I agree that risk allocation is a very important issue. Please explain what are the risk allocations and what results can be expected of two contracts under two extreme cases, say for 2007:

1) A very rainy year (the highest probability ever experienced); and

2) The opposite case (lowest probability)

Please also identify who wins and who losses in those two cases. Just to get a better idea of what you are proposing, I will add a few additional questions:

1. Do you expect the spot price going to zero under case 1 for a large part of the year?

2. If 70% of all industrials, commercial and institutional get over 30% reductions, what price increases do you expect the regulated customers under case 2?

3. Which fuel will substitute water case 2?

4. Which customers might have their load interrupted in case 2?

5. How long is the contract in years?

6. Do you expect intense price spikes developing in case 2?

7. How much demand response capacity is installed?

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 dispat

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.

As the California case showed, the time delay of the boom-bust cycle in electricity without demand response, under shortage conditions, leads to excessive profits for generators which make the customers and/or distributors the real losers. That I believe will happen under case 2 in Brazil, since under those conditions the ISO will not have a "sound" system. In that situation, politicians will definitely change the rules as they did in California, where the smelters and similar exceptions were totally insufficient.

The real problem is that it takes time to build the required facilities to manage physical risk on the supply side (generating units) or the demand side (demand response system). It is better to change the rules earlier to avoid the situation in the future by restructuring the sector to be under electricity WPC (without price control). See the lengthy discussion under Ferdinand E. Banks article A Few More Unfriendly Comments on Electric Deregulation.

It is a pity that under an intense shortage all customers are required to face rotating blackouts for lack of electricity WPC. From the customer perspective (my research is about Customer Oriented Electricity) the most important risk for commercial, industrial and institutional customers is the risk of supply security, which involves large shortage costs. Among those customers the risks vary widely. It is also a pity that the shortage expectation for those customers means they should invest in individual solutions because the system is unable to offer differentiation of supply security to customers. The value destruction associated with such deregulation model is going to be very costly to your country and small customers in the long run.

In the dedication of the book "Spot Pricing of Electricity," Michael Caramanis, Richard Tabors and Roger Bohn stated ‘shortly before completion of this book Fred C. Schweppe, our friend, colleague and senior author died suddenly. Fred created spot pricing and proved, again, that 'the forecast is always wrong!’" Since it is impossible to make predictions, the demand/supply scenarios vary. So in the case 2 scenario, with the lowest rain ever experienced, the most expensive units will be dispatched and many customers will be without electricity, unless they invest in individual solutions earlier. I don't see at all the convergence you mentioned.

To mitigate such extreme case, as far I know none of the generators are willing to risk their money for a few hours of operations per year, to recoup them in the long run. This is specially so in Brazil, where case 1 scenarios mean their cash flow runs completely empty. The main reason, however, is that the future of the power industry is very uncertain today (a bet that the future will be like today is very risky). In addition, many of the original derivatives are no longer available.

One of the laws of the Fifth Discipline says that “cause and effect are not closed in time and space in complex systems.” That being the case, regulators are not winners and losers: agents and customers win or lose. When regulators apparently lose, it is the customers they misrepresent that become losers, with higher than necessary (supply plus shortage) costs, or with higher taxes later on. That to me is the greatest problem of having regulators as intermediaries between the market and the customers. Customers should have choice to select the retailer or wholesaler, which offers them the minimum cost plan available to them in the long run under electricity WPC.

Regards,

José Antonio Vanderhorst-Silverio, PhD Interdependent Consultant on Electricity

Regardless of the regulators, the investments required to make sure that the market demand is being met by the adequate energy supply, are in the range of US$ 2 000/kW, to include generation, transmission and distribution.

Considreding the interest rates and load factor of the system, energy prices should be good enough to include, at a minimum, IUS$ 50/MWh of ammortization costs, otherwise there will be no addition of capacity.

Contracting formats (regulated or de-regulated) and other options are only viable if energy prices can include ammortization costs as well. It is a simple fact of daily business but sometimes polictics is more impoortant. Every time this happens all energy users are facing higher risks.

In my opinion, it is exactly this challenging sitation that makes the difference. Energy users that require good information about the energy markets, the suppl,y and demand scenarios, the available options (from the public grid and on-site) are the ones that will - potentially - make the best decisions - and ultimately come up with the best contractual arrangements.

So far, deregulation has been about profit taking via risk shifting - a shell game.

I would summarize the political decision on regulate/deregulate as buy vs.make. With a regulated utility industry, the customers and voters have management responsibility for investment decisions through their elected representatives. In a deregulated regime, customers and voters place themselves at the mercy of the markets.

Deregulation is a vote of no-confidence in our political system, really in our confidence in our ability to manage our own affairs via our political institutions and elites.

I like very much your answer , because it goes deep into the systemic problems that the electricity industry faces worldwide. I love the possibility of a real dialogue, not a debate, as Bill Isaac has envisioned it. The dialogue is not about deregulation, but about electricity WPC (Without Price Control).

The United States do have strong institutions which perform well when cause and effect are close in time and space. Governor Davis term was 1999-2003, but many of the important decisions on deregulation were probably made on the term of Governor Wilson.

I like to know your answer before continuing to the following 5 questions:

1. Was Governor Davis a casualty of deregulation because earlier irreversible decisions on such a vital infrastructure landed on his watch?

2. How much did Governor Wilson contribute to that situation?

3. How much of the problem is due to FERC?

4. How much was due to the very unlikely combination of California NIMBY, hydro condition, high gas prices, etc.?

5. Why were the recommendations of Fred C. Schweppe to develop demand response before deregulating not understood as?

Regards José Antonio