Working Paper: Power Market Declarations for Natural Gas-Fired Generation

Author: CEPA
Date: 7/11/2016

1. OVERVIEW
This Paper addresses several issues regarding how natural gas-fired generators “should” declare
costs for despatch purposes in Peru. This issue has been somewhat contentious almost since the
introduction of gas-fired generation when (in times prior to the development of the Camisea field)
gas from Aguaytia and Talara was the only gas used.
The principal issue has been (and remains) that electricity generators in the Peruvian system are
required to declare their actual (potentially subject to audit) marginal costs of production (which we
shall refer to as SRMC) for despatch purposes. This becomes problematic when it is recognised that
gas-fired generators generally purchase their gas in Peru through “take or pay” (ToP) contracts and
do not have effective access to short term (or spot) markets for purchases or sales of surplus or
deficit gas supplies. These circumstances are substantially different than those faced by certain
other generators (e.g., liquid-fuelled generators 1), and they lead to debate regarding how to assess
the SRMC of gas for despatch purposes.
We note that while this question is important today, it is probably somewhat less important than it
was in previous years when Osinergmin was fully forecasting the “busbar tariff” which at that time
served as the single benchmark value for passthrough of energy costs into regulated retail tariffs.
Today, when the energy component of regulated retail tariffs is based on actual contract purchase
prices (rather than a forecast of COES spot market prices), at least a portion of the contentiousness
of the gas SRMC question is reduced. Furthermore, in the future if the wholesale energy market is
changed to a more liberalised form, this question might also become irrelevant if all generators face
the same (liberalised, non-cost-reflective) bidding rules.
With this context, it is also necessary to point out that this Paper is not intended to recommend or
design “patches” or improvements to the current COES wholesale market. Instead, it is to analyse
the current approach to gas-generator declarations and to make observations for the future. In one
of the later sections of the Paper (Section 4.2), we do suggest how gas generator declarations might
be handled in each of the various future “Models for future development” set out in our main
Report, though the precise future details of how this issue is handled would of course depend on the
detailed development of whichever Model is chosen.
In the following sections, we first consider several points made in the 1998 report “Pricing Natural
Gas for Power Generation in Peru” (the “PHB Report”), and then summarise several of the key
aspects of today’s situation regarding gas supplies and markets which has of course evolved since

1
Though it is quite possible that limited-storage hydro generators might face some similar issues to gas-fired
generators.

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the PHB Report was written. We next comment on the likely implications for the bidding by gas
generators, both now (in the context of the current COES spot market and current law) and in the
future when possibly the law and electricity spot market structure will be changed. Finally, we
conclude by noting several issues which should be addressed in the future as the electricity sector
continues to evolve.

2. THE 1998 PHB REPORT

The PHB Report was written prior to the beginning of gas deliveries from the Camisea field. Its
objectives were to (1) consider generally how natural gas is priced for electricity generation; (2) the
potential effect of market power due to the new presence of a single dominant gas producer (i.e.,
Camisea); (3) the approach to pricing gas in the context of the Peruvian market, and (4) provide
estimates of the market price for gas for generators in four locations within Peru.
All of these questions were, at the time, generally forward looking and trying to assess how best to
deal with the issue of pricing (and related issues) in the future. From the narrow perspective of our
current consultancy engagement, it is broadly the conclusions related to the 3 rd issue -- how natural
gas should be “priced” (i.e., declared or bid) in the context of today’s electricity market – which is
most relevant. This is in part because it is a question still of interest to Osinergmin, and in part
because it is an issue raised by other stakeholders as well.
In this regard, it is probably simplest to quote relevant extracts from the PHB Report to summarise
its views on the issue at the time. These include:
The scarcity-determined price or SRMC or gas cannot be estimated by observing
the cost of supplying gas or even the prices stated in contracts for limited
quantities of gas. Such contracts will contain complex terms and conditions, with
take-or-pay provisions, minimum and maximum takes, carry-over arrangements,
etc. Determining the true SRMC of gas under such a contract is analogous to
determining the value of water in a hydroelectric reservoir in a complex river
chain. Even the holder of such a contract will have difficulty determining its true
SRMC of gas. There is no way for an external observer to do so by studying the
contract. (Section 7.1.3)

The only real market for gas in Peru is, and for some years will be, within the
electricity sector itself. Most of the transactions in this market will be through
contracts (or other business relationships, such as ownership) between gas
producers and generators, and perhaps some limited gas trading among
generators (or other consumers, if a gas pipeline system and market develops).
These transactions and their prices will usually be confidential and complex,
making it impossible for CTE or anybody else to observe “the market price of
gas.” But the final “sale” of gas will take place when the gas is converted into
electricity, and the price of this sale will be directly observable in the dispatch
prices declared by the generators themselves. These dispatch prices provide the
best estimate there is of “the market price of gas” used for power generation in
Peru. (Section 3.4)

Unless a generator is exercising market power – which, as discussed below, does

not seem to be a serious long-term threat in Peru – it has no reason to declare a

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 dispatch price that does not reflect its own assessment of the SRMC of its gas.
Thus, as far as practical, each generator’s declared dispatch prices should be
used as the best estimate of the SRMC for that generator. (Section 7.1.3)

The opinion of the PHB Report regarding how to appropriately reflect the SRMC of gas in despatch
declarations seems quite clear. The next questions to be considered would then be whether today’s
“actual” situation differs in any material way from the views of the PHB Report at the time it was
written, and if so, how that might affect these conclusions. These are addressed in Sections 2 and 3
below.

3. THE CURRENT SITUATION

Deliveries from the Camisea field began in 2004. Since then, the market for Camisea gas has grown
to about 1,500 million CFD, very approximately broken down as shown in Table 1 below.
Table 1: Approximate Usage of Camisea Natural Gas

Current (Approximate) Approximate Approximate Share

User
Price $/MMBTU Share of Market of Domestic Market
Power Generation $1.60 26 % 60%
Industry $2.98 8% 19%
Residential $2.78 <1 % 5%
Vehicles $2.78 7% 16%
Export (LNG) N/A 57 % N/A
Note: The price shown for industrial customers is for 100% load factor contracts. Swing” gas can be
purchased at 111% (i.e., 1/0.9) of the baseload price.
Export (LNG) gas comes solely from Block 56, while gas for domestic use comes from Block 88.
In terms of practical aspects of contracting for gas supplies by power generators, we understand:
● The gas generators’ contracts for annual quantities tend to be between 50% and
90% ToP, with the non-ToP gas (or “option” gas) being obliged to be provided by the
producer as the generator demands. There are various carry-over arrangements
regarding the “accounting” for ToP amounts on a monthly and annual basis.
● There are restrictive covenants in the contracts which prohibit the gas generators
from reselling commodity gas, even to other gas generators (i.e., to other customers
within the same price-defined customer class as shown in the above table).
● Individual generators can of course try to negotiate with the seller to adjust annual
deliveries (perhaps by engaging in “time swaps” or carry-over arrangements across
years, or simply to buy more or less gas in a particular year). But as a practical
matter this is a difficult process and rarely if ever results in any actual flexibility for a
generator.
In addition to these points on contracting, we also understand that at the moment LNG production
capacity is at maximum (or otherwise constrained) and has a long-term fixed-volume export contract

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for all of its capacity. Thus, until new gas-fired power generation comes on line, growth of gas
demand is limited to just the smaller consumption sectors 2. We understand also that the Camisea
operator is currently re-injecting gas in response to this and also in order to help manage liquids
production.

4. HOW SHOULD GAS-FIRED GENERATORS BID TODAY AND IN THE FUTURE?

4.1 In the Current Situation
In the current situation, generators are required to declare to the COES pool prices which reflect
their marginal cost of generation (including both fuel and variable O&M costs). The bidding rules
also allow gas generators to declare their cost to the COES pool once per year. We understand from
discussions with Osinergmin that gas generators are unique in that there is no lower or upper limit
on their declarations.3
The PHB Report anticipated that most of the gas would be sold to power generators under ToP
contracts, often with complex (and possibly opaque) additional provisions. Considering the points
about contracts noted in Section 3 above, it would certainly appear that this prediction has largely
proved correct. Not only are most sales under ToP arrangements but also that other aspects of
contracting (in particular, the prohibition on reselling (even to other generators) and the apparent
limited flexibility offered by time swaps or carry-over arrangements) are such that the gas
contracted by a generator would appear to be at least at times more likely to be a “fixed cost” rather
than a “variable cost”. However, most gas generators also have “option gas” available to them.
When they take “option gas”, depending on the precise rules for taking such gas, it could well be
that the gas commodity cost becomes a legitimate incremental cost.
Thus, depending on what “type” of gas a generator is burning (i.e., either ToP or Option), and
depending on the precise rules for taking option gas, we could easily see the true marginal cost for a
gas generator ranging from zero to the commodity cost of option gas (plus any variable O&M and
variable transportation charges for the option gas).
We point out here that we are not intending to “patch” the existing declaration rules for the COES
pool. But given the conclusion in the paragraph above, it would seem to make sense to allow gas
generators to make declarations within the boundaries described above. Because a gas generator’s
marginal cost position might change dramatically from day to day (as it switches from ToP gas to
Option gas), it would make most sense to allow declarations more frequent than once per year,
better moving toward once per day.
4.2 In the Future Potential “Models for Future Development”
In the context of the “Models” for the future presented in the main consultancy report, the
approach to how gas-fired generators declare their costs (or bids) might change. As we have noted
in the main report, we are providing general illustrations (rather than detailed or even firm

2
We understand that there are several current projects in both gas generation expansion and petrochemicals
which have contracted Camisea gas, but which are either not yet started and / or delayed.
3
We observe that the lack of any upper bound at all on gas generator declarations does not immediately seem
consistent with the concept of COES pool as a “true marginal cost declaration” pool. However, there may be
subtleties or other rationale for this that we are not aware of.

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recommendations) of such future models. Within the context of such general illustrations, we might
anticipate that:
● For Model 1, it is likely that all generators would be free to declare any bid price
(subject probably to an upper limit on bids which would be set substantially above
even liquid-fuelled marginal costs) on a daily (or other appropriate) basis to the
market. This would certainly allow gas generators much more freedom in managing
their ToP obligations. However, we also note that in the medium term there is a
substantial excess of zero marginal cost capacity (i.e., hydro and ToP gas generators)
on the system. This could well lead to quite low energy prices when demand is such
that liquid fuelled generators are not needed. There is nothing intrinsically bad
about this, recognising that the investments which have resulted in this situation are
already “sunk costs”. However, it does highlight the likely importance of having a
forward capacity market acting in parallel to the energy (as opposed to an “energy
only” market with perhaps a VLL / LOLP feature embedded in it) to allow the low-
marginal cost generators an opportunity to secure some forward revenues against
their fixed cost operations.
● For Model 2, it is likely that the current structure of the COES wholesale market
would likely remain in place (though possibly with a reformed or at least reviewed
capacity payment system as speculated about in footnote 3 above). In this case, the
declaration rules would probably stay as they are, although we would prefer to see
the sort of comments made in Section 4.1 above taken into account. Gas generators
would of course continue to depend on their PPA contracts to cover fixed costs.
● For Model 3, we might expect that a more “traditional” approach to the structure of
PPA contracts would be put in place (i.e., contracts with individually cost-reflective
capacity payments and rights to energy output at variable cost vested in the
offtaker) and auctioned to offtakers. This approach would potentially offer the
greatest security to recovery of fixed costs by generators (though at the likely cost of
transferring overcapacity cost risk to consumers) and could (depending on
implementation details of course) provide appropriate price signals for consumption.
In each of these cases, the precise way in which gas generation is handled will depend on the
detailed design of the respective market.

5. ADDITIONAL QUESTIONS TO BE ADDRESSED FOR THE FUTURE

Going forward, gas in Peru will continue to be of substantial importance to the power sector. Thus,
the development and evolution of the gas industry will be important. Future issues to be addressed
will probably include:
● Creation of a Gas Market: The creation of a proper competitive market for
commodity gas should be (and, we think, is) an important policy objective for Peru.
This will require both time (as the usage of gas penetrates society) and more
upstream players. Important issues to consider to help facilitate this long term
objective will include:

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 o Ensuring as large a potential market as possible, possibly through international
interconnection and promoting adequate export (LNG) capacity accessible to all
producers
o Promoting more players in upstream production, ideally through attracting
more bidding consortia for development of new fields (if they exist), or possibly
through other methods in the longer term (e.g., so-called “gas release” schemes
as applied in various other countries).4
o Ensuring that gas infrastructure and pipeline access are as much as possible
organised along “open access” principles.
These and other possibilities of course are strongly dependent on the existing legal
and contractual arrangements with field developers. We have not reviewed these
arrangements as part of this work.

● Relaxation of Restrictive Contract Covenants: The covenants restricting resale of gas

by purchasers are not unusual; they serve to guarantee a market for the gas
producer to allow him to make the investments to develop the field. However, they
are ultimately and obviously (and intentionally) anti-competitive. At some point in
time – ideally, after the initial developer has recovered his initial investment –
consideration should be given to relaxing them, possibly through application of
competition policy.
One important – and relatively easy – way to start this process would be to relax
those covenants by allowing resale of contracted gas purchases by a customer to
other customers in his same “customer class” (i.e., price class as shown in Table 1).
This would not damage the field producer since it would not reduce the total
quantity of gas delivered by him; it would simply reallocate from time to time who
took it. By limiting this freedom to intra-class resales, it would also not disturb the
current price discrimination scheme among users and of course nor would it affect
the revenues to the field developer. From the point of view of gas generators on
ToP contracts, it could be a very useful mechanism to help them “manage” their
contractual takes and balance that with technical needs of their plant. Finally, it
would also facilitate the start of an eventual gas market.
In order to implement this, it would be necessary also to allow trading or exchange
of transport capacity. We understand that this is currently allowed, though perhaps
not used as effectively as it might be. It seems likely that the Ministry, probably
together with Osinergmin and perhaps the pipeline operator should develop or at
least facilitate a simplified trading system (perhaps an “electronic bulletin board”

4
The fact that many upstream development projects – and Camisea is no exception – rely on consortia of
several partners further complicates this. The existence of consortia has practical and valuable business
purposes of sharing both the risks and financial investment burdens of field development. But it also takes
potential players “out of the market” for projects such as gas release schemes. One way to mitigate this
problem in future developments might be to break down developments into multiple lots for bidding and to
award different lots to different consortia, resulting in a diversity of upstream producers. This of course also
offers its own complexities and potential drawbacks, particularly if there are fewer interested or qualified
bidders.

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 style system initially) to allow this sort of trade. Such development, if it occurs,
should be undertaken following consultation with gas generators regarding
feasibility, need and possible alternatives.

● Appropriate Regulatory / Financial Treatment of Consumer Funded Developments:

Currently, a portion of the investment cost for the 2 nd Camisea gas pipeline is being
“pre-funded” through a surcharge on electricity sector transmission tolls. This
means that electricity customers are, in effect, financing at least a portion of this
asset. The future regulatory treatment of this asset – including tariff setting,
allocation of return on and of capital, beneficial ownership of capacity usage etc –
should all reflect the fact that at least a portion of this asset has been “bought” by
customers.
These few issues are strongly focused on some of the issues of importance to the power sector.
There are additional issues for the power sector of course, and doubtless many more issues to
consider in terms of natural gas development generally and the overall energy balances and plans
for the country.