1. business and industrial
2. energy
3. electricity

WHAT OBJECTIVES CAN BE ACHIEVED THROUGH ELECTRICITY SUPPLY
AUCTIONS INSTEAD OF “KEEPING THE LIGHTS ON”? Some comments about
the new way to ensure Supply Adequacy and to improve the performance of electricity
markets in Brazil, Chile and Peru
CARLOS GOMERO RIGACCI ∗
[email protected]
ABSTRACT: It is generally agreed that the process of deregulation implemented in most of
the Latin American electricity markets has shown a positive balance. However, some
weaknesses regarding supply adequacy have also been among the results. The problem is
that, apparently the market itself has not been enough to encourage new investment in
power generation in order to meet the growing demand of some countries. Thus, the wellknown model of capacity payments has shown its powerlessness to avoid some crisis in
countries such as Brazil, Chile and Peru. The crisis has forced these countries to look for
new alternatives to promote more investment in generation. The most important is the
auctioning of energy to be bought by the consumers creating a competitive process between
incumbent plants and newcomers. This mechanism for the purpose of this paper is called
Supply Electricity Auctions, and it implies selling forward contracts in a centralized
manner.
This paper aims to analyze the objectives that this scheme can achieve, highlighting those
that are solely “to keep the lights on”. The paper finds that the model could reach other
important objectives such as enhancing demand responsiveness to prices, making more
contestable markets and reducing market power, among others.
TABLE OF ABREVIATIONS
ESA
EU
FERC
IEEE
MW
NERC
OECD
OSINERG
PJM
PPA
SA
UK
US
∗
Electricity Supply Auctions
European Union
Federal Energy Regulatory Commission
Institute of Electrical and Electronics Engineers
Mega Watts
North American Electrical Reliability Council
Organization for Economic Co-Operation and Development
Organism Supervisor of the Energy Investment
Pennsylvania, New Jersey and Maryland Pool
Power Purchase Agreement
Supply Adequacy
United Kingdom
United States
LLM Candidate in Energy Law & Policy. Mr. Gomero is a lawyer with relevant experience in
policy making in both the electricity and oil & gas sectors. He has been a member of the Peruvian
Ministry of Energy and Mines staff of advisers.
1. INTRODUCTION
When the state left electricity market in private hands as a consequence of the process of
deregulation, there was confidence in that private agents would have sufficient incentives
to achieve the best market performance. The state would not be responsible anymore for
developing new investment and, in fact, the search for efficiency in general terms was
considered achieved.
In spite of this, the new electricity model established has suffered some shortcomings since
its implementation in the 1990s. Thus, many countries have experienced energy shortage
problems such as Chile in 1998; California, Yugoslavia and Brazil in 2001; Venezuela and
India in 2002; Dominican Republic and Norway in 2003; China and Peru in 2004; among
others.
Even though the shortage problems observed in the cited countries were associated with
many other deficiencies of the new model; it is possible to say that, in general, a common
problem is that since the beginning of the process of deregulation-liberalization, the reserve
margins (the difference between the whole capacity in the system and the peak load or
maximum demand) have clearly fallen. 1
In this context, many countries are implementing reforms to avoid problems in the future.
Some of them are trying to return to more regulated markets while others are trying to
solve the problem by deregulating more. Electricity Supply Auctions (ESA) is a new
modality to get resource adequacy that has been implemented in Latin American countries
such as Brazil, Colombia, Mexico, Chile and Peru.
Some states of the United States (US) (such as New Jersey, New England and Illinois) and
Spain have already experienced electricity auctions or are thinking about implementing
1
OECD/IEA, Security of Supply in Electricity Markets. Evidence and Policy Issues, pp. 28-32, (Paris,
France: OECD/IEA, 2000). This text discusses the experiences of UK, Australia and US (California and
PJM). Available in: http://www.iea.org/textbase/nppdf/free/2000/security2002.pdf. Likewise, Wen (et al.) has
pointed out that the reserve margins have been significantly declining in Sweden and Norway since
deregulation/liberalization started several years ago. The same problem is being faced by New York where
demand has gone up 12.2% since 1993, while generating capacity only up 2.6%. See: Wen, F. (et al.),
Generation Capacity Adequacy in the Competitive Electricity Market Environment. In: International Journal
of Electrical Power and Energy Systems No 26, p.266 (2004).
2
them. 2 However, there is a big difference between a simple electricity auction and ESA: In
ESA the back-up for the auctioned contracts is physical (there is necessarily an increase in
the capacity of the system), while in a common electricity auction there may not
necessarily be back-ups. It is note worthy to mention early that some of the comments of
this paper are applicable to simple electricity auctions as well.
The experiences of these countries in auctions contrast with the existent available theory. In
this context, the paper attempts to identify what other objectives, if any, may be achieved
by this regulatory instrument. The reason for which Brazil, Chile and Peru have been
chosen for the analysis is based on the similarities among their electricity systems.
However, it is not the objective of the paper to analyze the regulatory regimes of those
countries but just to present the problems associated with supply adequacy that they faced.
2. ANALYTICAL FRAMEWORK
2.1 POWER GENERATION, REGULATION AND DEREGULATION
Under the normative theory of economic regulation 3 the existence of regulation is
explained by the presence of market failures. In electricity markets, and specifically in
power generation, those market failures were explained by the presence of natural
monopolies.
Thus, the characteristic of being a natural monopoly justifies the state intervention in power
generation. The common argument to support this theory (generation as natural monopoly)
was the efficiency of the power plants. It was argued some time ago that the most efficient
size power plant was approaching 1000 MW and now that capacity has been reduced by
new technologies. 4
2
New Jersey carries out auctions of energy since 2002. In Illinois, an auction for 30000 MW will take place
next September. Likewise, this year New England would be approved by the FERC to carry out capacity
auctions next year. Finally, Spain will make energy auctions from July 2006 to meet the new demand. See:
http://www.mtpc.org/RenewableEnergy/public_policy/DG/resources/2006-03_ISONE_capacity_settlement_summary.pdf, and: http://www.chicagobusiness.com/cgi-bin/news.pl?id=20935.
3
Viscusi, W. (et al.), Economics of Regulation and Antitrust, (4th ed.), pp. 376-379 (London, UK: MIT Press,
2005).
4
Stoft, S., Power Systems Economics. Designing Markets for Electricity, pp.9-10 (United States: IEEE Press,
2002).
3
This idea, however, has been rejected in theory and in practice because, first, natural
monopolies do not explain the existence of regulation and, second, because power
generation, is not, in fact, a natural monopoly. On the one hand, the positive theory of
regulation points out that regulation is explained by more complex facts rather than the
existence of natural monopolies.5 On the other hand, the experience shows that power
generation is able to be competitive.
Within this context, all over the world, the possibility to leave the power generation to the
market forces has been part of the process of deregulation which implies that the market
forces replace government regulation and/or non market institution in controlling the
performance of the power sector. 6 Thus, if regulation is about controlling prices of
monopoly suppliers and restricting entry to the markets, deregulation implies to remove the
control on prices and entry of new suppliers. 7
The consequence has been to consider power markets as competitive market places,
trusting in competition as the best way to allocate resources. But more important, giving to
the private agents the responsibility of electricity provision.
2.2 “KEEPING THE LIGHTS ON”. THE PROBLEM OF SUPPLY ADEQUACY
In simple words, Supply Adequacy (SA) is the condition of an electricity system which
makes it able to face the growth of the demand in the long run. Of course, the capacity of
the system not only has to be enough to deal with the maximum demand of the market, but
also it should have a gap to cover its increases (reserve margin).
Even though SA and Reliability are concepts commonly used as synonyms, SA is one part
of the broad concept of Reliability.
In electricity industries, Reliability is the degree of performance of the elements of the bulk
electricity system that results in electricity being delivered to customers within accepted
standards and in the desired amount (Reliability is measured by the frequency, duration,
5
Viscusi, W. (et al.), op. cit., pp.380-382.
Teplitz–Sembitzky, W. Regulation, Deregulation, or Reregulation – What is needed in the LCDs Power
Sector?. WB, Industry and Energy Department, Energy Series Paper No 30, p.2 (1990).
7
Hunt, S., Making Competition Work in Electricity, p.7 (New York, United States: John Wiley & Sons Inc.,
2002).
6
4
and magnitude of adverse effects on the electricity supply). 8 This concept can be addressed
by considering two aspects of the electricity system: Security and Adequacy.
While Security is the ability of the electricity system to withstand sudden disturbances such
as electric short circuits or unanticipated loss of system elements; Adequacy is the ability of
the electric system to supply the aggregate electrical demand and energy requirements of
the customers at all times, taking into account scheduled and reasonably expected
unscheduled outages of system elements. 9
Both concepts are related but do not imply the same. Thus, an inappropriate policy on
operating reserves could cause insufficient security to the system in spite of adequate
capacity, though it is relatively cheap to maintain sufficient operating reserves in an
adequate system. 10
Certainly, SA is a relatively new concern in the industry due to the fact that it was born
with the process of deregulation. Before the replacement of the State in the organization
and performance of the industry, there was a mandatory expansion in the industry which
implied that the State decided which generation units have to be installed in the system and
when. 11 Now, instead, markets participants decide on their own, according to their business
expectations, whether they want to build a certain facility or not.
Even when the goal of SA is to minimize consumer costs including the cost of blackouts,
the real problem is to restore the missing money that prevents adequate investment in
generating capacity 12 . Thus, what SA tries to solve is related to the adequate return for
investment in power generation which is necessary to cover not only the current, but also
the future demand. Naturally, this problem is more critical in countries with high rate of
economic growth. 13
8
NERC, Glossary of Terms, p.21 (1996) in: http://www.gisb.org/pdf/weq_glossary072804w10.pdf (last
visited 14 April, 2006)
9
Ibid.
10
Stoft, S., op. cit., pp.135-136.
11
Vásquez, C. (et al.), A Market Approach to Long-term Security of Supply, IEEE Transactions on Power
Systems, Vol. 17 No 2, p.1 (2002) in: http://www.pcb.ub.es/ieb/arriagaII.pdf (last visited 28 June, 2006).
12
Ibid.
13
It is illustrative in the case of China: in 2004, it installed 51000 MW of generation; in 2005, 68400 MW
and to this year is planned to install 79500 MW. See: Fu, S. (et al.), Resource Adequacy Problems in China
and Proposed Solutions, IEEE/Power Engineering Society, Transmission and Distribution Conference and
5
2.3 INVESTMENT AND MISSING MONEY PROBLEM
Economic theory says that the spot market should be enough to give the right incentives to
new investment in power generation. If spot prices are sufficiently high, it will address the
expansion of the capacity through the participation of newcomers or investment of the
incumbents. The entry of the new capacity will cause the fall in spot prices and, as a result,
lower investment and shortages. That is how a common market works.
The question that arises immediately is, what is wrong with spot markets? Why do they not
give suitable incentives to build new plants? Or why does the theory not work?
Some schools of thought point out that well-functioning markets are always reliable
because the lights only go out if a consumer wants them to, given the price. Thus, at the
end of the day, only the lack of consumers' response to prices is the reason for worry about
SA and the reason for capacity markets, installed capacity requirements, price caps, and
other holdovers from regulation. 14
However, in reality, it is possible to identify four causes 15 for which the electricity market
cannot trust only in the spot prices to deal with SA: (i) Risk aversion of peaking plants; (ii)
Oligopolistic behaviour and entry barriers; (iii) Consumers’ demand-responsiveness to
prices; and, (iv) Price caps.
2.3.1 RISK AVERSION OF PEAKING PLANTS
In ordinary circumstances, a potential entrant should see the spot price and its own capacity
to determine if it is convenient to invest. If, from this calculus, the total costs and a
reasonable profit margin are covered, the investment should be done.
The case of peaking plants is quite different. They have to consider that their units will only
generate a few hours a year, when the market price is highest. As a result, they would
receive no remuneration most of the time and a high income in a few occasions. 16 This
Exhibition Asia Pacific, pp.1-2 (2005) in: http://conference.epri.ac.cn/t-d2005ap/speech/PL2-1.pdf (last
visited 12 April, 2006).
14
Hunt, S., op. cit., pp.75-76. One example is the case of UK in 1996. In February 1996, UK was severely
short of generating capacity. Blackouts were a possibility but they did not happen in practice. Just it was
needed to increase the prices to accommodate the consumption. See p.82.
15
Vasquez, C., op. cit., p.1.
16
Ibid.
6
means that risk-averse firms could feel that the volatility of the income makes the projects
too risky and, as a consequence, will not invest.
2.3.2 OLIGOPOLISTIC BEHAVIOUR AND ENTRY BARRIERS
Power generation industries are more like oligopolistic markets than competitively perfect.
This supposes that the incumbent utilities may under-invest in order to raise market prices
when the barriers to entry are sufficiently high to deter the entry of potential entrants.
It is common to accept that oligopolistic markets are one of the reasons for which the spot
prices do not give the suitable incentives to new capacity investment, but in practice, this
feature is more related to the prices the consumers have to pay and not necessarily to SA.
In fact, if there were no entry barriers the behaviour of the incumbents does not matter at
all because the new entry would be easy. The real problem, hence, are the entry barriers of
the industry which is indeed an intrinsic problem in electricity industries due to the
existence of high capital investment and sunk costs.
It is clear, however, that oligopolistic behaviours could make worse the problem due to the
impact that prices may have on consumers, but it is beyond the worries about SA.
2.3.3 DEMAND RESPONSIVENESS TO PRICES
In most cases, the consumers are isolated from spot prices by regulated tariffs or price caps
and, as a result, they see no advantage for hedging against high prices.17
If the consumers receive the real price signals there would be no concerns about SA 18 , but
the lack of metering and real-time billing, and the ability of the load to take power from the
grid without a prior contract with a generator 19 are certainly obstacles to give right signals
to investment. Both problems make impossible for the market to assess, even
approximately, the value placed on reliability by consumers. Without information on this
17
Ibid.
See Hunt, S., op. cit. Supra Note 14.
19
Stoft, S., op. cit., p.15
18
7
value, the market cannot determine the adequate level of capacity, since this is defined by
the value of reliability. 20
2.3.4 PRICE CAPS
One of the main reasons for the missing money problem is that occasional market price
increases are limited by administrative actions such as price caps. By preventing prices
from reaching high levels during times of scarcity, these administrative actions reduce the
payments that could be applied towards the fixed operating costs of existing generation
plants and the investment costs of new plants. 21
The logical consequence is the reduction of incentives to maintain generation plants but
mainly to build new generation facilities. The result is well-known: if the generators have
no sufficient incentives to invest in new infrastructure, there will be shortages and
blackouts in the future. According to this, it is possible to say that reliability and incentive
to invest are linked. 22
In short, from the perspective of the generating plants, price caps are a tool for
discouraging investment. Figures 1 and 2 (taken from Hogan W.) attempt to explain this
effect.
20
Cramton, P., and Stoft, S., The Convergence of Market Designs for Adequate Generating Capacity, A
White Paper for the Electricity Oversight Board, The Harvard Electricity Policy Group p.3 (2006) in:
http://www.ksg.harvard.edu/hepg/Papers/Cramton_Stoft_0406.pdf (last visited 14 April, 2006).
21
Hogan, W., On an “Energy Only” Electricity Market Design for Resource Adequacy, John F. Kennedy
School of Government, Harvard University, p.2 (2005). In: http://ksghome.harvard.edu/~whogan (last visited
2 May, 2006).
22
Stoft, S., op. cit., pp.76-77.
8
Figure 1: Returns for generators based on a marginal scheme
Figure 2: The effect of price caps in the return of generators
3. MODELS TO ENSURE SUPPLY ADEQUACY
The solution for the missing money problem seems to be obvious: the market must provide
sufficient incentives to new investment. The real problem, however, is how to give those
incentives. How to avoid the missing money problem without reducing the welfare through
high prices to the consumers.
9
In order to solve this problem, theory suggests some alternatives to complement the market
and provide the payments deemed necessary to support an appropriate level of SA. 23 This
topic leads to the treatment of the models to ensure supply.
With some variants, it is possible to identify five existing models for ensuring SA: 24
3.1 ENERGY ONLY MARKET
Energy-only markets work in California, Australia and New Zealand. In these countries,
generators are only remunerated by the produced energy. On-peak energy prices may be
quite high and must be allowed to rise in order to send the right signals. 25
The majority of systems around the world do not adopt this model because of the problems
that they could create with respect to the price levels. 26
3.2 ENERGY PLUS CAPACITY PAYMENT
This method is used in Brazil, Chile, Peru, Spain, UK and many other countries. The
concept of Capacity Payment is rooted in the theory of peak load pricing, which application
in the context of electricity power was pioneered by Boiteux. 27 This model derives from
the correct notion that charging the marginal cost at all hours will give generators just
enough revenue if they also charge the “marginal cost of capacity” at peak times. 28
The capacity payment is set to a “value of lost load” (VOLL), which is an estimate of the
value of consumers that is multiplied by the “loss of load probability” (LOLP) and paid to
all available capacity, no matter whether a generator is dispatched or not. 29 The capacity
23
Hogan, W., op. cit. p.1.
Gülen, G., Resource Adequacy and Capacity Schemes, CEE, University of Texas at Austin, (2002). In:
http://www.beg.utexas.edu/energyecon/thinkcorner/Capacity_payments.pdf (last visited 2 May, 2006). See
also: Fu, S., (et al.), op. cit., p.2.
25
Gülen, G., op. cit., p.2.
26
For more details about energy only markets, see: Hogan, W., op. cit.
27
Oren, S., Ensuring Generation Adequacy in Competitive Electricity Markets, University of California at
Berkeley, p.6 (2003). In: http://www.ieor.berkeley.edu/~oren/workingp/adequacy.pdf (last visited 2 May,
2006)
28
The investment cost not recovered through marginal cost pricing.
29
Fu, S. (et al.), op. cit., p.2
24
10
payments are collected from customers and may be set as a fixed charge or a fixed-variable
charge (in this case, the dispatched plants may have a premium 30 ).
The idea behind this concept is that the spot price of energy pays just for the short-run
marginal cost of generation but not for the fixed costs. For this reason, capacity must be
paid in order to maintain plants that are only used in dry years and that do not earn
inframarginal profits to pay for capital costs (peak plants). 31
3.3 ENERGY PLUS CAPACITY OBLIGATION
This method is applied in Northeast US, including PJM, New York and New England. In
this case, the obligation for capacity is imposed on the consumers (commonly distributor
concessionaries or retailers) by forcing them to sign long-term contracts with power
suppliers. 32 The authority determines how much capacity will be bought and sold, but not
the prices.
This model is commonly named capacity market because inside them there is an organized
market for the availability, and the plants may buy and sell their capacity and, as a
consequence, the price of the capacity is obtained through market forces.
Even though in the model of the cited countries, the regulator determines the amount of
firm capacity that each one of the consumption entities has to buy, in practice it admits the
possibility of a full requirement (for 100% of the load), like in Peru.
3.4 ENERGY PLUS CAPACITY INVESTMENT RETURN PAYMENT
Used in China, the goal of this model is to pay back the total investment for construction of
power plants, including interests. 33 The idea is to give more incentives for investors to
build power plants. The investors not only will not be worried about the return of
30
This is the case of Peru where capacity payments have a fixed component (it does not matter if the plant is
dispatched), and a variable one (dispatched plants are rewarded).
31
Fisher R., and Serra, P., Regulating the Electricity Sector in Latin America, Economia, LACEA, p.164
(2000). In: http://muse.jhu.edu/demo/economia/v001/1.1fischer.pdf (last visited 2 May, 2006). Inframarginal
profits are those earned by the base-load plants (these are not paid according with their marginal costs of
production, but with the marginal cots of production of the peak-load plants which is, at the same time, the
marginal cost of the whole system).
32
Fu, S. (et al.), op. cit., p.3.
33
Ibid.
11
investment, but also will receive the right to operate in the market and earn more money
only for the energy supplied. 34
Thus, after the recuperation of the investment, this model works as an Energy Only Market.
3.5 ENERGY PLUS LONG TERM BILATERAL FORWARD CONTRACT
BACKED BY PHYSICAL CAPACITY (ESA)
This model may be seen as a type of capacity obligation because the authority obligates to
the distributor concessionaries and large consumers, to have their entire load duly covered
by bilateral forward contracts. Its particularity, however, is based principally in two
criteria:
(i)
The capacity obligation is more specific and complex. Consumers have to offer
their load in an open auction with some anticipation (3 or 5 years ahead of time)
to let the participation not only of incumbents but also of newcomers (in that
time it is possible to build a plant). This is the characteristic of a common
electricity auction, such as those made in New Jersey, Illinois or Spain; and,
(ii)
The bilateral forward contracts which are sold in the auction imply a physical
commitment to develop new capacity. In other words, the contracts obtained
from the auction will not be mere financial contracts. The winners of the auction
have to develop the capacity to cover the necessary amount of energy
established in their contract. 35
This model is applied in Brazil, Chile and Peru 36 but there are proposals to apply it in
California (under a concept called capacity tag). Likewise, in FERC/EU directives are
34
Ibid., p.4.
The physical capacity does not mean that the winner of the auction will produce necessarily all the energy
for the counterpart. The rules of dispatch are still applicable and, as a result, the winner most of the time will
be enforced to buy energy in the wholesale market to attend the obligation established in the contract.
36
Last year, the government of Peru (The Ministry of Energy and Mines and OSINERG) submitted to the
Parliament a proposal to reform the electricity sector which has been approved and should be enacted this
month (July 2006). One of the proposed reforms is the implementation of ESA.
The text of the proposal and its foundations are in the document named White Book. Project to assure the
efficient development in power generation. See infra note 47.
35
12
being included establishing that the agents should show mid-long term supply coverage to
meet future demand. 37
This model requires the consumers to sign long-term bilateral forward contracts with power
suppliers able to back-up the commitment of delivery with physical capacity. Normally it
would encourage the construction of new plants in times of shortage. The particularity of
these contracts is based on the arrangement that they are auctioned in such a way that new
investors can also bid to obtain the right to supply electricity.
4. ELECTRICITY SECTOR RESTRUCTURING IN LATIN AMERICA 38
4.1 BACKGROUND
Likely, the biggest revolution introduced by reformers of the electricity sector in Latin
America was the notion that the profitability of the market would determine investment in
capacity generating. In fact, this idea was unprecedented in Latin America where most
generating companies were owned by the state and followed government directives in
investment. 39 With the reform, the supply side started to receive right signals in terms of
prices and, as a result, investment was attracted by the profitability of the industry.
With the exception of Chile, whose electrical market was restructured in 1982, the rest of
the Latin American countries began their process of reform during the 1990s. The reform,
almost like in the whole world, implied the separation of activities in generation,
transmission and distribution – which additionally act as a retailer with respect to
residential consumers. Only Colombia implemented a retail market. Almost in all the
countries the reform was accompanied by the privatization of the sector.
37
Moreno, R. (et al.), Energy Supply Auctions to Stimulate Generation Investment, Submitted to IEEE
Transactions
on
Power
Systems
p.1
(2005).
In:
http://www2.ing.puc.cl/power/paperspdf/morenorudnickmontero.pdf (last visited 3.April, 2006).
38
Rudnick, H., California Crisis Influences Further Reforms in Latin America. IEEE Power Engineering
Review, p.1 (2002). In http://www2.ing.puc.cl/power/paperspdf/californiacrisis.pdf (last visited 17 April,
2006)
39
Fisher, R., and Serra, P., op. cit., p.164.
13
Additionally, such reform schemes were conditioned by the main hydroelectric
characteristic of the systems (Over 70% of installed capacity in the region is hydro – see
Figures 3 and 4).
Figure 3: Sources of electricity generation (2003) 40
Figure 4: Electricity markets in Latin America 41
40
Source: Rudnick, H., (et al.), South American Reform Lessons. Twenty Years of Restructuring and Reform
in Argentina, Brazil and Chile. IEEE Power & Energy Magazine Vol.3 (2005) in:
http://www2.ing.puc.cl/power/paperspdf/rudnickbarrososkerkblanco.pdf (last visited 12 April, 2006).
41
Source: Ibid.
14
In general terms, all the countries have constituted centralized pools but with different
schemes for dispatch. Chile, Peru, Bolivia, Brazil, and Central America use a centralized
economic dispatch based on audited costs 42 , while Argentina uses bids with caps. Only
Colombia accepts unrestricted bids. All of them have incorporated a scheme of capacity
payment (as an adequacy signal), besides the energy one.
Latin American reform was based on the spot prices as adequate signal to new investment
in power generation. Thus, any disequilibrium between supply and demand would
increase/decrease the price and, as a result, increase/decrease the incentives to new
investment. On the other hand, the risks as a consequence of the volatility of the spot prices
were managed through forward contracts among the agents.
Some studies about the performance of the industry after the reform 43 agree that, in
general, the process has been successful.
4.2 ELECTRICITY CRISIS IN BRAZIL, CHILE AND PERU
In recent years, however, concern has grown on signals of a decreased interest by the
private sector in continuing the high rate of investment both in generation and transmission.
This has been worsened with supply deficits in Brazil, Chile and Peru, affected by severe
droughts. Because of that, the need for the so called: second generation reforms have been
considered a necessity. 44
Table 1 attempts to show, in general terms, the causes of the crisis in the selected countries
for this study.
42
Currently, though, Brazil has turned out into a dispatch system based on price bidding. See infra Table 1.
See, for instance: Fisher, R. and Serra, P., op. cit. See also: Rudnick, H., and Montero, J., Second
Generation Electricity Reform in Latin America and the California Paradigm. Journal of Industry,
Competition and Trade Vol.2, 1/2 (2002).
44
Rudnick, H., op. cit., pp.1-2 (2002).
43
15
Table 1: Electricity Crisis in Brazil, Chile and Peru
Crisis
Brazil
(2001) 45
Causes
Physical generation
capacity was
insufficient (the
generation system
was not capable of
supplying the load
under contract).
Chile
(1998) 46
Drought and lack of
demand
responsiveness to
prices.
Chile
(2004) 47
Peru
(2004) 48
Effects
Rationing of 20% of
the energy from June
2001 to February
2002, in regions
corresponding to 80%
of the country’s
population.
Rationing of 450 GW
of the energy was
imposed by 81 days
between November
1998 and June 1999.
Argentina cut the
Excessive increase of
natural gas supply to prices because of the
the country.
use of alternative
fuels. Low investment
because price caps
were perceived
insufficient.
Drought and lack of Excessive increase of
demand
prices because of the
responsiveness to
use of alternative
prices.
sources. Low
investment because
price caps were
perceived insufficient.
45
Main reforms
Change the cost-based
system dispatch by a price
bidding scheme.
Mandatory ESA for the
whole system,
Reinforcing of the faculties
of the supervisory entity
(non important reforms).
Mandatory ESA for the
whole system.
Mandatory ESA only for
uncontracted demand.
Rudnick, H., (et al.), op. cit., p.52.
Díaz, C., (et al.), Electricity Crisis of 1998-1999: Causes, Consequences and Lessons, Centre for Applied
Economics,
Working
Paper
No
81,
(2000).
In:
http://www.webmanager.cl/prontus_cea/cea_2000/site/asocfile/ASOCFILE120030328124018.pdf
(last
visited 17 April, 2006).
47
Rudnick, H, and Mocarquer, S., Contract Auctions to assure Supply Adequacy in an Uncertain Energy
Environment, IEEE Power Engineering Society General Meeting, Montreal, Canada, June 18-22, p.2 (2006).
In: http://www2.ing.puc.cl/power/paperspdf/rudnickmocarquermontreal.pdf (last visited 15 April, 2006).
48
Ministry of Energy and Mines of Peru and OSINERG, White Book: Project to ensure the efficient
development in power generation. In: http://www.minem.gob.pe/electricidad/index.asp (last visited 15 April,
2006)
46
16
5. ELECTRICITY SUPPLY AUCTIONS
5.1 GENERAL CONCEPTS
As it was said above, ESA are just one way to provide incentives to the investors and “to
keep the lights on”. Thus, ESA might be simply defined as a model to ensure SA.
However, likely the most important characteristic is being forgotten: Electricity supply is
ensured through auctions of energy which implies a process through which consumers
(distribution concessionaries or large clients) offer to the market (installed plants and
potential investors) a given amount of energy to be supplied in the next years. In practice,
this is like selling a forward contract. 49
The fact that there is an auction through which the bilateral forward contracts will be
agreed is certainly relevant, since it opens the possibility to have a competitive process and
to obtain market-based prices.
Another important characteristic of this model which is necessary to keep in mind, is that
the energy to be supplied by the winners of the auction, necessarily increases the capacity
of the system because it is required for the existence of physical capacity and not merely the
compromise to deliver the electricity.
5.2 TYPES OF ESA
There are many types of ESAs depending on the conditions of the contracts to be sold. For
example, it is possible to sell in the auctions not forward contracts but options contracts, in
which the consumer could have reserved the option to take the energy -paying a premiumonly if the spot prices are above the fixed price in the contract.
However, in terms of impact in the whole electricity system, it is possible to talk about two
types of ESAs. The first is a model applicable to the whole demand in the electricity system
and the second, just applicable to the uncontracted demand.
(i)
ESA to the whole demand
49
The bilateral forward contracts could have diverse modalities. For instance, there is an interesting
application of this model based in financial call options in Colombia. See: Vásquez, C., op. cit.
17
Implemented in Brazil and Chile, this type of ESA implies mandatory
auctions for the entire demand of the system and the elimination of the
bilateral forward contracts in its original conception (contracts one to one).
Each period (e.g. a year), the consumers have to offer their entire load to
generators.
(ii)
ESA as residual mechanism
Implemented in Peru, it supposes to apply the model only for the
uncontracted demand (those load that have not been covered by the ordinary
mechanism) and, of course, it does not imply necessarily the replacement of
the bilateral forward contracts.
In this type, the consumers have the opportunity to get contracts in the
common bilateral forward market (contracts one to one) only if there are
remaining loads without contracts; these must be offered in the auction.
5.3 EFFECTS OF ESA
As a general rule, considering that the real foundation for the implementation of ESA is
ensuring SA in power generation, their direct effect is to guarantee a suitable return to
investors and, as a result of that, encourage investment.
However, unlike other models in ensuring SA, ESA may achieve many other objectives:
(i)
Enhancing the existence of long-term contracts. Hedging risks.
One of the most important characteristics of ESA is associated with the existence of longterm contract as a way to ensure SA. This model recognizes the weakness of the spot prices
to promote new capacity investment.
Long-term contracts can and should be a significant part of any electricity market
undergoing deregulation 50 because they are the best way to hedge the risks that represent
50
Borenstein, S., The Trouble with Electricity Markets (and some solutions), Program on Workable Energy
Regulation (POWER), University of California Energy Institute, Working Paper PWP-081, p.7 (2001).
18
the volatility of spot prices. For this reason, ESA makes possible to achieve objectives
associated with risk management. 51
(ii)
Financing
Contract auctions not only encourage investment, but also allow investors to get financing
easily. In fact, with this kind of forward contracts, it is possible to get off-balance sheet
financing (Project Finance). Getting a contract in an auction is like having a PPA. This
feature is widely acknowledged in theory. 52
It is evident that from the financial point of view it is different to deal with a merchant
plant (in which the project is entirely dependent on the volatility of prices) rather than to
deal with a project that enjoys off-take contracts. In the first case, the project would only
sell electricity in the spot market, and only when it is dispatched. In the latter, the project
will sell electricity anyway; even when it is not dispatched (in this case the project will
receive a price fixed in the contract and would have to pay the spot price to the dispatching
producer). 53
(iii)
Promoting competition and reducing market power
A principal goal of auction theory is the design of auctions that produce competitive prices.
In this sense, ESA can lead to competitive power prices.
But, what is the competitive price in ESA?. Moreno (et al.) 54 points out that the floor for
the price is defined by the expected spot market. That is, generators will not sign a contract
with a price lower than the expected market spot price. It has an evident explanation:
considering that generators can decide getting a contract or selling the energy in the spot
51
Long-term contracts have important effects on managing risks in prices, quantity, fuel and availability. See
Hunt, S., and Shuttleworth, G., Competition Choice in Electricity, pp.121-129 (West Sussex, UK: John Wiley
& Sons, Inc., 1996).
52
Hunt, S., op. cit., p.77.
53
Behind the wholesale contracts there are many modalities such as the contract for differences, futures or
options which work in a different manner and usually respond to more sophisticated marketplaces. In the
Latin American markets, wholesale contracts are normally organized as spot contracts or internal transfers
between generators.
54
Moreno, R., (et al.), op. cit., p.2.
19
market, the expected value of selling in the spot market must be, at least, the same to
induce the decision to bid in the auction.
Thus, the condition to trade the contract is that the present value of cash flows in the
scenario with contract has to be higher than the present value of the cash flows in the
scenario without contract. 55
Figure 5: Scenarios of payments with contract and without contract
Source: Moreno (et al.), op. cit.
Thus, the possibility to reduce market power is based on two criteria. First, it is explained
by the presence of a competitive process created by the auction and the effect caused by the
entry of new plants in the market. 56
Second, because long-term contracts leave little energy to be traded through the spot
markets. This function of the forward contract market has been discussed first time by
Allaz and Vila 57 , but it has been well explained in a context of the UK electricity market by
Green. 58 The reason is almost intuitive: if there is less electricity traded in the spot market
55
Ibid.
Charles River Associates Inc. and Market Design, Inc., White Paper on PPA Auction Design Issues, p.10
(1998) in: http://faculty-gsb.stanford.edu/wilson/archive/E542/classfiles/alberta_ppa_auctions.pdf (last visited
13 April, 2006).
57
Allaz, B. and Vila, J., Cournot Competition, Forward Markets and Efficiency, Journal of Economic
Theory, Vol. 59 (1993).
58
Green, R., The Electricity Contract Market in England and Wales, The Journal of Industrial Economics,
Vol. 47, No 1 (1999). Green points out that the incentives of the generators to raise prices in the spot market
are reduced because their potential earnings would be limited to the uncontracted portion of their sales.
56
20
(as a result of more contracted energy), there would be less incentives to the incumbents to
raise prices.
Furthermore, this result is especially applicable when the suppliers are over-contracted
(when they have commitments for more energy than their real capacity), because the need
for buying in the spot market would cause a slope in prices. 59
(iv)
Promoting non-regulated prices and reducing uncertainty
The reform introduced by the analyzed countries has effect to avoid price cap regulation
because the price obtained in the auction is passed-through to the consumers. Even though
all the countries have established a limit to the final prices in the auction (which indeed
could be seen as a limitation to reach competitive prices), the important fact is that, at least,
the regulation (price caps fixed periodically by the authority) would be diminished by
market signals.
Defining the price to the consumers only for the result of the auction could have no sense if
the market is highly concentrated and there are high barriers to entry as in power markets. 60
The most prudent so far, is to put a limit to the resulting price. Likely the next step, with
more experience especially about the auction design, the price may be exclusively a result
of the auction.
The importance of this feature in countries where price caps are effective (like Brazil, Chile
and Peru), is that the regulatory agency is usually under constant attack each time it sets
prices. Any movement in prices generates a reaction from any immersed part in the
problem; if the price rises, the consumers exercise pressure to force down the prices. 61 If
the prices fall, the companies do the same trying to increase them. Additionally, the fact
that the prices are not set anymore by the administrative authority will reduce the
uncertainty each period the prices are fixed (in Peru for example, the energy price caps are
fixed every year). With the auctions, the prices will be known with an anticipation of 3 or
more years.
59
Stoft, S., op. cit., pp.347-348.
Collusion could be a problem. See infra.
61
It is especially critical in Peru where the Parliament and the Executive Power intervene continuously in the
regulatory process.
60
21
(v)
Enhancing demand responsiveness to prices
One of the elements to be achieved by competitive markets is demand responsiveness to
prices. The reason to look for more consumer response is that it makes it possible to limit
price rises because the consumers will receive right signals through market-based prices.
This feature is essential in cases of relative scarcity of supply. In fact, some authors think
that if the consumers received adequate price signals, there would not be possibility for
blackouts. 62
Even when price caps imposed in each auction could limit this effect, it has been pointed
out that contract auctions incorporate a real market signal in the price to the consumer 63 ,
because the price caps are not necessarily included in the theoretical model. The price caps
imposed are a result of the possibility of collusion among bidders, but it is evident that the
model can and should work without caps.
(vi)
Making more contestable markets
The theory of contestable markets shows that pure profits may be eliminated even though
the industry contains only a few firms and experiences no actual entry. 64 In this case,
potential entrants act as modulator of the market replacing actual competition.
Even though contestable markets are based on the level of entry barriers, it is also relevant
the effect that ESA may cause on making markets more contestable for potential investors
often restricted to the spot market. 65 In such a way, the threat of entry will cause the
incumbents to increase their contract cover, which will make their behaviour in the spot
market more competitive and reduce the average pool price.
Newbery 66 says that what defines the entry are the variable costs. If the new investment has
lower variable costs than existing capacity, the incumbents deter the entry (they will take
62
Hunt, S., op. cit., p.69. See also: Borenstein, S., op. cit. p.5.
Rudnick, H., and Mocarquer, S., op. cit., p.2 (2005).
64
Lipsey, R. and Chrystal, K., Economics (10th ed.), p.210 (New York, United States: Oxford University
Press, 2004).
65
Moreno, R., (et al.), op. cit., p.2.
66
Newbery, D., Competition, Contracts and Entry in the Electricity Spot Market, Rand Journal of Economics,
Vol.29 No 4, p.744 (1998).
63
22
more contracts). If the variable costs of new investments are higher than existing capacity,
they allow the entry. This statement, of course, does not take into account the existence of
auctions. In the presence of ESAs, the cost of the investment is not important at all, because
the incumbents have no opportunity to deter new entry (all can participate in the auction).
The only case in which the Newbery’s conclusion would be applicable is the case of Peru
where the proposal of reform includes a design of auctions only for the non-contracted
energy under the ordinary model. Only in this case can the incumbents exercise some
strategic behaviour to this respect.
(vii)
Establish market values - Efficiency
A well-designed auction process should result in payments that reflect the true market
values of the contracts. These are prices at which arms-length buyers and sellers are willing
to transact. Related to this is the notion of economic efficiency. Under normal conditions,
providing for the establishment of market values leads to efficient outcomes. With the
ordinary forward contracts model (ordinary bilateral contracts - without auctions)
efficiency is not necessarily achieved. Efficiency is established when Forward
contracts/PPAs are owned by those who value them the most, and it is only possible to
know when participate all the potential sellers of energy.
5.4 THE BAD NEWS
Indeed, the model may have some weaknesses. These problems, though, are more
associated with its design rather than with intrinsic negative effects.
(i)
Collusion
Collusion is always a problem in auctions, especially when the markets are highly
concentrated. Power generation markets are generally oligopolistic and, as a consequence,
it is always present the possibility to find out anti-competitive behaviours. Obviously, this
weakness does not disqualify the model. It is just necessary to take some contingent
measures in order to enhance a real competitive process. In fact, there are huge
developments about auctions that may help to deal with collusion.
23
(ii)
What is the best form of auction? Auction Models
This problem is, again, a design problem. In theory, there are four types of auctions: 67
1.
English, in which the buyer starts bidding at the low price and the highest
bidder wins and pays the last price bid. An English auction is the familiar
“going, going, gone!” auction;
2.
Vickrey (second price), in which buyer submits sealed bids, and the winner
pays the price of the highest losing bid;
3.
Dutch, in which the auctioneer starts very high and calls out progressively,
lower prices. The first buyer to accept the price wins.
4.
Sealed-Bid (first price), in which buyers submit sealed bids, and the winner
pays the price that is bid.
What is the best type of auction? There is no response so far. The question is in fact, what
the auctioneer (usually the regulator) wants. In the case of ESA, the auctioneer usually
wants the lowest price.
It is necessary to say that even when theoretically the four type of auction have the same
result (due to the revenue equivalence theorem 68 ), in practice it does not happen
necessarily. 69 This gives an idea about the importance of looking for the best type of
auction accordingly with each electricity system.
(iii)
What if there are no bidders?
In an ideal scenario in which the collusion is not possible, the inexistence of offers in the
auction probably indicates that the prices are not sending right signals. That is, that the
prices do not cover the fixed and variable costs of a plant.
The design of the auction, however, can help to deal with this. In fact, an auction may have
many rounds in order to succeed.
67
Stoft, S., op. cit., p.99.
Ibid, p.100
69
Moreno, R., (et al.) found different results depending of the type of auction using the Chilean market as
model. See p.8.
68
24
(iv)
Forecasting the demand
This feature appears to be, indeed, an intrinsic problem of the model. Considering that ESA
implies to sign contract in ahead of time, it is based on a forecasted load. The problem
arises since the forecasted demand and the real demand may not match. Naturally, this
problem may cause under-investment or over-investment because the plants are built as a
result of the initial requirement.
One way to deal with this is establishing tolerance ranges, say 10%. Thus, if the forecast of
the company does not match with the real demand by less than 10%, there will not be
major consequences. If the forecast exceeds the threshold, usually sanctions are imposed.
(v)
The installation of the plants is not so simple
This is another intrinsic problem of the model because the construction of a plant is not
only a buyer/seller’s decision, but also it is under the general regulation. Thus, if the plant
does not satisfy, say, the environment requirements to be built, it will not be possible to
fulfil the contract. This problem, though, could be addressed if the auctions are organized
with some anticipation.
6. CONCLUSIONS
In spite of its problems, it was found that the ESA may achieve important objectives rather
than just “keeping the lights on”. Principally, they allow the possibility to improve the
market performance through increasing competition, increasing demand responsiveness to
prices, enhancing long-term contracting, among others.
In general terms, it is possible to say that ESA trust in long-term contracts as a mechanism
to expand the electricity system and, accordingly, give the right price signals to consumers.
Both characteristics make the model, apparently, ideal. In fact, the Brazilian experience
(2004), involving 24,000 MW on average in a transaction of almost US$ 27,000 millions,
shows that the model can be successful in practice.
25
Of course, SEA is not the solution to all the problems in power generation markets, but
what is certain is that we are in front of a new conception to guarantee long-term
investment in generating capacity. Likewise, in the long-term, SEA could imply the end of
price caps in power generation sectors and the birth of real market prices to residential
consumers, which seems to be the next step in the development of electricity markets.
26
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