1 Colombia Capacity Auction Peter Cramton (with many ideas from Steven Stoft) 9 June 2006

2 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

3 Purpose of Market

4 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

5 Why forward procurement?

6 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

7 Key features

8 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

9 Product

10 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

11 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 US$130 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

target 2005 actual 0%50%100% Duration Load (GW) Firm Energy Target Load Duration Curve and Firm Energy Target growth Target peak load

13 Single product; single price In a hydro-dominated system, there is a single reliability constraint: firm 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

14 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 have—same 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

15 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 month’s 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

16 Settlement Settlement is just like settling a conditional contract for differences in each hour If spot price < strike price, then no obligation If spot price > 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

17 Planning period

18 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

19 Planning period First auction (2010): 3 year Second auction (2011): 3.5 year All later auctions (2012…): 4 year

20 Commitment period

21 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)

22 Demand curve

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

24 Descending clock auction

25 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

26 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)

27 CONE updates If auction in year t is successful, CONE in year t+1 =.7 CONE in year t +.3 clearing price in year t If auction in year t fails, CONE in year t+1 = CONE in year t

28 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

29 Price $7.00 $6.63 $6.17 $6.00 Quantity (MW) start-of-round price end-of-round price Individual Supply Bid, Round 6 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

30 Price $12.00 = P0 P1 P2 P3 QuantityDemand Round 5 Round 4 starting price clearing price Aggregate supply curve P4 P5 $6.17 = P6 Round 3 Round 2 Round 1 excess supply $6.00 = P6’ Descending clock auction

31 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)

32 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

33 Price formation

34 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

35 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

36 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

37 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

38 Performance incentives

39 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

40 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

41 Fail-safe mechanism

42 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

43 Protections if auction fails: Insufficient 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 supplier’s 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

44 Secondary market

45 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 –Supplier’s buy/sell to balance position (including dispatchable load)

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

47 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

48 Transition

49 Transition and timing Transition period –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

50 MW Demand Transition Auction date Firm energy to be auctioned Existing supply New supply Nov Jun Nov Nov Nov Nov

51 Supplier concerns

52 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.

53 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, …

54 2. Call option increases risk Price Coverage Forward Energy Contract US$130 US$250 US$0 US$250 Forward Energy Contract Energy Option 

55 3. Consumers will pay more Minimizing risk while addressing market power and performance incentives means that consumers will pay less

56 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!

57 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

58 Supplier alternative

59 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

60 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

61 Questions