By Cristián Muñoz and Alexander Galetovic →
Contracts to supply energy to regulated customers were awarded at surprisingly low prices. However, guarantees pledged are rather insufficient.
Last year, distributors announced the results of several tenders for contracts to supply energy to regulated customers between 2021 and 2040. The Chilean government auctioned 13,000 GWh/year, about 30% of the energy that regulated customers will consume in 2021, is equivalent to more than 30% of the energy that regulated customers will consume in 2021. Generators offered around 80,000 GWh/year and bids varied between US$29 and US$90/MWh with an average of US$50/MWh. These prices are considerably lower than those tendered in past auctions, which even exceeded US$120/MWh. The main winners were Mainstream, which bid, on average, US$41/MWh and was awarded just under 3,400 GWh; and Endesa, which bid, on average, a little less than US$51/MWh and was awarded almost 6,000 GWh/year.
Generators who win a contract must pledge guarantees. In this Brief, we describe these guarantees and calculate their amount. We also ask whether they are sufficient for ensure contract compliance.
Guarantees and Supply Contracts
Any generator who wins a contract must incorporate in Chile and her bond rating must be BB+ or higher. Alternatively, if the generator is not yet incorporated in Chile, it must pledge a bid bond to back its bid. As shown in Chart 1, column 1, this bond is for 100 Unidades de Fomento (around Ch$2.6 million or US$4,000) per GWh bid on for the last year of the contract. For example, a contract for 3,000 GWh per year (around one-fourth of total consumption in Chile’s Metropolitan Region), worth around US$150 million each year at the mean price bid in the auction, requires a guarantee of US$12 million, or 1% of the contract’s present value or US$0.50/MWh.
Second, in order to cover possible third-party damages during construction or operation of the new power plant, the winning generator must purchase insurance to cover damages of up to US$3 million. It must also purchase an additional US$3 million in coverage for catastrophic risks during plant construction or subsequent operation.
Lastly, and most importantly, the generator must pledge a bond to guarantee contract performance. This can be done in two ways: One is by providing a performance bond for UF 300 per GWh bid on for the last year of the contract. Therefore, as shown in Chart 1, a contract for 3,000 GWh per year requires a guarantee of around US$36 million, equivalent to approximately US$1.4/MWh or 3% of the contract’s present value. The performance bond is redeemed if the generator does not meet its supply commitments. Alternatively, the generator can take out an insurance policy for the same amount (UF 300 per GWh bid).
Guarantees and Performance
Is the guarantee required by the regulator sufficient? This question can be answered by examining the balance sheet of a company that has already been awarded an auction and has formed a corporation, but that only provided the performance bond and has not yet built its plant. As demonstrated in Figure 1, which shows the balance sheet using a T account, this company’s assets are the contract’s present value (Ch$100 in the example) and the performance bond for Ch$3. This company’s liabilities are the present value of the cost of the contract that was awarded and must be carried out.
Now, if the auction is competitive and the cost estimates by the company awarding the contract are on target, then the company’s liabilities should be on the same order as the value of the contract, Ch$100. In that case, its economic equity would be equal to the guarantee, Ch$3. Therefore, the terms and conditions enable it to form a company to participate in the auction with a leverage ratio of 100 to 3 or around 33:1. High or low, this leverage is more typical of a bank than an electrical power company1. More importantly, if the estimated cost of performing the contract increases by a mere 4%, the company losses its equity and it would be in its best interest to abandon the contract, even if that means losing the performance bond.
Postponing and Abandoning the Contract
The auction terms and conditions also allow start-up of the project backing the contract to be postponed for up to two years, paying a fine of UF10 per month of delay for each GWh contracted the last year. As demonstrated in Figure 1, the two-year delay could cost the generator up to 2.5% of the contract’s value, or US$ 1.2/MWh.
At the same time, and perhaps more interestingly, within the first three years of signing the contract, and on the grounds of third-party liability, the generator can request abandonment of contract by paying UF 360 per GWh that should have been supplied over the last year. Therefore, as demonstrated in Figure 1, during the first few years, the fine for abandoning the contract is equal to 3.6% of the contract’s total value, about US$1.7 per MWh supplied.
As with the guarantee, the options for postponing or abandoning the contract offer a cheap way out for the company that is awarded the contract.
The flip side of the benefits and cheap exit options available to companies that are awarded contracts is that, ultimately, liability for the supply is assumed by the generators that are already connected to the system. In effect, if the company that is awarded the contract fails to perform, the contract is re-auctioned. If the bids are greater than the ceiling prices imposed by the regulator and the auction is declared null and void, the supply obligation is prorated among the rest of the generators based on their injections. In that case, the price received by each generator is an average between the short-term node price and the plant’s variable cost2.
In the origins of Chile’s privatized electricity market, each distributor was compelled to contract enough energy to meet its obligations during at least the following three years. As a result, contracts normally required generators to have sufficient energy to comply with this obligation. Therefore, generators backed their commitment with real assets—their capacity to generate energy—and their equity.
Over time, the liability to supply was socialized. For example, for many years the regulator allowed distributors without contracts to withdraw energy, thus diluting the obligation among the generators. Finally, Law 20,805 of 2015 shifted the liability for guaranteeing supply from distributors to the regulator. Since then, distributors do not assume any liability for the quality of what they contract.
When the law changed, the regulator promised that, unlike distributors, it would be capable of guaranteeing that regulated customers would obtain cheap, reliable energy. However, the two objectives are in contention because reliability is achieved by requiring investors to risk their equity and charge for it. Thus, if guarantees are not appropriate, the auction attracts generators that charge little but have the option of selling a low-quality contract without sufficient back-up.
One of the defects of this law is that it did not foresee that a regulator committed to the reliability of supply must consider sensible regulation in supply contracts for distributors. Therefore, those that are awarded contracts must be obligated to back-up their supply with sufficient equity as soon as they make the commitment. The alternative is to return to private liability, where the distributor and the contracted generators guarantee the reliability of supply by putting their balance sheet and equity at stake. A healthy system acknowledges supply costs.
- In 2010, 25 financial economists sent a letter to the Financial Times arguing that sensible judgment recommended that banks should maintain a leverage ratio of at least six to one. ↩
- An analysis of this rule can be found here: An Economic Analysis of the New Auctions for Regulated Customers. Also see Notes on the Distribution Auction Bill of Law, BdE 13/14. ↩
Cristián Muñoz y Alexander and Galetovic
Publishers of Breves de Energía.