IEEE Power & Energy Magazine - January/February 2021 - 65

Lessons Learned From Hydro Systems in Latin
America Might Be Applicable for Decarbonization

L

LARGE REDUCTIONS IN THE COST OF RENEWABLE
energy technologies, particularly wind and solar, as well as
various instruments used to achieve decarbonization targets
(e.g., renewable mandates, renewable auctions, subsidies, and
carbon pricing mechanisms) are driving the rapid growth of
investments in these generation technologies worldwide.
Despite the overall benefits of producing electricity using
renewables instead of relying on fossil fuels, incorporating
large amounts of solar and wind generation can be challenging for power systems. Solar irradiance and wind speeds
are variable and, to some extent, unpredictable, which can
compromise the stability of the power grid. Private investors, electric utilities, and independent system operators
(ISOs) are addressing this challenge through a combination
of measures that include the geographical diversification of
resources, utilization of energy storage, and implementation
of demand-response programs.
Another feature of renewables that is making market participants, lenders, policy makers, and regulators concerned is
their effect on equilibrium prices of electricity. Most wholesale electricity markets set real-time prices (also referred to
as spot prices or locational marginal prices, depending on
the implementation) as the marginal cost of producing one
incremental unit of electricity at any given instant. Under
this paradigm, there are concerns that increasing levels of
generation from technologies with near-zero marginal costs
such as renewables will inevitably depress spot prices to
the point that revenues from the energy spot market will be
insufficient to cover the capital costs of merchant generation
technologies. This has raised questions about the ability of
current electricity markets based on spot pricing to incentivize investments that will deliver efficient and reliable power
systems in situations with high shares of renewables.
This article calls upon the experiences of hydro-dominated
Latin American electricity markets to highlight the parallels
among renewable-driven energy systems of the 21st century
and hydro-driven systems that Latin America has been operating for decades (in particular, during the 1990s). Several Latin
American countries have found that the liquidity of long-term
financial instruments is essential to incentivizing investments
in generation capacity. This is particularly important in situations where spot prices are extremely volatile, alternating
between periods with high prices, driven by scarcity pricing
mechanisms, and extended periods of time with zero prices,
when hydro resources are abundant. In many Latin American countries, regulators have imposed minimum mandatory

january/february 2021	

forward contracting requirements to guarantee a minimum
level of liquidity of long-term financial instruments, complementing voluntary bilateral markets for these products.
Centralized auctions for long-term contracts are also common in the region. They act as market-based mechanisms to
procure electricity and ensure some tariff stability for retail
customers when there is no competition in the retail segment.
Mandatory long-term products can be simple forward energy
contracts (as they are in Chile and Peru), energy bundled
with reliability products (in Brazil), or contracts for a standalone reliability product (in Colombia), with energy contracts
traded in bilateral markets. The experiences of countries in
Latin America dealing with systems with high shares of generation from near-zero-marginal-cost resources can be useful
for electricity markets in other parts of the world, particularly
if new renewable-dominated systems do not have enough
liquidity of long-term financial contracts to hedge risk.
The overall experience of Latin America's long-term
markets to attract and retain investors in new generation has
been positive. However, there are some issues related to the
design of both long- and short-term markets that need to be
addressed. For instance, auctions for long-duration contracts
facilitate investments and benefit lenders; however, they
can introduce inflexibilities to the market, preventing cost
reductions in technology from being passed on to consumers. Short-term markets will also need to be improved to
accommodate increasing shares of generation from renewables. Some of the needed enhancements will require mirroring features of short-term markets in the United States
and Europe, such as increasing the temporal granularity of
real-time prices, introducing multisettlement mechanisms
(absent in many prominent Latin American markets, such as
Brazil and Chile), and allowing emerging technologies and
demand-side resources to participate in wholesale markets.
In this vein, there could be learning opportunities both for
Latin America and electricity markets in the United States
and Europe to find the best market design to accommodate
increasing shares of generation with zero marginal cost.

The Pricing of Electricity:
What Does the Theory Say?
The foundations of electricity pricing were developed in the
mid-1980s, with Fred Schweppe in particular having made
significant contributions to its underlying theory and practice. Spot pricing is fundamental to the design and operation
of electricity markets worldwide and has powerful implications
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IEEE Power & Energy Magazine - January/February 2021

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