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Future Of The Colombian Electricity Market

August 26, 1999

Teknecon Energy Risk Advisors, LLC 1 Hedgefield Court, Suite 200

Austin, Texas 78738-1322 V:512.261.3663 F:512.261.3993

E: [email protected]

DRAFT

The attached material represents the work product of TERA, LLC. The material is intended tostimulate ideas, suggestions, and discussions between industry and market actors, but should not

be construed as endorsing a particular approach, or providing a recommendation for action.

This material does not represent statements of opinion by CREG or the Ministry of Energy and

Mines. This material may be used by others with advance written permission of TERA.

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2Confidential - Teknecon Energry Risk Advisors, LLC - 1999

Agenda

Introduction.

Objectives Of Future Process.

Analytical Process.

Definitions.

Ideas For The Future Market.

Next Steps.

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Analytical Process - First...

A. Examine Existing ISO Plans, Physical System Characteristics,

and the Current Colombian Power Trading Market.

Review existing studieson the Colombian market. Investigate the trading activityof the current market including volume

of trade, participants in trade, the structure of trade, and the relationship

of the long term to short term market.

Conduct a load characteristics examinationof the current marketincluding a load shape evaluation, correlation of generation load

response, and an overview of distribution system load losses.

Evaluate the price risk of purchasers in the marketincluding the

characteristics of existing distribution tariffs. Develop company capital profilesthrough an examination of credit

ratings, credit history, parental guarantees, and possible enhancements.

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Analytical Process - First...

B. Examine Existing ISO Plans, Physical System Characteristics,

and the Current Colombian Power Trading Market.

Examine existing institutions capabilityfor hosting the new marketand contingency provisions.

Examine the existing spot marketfor pricing consistency, suitability

for settling a forwards market, and for regulatory stability.

Examine constraintson transmission, generator must run conditions,and possible current and future market participants to determine liquidity

development has the potential to be affected.

Examine current metering policies, interconnection points, and capture

of existing metering information to assure consistency and availability orconfidentiality as appropriate.

Examine current market conditionsincluding capitalization, liquidity,

and credit to examine how these factors may influence implementation.

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Analytical Process - Second...

A. Creation of Recommendations on Future Forward Power

Trading Market.

Define and explain market drivers including sources of volatility,convergence, and areas of opportunity for the trading community.

Examine theoretical market power characteristics from the

international perspectiveincluding sources, constraints, successes and

problems of various structures, regulatory issues, and enforcement

structures.

Examine trading techniques to take advantage of fixed price trading,

volatility trading, and basis trading.

Examine current artificial markets for capacity charges, transmission

rates, and ancillary service requirements.

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B. Creation of Recommendations on Future Forward Power

Trading Market.

Proposed structure of the market manager ownership structure, and

method of enabling trading.

Proposed structure of the standardized market contractincluding

trader qualifications, hours of the bolsa, size of contract, period(s) of the

contract, daily settlement procedures, end of contract settlement, margin

requirements, clearing processes, arbitration and dispute resolution,enforcement procedures, and sanctions/fines.

Confirm details of self-regulatory structure.

Define governmental relations with the new self regulatory body for

capacity charges, transmission rates, and ancillary service requirements. Develop a draft documentthrough two editing stages that is sufficient

to legally enable trading, and provides draft resolutions for constituting

the regulatory body.

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C. Evaluation of the Potential Development and Adaptation of

Existing Software.

Review existing software to determine usefulness, completeness, and

applicability of software in the management of the new forwards market.

Determine inadequacies of existing software.

Investigate and evaluate requirements to fill software gaps .

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What is a Forward Contract?

A forward contract is a firm commitment to deliver or to receive a specified

quantity and grade of a commodity at a specific location within a designatedmonth or at a future date.

What happens during Commoditization?

Markets are characterized by increased price uncertainty, price volatility, price

risk. Price for different products and levels of service become more transparent.

Standardized product building blocks are developed.

Standardized contract specifications usually follow. A forward thus becomes a

future. Binding contract to deliver is created.

Forwards or futures have correlation and convergence with cash market prices.

Definitions

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What is the importance of standardization?

Allows for economic efficiency.

Creates more potential participants to a transaction.

Reduces transaction costs and time.

Adds liquidity and market efficiency.

narrow bid/ask spreads.

buy/sell in size without moving the market.

Definitions

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Definitions

Open Interest

The number of open or outstanding contracts for which thatindividual has not yet made an offsetting sale or purchase.

Trading Volume

The number of contracts that change hands during a specified

period of time.

Liquidity

A market is said to be liquid when it has a high level of trading

activity and open interest.

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Primary Economic Roles of Commodity Exchanges

Price Discovery

They record prices made through trades in an open marketplace Purchase and sales prices are transmitted immediately to be seen

(discovered) by all

Commodity exchanges do not determine prices

Hedging Function Price risk is shifted or (hedged) by using forwards, futures, or

options, like insurance companies shift risk between premium

payers and collectors

Definitions

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Definitions

A hedge is a position in the futures or forwards market that is equal and

opposite to a position at risk in the cash market.

A hedge shifts risk to other market participants, like commercials (or

speculators) with inverse risk.

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Definitions

What might be hedged?

Sale and/or purchase price of electricity.

Cost of fuel for thermal generation. Volatility, instability, price uncertainty.

Maintenance of development, margins, cash flows, market share.

Cost of borrowing funding for development.

It is important for a Company to develop its own hedging strategyand risk tolerance.

If you do not hedge, you accept total price risk.

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Definitions

Characteristics of an Effective Exchange

Liquidity

Ability to trade forwards, futures, or options contracts from 3 to 6 years out,

with high levels of trading activity (volume) and open interest.

Safety

Market, financial and trade safeguards enforced to prevent market

manipulation and anti-competitive activity in a regulated, anonymous

marketplace. Flexibility and Ingenuity

Spreads and strips make trading easier and more efficient such as strips

(combinations of monthly instruments to hedge for longer periods of time)

and spreads (managing prices between markets or geographic points). Hours of operation that match marketplace needs.

New product development - fuels, differing product structures.

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Definitions

Cash market price convergence at contract termination typically

provides hedge reliability.

Cash settlement.Survey of cash market deals can provide protection if well defined.

Calculation of settlement price.

Physical delivery.

Ensures convergence for product at that point.

Mirrors value of product in the cash market.

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Definitions

How can liquidity be developed?

Confidence in reference product (spot-market).

Encouraging a base group of parties to engage in continuoustrading

Encouraging a group of effective market-makers who can price

effectively.

Real-time price information on-line. Participant confidentiality.

Highly standardized products.

Product development tailored to market needs.

Clear and established rules and agreements.

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Ideas For The Future Market

MW

The CND System Operator

During hour of operation:

Technical ClearancePrior to hour of

operation:

Market clearance

Ancillary Services:

Frequency RegulationVoltage Regulation

Price

Regulation services-- Handling of imbalances

Prices for each hourA tool for System Operator

Hour of operation InstantOperations

Futures and

Forward

trading

1 week -3 years

Weeks Blocks

Price

Continons trading

System price in the

Spot market=Reference Price

Clearing service,

Guarantees, margins,

Accounting of gains or losses

Reporting, Risk Management

The MEM Exchange

Futures

Seasons YearsMW

The Day-Ahead Market -- A Spot Market--

Prices for each hour

Time horizon: One day

physical contracts

Forwards

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Refine the spot market pricing mechanism in a manner that

encourages accurate and appropriate settlement.

Consider ways to move away from volume weighted settlementmethod that causes prices to be restated after the fact.

Alternatives For Market Manager:

CND-MEM owned electronic exchange.

Partnership with MEM with third party such as Bolsa de Bogota -open outcry and/or electronic exchange.

Subcontract from MEM with third party such as Bolsa de Bogota -

open outcry and/or electronic exchange.

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Credit guarantees and enhancement will be a major issue.

Want to encourage a number of actors to participate.

Need to assure counter-party performance on commitments.

Credit alternatives include:

Bilateral or Clearinghouse approach.

Creation of a Clearinghouse within MEM.

Features To be Addressed: Credit enhancement requirements for market.

Availability of credit enhancement from third parties.

Possibility of daily settlement.

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Participants

Power Exchange

Financial MarketBilateral Financial Market

MEM Clearing

Netting of

positions

Entry

Registration

Electronic Trading System

Or Open Outcry

Clearinghouse Option

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MEM - MarketMEM - Clearing

Collateral Banks+ Settlement Bank

Central OrPrivate Bank

Relationship DAILY CASHSETTLEMENT

REQUIRED

ACCOUNT

BALANCE

TRADE

INFORMATION

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Safety Net

In the event of a clearing members failure to meet its obligations, i.e.

maintain margin payments, the loss is restored through the safety netsystem.

That clearing members assets.

Exchange surplus as determined by the Board of Directors.

Payments from the Guaranty Fund.

A pro-rated assessment of other clearing members or collateral banks

based on trading participation.

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The MEM Exchange will be as secure as the collective strength

of its clearing members or collateral banks.

Requirements to qualify as a clearing member or collateral bankwill need to be set. Example criteria include:

Must show a minimum working capital of $X,000,000.

Must maintain an account with an approved Bank.Must make a deposit to a Guaranty Fund based upon capital.

Position Limits

Hold clearing members or collateral banks and their customers to a

value of trade commensurate with their capitalization.

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Need For Margin Account

Cash or near cash securities are necessary to cover the overnightcollateral requirement. Changes associated with the traded volume to be

cleared the following day (overnight risk). Requirement: Depends on size and trading activity of counterparty.

A Margin Requirement which reflects the maximum estimated pricechanges from day to day.

Security for unrealized losses (forwards) is also necessary. The amount of collateral required various daily depending on closing

prices, positions and time to financial delivery.

The amount of collateral required can also be varied by the MEM

Exchange due to changes in market price volatility.

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MEM Banking Relationships and Deliveries

Works with clearing members directly or through settlement banks who

act as a transfer agent between those traders who generated gains withthose that incurred losses.

Matches companies choosing to take physical delivery of contracts to

companies choosing to receive physical delivery.

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Typical Contract Characteristics.

Trading Hours: 10:30 a.m. - 3:30 p.m.

Contract Size: 736 MWh Peak Hours: 16 hours from HE 07:00 to HE 22:00

Peak Days: 23 Delivery Days

Monday through Friday

Makeup on Saturdays and Sundays if necessary Rate: 2 MW

Minimum price fluctuation: $0.01 per MWh

$7.36 per contract

Termination: two (2) business days prior to the first calendar day

of the delivery month

Delivery Term: 18 consecutive months

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Other Alternative Product Structures.

S01-9X

W1:

1/1-

4/30

S:

5/1-

9/30

W2:

10/1-

12/31

W1:

1/1-

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S:

5/1-

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W1:

1/1-

4/30

S:

5/1-

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W2:

10/1-

12/31

W2:

10/1-

12/31

Forwards: Seasons (W1 = Winter 1, S = Summer, W2 = Winter 2) and

Year contracts (YR) for 1999, 2000 and 2001

Futures: Weeks, blocks and seasons**

1 year 2 year 3 year

S02-9X S03-9X S01-9X S02-9X S03-9X

YR:

1/1-12/31

YR:

1/1-12/31

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Typical Trading Business Process Flow (Day 1)

08.00 The Exchange opens (too early?)

10:00 Bids and offers are due for next day

12:00 Spot prices for the next day are announced

15:30 The Exchange closes

15:45 Trade comfirmation period16.30 Closing routines

17:00 Data validations completed before clearing phase starts

Note: Forwards can be traded in a subset of this time.

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CREG

Approves all futures and options contracts before they can be listed.

Reviews terms and conditions of proposed contracts.Oversees registration of firms and individuals who handle either

customer funds or give trading advice.

CND-MEM Board

Ensures the economic utility of the futures or forwards market as a

hedging and price discovery vehicle.

SSPD

Oversees rule enforcement at MEM Exchange.

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CND/MEM Market Surveillance

Monitors market participants.

Analyzes speculative and commercial participation. Analyzes trading activity with fundamental factors in the cash market.

CND/MEM Financial Surveillance

Monitors market participants. Audits contract position of clearing members or settlement banks.

Insures that clearing members or settlement banks maintain position

limits and margin requirements.

Maintains daily communication with clearing members or settlementbank with large positions.


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CND/MEM Trade Surveillance

Enforces a program to prevent market manipulation and anti-

competitive activity.

Monitors floor or electronic activity for proper trading procedures.

Uses penalties and tight recording procedures to prevent abuse.


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Substantial opportunity for market-place change exists.

Requires involvement of industry.

Staged implementation. CND-MEM separation from ISA Transmission required.

CND-MEM governance structure needs to be implemented.

Revised CND-MEM duties need to be defined.

Artificial markets will be carefully examined; recommendations froma liquidity perspective may require a phase-in over several years.

Additional physical investments to encourage liquidity may be

suggested.

Conclusions

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Documents