Chile’s Energy Insecurity

Just when the energy sector seemed to be getting back on track after a period of extreme volatility, a series of questionable policy decisions threaten to derail this progress with important economic repercussions.

Chile’s history of struggles in the energy sector dates back to the creation of the Electricity Law in 1982, which focused on aligning wholesale prices (or node prices, revised every six months) with near to mid-term marginal costs. This model functioned well enough for roughly 15 years, largely due to little change in the predominantly hydro/coal-based matrix (in 1997, 76% of electricity generation in the country was hydro-based, while 18% was coal). At the time, there was little regard for matrix diversity or creating longer term investment incentives. However, as the country faced rising demand and an impending drought heading into the late 1990s, the government turned to a quick solution in the form of cheap Argentine natural gas piped over the Andes. In 1998, natural gas accounted for 15% of total generation and by 2004 it had reached 36%, while hydro generation declined to 43% of the total.

This solved Chile’s supply needs in the short term, but made other generation alternatives, including new hydro and coal-fired facilities, less economically viable. With investment concentrated solely in natural gas-fired facilities, Chile became dangerously dependent on Argentina for its fuel needs. As Argentina recovered from its economic crisis of 2001/02, domestic natural gas needs rose dramatically, but a lack of investment incentives resulted in scarcity, causing the government to curtail exports starting in 2004. By 2007, gas exports to Chile had fallen to nearly zero and have never recovered.

Given the long development timeframes for new large-scale hydro and coal facilities, Chile quickly had to replace its natural gas-fired capacity with idle coal facilities and, more importantly, diesel substitution at international prices. The impact on prices was dramatic with average contract rates climbing more than 200% between 2003 and 2008 to nearly US$115/MWh, not helped by rising global fuel prices. Although pricing now appeared more attractive, the lack of long-term price stability kept investors away.

Given these dire circumstances, the government enacted key reforms in 2006, creating an auction system which allows generators to lock-in fixed prices with indexation mechanisms over 10-15 year periods. At that point Chile embarked on a plan to wean itself off diesel, reduce costs, diversify the matrix, and ultimately improve energy security. At the same time, new incentives for transmission line development and renewable energy were introduced. As a result, investment in the sector boomed while wholesale prices stabilized at around US$85-US$110/MWh.

Although drought conditions in the last few years haven’t helped the recovery process, sending prices higher once again, there was a consensus among industry experts that, under normal hydro conditions, Chile would achieve the desired cost/pricing normalization by 2012/13.  Unfortunately, just as Chile neared inflection, a new nemesis emerged in the form of emboldened social opposition to generation projects.

The powder keg was sparked in August 2010, when President Piñera unilaterally intervened to block the 540MW Barrancones thermoelectric generation project in the Coquimbo Region in response to strong resistance from the local community, despite initial approval from regional authorities. This set a negative precedent, encouraging opposition groups and increasing uncertainty in the entire approval process. In its wake, it left other major projects in limbo, including the coal-fired Castilla (2,100MW) and HidroAysén (2,750MW) megaprojects. Currently, there are about 8,000MW, or US$20bn, in delayed projects.

This situation threatens to push back the normalization process and creates uncertainty regarding the long term stability of the system. Although improving hydrology and projects already under development should help the supply/demand balance heading into 2013, the real risk lies in the period 2014-2021.

Considering that electricity demand typically grows in line with GDP, if Chile were to grow 5-6% annually in that period, it would require an average of 700-800MW of new capacity per annum. Currently, the National Energy Commission (CNE) is forecasting a more conservative 500-600MW. But even then, the delays in new generation projects are creating considerable execution risk. Given that most projects take at least 3-4 years to develop, it is quite possible that Chile will fall short of its requirements. Ultimately, this threatens to have a widespread negative effect on real GDP growth as investment, especially by energy-intensive sectors like mining and industrial manufacturing, has been and is expected to be a key driver of growth. 

The current circumstances require drastic measures, which will hopefully mean key reforms to establish clear rules of the game in the project approval process. However, time is of the essence and if the government fails to act, Chile could face a significant setback on its path to developed country status.

Brian P. Chase is Portfolio Manager, Head of Andean Equities, at Itau Asset Management