This year’s Nobel Prize winners in economics were two economists from Stanford University. Robert Wilson and Paul Milgrom improved upon the auction theory and developed new modalities of auctions, thereby opening novel options to improve market efficiency and appropriate resource allocation.
Robert Wilson was the first to create a framework for analyzing auctions[1] in order to reveal information and allocate resources efficiently. Milgrom’s analysis included new insights about auctions. One concern their work addressed is how different auction formats deal with the winner’s curse problem, in which a winner gets a bad outcome. Among the different uses of auctions to introduce market mechanisms in network industries is the allocation of long-term contracts for power generation, which have been applied worldwide. In fact, the auction has been one of the most important mechanisms to improve efficiency and drive the electricity sector’s sustainability.
According to IRENA, at the end of 2018, 106 countries had already held at least one renewable energy auction. In Latin America and the Caribbean, at least 15 nations have already held specific auctions to procure renewable energy.
Given the importance of the auction as an instrument, the energy division of the Inter-American Development Bank recently launched three studies on the topic. The first two studies focused on the analysis of different auction designs (“Advancing the policy design and regulatory framework for renewable energies in Latin America and the Caribbean for grid-scale and distributed generation” and “Clean energy auctions in Latin America”). The third study, recently launched, focuses on the process of contracting auction winners (“Guide for designing contracts for renewable energy procured by auctions”).
The energy auction can be divided into three stages: 1) auction design and qualification, 2) winner selection, and 3) contract design. We describe each of these stages below.
Auction Design and Qualifications:
Demand: The demand to be auctioned can be a value -determined by a central planning authority or by the aggregation of demand informed by power system operators, distribution companies, traders or free consumers and other buyers — or a price-sensitive volume, in that the contracted value corresponds to the prices offered.
Volume auctioned: The amount contracted is critical and can influence the level of competition in the auction. In markets with a limited number of project developers, there may be a lack of competition when contracting a large volume of energy or capacity in a single auction.
Allocation of costs:
- Consumer: The cost of renewable energy contracts is passed throughthe energy tariff (ultimately to consumers).
- Taxpayer: The cost of renewable energy contracts is wholly or partially covered by the government, mainly through general state budgets.
- Renewable Energy Certificate (or green certificate): The cost is partially or entirely covered by certificates that certify the bearer owns one megawatt-hour (MWh) of electricity generated from a renewable energy resource.
Types of Auctions:
- Technologically neutral: This auction allows bidders to participate in the auction by providing energy or capacity regardless of technology. An advantage of this type of auction is to maximize competition between technologies to obtain a lower price. A technology-neutral project is quite challenging, given the difficulty of comparing characteristic sources (firmness of generation). In addition to the challenge of designing a technology-neutral auction, another fundamental problem is the impossibility of guaranteeing the promotion of renewable energies.
- Technologically neutral with restriction: This auction may include fossil and renewable technologies, but exclude certain technologies, even if their capped costs are competitive. For example, these auctions may exclude high-emission plants, such as heavy fuel oil and coal, but allow other fossil fuel plants, such as natural gas and liquefied petroleum gas, to compete with renewables.
- Technologically neutral exclusive to renewables: In this auction, fossil fuel plants are excluded, and renewable solutions compete for the lowest price that meets the demanded energy.
- Technologically specific for renewable: This is one of the most common auction types. Under this scheme, in each auction, participate projects for a specific renewable energy source (solar photovoltaic, wind, biomass, and small hydroelectric plants). An advantage of this scheme is to promote a specific technology.
- Specific project auction: This auction involves bidding on a particular plant project. This scheme requires less effort from bidders, as most of the project’s details, such as location, power grid connection, or acquisition, are predefined.
Products:
- Energy contracts: These are a kind of forward contract, where the buyer purchases an amount of energy that it will receive in the future. Usually, the agreement includes a take-or-pay clause that guarantees payment to the generator even if there is no consumption.
- Capacity contracts: These contracts adopt an explicit remuneration for installed capacity as an economic signal that aims to increase the volume of installed and available generation.
Prequalification Requirements: One of the biggest challenges in auction design is ensuring that companies get financing and build their projects on time. The auctioneer may impose criteria on potential bidders to ensure that only those who are best able to complete the project within the stipulated time can participate. Prequalification requirements can prevent speculative bids. Examples of such conditions include: land use rights and environmental licensing for the proposed project site, certification of natural resources (wind, solar radiation), network connection studies or even a power grid access license, a history of having built a project of the proposed, proof of sufficient assets or credit rating to finance the project, and an access fee to the auction rules.
On the other hand, prequalification requirements that are very strict can reduce competition, presenting an insurmountable barrier to entry for small or new (still competent) potential bidders.
Regularity and frequency: Participation in auctions has a significant transaction cost, including preparing and developing the project for the new plant, and obtaining all necessary licenses, and providing financial guarantees. If auctions are not part of a systematic and predictable process, the risk of potential bidders increases, reducing their participation and, consequently, competition in the auction, thus increasing the final price.
Winner Selection
The selection process is a critical element in designing a competitive auction. The bidding process defines the rules by which the auctioneer receives bids and determines winning bids. The most commonly used designs are:
- Sealed bid auction, in which all bid information is provided to the auctioneer in advance and participants bid simultaneously, without information about the bids of other competitors. These auctions are also known as pay-as-bid auctions since each winner receives the price it offers, not an equilibrium market price.
- Descending watch auction is an iterative process in which the bidders place bids in a succession of descending price rounds. In these auctions, all winners receive the same price; and
- Hybrid auctions, in which the auctioneer carries out the bidding in sequential auction phases with a sealed bid and a decreasing clock, or vice-versa.
Contract Design
Lead time. The time required to start commercial operations is a key variable to determine whether the kind of investment is viable. The lead time in the contract must be compatible with the time necessary for the independent producer to obtain all technical and environmental licenses, build the plant, connect it to the power grid and get it ready to start commercial operation. Thus, in auctions where different energy sources and technologies can compete, the lead time must correspond to the longest required deployment time. However, it is essential to point out that the longer the lead time, the greater the difficulty of forecasting demand. In addition, the longer the lead time, the greater the risk that, given the sharp price reduction trend, that cheaper energy will be available when the plant starts to operate.
Duration. The contract duration should be sufficient to provide investors in new generation projects with a stable, predictable, and adequate cash flow to honor the plant’s financing. In general, the longer the contract term, the lower the risks for the investor, as it prevents him from having uncontracted energy when the plant’s useful life exceeds the contract’s duration. More extended agreements increase investor interest, thereby increasing competition, benefiting the consumer.
The benefits of long-term contracts for consumers, however, are more tenuous. On the one hand, long-term contracts may lead to lower prices in the short-term and protect consumers against spot price variations. On the other hand, the trend of falling costs may cause the contracted value to become expensive in the future, in the face of a new price reality. Besides, in a context of demand crises such as that caused by COVID-19, long-term contracts are protection for generation companies; however, it is a risk for distribution companies, which may be over-contracted, and, eventually, for the consumer, to whom the cost may be passed. Thus, governments may prefer to protect themselves against the risk of unforeseen changes in electricity demand or cost savings by offering contracts that are not long in duration.
Power grid connection costs. The allocation of grid connection costs is an essential issue for renewable energy developers, mainly because the site’s selection is limited by the availability of natural resources, such as solar radiation and strong winds. Reducing or eliminating grid connection costs for renewable energy developers is a form of subsidy, as renewable energy projects are not exposed to real economic costs.
Indexation clauses. Long-term contracts in developing countries often require indexation clauses linked to the dollar or national inflation rates. As many Latin American and Caribbean countries have persistent and volatile inflation rates, indexation seeks to maintain the real value of revenues. The reduced capacity that many countries in the region have to produce equipment locally or obtain financing in the local market justifies indexing to the dollar. While the government generally does not have concerns with inflation indexation, it often resists indexation to the dollar, given the macroeconomic risk posed by the electricity tariff’s dollarization.
Warranties. Guarantees are financial instruments that fulfill the function of ensuring contractual compliance that complements penalties. The main types of warranties typically required in RE contracts are:
- Surety and performance bonds: Surety and performance bonds are a financial guarantee, usually provided by a bank or insurance company, which indemnify the buyer if the IPP does not fulfill the contract until completion, or does not meet the schedule of construction, or not meet quality standards.
- Completion bond: A completion bond is a financial contract that guarantees that the plant will be completed even if the IPP runs out of money or if any financial problems occur during the project’s construction.
- Risk Assessment Report: Bidders must periodically submit an updated risk rating report, issued by the Credit Rating Agency, which demonstrates the financial strength of the project and its ability to obtain financing.
Measurement, invoicing and billing. The measurement, invoicing, and billing clause sets the timeline and deadlines for payment activities, and the conditions for challenging the values charged. The measurement, invoicing, and billing clause is also an important element in the risk allocation in contracts, determining responsibilities for and costs of measurement.
Penalties. Failure to comply with contractual commitments may result in implicit and explicit penalties. An example of an implicit sanction is the independent producer’s obligation to purchase an equivalent amount of energy or capacity not delivered on the market to honor its contract. An explicit penalty may take the form of a contractual fee for non-compliance, a price discount, or early termination of the contract. However, it is worth noting that the purpose of the penalty is to create an incentive to comply — and not to compensate — for the buyer’s losses. That is, the economic penalty for non-compliance with the contract must be high enough to dissuade the independent producer from intentionally deciding not to fulfill the deal, but at the same time, it should not be excessive to the point of compromising the project’s viability. Although undesirable, a delayed plant is often better than none. The requirement for financial guarantees is also an alternative to contractual compliance based on incentives.
Liabilities. The indemnity clause establishes the extent of each party’s liability for damages caused by a breach of contract, especially in early termination. The indemnity clause also specifies liability for economic, social, and environmental damages caused to third parties. The agreements also have a fortuitous and force majeure clause, limiting the party’s responsibilities and the effects of non-compliance in terms of the application of penalties, indemnities, and guarantees. It is not uncommon that independent producers try to use this clause in the event of delays or other unforeseen circumstances, often giving rise to legal disputes.
Act of God and force majeure. The act of God and force majeure clause limits the parties’ responsibilities and the effects of non-compliance in terms of penalties, indemnities, and warranties enforcement.
Arbitration instruments. Considering that energy and capacity contracts are complex and subject to unforeseen uncertainties, it is essential to establish the possibility of resolving disputes through arbitration. The arbitration instrument is usually faster than the judicial and administrative courts, and guarantees that the arbitrators will have significant expertise.
Developing the most efficient mechanism should take into account the results of the theoretical model and draw lessons from the specific objectives and restrictions of each country. When applying auction mechanisms, it is important to take into account the contract design for the success of the auction. In practice, there is no one-size-fits-all contract. As we have seen, there are several contract parameters (time for delivery in commercial operation, duration of the agreement, indexing, etc.) that must be calibrated according to the specific reality of the electricity sector in each country.
Summarizing, auction studies for the network industries have been an important contribution to understanding and improving market design for unconventional markets, such as network industries. It has been a milestone in the process of liberalization in these industries. Furthermore, we have accumulated an impressive amount of knowledge (both theoretical and practical) to improve markets. The electricity sector has been one of the most positively impacted by this knowledge. More precisely, in Latin America and the Caribbean (LAC), the auction has become an essential instrument for the procurement of renewable energy. It has led to excellent results with respect to improving efficiency in the LAC electricity sector by boosting competition (increasing the number of players), decreasing generation costs and by increasing transparency.
[1] Wilson’s framework focuses on the most used actions for network industries, i.e, the common value auctions. The idea of common value means that value of the item for sale is the same amongst bidders. However, this economic value is not known for the policy maker, and in this context, the auction is a tool to reveal information.
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