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Mexico’s Capacity Market—Demystifying the Riddle

JIM HEIDELL, ETHAN PATERNO and MARK REPSHER I power finance & risk | 2 december 2016

This article first appeared in Power Finance & Risk.

Winston Churchill once wrote that Russia was a "riddle wrapped in a mystery inside an enigma", and for many energy investors, the recently deregulated Mexico power market is no different—especially the capacity market. In an effort to unwrap the mystery, we have distilled the Mexico capacity market structure into three basic elements based on the tenor of its capacity auctions—short, medium and long term.

Based on this distillation, our message to energy infrastructure investors is that the capacity market structure reflects some elements of New York’s Installed Capacity (ICAP) market (e.g., a downward sloping demand curve). But this is where the comparisons end, as the market really looks a lot closer to utility ­driven long-­term resource procurements, with the "back­up" resource adequacy constructs present in the California and MISO power markets.

What Does the Capacity Market Look Like?

Similarly to those in the U.S., Mexican load serving entities (e.g. electric utilities, retail electric providers, etc.) are required to demonstrate they have sufficient capacity reserves to meet their reliability requirements. Capacity can then be purchased either across three capacity auctions or bilaterally in the case of qualified suppliers (i.e. retail electric providers). The capacity auctions are (1) the long-­term auction, (2) the medium-­term auction, and (3) the balancing or short­term auction. 

The short-­term auction is most similar to the U.S. capacity auctions. It is held one month before the capacity commitment period, and it is the only one of the three auctions that relies on a demand curve construct.  The demand curve construct is typical of the Northeast U.S. capacity markets in ISO­NE, NYISO and PJM Interconnection. However, the short­-term auction effectively only buys the "left­over" capacity that is not contracted through either the medium and long­-term auctions or through bilateral transactions.

The Short-Term Auction

The short-­term auction, which has a contract period of only one year, functions more like a balancing market than the forward-­looking centrally-clearing auction mechanisms U.S. investors are familiar with in PJM and ISO­NE. Additionally, the short timeframe of one month between when the auction is held and the capacity commitment period makes it more closely resemble New York’s ICAP market and its spot auction than PJM’s base residual auction or ISO­NE’s forward capacity auction (which are held approximately three years prior to the commitment period).

However, an important point is that the New York market has recently seen one new power plant close financing even with this short-­term structure (Competitive Power Ventures’ Valley Energy Center ( PFR, 6/15/15)), ostensibly because of some degree of investor confidence in the range of outcomes that this short­-term mechanism will consistently produce year-­over­-year—which may not yet be the case in Mexico.

Medium and Long-Term Auctions

In contrast, the medium­ and long-­term auctions rely on a process more similar to utility resource procurement than a formalized capacity auction. More specifically, Mexico's National Center for Energy Control (CENACE) facilitates the purchase of capacity under 15­year power purchase agreements for the long-­term auction for retail electric providers (currently, only the Comisión Federal de Electricidad (CFE)), and three ­year contracts for the medium-­term auction, via auctions held 36 months and 12 months, respectively, before the capacity commitment period. Similarly to resource procurements held by California’s utilities, not all capacity bidders receive the same price. Bidders, if selected, receive their bid price, which could be different from other selected bidders. This price discrimination, all else equal, advantages the buyer not the generation bidders—and even more so to the extent that the medium­ and long-­term auctions discriminate against existing generation.

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What Has Happened So Far?

To date, CENACE has held two long­term auctions (the first auction results were released in April 2016 and the second auction results released in

October 2016) focused on purchasing renewable generation for CFE to meet Mexico’s goal of 35% renewable generation by 2024 and 45% by 2036. Collectively, the two long­term auctions purchased nearly 5 GW of wind and solar. However, the second auction also purchased nearly 1 GW of gas­fired combined­cycle capacity, including from Blackstone Group’s 500 MW Frontera project, located north of the border in Texas ( PFR, 10/6). According to CFE, the average price for this capacity was approximately $30/kW­year ($88/MW­day). It’s expected that the third long­term auction, scheduled for April 2017, will be opened up to a wider array of conventional and renewable generation sources.

What Does This All Mean?

For energy infrastructure investors looking south of the U.S. border for investment opportunities, there are several things to consider:

- Based on the first two long­term auctions, we expect there will be significant competition for long­term capacity contracts, which will likely result in a continuation of relatively low capacity prices (especially compared to certain outcomes in U.S. capacity markets).

- Capacity value is more likely to be realized in the long­term auction, which is held 36 months ahead of the commitment period for 15­year commitments.

- Economic theory suggests that there will be price convergence between the three different capacity auctions. However, price convergence requires transparency in the processes for determining capacity requirements in each of the three auctions. Since some of the market mechanisms are still being developed and tested, we suspect it may be some time before price convergence happens.

- Capacity resources will likely have more flexibility working with qualified suppliers to develop bilateral contracts since the tenor and terms of those contracts are negotiable and there will not be restrictions on what capacity resources can qualify.

 

Jim Heidell, Ethan Paterno and Mark Repsher are energy and utility experts at PA Consulting Group

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