Electricity Sector Reforms Threaten Private Sector Profitability

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¶1. SUMMARY. Proposed regulatory reforms in the electricity
sector will introduce a cost-based pricing system with publicly bid
long-term contracts, designed to promote transparency in energy
costs, reduce price volatility, and foster healthy competition in
the sector. While both private sector energy generator and
distribution companies support the transition to a cost-based
model, the generators have criticized several key elements of the
reform which they believe, if not properly modified, could damage
profitability and prompt companies to leave the Salvadoran market.

¶2. (SBU) The GOES plans to implement new electricity regulations in
June 2010 that introduce a framework for long-term publicly bid
contracts between electricity generators and distributors and
establish pricing formulas for wholesale electricity. The proposed
reforms will transition the sector from a marginal cost “spot
market” methodology to a cost-based pricing system. Currently,
electricity is sold on the spot market in marginal cost increments,
where the highest price per unit purchased each hour determines the
rate that all generators receive, regardless of the true cost of
energy produced. The current price regime creates volatility in
electricity prices and led the GOES to intervene for political
reasons in the market several times to freeze electricity prices
(see reftel).

¶3. (SBU) The proposed cost-based model will have two price
components: a capacity payment for fixed costs and a variable
payment for variable costs such as fuel. Generators will be
required to calculate their capacity payment using a gas turbine
model, which represents the lowest capacity cost in the industry at
$6.75 per Mega-Watt Hour (MWH), but has high variable costs. The
reform also calls for 50 percent of the total energy generated by
private sector companies to be sold through publically bid
long-term fixed contracts by 2012, with the remainder sold on the
spot market and through private bilateral contracts.

¶4. (SBU) Private sector electricity generators and distributors
are in general agreement that the transition to a cost-based model
is a positive step and will bring El Salvador in-line with modern
industry standards already in place in the majority of Central
America. However, generators assert the proposal fails to capture
the true costs of generation. According to Alberto Triulzi,
President of Cenergica, and Carlos Polanco, Director of Commercial
Development at Duke Energy, executives from the two largest private
generators in the country, the primary flaw in the GOES model is
that none of the generators in El Salvador utilize gas turbine
technology. Triulzi said their motors cost three-times as much as
a gas turbine, although their variable costs are much lower. He
said the Salvadoran Electricity Regulator (SIGET) has argued that
generators can compensate for the difference by increasing their
variable costs. Their variable costs will be audited, however, and
they are therefore unable to artificially inflate these costs to
compensate for such a large difference. Triulzi and Polanco stated
the use of the gas turbine model for capital costs is a thinly
veiled attempt to keep energy costs low at the generators’ expense.

¶5. (SBU) Triulzi and Polanco also criticized the approach to
long-term contracting. They argue that contracting out only 50
percent of the demand does not provide the stability needed in
order to guarantee existing investments or attract new investment.
In their view, the GOES should follow the example of Guatemala and
Panama where 100 percent of demand is contracted. Polanco said
this factor recently led Duke Energy to decide upon building a
coal-fired plant in Guatemala instead of El Salvador because banks
are more willing to provide credit based on the added stability of
long-term contracts. Additionally, both complained that the
state-owned CEL and La Geo, which supply 60 percent of the
country’s electricity, are not required to participate in long-term

¶6. (SBU) Private sector groups and U.S. owned generation and
distribution companies have been lobbying the Salvadoran

Superintendent of Electricity Regulation (SIGET) to modify the
proposal. However, generators and distributors have significant
differences in opinion over the provision on long-term contracts.
According to Ingrid Mendoza, Commercial Planning Manager of the
distributor Delsur, long-term contracts for 100 of demand represent
a huge financial risk. Mendoza said the Salvadoran law does not
provide geographic exclusivity to distribution companies and
permits other companies to enter into their territory and “poach”
large profitable clients. Under existing law, clients in their
geographic area can enter into private contracts with secondary
companies who offer to provide energy at a lower cost and use their
electric grid through a fee.

¶7. (SBU) On December 7, Econoff discussed the reforms with
Geovanny Hernandez, the Electricity Regulation Manager at SIGET.
Hernandez said the reforms were originally developed in 2005 during
the Saca Administration, but at the time, the former Superintendent
did not meet with the private sector and refused to consider
changes to the model. Hernandez said the new Superintendent, Tomas
Campos, has already held several meetings with the private sector.
Hernandez said the Superintendent agrees with the argument that
mandating only 50 percent of electricity demand in long-term
contracts is not sufficient to guarantee new investment or to
reduce price volatility, but he added that 100 percent may not be
the answer. Hernandez said they are considering supporting a
modification to 80 or 90 percent of demand. Hernandez also
acknowledged that distribution companies face financial risks with
long-term contracts and SIGET is analyzing possible solutions.

¶8. (SBU) COMMENT: The transition to a cost-based model is a
positive development for the energy sector and will provide needed
transparency and stability to electricity prices. The planned
reforms will align El Salvador with regulation standards already in
place in neighboring Central American countries, which will assist
in harmonizing Central American Electrical Interconnection System
(SIEPAC) regulations. The pragmatic approach taken by SIGET in
negotiations with the private sector demonstrates a willingness to
find mutually acceptable solutions. Long-term contracts will help
attract much needed private investment in the sector. The
exclusion of state-owned companies from participating in long-term
contracts shows a troubling bias affecting the end users of energy
and limiting economic growth.