Colombia Firm Energy Auction: Descending Clock or Sealed-Bid?

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1 Colombia Firm Energy Auction: Descending Clock or Sealed-Bid? Peter Cramton University of Maryland 3 June 2015 I am grateful to CREG for funding this research. The views are my own. 1

2 Outline Review of key features of market Purpose of market Why forward procurement? Commitment period Demand curve Comparison Descending clock auction Sealed bid auction Recommendation Other issues Questions 2

3 Purpose of market Induce just enough investment to maintain adequate resources Induce efficient mix of resources Reduce market risk Avoid market power in firm energy market Reduce market power in energy market Pay no more than necessary 3

4 Why forward procurement? New projects compete in advance of entry Coordinated entry Less uncertainty in achieving target Avoid boom/bust New resources set price directly Less reliance on demand curve for price setting Long-term commitment for new resources Reduced investor risk Better price signal for new investment 4

5 Commitment period New resources up to 20 years Generator selects duration at qualification Long commitment lets new resources lock-in firm energy price, reducing risk and encouraging investment Price is in constant $ (adjusted for inflation) Existing resources one year Does not need long commitment, since costs are already sunk Short commitment reduces risk (more draws from price distribution) 5

6 Demand curve Price of firm energy 2 CONE Price ceiling CONE ½ CONE 4% 0 Target CONE = Cost of New Entry (marginal unit) Existing supply can exit at prices below 80% of CONE Price floor Firm energy Uncertainty added of 1.5% to address generator market power; set by auctioneer 6

7 Comparison of descending clock and sealed-bid 7

8 International experience Descending clock Colombia Brazil New England United Kingdom Sealed bid (currently under consideration) PJM (New England) (Ireland) (Colombia)

9 Descending clock auction Auctioneer announces high starting price Generators name quantities Excess supply is determined Auctioneer announces a lower price Process continues until supply equals demand 9

10 Descending clock auction (Auctioneer s perspective) Price of firm energy Supply Rejected Supply curve is expressed in a series of rounds, starting with price ceiling P C Accepted Demand 0 Q C Firm energy 10

11 Descending clock auction (Bidder s perspective) Price of firm energy Supply P 1 P 2 P 3 P 4 Only supply at end of round is revealed to bidders P 5 0 Demand Firm energy 11

12 Sealed-bid auction (Auctioneer s perspective) Price of firm energy Supply Rejected Supply curve is expressed in a single round, starting with price ceiling P C Accepted Demand 0 Q C Firm energy In all other respects the two approaches are identical! 12

13 Descending clock Sealed-bid Price of firm energy Both formats are single-price auctions Supply Rejected P C Accepted Demand 0 Q C Firm energy The two only differ to the extent generators change exit bids in response to information revealed after each clock round 13

14 Why change your exit bid? Reason 1: Exercise market power Price of firm energy Supply Rejected P C P C Generator sees an opportunity to increase price! Accepted Demand 0 Q C Firm energy This unilateral exercise of market power is undesirable, as it may lead to prices that are above competitive levels. 14

15 Why change your exit bid? Other reasons Revelation of common value uncertainty Causes bidders to bid more or less aggressively as they get information about the supply curve Outcome discovery Budget, portfolio, or other constraints cause a shift in business plans Both of these reasons are good reasons for the adjustment of exit bids consistent with economic efficiency But neither seems too important in the case of a small number of new bids and a single merit order

16 Other factors to consider Privacy Clock auctions respect the privacy of infra-marginal bids Only reveal the high (rejected) portions of supply curve Winning generators only reveal, I m willing to supply at the clearing price Transparency Clock auctions have a higher level of transparency as bidders can see the supply curve as it is bid Simplicity A clock auction is slightly harder to conduct and participate in than a seal-bid auction; auctioneer introduces uncertainty to address market power However, with proxy bidding, participation can be just as easy But none of these factors are important in this case of a small number of new bids and single merit order

17 Summary of pros and cons and there importance in this setting Issue Exercise of market power Revelation of common value uncertainty Outcome discover to manage aggregate constraints Privacy of infra-marginal bids Transparency Simplicity Descending clock Sealed-bid

18 Recommendation Colombia should shift to a sealed-bid auction

19 Other issues 19

20 Addressing lumpy resources Single-price auction is easily defined for divisible products Clearing price and quantity established by intersection of supply and demand Market clearing is exact With lumpy resources Exact clearing is not possible Select winnings with efficiency objective Accept collection of offers that maximize net value (gains from trade) Supporting prices generally do not exist Best pricing approach is complex and setting specific

21 Clearing rule: maximize net value P 1. P 2. P 3. S S S P C Unit accepted P C P C Unit rejected D D D Q Q Q 21

22 Example maximization of net value P net value A = minus B S P A A D Q 0 Q A Q 22

23 Example maximization of net value P net value B = minus P B B S D Q 0 Q B Q 23

24 Auction frequency All reliability markets other than Colombia have annual auctions Annual auctions provide steady opportunity for entry and exit Annual auctions send price signal based on need Higher price when new entry is required Lower price when surplus New and existing compete in all years Colombia should consider shift to annual market

25 Recent developments in reliability markets All reliability markets other than Colombia have had performance incentives that were too weak Rules allowed many excuses for not delivering energy during scarcity periods This led to poor performance and near crisis situations Several markets now have adopted strong performance incentives, which like Colombia s reliability option, eliminates all excuses New England: pay-for-performance (shortage price = $5400/MWh) PJM: capacity performance (shortage price = $2700/MWh) Texas: scarcity pricing (shortage price = $9000/MWh) High spot price in reserve shortages is essential to motivate operational reliability in thermal systems Colombia needs high spot in its long and rare scarcity events In all markets, it is important that load is properly hedged

26 Questions 26