Questions and Answers About Reregulated Energy Contracting Part 2

Rafael answered my questions of Questions and Answers About Reregulated Energy Contracting:

Risks allocation

A regulated energy user, by definition, pays a pre-established (by the regulator) set of tariffs (denominated in terms of kW demand and kWh energy, off peak and on-peak). The de-regulated energy user negotiates prices and conditions for the energy contract. As it is a different contractual arrangement, different risks are at stake.

Let me stick to the Arcor case. The de-regulated contract was established for 3 years. Prices were negotiated – fixed for each year. How will these prices compare with the regulated prices?

In the de-regulated contract we negotiated a clause by which Arcor was supposed to pay a price denominated in R$/MWh within limits of +/- 15% in terms of kWh/month consumption. If the actual energy consumption was above the maximum then Arcor should buy the difference at the spot market price plus a 20% fee. If the consumption was below the minimum then the difference was to be sold at the spot market price. So depending on the spot price, nthe energy consumption level this will effect the energy actually paid (a mix of the negotiated price and the spot price).

For other clients for example we negotiated well known financial tools such as derivatives to mitigate these prices risks.

Energy prices fluctuations

Energy prices in a market driven environment depend on supply and demand. If demand is above supply energy prices increase. Investors attracted by the higher prices and develop new power plants. Once these plants are installed and become commercially operational, the supply will be more abundant and a new equilibrium is reached at a lower price.

Specifically regarding your questions (rainy or dry seasons in Brazil), it must be said that most our generation comes out from hydro power plants which include large water dams. It means that there is a large reserve. The independent system operator (ISO) is in charge of dispatching electric energy from all power plants considering the reserves of each hydro basin - this to optimize the system. Accordingly prices do not show very strong and quick variations. More importantly there are tools (softwares) that can estimate very well supply x demand for given scenarios of demand vis-à-vis availability of water. So actually there are no surprises.

The interesting point is that regulators actually have to predict future supply and demand and establish fixed prices anyway. They have in mind that if energy prices do not include the amortization costs they cannot expect to increase supply because no investor will be interested in the business.

At the end of the day the problem is exactly the same. A regulated energy user is leaving this responsibility to the regulator. The de-regulated energy user is handling this risk himself.

Who wins and who loses

It depends on future predictions. The one who makes better and more accurate predictions gets the best results. Interestingly enough is observing that in the long run, given the same demand-supply scenarios, the incremental cost of any system is basically the same, regardless of the contractual arrangement between energy suppliers and energy users, because it is the fuel, the power plant, the distribution system (public grid).

Regulators have their own tools to predict future energy demand. They try as much as they can to shape future energy prices so that the energy sector (suppliers) meets the predicted demand. If they over-estimate demand the regulated prices will be too expensive. On the other hand if they under-estimate the regulated prices will be too cheap and possibly supply will not meet demand.


The winners are the ones who predict with better accuracy future supply and demand.

Spot prices

Historically spot prices have a tendency to vary in the following range: Minimum is the cost of the fuel plus a very small margin (in a supply >> demand scenario) and maximum is many times (10 in Brazil back in 2001 or even 100 in California) the regulated rates (demand >> supply).

Most energy users do not contract spot prices though. They go for fixed prices negotiated in long term contracts (3 to 8 years usually).

In the long run

Since energy prices reflect our own perceptions about future scenarios it is fair to say that we will not win every time because nobody is that perfect! Some times de-regulated energy users make better decisions sometimes not. It would be a mistake to say that the regulators do a better job with every prediction. They are humans after all!!!!

The bottom line is: a good understanding of what is at stake is vital. Well informed decisions is the name of the game as in any business.

Interruptions

You asked a very interesting question. It must be said that de-regulation is about energy prices risk. It is not about physical production risk. Let me explain. De-regulated energy users have the same physical risk (of interruption) as the regulated ones.

One has to understand that the physical dispatch of energy is the independent system operator’s (ISO) concern. In a sound system the ISO only knows the electric loads that have to be met by the system (as a result of the contracts). The ISO is not concerned about the energy prices of the contracts (actually they are not allowed to know the prices).

In a solid and isonomic system, if supply < demand rolling black outs, rationing, or other ways will be implemented to make sure supply = demand. Energy prices (spot) may skyrocket but still all energy users will be treated in the same manner. The difference is the price they will be paying in this situation. Let me give you a few examples.

In California when there was a severe shortage a few years ago, rolling black outs were established. A small grocery store or a large industrial corporation had to comply with this imposed situation. The small grocery if a regulated customer, paid the same as any other regulated customer of the same rate schedule. A de-regulated energy user – let´s say a huge aluminum smelter. The difference was that, as a de-regulated customer, this aluminum smelter decided that it was a better deal to stop the operations and sell their energy and make money on the spot market.

This sale made sense because other de-regulated energy users who run higher value added operations could pay a higher energy price and still make a better deal (if the comparison was to stop their operation because there was no energy available).

This line of thought brings us back to on-site energy production. In real life we have all types of energy users. The conservatives will welcome on-site gen sets to make sure that they are prepared to the public grid interruptions. The aggressive ones will tell you that for them it is better to invest the same money on other areas.

It is up to the energy user to decide! This decision however comes with a price tag. De-regulation is only but putting this price tag on the table!

Conclusion

In the long run regardless of the contractual arrangement energy prices have a natural tendency to converge to the same value because the driving cost is the amortization of new power plants, new transmission lines and new distribution systems.

At stake is short term x the long term. There is where de-regulated and regulated energy users might have different perceptions and different decisions.