IEEE Power & Energy Magazine - January/February 2021 - 71

Long-term contracts can also provide insurance against both
policy uncertainty and some political risk, reducing the risk
premium required to justify investments.
from price caps that are set too low (leading to artificially
low spot prices on average and, thus, insufficient incentives
for system expansion) and also as instruments to stabilize
revenues for generators in light of volatile signals from
spot markets. They operate just as capacity markets do in
the United States, relying on an administrative definition of
what constitutes the firm capacity product that drives a component of agents' remuneration.
At the time of the initial market reforms in Latin America
in the 1990s, most implementations of capacity mechanisms
were in the form of a regulated capacity payment (as seen
in Colombia, Chile, and Peru), where the capacity price was
determined by the regulator based on an administrative estimate of the cost of new entry. At that time, Brazil was the
only country that imposed a forward contracting requirement on load-serving entities and deregulated consumers to
mandatorily cover a high percentage of their loads through
energy contracts, which had to be negotiated bilaterally and
backed by firm energy credits. These initial designs, however, faced numerous challenges in practical implementation
during the following decade.
In the case of capacity payments, experience showed
that both the administrative definition of capacity price and
capacity product could have a large impact on investment
incentives for individual firms. In addition, forward contracting requirements alone did not ensure that regulated distribution companies were incentivized to choose least-cost contracts for retail customers, thus leading to self-dealing issues
and inflated prices. The previous challenges, combined with
the fact that short-term prices did not provide an adequate
incentive for generation expansion (given the absence of liquid marketplaces for financial hedging), motivated a second
wave of market reforms in Latin America in the 2000s, following the first wave of reforms in the 1990s. This second
wave of reforms was focused on improving the mechanisms
used to safeguard resource adequacy and led to the introduction of market-based capacity products (or reliability products) in some countries.
Brazil pioneered this new wave of reforms in 2004, introducing a mechanism that put auctions front and center and
served as an inspiration to several other countries, such as
Chile in 2005 and Colombia and Peru in 2006. These new
designs typically combined centralized auctions with a
quantity-based mechanism that required a minimum level
of contracting for loads. Implementation details vary among
countries, particularly regarding the following core elements,
which can be used to describe most auction mechanisms for
january/february 2021	

long-term contracts introduced in real-world electricity markets over the years:
✔✔ Demand-side obligations: These include, among others, 1) the assignment of responsibility for forecasting the demand several years ahead for the procurement of contracts, 2) a mechanism for assigning the
cost of forward contracts to consumers, and 3) rules
to specify under which conditions agents can opt out
of the standard mechanism to procure their own demand. For example, although the auctions in Colombia involve only the purchase of a reliability product,
the auctions in Peru and Chile involve only a forward
contract, while Brazil requires contracts for bundles
of reliability products and forward contracts.
✔✔ Supply-side liabilities: These include, among others,
1) what exactly generators' reliability commitments
entail regarding firm supply backing and 2) penalties
for noncompliance with contract clauses and specific
obligations for energy and/or reliability delivery, often
tailored to physical attributes of different generation technologies.
✔✔ Auction design elements: These include, among others,
the definition of 1) lead times; 2) contract duration; and
3) the eventual technology segmentation of potential
suppliers, such as differentiating between existing projects and new projects for contracting purposes.
In practice, the implementation of minimum contract
requirements and centralized auctions by Latin American
regulators in the 2000s emerged as a practical short-term
solution to issues that were primarily related to the lack of
investments in past periods, when demand was growing
too fast compared to new capacity additions. Consequently,
there was a need to take some action to accelerate private
investments in new capacity. Furthermore, although it might
not have been the primary intent to correct for the market
failure that results from incomplete financial markets for
risk sharing, there is now robust empirical and theoretical
evidence suggesting that mechanisms that introduce this
type of financial contract can indeed improve market liquidity and market efficiency.
Long-term electricity auctions are now one of the driving forces for the expansion of the power sector in Latin
America. To date, more than 100,000 MW of new generation capacity from all technologies have been contracted
and delivered at competitive prices via those auctions. In
addition, since the late 2000s, countries all over the world
have started using different variants of these auctions as
ieee power & energy magazine 	

71
IEEE Power & Energy Magazine - January/February 2021

Table of Contents for the Digital Edition of IEEE Power & Energy Magazine - January/February 2021
