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California's 1993 qualifying facility (QF) auction dramatically illustrates problems that can be encountered in structuring auctions for electric utility solicitations of supply-side resources from qualifying cogeneration and small power production facilities.

In the 1993 California QF auction, three California utilities were to select QFs that would be awarded long-term purchased-power contracts. The auction produced some unexpected outcomes that could potentially cost the utilities and their customers tens of millions of dollars per year. A year after the auction was held, the parties were still attempting to revise contracts, or even rebid a portion of the auction. And all of this effort may come to naught, depending upon what happens now that the Federal Energy Regulatory Commission has struck down the auction process under California's Biennial Resource Plan Update, claiming that it violates the Public Utility Regulatory Policies Act (PURPA) by using an improper method to calculate avoided costs.1

A study of the California QF auction illustrates yet again that "the devil is in the details." And the stakes will only rise farther as regulators in other states rely more on auctions to open up the electric industry to further competition.

THE SECOND-PRICE DESIGN

The California Public Utilities Commission (CPUC), the utilities, and the QFs used a very simple second-price auction as a design model:

s Each bidder supplies one item, identical to the item supplied by any other bidder.

s Each bidder submits a single sealed bid specifying the price at which he is willing to supply the item.

s A set number of lowest bids win the auction.

s Each winning bidder receives the price bid by the first losing bidder (em that is, the lowest supply price that failed to win.

In this auction, each bidder will maximize his expected profit if he bids his actual cost of providing the item, including any opportunity costs and risk premiums. A winning bidder cannot increase the price he receives, even by bidding a price above his actual cost, since the auction price is set at the level of the first losing bid. A bid far above cost only increases the bidder's chances of losing. By bidding less than his actual cost, he increases his chances of winning, but at a price below his cost. In this simple second-price auction, theory and experiment show that a bidder will bid his true cost. This effect is often referred to as the "true-cost-revealing property" of the second-price auction.

Another feature is also noteworthy. In the simple second-price auction, all winning bidders are paid the same price for the items they sell. That is, the second-price auction sets a uniform price that is paid to all winners.

The CPUC mandated a second-price auction because of these two features. It wanted each QF to bid its true costs, and such an auction would naturally select generation resources with the lowest cost to society as a whole.2 It also wanted an auction in which the winners were paid a uniform price for their capacity and energy. In selecting a second-price format, the CPUC noted that "paying QFs at