Managing volts can give you the jolts
With Chilean economic growth comes growing electrical consumption. Forest Reinhardt and Gustavo Herrero (Harvard Business School) study Chile’s energy market and especially its second largest electricity producer, Colbún.
Colbún has come to be the second largest generator in Chile accounting for some 25% of Chile’s electricity. Its origin and history follow closely the liberalization of the Chilean economy – Colbún can perhaps be thought of as an offspring of the University of Chicago’s economics department. In 1982, barely ten years after the death of Salvador Allende, the Electricity Act was passed with the goal of deregulating the transmission sector. In 1986, Endesa, the large state-owned generator was broken up into 14 companies, including Colbún Machicura S.A. In 1997 the government sold its 37.5% share of the company. That set the stage for the Matte Group, a very large family-owned conglomerate, which already owned two hydropower firms, Guardia Vieja and Cenelca. In 2005 Colbún merged with those two firms, with the Matte group ultimately controlling some 49% of the new Colbún. A family insider, Bernardo Larraín Matte, took the helm of the new company.
Apart from presenting the specificities of the energy sector and electricity market in Chile, the case (see reference below) focuses on the challenges of managing Colbún. The problems facing Larraín arise from the mix of energy sources as well as the mix of customers. Prices for regulated customers (smaller customers requiring less than 2000 kW) were to be set freely by the market after 2009. Prices for industrial customers (requiring more than 2000kW) were negotiated in long-term contracts. Among its industrial customers Colbún counted Codelco (copper production), Anglo-American (The South African mining company) and CMPC (a forestry and paper company in the Matte group). As for its energy sources, half of Colbún’s electricity was generated using hydropower with the other half coming from thermal sources.
Risk on the hydropower side took the form of insufficient rainfall resulting in low output. Risk on the thermal side took the form of unreliable supply or high prices due to geopolitical conditions. The strategic alternative could be formulated as follows: if Colbún maximized its revenues by taking on a large number of long-term obligations, it ran the risk, in case of production shortfalls, of having to buy costly energy on the spot market or producing it in more expensive backup plants; minimizing long-term contracts meant sales on the spot market which carried a less attractive best case scenario. So to a large extent, the strategic question for Colbún’s management was to determine the optimal mix of sales via long-term contracts and via sales on the spot market.
Geopolitical volatility
The case brings up some of the specific challenges that Colbún’s management has had to deal with. One concerns the weight of natural gas in the energy mix. When considering thermal power plants in Chile, natural gas had a distinct cost advantage over coal. This led Chile in general and also Colbún to turn to Argentinean natural gas as a source for its thermal plants. In 2002 the Argentinean economic crisis led to a devaluation of the peso, causing in turn a substantial drop in the dollar cost of gas. But in 2004, as the Argentinean economy rebounded, demand skyrocketed and the Argentine government restricted gas exports to Chile drastically. The restrictions reoccurred in subsequent years, making Argentina unreliable as a source of gas for electricity production. And Chilean attempts to purchase Bolivian gas failed due to land conflicts dating back to the 1878 War of the Pacific.
Thus Colbún found itself in a position where it was being forced to find other more expensive sources of natural gas as well as diesel to run its thermal plants. It reacted in three ways. First, it renegotiated the price of its long-term contracts with its industrial customers to take into account the rise in cost of natural gas. For example, the price in 2007 was set at $73/MWh up from $56/MWh in 2006. Second, it reduced the energy to be delivered on its long-term contracts, from 12000 GWh in 2007 to 10000GWh in 2008. Finally, it turned to alternative thermal energies, with its first coal-fired plant due to come online in 2009.
Environmental obstacles
Faced with these risks on the thermal front, logic would have management turn toward hydropower. But there too, obstacles made the going tough. As already mentioned, variation in rainfall could lead to lack of necessary capacity. But just as significantly, the environmental review process prior to permission for construction made the creation of additional hydropower plants, lengthy, costly and uncertain.
The final decision for an environmental permit lay with the local COREMA (Comisión Regional del Medio Ambiente). While the review process was supposed to require no more than 180 days, permits took on average nearly 360 days to obtain, because of an additional question-and-response process. What’s more coal-fired plants seemed to encounter an easier time through the process, taking nearly two months less for approval. Finally, approved permits could be contested in court afterwards, adding to the length and uncertainty of the process.
Colbún had had to learn to exercise diligence in this process. The Aysen project (a $3.5 billion joint venture with Endesa) calls for five hydropower plants in the Aysen region to be built by 2019, generating enough power for 10 million Chileans. The two companies spent some $12 million on the environmental impact study.
But Chile is almost as close to the US as is Mexico and a few American players are driving opposition to the project. A US-based NGO, the International Rivers Network, helped a local civil service organization organize its opposition. And the American businessman of North Face and Esprit fame, Douglas Tompkins, had bought land in this area to create a national park. All the opponents of the project gathered some 3000 questions which would have to be answered by the project managers by December 2009.
Kyoto and Colbún
The Kyoto Protocol has had two interesting consequences for electrical generation in Chile. First, since Chile is under no obligation to cut CO2 emissions, it has, in the wake of the Argentinean gas problems, resorted to building coal-fired plants. An unfortunate development from a green perspective.
On the other hand, the Clean Development Mechanism allows developed countries to buy certified emission reduction credits (CERs) from developing countries. With its clean hydropower plants, Colbún has entered five agreements to sell CERs for a total value of $10 million. And it hopes to pursue other CER opportunities. Provided that local greenery does not block global greenery.
Reference:
Harvard 9-709-060
“Colbún – Powering Chile”
Professor Forest Reinhardt (Harvard), Gustavo Herrero (Director of the HBS Latin America Research Center), Sanjay Patnaik
Published April 2010
