Elsevier

Energy Policy

Volume 148, Part B, January 2021, 111997
Energy Policy

Electricity market design for low-carbon and flexible systems: Room for improvement in Chile

https://doi.org/10.1016/j.enpol.2020.111997Get rights and content

Highlights

  • We overview the electricity market design in Chile.

  • The transition to low-carbon systems will require addressing several market design limitations.

  • Promoting flexibility will require enhancing pricing mechanisms.

  • These limitations are also present in other electricity markets in Latin America.

Abstract

Chile was the first country that privatized all generation, transmission, and distribution services, and introduced competition in the generation segment. Nearly four decades after its creation, many features of the original electricity market design remain unchanged. In this paper, we provide a brief history of the Chilean electricity market and explain its main limitations going forward. Some of these include the use of a cost-based mechanism for spot transactions based on a merit-order curve, low temporal granularity of spot prices, missing forward markets to settle deviations from day-ahead commitments, inefficient pricing of greenhouse gas emissions due to administrative rules, and a capacity mechanism that does not reflect a clear resource adequacy target. Many of these limitations are also present in other electricity markets in Latin America that, when privatized, mirrored many features of the electricity market design in Chile. Failing to address these limitations will provide distorted incentives for the efficient entry and operation of resources that could impart flexibility to the system, increasing the cost of decarbonizing the power sector.

Introduction

In 2019, Chile became the first country in Latin America to announce its commitment to become carbon neutral by 2050. Achieving this goal will involve large transformations of the mining, transportation, agricultural, construction and infrastructure, and energy sectors in the country over the next three decades.

One of the industrial sectors that has already initiated a transition to low-carbon energy sources is the electric power system. From 2008 to 2019, the installed capacity of wind, solar, and small hydro projects increased from nearly 120 MW to more than 5000 MW, with many more renewable projects in line for construction in the next years (CNE, 2019a). Currently, nearly 50% of the 24 GW of installed capacity in the Chilean electric power system is carbon free, including large hydro units and carbon-neutral biomass generation. Factors that underpin such large growth of investments in renewable energy generation in the country include the availability of high-quality renewable resources (Watts and Jara, 2011; Jimenez-Estevez et al., 2015), massive cost reductions of wind and solar projects (Vimmerstedt et al., 2019), a period of high electricity prices until 2014 (CNE, 2019a), a liquid market for Power Purchase Agreements (PPAs) (Moreno et al., 2010; Reus et al., 2018), and strong social opposition to the development of large coal and hydropower plants (Bronfman et al., 2012).1

The ongoing decarbonization of power systems is creating challenges in electricity markets. For instance, the variable and unpredictable nature of generation from the fastest-growing renewable energy technologies—wind and solar—requires the availability of other flexible resources to balance unexpected changes in generation supply and reductions of synchronous inertia (Denholm and Hand, 2011; CDEC-SIC, 2014; Inzunza et al., 2016). The volatility of wind and solar resources creates a need for increasing the temporal granularity of price signals to ensure that spot prices reflect the changing physical conditions of the system (IRENA, 2019). Consideration of renewable energy units in resource-adequacy mechanisms has been problematic because the lack of a uniform framework to assess their contribution to the system (Munoz and Mills, 2015; Bothwell et al., 2017). High shares of wind and solar generation can increase the frequency of periods with zero or negative spot prices, which affects revenue streams for generators that expect to recover investment costs from the energy market (Ela et al., 2014). Additionally, it has been difficult to implement first-best carbon-pricing mechanisms, with carbon prices that reflect current estimates of the social cost of carbon emissions (Jenkins, 2014).

Worldwide, regulators are addressing these challenges using different approaches. In 2016, the Federal Energy Regulatory Commission (FERC) in the US approved Order 825 that requires Regional Transmission Organizations (RTOs) and Independent System Operators (ISOs) to settle energy and ancillary service markets at the same time interval of dispatch decisions (i.e., every 5 min) (FERC, 2016). This change ensures that real-time prices reflect the changing physical conditions of the system—including periods of scarcity of energy or ancillary services—and that market participants have the right incentives to respond to dispatch signals. The same year that FERC Order 825 was approved, both the California and the Midcontinent ISOs introduced new ramping products in the reserves market to ensure sufficient upward and downward ramping capability due to demand and renewable forecast errors with increasing shares of generation from wind and solar resources (Wang and Hobbs, 2014, 2015). In 2014 the Electric Reliability Council of Texas (ERCOT)—the market with the fastest-growing wind capacity in the US—introduced Operating Reserve Demand Curves (ORDCs) to ensure that the incremental value of reserves is accurately reflected in the price of electricity and reserves (Hogan and Pope, 2017). The PJM market recently proposed introducing ORDCs such as the ones used in ERCOT, because reserve products are not being valued appropriately in the current market (PJM, 2019). In addition, there is a recent FERC order that requires RTOs and ISOs ‘‘ … to remove barriers to the participation of electric storage resources in the capacity, energy, and ancillary service markets’’ (FERC, 2019). States are also employing a variety of policy instruments that incentivize increasing shares of generation from renewables and low-carbon resources, including production tax credits, renewable requirements, and carbon cap-and-trade mechanisms (Wiser et al., 2007; Perez et al., 2016; Borenstein et al., 2019).

Electricity markets in Europe are also going through a process of reform. In 2019, the EU Parliament adopted a package of new market design proposals that aim at the efficient decarbonization of the electric systems of member countries, improving market design features from the latest reform in 2009 known as the Third Energy Package. According to a report for the European Commission ‘‘ … the rules of the Third Energy Package appear to be insufficient to cope with such current levels of R(enewable) E(nergy) S(upply). Different rules appear needed to ensure in particular the development of short term markets and the emergence of prices that reflect actually scarcity. Rules to ensure closer cooperation of grid operators are also insufficient as they stand’’ (EC, 2016). The new package includes measures that will facilitate cross-border trade, restrictions on the participation of carbon-emitting generators in capacity mechanisms, and the introduction scarcity-pricing mechanisms. Countries in Europe also employ carbon cap-and-trade mechanisms, carbon taxes, and other policies to promote investments in renewable energy technologies (Grubb and Neuhoff, 2006; Kitzing et al., 2012).

With the exception of some elements of the Colombian system, electricity markets in Latin America are not as sophisticated as the ones used in the North America, Europe, and Oceania (Rudnick and Velasquez, 2018; Munoz et al., 2018) and have lagged behind the last wave of reforms in developed countries. The simplicity of these market designs has been justified for a number of reasons, including the high implementation and ongoing costs of operating and maintaining sophisticated market platforms, the lack of competitive forces coupled with the absence of market monitoring departments that could prevent or mitigate the exercise of market power, and the lack of independent regulatory institutions (Wolak, 2003; Estache and Wren-Lewis, 2009). However, there is an increasing number of developing countries that have adopted decarbonization targets or carbon-pricing mechanisms for the next decades. Furthermore, renewable energy and storage technologies have become competitive alternatives to conventional forms of generation, even in regions without renewable energy policies or carbon-pricing mechanisms. Failing to adapt electricity market designs to these new technologies and societal goals will likely distort electricity prices, lead to inefficient entry and exit of generation and other technologies such as energy storage, prevent innovation, and limit the participation of demand-side resources and the electrification of other energy vectors such as heat and transport. These limitations will also make it much more expensive to achieve carbon emissions reductions than if these markets adopted some of the elements of the recent reforms in the US or Europe.

In this paper, we address some of the main limitations of the current electricity market design in Chile going forward, considering the ongoing transition of the system to low- and zero-carbon energy sources. Although there are multiple aspects of the market that could be improved, we focus on five features that require modifications in the near term to ensure efficient price signals and investment incentives under increasing shares of generation from renewables and the potential entry of energy storage devices. These include: 1) price distortions caused by the use of a merit-order curve to settle spot transactions, 2) the importance of increasing the granularity of spot prices, 3) the need for multi-settlement markets to settle deviations from committed schedules and hedge risks, 4) the long-term effects of the administrative rules present in the current carbon-pricing mechanism, and 5) an overview of the main limitations of the current capacity mechanism. Many of these limitations distort investment incentives for the efficient entry of technologies that could impart flexibility to the system, including energy storage devices. Limitations 4) and 5) have a direct impact on incentives for the entry of more low- or zero-carbon generation capacity and for the exit of conventional generation units.

Additionally, we also discuss other modifications to the electricity market design in Chile that could improve price signals but that—from our perspective—have a lower priority than the first five measures mentioned before. Here we discuss the potential benefits of introducing reserve products to hedge against steep ramping events and sloped Operating Reserve Demand Curves to enhance short-term price signals under scarcity conditions. We also discuss the potential benefits that could result from introducing demand participation in the wholesale market, which could reduce reserve requirements both in the short and long term. Finally, we include a qualitative discussion about the potential benefits and costs that would result from a transition from the current cost-based electricity market design to a bid-based pool.

We structure the rest of the paper as follows. In Section 2 we provide a brief history of the Chilean electricity market, describe the current electric power system, and outline the country's future goals with regards to decarbonization and renewable energy targets. In Section 3 we provide a thorough description of the main limitations of the current electricity market design and their implications for the efficient remuneration of technologies that provide flexibility. In Section 4 we discuss more challenges and potential solutions going forward, in the context of systems with high shares of generation from renewables. Some of these include the introduction of scarcity pricing mechanisms and ramp products, allowing for demand participation in the wholesale market, and a potential transition from a cost-to a bid-based market design. Finally, in Section 5 we provide some policy recommendations and conclude.

Section snippets

The chilean electricity market

Chile pioneered the deregulation of the electricity sector with the 1982 Electricity Act (Rudnick, 1994; Raineri, 2006), nearly 100 years after the inauguration of the first lighting system in Santiago's city center in 1883. This Act, which laid the foundations of the current electricity market in Chile, separated the electricity sector into private generation, transmission and distribution segments. The generation sector began operating as a competitive market, whereas the transmission and

Main limitations of the current electricity market design

In this section, we describe some of the main limitations of the current electricity market design in Chile and discuss potential solutions. From our perspective, fixing this set of limitations should be a priority for the regulator because they can lead to inefficient remuneration and entry (or exit) of resources that could impart flexibility and contribute to achieve decarbonization goals.

Further room for improvement

We now include a second set of limitations that should be addressed after the ones listed in the previous section. Here we discuss measures that include the implementation of markets for attributes such as ramping capability, improving administrative mechanisms for scarcity pricing, allowing for demand participation in wholesale markets, and an eventual transition from a cost-to a bid-based market. From our perspective, implementing elements of this second set of proposals before the ones

Conclusions and policy implications

Decarbonization targets and large reductions in the cost of renewable energy technologies are driving a deep transformation of electric power systems. While the foundational theory to design efficient electricity markets is, in general, well understood, the characteristics of low-carbon resources raise questions about the ability of current market designs to attract efficient investments and to incentivize flexibility to accommodate the intermittency and unpredictability of wind and solar

CRediT authorship contribution statement

Francisco D. Muñoz: Conceptualization, Methodology, Supervision, Writing - original draft, Writing - review & editing, Project administration, Funding acquisition. Carlos Suazo-Martínez: Conceptualization, Writing - review & editing. Eduardo Pereira: Software, Formal analysis, Data curation, Visualization. Rodrigo Moreno: Conceptualization, Writing - review & editing.

Declaration of competing interest

The authors declare that they have no known competing financial interests or personal relationships that could have appeared to influence the work reported in this paper.

Acknowledgements

This research was supported by CONICYT FONDECYT #1190228, FONDECYT #1181928, ANID/PIA/ACT192094, ANID/FONDAP/15110019 (SERC-CHILE), ANID-Basal Project FB0008, and the Complex Engineering Systems Institute (ANID PIA/APOYO AFB180003). We thank Pablo Serra, Serguey Maximov, and two anonymous referees for useful comments that helped us improve previous versions of this paper.

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