HIGH OIL PRICES RAISE EL SALVADOR'S ENERGY SUBSIDY

UNCLAS SAN SALVADOR 002383 SIPDIS SIPDIS E.O. 12958: N/A TAGS: ECON ENRG EINV EPET ES SUBJECT: HIGH OIL PRICES RAISE EL SALVADOR'S ENERGY SUBSIDY ¶1. SUMMARY: A freeze on El Salvador's electricity rates is exhausting the capacity of the state-run renewable energy sources to subsidize more expensive oil-fueled electricity and may increase public debt in 2008. Despite high oil prices, the GOES has maintained electricity rates since June 2006 and it recently promised no rate hikes through the 2009 elections. The GOES may need to borrow up to $50-60 million to cover a projected 2008 shortfall in a subsidy fund for the electricity sector. Distribution companies have protested recent cuts in distribution rates and are exploring their legal options. Pressure to control prices may delay regulatory reforms needed to stimulate investment in new generation capacity. The political expediency to avoid unpopular rate hikes is causing the GOES to postpone the day of reckoning when electricity rates will need to reflect generation costs. END SUMMARY RISING ENERGY COSTS EXHAUSTING SUBSIDY FUND -------------- ¶2. In a national address on December 3 to announce a series of popular measures in the "Alliance for the Family", President Saca promised not to increase electricity rates through the end of his term (June 2009). This follows an October decision to avoid a rate increase despite rising generation costs due to high oil prices. To avoid a rate hike, the GOES approved a $42 million subsidy by the state-owned Hydroelectric Executive Commission of Rio Lempa (or CEL by its Spanish acronym) to a "compensation fund" that helps to pay higher generation costs of oil-based power producers. CEL Executive Director Irving Tochez told Econoff that CEL was only able to pay $30 million it had budgeted for the compensation fund but offered a $12 million credit to power distributors to cover the remaining subsidy cost. In addition to the compensation fund, the GOES pays $35-40 million per year to subsidize electricity for low-income customers that consume 99 or less kilowatt hours per month. ¶3. According to Tochez, annual compensation fund costs may rise to nearly $100 million in 2008 if current oil prices and market trends continue. He estimated that CEL can only cover $40-50 million of this cost, so the GOES will be looking for a way to fund the remainder. He suggested three possible measures to reduce subsidy costs: (1) making distributors pay $10 million in transmission costs currently shouldered by the GOES; (2) limiting who can receive the 
subsidy for the first 99 kwh of consumption; and (3) making the water company (ANDA) pay the full cost for its electricity. (Comment: Each of these measures would likely be controversial and together they would not be enough to cover the projected shortfall in the compensation fund. End comment.) ¶4. The subsidy has increased as rising oil prices have raised power costs for oil-fueled thermal generators that provided 44% of El Salvador's electricity production in 2006. Hydroelectric plants accounted for 31% of production while geothermal plants provided 25% of production, but the actual energy mix varies seasonally with hydroelectric production typically ranging from 55% of total production during the rainy season to 25% during the peak dry season. When hydroelectric capacity declines during the November-April dry season, oil-fueled generators make up the difference, providng up to 50% of monthly production. As oil prices have exceeded $90 per barrel in 2007, the energy regulator, SIGET, reports that oil-fueled electricity costs have risen to roughly twice the cost of renewable energy. DISTRIBUTION RATES CUT -------------- ¶5. While electricity rates are frozen, SIGET has moved to cut distribution charges which represent roughly 30% of consumers' electricity bills. On December 4, SIGET announced a new distribution rate schedule for the next five years that it says will reduce distribution rates by 18%. Distributors say the new rate schedule will reduce their income by 30% and threaten their financial viability. The regional manager of one distributor told Econoffs the new rates will push distribution companies into "survival mode" resulting in probable layoffs and possible reduction in service quality. Distributors offered a 9-10% reduction, but were rebuffed. In addition, the distribution companies assert that by focusing on the distribution tariff, which makes up only 30% of the total cost of electricity, the GOES is not getting to the root of the problem, the high costs of fossil fuels that constitute the majority of electricity costs. The companies are also looking for ways to contest the new tariffs, but they have noted that the law gives SIGET considerable discretion in regulating rates. DEMAND APPROACHING CAPACITY -------------- ¶6. As energy costs are subsidized, demand is approaching capacity and increasing the possibility of short-term energy shortages during the next few years. CEL President Nicolas Salume had warned in August of potential power shortages by April-May 2008 due to high demand growth and unusually low rainfall. He estimated that peak demand will approach 870 MW during the 2008 dry season, not far from the operating capacity of 900 MW (not including 200 MW of "cold" capacity - less cost-efficient generators reserved for emergencies). Another member of CEL's board told Econoff that CEL narrowly averted a probable dry season energy shortage after heavy late-October rains filled reservoirs to increase hydroelectric capacity during the dry season. In the short-term, generation capacity has been reduced by the breakdown of a 44 MW geothermal plant currently under repair from October 2007 and scheduled to return to operation by January 2008. ¶7. In order to meet the projected 6% annual rise in demand (currently about 50 MW per year),CEL is pursuing several small-scale generation projects. To meet demand in 2008, CEL is working on a 50 MW expansion of its oil-powered generating station in Talnique, where an additional 50 MW expansion could follow. (Comment: CEL originally planned to exit from fossil fuel generation projects, but has since commenced new projects to make up for the gap in new private electricity generation. End comment.) CEL has also conducted studies of a 30 MW expansion of its "September 15" hydroelectric facility and a 10 MW wind energy project. ¶8. Generation companies are planning several long-term projects to expand electricity supply after 2010. CEL plans to build two hydroelectric plants: the 66 MW El Chaparral project scheduled for completion in 2011 and the 261 MW Cimarron project currently undergoing a feasibility study. AES recently obtained an environmental permit to build a 250 MW coal-fired power plant in La Union and plans to begin construction in early 2008. Another U.S. firm, Cutuco Energy, has obtained environmental permits for a large Liquified Natural Gas depot and 525 MW generating station also based in La Union. However, even if both projects get underway in 2008, which is by no means certain, they would not come on-line until at least 2010. REGULATORY REFORMS MAY BE DELAYED -------------- ¶9. Delays in conversion to a cost-based pricing model with long term contracts may affect long-term investments in new generating capacity. Following the 2003 reform of El Salvador's electricity law, the GOES issued Decree 57 in 2006 to implement these reforms. Although the conversion to cost-based pricing is currently scheduled for January 2008, MINEC's electricity manager, Jorge Rovira, told Econoff the GOES is still finalizing details of implementation which will likely include a six-month transition period. ¶10. The reforms may increase electricity rate in the short term but should encourage long-term investments in larger and more efficient energy projects. U.S.-owned Duke Energy plans to invest $100 million in a two-year project to convert an existing liquid-fuel generator to cheaper coal generation, but Duke's Managing Director Julio Torres told Econoff this project is contingent upon the regulatory reforms. (Comment: AES, El Salvador's main electricity distributor serving 75% of the market, can sell the power it will generate to itself, so its coal-fired project does not depend as much on regulatory reforms; however, it remains to be seen how SIGET's handling of distribution tariffs may affect AES's investment decision. End Comment.) ¶11. Regional integration of the power sector is helping to stimulate interest in larger and more cost-competitive energy projects. According to CEL, a 300 MW regional transmission line may be completed by 2009-2010 and regulatory integration has also progressed. SIGET noted that El Salvador was the first country to ratify a regional accord for the integration of electricity markets including provisions to create regional institutions to operate and regulate the market. COMMENT -------------- ¶12. The GOES will face a challenge to pay the compensation fund in April 2008 when it will need to subsidize higher dry-season consumption of oil. Its determination to control energy costs is part of a general focus on pocketbook issues aimed at forestalling opposition criticism leading up the 2009 elections. By pursuing the short-term political expediency to control energy prices, the GOES may damage longer-term interests in reforming the energy sector to encourage investment, increase competitiveness and ensure adequate energy supply. It is also increasingly possible that in the dry season just before the January and March 2009 elections, the energy companies could become more vocal in their demands for a rate increase after having rates frozen or reduced over the past two years. Worse still, El Salvador might even see energy shortages just before the elections. Neither scenario would bode well for the ruling party. GLAZER