Market-oriented reforms in power sectors in Latin American countries: learning by doing

Market-oriented reforms in power sectors in Latin American countries: learning by doing Nepal, November 2018

Outline ► Background: attracting capital to infrastructure sectors in emerging countries ► Phases in reforms ► Common elements inreforms ► Lessonslearned

Outline ► Background: attractingcapital to infrastructure sectors in emerging countries ► Phases in reforms ► Common elements inreforms ► Lessonslearned

Attracting capital to infrastructure sectors in emerging countries • ► Economic growth rates are in general high, butvolatile. • Electricity demand also grows strongly, but with significantvolatility. • ► Macroeconomic conditions are not fullystable: • Volatile currency exchange rates, inflation, fiscalsituation. • Contribute to increase risk perceived by foreign investors, needto • manage risks to attractcapital • ► High demand for capital in all infrastructuresectors Source: ECLAC Investment in infrastructure (left) and infrastructure investments per sector (right) for Latin America, in % of GDP

Attracting capital to the powersector in countries in Latin America ► Strong reliance on hydropower in many countries - Low cost of supply during long periods (+) - Inherent price volatility contributes to high-risk perception (-) ► Challenge: maintaining a sufficiently high flow of investment to the capital intensive energy sector at a reasonable cost of capital to achieve sustainable development: secure affordable universal access to electricity service Countries in the region have adopted different models over time, including market-oriented reforms in the last 20-25 years, and learned substantial lessons from their application

Outline ► Background: attracting capital to infrastructure sectors in emerging countries ► Phases inreforms ► Common elements inreforms ► Lessonslearned

Phases in power sector reform in LatinAmerica First wave of power sectorReforms Problems Second wave (and initial ideologicalsplit) Failed South American gas market integration due to poor exploitation and pricing policies Energy Rationings in Argentina and Chile (Gas & Electricity), Brazil (Electricity) Motivation: pragmatic (Brazil, Peru) or pragmatic with ideological component (CH, AR, CO). Brazil, Chile, Colombia and Peru retained the market scheme and improved rules to ensure the entrance of new capacity: • Capacity adequacy requirements: emphasis in the forward market • Use of contract auctions for new capacity (“competition for the market”) • Institutional reorganization Successful privatization and strong private investments (self-dealing) Active gas industries in Argentina, Bolivia, Peru Energy Crisis in Argentina Poor pricing policies on electricity and gas & govt intervention led to deficient supply, electricity and gas exports suspended Wholesale competition implemented in most countries, regulated capacity payments to assure supply adequacy (Brazil: obligation of loads to be 85% covered in contracts with physical coverage) ... ‘92 ’94 ‘96 1990 ‘82 2016 Reform in Brazil 1980 2000 2004 Argentina interfered in the energy market and it went currently under strict governmental control • Subsidized tariffs jeopardize the whole market functioning • Market is driven by governmental initiatives Argentina: drive towards change with new gov. Chile: law strengthens planning; successful auction. Disruption of energy exchanges: ArgentinaChile (Gas) Argentina Brazil (Electricity) Argentina Uruguay (Electricity) Reform in Argentina and Peru Reform in Chile Despite huge reserves, Brazil, Argentina became gas importers; Chile was severely hit Reform in Colombia

Phases in power sector reform in LatinAmerica () Argentina Brazil Chile Colombia Peru 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 Vertically-integrated monopoly under cost-of-service First wave: liberalization and marginalism Second wave: strenghening planning and competition for the market 19781980

Outline ► Background: attracting capital to infrastructure sectors in emerging countries ► Phases in reforms ► Common elements inreforms ►Lessonslearned

Common elements: anoverview (1/2) 1st Wave: liberalization &marginalism Design • Textbookelements • Institutionalreorganization • Restructuring (vertical and horizontal unbundling) • Liberalization • Additional elements • Privatization • Capacity markets/payments (in somecountries) Outcomes (in mostcountries) • Generation adequacy • Sluggish investments (especially in capital-intensivetechnologies) • Crises: affected affordability and security ofsupply • Other • Strengthened performance of distributioncompanies • Electrification: targetedinitiatives

Common elements: anoverview (1/2) 2nd Wave: adding planning and auctions for long-termcontracts Design • Auctions as means of awarding long-termcontracts • Competition for the market • Long-term contracts easing financing for capital-intensiveassets • Contestability of centralizedplanning • Planning • Indicative plans, often associated with guidance inprocurement • Backstop mechanisms to ensure security/affordability ofsupply Outcomes • Generation adequacy • Change in investment profile, investments in capital-intensiveassets • Support to roll-out of (non-conventional) renewabletechnologies • Recent crises in some countries (e.g., Brazil,Colombia): • Tied to regulatory instability, poor enforcement and/or needsof • specific regulatory improvements 2nd part ofworkshop

Outline ► Background: attracting capital to infrastructure sectors in emerging countries ► Phases in reforms ► Common elements inreforms ►Lessonslearned 12

Overview of mainlessons 117

Paving the way forreforms (1/2) ► Legal framework established at onset of reform prevented governmental institutions from awarding concession contracts via acceptance of unsolicited bids competitive tender required: • Mechanism targeted initially at setting context for privatizations, but played important role for introduction of auctions later: • E.g., project-specific auctions to award generation concessions associated with long-term contracts, transmission concessions, etc. • Mechanism does not preclude market entry of merchant projects: these require only an authorization (or similar), rather than concession. • Examples: • Brazil: Laws #8,987 (“Concessions Law”). • Peru: system of public tenders for privatization. 14

Paving the way forreforms (1/2) ► Restoration of financial capabilities of distribution companies is an important step for strengthening confidence of gen. investors (creditworthiness): • Efforts to make tariffs cost-reflective were made in all countries. • Direct capital injections by treasury were an important element in some. • Commonly, restoration of financial capabilities is also instrument to restore value of assets before privatization value generation leveraged by confidence. • And initiating the process of privatization via distribution companies was part of the strategy in many countries. • Examples: • Brazil: efforts towards cost-reflectiveness with Law #8631/1993, privatization started with distribution utilities. • Chile: efforts involving cost-reflectiveness of tariffs and divestitures (“dispensable assets”) initiated in 1974. • Turkey: privatization efforts started with distribution utilities. 15

First reform:need for clear institutionalattributions ► In some Latin American countries, the first reform already sought to include a component of oversight of security of supply and/or planning, but to little effect: • Enforcement of this attribution was limited due to lack of technical capabilities or unclear allocation of responsibilities. • Example: In Brazil, National Council for Energy Policy had attribution of overseeing security of supply, but the cabinet-level body did not have technical means to fulfill this requisite. • Or there were no mechanisms to ensure that (indicative) generation expansion planning effectively resulted in guidance to the market. • Example: In Colombia, UPME was established as a planning body before the first reform and was maintained after it. But the issuing of indicative generation expansion plans (facilitating access to information) or the backstop mechanism to contract new generation (yearly supply/ demand balance) were only established as part of second reform. 16

First reform:liberalization andmarginalism (1/2) ► In some countries, the marginalist approach based on signals sent from spot market prices did not suffice to attract investments and ensure security of supply: • Even where there was an obligation to cover demand via long-term contracts, the prevailing contract terms (durations, lead times) resulting from free negotiation in the market were not fit to support investments in new generation. • Problems verified even in countries that implemented regulated capacity payments. • Examples: • Brazil: obligation to cover 85% (later 90%) of demand via contracts, no capacity payments. Rationing in 2001. • Peru: obligation to cover 100% of demand via contracts; administratively- set capacity payments (with settlement markets). Sluggish investments after 2001 and deterioration of reserve margins. • Chile: obligation to cover 100% of demand via contracts; administratively- set capacity payments (with settlement markets). Rationing in 1998-1999. • Turkey may be seen as a counter-example. • Yet, demand slowdown/retraction in 2008/2009 was key in dissipating concerns about security of supply, and context of reform included very specific items. 17

First reform:liberalization andmarginalism (2/2) ► Incentivizing efficient contracting behavior of distcos via administratively- set price caps proved hard, highlighting need for other solution. • Examples: • Peru: • ‘Busbar tariff’ was determined by governmental institutions by means of simulation and functioned as basis for determining pass-through to tariffs of regulated distribution consumers. This aimed at providing incentives for efficient contracting by distcos. • But simulations failed to capture market dynamics and did not function as inefficient benchmark for contract prices, constraining investments in generation. • Chile: analogous situation with ‘Node Prices’. • Solution to problem would later involve auctions as a transparent mechanism of price discovery. 18

First reform:profile of investments immediately afterreform ► Immediately after first reform, some countries saw a concentration of investments in opex-intensive thermal technologies: • Hesitance to commit to capital-intensive technologies with large payback times is an expected response from investors to an incipient market. • These capacity additions played an important role in these countries, and some facilities were later subject to conversions to more efficient fuels (natural gas) and configurations (closed-cycle gas turbines) when the conditions regarding fuel availability and investment context evolved. • Examples: • Argentina ,Chile • (Also,Colombia andPeru . to someextent). 19

Second reform:planningand guidance to market-basedexpansion ► A strengthening of the functions of planning and oversight of security of supply was a common element in the second wave of reforms in Latin America: • This included a clearer definition of institutional attributions, though not all countries created a agency dedicated exclusively to planning. • Planning offers guidance to market-based generation expansion, which can be done by: • Periodic issuing of indicative plans to facilitate access to information and reduce information asymmetries (e.g., Brazil and Colombia). • Generating relevant information for the application of backstop mechanisms to ensure security of supply (e.g., Brazil, Peru, Colombia). • Aiding policymakers in their role of defining rules and attributes of auctions that relate to guidance to market-based expansion (e.g., Brazil, Peru, Colombia and, more recently, Chile). • Decentralized declaration of demand by distribution companies in auctions is also part of planning process. † Including CNE andMoE. ‡ Including MINEM andOsinergmin. 124

Second reform: creating demand for long-term contracts ► The creation of mechanisms to ensure the demand for long-term contracts with conditions adapted to needs of new projects was a common element of reforms: • Contracts adapted to needs of new projects not only due to duration (long durations easing financing), but also lead times (to allow implementation). • This was invariably associated to the use of auctions as means of contracting capacity/energy (or reliability options, in the case of Colombia), mainly for distcos. • Generators must back up their commitments in auctions with firm energy/capacity. • In Chile, only identification of underlying physical facilities since 2013. • Examples: • Brazil: centralized auctions to contract new energy by distcos, with contract duration and lead times defined by government. • Peru and Chile: decentralized auctions to contract firm capacity and associated energy by distcos, auction design by distcos but rules on lead times (and contract duration for Peru) • Colombia: centralized auctions to contract reliability options, specific rules on contract duration and lead times fit to new projects. 21

Second reform:competitivetenders to award long-termcontracts (1/2) ► Auctions used in Latin American countries as means of selecting agents to which long-term contracts are awarded: • Auctions represent efficient & transparent means of awarding contracts: • Efficiency affordability ensured by competition. • Transparent mechanism of price discovery. • These are attractive features to all countries – particularly these seeking solutions to problems in determining administratively-set capacity prices (in Colombia) and price caps for pass-through of energy contracting to consumers (in Peru, Chile). • Auctions make it easier to operationalize guidance to market-base expansion: • Policymakers can determine parameters such as reservation prices, type of auctioned contracts (tailored to certain technologies), eligible technologies. • Still, the competition process allows the contestability of central plans: • Policymakers can interpret signals sent by the market, such as closing prices, void auctions, etc. 22

Second reform:competitivetenders to award long-termcontracts (2/2) ► Examples: • Brazil: centralized auctions held by EPE, various guidance mechanisms used. • Peru: auctions held by Discos under oversight of regulator, or by central government via Proinversión, guidance used. • Chile: auctions held by Discos under oversight of regulator, guidance has been gaining a more important role (for instance, contracts tailored to renewable energy generators). • Colombia: centralized auctions, little guidance embedded in auction design. 23

Country case: Brazil ►

Motivation & period preceding firstreform 1930’s Brazilian State starts participating in generation segment. 1960’s 1962: Eletrobras, federal company, vested with responsibility of promoting and enabling G+T+D expansion and ops. 1970’s 1973: Oil crisis triggers increasing inflation and interest rates. 1980’s Low tariffs and increasing debts lead to financial distress of utilities. 1934: Water Code and National Council for Water and Electricity created. Federal government takes responsibility for G+T. Distribution activity slowly incorporated by State governments. Tariff equalization & tariffs below cost- reflective levels: disincentives to operational efficiency Investments in nearly all segments come to a halt. Centralization of financial resources and decision processes in Eletrobras seen as positive. Massive investment in hydropower to reduce oil dependence. Governments using electricity as instrument to manage inflation. Predominance of public (federal and state) companies.

First reform: sequence of mainevents 1996-1998 Institutional organization and attributions: regulator (1996), ISO and market operator (1998) 1998 Wholesale competition and contracts 1993 Restoration of financial capabilities 1995 IPP, deregulated consumer, partial restructuring, open access 1995-1998 Privatization (partial, focus ondistribution)

First Reform:legal fundaments before ElectricityLaw ► Important legal fundaments established before 1995: • 1993: Law #8,631: • Restoration of creditworthiness of off-takers • 1995: Laws #8,987 (“Concessions Law”): • Laid legal basis for concession contracts. • Established that competitive processes (tenders and auctions) are mandatory to award new concessions. • Created solid framework for concessions in all infrastructure sectors (enforceability of contracts, mechanisms for resolution of disputes, etc.).

First reform: restoration of financial capabilities and creditworthiness of off-takers ► 1993: Law #8,631: • Removes national uniform electricity tariff to eliminate cross-subsidies between companies, step towards cost-reflective tariffs. • Established obligation of supply contracts between generators and distribution companies (Discos). • Treasury assumed USD 26 billion of utilities’ debt

First reform:restructuring ► Vertical unbundling: • Separation of G&T and D&C, provisions for creation of traders. • G&T allowed to remain bundled, but open access introduced (for T and D). • D and commercialization for regulated consumers as a bundled activity. • Competition in G and commercialization. • However, self-dealing between G and D allowed up to 30%. • Regulated monopolies in T&D (with auctions for T). ► Horizontal unbundling: • Facilitated by existence of several subsidiaries of Eletrobras (federal level) and several state-level companies • Vesting contracts introduced to limit market power (theoretically only 5 years).

First reform:privatization • ► Distribution: • First segment to be privatized. • Important step towards creditworthiness ofoff-takers. • Very successfulprocess: • Paid prices 50% above the floor established bygovernment. • USD 19 billion in revenues forgovernment. • ► Generation: • Only ~30% of generation assetsprivatized. • Political opposition interruptedprocess. • ► Transmission: • Similarly, low privatization rate (~10% at that time) andinterruption.

Improvements of operational and financial performance of distcos (1/2) DEC - Durationof interruptions[hours] FEC - Frequency of interruptions [1/y]

Improvements of operational and financial performance of distcos (2/2) ► CPFL, privatized in1997 EBIT[BRL] Net revenues [BRL] EBIT margin [BRL]

First reform: institutionalorganization ► Ministry of Mines and Energy retained policy-making attributions ► Creation of regulator: ANEEL • Incentive-based regulation for distribution established. ► Creation of independent system operator (ISO): ONS (not a TSO) • Open access to electricity grid managed by ONS ► Establishment of wholesale market (MAE later CCEE) ► The National Council of Energy Policy (CNPE) had formal competence to carry out indicative planning: • In practice, it didn’t do so (cabinet-level board, limited technical staff) • Lack of formal instruments to guide market-based system expansion

First reform: competition and capitalattraction ► Spot prices and contracts freely negotiated in the market as sole signals to attract investments in generation capacity additions: • Main assumption: signals from spot prices would suffice to attract investments in new capacity. • Lack of support by long-term contracts: • Discos were free to negotiate supply contracts. • Obligation to be 85% contracted, but terms (duration and lead times) often not conductive to new investments. • But self-dealing allowed up to 30%, as already seen. • Hesitation to invest: • In thermal capacity: price/dispatch volatility in hydro-dominated system. • In hydro capacity: limited support to capital-intensive technologies.

First reform: sluggish investments &crisis (1/3) • ► There was increased efficiency in implementation ofgeneration: • Construction costs reduced by 30% for the more than 10 GWlicensed. • Construction times reduced from 6-8 years to 4years. ► But the pace of investments lagged behind Brazilian needs: High thermal capacity increment due to emergency Priority Plan for Thermal Plants (already pre- rationing emergency measure) Low investment levels

First reform: sluggish investments &crisis (2/3) ► Rationing:June/2001-February/2002: • Reduction of 20% of all electricity consumption for ninemonths • Rationing affected 80% of thepopulation • Direct economic losses: US$ 15billion • Decrease in GDP growth for threeyears

First reform: sluggish investments &crisis (3/3) ► Results of formal assessment by Investigation Committee • Rationing was not caused by the privatization or creation of wholesale market, but by failure to foresee institutional problems: • Unclear allocation of responsibilities to address security of supply. • Market design had flaws that would make the power system vulnerable to rationings in the future: • Basically, economic signals from spot markets alone would not ensure installation of new generation capacity

Outline • ► Background: capital attraction to infrastructure (LatinAmerica) • ► Chronology ofreforms • ► Common elements inreforms • ► Experience of countries:Brazil • Firstreform • Secondreform • ► Lessonslearned

Second reform: back to drawingboard ► “New model” introduced in 2004. ► Clear allocation of responsibilities for planning: • Creation of Energy Planning Company (EPE) • Clarification of roles of other entities (CMSE, CNPE) • Implementation of auction scheme with mechanisms for government guidance of market-based generation system expansion ► Attracting investments in new generation capacity: • Consolidation of demand for long-term financial supply contracts (mandatory coverage of demand) • Auctions for new long-term contracts as main means of attracting new generation capacity

Second reform: planning andguidance ► Institutional responsibilities: • CNPE: Guidelines for Energy Policy • EPE: Planning agency (technical body subordinated to MME) • CMSE: Monitoring security of supply ► Planning process (regarding generation expansion): • Periodic (annual) indicative planning: • Access to information, helps creating reasonable expectations • Planning bodies provides support to MME in: • Offering guidance to market-based expansion via auctions (MME defines eligible technologies, price caps, etc.). • Directly controlling security of supply via Reserve Energy auctions. • Besides, decentralized demand forecasts by distribution companies that substantiate their declaration of demand in auctions can be seen as part of planning.

Second reform: competition & capacityadequacy ► Security of supply: • Obligation of coverage of 100% of consumption via long-term contracts: creates demand for contracts to ease generation financing • Auctions: provide a sound and solid framework for awarding of contracts competitively, whose results are unlikely to be challenged. ► Affordability of supply: • Auctions also have the role of selecting the most efficient project developers for system expansion via competition, thus contributing to affordability of electricity supply.

Second reform:results 1970’s: • Import substitution • Availability of capital • Development policies 1980’s: • Hydro development slows (debt crisis), but doesn’t stop 1995 -2004: • Under 1st reform, hydro development continues, but total generation lags demand growth Installed capacity[GW] 2004 and beyond: - Hydro development continues, but growth of other technologies gain momentum Emergency measures (rationing) Source:EPE

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Market-oriented reforms in power sectors in Latin American countries: learning by doing