SECOND GENERATION REFORMS IN CHILE, POWER EXCHANGE MODEL. THE SOLUTION?

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1 SECOND GENERATION REFORMS IN CHILE, POWER EXCHANGE MODEL. THE SOLUTION? David Watts Paulo Atienza Hugh Rudnick Department of Electrical Engineering, Universidad Católica de Chile. Casilla 306, Correo 22, Santiago, Chile. ( ABSTRACT Many countries have decided to restructure their electric power systems, encouraging competition in generation and allowing private investments to participate. Chile was the pioneer introducing this kind of reforms, through the application of a centralized Poolco model, trying to emulate a dispatch under perfect competition. The energy crisis and the rationing occurred in second half of the 90 s, in addition to the lack of competition made the regulator to review the regulatory framework The Chilean electrical services law draft suggests major modifications in the structure of the market. One of the main changes is the replacement of the Chilean electricity pool (CDEC) by two organizations, the Power Exchange (PX) and the Independent System Operator (ISO). Based on the electricity market s international experience and considering the characteristics of the Chilean market, an analysis of the consequences that a change in the pricing and dispatch mechanism, is done. Topics like Market Power (MP), horizontal concentration, transmission constrains, withdraw of the capacity payment and the strategic use of the hydro resources must be carefully analyzed in a market design, in order to increase competition and assure peak demand supply, especially in hydro-thermo systems like the Chilean SIC. KEY WORDS Deregulation, Market Power, PX-ISO, Capacity payment. assess the water opportunity cost and to plan in a centralized way the use of it. The purpose of this mechanism is to emulate free competition marginal principles and mitigate the exercise of market power. Even though the model was successful [1], and it was improved and introduced in other South American countries (Argentina in 1992, Peru in 1993, Bolivia 1994, etc), some agents in the Chilean main system (SIC) started to doubt the suitability of the model. Potentially new agents experienced restricted access to the market, water right troubles and low competition level. Issues like the arrive of the natural gas opened a new field for competition but this was overshadow by the questions about the model. Second Chilean System: Northern SING (Thermal) Main Chilean System: Central SIC (Hydrothermal) 1. INTRODUCTION Chile was the pioneer deregulating its electricity market, introducing competition on power generation, open access to the transmission network and yardstick competition on the distribution activity, encouraging the entrance of private capitals in each of the market s traditional segments. The Chilean model, introduced in 1982, is based in a centralized pool known as CDEC (Centro de Despacho Económico de Carga). This institution, formed by generation and transmission companies, determines the dispatch building a merit list based on minimum cost criteria, to reduce the thermal unit fuel variable costs. Additionally, the model uses mathematical models to Fig. 1. Evolution of Nodal Prices in two Chilean Markets (Central SIC and Northern SING. Many disagreement started to appear inside the CDEC and important discussions about several topics like capacity payment, the meaning and assessment of firm s power to allocate capacity payment, ancillary services, transmission fees, etc. Under these circumstances and after the promulgation of a new regulation where some of these topics were resolved, a period of water scarcity began and put the regulation authority, the companies, the

2 consumer as well as the framework under a great deal of pressure. 1.1 The Chilean Electricity Crisis At the same time as the divergences took place, in 1998 and 1999 the worst water draught of the century affected the country, the disagreement within the CDEC were not settled properly and fast enough by the authority and some legal flaws, hindered the proper operation of the pricing system. This situation produced uncertainty and agents ignorance about the price the power was traded at the spot market. In other hand, previously the energy crisis, the level of the dams was kept low because of the entrance of Nehuenco, a new and important generation central that was expected [2]. This project underwent several delays and started to operate with very low availability levels, significantly increasing the energy shortage. In the meantime, the regulated consumers energy price (Nodal Prices) significantly decreased, due to the assessment structure included in the future simulated market, among other factors, the expected entry of cheaper energy produced by natural gas combined-cycle units and without accounting the delays or withdraw of some investments due to the lower profitability as a result of the inferior prices. This prices were not a sign of the scarcity of the system during the crisis, undermining the investments in generation and promoting a higher consumption. All these facts confabulated, under some months of 1998 and 1999, to finally set up a crisis with programmed supply shutdowns and with huge economic, political and social losses. To face and solve this emergency some law and rule changes were done, but those did not work out, so it became clear the necessity of a new regulatory framework for the industry. 1.2 Power Exchange Model Development During the 90 s, the deregulation process of the international electricity markets evolved away from the Chilean model [3] and toward to the one in use in England and Wales and Australia. Power Exchanges has been developed in several countries, integrating aspects of the pools and the private bilateral contracts, two of the traditional structures of deregulated markets. Chile has not been absent from this process and with the purpose of promoting the competitiveness of this sector and avoiding new energy crisis, the government recently proposed a new law; major changes are considered in the pricing and dispatch mechanisms. A Power Exchange (PX) or Market Maker and an Independent System Operator (ISO) would manage the tasks previously performed by the Chilean Pool (CDEC). 2. THE POWER EXCHANGE AND THE INDEPENDENT SYSTEM OPERATOR S MODEL (PX-ISO) In every deregulated electric market it is possible to recognize three essential functions that allow them to operate: the Physical operation, responsible for the grid operation in terms of reliability and stability; the Economic operation, whose purpose is manage energy markets and supplying the system demand at minimum cost, and the Commercial operation, as a result of the two others, in charge of the settlement and conciliations of the obligations contracted in the market [4]. Unlike centralized models, in which only one institution assumes the three main functions of the market, the PX- ISO model contemplates an explicit separation between the market and physical functions. As a result of this dichotomy the PX becomes the energy market operator and the ISO is in charge of the physical operation of the grid. Contracts Generators Bids Transmission Traders Retailers Major Consumers PX -ISO Model Power Exchange Economic and Commercial operation Bids Informs Standardized Forward Markets Demand Supplies Fig. 2. Power Exchange and the Independent System Operator s Model. The model functions disjointing is supported by the hypothesis that the principles behind the market and the grid operation are quite different. While the markets operated by the PX are based on economic principles, the ISO must operate according to physical and safety requirements. 2.1 The Power Exchange ISO Physical operation Real Time Markets Transmission Demand Distribution Regulated Consumer The PX is an institution created by the regulatory framework and its main objective is to employ and run competitive auctions of energy, on non-discriminatory basis, supplying the electricity demand at market prices. The PX assumes as counterpart in each purchase and sale operation, and for this reason it usually manages the settlement process, establishing guarantees and processes of conciliation to smooth differences among the agents.

3 Normally the PX is not authorized to make purchases and/or sales on its own behalf, since it has access to privileged information that can be used for its own benefit How does a PX work? The PX is a virtual forum where the agents concur to trade blocks of energy according to their requirements. The PX receives daily and hourly supply bids from the generators. With these bids it builds a merit list, sorting the prices supplied from least to most expensive until the generation match up the aggregate demand curve, obtaining as result of this operation the Market Clearing Price. The work of the PX is the accomplishment of periodic auctions for the different markets it operates. The most frequent ones are day-ahead and hour-ahead markets that contemplate the deliveries of energy for the following day and during the same day, respectively. Additionally the PX usually manages the bids in real time and an ancillary services market. However, the decision to purchase, in this case, is made by the ISO, and the job of the PX is purely administrative. What at first began with the operation of physical markets, has been evolving towards more sophisticated markets, with the developing of financial instruments like forward contracts and options, allowing mid and long term transactions. 2.2 Independent System Operator The operation of the grid requires of certain synchronization among the agents. In this case the ISO accounts for the coordination and the operation of the transmission system. The ISO determines the additional generation and the ancillary services required to make the necessary adjustments to guarantee the real time balance between generation and load, while maintaining the stability of the system. The scope or jurisdiction of the ISO is circumscribed almost exclusively to the real time operation. Nevertheless, in some cases it can have some degree of authority in the planning and the expansion of the system. The ISO has also another task, which is the validation of the PX operations, since these are not always physically feasible. If this is the case, the ISO must make the corresponding adjustments. 2.3 PX Analysis The main advantages of this model are the transparency and efficiency in the commercialization of the energy, in particular the open character of the auctions and the low transaction costs. From the market point of view, the PX is able to provide clear signals to all the agents, assigning a real value to each one of the services traded in the market. This does not always happen with the optimization system by pools, which can sometimes be perceived as arbitrary and non-transparent. The separation of the PX markets and the system s physical operations is seen, by its detractors, as a disadvantage or weakness of the model, because it constitutes an additional difficulty in terms of coordination and transference of information between the PX and the ISO. The periodic auctions allow daily price fluctuations. This and the system s pricing model are likely to produce a high volatile and unpredictable price pattern and make the model more susceptible to a monopolist behavior, also known as market power, usually executed by generators who take advantage of contingencies and grid transmission s constrains to raise the energy market price away from competitive levels. 2.4 Market Power Market Power (MP) has become one of the major concerns for authorities, regulators and researchers who look into the risks of design flaws that may cause abuses of companies with privileged positions within the industry. Cases of MP are found in the England/Wales [5] and California [6] markets. Because these systems are predominantly thermal, only some aspects can be extrapolated to the main Chilean electricity system (SIC), which has an important hydraulic component, like for instance, the presence of mechanisms with perverse incentives to make the system fail or drive it to extreme situations in order to artificially raise the energy prices. Another key feature is the necessity of implementing a flexible pricing system to increase the consumer s elasticity. Two markets are comparable to the Chilean market SIC, due to the importance of the dam hydro power stations: Colombia and the Southwest of Brazil. In studies related to these markets [7] [8], the authors cite as the main causes of MP a small gap between the generation capacity and the demand for power where there are companies with important market shares. At the same time a new element is added to the agents decision-making, the strategic use of the water resources stored in the dominant companies reservoirs. Depending on the dispatch method selected, the behavior of companies will be different. If the competition settles down by costs, with a centralized optimization, the MP of the dominant companies is mitigated in part but it still can be accomplish by declaring certain generation units on maintenance for certain period of time, and forcing to replace these units with more expensive ones, in order to raise the system s marginal cost [9]. On the other side, if the dispatch is decentralized, then the strategic companies have two choices: either restrict the supply or raise the bids. The direct consequence of the MP is transference of

4 wealth from consumers to generators, who raise their profits above competitive levels. 3. THE POWER EXCHANGE IN THE CHILEAN MARKET The Chilean regulator has suggested that the PX s function will serve as a convergence mechanism for mid and long term contracts [10], and for doing the dispatch of generation units. To fulfill this commitment, the PX will run energy auctions in two markets, the day ahead and the day of market, as well as receive the bids in real time and manage an ancillary services market. Another remarkable aspect is that the PX will be an independent organism from market agents, therefore eliminating the conflicts of interests that appear sometimes inside the actual pool (CDEC), which is currently managed by generators and transmission companies, with important governance troubles. The PX should also solve some of the existing discrepancies about dispatch mechanism like marginal costs and water reservoirs management. At the same time the periods with spot prices equal to cero should disappear (it happens when the damns are spilling water). Additionally, the consumer s involvement in the pricing process could make the demand more elastic and flexible to price changes, and effectively contributing to reduce the MP. However, the real consequences that free bids auctions may have in the Chilean electricity markets are strongly dependent of the following topics: 3.1 Regulatory Framework The character of the auctions going to take place in the PX s markets remains unclear. In the law draft, daily auctions were contemplated, with daily and hourly bids. Nevertheless, according to later explanations, at least in a transitory period, the bids format would be on an annual basis, and considering the differences between hydraulic and thermal plants, restraining the strategic use of the water due its importance. The annual bids mechanism has two advantages, the fact that generators are allowed to freely make their bids, eliminates the disagreements about the calculation of the variable costs, which is a problem in the actual framework. At the same time, the MP is partially mitigated, since the bids cannot be changed during the current period, taking advantage of the network congestion or the sudden outage of generation units. Although, these type of bids seem to aim in the right direction, from the MP point of view in the PX, this format weakens its character, since it does not allow the periodic adjustment of the supply bids according to the evolution of the market and the agents expectations becoming a pool where instead of costs, half rigid prices are used, at least while the bids had such a long life cycle. In the annual supply bids system, the moment in the hydrological year when the bids are submitted is crucial, because the amount of information the agents will have to commit their generation plants will depend on that. It seems then relevant that the supply bids must be done once the precipitation season has ended, and the bidders will have a smaller risk and higher accuracy over the amount of water available. 3.2 Market Power The Chilean energy market is highly concentrated, and the installed generation capacity in Chilean SIC does not exceed the demand with enough slackness. This situation makes the PX ISO model vulnerable to MP. This phenomenon has been observed in markets with a much smaller property concentration than the Chilean one. England/Wales and Colombia are good examples of this Hydrothermal Systems: SIC The presence of a high hydroelectric component in the SIC, reaching approximately 60% of its installed capacity, introduces an additional factor that has to be included in the analysis: the strategic use of water resources. The midterm uncertainty over the rainfalls and the importance this resources have in the SIC makes the use of hydro resources a sensible issue, because the optimal use of the water, from a social point of view, will not always be aligned with the private interests of the power plants owners. An irrational use of the hydro resources, altogether with other contingencies can originate situations of electrical supply failures, like it happened in 1998 and Researches about PM in hydro-thermal systems like the Brazilian, has shown that a dispatch mechanism based on free bids are likely to experience a price raise through the water reservoirs manipulation. The strategic agents are able to restrict the water transferences from wet periods to dry ones, diminishing the energy available in the system and artificially increasing the prices. In SIC System, Endesa almost has a technology monopoly over the hydro resources, since it has rights over most of the Chilean rivers, while at the same time, it has an important market share. This kind of situation affects the potential competition and other benefits of this model and puts requirements and demands over the regulatory framework. According to market simulation in the SIC and trying to identify the possible consequences of the free bids dispatch regarding MP issues, the result using annual bids [11] was an average price increase around 27%.

5 Other simulations, modeled a short term dispatch in the SIC using a Nash-Cournot [12] equilibrium, also showed MP situations and a strategic water use. With all these facts it is easy to foresee the outcome of PX-ISO model in Chile, unless the hydro units have a tight regulation with a special care of the resources available in the system. Among the choices to avoid or diminish the MP are the submission to the PX of pricequantity mid term generation curves. This means that the bids will be fix for some months, allowing a controlled and coherent use of the water. However, the MP threat will not completely disappear. At this point the solution suggested by the model do not solve the problems related to the use of the water in a better way than the existing centralized planning. On the other hand, the consumption committed to private bilateral contract reaches barely the 40% of the total demand, making the PX operations too relevant to be consider just as an adjustment mechanism or market place Thermal System: SING In case of the SING, the second Chilean system in importance considering the size, the risk of facing MP is much smaller due the excess of installed capacity and the high presence of industrial and mining consumers representing almost 90% of the total demand. These consumers are allowed to buy energy in the wholesale market, and these bilateral contracts are a very important tool to mitigate PM, and the PX role will be reduce to just the adjustments as the original idea wished-for. However, the challenge in this system is the development of a pricing system capable of assuring the continuity and reliability of the service. The explicit payment for ancillary services must aim to avoid episodes like the blackouts and the loosening of loads, occurred at the end of the 90s. On the other side the PX-ISO separation could complicate the system operation. 3.3 Transmission Constrains Transmission constrains are surely, one of the bigger challenges regulators must face in designing electricity markets, particularly, the network congestion occasioned when the ideal dispatch exceeds the grid capacities. Actually this not only means the separation of markets, but also produces a situation against the market competitiveness and adds another strategic issue to be managed by the agents, in most of the cases, the supply bidders. They can take advantage of this situation and raise the prices. The Chilean SIC transmission networks have a radial topology, due to the shape of the country; this characteristic enhances the presence of bottlenecks in the grids. The stochastic nature of the hydro resources in the SIC, changes the amount of energy generated by each kind of technology and therefore, the power flow direction will depend where the injected energy comes from. A rainy season increases the contribution of the hydroelectric power stations, located mainly in the middle and the south of the country. Dry season demands the generation of more electricity at the thermal units, located mainly in the middle and north of the country. This singularity can give MP not just to hydroelectric plants, but also to thermal ones when the hydro resources are scarce. 3.4 Securing Peak Load Capacity: Capacity payment withdrawal The Chilean law draft proposes to elimination of the present capacity payments. Although it could be interpreted as a step forward in the liberalization of the market, this payment is a strong signal to expand the generation system and specially important for the entrance of new agents, since incoming generators are not likely to have their production previously committed in contracts and they will face the spot market volatility and seasonality. The capacity payment is a financial mechanism that assures money flow stability, resulting in a lower discount rate in the investment project evolutions and making a larger number of business enterprises profitable. A raise in the energy prices to internalize this effect must compensate the withdrawal of the capacity payment. In October 2001, the capacity payments stand for roughly 20% of the energy final price. The securing of peak load capacity is a topic abundantly discussed nowadays. Each market has chosen different models to encourage and properly remunerate the capacity. Among the existing alternatives, the explicit payment has become very efficient, therefore the capacity payment withdraw is not recommended due the tightness of the generation capacity. 4. CONCLUSIONS The application of the PX model in Chile brings up conceptually correct elements to improve the current model: the independence of the market operator from the other agents, a pricing mechanism based on free supply bids instead of costs, makes the market process more transparent by avoiding controversies and diminishing some entrance barriers. The accomplishment of open auctions and the introduction of financial instruments will aid the creation of a more robust and liquid market. In addition to this, the possible interconnection of the Chilean and Argentinean systems SIC-SING-SADI would open the market to a greater number of agents, improving the market competitiveness. Although, the PX-ISO just as

6 it is proposed, must take some considerations and solve some problems before its establishment. The new regulatory framework must deal with requirements like clear market signals, stimulating the investment in generation and reserve capacity and suitably remunerating these services to avoid, if possible, all supply failures keeping a service with high standards. The high horizontal concentration in generation in Chile, together with the small slackness between the installed capacity and the demand in the SIC, establishes exigencies to the regulatory frame to avoid MP and speculation in the PX. It is necessary to develop mechanisms to mitigate these practices. This consideration is based on the fact that electrical systems like England/Wales and Colombia have experienced this type of practices with much lower property concentrations than the Chilean system. On the other side, the amount of energy committed in bilateral contract must and should be higher before the PX starts to operate, and this situation at least in the SIC is not solved yet. The use of annual supplies bids, at least transitorily, aims to mitigate MP, although it is questionable, since this format denaturalizes the PX, as a dynamic adjustment market device. The simulations become a must in order to know the real impact of a major change in the dispatch methodology and the competition within the industry. The strategic use of water is a subject that must be analyzed in detail since the private interests not always will be aligned with the efficient use of the resources from the social point of view. The proposed model does not seem to have a better solution than the centralized planning for the hydro resource issues. The presence of large mining and industrial consumptions in the SING, make the relation between buyers and sellers more equal than in others systems. The overcapacity levels and the high amount of energy committed in contracts should mitigate the potential monopolist behavior. The challenge of the SING system is the development of mechanisms that allocate and remunerate properly the ancillary services, to improve the services quality. From this point of view the PX-ISO model seems quite suitable to this market. The international experience has exposed the peak load supply as a relevant matter, without an obvious solution. In this context the capacity payment withdraw may be interpreted as a step forward in the market liberalization. In case the change is adopted, a raise in the final energy price compensating the downward should be expected. However, the explicit capacity payment has been efficient, and its withdraw is hazardous considering SIC scarcity of generation capacity. The creation of a PX with important consumers participation is crucial to eliminate the artificially low demand elasticity. This certainly contributes to mitigate MP abuses. At last but not least, from our point of view, the regulatory commission must be independent of governmental authorities. Only this will allow and assure the design of long-term power policies in consensus with the market s agents and protecting the interest of the society as a whole. REFERENCES [1] H. Rudnick, and J. P. Montero, Second generation reforms in Latin America and the California paradigm, paper submitted to a special issue of the Journal of Industry, Competition and Trade, [2] C. Díaz, A. Galetovic, and R. Soto, La crisis eléctrica de : Causas, consecuencias y lecciones, CEP- Chile, P-Nº 80, pp , [3] H. Rudnick, "The Californian model as the paradigm for second generation reforms in Latin America", 2001 IEEE Power Engineering Society Summer Meeting, Vancouver, Canada, July [4] D. Watts, P. Atienza and H. Rudnick, Application of the PX ISO Model in Chile, 2002 IEEE Power Engineering Society SM, USA, July [5] C. Woltfram, Measuring Duopoly Power in the British Electricity Spot Market., American Economic Review 89, , [6] P. Joskow, & E. Khan, A Quantitative Analisys of Pricing Behavior in California s Wholesale Electricity Market During Summer Draft, MIT, [7] E. Stachetti, Auction Design for the Colombian Electricity Market, Mimeo, U. of Michigan, [8] M. Pereira, L. Barroso and R. Kelman, Market Power Assessment and Mitigation in Hidrotermal Systems. IEEE Transactions on Power Systems, Vol. 16 Nº3, August 2001, pp [9] F. Wolak and R. Patrick, The impact of Markets Rules and Markets Structure on the Price Determination Process in the England and Wales Electricity Market., Working Paper, University of California,1997. [10] Comisión Nacional de Energía CNE, Project to reform the current electricity law, Document for public discussion, September 2000 ( [11] D. Watts and H. Rudnick, Teoría de Juegos Aplicada al Mercado Eléctrico Chileno, Research Report, Pontificia Universidad Católica, [12] J. Villar and H. Rudnick, Hydrothermal Market Simulator Using Game Theory: Assessment of Market Power, paper submitted to IEEE Transactions on Power Systems, 2002.