Colombia auctioned drought-proof energy as call options to fund dry-year reliability

Colombia runs on water: about 80% of its electricity is hydro. Every drought turns the adequacy question into 'will reservoirs plus backup thermal cover demand when the rain stops?' Energy-only markets handle this badly — a peaker that runs two weeks a year cannot earn its keep on spot revenue, and in a small system the spikes that would pay for it are the spikes a dominant generator can engineer. CREG, the regulator, had watched repeated near-rationings and commissioned auction designers Peter Cramton and Steven Stoft to build a forward product for reliability.

The designers defined the product before choosing the auction. In a thermal system regulators pay for capacity; in Colombia, capacity without reservoirs or firm fuel means nothing in a drought. The salable unit became firm energy: a resource certified as deliverable through a design dry period, bundled with a financial call option whose strike is the scarcity price — $100/MWh in transition. Consumers pay the clearing price as an annual reliability charge, and in a dry year the option payout hedges them from the very spikes scarcity produces.

The auction is a descending clock run three to four years before the commitment year, opening near twice the cost of new entry and ticking down until supply meets a demand curve floored at half and capped at twice that cost. The lead time makes the market contestable and smooths investment; winners lock the clearing price for up to twenty years, which is what lets a new gas plant or dam get financed. The quiet masterstroke is the market-power rule: incumbents may decline to participate, but their presence cannot move the price — only new entry can.

The scheme started on a transitional basis in December 2006, with the first competitive auction slated for November 2007 to set prices for the 2011 commitment year. Cramton and Stoft closed their design paper with a warning the mechanism's fate would rest on: entry barriers and political risk can sink even good market designs, so the government's commitment to honor twenty-year contracts mattered as much as the clock algorithm.

Auction dry-year energy as a call option, not capacity

It buys the scarce thing: certification is against a design dry period, not against nameplate capacity, because in a hydro system drought energy is the binding constraint.

The call option at the scarcity price hedges consumers from drought-driven spot spikes, making tolerable the high prices that discipline poor performers.

Pricing from new entry only neutralizes incumbent market power — the problem that wrecked California's ad hoc capacity payments in 2000–01.

Twenty-year price locks turn a regulatory signal into a financeable contract, so the auction coordinates real investment rather than paper positions.

A descending clock with an activity rule forces bidders to reveal real supply curves gradually instead of gaming a single sealed bid.

Buy the reliability you need, not the widget the industry sells. Colombia's scarce good was dry-year energy; pricing it as a call option made the hedge self-financing.

The transitional scheme with an administratively set price began in December 2006, and the first competitive auction was scheduled for November 2007 for the 2011 commitment year, with the price floor and ceiling tightening as confidence grew. By 2013, Cramton, Ockenfels and Stoft cited Colombia — alongside New England — as the working example of an option-based capacity market: payments made regardless of weather, hedging backed by physically certified resources, prices set only by new entry. The reliability charge remains a standing, contested pillar of Colombian electricity regulation.