OREANDA-NEWS. Fitch Ratings forecasts that Chilean generation company profitability will be undermined in 2016 by the current sustained decline in prices, given the sector's exposure to the Spot market and falling marginal costs, which accelerated in the second half of 2015. Increasing competition in the industry also resulted in lower prices for the recent public bidding for regulated clients, modifying expectations of future contract prices and thus moderating the sustained increases seen in 2013 and 2014.

Case by Case
Each generator could see its profitability affected by the drop in prices depending on: the characteristics of its installed capacity matrix, contracted position versus exposure to the spot market, and indexation structure of its contracts, among other factors. However, the greatest impact is likely to come from current price declines, and Fitch expects a drop in profitability from 2H15 to 2016.

Among the generators rated by Fitch, Endesa SA (IDR 'BBB+') and Colbun SA (IDR 'BBB') show generation matrixes with a strong hydrological component, and thus their cost structure is more favorable in years of average hydrology. For Endesa, its conservative business strategy, coupled with access to natural gas (LNG) through its stake in GNL Quintero (IDR 'BBB+'), provides headroom to face scenarios of price volatility with comfort. Colbun looks more vulnerable due to a tighter contractual position compared to its efficient generation capacity, although access to LNG in the short to medium term has provided more flexibility.

E.CL S.A. (IDR 'BBB') and AES Gener SA (IDR 'BBB-'), whose generation matrixes are mostly thermoelectric, would be more harmed by low spot prices, as their average generation costs is higher.

E-CL shows more financial headroom to cope with lower returns, while AES Gener, in the midst of an expansion stage and with a more aggressive capital structure, will be more vulnerable when incorporating lower profits.

Decline in Spot Prices:
The overall decline observed in energy prices in Chile results from several factors, both internal and external. On one hand, the offer is increasing through the addition of new generation capacity for 3,730 megawatts (MW) in the next 15 months, with a high solar component, while the demand is slowing down due to lower than expected economic growth. Additionally, there is a higher availability of hydroelectric plants as a result of increased rain in 2015, and the sharp decline in international commodity prices has reduced generation costs with such fuels.

The marginal costs of the industry, both in the Sistema Interconectado Central (SIC) and the Sistema Interconectado del Norte Grande (SING) have shown sustained declines in recent years that accelerated in 2015. And thus the price scenario has changed. As of September 2015, SIC showed an average Spot price for the nine months of the year USD108.8 megawatt hour (MWh), down from 148.2 / MWh and 179.6 / MWh average for the years 2014 and 2013, respectively. As of the same period, the SING reported an average spot Price of USD54.3 / MWh, from USD81.9 / MWh and USD76.7 / MWh for the previous years, respectively.

For the last quarter of 2015 and 2016, the SIC is expected to add 1.810MW of new capacity, including 136MW of the fifth unit of Guacolda and 1,192 MW of solar plants. In the same period, the SING is expected to incorporate new generation capacity for 1.920MW, including a 517MW combined cycle, the two coal-fired units of AES Gener's Cochrane with 236MW each, and 724MW of photovoltaic plants.

Last Bid Supply emphasized Downward Trend in Prices:
The last public bidding for distribution companies held in late October 2015 received 31 offers. The volume of 1,200 gigawatt hours (GW/h), which will begin supplying energy in 2017 for a period of 20 years, was awarded at an average price of USD79.3 / MWh, showing a significant reduction of 26% and 38% compared to the prices achieved in the 2014 and 2013 bids, respectively. Economic offers received ranged between 65 USD / MWh and 108 USD / MWh.

In addition, 100% of the blocks were awarded to companies with generation assets or projects of non-conventional renewable energy (NCRE), mainly solar, with no current contracts. The large traditional generating companies were not awarded, although some of them tendered for the total volume but at a higher price.

What is expected for 2016's Bidding Process?
While the outcome of the last bidding process for regulated customers could be seen as a sign that the traditional large generating companies need to change their pricing strategy for the next tender to be held in April 2016, the size of this process could hinder a sustained fall in prices. With 13,750 GW / h per year, the upcoming auction is over 10 times the recent tender. This tender was designed to award up to 29% of the regulated demand projected for the next decade and will be the first process to be developed under the new legal framework that provides greater flexibility to generators in terms of conditions and terms, increasing the level of competition in the industry.

Fitch believes it is difficult to project that such a significant volume of energy could be entirely supplied by small projects, especially because of the difficulties/challenges in terms of transmission that this scenario would present. Although the time gap until the supply start in 2021 provides enough time to build new large projects, this growth on the base of efficient supply would keep pushing the prices down, discouraging investments in large projects.

Future Challenges:
Among the main risks and challenges that face these new processes and projects is the great challenge to broaden and strengthen the national transmission system in a timely and proper way, so as to provide adequate access to the grid to the more efficient plants in operation. Development of photovoltaic and solar projects, which by their intermittent nature present challenges in terms of coordination of dispatch could especially be hampered by limited access to transmission lines.

In addition, obtaining required permits and environmental approvals continues to be an issue, including relationships with affected communities in the areas of construction and operation of projects and transmission lines. The viability of several projects and therefore the sustainability of an efficient and reliable generation base depends to a large extent on the development of these industry factors.

To this end, the Chilean government started discussion in congress on a new transmission law that would give the state a central role in the definition of paths and location of new transmission lines, especially those that are considered of public interest. Finally, as several of the projects awarded are 'greenfield,' Fitch believes it is important to maintain adequate monitoring of the progress of their construction and development to avoid any future supply problems.