Privatesector P U B L I C P O L I C Y F O R T H E The World Bank June 1996 Note No. 85 Reshaping Power Markets—Lessons from Chile and Argentina R. Peter Lalor The first experiment in transforming a govern- Chile’s bold initiative and Hernán ment-owned and -operated power industry be- García gan in Chile in 1980. A 1982 law restructured Chile instituted market mechanisms to encourage the sector and defined basic regulations, and competition. First, it allowed large consumers utilities were privatized between 1986 and 1989 to purchase from any generator or distribution after financial and corporate restructuring. The company, giving suppliers an incentive to lower sector had been operating fairly well, but was costs in order to capture more of this market. reformed as part of a broader rationalization of Second, it linked the regulated price to the mar- the economy. In Argentina, by contrast, the mar- ket price, so that small consumers would share ket-based structure and privatization introduced in the efficiencies resulting from competition. in 1992 were intended to improve efficiency and Third, it used the unregulated price as a signal reliability and to attract the substantial invest- for investment, so that expansion decisions ment needed to upgrade the system. would reflect market forces. The “Southern Cone” model underlying the sys- The reforms have demonstrated the effective- tems in Chile and Argentina is now being ap- ness of having a central dispatch and clearing plied elsewhere in Latin America, including system dispatching privately owned generators Peru (starting in 1993), Bolivia (1995), and Co- and the practicality of the competitive market lombia (1995). This model divides the industry mechanics the system uses. The northern sys- into five functions—generation, dispatch, trans- tem, the SING2 (dominated by large, sophisti- mission, distribution “wires,” and distribution cated industrial purchasers), has developed supply—and deregulates the utility systems at fierce competition to supply consumers. The both the wholesale and the retail levels. The other system, the SIC, has also seen efficiency wholesale portion of the model, fully unregu- gains, price reductions, and high service quality. lated, relies on open competition in genera- tion. The model’s retail portion ensures direct As in England, however, there have been tran- access to generators for medium-size and large sitional problems in converting to a competi- users under freely negotiated contracts, and tive market structure. A major concern is the regulated prices for smaller consumers.1 predominance of one generator in the SIC. At the time of privatization, there were no restric- The reforms in Chile and Argentina, now tions on cross-ownership of assets in different roughly fourteen and four years old, show that segments; the bulk of the generating capacity large efficiencies can be realized through re- and all of the transmission capacity serving the structuring and deregulation. By any standard, SIC were acquired by one private company. A both systems have improved. There has been controlling interest in this company was later active entry by new generators, the quality of purchased by an investment group that also had supply has improved, and prices have fallen a controlling share in the largest distribution in constant terms. But experience shows that company. Thus, one investment group controls precautions must be taken to introduce and most of the system’s generating capacity, the preserve competition. largest distribution company, and the transmis- Industry and Energy Department ▪ Vice Presidency for Finance and Private Sector Development Reshaping Power Markets—Lessons from Chile and Argentina sion assets. Cross-ownership and consequent allows free entry into the generating market. Cur- conflicts of interest have hindered the develop- rent and prospective generators make their own ment of a more competitive generation market. judgments, and take their own risks, on demand growth, investment levels, fuel market trends, Argentina: The next generation the evolution of production technologies, and so on—just as producers in other commodity Argentina, privatizing much of its power sys- markets do. New generators must construct any tem more than ten years after Chile, benefited transmission facilities needed to deliver their out- greatly from observing that country’s successes put to the trunk system, and meet industry con- and problems. It adopted the basic market me- ventions for interconnection in accordance with chanics that had worked in Chile: open access a grid code. to the wholesale capacity and energy pool for generating facilities, and least-cost centralized Transactions between sellers and large custom- dispatch. But it replaced or modified the less ers are normally based on long-term contracts, successful aspects—most important, adopting and bulk power transactions between genera- mandatory separation of dispatch and transmis- tors are normally made at spot prices. In fulfill- sion from generation and distribution and es- ing long-term contractual obligations, generators tablishing an independent dispatch agency. No can use their own energy or purchase energy generator is permitted to control more than 10 from other generators at freely negotiated prices, percent of the system’s capacity, and restrictions or from the pool at spot prices. Generators re- on reintegration and cross-ownership are en- ceive two types of payment from the pool: a forced. In the generation sector, of the thirty- payment for energy dispatched and a payment three units with about 16 gigawatts (GW) of for capacity offered to the grid. They are paid capacity, twenty-six units were sold to the pri- only the market value of their output, not the vate sector and seven remained under national actual cost of generation. In other words, full or provincial ownership. 3 The resulting diver- cost recovery is not guaranteed. sity in ownership ensured a more competitive environment for generation than in Chile. A generator is paid a price for energy, when dis- patched, based on the system’s short-term mar- The Argentine privatization has been a clear ginal cost of production (for example, the variable success. Plant performance has noticeably im- operating cost of the most expensive unit in op- proved, wholesale and retail prices have de- eration). Plants are selected for dispatch by a dis- clined, and consumers have also benefited from patch center on the basis of their variable costs, reduced outages and increased reliability. as posted with the dispatch center. Because the price a plant receives is unrelated to its posted Deregulation price, there is no advantage (assuming the mar- ket is truly competitive) to be gained from “bid The following sections describe general features strategies.” Generators maximize their profits by of the model for each of the five functions. keeping costs low and posting accurately. Generation Pooling and dispatch Effective competition requires that there be Chile and Argentina have adopted somewhat enough companies generating power to prevent different pooling arrangements. In Chile, each dominance by one or a few, that capacity and of the two principal integrated systems has a energy payments at system marginal cost be coordinating committee (Centro de Despacho available to new market entrants, that genera- Económico de Carga, or CDEC) responsible for tors lack the ability to affect access to or pricing system operation (ensuring security of supply of transmission or dispatch services, and that and optimizing generation). The coordinating the retail market be at least partially open (for committee for the SIC is limited to representa- example, for large users). The model therefore tives of the largest generators. And it turns out that committee members have the ability—and the replacement values of transmission lines. Not perhaps the incentive—to “interpret” data and surprisingly, there have been disagreements—as results in favor of the generation company well as some cases of unsuccessful wheeling shareholders. The asymmetry of information in negotiations, attributed to an investor’s cross- Chile may have benefited the large generators, ownership of generation and transmission which are able to use their superior access to companies. But some large consumers have market information, and to the market itself, successfully opted for independent supply. to the detriment of smaller competitors. Transmission companies in Argentina do not To avoid such conflicts of interest, Argentina have an obligation to invest in new transmis- set up an independent dispatch entity, Compañia sion capacity. Investment in transmission may Administradora del Mercado Mayorista Eléctrico be undertaken by existing companies or by new S.A. (CAMMESA), owned in equal parts by the entrants, subject to an assessment of need by generation, transmission, and distribution sec- the regulatory authority. 4 Concession agree- tors, as well as by large consumers and the gov- ments for transmission and distribution were ernment. Because each generator has a relatively granted under fifteen-year agreements with ten- small share of total capacity, no one generator year extension periods (except for provincial can “game” the system to its own advantage—a distribution companies, which were not priva- major strength of the Argentine reform. tized). There is international competitive bid- ding for the right to take over the asset at the Transmission time of each extension, with the winner pay- ing the bid amount to the former concession- Privately owned, transmission companies must aire in the event of change. There are some provide open access to all generators, but may concerns that the system lacks the right incen- not buy or sell energy for their own account. tives to encourage optimal new investment in They deliver power from the generators to distri- transmission. The recent decision by new en- bution companies, or directly to large customers. trants to install additional generation close to consumption centers while there is available With transmission considered a natural monopoly capacity in the system suggests increasing trans- and therefore subject to government regulation, mission constraints that the current institutional transmission companies are entitled to payments arrangements are not properly addressing. from generators adequate to cover the costs that would be incurred by an efficient transmission Distribution wires and supply company of comparable size. In Chile, these costs are based on the replacement value of the assets Distribution services are separated into wires plus the operating expenses of a “model” com- and supply sectors. Like transmission facilities, pany. In Argentina, transmission charges are they are considered a natural monopoly and capped, and a transmission company that can are privately owned and regulated. Distribu- exceed the benchmark performance can retain tion companies operate under concession and all the benefits for its stockholders. have an obligation to serve. They can meet their power needs with long- or short-term con- In Chile, independent generators can sell energy tracts or spot market purchases. Under the to large consumers at negotiated prices and to principle of third-party access, supply is un- distribution companies at regulated prices. The regulated for consumers larger than a certain law establishes general guidelines for setting size,5 but the wires portion of the services is wheeling charges, but the method for calculat- regulated. Both supply and wires charges are ing both the cost and the cost sharing formula regulated for smaller consumers. for transmission assets has proved contentious. The calculation requires determining the “influ- The main difference between the Southern ence areas” for each generator, the allocation of Cone model of regulation for distribution com- the load served by it and other generators, and panies and the conventional rate-of-return Reshaping Power Markets—Lessons from Chile and Argentina model is that the first does not base estimates must strike a difficult balance between increas- of cost of service on the distribution compa- ing efficiency and maintaining employment. nies’ assets. Instead, it uses as a benchmark the facilities that an efficient company would Conclusion require to properly run the corresponding dis- tribution services. In Chile, the benchmark is The power sector reforms in Chile and Argen- based on a hypothetical “model utility.” Chile’s tina have brought real benefits to consumers large distribution sector has become more efficient, and small, though public and political pressures it has made comfortable returns since the re- may have supplemented market forces in ensur- structuring, and rates to end users have de- ing that efficiency gains were shared with con- creased (though there is a perception that more sumers. Still, the Southern Cone model shows of the efficiency gains could have been passed that several conditions are important for creating on to consumers). But competition for retail competitive and efficient energy markets: customers has been slow to develop. Because ▪ Mandatory separation of functions, and clear the largest distribution company is also the larg- delineation of the limits on cross-ownership est wholesale consumer, its importance as a and vertical integration. purchaser may have suppressed competition ▪ Limits on the size of generators to ensure for customers in its market area. competition. ▪ The unbundling of transmission charges and Some problems have been reported in the pro- the provision of fair access to transmission. cedures for regulating distribution rates in Chile. ▪ Clearly defined, published transmission prices The regulated price to small consumers has two reflecting incremental costs. elements: the energy purchases passed through ▪ Establishment of a centrally dispatched bulk by the distributor, and a distribution value-added supply market, with energy priced at the The Note series is an open forum intended to component. The value-added component is the system’s marginal cost, and a parallel bilat- encourage dissemina- problematic one. During its review every four eral market based on long-term contracts. tion of and debate on years, the regulators and the utility each pro- ▪ Access by generators and marketers to at least ideas, innovations, and best practices for pose a tariff structure, based on the infrastruc- part of the retail market. expanding the private ture necessary for a model utility to serve actual sector. The views and projected loads in an optimum manner. But This Note is an abbreviated version of an article that appeared in published are those of the authors and should the criteria for determining the appropriate in- Electricity Journal [9 (2): 63–71, March 1996]. 1 In Chile, the cutoff for users considered medium-size and large is 2 not be attributed to the frastructure are in dispute, and price setting has megawatts (MW); in Argentina, it started at 1 MW and was reduced World Bank or any of its become complex and crisis-prone. The asym- to 100 kilowatts (KW) in 1995. affiliated organizations. 2 Nor do any of the con- metry of resources between the distributors and Because of its geographical characteristics, Chile has two power systems, the Sistema Interconectado del Norte Grande (SING) and clusions represent the regulators, and the stakes, emphasize the the Sistema Interconectado Central (SIC). The SING, about 1.2 GW, official policy of the importance of continuing scrutiny of financial is predominately thermal, with less than 2 percent hydro. The SIC, World Bank or of its Executive Directors returns in “deregulated” systems. 3 about 4 GW, includes about 75 percent hydro and 25 percent thermal. Before privatization, the Argentine power sector consisted of four or the countries they national utilities, one international hydro plant, nineteen provincial represent. Distribution tariffs in Argentina are regulated utilities, and several cooperatives. Three of the federally owned utili- Comments are welcome. through a price cap mechanism and do not dis- ties were privatized. The fourth, the power generation branch of the CNEA, the national atomic energy agency, remains in state hands. Please call the FPD tinguish between wires and supply. Increases 4 The licensing arrangement for new transmission requires potential Note line to leave a in electricity costs and transmission tariffs are beneficiaries to propose new lines. The need is then evaluated by message (202-458-1111) or contact Suzanne reflected in periodic reviews, but cost reduc- the regulator, CAMMESA, and the high-voltage transmission com- pany. If they agree that there is a need, the project is opened to Smith, editor, Room tions due to productivity increases are to be competitive bidding. G8105, The World Bank, shared between the investor and the consumer. 5 See note 1. 1818 H Street, NW, Washington, D.C. 20433, The distribution utilities have found it difficult or Internet address to improve efficiency. Electricity theft has re- R. Peter Lalor, President, Commonwealth ssmith7@worldbank.org. mained high, and it has proved difficult to col- Power Corporation, and Hernán García, 9 Printed on recycled lect overdue payments. Provincial distribution Principal Power Engineer, Industry and Energy paper. companies, which are still not privatized, also Department (email: hgarcia@worldbank.org)