Learning from Developing Country Power Market Experiences: The Case of Colombia

|**Special resource:**those in the process of|Between one and ten|
|---|---|
|construction or installation when the auction<br>is held|years|

Source: (CREG, 2007)

# 4.1.2 Call option and the Scarcity Price

As previously described, Gencos with Firm Energy Obligations receive a stable reliability payment. In exchange, Gencos commit to provide a given amount of energy (the “firm” energy allocated in the auction), at a fixed price during tight supply conditions (i.e. dry hydrology). Such tight conditions are defined as the hours when the spot price exceeds a pre-defined strike price, called _“scarcity price”_ .

The scarcity price is calculated and updated by the regulator (CREG), and its initial value was set so that 5% of the historic spot prices were above this scarcity price. The selected value was equal to the variable cost of the most inefficient operating power plant, which was therefore selected as a reference for the initial calculation. The scarcity price is therefore composed of three parts: fuel, variable O&M, and other variable costs of the National Transmission System. The fuel component of the scarcity price was originally set to 101.6 USD/MWh (in June 2006), and is updated monthly according to an international fuel price index (the New York Harbour Residual Fuel Oil 1% Sulphur LP Spot Price) (CREG, 2007). The variable O&M cost was set to 10.667 COP/kWh (in June 2006), and is updated monthly according to the Colombian Consumer Price Index. Other costs are calculated on a monthly basis depending on operating conditions, including the costs of Automatic Generation Control (AGC, see section 3.1) (CREG, 2006a).

The Firm Energy Obligation resembles a call option on electricity during tight supply conditions, with a strike price equal to the regulated _“scarcity price”_ . Whenever the spot price surpasses the scarcity price, energy generated over the day in the ideal dispatch (see section 3) by Gencos who have Firm Energy Obligations must cover their firm energy commitments. Energy required in every hour of the daily ideal dispatch, by every power plant of a given Genco, is added to the complimentary energy that the Genco acquires through the available contingency mechanisms (see section 4.1.3). This total energy should cover the Genco’s daily Firm Energy Obligation. Thus, the Firm Energy Obligation requires that Gencos produce a determined quantity of firm energy on a daily basis, without imposing the time this energy should be generated (CREG, 2007).

During scarcity hours, the Genco receives the scarcity price for each unit of power produced associated with its Firm Energy Obligation. If the total energy (generated and acquired through contingency mechanisms) does not cover the Firm Energy Obligation, the Genco must purchase the difference in the spot market. On the other hand, if energy generated in the ideal dispatch exceeds the Firm Energy Obligation, the excess energy is paid for at the spot price (CREG, 2007).

In theory, the design of the reliability mechanism does not distort the spot market since the call option works as a hedge against the spot price, just like a conditional contract for differences. Thus, incentives in the spot market remain based on the spot energy price. Moreover, the call option on the spot price reduces the incentives of generators to exercise market power in the spot market during times of scarcity (Cramton & Stoft, 2007).

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