Transcript Note: Rule does not discourage new projects

Colombia Capacity Auction
Peter Cramton
(with many ideas from Steven Stoft)
9 June 2006
1
Outline
• Purpose of market
• Why forward procurement?
• Key features
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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
2
Purpose of Market
3
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
4
Why forward
procurement?
5
Why forward procurement?
• New projects compete in advance of entry
– Coordinated entry
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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
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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
10
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
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Load Duration Curve and Firm Energy Target
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Load
(GW)
Target peak load
8
2010 target
growth
6
2005 actual
4
Firm Energy Target
2
0
0%
50%
Duration
100%
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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
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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 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
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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 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
15
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
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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
18
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 of
firm energy
2 CONE
Price ceiling
Curve reflects marginal
value of firm energy
Able to withstand scarcity
events worse than worstcase benchmark
CONE
½ CONE
Price floor
 4%
0
Load not fully hedged
Target
Firm energy
CONE = Cost of New Entry (marginal unit)
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Descending
clock auction
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Descending clock auction
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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 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
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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-round
price
$7.00
$6.63
$6.17
$6.00
175
300
end-of-round
price
400 Quantity
(MW)
• 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
starting price
$12.00 = P0
Aggregate supply curve
excess supply
P1
Round 2
P2
P3
Round 3
P4
P5
$6.17 = P6
$6.00 = P6’
Round 1
Round 4
Round 5
clearing price
Demand
Quantity
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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
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New capacity
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New capacity bids are not mitigated in any way
Assumes competition for new capacity
Existing capacity
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Capacity can opt out of market with either an opt-out bid or retirement bid
Opt-out bid
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Retirement bid ― permanent opt out of capacity market
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Not revealed during auction
Cannot impact the price for existing supply
May be rejected for reliability reasons; gets reliability must run payment if rejected
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
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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
36
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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Performance
incentives
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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
42
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
43
Secondary market
44
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)
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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
Existing
commitment period
Administrative Pricing for New and Existing Based on CONE
2010
2010
2010
Primary
First
Second
auction reconfig. reconfig.
2010
Third
reconfig.
2010
Existing
Fourth
commitment period
reconfig.
New capacity
commitment period
Planning period
… 2006
2007
2008
2009
2010
2012
Primary
auction
2011
Second
reconfig.
2011
2012
… 2019
2020
New capacity
commitment period
Planning period
2011
Primary
auction
New capacity
commitment period
2011
Third
reconfig.
2011
Existing
Fourth
commitment period
reconfig.
• 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
2012
2011
Transition
2010
2009
Existing
supply
2008
2007
Nov Jun Nov Nov Nov Nov
2006 2007 2007 2008 2009 2010
Auction date
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Supplier concerns
51
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
US$250
Forward
Energy
Contract
US$250
Energy
Option

US$130
Forward
Energy
Contract
US$0
US$0
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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 marketbased 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
61