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Changing settlement rules might offer a fix for broken power markets.

Before consumers endure yet another summer of tenuous reliability and high electricity prices, perhaps it is time to consider changing the rules of the game. One such rule is the common practice in regional electricity spot markets whereby the last (highest) accepted supply bid sets the clearing price for all generators. Does this practice, known as a "uniform price auction," make spot markets more vulnerable to anti-competitive behavior and the abuse of market power?

In fact, some experts have suggested that the likelihood of market power abuse depends, to some degree, on the settlement rule used to determine payments in wholesale auctions. They suggest that the exercise of market power is likely when auctions adopt uniform pricing-i.e., "last bid sets price"-in a market with high demand and low supply. 1# The analysis I offer here appears to confirm this theory. More importantly, my analysis suggests that a "discriminatory price auction"—i.e., "pay according to bid"—might offer a better approach for reducing prices in bulk power markets.

This article evaluates both types of auction settlement rules: (1) "last bid sets price," by which the last offer accepted determines the price paid to all participants; and (2) the "pay as bid" model, by which each participant is paid the amount bid by that party. By modeling the markets for energy and various ancillary services in a large control area, it is demonstrated that under conditions of market power, substantial revenues with commensurately high profits can be commanded under a "last bid sets price" price auction.

By contrast, by employing a "pay as bid" price rule, much of the impact of market power can be ameliorated. In addition, a "pay as bid" price auction, by virtue of requiring each bidder to explicitly state their desired revenue rate, is more transparent and more readily exposes attempts to make use of strategic pricing and market power. By discouraging the use of market power through greater price visibility, "pay as bid" price auctions also may reduce instances of strategic capacity withholding, which in turn, should enhance overall system reliability.

Settlement Rules: A Look At Theory

The trading of electricity in today's open market is coordinated by an entity that seeks to match buyers (i.e., loads) and sellers (i.e., generators). That entity may take the form of a power exchange, as in California, and/or an independent system operator (ISO), as found in many states. In addition to serving as matchmaker for electrical energy consumers and suppliers, the ISO also must ensure that the overall grid system remains stable, responsive, and reliable in the face of unexpected events such as an immediate plant outage (trip). To do so requires the commitment of generation assets that must stand ready to react to system changes. These activities, referred to as ancillary services, 2 have been defined such that they, too, can be procured in a competitive market environment. Thus, suppliers have multiple, interdependent markets in which they can choose to participate.

In its simplest form, an auction is conducted for energy