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Energy contracting in Brazil and electricity prices

By Prof. Joo Lizardo R. Hermes de Arajo


Agnes Maria de Arago da Costa, M.Sc. * Tiago Correia, M.Sc. ** Elbia Melo, D.Sc.
*

Abstract
In the Brazilian electricity supply industry, the first market-oriented reform ran into investment troubles. The reform of the reform, led by the Lula administration, purports to overcome this through a combination of free bilateral contracts between free consumers, traders, distributors and producers, and regulated contracts between generators and distributors through auctions. This chapter analyses the characteristics of Brazilian contracting in both reforms and the experience so far with power auctions, concerning investments in generation and electricity prices.

1.

ESI structure, agents and contract environments.


The present Brazilian Electricity Supply Industry (ESI) has generators, large and small; independent producers, mostly with gas-fired power plants; large consumers; power traders; and distribution utilities. In addition, the National Agency for Electric Energy (ANEEL) regulates and monitors the working of the ESI; the National System Operator (ONS) does the centralized physical dispatching; and the Trading Chamber for Electric Energy (CCEE) buys and sells electric power in the Regulated Contracting Environment (ACR), besides registering contracts made in the Free Contracting Environment (ACL). Above these bodies, there is also the interministerial National Council for Energy Policy (CNPE) and the Monitoring Committee for the Power Sector (CMSE). The Ministry of Mines and Energy (MME) makes the plan and grants concessions. CCEE is charged with carrying out auctions for buying and selling electric energy, registering short and long term contracts, and with the accounting and settlement of short term pool contracts. The present format of the pool results from a series of changes made to the former Bulk Electricity Market (MAE), replaced by CCEE after running into serious problems of design and operation. We refer to Arajo (2006), and to Arajo et alii (2007) for further discussion of these problems.

Director-General, CEPEL - Centre for Electric Energy Research. Senior Economist, MME - Ministry of Mines and Energy. ** Director, CCEE - Chamber for Electricity Trading

1.1. CCEE and the Regulated Environment (ACR)


From March 2004 onwards, electricity policy changed substantially in order to attract investment for sustained development of the sector. It had five explicit aims: i) build a stable regulatory set-up; ii) guarantee security of supply; iii) achieve fair tariffs; iv) respect contracts; and v) reintroduce planning in order to cope with demand growth. To this end, mechanisms were inserted into the market to enhance security of supply, among which: a) a requirement that distribution companies contract for 100% of their forecast demand over a five-year horizon; b) build realistic estimates for guaranteed energy of plants; c) contracting hydropower and thermal plants in a mix that balances guarantee and cost; and d) permanent monitoring of the security of supply, in order to have early detection of imbalances between supply and demand and to take steps to restore security of supply at least cost to consumers. In order to attract investment in generation, energy auctions for long term energy contracts (15 and 30 years) were created to direct energy contracting by distribution utilities. This scheme aims at reducing risks for investors, while the auction by least price stimulates economic efficiency and in principle gives correct signals for the system expansion cost through competition. These auctions contemplate blocks of hydro and thermal plants, auctioned separately; this obviates the issue of thermal investment in a hydro-based system. A peculiar characteristic of this arrangement is that all distribution companies form a pool that contracts with each auction winner; in effect, each contract is split among distribution companies according to their share of the market, one contract with the generator for each. This spreads risks and benefits, and tends to equalise supply tariffs. The auction system (see also Arajo, 2006) is aimed at the Regulated Contracting Environment (ACR), i.e. relating to the service of captive consumers by distribution utilities. There is also a Free Contracting Environment (ACL), in which energy is contracted for free consumers through freely negotiated bilateral contracts. To deal with both environments, the Chamber of Electricity Trading (CCEE) was created. This institution replaces MAE, absorbing its functions and incorporating all its organizational and operational structures. It is a private, not-for-profit entity, with governance structure similar to that of MAE, and is funded through contributions of its associates, which do not carry through to consumer tariffs. CCEE administers energy contracting under ACR and mediates the bilateral supply contracts each generator signs with each distribution utility. In this way it calculates the supply tariff to distribution utilities, to be used by ANEEL in defining the captive consumer tariffs. CCEE also mediates the supply guarantee contracts each distribution utility has to sign, in order to reduce defaulting risks.

Regarding the short term (spot) market, CCEE accounts and settles differences between the amounts of energy contracted and those effectively consumed or produced by the agents, according to Energy Contracting Procedures homologated by ANEEL. In this market, every contractual difference is accounted for and financial settlement is made monthly, being based on the Differences Settlement Price (PLD), which is published by CCEE in advance and was known as PMAE under the MAE. PLD is weekly calculated and published by CCEE, having for base the system marginal operational cost with lower and upper price bounds. The upper bound for PLD is defined as the variable operation cost of the dearest thermal generation existing in the centralized dispatching programme, and the lower bound is established by ANEEL considering hydropower plant operation and maintenance costs, as well as financial compensation for the use of water resources. For accounting and settlement purposes, contractual differences must be valued at PLD and settled monthly. Nevertheless, gains, losses and penalties from contractual deviations of distribution utilities shall be the object of a yearly conciliation, taking into account the effects of seasonal variation in consumption as well as atypical intraannual variations that might require compensation. Distribution utilities must prove that their measured market is 100% covered by contracts. When a utility is over contracted, difference settlement will produce revenue gains or losses, in case the monthly PLD is higher or lower than the contracted purchase price in ACR. Allocation of these gains and losses must obey the following rules: Over contracting up to 3% of the market: gains will be appropriated by the utility and losses will be passed through to consumers next year. Over contracting above 3% of the market: gains and losses are absorbed by the utility. Auctions exist for contracts with delivery five (A-5) or three (A-3) years ahead, with durations between 15 (thermal) and 30 (hydropower plants) years; contracts from A-1 auctions have durations from 5 to 15 years. There are two modalities of regulated long term contracts: by amount of energy to be delivered, in which the seller takes all hydrologic risks, and by energy availability, in which the buyers take on hydrologic risks (and can buy energy at a cheaper price). For regulated long term contracts involving energy from existing plants, rules define three possibilities for decreasing amounts contracted: Compensation for the exit of free consumers distribution utilities, after compensation for surplus and deficit (part of the Trading Convention), may reduce their contracts for the uncompensated balance due to the exit of free consumers.

Reduction, at the demand of a distribution utility, of up to 4% of the amount contracted, to adapt to market deviations of demand forecasts. Reductions due to increases in bilateral contracts signed up to 16 March 2004. These concern contracts that started with small amounts, but with clauses increasing energy transacted, mainly as new plant entered operation. It should be noted that reductions are applied uniformly to all regulated LT contracts of the distribution utility with existing plants derived from ACR auctions. Note also that distribution utilities may pass through contracted amounts up to 103% of their load (in energy; we stress once again, as in [Arajo, 2006], that in a hydro-based system with large reservoirs energy rather than capacity is the limiting factor); this acknowledges that a perfect forecast does not exist and allows a tolerance for forecast errors. Finally, when contracts from A-3 auctions exceed 2% of demand, passthrough is limited to the least cost contracts from A-5 and A-3 auctions. These measures are justified to avoid inefficient outcomes. In effect, if a distribution utility contracts an excessive amount of energy from new plants, and later reduces energy from existing plants, this would be a socially inefficient use of resources. Therefore, in order to provide correct stimuli, if the purchase of energy from existing plant is less than the lower bound for contracts the pass-through of the cost of energy purchased from new plants will have an upper bound. This is done as follows: distribution utilities have to contract 100% of their market through auctions; if after a twelve-month period the utility finds itself short of energy, it will have to buy energy through short-term contracts, with prices subject to the vagaries of the spot market. The cost of the energy bought above the limit of 103% to supply final consumers may not be passed through to final tariffs. As mentioned above and as discussed by Correia et alii (2005), energy supply contracts in ACR may vary only between two modalities1: Contracts for delivered energy, in which all risks are taken by generators to supply the energy contracted. Contracts for energy availability, in which all risks of production deviations relative to assured energy are assigned to the pool and passed through to captive consumers. To the general rule that contracts in ACR are formalized in bilateral contracts between each generator and all distribution companies, there are three exceptions: Itaipu, the Incentives Programme for Alternative Energy Sources (PROINFA), and

Note that all contracts in the distribution pool refer only to distribution companies in the National Interconnected System, which represent 98% of the market.

distributed generation2. Distribution companies are allowed to contract energy from distributed generation plants; this must be done through public bidding directly promoted by the distribution utility, and may not exceed ten per cent of its load.

1.2 The Free Contracting Environment for Bilateral Contracts (ACL)


Another form of contracting in the Brazilian power system is through free bilateral contracts. Given the characteristics of the Brazilian power system, contracts are a useful tool to reduce agent exposition to price uncertainty. Both Brazilian electricity reforms have paid attention to bilateral contracting. In the first reform, the development of longer-term contracts was expected to arise from expectations regarding the evolution of electricity prices. To deal with market power, an additional mechanism was to limit the possibility for distribution utilities holding generation assets to contract their own energy at strategic prices. An upper bound to self-dealing would also signal against vertical reintegration through power purchase agreements, while allowing an agent to invest both in distribution and in generation. Nevertheless, signals emitted by the government as to self-dealing were inconsistent. In some cases, they even induced an increase, rather than decrease, of generation investment by distribution utilities. Considering that the rules established during the implementation of the Cardoso reform had stimulated self-contracting at prices detrimental to consumers, the Lula reform forbade self-dealing, or bilateral contracting within a single economic group (articles 20 and 30, law 10848/2004) and extinguished VN3 and its readjustments based on K1, K2 and K34 (paragraph 40 of article 20, law 10848/2004).
2

Article 14 of decree 5163/2004 qualifies as distributed generation in Brazil the production of electric power from generation plants directed connected to the buyers distribution system, except that from (I) hydropower plants with nameplate capacity above 30 MW; or (II) thermal power plants, including co-generation, with energy efficiency below 75%. 3 Legislation also guaranteed the pass-through of energy costs to final consumer tariffs up to a certain value, the Normative Value (VN), which varied according to plant technology. 4 ANEEL created a correction formula for VN with three factors, according to resolution 22/2001, article 90: K1 (correction by a brazilian bulk price index - IGPM), K2 (fuel price variation) and K3 (exchange rate variation). Since both K1 and K2 were affected by K3, readjustments were systematically higher than inflation indices in each period. Moreover, since these distribution companies saw in this a very attractive guarantee of revenues, they signed extremely long-term selfdealing contracts; thus, CELPE signed a 20 year supply contract with its thermal power plant, beginning December 2003.

In order to protect captive consumers, this reform defined that the purchase criterion should be minimal tariff or price and forced all purchase of energy traded by distribution companies to be done through public and transparent auctions. To this end captive consumers would be sheltered in the regulated environment (ACR), with competition for bilateral contracts and effective freedom of large consumers in the free environment (ACL). Since the reform was not aimed at making a clean break with its predecessor, but rather to consolidate institutions, all contracts signed till then received guarantees that they would be respected, including those of self-dealing; all of them will be administered within ACL until their expiration. Agents are free to make bilateral contracts in ACL, defining prices, quantities, durations and hedge clauses, with one important exception: State-owned generators, even when contracting in ACL, must do it through public auctions approved and supervised by ANEEL. Besides free consumers, ACL may comprise concession holding generators, independent producers, power traders and power importers.

2.

Electricity auctions in Brazil


According to the present Brazilian regulatory framework established by Law 10848 of 15 March 2004, distribution utilities must ensure that their market demand has full contract coverage by purchasing electric energy through public auctions conducted within ACR. Auctions may be understood as a space for regulated competition, with rules and institutions that make competition more transparent and minimize the use of market power. The existence of an official market for electric energy, operating through public auctions, may operate as an important instrument to consolidate the liberalisation process of the Electricity Supply Industry in Brazil. This role of reference market could be played by transactions in the spot market made through daily auctions; nevertheless, specificities of electricity and of the Brazilian market hinder this approach. The supply curve of electric energy is inherently very steep when approaching the supply capacity and some volatility with price spikes cannot be avoided. Besides, new investment normally means maturation lags above three years; in countries like Brazil, with a high potential demand growth, this implies a relatively high risk of recurring supply scarcity, with rationing and black-outs. This risk is even greater in hydropower-based systems, since these have an additional uncertainty for rainfall and thus for energy available in reservoirs. Another feature of the Brazilian supply industry is the dominant role of public agents in the generation activity. The new institutional framework was designed to allow public and private firms to coexist in a competitive environment. Auctions play a central role in this design, since clear rules and a transparent trading process work as a guarantee to private firms against a possible abuse of power by public firms.

In this context, ACR may be considered as a buyers pool that aggregates the demand of the various distribution utilities in periodic auctions, so that utilities sign bilateral contracts with the generators who offer winning bids in each auction. By pooling utility demands into a monopsony, ACR is expected to achieve gains of scale; since each generator signs contracts with every utility, risks are spread out among sellers (as well as among buyers). Electricity supply auctions and contracts may take three forms: contracts for energy from existing plants, contracts for energy from new plants, and adjustment contracts.

Auctions to Purchase Electricity from Existing Plants


First, auctions of existing energy were formatted to contract surplus installed capacity (due to progressive ending of initial contracts5) before auctioning energy from plants yet to be built. Auctions were done for staggered energy supply contracts with 8 year duration, starting supply in 2005, 2006 and 2007 on 7 December 2004, and likewise auctions for supply contracts starting in 2008 and 2009 on 2 April 2005. In order to improve decision-making by sellers and provide exchange of information on the value of electricity, there was a first phase with open bidding, where agents modified the quantity offered according to current price announced, and a final phase with sealed bids and discriminatory prices. To protect against collusion, there was a secret reserve price and some demand might thus remain subcontracted. The outcome of the first auction for existing energy was a goodly volume of contracts, and most surplus capacity was contracted. Nevertheless, despite the initial open phase to allow learning, final prices had large variations (3.5 to 4 R$/MWh standard deviation among winners in the distinct lots; this is large considering that this was an open auction for a homogeneous good, and variability was substantially reduced in the other auctions). To a great extent this reflected aversion of some agents to the risk of remaining without contracts. These results earned negative comments in the press and among sector agents, leading to speculation with Eletrobrs stocks, since in the fortnight preceding the auction high price estimates had been published by generator associations and some banks as well; investors were thus disappointed and Eletrobrs stocks fell. The figure below shows these vagaries of mood: optimism followed by disappointment, till the first expansion auction changed this behaviour.

These contracts were middle to long-term bilateral contracts signed in 1998 between generators and distribution utilities, based on assured generation and programmed load demands until December 2005, with prices defined by ANEEL, and aiming to provide a smooth transition to free contracting.

Figure 1 Eletrobrs Stock Price in BOVESPA


60

1 Existing Auction
50

st

3 and 4 Existing Auctions

rd

th

40

t o L30 / $ R
20

nd

New Energy Auction

nd

Existing Auction

1 New Energy Auction

st

10

0 1/ 2/ 3/ 5/ 6/ 8/ 9/ 11 12 1/ 3/ 4/ 6/ 7/ 9/ 10 12 1/ 3/ 4/ 6/ 7/ 8/ 10 11 1/ 2/ 4/ 5/ 6/ 8/ 9/ 2/ 13 31 15 27 11 22 /3 /1 30 16 29 11 26 6/ /2 /3 18 4/ 18 1/ 13 24 /6 /2 4/ 16 3/ 18 30 11 25 03 /0 /0 /0 /0 /0 /0 /0 5/ /0 /0 /0 /0 /0 04 0/ /0 /0 05 /0 05 /0 /0 /0 2/ 06 /0 06 /0 /0 /0 /0 04 4 5 3 3 3 3 3 3 3 03 4 4 4 4 4 5 5 5 5 05 6 6 6 6 6

Source: Reuters

In effect, bids made by some companies were lower than necessary; this resulted from limited capacity of assessment by agents, whose rationality was bounded by uncertainty in the auction context, especially the fact that generators had 50% of their energy exposed to extremely low spot prices, soon to become 75% by January 2005 with the progressive ending of initial contracts, whatever the format chosen for the auction. The format adopted minimized the prospects for collusion and use of market power, to deal with the concentrated structure of the Brazilian electricity supply industry. Besides, even companies making the lowest bids had a significant improvement in their cash flow, by reducing their exposure to spot market prices which were at the time R$ 18.33/MWh, or roughly 6 US$/MWh In the second auction, in April 2005, the energy block to start in 2009 did not converge to deals, arguably because of expectations about the coming auction for new plants to start operation in 2010. This happened because a significant share of the supply in the second auction came from botox6 plants; these could participate in auctions for new plants, where higher prices were expected. Besides, the behaviour of sellers showed a misunderstanding of auction rules since final bids cut prices unnecessarily. With demand cuts signalled during the first phase, in order for competition to go on and hit reserve prices, the second phase had no surplus offer and all the quantity offered could be sold. Since auction mechanisms transmitted this information to agents, variation in the final outcome (much less than
6

These were plants that were in operation since January 2000 until the enactment of law 10848/04, but which had no contracts. Article 17 of this law, complemented by article 22 of Decree 5163/04, allowed them to participate in auctions for new plants until 2007. They could thus arbitrage between participating in existing energy or new energy auctions.

in the first auction) was apparently the result of irrational behaviour by sellers rather than of misinformation. There were two further auctions for existing energy, both on 11 October 2005; these concerned separate purchases and no arbitrage between contracts was allowed. The third auction for existing energy was for three-year contracts, starting delivery in 2006, and the fourth auction for eight-year contracts, starting delivery in 2009. Outcomes were consistent with values revealed in former auctions, and no problems occurred with price deviations or frustrated purchase. See Figure 2 for volumes traded and average prices. Taken as a whole, auctions to purchase energy from existing plants accomplished their purpose since they allowed early contracting of a large volume of surplus electric energy, restoring an acceptable level of risks and uncertainties and thus creating room for new investments. Besides, trading rules showed that public and private firms could coexist in a competitive and transparent market. Figure 2 Auctions to contract energy from existing plants
10.000 9.000 8.000 7.000 W 6.000 M e g 5.000 a r e 4.000 v A 3.000 2.000 1.000 Supply in 2005 (1st Auction) 102 0,00 2006 (1st Auction) 2006 (3rd Auction) 2007 (1st Auction) 2008 (2nd 2009 (4th Auction) Auction) 6.782 72,26 61,72 64,50 80,98 86,89 9.054 120,00 97,25 100,00 80,00 60,00 40,00 1.172 1.325 1.166 20,00 h W M / $ R

Energy Purchased

Price

Source: CCEE

Auctions to Purchase Energy from New Plants


These auctions are carried out five and three years before the year where energy is demanded, and are known as A-5 and A-3 auctions. The former ones regard

generating plants that can start operation in five years time, mostly hydropower plants; the latter ones, plants that can operate within three years, mostly thermal plants. This is intended to allow contracting a portfolio of plants that efficiently combine fixed capital costs (higher in hydro and nuclear plants) and variable costs (higher in conventional thermal plants), and permit an optimal dispatching according to hydrological context. Contracts signed to purchase new generation must have duration between 15 and 35 years and have clauses to stimulate efficient pricing. Two contract modalities exist, upon decision by MME: Contracts for energy volumes, where sellers take on all the risks, and contracts for energy availability, where the pool takes on the risks and passes costs and benefits through to final consumers. Energy requirements not contracted, through auctions for existing or new plants, are supplied through bilateral adjustment contracts. These contracts are utility-specific and are made through public auctions authorized by ANEEL, one to two years before the date the energy will be needed, and last no more than two years. The pass-through of prices of these contracts has an upper bound in the Reference Value (VR) for the current year. In the present framework, VR is the price resulting from pool contracts in A-5 and A-3 auctions and due to start delivery in the year where the adjustment energy is required. There is thus a regulatory incentive for distribution companies to contract early on their expected market instead of risking a high exposure to adjustment auctions. Auctions for new plants operate then as catalysers to reengage in energy planning in order to minimize investor uncertainty regarding future cash flows. They also create conditions for a market in long term contracts, which may be taken as guarantees of receivables to obtain more favourable financing conditions. The first two auctions for new plants were an A-5 in 16 December 2005 and an A-3 in 29 June 2006. These auctions purchased energy volume contracts from hydropower plants with 30 year duration (H30) and energy availability contracts from thermal plants with 15 year duration (T15), with the following results (Figure 3):

Figure 3 Auctions to Purchase Energy from New Plants


1.028 1.000 134,29 800 W M 600 e g a r e v A 400 126,77 644 561 116,04 123,68 117,78 115,00 110,00 46 2009 (A-5) 2009 (A-3) 2010 (A-5) 105,00 100,00 2008 (A-5) 855 131,25 134,25 889 862 140,00 135,00 130,00 125,00 120,00 h W M / $ R

200 71 Supply in

108,59

Hydro (Mwa)

Thermal (Mwa)

Hydro Price

Thermal Price

Source: CCEE Despite expectations that A-5 auctions would be dominated by hydropower plants and A-3 auctions by thermal plants7, the first auction was dominated by thermal plants and the second one by hydropower plants, inverting the logic. The explanation is that there was a large supply of built hydro plants without a contract (botox plants). Because of this, both A-3 and A-4 lots were auctioned, in addition to A-5, and botox plants won most of those. Nevertheless, the price of energy contracted for 2009 in both auctions was similar and did not lead to higher system costs. Contracts for supply starting in 2010, by their turn, resulted in a significant fall in relation to costs affixed in the two years before, which reflects the greater availability of hydropower plants from this year on. The main criticism one could make to the format chosen regards the rigid competition pattern set by the prohibition of combination bids to exploit possible economies from the joint contracting of two or more new plants. In fact, optimization of the objective function of an auction with multiple indivisible items (like new plants) needs minimizing the generation cost of all contracted plants. The satisfaction of this condition is not trivial; if synergies and correlations among contract prices exist, the
7

There was also a feeling of a repressed demand for hydro, all the more so because since the 90s no new inventories of hydropower potential had been done and few new hydro plants had been built.

optimal combination assignment is a difficult mathematical challenge (Xia, Stallaert and Whinston, 2005). Despite this, one might adopt rules for energy contracting that allowed investors to make bids freely combining sets of plants in search of optimal complementarity relationships in logistics, construction, fuel purchase etc. Since they did not allow this option, auctions carried out led to prices that reflected only fixed costs in availability contracting of thermal plants, failing to apprehend the real (fixed + variable) energy production costs. Ultimately, in availability contracts plants could be contracted having so high a variable cost that they would only be dispatched in critical situations; they would be an insurance rather than a reinforcement to the supply of electricity, detracting from economic efficiency. Since plant dispatching is based on the marginal cost of producing electricity, such thermal plants would overburden hydropower plants instead of easing their operation, distorting reservoir management. This remains however a hypothetical case; and the choice of the present format may be explained by preoccupations with the consolidation of the new reform framework, and keeping the mechanisms as simple and transparent as possible to encourage investment.

Adjustment Auctions to Purchase Power and Settling Differences


According to ACR trading rules, uncertainty as to market growth is absorbed by distribution companies, which must declare their expected demand and contract the necessary energy in auctions 1 to 5 years before the date. In order to allow proper management of this risk, the main mechanism for complementary contracts is: Adjustment Auctions for Electricity Purchase. Adjustment Auctions have the purpose of complementing up to 1% the energy load required for serving the consumer market of distribution utilities. The first adjustment auction should have taken place on 31 August 2005, but was called off for lack of demand from the utilities. The sole adjustment auction carried out to date happened on 01 June 2006, with the participation of three distribution utilities from the Northern and North-Eastern submarkets, CELB, CELPA and SAELPA. Following the format used, the buyers informed the auctioneer of required energy in average MW, duration of contracts and maximum acceptable price. Would-be sellers were invited to make quantity bids at the going price, which would vary until supply equated demand, characterizing a clock-auction design. The result of the Adjustment Auction is shown in Table 1.

Table 1 2nd Adjustment Auction for Electric Energy Purchase


Duration (months) Sub-Market Northeast 3 6 Sub-Market North 6 Quantity (Average MW) 2,5 1,5 13,5 Average Price R$/MWH 29,12 34,31 45,63

Source: CCEE

3.

Preliminary assessment
The first market-oriented reform of the Brazilian Electricity Supply Industry, carried out in the nineties, failed to attract investment in the levels required to keep the economy growing and remained incomplete, because the trading arrangements set in place did not emit adequate investment signals and the market organisms themselves became paralysed. In consequence, a new direction for reform was set up in March 20048. This reform of the reform, besides several structural purposes, is aimed at attracting private investment to the expansion of electricity generation supply, in view of growing demand and restrictions on the State capacity to invest. To this end, the trading environment centres upon auctions for (mostly long-term) electricity supply contracts in which private and state-owned investors compete for capacity expansion. Given this central role, the main preoccupation behind the Brazilian auction design was to guarantee the working of the new institutional framework for the Brazilian power sector, and to ensure real competition in the generation activity, independently of the large share of state-owned agents. Auctions are trading mechanisms that can lead to the revelation of prices and costs of goods having uncertain value. Auction format may vary in function of product characteristics and of its market, in order to obtain better conditions for competition. Auctions should be as attractive as possible, and opportunities for collusion should be minimised. Nevertheless, perfect and efficient formats do not exist, because auctions have to reflect real world conditions. The design of auctions for the purchase of electricity should be based on these considerations, and evaluation of its results should consider sector context. Another aim of the 2004 reform was to profit from the surplus supply that existed after the 2001 rationing to reduce the rate of growth of final consumer tariffs, which had grown significantly above inflation9, especially for captive consumers, who had

8 9

This was formalised in Laws 10.847 and 10.848 of 15 March 2004. Cf. Figure 16.11 in Arajo (2006).

borne most of the costs and inconvenience of the 2001 rationing and the following sector crisis. Therefore, the reform created the concept of old or existing energy, based on cheaper generation technologies and having a large part of costs already depreciated. This was a power play by the federal government to reduce electricity prices. Generators were not interested in this distinction, since they hoped to raise cash for future investments. A bargaining process began, the generators sending signals that auction prices should be high to ensure the attractiveness of power business in Brazil. From this point of view, the auctions carried out were reasonably successful because they were able to break the inflationary bias in prices and to return part of the revenue extracted from consumers during the 2001 crisis. Besides, they were able to protect the expectations of future prices for new energy (whether from botox plants or from expansion projects), signalling values compatible with investment costs and capital remuneration. This may be verified through inspection of prices of energy to be delivered in 2009 in auctions for new plants, compared with prices for existing plant. Another independent check results from comparison of the behaviour of stock market prices: After energy auctions, the IEE index (which aggregates all open capital electricity companies) shows an autonomous dynamics relative to the aggregate stock market index IBOVESPA, growing 50 percentage points above IBOVESPA since January 2003 (Figure 3).
Figure 3: Comparison between IBOVESPA and IEE
400

350

1st New Energy Auction


300

250

200

2nd Existing Auction


150

100

50 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 1/ 3 5/ 7/ 9/ 11 1/ 3/ 5/ 7/ 9/ 11 1/ 3/ 5/ 7/ 9/ 11 1/ 3/ 5/ 7/ 9/ 20 /20 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 / / / 03 03 003 003 003 200 004 004 004 004 004 200 005 005 005 005 005 200 006 006 006 006 006 3 4 5 ibovespa IEE

Source: Reuters

Auctions for electricity trading, both in short and in long term markets, are set to become a fixture of the Brazilian Electricity Supply Industry. It is normal that a gradual evolution for rules and formats adopted exists, correcting flaws and keeping uncertainty at a level that avoids super games with sequential auctions, where market power and collusion would find a favourable environment. Investors may come to recognise patterns of repeated games as new auctions are carried out; it is likely that their strategy will incorporate long term concerns like reputation and reprisals. This could imply more co-operative behaviour in determining equilibrium price (Osborne, 2004; Romp, 1997), since there will be opportunities for learning and information exchanges, which may lead to investor co-ordination (Correia, 2004). Government should be attentive to perfecting and correcting auction mechanisms and to using information made available in auctions. Full disclosure of information (like identifying agent bids) during an auction may facilitate collusion. To reduce prospects for cartel formation, information disclosure may thus be limited. This also simplifies decision making, since it hinders strategies that are not exclusively based upon price signals and on individual preferences (Correia et alii, 2006). Contract arrangements based on auctions appear to be a positive step towards solving the issue of stimulating investments in power expansion in a market context (Joskow,2006). However, it is but one instrument among others. Several issues still require solution, in order to guarantee security of electricity supply. The single most urgent issue is the definition of efficient, integrated procedures of municipal, state and federal organisms to carry out the process of environmental licensing for new projects. Constant delays in granting operating licensing for hydropower plants, while granting easier terms for thermal power plants (gas, oil or coal-fired), may lead to more expensive, as well as more polluting power plants. Financing restrictions remain, for the time being, another bottleneck for sustained supply expansion. The government expects that PPAs with duration compatible with the concession period, and new financing tools in the capital market, may leverage the resources required. Nevertheless, without a specific policy by the National Economic and Social Development Bank (BNDES) and the participation of private institutions through Project Financing for instance, the flow of resources may not be sufficient. Aiming to remedy this, a special line of funding has been created for investment in electricity generation and transmission. Finally, it should be stressed that the present reform model still needs adjustments despite its merits. There remain conflicts of competence between organs of direct and indirect public administration, as well as between different regulatory agencies. There also are significant gaps in the legislation dealing with natural gas and with isolated systems, which have strong impact on the power sector and may jeopardise the expansion of thermal generation. Last but not least, special attention should be given to demand expectations signalled by the fast growth of the free contracting environment, which now represents 26% of the market. Up to now the government has mostly been concerned with the regulated environment, but future expansion will

have to provide energy for the whole market, both regulated and free. The present setup may require further adjustments towards this end.

4.

References

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