ELECTRICAL INDUSTRY

SEBASTIAN BERNSTEIN L.

I. BACKGROUND INFORMATION

1. THE FIRST 50 YEARS: 1880-1930

The origins of the electrical industry in Chile can betraced to the mid 1880s with the inauguration of public lighting in Santiago'smain square (the Plaza de Armas). The following half century producedimportant developments in this field; developments launched by the privatesector.

During this time period, a large number of public serviceelectrical companies were formed, some of which later merged to form largerfirms. By the 1930's four key companies had emerged: the Chilean ElectricalCompany (CHILECTRA), the General Industrial Electrical Company (CGEI), theSouthern Electrical Society (SAESA) and the National Electrical Force Company(CONAFE). Moreover, self-generation of electrical power grew tremendously,in part as a response to the deficiencies of the public services in providinga timely supply of energy to important industries and mining installations.

As of the 1930s, electrical development diminished significantly.The reasons behind this reduction include the world economic crisis as wellas the setting of electrical rates on the basis of political criteria andgrowing governmental regulations which tended to check electrical companies'freedom of action.

2. THE PERIOD BETWEEN 1940 AND 1973

As a result of the lack of investment by private firmsin the electric industry, the State elected to intervene actively throughthe Corporation for Fostering Production (CORFO). Thus, physical developmentbetween 1940 and the end of the 1970s was controlled through the implementationof the National Electrification Plan. This program, initially formulatedby the Chilean Institute of Engineers, was studied by CORFO and implementedessentially through ENDESA, a CORFO subsidiary, formed in 1944. ENDESA subsequentlytook control of planning for development in the electrical industry andreported its progress to CORFO and the Ministry of Finance. The followingchart shows the general structure of the industry in 1940, the startingpoint for the aforementioned Plan (Chart 1):

Table 1

Electrical Sector in 1940

(1) Estimated at 330 kWh/Inhab net. In comparison, in 1933the net kwh/inhab consumption ratio in the USA was 1020, in Germany it totalled540 and in France the figure was 380.

The Plan's foremost protagonist was ENDESA although theprivate CHILECTRA was also able to participate, primarily during the 1960s,in the development of thermoelectric power stations and electrical distributionin the metropolitan areas of Santiago and Valparaíso. The ElectrificationPlan called primarily for the development of hydroelectric plants in thecentral-southern portion of the country and the construction of transmissionlines which would connect a series of electrical systems which until thatpoint had operated in isolation.

In 1970, CHILECTRA -- the company responsible for generating,transmitting and distributing electrical power in the areas of Santiago,Valparaíso and Aconcagua -- was nationalized. Therefore, by the early1970s the generation of practically all public service electrical powerand a large portion of the distribution networks were in the hands of theState.

The following graph reflects the development of electricalgeneration in Chile for the period 1930-1990 (Graph 1):

Chart 1

Total Electrical Generation

(GWh)

The physical and institutional development of Chile's electricalindustry was the result of the evolution of the regulatory framework. Thus,there was growing confusion over the notion of public service, in termsof electrical supply, with the active participation of the State in thebusiness and the objectives assigned to the industry (particularly in theperiod 1970-1973) which tended not to coincide with the criteria which shouldguide an economic undertaking of this nature. The following section is abrief summary of the history of regulations in Chile's electrical industry.

3. HISTORY OF THE REGULATORY FRAMEWORK

Initially, the development of the electrical industry wasconducted quite freely, without any special regulation. In 1904, legislationentitled "Prescriptions for the Concession of Permits for the Installationof Electrical Companies in the Republic" was approved. This 5-articlepiece of legislation was short and simple: essentially, it granted concessionsto utilize public or fiscal possessions for the installation of electricalnetworks and established security conditions to avert danger to humans fromthese constructions.

In 1925, the State began to take an increasingly activeregulatory role. The first "General Law on Electrical Services"passed that year regulated concessions for the use of water to be utilizedto generate electricity, as well as the use of public property and compensationto private parties for the installation of transmissio lines. Furthermore,an oversight organism was created to ensure compliance with the law andestablish a formal linkage between businessmen and the State.

This legislation referred explicitly to the proceduresfor setting rates: essentially, companies were authorized to obtain 15%return on net fixed assets which could be set in gold pesos, thereby providingan automatic indexation clause.

The second version of this legislation was passed in 1931.Here, the State increased its control through the Direction of ElectricalServices. In terms of rate control, the fixed assets of the companies wereto be assessed every five years but new rates could only be requested ifprofitability failed to reach 10% over 3 consecutive years. This clause-- a significant set-back as compared to the 1925 regulations -- was accompaniedby the elimination of the gold standard, thereby revoking the automaticrate adjustability which had been inherent in the previous legislation.

The disincentives contained in these regulations, combinedwith the international crisis of the early 1930s and the repercussions forthe financing for new works, increasingly led private companies to abandontheir participation in the development of the industry.

As a result, the State took charge of the generation andtransmission of electrical power, while the private sector limited its activitiesto participating in distribution and maintaining wholly-owned power stations.Planning for the system was conducted centrally by ENDESA, with a high degreeof technification. Eletrical rates, particularly as of the 1950s, were sufficientto provide adequate levels of revenue.

A statutory decree passed in 1959 (DFL No. 4), establishedcriteria for the granting and cessation of concessions, as well as on proceduresfor rate calculation. Tariffs were to allow a profitability of 10% overnet fixed assets with annual re-adjustability clauses for capital and theoption of temporary rate adjustment when fluctuations over 10% in the costof primary components occurred. The legislation called for the establishmentof a rate commission to be comprised of delegates named by the Presidentof Chile, electrical companies, consumers and the Superintendency of ElectricalServices.

DFL No. 4 established a clear framework for the electricalindustry and made it possible for private firms, such as CHILECTRA, to developimportant thermoelectric projects in the Santiago-Valparaíso areafor a total of 338 MW.

In 1966, the regulations on electrical rates were modified.Henceforth, the Ministry of Economy was required to approve any rate hikesproposed by the Tariff Commission. As a result, political factors were broughtinto play in the rate-setting process which served as an additional disincentiveto private industry. As noted earlier, CHILECTRA was nationalized in 1970.

In 1971, prices were frozen. The skyrocketing inflationregistered as of 1972 resulted in huge operational deficits for both publicand private electrical firms. These difficulties led multilateral banksto discontinue loans to the Chilean electrical industry, effectively bringingdevelopment programs to a standstill.

II. GENERAL ASPECTS OF THE NEW ELECTRICAL POLICY

1. SHORT-TERM MEASURES

In the first few years following 1974, a process of financialrecovery was instituted among state-owned and private electrical firms.This process led primarily to the progressive recovery of prices for electricalenergy. Management ofi state-owned enterprises was rationalized and responsibilitieswhich could be better handled by the private sector were transferred toprivate firms. Thus, the construction activities conducted by ENDESA wereactually implemented by private contractors, as was the case with otherservices such as transportation and repairs.

2. REMAINING STRUCTURAL PROBLEMS

The changes introduced in the period between 1974 and 1979contributed to the rationalization and normalization of a large portionof the industry, but failed to attack the roots of a series of structuralproblems which made it difficult to increase efficiency and make managementof the electrical industry compatible with the policies applicable to otherfields of economic activity. The following are among the most importantproblems in this area:

- Preponderant State participation in the industry: almost90% of generation, 100% of transmission and 80% of distribution was in Statehands. This meant controlling resources of some US$ 200 million per yearwhich competed directly with the State's priorities in social areas.

- The practically monopolistic role of ENDESA in the developmentof the industry. The possibility the participation of the private sectoror other State entities in the formulation of new projects -- particularlyin the area of electrical generation -- was limited.

- Control was difficult: although the electrical companieswere overwhelmingly state-owned, there was no effective control over theindustry; moreover, in terms of overall energy-producing entities, therewere no appropriate mechanisms for coordination among the various sub-sectors.In practice, the power of the large State firms was greater than that ofthe governmental organizations charged with their oversight.

- Political impositions on state-owned companies of un-profitableactivities, such as the development of inappropriate projects or the hiringof excessive personnel.

- Generation of technological monopolies and occupationalmonopolies at the technical level, particularly in the fields of generationand transmission.

- Definition of the role of state-owned companies: untilthe creation of the National Energy Commission (NED) and the definitionof policies on the macro and sectoral levels by the Office of National Planning(ODEPLAN) -- as well as the redefinition of CORFO's responsibility in themanagement of its subsidiaries -- there was a certain degree of confusionin the electrical industry as to the State's regulatory and business roles.In effect, the largest state-owned firms fulfilled both roles, creatingfrequent conflicts of interests between their objectives and those of thecommunity as a whole.

- Inefficient rates from the economic perspective: in essence,the rates based on ensuring profitability over a portion of assets failedto recognize the costs associated with production, transmission and distributionof electrical power. Thus, a system of premiums for the most efficient companieswas not generated, nor did the most inefficient firms pay the price fortheir extravagance as would occur in a competitive market.

Furthermore, the legislation failed to specify criteriafor the establishment of rates within and among companies. This led to avast array of rates schedules among power companies. Lastly, the enormouslyhigh inflation registered in Chile during the early 1970s further servedto complicate the adjustment of rates in accordance with accounting principles.

3. OVERALL STRATEGY

The strategy designed to deal with energy production --and electrical power in particular -- was consistent with the general economicand social development policies adopted during the mid 1970s. In essence,these measures sought to maximize social well-being by introducing increasedefficiency into the industries in question within the conceptual frameworkof a subsidiary role for the State.

Economic efficiency is understood here as achieving anoptimum distribution of resources in the economy, in direct reference toPareto's optimum.

The subsidiary role of the State means that the governmentdoes not act so long as there are intermediary individuals or organizationsin society which are capable of acting on their own initiative. Moreover,the State should provide sufficient mechanisms to ensure the basic needsof those individuals who are unable to do so for themselves, so long asthis support does not curb the activities of other social actors who arecapable of satisfying those needs efficiently.

In terms of energy, the subsidiary role of the State translatesinto the non-participation of the State in business activities relatingto the industry to the extent that said activities are or can be implementedby private entities. The State's participation, therefore, should focuson ensuring adequate service and coverage for the lowest income groups.

Among the variety of mechanisms utilized in Chile to achievethese goals in terms of energy production, the following are of particularimportance:

a. The clear separation of the regulatory and business-relatedactivities of the State.

The regulatory function was handed over to the NationalEnergy Commission (formed in 1978) and the National Planning Office (ODEPLAN).

The NEC is a decentralized advisory body which reportsdirectly to the President. It is composed of a 7-member Council and presidedover by an Executive Secretary. The Secretariat is responsible for the Commission'stechnical activities as well as its administration.

ODEPLAN prepared, in conjunction with other governmentalentities, its so-called annual "Ministerial Programs," which establishedspecific goals in the field of defining the "rules of the game"for public administration and for state-owned firms in particular. In termsof energy, there was close collaboration between ODEPLAN and the NEC.

The management of the energy-producing state-owned companies,whose structures most often mimicked private enterprises, was submittedto the Corporation for Fostering Development (CORFO), a government-controlledentity which served, in essence, as a holding company. As such, CORFO wasnot responsible for issuing regulations controlling the industry, but ratherplayed a crucial role in re-organizing companies, controlling their management,division and privatization.

b. In an effort to maximize community benefits, the NECwas charged with coordinating the large-scale investment decisions madeby state-owned electrica utilities. Once a large portion of the industryhad been privatized, this central planning was replaced with individualefforts undertaken by private companies.

c. Implementation of institutional and legal adjustmentsin an effort to:

- Achieve efficient management within state-owned companiesand subject them to the same regulations as private firms.

- Open new areas to the participation of the private sectorin electrical industry, either through the creation of new companies orby privatizing those held by the State.

d. Subjecting State participation in the evaluation ofenergy resources to strict socioeconomic criteria and restraining Stateparticipation where other organizations could effectively complete specificprojects.

e. Lastly, one of the most decisive elements of the newpolicies was the formulation of a realistic and efficient price system whichaccurately reflected the value of electrical energy.

III. SPECIFIC ASPECTS OF ELECTRICAL POLICY

1. CENTRALIZATION VS. DECENTRALIZATION

Before delving into the specifics of Chile's electricalpolicy, it is important to pause for a moment to discuss a factor that wascrucially important in determining the best strategy for continued developmentin this area: the level of decentralization acceptable in the productionand distribution of electricity which, over the previous 4 decades, hadbeen characterized in Chile by a high degree of centralization.

The questions Chilean regulators asked themselves were:to what extent is possible and appropriate to decentralize the generationand distribution of electrical energy? To what extent can the industry bemade competitive and be privatized? What were the real reasons behind centralizingand maintaining State control over these activities? In the early stagesof the debate, serious consideration was given to the formulation of a single,state-run company, following the French model. However, this proposal wasdiscarded as it was quickly agreed that such a company would, for the reasonsnoted earlier, go against the grain of the long-term economic activity policiesbeing designed for Chile.

Thus, the following elements were considered in the discussionover the need to retain the levels of centralization on which the Chileanelectrical industry had been constructed.

a. Economies of Scale in Generation and Distribution

As demonstrated through the comparison of hydroelectricprojects in Chile, the concept of an economy of scale does not appear beapplicable to the generation of electricity.

Furthermore, economies of scale are not important elementsin the growth of distribution companies. In effect, a comparison of theaverage distribution costs of different sized companies (defined as theratio between the yearly renewal costs plus annual development expensesand the power delivered by the network) indicates that size plays almostno role in cost. Thus, the presence or lack of economies of scale in thegeneration and distribution of electrical energy is not significant.

Chart 2

Average Cost of Generation at Several

Hydroelectic Plants in Chile

Chart 3

Average Distribution Costs

Once the need for economies of scale had been discarded,the advantages of having a variety of competing electrical generation anddistribution companies became apparent. However, three problems remainedto be resolved:

- Investment planning decisions, that is, the degree ofcentral coordination required to bring generating plants on line. This problemis only relevant to the extent that the projects comprising an optimum expansionplan are all of a structural nature, thereby requiring coordination amongthem.

- Cooperation in operations and in devising an efficientsystem of pricing for transfers among utility companies. In Chile, the presenceof large reservoirs whose management conditioned the operation of the entiresystem made coordination of such operations particularly important.

- Establishing fees for the use of transmission lines.

The measures taken to address these problems will be discussedin a moment.

b. Private Participation in a Decentralized Industry

Clearly, private participation in the generation and distributionof electrical energy is possible if: there is a demand for electrical power,profitable projects exist, processes for planning works and setting rateson the basis of solid technical-economic criteria are utilized, and if theso-called rules the game are stable and rational. Furthermore, an environmentof decentralization favors the participation of the private sector.

c. Competition in the Electrical Industry

Competition in operation can be achieved through the identificationand development of a variety of power plant projects. These projects maybe implemented on the basis of the different styles and criteria utilizedby companies to study, finance, implement and operate power stations. Inlarge state-owned companies, on the other hand, there is a tendency forpriorities to be placed on large projects which are most often based onengineering criteria than on economic or financial viability. Moreover,alternatives for such companies are frequently unavailable and the Stateis obligated to support such large-scale projects.

In distribution, concessionaires can compete in effortsto expand services with other private, unregulated distribution services,such as rural electrification cooperatives. Moreover, public service concessionscan be allowed to overlap in cases where the quality of service by a givenconcessionaire fails to meet expectations. Lastly, when the framework forestablishing distribution prices is based on a the aggregate referentialvalue of a standard, model company (rather than on expenses of individualdistribution firms), concessionaires end up competing with the model company.

d. Decentralization, Privatization and Efficiency

The decentralization and privatization of electric companiesalso present advantages in terms of the stability of the rules of the game.

- Government officials are no longer faced with a singleinterlocutor but rather have several sources of information. Thus, an environmentof greater competition is encouraged.

- The diversity of companies and private participationconstitute good protection against lobbying efforts by certain groups toobtain arbitrary reductions in rates.

- An incentive is provided to improve technology, diversifytypes of employment and allow for greater work-related mobility.

Furthermore, privatization provides an important sourceof revenue for the Government without having to tax the private sector.Privatization also requires diversification in the ownership of installations,the development of capital markets and the participation of strong institutionalinvestors such as pension funds, insurance companies and the employees ofelectrical companies themselves.

De-concentration, decentralization and privatization incomplex fields, such as the electrical industry, require that policies bedesigned and implemented with great care. The relationships between differentcompanies in a decentralized, privatized framework mean that obligationsand reciprocal justifys -- particularly in the area of pricing for energytransfers -- be clearly stipulated (whether they are regulated or not) andthat coordination mechanisms be explicitly established.

2. INSTRUMENTS FOR IMPLEMENTING ELECTRICAL POLICIES

In 1978, Chile initiated a process aimed at an institutionalrestructuring of its electrical industry in an effort to decentralize, enhanceefficiency, establish competition and attract private participation. Ingeneral terms, electrical service was recognized as just another type ofeconomic activity -- responding to the same stimuli as other fields -- andtherefore the regulations implemented could not work against natural forces.

The instruments designed to achieve these objectives were:

- Rates set at marginal cost for small consumers and freedomof pricing for large end users.

- Division of large state-run companies and the separationof generation and distribution activities. Rates set at marginal cost forsupply by generators to distributors.

- Creation of a Economic Load Dispatch Center, a key elementin competition among generators.

- Design of a fee system applicable to common carrier transmissionsystems.

- Establishment of a new framework for generation planning.

- Changes in the types of financing available for investmentsand the drawing down of profits from state-owned firms.

- Clear definition of regulations, obligations and justifysof Public Service Distribution concessionaires.

- Authorization of the operation of non-regulated privatedistribution services.

- Privatization of the majority of the electrical industry.

The following is a brief description of each of the basiccomponents of these instruments.

2.1 RATES

Rates should reflect the efficient costs of supplying electricity.Special emphasis was placed on establishing efficient prices for transfersbetween and among the different actors participating in the system, namely,generators, distributors and end users.

The tariff system was based on a clear distinction betweenelectrical supply with natural monopolistic characteristics (such as electricaldistribution to a large number of clients utilizing streets and roadways),for which regulated prices were established, and areas in which it was possibleto create competitive conditions (supply to large clients) for which freedomof pricing was established. The pricing system for electrical energy wasdevised and implemented by the NEC in 1980 and was described in detail inthe new legislation on Electricity approved in 1982.

These legal bodies established four basic prices linkedto the marginal costs of supply:

- Prices for transfers among generators;

- Prices for sales between generators and distributors;

- Prices for clients of distribution companies;

- Freedom of pricing for large end users (over 2MW).

Prices for transfers among generators correspond to theshort-term marginal costs of the electrical system and were calculated onthe basis of the Economic Load Dispatch Center (ELDC). This matter willbe discussed in greater detail in a moment.

a. Rates between Generators and Distributors

These rates, known at "node" prices, are calculatedby the NEC as the marginal cost needed to satisfy peak power (kW) and energy(kWh) at the sub-stations located throughout the system. These marginalcosts are calculated for the generation-transmission system on the basisof optimum development and operations.

The marginal cost of peak power is based on the unit costof gas turbine installations (considered the most economic fashion of supplyingpower during peak hours.)

The price of energy is calculated as the short-term marginalcost of the expanded electrical system operating under optimum conditions.In order to avoid fluctuations which might affect the stability of the tariffto end users, a flexible average of sort-term marginal costs for the following48 months is utilized. Projectred short-term marginal costs are computedthrough an optimization model based on dynamic programming, appropriatefor the multi-year management of Chile's Central Interconnected System ofreservoirs.

The "node" prices are calculated every 6 monthsand are expressed through indexation formulas based on a variety of theprincipal cost components of electrical generation and distribution (fuelcosts, reservoirs levels, demand and others). These formulas make it possiblefor rates to be indexed automatically within any given semester.

b. Rates for Clients of Distribution Companies

These prices are calculated on the basis of two components:node prices and distribution costs (known as the "aggregate cost ofdistribution").

The aggregate cost of distribution is roughly equivalantto the ratio between annual capital costs plus the operating cost of a "model"distribution network and the peak power it delivers. Over time, it has becomeclear that these aggregate costs are representative of the long-term marginalcost of distribution given that practically no variation occurs as a resultof company size.

The aggregate cost is calculated for a "model company,"that is, one of an optimum size and efficient management operating in aarea defined on the basis of the density of distribution areas. These areasare, in turn, divided into high, medium and low density areas and the nation's23 concessionaires are classified in accordance with this system.

The aggregate cost is expressed in terms of three basiccomponents: fixed costs associated with clients which are unrelated to consumption;investment, operation and maintenance costs, as well as reduced use of distributioninstallations (associated with the demand for power during peak hours);the cost of supplying power during non-peak hours; and, lastly, losses associatedwith the distribution of energy.

This regulatory framework does not recognize the expensesgenerated by each distribution company, but rather those of a hypotheticalmodel company which serves as an incentive for real firms to reduce theircosts. The aggregate costs are established every four years and are expressedthrough formulas indexed in such a fashion as to allow companies to adjusttheir rates accordingly.

c. Prices for Large End Users

Sales to end users of power over 2,000 kW are contractedfreely between electrical companies and users. At present, approximately35% of Chile's public service energy is provided in this fashion. The applicationof free pricing is based on the presence of a number of generation-transmissioncompanies and the possibility of competition among them (even when theymay use transmission systems belonging to third parties).

Furthermore, such large clients have both the power tonegotiate and the ability to develop, either on their own or in conjunctionwith other users, projects aimed at satisfying their electrical needs whichwould compete with the services supplied by the public utility companies.

It is important to note that to a certain extent, the freepricing system serves as a guideline for "node" prices. In effect,current legislation indicates that node prices may not be more than 10%higher or lower than the free market rates for the system at large.

2.2 DECENTRALIZING STATE-OWNED COMPANIES

Chile's large, vertically integrated, state-owned electriccompanies were separated into generation and distribution firms (the latterwere also sub-divided into regional companies).

Thus, subsidiaries of ENDESA and CHILECTRA were formed,as were new companies which depended on CORFO. Chilectra was divided intothree sub-divisions, CHILGENER, was charged with generating and transmittingenergy in the Santiago-Valparaíso area; Chilectra Metropolitana,distributed electricity in Santiago; and Chilectra V Región tookcharge of distributing electrical energy in Valparaíso and the Aconcaguariver valley.

ENDESA was transformed into a company dedicated exclusivelyto the generation of electricity while its old Distribution Administrators,EMELAT (Atacama), EMEC (Coquimbo), EMELIG (Ligua Valley), EMEL (Melipilla)and EMECO (Colchagua) became distribution subsidiaries. Subsequently, manyof these companies located in rural areas merged.

ENDESA also created generating subsidiaries, namely PULLINQUEand PILMAIQUEN S.A. (each with a capacity of approximately 40 MW), COLBUNS.A. (490 MW). PEHUENCHE S.A. (500 MW) was formed as a subsidiary of CORFO.

In addition, some ENDESA affiliates broke away to formindependent companies, as was the case in the farthest-flung reaches ofthe country: ENDELNOR (Northern Chile), EDELAYSEN (Aysen) and EDEMAG (Magellan).

2.3 ECONOMIC LOAD DISPATCH CENTERS (ELDC)

Undoubtedly, the coordination of the operations of a large,inter-connected system is a technical, economic and political necessityif efficiency is to be achieved through the decentralization and de-concentrationof the generation and distribution of electricity. With this purpose inmind, the NEC designed the so-called Economic Load Dispatch Center (ELDC)which primarily sought to:

- Ensure the viability of the electrical system;

- Ensure operations at a minimal cost for the system asa whole;

- Charge fees for transfers among companies generatorsin accordance with the system's short-term marginal costs;

- Establish equal conditions for marketing the energy.

The ELDC was conceived to:

- Plan the operations of the existing system, consideringthe schedule for the incorporation of power stations. The ELDC plans operationsover the long-term (5 years), medium-term (1 year) and short-term (1 weekto 1 month), including operations for the following day. In addition, theCenter calculates the short-term marginal costs associated with optimumoperations and ascertains and assigns the cost of transfers of electricityamong companies and ensures their payment to the owners of the transmissionsystem.

- Conduct the operations of the system, considering exclusivelythe generation activities of each company, independent of the conditionsunder which they sell their energy. Thus, the Center did not take pricescontracted with end users into consideration.

- Plan operations. However, the Center does not operatethe system on a real-time basis.

Small inter-connected generators were not required to belongto the Center and were authorized to sign contracts freely with larger generators.

This meant that for planning purposes the ELDC was independentof the particular preferences of each generator and made its decisions onthe basis of broadly accepted criteria: reservoir level, price of coal andoil, demand, etc.

Prices for transfers of energy among generators are establishedin accordance with short-term kWh marginal costs as measured at the sub-stationwhere the transfer takes place.

Transfers of peak power are established on the basis ofkW marginal costs, utilizing the investment cost of gas turbines (as a reference)located at the most convenient point on the system. Prices for these transfersare established in advance, in January of each year.

In order to keep generators from selling more power orenergy than their company has available, contracts are inspected so as toensure that commitments do not exceed production and/or supply contractedwith other generating companies. Prices for power supplied through suchcontracts with outside companies are free to fluctuate. This tends to limitover selling by generators.

It is important to note that the ELDC does not purchaseenergy nor establish prices for end users but rather serves as an intermediarybetween generators in order to enhance the organization of their services.

2.4 FEES FOR UTILIZING THE TRANSMISSION SYSTEM

Sharing of the transmission system is a critical tool fora successful policy of competition among generators of electrical energy.Given the importance of the transmission system, the regulations establishinga fee structure for its use is contained in the general Electrical Law.

Obviously, the use of transmission lines owned by thirdparties for the transmission of electrical energy requires that fees bepaid for this service. If economies of scale did not exist, there wouldbe no problem in charging a general fee for production and transmission(such fees would simply be the difference in rates between the two endsof the line in use). However, the presence of economies of scale in thissegment of the electrical industry means that the so-called "tariffrevenue" (difference in rates at each end of the line) must be supplemented.This need is even more evident when power stations generating electricalenergy are brought on line which do not have contracts with end users butmake use of the transmission system.

Thus, the annual income received by the owner of the transmissionsystem must be supplemented when third-party power stations make use ofthose installations. As a result, a connection fee or "basic toll"is established. This toll is calculated on the basis of the total supplementcorresponding to the "area of influence" where the latter is definedas that portion of the system where the presence of a power station resultsin alterations in the flow over those lines. The proportion is calculatedas the ratio between the maximum power emitted by the owner of the powerstation and the maximum power emitted by all of the users in the area ofinfluence, including the owner of the transmission system.

Payment of this toll enables the owner of the power stationto sell energy to end users located at any point within the area of influencewithout the need to charge an additional fee. When a power station doesnot have end user clients, the station is authorized to sell its energythrough the ECDC at the price corresponding to the short-term marginal costat the sub-station generating the energy.

2.5 PLANNING

Because of their characteristics, distribution-orientedinvestment programs lend themselves to full decentralization. That is, suchdecisions can be adopted independently by each company. Nonetheless, a clearframework of justifys and requirements is needed in order to ensure that activitiesin this area, which tend to form a natural monopoly, actual serve the community'sinterests.

In generation and transmission, however, large-scale projectstend to be of a structural nature and therefore have a significant impacton the operation of existing and future power stations. Thus, coordinationis extremely important in order to minimize the total cost of supply, marginalexpenses and, eventually, the rates end users pay for electricity. The exceptionsto this rule, however, are the small-scale projects whose feasibility canbe independently evaluated through existing pricing mechanisms.

The role of the State in coordinating large-scale investmentprojects in these areas is important in terms of both the impact these effortsmay have on rates and the position the State adopts when confronted witha potential disequilibrium between supply and demand.

When Chile's electrical companies were owned by the State,proposals resulting from such planning activities were obligatory. Withinthe framework of active private participation in the industry, however,such planning is considered a recommendation.

Responsibility for planning Chile's large-scale electricalgeneration projects has resided with the NEC since its formation 1978. Theagency worked with companies generating electrical power which were requiredto submit their expansion projects to the Commission for consideration.These requirements remained in place until 1989, when the privatizationprocess was finalized. As of that date, the NEC's findings have been considered"recommendations."

Because the electrical industry is a competitive one inwhich there is no direct relationship between producer and consumer (transmissionlines owned by third parties can be utilized), the new legislation did notrequire that electrical generation services be provided. Moreover, the pricingsystems -- both free and regulated -- were sufficiently attractive so asto ensure that such development activities in fact took place without governmentintervention.

2.6 FINANCING POWER PLANTS

Small and mid-sized projects were initially conducted directlyby state-run companies and work continued on them following privatization.In order to finance these projects, a variety of mechanisms were utilized,including depreciation, and credits from suppliers and multi-lateral lendinginstitutions (primarily the IDB) as well as the so-called "reimbursablecontributions" electrical companies received from new users.

Chile's largest power stations (those generating over 200MW),were developed through the creation of new CORFO subsidiaries. These companiesundertook the activities relating to the development of the stations, utilizing,for the most part, a portion of the engineering know-how accumulated throughENDESA, as was the case with COLBUN S.A. and PEHUENCHE S.A. (500 MW each).Financing of these projects was structured through minority capital contributionsmade by existing companies and CORFO, as well as credits from suppliers,the IDB and IRDB.

A policy of distributing the largest possible percentageof profits among shareholders was established. While the State continuedto own the companies, such dividends naturally went to the State. Obviously,this policy was designed to sustain a healthy financial situation withinthe new companies. The exception to the rule in this case was ENDESA itself.The company's enthusiastic use of favorable international market conditionsjust prior to the economic crisis of 1981-1982 contributed heavily to thenegative results on the firm's balance sheet.

In fact, ENDESA's indebtedness was sustained at acceptablelevels through 1981. With the devaluation of the Chilean currency in 1982,however, the situation became critical and special measures were neededto resolve the company's financial woes. These measures will be discussedin a moment.

The State's policy of drawing down profits must be understoodwithin a context of maximum flexibility in the use of revenue, taking intoaccount its fungibility and without establishing re-investment requirements:an effort was made to keep the electrical industry from becoming a "closedcircuit" where the revenue generated was automatically re-investedin the industry itself. The concept was -- and continues to be -- that theviability of each electrical project should be sustainable on its own meritsand that financing for such ventures should be a separate matter.

2.7 ORGANIZATION OF DISTRIBUTOR justifyS AND RESPONSIBILITIES

Although the concept of competition is not foreign to electricaldistribution, it is clear that, in practical terms, the field for such activitiesis limited. Thus, a system of pricing and quality regulation needed to beestablished to ensure adequate supply of electrical energy at a reasonablecost. Toward this end, geographic areas were outlined for distribution concessionsand the responsibilities and justifys of each of the distributors were established.

Legislation was approved calling for "Concessionsof Public Service Distribution" for electrical energy in the establishment,operation and use of public service distribution networks.

The concession defines a framework for the justifys and responsibilitiesof distribution companies. The former include the justify to utilize publicgoods and private property, the justify to a fair rate (but which does notsubsidize inefficiencies), and the justify to request that users contributeto the financing of the expansion of distribution installations as wellas increasing the capacity of existing installations for electrical generation,transmission and distribution. These contributions must be reimbursableand are therefore unrelated to the rates established for services.

Among the latter, companies are required to provide serviceto any person or institution requesting service within the concession areaand to comply with the regulations governing service quality.

Users located outside the concession area are authorized,by law, to link up with the concessionaires installations through privateor third party lines. The price of energy at the contact point is the sameas throughout the rest of the concession area.

The time-frame granted for each concession is unlimited.However, concessions can be canceled if the quality of service falls belowacceptable levels. Prior to cancellation, reminders and fines must be issued.

2.8 THE PRIVATE SECTOR

The legislation allows for the private sector to engagein non-regulated distribution activities. A good example of this participationhas been the activities of rural electrification cooperatives and small-scaledistribution companies. These services are not regulated in either qualityor price.

When non-regulated services require the use of public landsto string lines, governmental authorization must be obtained.

IV. PRIVATIZATION OF THE ELECTRICAL INDUSTRY

The privatization of the electrical industry -- fosteredby the need for coherence in the framework of socioeconomic developmentimplemented in Chile as of late 1973 -- was conducted with considerablecare and pragmatism, particularly in terms of the speed with which changesoccurred. In fact, the earliest privatizations did not occur until 1980and the process was not completed until early 1990. The measures taken inthis field were adopted over time, and care was taken to respect institutional,political and financial situations which arose along the way. Frequently,these situations meant that strategies which had initially appeared viablehad to be altered and, in fact, not all of Chile's electrical companieswere privatized.

It is important to note that in the early years, therewas no consensus within the government as to the advantages of privatizingan industry considered of strategic importance. These initial doubts meantthat the process was conducted slowly. Solutions were found to the industry'sfinancial problems and many people within the government who felt that theindustry functioned efficiently opposed its privatization. The primary problem,however, continued to be one of definitions. In terms of efficiency, onemust not, obviously, confuse the efficiency of a company's personnel --who may be capable and the most appropriate individuals for the job -- withthe efficiency in executing specific tasks on the macro level of a state-ownedcompany subjected to pressures, obligations and distortions which, in effect,impact negatively on its management.

It was also clear that the incorporation of private capitalinto the electrical industry would not be trouble-free; it was no longera matter of normalizing the situation of companies which had been nationalizedduring the previous administration, but rather a shift in the overall focusof development policy. As a result, opposition to the privatization processemerged in a variety of quarters:

- From elements within the government itself, who fearedloosing the ability to manage the industry politically.

- From company employees who feared for their jobs andthe so-called "social achievements" (benefit packages) which werefrequently much more attractive than those of the rest of the nation's workers.

- From company professionals and executives who, to a certainextent, controlled the day-to-day operations of the companies as a resultof the weak, rotating, directors appointed by the State.

- From extensive sectors within the Armed Forces whichperceived the electrical industry as being of particular strategic importance.

- From the political opposition, imbibed primarily witha statist culture and even from within the ranks of the government's supportersfrom those who feared taking a step of this magnitude.

- From some business groups who perceived state-owned electricalcompanies as a vehicle for obtaining subsidies through prices.

In any case, it was clear that privatization required,in addition to a clear definition of the rules of the game, the presenceof strong, important capital markets. The emergence of such markets in Chilewas closely linked to the participation of institutional investors arisingfrom the reforms implemented in the nation's social security system. Inessence, the Pension Administration Funds (AFPs) which managed the individualcapitalization funds of the nation's work force became the largest singleinvestors in the privatized electrical system. Thus, AFPs and other institutionalinvestors, such as insurance companies, the employees of the electricalindustry themselves, and foreign investors (operating through debt conversionmechanisms) became key actors in the privatization process.

As a result, two paths for privatization were identified:sale of entire companies to individual investors and "share packages"to institutional investors; and the widespread, broad sale of smaller packetsto individuals through so-called "popular capitalism."

As noted earlier, a prerequisite for privatization wasthe establishment of clear rules of the game -- regulations, obligationsand justifys, rates, guarantees on the justify to property, etc. -- that wereboth transparent and grounded in sound technical and economic analyses.

Another prerequisite was transparency in the process ofselling shares; except in those cases where the price of the shares wasnegotiated directly with employees (most often at a rate set in accordancewith prices on the stock market). The sale of shares in the electrical companieswas done through public bidding or through the auctioning off of "sharepackets" on the local stock market.

During the early stages of the privatization process, theargument most often given to oppose these sales (in addition to those ofa purely ideological nature) had to do with the prices at which the shareswere sold. Thus, arguments such as the following were heard:

a. The State is selling property at prices below theirbook value. Thus, the argument goes, the government is "giving away"national property to a few select individuals. The error in this logic isclear: assets are worth the cash flow they can generate (this may bear norelationship to the book value).

b. The price charged for the installations is lower thansimilar facilities being built by the State; thus, national patrimony isbeing given away to the private sector. Again, there is a conceptual errorin this argument which is similar to the preceding one: if rates are setbelow costs, the flow of future income -- and therefore the economic worthof the installations -- may be much lower than the cost of similar facilitiesunder construction. This example serves to reinforce the importance of establishinga rational price system prior to privatization.

c. An argument was made that if the private sector wishedto participate in the electrical industry, it should be willing to makeits investments under the same conditions as the State, that is, with lowrates of return (given that electricity is a public utility). The conceptualerror continues to be the same: discount rates -- linked to the cost ofmoney -- are set by the economy, just like any other price; the State cannotimpose a discount rate below what the market stipulates for the service.

Nonetheless, it is clear that the State, upon privatizing,cannot accept just any discount rate; setting this component -- which tendsto diminish as public trust in the system increases -- is clearly one ofthe most delicate aspects of the privatization process. The indicationsof confidence exuded by the State itself, as well as the stability and rationalityof the regulations affecting the industry, are therefore the keys to a successfulprivatization process.

The first privatizations in Chile consisted of the publicsale of two ENDESA distribution subsidiaries, SAESA and FRONTEL in 1980.Both companies were acquired by the COPEC conglomerate.

From 1980 through 1983, almost no progress was made inthis area as a result of opposition within CORFO to the privatization ofits largest subsidiaries, ENDESA and CHILECTRA. Progress was made, however,in the formation of regional distribution companies stemming off from ENDESAand in the break up of CHILECTRA into local subsidiary companies.

In order to continue progressing toward privatization,the NEC issued regulations requiring that the reimbursable financial contributionscompanies were authorized to request of new clients be paid back in companystock. Through this procedure, the public became more aware of the presenceand behavior of electric company paper on the stock market. Between 8 and10% of two Chilectra distributors were privatized in this fashion.

Between 1983 and 1987, 3 small-scale hydroelectric plantsbelonging to Chilectra-Generating (CHILGENER, for a total of some 20 MW)were sold through public bids. In addition, PILMAIQUEN (35 MW) and Pullinque(49 MW), both ENDESA-owned stations which had been transformed into subsidiarycompanies, were also privatized through this mechanism.

Although a large number of interested parties participatedin the bidding process, the properties were eventually sold to Banker'sTrust (whose offer of some US$21 million for PILMAIQUEN bettered those offive other contenders) and the Fernández business group, associatedwith the Rural Electrification Cooperatives (who paid some US$31 millionfor Pullinque). It is important to note that the sale of these power stationsincluded a temporary option for the companies themselves to purchase theenergy produced. This arrangement was based on the system's marginal costs,with discounts of approximately 10% for the use of transmission lines andcharges for frequency regulation.

Following those sales, privatizations in Chile picked upspeed with the full sale of Chilectra Metropolitana, Chilectra V Regiónand Chilectra-Generating. Employees were particularly active in acquiringshares through the early withdrawal of retirement funds. In addition, AFPsand banks invested heavily, the latter through such mechanisms as debt conversionand swaps.

In order to privatize ENDESA, the company's financial problems-- arising from its indebtedness -- needed to be solved. It is importantto note that with the devaluation of Chilean currency, a so-called "preferential"exchange rate for the dollar had been established to avoid excessive lossesfor domestic companies holding loans in U.S. currency. The "preferential"rate was set at a mid-point between pre and post-devaluation levels andwas adjusted over time so as to match, eventually, the real value of foreigncurrency in the Chilean market.

In 1985, the preferential rate for the dollar was eliminated,and ENDESA was left with losses totaling some 360 million dollars. The debtwas absorbed through a reduction in the firm's capital holdings. This proceduremade it possible for ENDESA to continue to make profit payments on its shares.

With the patrimonial absorption of this loss, the company'sfinancial position -- although not its operational conditions -- progressivelyweakened. By the end of 1985, in fact, its debt/capital ratio had risento 2.3.

As a result, the Chilean government decided to adopt twoconcurrent measures: first, the Colbún-Machicura power station, whichbelonged to ENDESA, was transferred to CORFO as COLBUN S.A. The debt/capitalratio of the new company was 1.5; second, 500 million dollars worth of ENDESAdebt were capitalized, leaving the company with a healthy debt/capital ratioof under 1.0.

It is important to note that, from the State's perspective(that is, in CORFO's rather than ENDESA's view), this capitalization didnot produce tangible any changes, given that ENDESA's debt belonged, inconsolidated terms, to CORFO. Nonetheless, it was clear that the improvementin ENDESA's indebtedness would improve the company's position via-a-visprivatization. Moreover, in terms of obtaining a better selling price forENDESA, the capitalization proved to be important given that investors perceivedthe risk of investing in a financially healthy company as significantlylower than that of investing in a financially troubled firm.

The privatization of ENDESA was conducted through the saleof "share packets" to AFPs, employees and, most importantly, throughso-called "popular capitalism." The latter format consisted ofsales of discounted shares (calculated on the basis of stock market rates)to the public at large. The number of shares an individual could acquirewas limited, and the credit extended for such purchases was favorable. Asa result, the privatization process was completed even faster than originallyprojected.

V. RESULTS OF THE NEW POLICIES

1. GENERAL ASPECTS

The policy modifications and privatization processes introducedin the electrical industry are entirely too recent to provide conclusivequantitative results.

Moreover, such an analysis is further complicated by thefact that the privatization was preceded by a complete restructuring ofthe industry. Thus, the question is, what portion of the results can beattributed directly to restructuring, even within the state-dominated framework,and what portion resulted exclusively from privatization?

These questions are not easily answered. Nonetheless, itis possible, from a qualitative perspective, to formulate some conclusionson the results of the overall process conducted in Chile. We will brieflyreview the behavior of the industry in terms of its financial position,level of operational efficiency and the level of stability of the currentrules of the game. Lastly, we will look into the challenges facing in industryin years to come.

2. FINANCIAL STANDING OF ELECTRIC COMPANIES

First, let us compare the standing of Chilean electriccompanies with those of other Latin American nations (many of which arefacing crisis situations) and those of developed nations. From this comparison,the Chilean industry appears to be on solid ground, both financially andin terms of operations, despite some persistent problems which will be discussedin greater detail in a moment. (Charts 4 and 5).

Chart 4

ENDESA

Chart 5

CHILMETRO

The data indicates a important evolution in the key variablesfor Chile's primary electric companies, including:

- Profits: operational and non-operational, balance andaccounting patrimony.

- Profitability: defined as operating profits over fixednet assets (gross depreciated fixed assets).

- Profitability: defined as operational results plus depreciationdivided by gross fixed assets. This variable is similar to an internal rateof return on the investments conducted to the extent that the gross fixedassets are not overly distorted by the worth of new installations.

Important fluctuations can be seen in the accounting profitability,which result primarily from external factors such as currency devaluations.The devaluations led to significant non-operational losses in 1982 and 1985and their impact was particularly strong among the firms generating electricalpower (which tend to hold most of their debt in foreign currency.)

The current rates of profitability for Chile's primarysuppliers of electrical power are given in greater detail in the chartson the following pages.

In addition, these charts show clearly that ENERSIS isnot only a holding corporation for distributors, but also owns shares inENDESA (some 12%) and has subsidiaries dealing in real estate and services.Thus, the overall results for the company are, in truth, not limited todistribution activities, even the latter do compose the bulk of the firm'sbusiness dealings.

Moreover, the data makes it clear that the operating profitabilityof distribution companies tend to be higher than those of generators interms of fixed net assets. This is due to the fact that the accounting depreciationsaccumulated by distributors, in terms of gross assets, are much greaterthan those of generation companies. Thus, the result is more of an accountingeffect than an economic one.

It is also important to note that, in 1991, the profitabilityof the two largest generators was even greater than in 1989 and 1990 (inthose years, Chile was affected by a severe drought which limited results.)Moreover, in 1990 ENDESA brought a new hydroelectric power station (Canutillar,145 MW) on line. The energy produced at that plant will not affect the datauntil 1991 even though the investments were completed in 1990. A similarsituation arises with other stations being brought into service, such asPehuenche, a 500 MW station developed by an ENDESA subsidiary, and Alfalfal,a 160 MW station under construction by CHILGENER. Both plants were expectedto be operational by late 1991.

In any case, it is clear that the distributors presenta higher rate of return (measured as net operatioal income plus depreciationover gross fixed assets). However, it is interesting to note that for recentprojects and those under construction, that rate is similar to those achievedby distribution companies (8-18%). (See Tables 2 and 3 below).

Table 2

FINANCIAL INDICATORS

(US$ per year) 2 GENERATING FIRMS

Table 3

FINANCIAL INDICATORS

(US$ per year) 2 DISTRIBUTION FIRMS

3. EFFICIENCY

A second aspect of the evolution of Chile's electricalindustry in recent years is the overall improvement in efficiency, as demonstratedby the following:

- Low rates as compared to nations where the industry operatesnormally. Even at the Latin American level, where there has been a traditionof subsidizing consumer consumption in a variety of fashions, Chile's ratesmeet the average. The following tables show typical rates for residentialand industrial power in foreign countries and in three areas of Chile: north(thermoelectric generation based on oil and coal); central (hydroelectric)and south (thermal generation based on natural gas). (See Tables 5 and 6).

Table 4

AVERAGE RESIDENTIAL RATES

(US$/kWh)

Note: - Includes taxes. As of 6/90

Source: - Unión Internacional de Productores y Distribuidoresde Energía Eléctrica. (UNIDEPE)

Chilectra Metropolitana (Poll dated 1/89)

- Sistema de Información Económico Energéticode la Organización

Latinoamericana de Energía (SIEE-OLADE) (Poll dated6/90)

AVERAGE INDUSTRIAL RATES

(US$/kWh)

AVERAGE INDUSTRIAL RATES

(US$KWH)

Theses figures indicate that the healthy financial conditionof Chile's electric companies is not the result of high rates, but ratherof sound management.

- The efficient and rational use of energy: the pricingsystem, not only in terms of electricity, but for other types of energyas well (particularly liquid fuels), has provided an incentive for the properallocation of energy products. Thus, although the utilization of electricityin Chile is relatively high (1374 kWh/resident in 1989), use is concentratedin areas where it is economically viable. As a result, the inefficient useof electricity in such areas as heating, water heaters and, above all, kitchenstoves, is not a problem in Chile given that there are more cost-efficienttypes of energy available for these purposes and the appropriateness ofthe pricing policies for such products. In some Latin American countries,the use of electricity in heating water and kitchen stoves -- as a resultof price distortions -- constitutes a serious problem.

- Some indicators, such as the evolution of the ratio betweenthe number of company employees and energy sold, bear further testimonyto the productivity of Chilean firms. Chart 6 demonstrates this evolution.

Chart 6

Number of Workers per Amount of Energy Soldor Generated

- Competition has become the catalyst for further developmentsin the electrical generation industry in Chile. This competition has beenreflected in recent years in the growing number of occasions on which largeindustrial and mining complexes call for public bids to supply them withelectricity.

- In terms of service, quality and sensitivity toward publicimage, important progress has been made. In fact, current legislation callsfor periodic polls to be taken among clients in order to enable both companiesand government officials to evaluate the performance of concessionairesin terms of service quality. Thus, important firms, such as Chilectra Metropolitana,have completely revamped their customer service and billing systems andimplemented policies aimed at providing electrical installations quickly(24 hours after a request is filed for small consumers whose installationsdo not require that the network be expanded, and a maximum of 1 week inall other cases).

Coverage in Chile is high by Latin American standards.In 1987, for example a poll among low income sectors (CASEN) showed thefollowing electrical coverage rates for the nation as a whole:

Source: El Sector Energía en Chile. CNE, 1989

Estimates indicate that improvements have continued to