Colombia Capacity Auction

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Colombia Capacity Auction

• Peter Cramton(with many ideas from Steven Stoft)
• 9 June 2006

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Outline

• Purpose of market
• Why forward procurement?
• Key features
• Product
• Planning period
• Commitment period
• Cost of new entry (CONE)
• Demand curve
• Descending clock auction
• Price formation
• Performance incentives
• Fail-safe mechanism
• Secondary market
• Transition
• Supplier concerns

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Purpose of Market
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Purpose of market

• Induce just enough investment to maintain
  adequate resources
• Induce efficient mix of resources
• Reduce market risk
• Avoid market power in capacity market
• Reduce market power in energy market
• Pay no more than necessary

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Why forward procurement?
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Why forward procurement?

• New projects compete in advance of entry
• Coordinated entry
• Less uncertainty in achieving target
• Avoid boom/bust
• New capacity sets price directly
• Less reliance on demand curve for price setting
• Long-term commitment for new capacity
• Reduced investor risk
• Better price signal for new investment

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Key features
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Key Features

• Product
• Planning period
• Commitment period
• Cost of new entry (CONE)
• Demand curve
• Descending clock auction
• Price formation
• Performance incentives
• Fail-safe mechanism
• Secondary market

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Product
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Product

• Firm energy ? availability of energy during
  scarcity events
• Dry year (seasonal scarcity)
• Outages (spot scarcity)
• Scarcity event defined by high energy price
• Energy price is a transparent trigger
• Energy price is a reliable trigger

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Product

• Capacity-backed energy option
• Capacity defined by delivery capability in
  worst-case benchmark ? a very dry year
• Nameplate capacity (maximum output rate)
• Firm energy capacity (average energy output rate
  in worst-case benchmark)
• Thermal example 92 of nameplate due to outages
• Hydro example 35 of nameplate due to limited
  water
• Strike price Gas index ? high heat rate
• Gas index New York Harbor residual fuel oil
• High heat rate 15 MBTU/MWh (about US130 as of
  May 2006)
• This is less than the heat rate of all existing
  thermal units
• New thermal peakers have heat rates of 9-10

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Load Duration Curve and Firm Energy Target
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Target peak load
Load(GW)
8
2010 target
growth
6
2005 actual
4
Firm Energy Target
2
0
0
50
100
Duration
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Single product single price

• In a hydro-dominated system, there is a single
  reliability constraintfirm energy to cover dry
  year
• Single constraint implies single product and
  single price
• Each new resource is rated for its incremental
  contribution to the firm energy constraint

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Product is

• Firm energy mandatory hedge
• Firm energy
• Expected annual drought-year energy contribution
  to system (if unit disappeared, how much less
  energy would the system havesame for hydro and
  fossil)
• Mandatory hedge
• Hedge of your share of hourly load
• If supplying 10 of firm energy target, then have
  a 10 obligation to serve load in every hour of
  scarcity event
• Can spread obligation across hours or units
  without penalty
• Rewarded if shift output to higher priced hours

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Obligation

• Purchase by load is translated into a percentage
  share of load for each supplier
• If 98 of target is purchased, then aggregate
  supplier obligation is 98 of load in each hour
• Load is unhedged for 2 of load that is not
  purchased
• Supplier with a 10 share of target has sold a
  call option for 10 of load in each
  hour(obligation follows load)
• True-up at end of each month to adjust for
  deviation between monthly target and actual
  monthly load
• If actual load is 102 of months target, then
  obligations are scaled down by 100/102.
  Penalties/rewards are calculated on this basis.
• Risk from unanticipated load growth is born by
  load

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Settlement

• Settlement is just like settling a conditional
  contract for differences in each hour
• If spot price lt strike price, then no obligation
• If spot price gt strike price, then settle
  differences reward or penalty (Q supplied Q
  obligation) ? (P spot - P strike)Same as
  supplier buying from spot market to satisfy
  obligation.
• Same outcome if done on unit basis or portfolio
  basis
• Supplier optimizes portfolio just as without
  option

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Planning period
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Planning period

• Time between auction date and start of commitment
• 3 to 4 years ? long enough for new entry to occur
• Makes capacity market contestable and allows new
  entry to set the price
• Existing capacity would set the wrong price
  because of sunk costs and market power

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Planning period

• First auction (2010) 3 year
• Second auction (2011) 3.5 year
• All later auctions (2012) 4 year

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Commitment period
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Commitment period

• New capacity ? up to 10 years
• Supplier selected at qualification
• Long commitment lets new capacity lock-in
  capacity price, reducing risk and encouraging
  investment
• Price is in constant (adjusted for inflation)
• Existing capacity ? one year
• Does not need long commitment, since costs are
  already sunk
• Short commitment reduces risk (more draws from
  price distribution)

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Demand curve
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Demand curve
Price offirm energy
Price ceiling
2 CONE
Curve reflects marginal value of firm energy
Able to withstand scarcity events worse than
worst-case benchmark
CONE
½ CONE
Price floor
? 4
0
Target
Firm energy
Load not fully hedged
CONE Cost of New Entry (marginal unit)
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Descendingclock auction
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Descending clock auction

• Auctioneer announces high starting price
• Suppliers name quantities
• Excess supply is determined
• Auctioneer announces a lower price
• Process continues until supply equals demand

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Starting price

• Starting price must be set sufficiently high to
  create significant excess supply
• Setting too high a starting price causes little
  harm
• Competition among potential projects determines
  clearing price high start quickly bid down
• Setting too low a starting price destroys auction
• Inadequate supply or insufficient competition
• Price of 2 times Cost of New Entry is recommended
• Note that clearing price will exceed CONE in some
  years to the extent it is below CONE in other
  years (of surplus)

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CONE updates

• If auction in year t is successful,
• CONE in year t1 .7 CONE in year t
  .3 clearing price in year t
• If auction in year t fails,
• CONE in year t1 CONE in year t

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Mechanics

• Clock auction done in discrete rounds
• In each round,
• Auctioneer announces
• Excess supply at end of prior round
• Start of round price (higher price)
• End of round price (lower price)
• Each bidder submits a supply curve at all prices
  between start of round price and end of round
  price
• Auctioneer determines excess supply at end of
  round price
• If no excess supply, clearing price determined

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Individual Supply Bid, Round 6
Price
start-of-roundprice
7.00
6.63
6.17
6.00
end-of-roundprice
Quantity (MW)
400
175
300

• Activity rule
• Bidders can only maintain or reduce quantity as
  price falls(upward sloping supply curve)
• Intraround bids
• More accuracy without too many rounds
• Better control of pace of auction
• Ties are reduced

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Descending clock auction
Price
Aggregate supply curve
starting price
12.00 P0
excess supply
Round 1
P1
Round 2
P2
P3
Round 3
Round 4
P4
P5
Round 5
6.17 P6
clearing price
6.00 P6
Quantity
Demand
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Information policy

• Demand curve and starting price announced before
  auction
• After every round, auctioneer reports
• Excess supply at end of round price
• End of round price for next round(determined
  from extent of excess supply)

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New projects are all or nothing

• Lumpy investment respected investor does not
  fear partial acceptance
• If multiple bidders drop at the clearing price,
  the group of bids are accepted that minimizes
  excess supply

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Price formation
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Market power

• Addressing market power in capacity market is
  essential
• Strong incentive to exercise market power
• Existing capacity has substantial sunk costs
• New capacity is only a tiny fraction of total
• Market is concentrated
• Any of top-4 suppliers could unilaterally set
  price
• Long-term price signals are more stable and
  efficient if determined from competitive forces,
  rather than market power

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Market power solution

• New capacity
• New capacity bids are not mitigated in any way
• Assumes competition for new capacity
• Existing capacity
• Capacity can opt out of market with either an
  opt-out bid or retirement bid
• Opt-out bid
• Not revealed during auction
• Cannot impact the price for existing supply
• May be rejected for reliability reasons gets
  reliability must run payment if rejected
• Retirement bid ? permanent opt out of capacity
  market
• Submitted four weeks before start of auction
• Accepted retirements excluded from any future
  capacity payments
• Retirements may be rejected for reliability
  reasons, but only if the reliability problem
  cannot be resolved during the planning period
  with alternative actions, such as transmission
  upgrades or new capacity
• Retirements are posted as soon as they are
  accepted
• Retirements are replaced with new capacity in the
  auction (represented as a shift to right in the
  demand curve for all prices below the retirement
  bid)
• Re-power bids
• Replacement of generating unit(s) at existing
  plant
• Replacement unit is bid as new capacity
• Existing unit is a conditional-retirement

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Market power solution

• New capacity almost always sets the price
• Demand curve sets the price in surplus years in
  which new entry is not needed
• Retirements occasionally set the price
• Other than retirements, existing capacity never
  impacts the price

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Replacing accepted opt-outs

• Opt-outs are replaced by new capacity
• March up the supply curve revealed in the clock
  auction
• But not more than a 30 increase in price
• Any additional replacements occur in
  reconfiguration
• All new capacity receives this higher price
• Existing capacity receives the original clearing
  price

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Performanceincentives
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Incentives and hedge

• Performance incentive comes primarily from energy
  spot price this is not changed by hedge
• Hedge assures that normal performance will
  receive normal reward in wet and dry years alike
• Every extra MWh of energy is rewarded the same
  with or without hedge

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Energy price motivates performance

• Hedged resources still face the energy spot price
  at all times
• Those that perform better receive more
• Those that perform worse receive less
• An additional incentive to perform is impact on
  firm energy qualified for sale in auctions in
  future years
• Under performing units are downgraded
• Over performing units are upgraded

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Fail-safe mechanism
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Protections if auction fails Inadequate supply

• If, at the starting price, there is insufficient
  supply of firm energy
• New capacity is paid starting price
• Existing capacity is paid 1.1 CONE
• Note Rule does not discourage new projects

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Protections if auction failsInsufficient
competition

• Existing capacity, less retirements, is less than
  demand at the starting price, and
• At the starting price, the capacity bid exceeds
  demand but less than 4 excess, or a suppliers
  new capacity is pivotal
• Auction is conducted
• New capacity is paid the clearing price
• Existing capacity is paid the smaller of the
  clearing price and 1.1 CONE
• Note Rule does not discourage new projects

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Secondary market
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Reconfiguration auction

• Takes place at same time as primary auction
• Primary 4 years ahead (52 months ahead)
• Reconfiguration 3, 2, 1, 0 years ahead (40,
  28, 16, 4 months ahead)
• Reconfiguration includes
• Adjustment of firm energy target for current
  forecast
• Suppliers buy/sell to balance position(including
  dispatchable load)

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Reconfiguration auction

• Standard sealed-bid clearing-price auction
• Same demand curve as in primary auction, netting
  out capacity already purchased
• No bid mitigation

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Monthly spot exchange

• Monthly simultaneous clearing
• Standard sealed-bid clearing-price auction
• Suppliers buy/sell to balance positions
• Demand curve same as in primary auction

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Transition
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Transition and timing

• Transition period 2007-2009
• Administrative capacity price includes a premium
  for cost of energy option
• Existing contracts are modified to subtract the
  same premium since prices above the strike price
  are now covered by the capacity payment, not the
  contract

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Firm energy to be auctioned
Demand
MW
New supply
2015
2014
2013
Transition
2012
Existing supply
2011
2010
2009
2008
2007
Auction date
Nov Jun Nov Nov Nov Nov 2006 2007 2007
2008 2009 2010
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Supplier concerns
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Supplier concerns

• Please note that these concerns were as expressed
  to CREG on Monday, 5 June 2006, in response to
  the original CREG proposal. These concerns may
  not apply to proposal presented here, which is
  significantly different from the original
  proposal.

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1. Approach not used elsewhere

• Similar approach was adopted in New England (32
  GW peak load) in March 2006
• Approach currently being implemented
• Approach endorsed by FERC
• All elements of proposal are commonly used in
  markets around the world
• Options are used everywhere
• Clock auctions used for many years in US, UK,
  France, Germany, Belgium, Hungary, Denmark,

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2. Call option increases risk
Price Coverage
US250
US250
Energy Option
Forward Energy Contract
?
US130
Forward Energy Contract
US0
US0
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3. Consumers will pay more

• Minimizing risk while addressing market power and
  performance incentives means that consumers will
  pay less

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4. Price not a reliable measure of scarcity

• High prices come from two sources
• Scarcity
• Market power
• Option fully addresses market power in spot
  market thus, high prices can only come from
  scarcity
• If spot prices are still unreliable, then market
  must have another flaw. Fix it!

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5. Approach is complex

• Effective capacity markets are necessarily
  complex because the economic challenges are
  great, especially market power
• Proposal uses clear and simple market-based
  methods

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Supplier alternative
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Does not adequately address performance incentives

• Fails to induce right mix of resources
• Fails to induce efficient operation of resources
• Requires greater command-and-control regulation

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Does not address market power

• Yields unstable an uneconomic capacity prices
• Greater financial and political risk
• Higher contract costs due to potential for market
  power in energy spot market
• Higher energy spot prices and less efficient
  energy spot market

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Questions