform program. Or many disturbances from political parties can be expected. And the other factor is the economic stability and the liberal economic policies regarding the reforms, such as encouragement to the private sector to involve in investments in electricity sector21. However public ownership of the electricity sector would create problems in the electricity system. When considering Chile it has fully privatized its electricity system due to the serious problems created by the public ownership. However privatization also created more problems to the Chile, for example privatization of Colburn which is identified as a third largest generator couldn't complete until 1997. The CNE (National Energy Commission) and SEC (Superintend of Prices of Electricity and Fuels) impressed as of two regulatory bodies in Chile. It confuses the responsibilities of each bodies and it would lead to an inefficiency, enforcement and transparency among the CNE and SEC. Therefore CNE should act as independent regulatory body which is free from the ministerial control. Thus the Chilean law of the electricity sector can be identified as an inflexible by its detailed specifications of the regulations. This creates two problems to the electricity sector such as difficulty in changing legislation with the market evolution and detailed specifications. For instance in 1982 specification of such rules has limited the technical progress in a competitive market. Recommendations The electricity reforms in Chile in 1982 were based on the primary need to increase all three aspects of supply, viz. the generation, transmission and distribution with, total emphasis on comparative cost efficiency. However even by the year 2000 these aims were not realized. Therefore the country should focus on not so much privatization of one aspect or the other of the three mentioned above but pure restructuring of the entire Chilean energy sector. Restructuring of Chilean electricity industry must be carried out with emphasis on cost efficiency directly related to generation and distribution because generation costs might rise much faster in the region due to the fact that fixed costs have been rising as much as the variable cost. The same can be said about the marginal cost factor associated with distribution. It is the distribution bottlenecks that have hampered Chilean electricity supply much more than any other variable and therefore Chilean government must focus its attention on alternative and cheap sources of energy including solar power and nuclear power though the latter choice might not be practical due to safety and security issues. The government of Chile must encourage private sector participation in research and development rather than opening the whole energy sector to private enterprise which at any rate is unlikely to commit itself to development programs that are much less likely to produce positive returns in the short run. In this respect labor cost play a very significant role. Finally the Chilean government must have an independent regulator for the electricity industry solely because electricity supply can be hindered by the kind of irregularities that exist currently in the industry. The most obvious irregularity is associated with the haphazard privatization. Findings Electricity consumption in Chile increased on average by 6.7% per year between 1985 to 1997 with the growth of 6.7% GDP and from 1997 to 2002 electricity consumption increased by 3.3% per year with the growth of 2.4% of GDP. In the year 2005, electricity demand growth is identified as 5.3% and also GDP growth is 6%. Due to the introducing of natural gas power plants in Chile, it has been reduced its electricity rates by 35% at SIC and reduced by 45% at SING. Investments in power generation is considered to be less attractive due to the following reasons - delaying of approving new projects due to the environmental studies; and not increasing the node prices in a necessary amount. However all electricity reforms implemented in Chile have been successful during the period of three decades under review. Conclusion Chile has the most comprehensive and longest sustaining electricity reforms program in the developing world. A healthy economic trend has been seen in Chile beginning from the mid 1980s continuing up to the early 1990s. The electricity reforms in Chile have drawn inspiration from the electricity systems of most developed nations. The Electricity Act passed in 1982 is presently the most important legislation in the sector. After the passage of Lay Corta there were some marked developments in the rules governing the electricity sector after January 2004. There are two main regional power markets in Chile. They are SIC- covering such areas as Santiago and the SING covering the northern part of the country. Beginning from 1982 leading up to early 2004 the installed capacity in the major SIC system increased from 2713 MW to 6991 MW (4.15 p.a). At the same time the installed capacity in the SING system rose from 428MW to 3634MW (10.2% p.a.). The cost of electricity in Chile is low when compared to most other countries. Electricity is cheap and high rates of investment in this sector have accompanied good financial performance by the companies involved. Financial performance which was reasonably good before privatization saw a marked improvement afterwards. More and more rural communities have been able to gain access to electricity in the recent past. Since 1982 there has been a significant leap forward in the quality of electricity produced. REFERENCES 1. Antonio, E & Martin, R. & Christian A. 'The case for international coordination of electricity regulation: evidence from the measurement of efficiency in South America', Journal of Regulatory Economics. Vol. 25, issue. 3, 2004. pp. 271-295. 2. Arellano, M.S., Diagnosing and Mitigating Market Power in Chile's Electricity Industry. CMI Electricity Project Working Paper, No.27. , 2003, (accessed 18 May 2010). 3. Bernstein, S. & Agurto, R. 'Use of Outage Cost for Electricity Pricing in Chile', Utilities Policy, Vol. 2, issue. 4, 1992. pp. 299-302. 4. 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