I',"', Viewpoint The World Bank Group February 1997 Note No. 106 The Real Possibility of Competitive Generation Markets in Hydro Systems- The Case of Brazil Antonio Estache Brazil's electricity sector, one of the largest in tive generation. The proposed unbundling of andMartin the world, is made up of more than sixty-five, the sector parallels the reform model in Argen- Rodriguez- mostly vertically integrated, federally and state- tina, Chile, Colombia, and the United Kingdom. Pardina owned monopolies. The most pressing prob- But while these countries have thermal-based lems in the sector are excessive operational systems, Brazil's electricity sector is largely hy- costs-estimated to be 20 to 30 percent too dro-based, requiring a different set of rules to high on average-and large investment needs make competition work in the wholesale gen- in the face of rapidly growing demand and very eration market. There are two main issues. First, limited public finance. Both of these problems to ensure open entry and the long-term viabil- can be addressed through more competition ity of competition in the electricity sector, the and more private participation in the sector. government must figure out how to competi- Competition would lower costs and thus re- tively allocate water rights. Second, to provide duce the need for politically costly tariff in- incentives for investing in generating capacity, creases to finance investment needs. And a pricing system must be put in place that will opening the sector to private participation and ensure recovery of the high sunk capital costs ensuring competition under transparent, equi- characteristic of hydro systems. table operating and pricing rules should gen- erate the resources to meet investment needs. This Note describes one consistent approach, using incentive-based organization and regula- While the shape of reform in the sector has yet tion, for overcoming the technical challenges to to be finalized, there is a consensus among fed- effective competition in the generation market. eral and state policymakers and key operators that the sector's potentially competitive segments Open entry -generation and supply-should be separated from its natural monopoly segments-transmis- The most pressing requirement for ensuring sion and distribution-and awarded as conces- the long-run viability of competition in hydro sions or sold to private investors. There is also generation is to figure out how to allocate and a consensus that there should be a single, pub- enforce water rights. In Brazil, the government licly owned transmission entity, that dispatch owns all water rights. Because monopolistic should be centralized, and that prices should ownership of primary energy sources allows reflect opportunity costs and cross-subsidies the owner to appropriate the rents of all down- should thus be unraveled. But formidable po- stream activities, there should be competition litical challenges remain-not the least of which, for the right to use these water rights rather given the complex web of ownership in the than for the right to own or control them. When sector, is getting overall agreement on the de- a power generation company owns the water tails between the federal government and the rights, this constitutes an entry barrier to new states. There are important technical challenges generators, because when analyzing the con- too. One set of challenges relates to competi- struction of a new plant, the incumbent will Private Sector Development Department . Finance, Private Sector, and Infrastructure Network The Real Possibility of Competitive Generation Markets in Hydro Systems-The Case of Brazil internalize the impact on its existing plants. future use. Water in a reservoir has an opportu- Thus, one mistake that must be avoided is sell- nity cost set by future prices (or costs) and the ing the water rights as part of the existing com- probability of overflow (once the reservoir is panies, as was done in Chile. full). When storage capacity is full, and for run- of-river power producers, the opportunity costs Public bidding seems to be the best approach are nil and water must be run through the tur- to franchising water use rights, and Brazil has bines or spilled. Thus, to determine the optimal already advanced in this direction through its use of water today requires simulating the evo- public service concessions law, which requires lution of the system in the future. The length of public bidding for all hydropower potential of the simulation period depends on the storage more than 10 megawatts. The law accepts ei- capacity of the system-in Brazil, the horizon ther of two mechanisms as the basis for award- for simulation is five years. The difficulty of pro- ing bids to achieve efficiency in the allocation jecting demand pattems, rainfall, equipment fail- of water resources-the lowest asking price for ures, and the like for such a long period makes energy, which allows different prices for dif- the problem of hydro dispatch a very complex ferent plants, and the highest payment for wa- one to address through market mechanisms. ter use, which leads to a single price set by the market. But to optimize competition, Brazil Another complicating factor in the Brazilian should choose the mechanism based on the hydro system and in many other hydro sys- highest payment for water use because it re- tems is that there are often several generating sults in a single price for all plants. At the same units on a single river, so that the generation time, it should allow no preferences for or dis- capacity of one plant is influenced by the stor- crimination against different types of bidders- age capacity of upstream generators. All this including generating companies, industrial implies a strong interdependence of produc- self-generators, and distribution companies. tion costs across generators-which is why it is a good idea to have central dispatch for each An important benefit of such competition is interconnected system.1 that it allows the market to decide when, how much, and what type of generation is needed. The predominance of hydro in the Brazilian In Argentina and the United Kingdom, for ex- electricity sector means that marginal prices can ample, the increasing share of gas generation, be very low over long periods, hindering the which involves lower capital costs and shorter timely recovery of capital costs. Pricing rules construction time, is probably an outcome of such as those in Argentina, Chile, and the granting free entry to the generation market. United Kingdom, which set energy prices at This diversification of primary energy sources cost (or bid) of the marginal plant, would re- can help reduce the expansion costs of a rap- sult in highly volatile prices in Brazil, ranging idly growing system, and new energy sources from zero to the costs of unserved energy as should be allowed to compete on equal foot- the system swings between excess water and ing with hydro generation. drought conditions. Ensuring cost recovery in the Brazilian system therefore requires a dif- Cost recovery ferent approach for setting dispatch rules. Optimal dispatch in a hydro system does not Efficient competition in generation requires depend only on the demand and the available two markets capacity at a particular moment (as in the eco- nomic merit order dispatch conceived for purely Reconciling central dispatch with the desire to thermal systems). It also has to take into account introduce competition and achieve cost recov- the intertemporal problem posed by water stor- ery requires focusing competition not on the age-whether to use water now or save it for physical dispatch of energy but on relevant fi- nancial (contractual) arrangements. Thus, there monitoring is to impose a financial sanction should be two generation markets: a spot mar- on purchasers who withdraw energy from the ket and a contracts market. As in other power system exceeding their holdings of FECs. If the sector models, the spot market would be used sanctions are set at an appropriate level-for to trade energy within a defined period (typi- example, at the system's long-run marginal cally one hour) and would determine short-run cost-and properly enforced, there will be no marginal cost dispatch. Generators would re- incentive for purchasers lacking the FECs they cover their variable costs, excluding fuel costs, need to buy unauthorized energy on the spot in this market. But unlike in thermal-based sys- market.4 The proceeds from the sanctions can tems, generators would recover capital (and fuel) be divided among all generators in proportion costs in the contracts market, and the price of to their firm energy. the financial instruments traded in that market would be the price signal for investment. To ensure that FECs are used properly and ef- fectively in the market, they should be fully The contracts market would work as follows. tradable until they are "cashed in" for immedi- Generators would be issued firm energy cer- ate delivery. Agents in the market need to be tificates (FECs), which they would sell to dis- able to freely buy and sell the certificates to tributors and large users. Each FEC would give accommodate their needs at any given moment. the holder the right to obtain from the system As in any financial market, paper transactions a specified amount of energy. The certificates in the energy market are expected to exceed could be freely traded in the contracts market actual physical transactions by several times. among generators, distributors, and large de- regulated users, and distributors and large de- Implementation regulated users would be required to hold FECs as a condition of access to the spot market. This market structure implies that the contracts The basic idea is that, with the FECs, the gen- market should be completely independent of erator sells its capacity to the system during a physical dispatch. But it may be difficult to per- given period, rather than the energy produced suade the current dispatch managers of the need during that period.2 The requirement that dis- to delink the two. One possible enticement to tributors and large deregulated users buy firm persuade generators to transfer control over pro- (contracted) energy as a precondition for pur- duction decisions to the central dispatch entity chasing energy from the spot market creates a is to provide them with entitlements to energy market for the FECs.3 proportional to their contribution to the system. Because the central dispatch entity, seeking to The requirement for purchasers in the spot mar- optimize system operation, is bound to increase ket to hold FECs in direct proportion to the the amount of energy obtained from plants, each amount they want to buy solves the problem generator would receive entitlements at least of creating incentives for users to buy all en- equivalent to its own (isolated) physical contri- ergy requirements on the spot market when bution. These entitlements (FECs) could then marginal costs are very low, thus paying only be freely sold to purchasers in the contracts mar- variable costs and not contributing to the re- ket. There should be no constraints on trading covery of generators' fixed costs. The risk that in these energy contracts by generators, distribu- buyers without FECs will make spot market tors, large deregulated consumers, and brokers energy purchases can be handled in different (if any). Trading could be organized in a physi- ways. One possibility is to simply prohibit these cal market (similar to a stock exchange) or on purchases. But this solution would require the an over-the-counter basis, or it could be done central dispatch entity to keep track of exist- through bilateral transactions, which would ing FECs to see whether demand will be cov- probably lead to the spontaneous emergence ered. An alternative that would require less of some kind of centralized market. The Real Possibility of Competitive Generation Markets in Hydro Systems-The Case of Brazil Summing up the maximum price users are willing to pay for the service (the reserve price), would have to In the system described in this Note, costs could be determined by the regulator through peri- be recovered by requiring distributors to pur- odic reviews. New investment would occur up chase sufficient amounts of firm energy to cover to the point at which the cost of new plants their expected demand as a precondition for exceeds the reserve price. buying energy on the spot market. This obli- gation would eliminate any free-riding by pur- The model proposed by this Note is not the chasers who would otherwise gamble on only solution to the technical challenges of buying secondary energy in the spot market. introducing effective competition in Brazil's The value of firm energy would be freely ne- power generation sector. Alternative solutions gotiated in this market and would signal any may well emerge from ongoing work. But the need for new generation capacity. Note does outline one approach to develop- ing an internally consistent set of reforms that Distribution companies would be responsible recognizes the special characteristics of hydro- for buying firm energy (in the form of FECs) to based electricity systems such as Brazil's and cover the forecast demand of their captive con- takes advantage of the benefits of incentive- sumers. Once this obligation is met through based organization and regulation. the contracts market, the distributors could buy The Note series is an energy on the spot market. The cost of both For more information, see Martin Rodriguez-Pardina and Antonio open forum intended to contract and spot market purchases would then Estache, 'Exploring Market Options for the Reform of Brazil's Elec- encourage dissemina- be bundled with the cost of distribution to set triciry Sector' (Economic Note 12, WVorld Bank. Latin America and tion of and debate on tariffs for retail sales to captive users. the Caribbean, Country Department I, Washington, D.C., August 1996). ideas, innovations, and Some estimates put the losses associated with decentralized dis- best practices for patch in Brazil as high as 18 to 20 percent of annual energy gen- expanding the private Large users (those above a defined size thresh- eration, representing a cost of Us$1.2 billion a year, sector. The views old) could bypass the distributors to purchase Certificates are based on firm energy rather than capacity because published are those of byashydro systems are energy- rather than capacity-constrained. The the authors and should their requirements directly on the contracts and firm energy of a system is defined as the maximum amount of not be attributed to the spot markets. They would have to pay regu- energy that it can produce without exceeding the predetermined World Bank or any of its lated tariffs for the related distribution service loss-of-load probability (which in Brazil is 5 percent). For each affiliated organizations, generating plant, the firm energy is the contribution by that plant Nor do any of the con- (use of wires) provided by the distribution com- to the system's firm energy. To calculate the contribution of a clusions represent pany to which they are connected. Large users plant requires running a simulacion model for the entire system official policy of the could also buy FECs in the contracts market with and without that generator. The difference between the two World Bank or of its results is the firm energy of the plant. This approach captures all Executive Directors and resell them to other large users or to dis- externalities associated with the plant as part of its firm energy. or the countries they tribution companies. But they could not pro- I This kind of arrangement partially mimics the capacity-contract- represent. vide distribution services, which is the exclusive based pool operating in New England. If ex post trading of FECs is authorized (and it should be), any To order additional right of distribution companies. agent would be able to cover its position unless the system is copies please call 202- short of firm energy-in which case, the market price sends a 458-1 111 or contact For this mechanism to be effective, an obliga- signal to cut consumption in the presence of excess demand. Suzanne Smith, editor, Room 68105, The World tion would have to be imposed on distribution Bank, 1818 H Street, companies to serve all captive users in their Antonio Estache, Economic Developnzent NW, Washington, D.C. concession areas. Setting the penalty for not Institute (aestacbe@worldbank.org), and Martin 20433, or Internet address ssmith7@ meeting demand as a function of the value of Rodriguez-Pardina, Private Consultant worldbank.org. lost load would send the proper signal on how The series is also much should be invested in new generation available on-line (www.worldbank. plants. As long as the cost of FECs is lower org/htmllfpd/notes/ than the value of lost load, it is efficient to notelist.html). build a new plant. Because distribution com- @Printed on recycled panies act as representatives of their captive paper. users, the value of lost load, which represents