IBP1798_12 MERIT ORDER OUTLOOK IN BRAZIL: IS PARTIAL INFORMATION BETTER THAN NOTHING? Ferreira da Cunha, Roberto P.

1 and Timponi, Raul R. 2

Copyright 2012, Brazilian Petroleum, Gas and Biofuels Institute - IBP

This Technical Paper was prepared for presentation at the Rio Oil & Gas Expo and Conference 2012, held between September, 1720, 2012, in Rio de Janeiro. This Technical Paper was selected for presentation by the Technical Committee of the event according to the information contained in the final paper submitted by the author(s). The organizers are not supposed to translate or correct the submitted papers. The material as it is presented, does not necessarily represent Brazilian Petroleum, Gas and Biofuels Institute opinion, or that of its Members or Representatives. Authors consent to the publication of this Technical Paper in the Rio Oil & Gas Expo and Conference 2012 Proceedings.

Abstract
The uncertainty of water inflow levels into hydro reservoirs is not the only factor affecting the dispatch schedule of Brazilian thermal power plants. Also playing a key role is the evolution overtime of the unit variable costs composing the merit order of dispatch of thermal power plants. Power demand from thermal generation derives from the opportunity cost of stored water in hydro reservoirs, which can only be assessed under the premise that the future merit order of thermal dispatch is known with some degree of certainty. Several external factors, however, affect the evolution of unit variable costs overtime. A subset of thermal plants may request revisions to the power regulator based on various grounds such as changes in their cost structures, test and maintenance periods or general force majeure. Another subset, composed of standard contracts signed after the enactment of the countrys new regulatory framework (CCEARs), sees unit variable costs adjusted by predetermined pricing mechanisms. Focusing on the case of natural gas within the latter subset, this paper investigates whether the consideration of a model based on these existing mechanisms would provide a good fit in describing the evolution of their unit variable costs. A nave model considering the first observed value as a static forecast benchmarked our results by a mean squared error criterion.

1. Introduction
Following Brazils power sector reform in 2004, new thermal power plants projects were selected based on their ability to provide the lowest price of power to the end user. In order to guarantee an adequate economic return to investors upon their bids, thermal power plants began to enjoy received capacity payments in exchange for their availability for power generation at all times. At the same time, in order to guarantee a plants commitment to its original bid on the cost of power, contracts had to impose a predetermined adjustment mechanism for unit variable costs to be enforced during the entire contractual life. This new framework imposed significant consequences to Brazils nascent natural gas industry. As the installed capacity of gas-fired generation grew significantly and Brazil did not have any natural gas storage capacity available, flexibility requirements to Brazils nascent natural gas industry grew significantly. As a consequence, natural gas carriers acquired the obligation to maintain either hard spare supply capacity or the ability to reduce demand from interruptible consumers with fuel-switching capacity in order to be able to supply a simultaneous dispatch of gas-fired power plants. The Brazilian natural gas demand for power generation peaked in 2010, reaching a year average of 19 million cubic meters per day and a peak demand over 30 million cubic meters per day, nearly equivalent to 50 percent of the countrys overall supply capacity at the time. In the particular case of natural gas, plants operating under new availability contracts (CCEARs) adjust their unit variable costs according to a contractual mechanism that varies according to the auction in which contracts were tendered. Because the actual evolution of these indexes can shift significant volumes of natural gas either to or away from the Brazilian power sector and affect the overall flexibility requirements of the Brazilian natural gas industry, this paper investigates whether these contractual mechanisms provide a good model to predict the evolution of unit variable costs of gas-fired plants throughout the 2007-2011 period (See Figure 1).

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1 2

MA, Economics Research Associate at IHS Cambridge Energy Research Associates (IHS CERA) MA, Economics Research Associate at IHS Cambridge Energy Research Associates (IHS CERA)

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Monthly Merit-Orders of Brazilian Thermal Power Plants 2007-2011 1.200 1.000 800

R$ per MWh

600

400
200 5.000 10.000 MW 15.000 20.000

Figure 1. Monthly Merit-Orders of Brazilian Thermal Power Plants 2007-2011. Source: IHS CERA.

2. Background
Natural gas flexibility requirements arise from the predominance of hydro energy in Brazils overall energy mix. A tropical developing country with one of the largest hydro potentials in the world, Brazil relies on power generation from hydro to supply nearly 80% of its total energy consumption. A side consequence of this energy policy choice is the need to deal with the seasonal and volatile regimes for water availability from one year to the next. An energy system so dependent on variable water inflows needs protection against adverse rain scenarios. Adequate reliability levels require the promotion of backup power generation capacity on the base of physical-risk insurance: the proper scheduling of non-hydro capacity allows the management of water reservoirs, making water available in case of a drought. However, as side-effect, complementary plants end up operating with low load factors most of the time when water availability and reservoir levels are sufficient. Low load factors mean capital expenditures in spare supply capacity. Making economically viable thermal power generation project that might actually operate only 30% of the time requires capacity payments. These payments represent the premium for the provided insurance to the power generation system. Brazilian energy policy makers understand that increasing system reliability compensates the burden imposed by capacity payments. A direct consequence of maintaining spare power supply capacity is the need to maintain spare supply capacity of their fuel inputs. The lower the load factor of power plants, the costlier it is their derived flexibility requirements. Since source fuel supply assets are highly capital intensive, the derived capital cost to provide flexibility are high as well. However, a striking feature of the Brazilian natural gas system is precisely the lack of economical storage capacity. All source fuels but natural gas may rely on the appropriate levels of inventories on site as the cheapest flexibility tool to handle demand variability from power. For natural gas, the only available means of complying with flexibility requirements are either maintaining spare supply capacity or an ability to interrupt demand from non-power customers in order to relocate the flow towards power generation. Managing natural gas flexibility requirements and sizing natural gas supply infrastructure in Brazil depends upon the dispatch schedule of natural gas fired thermal plants. Several factors other than the uncertainty of water inflow levels also affect the dispatch schedule. For example, the relative position of gas-fired plants in the overall merit order of thermal power plants in the system will alter the natural gas demand for power generation for any given water inflow scenario. The traditional approach to estimate future thermal dispatch concentrates on hydrologic scenarios only. However, the position of each source fuel in the overall merit order also determines of the overall dispatch schedule. After all, it is the future cost of thermal generation given by the future merit order of dispatch that benchmarks the opportunity cost of water in reservoirs. As a result, it is important to assess the evolution of the merit order of dispatch overtime when trying to assess the opportunity cost of water into different water inflow scenarios in the future.

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Table 1. Indexing Rules for Gas Power Plants Availability Contracts Auction A-5 2005 (Dec 16 , 2005) A-5 2006 (Oct 10 , 2006) A-3 2007 (Oct 16th, 2007) A-3 2008 (Sep 17th, 2008)
th th

Variable Costs O&M Annually, based on inflation IPCA index Annually, based on inflation IPCA index Annually, based on inflation IPCA index Annually, based on inflation IPCA index Fuel Annually, PPT index

Regulatory Reference Por. MME nb. 510/2005 Por. MME nb. 561/2005

Annually, choice of PPT index or a Por. MME nb. 112/2006 fixed basket of fuel oil benchmarks Monthly, choice of PPT index, Month-ahead Henry Hub or Dated Brent Monthly, choice of PPT index, Month-ahead Henry Hub or Dated Brent Por. MME nb. 42/2007 Por. MME/MF nb. 234/2002 Por. MME nb. 42/2007 Por. MME/MF nb. 234/2002

3. Proposed Exercise
Basing our analysis on 2007, current under operation gas-fired power plants unit variable costs are used as a starting point. The merit-order outlook for 2011 is compared under three different in-sample forecasts: 1. 2. 3. Absence of information or nave forecast: considers the unit variable cost of January 2007 statically as the outlook for the 2007-2011 period. Partial information or models forecast: considers estimated unit variable cost for the period based value on January 2007. Perfect information or perfect forecast: considers the actual observed evolution of unit variable costs based on the historical evolution of benchmark prices.

The nave forecast was used to provide the benchmark to evaluate the user of partial information to predict the actual evolution of the unit variable costs from selected contracts. However, the contractual parameters of gas-fired power plants adjusting CCEARs varied considerably since the first auction for new capacity in 2005. For this reason, we have restrained our analysis to projects that went online before December 2011. Withing this subset, three categories of contractual mechanisms exist. The different indexation rules can be found summarized in Table 1 and in Section TK.

Table 2. Comparison of Mean Squared Errors (R$ per MWh) Auction and Plant Absence of Information MSE Partial Information MSE Perfect Information MSE 3,27 24,12 8,69 5,66 3,92 14,16 17,01 4,77 11,82 16,84 25,78 5,49 23,11 3,91 3

2005-A-5 Barbosa Lima Sobrinho (Ex-Eletrobolt) Euzbio Rocha (Ex Cubato - CCBS) Governador Leonel Brizola (Ex TermoRio) Luiz Carlos Prestes (Ex-Trs Lagoas) Termocear 2006-A-5 Mrio Lago (Ex. Maca Merchant) 2008-A-3 Linhares

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4. Results
Results indicate that the use of contractual formulas is able to reduce the mean squared error of nave forecasts in two out of the three analyzed contractual mechanisms. The only exception was the 2005 A-5 case. In this case, our model correctly predicted the direction of adjustments to unit variable costs, but overestimated the magnitude of the shifts. At the same time, the unit variable of three plants Barbosa Lima Sobrinho, Luiz Carlos Prestes and Termocear happened to evolve around the value of January 2007. More specifically, differences in level led the nave forecast to be closer to the perfect forecast in three out of the five years under analysis. A possible reason behind this result lies in the index adjusting these contracts. The index from Portaria MME nb. 234/2002 (PPT index) only takes into account the evolution of inflation both in Brazil and in the United States, as well as the exchange rate between the Brazilian Real and the US Dollar. Without considering any international energy benchmarks, this mechanism tends to be less volatile and thus less susceptible to sharp variations over time. This is indicated by comparing the MSE of static forecasts from the 2005 A-5 Auction to the ones from the other two auctions. Despite our initial positive results, it is important to point out that certain key factors constrained our ability to reduce the mean squared errors even further. First, some mechanisms contain parameters that are plant specific and not publicly disclosed. The considered parameters in the model did not vary according to the plant or contract, which could have increased the accuracy of our estimates. Second, some of the considered series for benchmark prices, such as Henry Hub prices, were not the ones defined in the pricing mechanism. In the case of Henry Hub, our model considered the historic monthly average prices, while contracts are adjusted by the closing price on the second to last business day of each month of the NYMEX month-ahead natural gas futures contract.

5. Conclusions
Whether to adopt or not forecasts of benchmark prices such as Henry Hub has been open to debate over the past years. Historically, the already high level of complexity of the methodology to assess the opportunity cost of water in hydro reservoirs have led to the use of static forecasts for unit variable costs. At the same time, unit variable costs were not affected by predetermined contractual mechanisms as they became since Brazils last regulatory reform in its power sector. Opposing parties to the incorporation of forecasts claim that forecasts are unreliable and lack a generally accepted methodology. Their use, as a result, would create the potential to make matters even worse than using static forecasts, which actually happened in our exercise in the case of the 2005 A-5 Auction. Defenders claim that the use of static forecasts could lead to a potential waste of valuable information, which happened in the case of the two other auctions. Our model suggests that the use of this information would have increased the accuracy of estimates, leading to a more efficient use of energy resources. This analysis was restrained to assessing the adequacy of considering existing pricing formulas from long-term availability contracts as a model to describe the evolution of Brazils merit order of thermal dispatch overtime, to which some conclusions can be drawn. First, at this point only a small share of the existing merit order is adjusted by predetermined contractual mechanisms. While this makes it hard to assess the behavior of the overall merit-order of dispatch in the period, it is important to notice that overtime this share is likely to increase. In the long run, old contracts will expire and be replaced by new ones, in a way eventually the entire merit order would be described by predetermined adjustment mechanisms. Second, our ability to improve the results from a nave forecast was limited in part by the lack of publicly available information on the inputs for contractual mechanisms. As some of the inputs are not publicly available information, we have relied on proxies to complete our modeling exercise. As a result, access to the actual inputs considered on our results would have reduced the mean squared error of our forecasts. Third, between the first new energy auction in 2005 and the last in 2011 rules for the evolution of unit variable costs changed considerably. Back in 2005, plants were only allowed to adjust unit variable costs from fuels once a year. In more recent auctions, these costs are now adjusted monthly by a benchmark chosen by plant itself. As several different contracts will coexist in the Brazilian merit-order, the amount of factors affecting it is likely to grow. As a larger share of contracts will enjoy the ability to adjust fuel costs monthly, the volatility of the overall merit order going forward will increase. As more natural gas fired plants are added into the grid, the larger will be the impact variations of international benchmark prices will have on the Brazilian merit-order of dispatch.

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6. References
Cmara de Comercializao de Energia Eltrica. Regras de Comercializao Reajuste da Receita de Venda de CCEAR por Disponibilidade. 2010. Ministrio de Minas e Energia, Ministrio da Fazenda. Portaria Interministerial n. 234, de 22 de julho de 2002. Dirio Oficial [da] Republica Federativa do Brasil. Braslia, DF, p. 18-19, 24 jul., 2002. Seo 1. Ministrio de Minas e Energia. Portaria n. 510, de 20 de outubro de 2005. Dirio Oficial [da] Republica Federativa do Brasil. Braslia, DF, v. 142, n. 203, p. 82, 21 out., 2005. Seo 1. Ministrio de Minas e Energia. Portaria n. 561, de 14 de dezembro de 2005. Dirio Oficial [da] Republica Federativa do Brasil. Braslia, DF, v. 142, n. 240, p. 65, 15 dec., 2005. Seo 1. Ministrio de Minas e Energia. Portaria n. 112, de 16 de maio de 2006. Dirio Oficial [da] Republica Federativa do Brasil. Braslia, DF, v. 143, n. 93, p. 69, 17 mai., 2006. Seo 1. Ministrio de Minas e Energia. Portaria n. 42, de 09 de maro de 2007. Dirio Oficial [da] Republica Federativa do Brasil. Braslia, DF, v. 144, n. 48, p. 180, 12 mar., 2003. Seo 1. MME. Portaria n 42 de 2007. STOCK, J. H., WATSON, M. W. Introduction to Econometrics, Addison-Wesley, 2011.