Stanford University, Department of Economics
July 15, 2008
This report describes the results of my analysis of the options for short-term price determination in the Brazilian electricity supply industry. The three major questions considered are: What are the initial conditions necessary for the introduction of bid-based short-term market for the Brazilian electricity supply industry? What should be the transition process from the current cost-based market to the final bid-based market. What is the recommended form for the final bid-based short-term market in Brazil? To provide a framework for considering these questions, the economic theory of the electricity market design process is first introduced. The two fundamental challenges of the market design process are how to obtain: (1) technically and allocatively efficient production and (2) economically efficient pricing of wholesale electricity.
Six major dimensions of the short-term electricity market design process are then introduced. I then discuss how each of these dimensions is dealt with in the current Brazilian short-term wholesale electricity market and how each might be addressed in my recommended future short-term market. The major issue dealt with in this section of the report is the issue of a cost-based versus bid-based short-term wholesale market. In order to understand the potential market efficiency and system reliability benefits of a bid-based market for Brazil, I then present the results of a comparative empirical analysis of the performance the current Brazilian shortterm market and the short-term markets in hydroelectric-dominated industries with bid-based markets in Colombia, New Zealand, and Norway. I believe that the results of these market performance comparisons provide evidence that there are significant market efficiency benefits associated with Brazil adopting a bid-based short-term market.
The next section of the report describes the initial conditions necessary to implement a bid-based short-term market in Brazil. These necessary conditions are: (1) coverage of close to 100% of final demand in fixed-price forward contract obligations negotiated far enough in advance of delivery to allow new entrants to compete to supply these contracts, (2) a local market power mitigation mechanism that applies to all market participants, (3) a cap and floor on supply offers into the short-term wholesale market, and (4) a prospective market monitoring process with public release of all data necessary to operate the short-term market. A key recommendation from this section of the report is that a bid-based short-term market should not be implemented in Brazil without these necessary pre-conditions.
The report then presents a recommended bid-based short-term market design and suggests a transition process from the current cost-based market design to this market design that initially involves minimal changes in the current cost-based market. Although I believe that this transition process should take between 12 to 18 months to complete, I do not think that this timetable should be adhered to without regard to events in the short-term market. In particular, further moves towards introducing flexible market mechanisms should not be made without the appropriate safeguards against the exercise of unilateral market power in place and validation that these safeguards are working as intended.