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Forward markets, both medium term and long term, complement the spot market for wholesale electricity. The forward markets reduce risk, mitigate market power, and coordinate new investment. In the medium term, a forward energy market lets suppliers and demanders lock in energy prices and quantities for one to three years. In the long term, a forward reliability market assures adequate resources are available when they are needed most. The forward markets reduce risk for both sides of the market, since they reduce the quantity of energy that trades at the more volatile spot price. Spot market power is mitigated by putting suppliers and demanders in a more balanced position at the time of the spot market. The markets also reduce transaction costs and improve liquidity and transparency. Recent innovations to the Colombia market illustrate the basic elements of the forward markets and their beneficial role.

Electricity market design seeks to satisfy consumers’ demand for electricity at minimum cost. This requires both short-run efficiency—the operation of existing resources at minimum cost—and long-run efficiency—investment in the right quantity and mix of resources. Both goals are made difficult by features of electricity markets. Supply and demand must be balanced at every instant and at every location. The physical constraints of the network must be respected. And demand often is unresponsive to spot price fluctuations. Our thesis is that the goals of electricity market design are better met when the spot market is complemented with two forward markets, one medium term and one long term. A well-designed spot market is necessary for efficiency, but is not sufficient. Efficiency requires that issues of risk, market power, and investment be addressed. The two forward markets address risk by enabling the market participants to lock in prices and quantities, limiting exposure to the more volatile spot market. Market power is addressed by putting participants in a more balanced position entering the spot market, mitigating the incentive to distort bids. Finally, the long-term market coordinates investment in new resources, assuring that adequate resources will be available when they are most needed. The California electricity crisis of 2000–2001 illustrates all too well the problems that can arise when one relies excessively on the spot market. Key conditions of the crisis were insufficient forward contracting and tight supply. During this prolonged period of tight supply, the unhedged demanders were exposed to sustained high spot prices. Suppliers, also positioned without forward contracts, had strong incentives to exercise market power further exacerbating the high prices. The load serving entities, despite initially being well capitalized, ultimately teetered toward bankruptcy and the market collapsed. The proposed forward markets would have reduced or perhaps prevented the crisis. To the extent that the crisis was caused by inadequate resources, the long-term market would assure sufficient investment to relieve the tight supply conditions that contributed to high prices. Even if spot prices became high for an extended period, with the forward markets the vast majority of the quantity would be transacted at sustainable forward prices, preventing the large wealth transfers that pushed utilities toward bankruptcy. Finally, suppliers in roughly balanced positions entering the spot market would have much reduced incentives to exercise market power, so the behavior of the spot market would have likely been less extreme. Our view is that forward markets can address three of the pressing problems in current wholesale markets: investment, risk, and market power. The need for forward markets and the form that they take will depend on the setting. We use Colombia to illustrate one approach to the forward markets. Colombia recently adopted both a long-term market and a medium-term market. Similar markets have been adopted in parts of the U.S., such as New England. We present the essential features of each market and discuss some of the design choices. We begin with the long-term market and then discuss the medium-term market. The need for regulated forward markets in electricity comes largely from market failures on the demand side. Consumer demand response is limited; consumers have limited exposure to spot prices and have no ability to express preferences for reliability. As a result, in most markets, regulators establish the quantity of resources needed. The long-term market assures that adequate resources exist and establishes a transparent competitive process for identifying and pricing these resources. Regulation of medium-term (1–3 year) markets may be justified to avoid self-dealing by vertically integrated distribution companies, to address market power, and to reduce transaction costs.

Forward markets can greatly improve the performance of wholesale electricity markets by addressing the critical problems of risk, market power, and investment. Colombia recently adopted both a long-term investment market (the firm energy market) and a medium-term market for forward energy. Early capacity markets suffered from serious flaws that ultimately led to their elimination or replacement. The firm energy market design presented here corrects each of the principal flaws of earlier capacity markets. In particular: 1. The product is defined as a physically-backed call option on energy. The physical requirement assures adequate resources. The call option improves the performance of the spot energy market in times of scarcity and reduces supplier risk. 2. New entry is coordinated by holding the auction well in advance of the commitment period. This mitigates the boom–bust cycle that is common in electricity markets. More importantly, it allows the firm energy price to be more directly tied to the cost of new entry. 3. Strong performance incentives are maintained from the spot energy price. Additional incentives come from the link, especially for thermal resources, between historical performance and the level of firm energy certification. 4. Price formation is supported by minimizing the ability of existing suppliers to exercise market power in the firm energy market. In addition, the descending-clock auction format encourages price discovery and improves the efficiency of the auction outcome. A successful firm energy market depends on more than good design. First, the firm energy market has at its foundation the spot energy market. It is important that the spot energy market send reliable price signals. Second, the firm energy market relies on competitive entry; hence, entry barriers must be kept to a minimum. And finally, the firm energy market depends on long-run price expectations; thus, it is important that investors have faith in the stability of the market over the long run. Colombia’s forward energy market promises to reduce transaction costs and enhance competition for regulated and nonregulated customers. The market is based upon two financial products, one for regulated customers and one for nonregulated customers. Suppliers bid to supply a quantity of the regulated load and a quantity of the nonregulated load—aggregated across all load serving entities. This simple approach enhances liquidity and competition, since all suppliers are competing for and trading in the same two products. Since regulated customers are procuring 100% of the expected regulated load, these customers are nearly fully-hedged from the spot price. Similarly, suppliers are able to lock in a long-term price to stabilize their revenues. Including nonregulated customers in the centralized market has two important advantages. First, substitution between the regulated and nonregulated products assures that both customer classes pay market-based rates for electricity. And second, the demand response of nonregulated customers in the forward energy market helps protect both nonregulated and regulated customers from supplier market power, and reduces the importance of the regulated demand curve in determining prices. Competition among suppliers and the competitive choices of the nonregulated customers determine the auction clearing prices. The forward energy products are fully consistent with, and indeed complementary to, the other key elements in the Colombian market: the spot energy market and the firm energy market. The firm energy market together with the forward energy market put suppliers in a more balanced position in the spot market. Not only does this reduce risk for both sides of the market, it greatly mitigates incentives to exercise market power in the spot market. Thus, we anticipate that the forward energy market will not only reduce problems in the bilateral contracting market, but will improve the performance of the spot energy market. Both the electricity industry and its customers will benefit from these markets. Efficient price formation is one of the most important objectives of the forward energy market. The simultaneous descending-clock auction is well suited to generate efficient price formation. The descending-clock auction provides excellent price discovery and enables suppliers to freely arbitrage across the regulated and nonregulated products. This assures that any price difference between the two products is a reflection of cost differences. Our view is that Colombia’s two forward markets support both the short-run and long-run efficiency goals of the wholesale market. The forward markets effectively address the key problems of risk, market power, and investment. Some may view these forward markets as excessive central planning. We contend that the alternative of incomplete markets may be more dangerous, at least while demand-side market failures remain severe. The California electricity crisis of 2000–2001 demonstrates the importance of addressing risk, market power, and investment. The global financial crisis of 2008–2009 demonstrates the importance of doing so with transparent markets that trade economically-sensible products.