Colombia Firm Energy Market
1
Peter Cramton and Steven Stoft
2
11 February 2007
Abstract
A firm energy market for Colombia is presented. Firm energy—the ability to provide
energy in a dry period—is the product needed for reliability in Colombia’s hydro-
dominated electricity market. The firm energy market coordinates investment in new
resources to assure that sufficient firm energy is available in dry periods. Load procures
in an annual auction enough firm energy to cover its needs. The firm energy product
includes both a financial call option and the physical capability to supply firm energy.
The call option protects load from high spot prices and improves the performance of the
spot market during scarcity. The market provides strong performance incentives
through the spot energy price. Market power is addressed directly: existing resources
cannot impact the firm energy price. Since load is hedged from high spot prices, the
market can rely on high prices to balance supply and demand during dry periods, rather
than rationing.
1 Summary
This paper presents a market design for the Colombia firm energy market, which began on a
transitional basis in December 2006 with an initial auction scheduled in November 2007.
A fundamental characteristic of the Colombian electricity market is that it is hydro-
dominated. Roughly 80% of Colombia’s energy is produced from hydro resources, and about
two-thirds of its capacity is hydro. As a result, the reliability adequacy constraint in Colombia is
having sufficient thermal resources and hydro reservoirs to provide firm energy during a dry
period. The proposed firm energy market provides the investment and operating incentives for
suppliers to build and operate the efficient quantity and quality of energy resources. The market
both reduces supplier risk and improves reliability, resulting in reliable electricity at minimum
cost to consumers.
1
This paper was funded by Colombia’s Comisión de Regulación de Energía y Gas (CREG). We thank the
commissioners and staff for many helpful comments.
2
Peter Cramton is Professor of Economics at the University of Maryland and Chairman of Market Design Inc. Over
the last 20 years, he has published research on auction theory and practice in the leading peer-reviewed economics
journals. During the last 12 years, he has applied this research in the design and implementation of auction markets
worldwide. He has led the design and implementation of dozens of high-stake auctions in the energy and
telecommunication industries. He has advised over 26 companies on bidding strategy in energy and
telecommunication auctions. Since 1997, he has advised ISO New England on electricity market design, and with
Steven Stoft led the design of the proposed forward capacity auction in New England. He received his B.S. in
Engineering from Cornell University and his Ph.D. in Business from Stanford University.
Steven Stoft is an independent consultant. He is the author of Power System Economics: Designing Markets for
Electricity (Wiley-IEEE, 2002). He has been an advisor to PJM’s Market Monitoring Unit since 1999. He was an
expert witness for the California Electricity Oversight Board and the California Public Utility Commission in the
Long-Term Contract Proceeding before FERC, and for ISO New England in their LICAP proceeding, also before
FERC. With Peter Cramton he led the design of the proposed forward capacity auction in New England. He received
his B.S. in Engineering Math and his Ph.D. in Economics from the University of California at Berkeley.
1
The market has a number of key features outlined below.
1. Product. The firm energy product is a financial call option backed by a physical resource
certified as capable of producing firm energy during a dry period. The physical
requirement guarantees that sufficient resources will be available to produce firm energy.
The financial call option hedges load from high energy prices during periods of scarcity.
3
The supplier’s generating units and fuel provide a physical hedge to limit the risk of
selling the call option. Indeed, relative to an energy-only market, the supplier’s risk is
reduced, since the firm energy market substitutes highly variable energy rents with a
constant firm energy payment. The obligation is load following in aggregate: in each hour
the total obligation is equal to load. A supplier’s obligation in any day is equal to its share
of firm energy. The obligation is distributed over the day based on the hourly dispatch.
This definition—tying a unit’s obligation to its hourly dispatch during scarcity—reduces
market power and improves the performance of the spot energy market. A baseload unit’s
obligation is spread throughout the day; a hydro unit with high opportunity cost has its
obligation concentrated on the peak hours of the day.
2. Planning period. Initially, the planning period—the time between the primary auction
and the beginning of the supplier’s commitment—is 3 years, but this will increase by six
months in each successive auction, until it reaches its permanent value of 4 years.
Projects with even longer lead times can sell firm energy as a price-taker up to 7 years
ahead.
3. Commitment period. The commitment period for existing resources is one year. The
commitment period for new resources is between one and twenty years. New resources
select their preferred commitment length during the auction qualification. The firm
energy price is adjusted for inflation during the commitment period.
4. Cost of new entry. A parameter in the auction is CONE, the cost of new entry. Initially,
CONE is estimated by the regulator. Subsequently, CONE is adjusted based on
competitive auction results.
5. Demand curve. The demand curve specifies how the purchased quantity of firm energy
depends upon price. At CONE, load purchases its firm energy target (100% of estimated
firm energy demand). At higher prices, load purchases slightly less than the target
quantity; at lower prices load purchases slightly more than the target quantity. The firm
energy price has a ceiling of two times CONE and a floor of one-half times CONE.
6. Descending clock auction. The auction uses a dynamic auction design intended to
promote price discovery. The price starts at a high price (two times CONE) and suppliers
bid the quantity they are willing to supply at that price. If there is excess supply, the price
is reduced and again suppliers respond with their willingness to supply. This process
continues until supply and demand balance, which determines the quantity won by each
supplier and the clearing price paid to all suppliers during the commitment period.
7. Price formation. The clock auction includes a simple activity rule: as the price declines
suppliers can maintain or reduce quantities; quantities cannot increase. Thus, a supplier’s
3
Many papers have suggested the use of call options. See Bidwell (2005), Carlos et al. (2002), Chao and Wilson
(2004), Cramton and Stoft (2006), and Oren (2005).
2
offers must be consistent with an upward sloping supply curve. In addition, there is a rule
that prevents existing suppliers from exercising market power. Existing resources can opt
out of the market, but this choice does not impact the firm energy price paid to existing
resources.
8. Performance incentives. Performance incentives largely come from the energy spot price.
Those that supply more than their share during scarcity periods are rewarded and those
that supply less are penalized. In each case, the marginal incentive comes from the energy
spot price. In addition, a supplier’s certification of firm energy depends on its estimated
ability to supply firm energy in a dry period. This estimate depends at least in part on
historical performance, and this provides an additional incentive.
9. Fail-safe mechanism. The auction design recognizes the possibility that there may be
either inadequate supply or insufficient competition. The fail-safe mechanism specifies
what happens in these unlikely events.
10. Secondary market. Shortly after the primary auction, a reconfiguration auction is held for
each commitment year that has not yet occurred, but for which firm energy has already
been procured in an earlier primary auction. These reconfiguration auctions allow
suppliers and load to balance their positions in light of improved information. For
example, a project may proceed faster or slower than anticipated, and load growth may be
faster or slower than expected. In addition, a monthly auction is held during the
commitment year to further balance positions. All these auctions are sealed-bid clearing-
price auctions.
11. Transition. The firm energy price is set administratively in each of the first four years
(2007 – 2010). During this period, the product includes the hedge for load. Beginning in
2011, the firm energy price is set in a competitive auction. The first auction is to be held
in November 2007 for the 2011 commitment year. To reduce risk in early auctions when
the planning period is shorter, the firm energy payment for existing resources has a
tighter floor and ceiling. The floor decreases and the ceiling increases for existing
resources following each of the first three competitive auctions.
These features work together to produce firm energy payments that will motivate efficient
(least-cost) investment in generation resources. A critical assumption of the approach is that the
market for new entry is competitive. Thus, as part of the market implementation, it is important
for regulators to take steps to reduce barriers to entry. A second critical assumption is that
suppliers have faith that the market, once implemented, will endure for the lifetime of new
plants. Hence, it is important for the government to make a commitment to the approach and to
honor the commitment. Entry barriers and political risk can undermine even the best market
designs. The regulators and government must recognize and address these challenges, otherwise
the market could provide high-cost, not least-cost, investment.
2 Introduction
This paper presents an auction design for the Colombia firm energy market. Colombia’s
electricity market is hydro-dominated, with about 80% of its energy coming from hydro
resources and about two-thirds of its capacity. As a result, the adequacy component of
Colombia’s reliability constraint must assure that the system has sufficient energy during dry
periods. This is accomplished by having the right blend of thermal resources together with
3
sufficient reservoir capacity to meet Colombia’s energy demand during a dry period. The
purpose of the electricity firm energy market is to provide market-based incentives for suppliers
to invest in the efficient mix of energy resources and then to operate these resources efficiently.
The firm energy market is needed both to reduce investment risk and to improve the performance
of the energy spot market. In this way, the firm energy market improves the reliability and
efficiency of the electricity market. Consumers benefit from reliable electricity at minimum cost;
suppliers benefit from market incentives and reduced risk.
The firm energy auction is a forward market for firm energy. Firm energy is the ability to
deliver energy in periods of scarcity, such as during a dry period. The auction is conducted three
to four years in advance of the commitment period. This allows new entrants to compete for
supply, making the firm energy market contestable. Moreover, the auction coordinates the entry
of new resources so as to avoid the pronounced boom-bust cycle common in most markets. The
auction allows new resources to lock-in a firm energy price for up to twenty years. Existing
resources receive the price set by new entry each year. All resources, both new and existing, are
paid the same firm energy price, except in unusual circumstances. Moreover, this price is the
same for all locations and for all types of resources.
The auction uses a descending clock format. The price starts at a high price, approximately
twice the cost of new entry. Suppliers respond with the quantity each is willing to supply at that
price. If there is excess supply, the price is reduced and the suppliers again specify the quantity
desired at the lower price. This process continues until a price is reached in which supply and
demand are balanced. This defines the clearing price, which is paid to all winning bidders
throughout their commitment periods.
The quantity of firm energy demanded increases slightly as the price falls. Additional firm
energy beyond the target has value for consumers, but this marginal value declines fairly rapidly.
The demand curve has both a price ceiling and a price floor. The price ceiling at two times the
cost of new entry (CONE) reflects the fact that entry at high prices is not limited by the price
incentive, but rather other non-price constraints. The price floor at one-half CONE is intended to
prevent the firm energy price from falling too low in times of surplus. This provides stability to
the firm energy price, which reduces supplier risk and thus reduces consumer cost.
The descending clock auction includes important price formation features. First, to promote
price discovery, there is an activity rule that requires each supplier’s offers to be consistent with
an upward-sloping supply curve; that is, as the price declines a supplier can only maintain or
decrease its supply. Second, to prevent the exercise of market power by existing suppliers,
existing supply can opt out of the market, but this choice is not allowed to impact the price paid
to existing suppliers.
Performance incentives are provided primarily from the spot energy price. The firm energy
product is a call option together with the physical means to produce firm energy. The total
quantity of the call option follows load. The obligation is distributed over the day based on the
hourly dispatch. To the extent that the supplier provides more than its obligation, it is rewarded
by the spot energy price; to the extent it supplies less than its obligation, it loses the energy price,
just like in a contract for differences. Hence it has exactly the same incentives as if it had not
4
sold a hedge.
4
If the supplier is able to shift its output to higher-priced hours, it will be rewarded.
Because such shifting is rewarded, the option has no effect on performance incentives, but acts
only to hedge load and suppliers. Performance incentives come from the spot energy price, as
they should, and are not affected by the hedge.
An advantage of the hedge is that it eliminates the incentive to exercise market power during
times of scarcity. This is because suppliers have effectively sold forward energy covering 100%
of load during times of scarcity. The forward sale improves the performance of the spot energy
market during the scarcity periods, which is exactly when the market is most vulnerable to
market power. Additionally, the hedge reduces supplier risk by removing the energy rents above
the scarcity price, which tend to have high variance, and including them in the firm energy
payment, which does not vary with weather or other factors outside of the supplier’s control.
The scarcity price is a heat rate times a gas index plus other (non-fuel) variable costs. For
other variable costs we use $15.20/MWh. The gas index is the New York Harbor residual fuel oil
index, averaged over the prior month, and the heat rate is 12.482 MBTU/MWh, above the heat
rate of all gas units. During the transition period the scarcity price is $100/MWh.
The auction design includes fail-safe mechanisms that determine what happens in the
unlikely event that there is inadequate supply offered in the auction, or there is insufficient
competition.
The auction design facilitates an active secondary market. Although the primary auction is
intended to procure all or nearly all of the target quantity, the purchase occurs several years in
advance and circumstances may change. Thus, on an annual basis reconfiguration auctions are
held, so that suppliers and demanders can balance their positions for each commitment year that
has yet to occur. The reconfiguration auction is a sealed-bid clearing-price auction. Sellers
submit offers and buyers submit bids, and a uniform clearing-price is determined. Trades can
also occur during the year in a monthly sealed-bid clearing-price auction. Although the monthly
market is likely to be extremely thin, this is not a problem, since only a small volume will be
traded at the monthly price, and in any event the monthly price has both a floor and a ceiling as
given by the demand curve. Bilateral trades are also supported.
Finally, the proposal includes a transition period from 2007 to 2010. Firm energy payments
in these years are set administratively. Nonetheless, the product in the transition years includes
the hedge at the scarcity price.
The paper is structured as follows. First we state the purpose of the firm energy market, and
explain the motivation for forward procurement. Next we describe the key features of the market.
We define the product, discuss the auction mechanics, and describe how price formation and
performance incentives are handled. The paper concludes by addressing some of the common
misunderstandings about the market.
4
Note that if the supplier is short 1 MW it must pay load the spot price minus the scarcity price, whereas if it is not
short, it must still pay load this same amount but it receives the spot price. Hence the loss from being short is the full
spot price and not the difference.