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Avoiding Overpriced Risk Management: Exploring the Cyber Auction Alternative

Should an LDC procure electricity hedge products by using an Internet-based auction?
Fortnightly Magazine - January 15 2003

Should an LDC procure electricity hedge products by using an Internet-based auction?

We propose that local distribution companies (LDCs) should use an Internet-based auction to procure inactively traded products, because the auction is a superior alternative to common procurement methods, such as bilateral negotiation and request for offers (RFO). Supporting our proposal is the empirical evidence from two auctions recently held by a municipal utility in Florida. The auction results show that an Internet-based auction can yield competitive price offers from prospective sellers, achieve cost savings when compared to an LDC's benchmark for price reasonableness, reduce the time required for transaction consummation, and provide documentation that can withstand close scrutiny by an LDC's management and regulators.

As part of their regulatory mandate, LDCs are required to supply electricity, upon demand, to their customers. An LDC has three basic options for acquiring that electricity: (1) generation through its own plants; (2) spot-market purchases; and (3) fixed-price forward contracts and call options. The LDC can satisfy some of its anticipated future requirements through forward contracts and call options to help it better manage the electricity procurement-cost risk that stems from spot-price volatility. By buying forwards and options, an LDC may be able to avoid the potentially disastrous financial consequences of over-reliance on volatile spot markets, which were so dramatically evidenced by the April 2001 bankruptcy of Pacific Gas and Electric Co.

The idea of using forward contracts and call options to manage procurement-cost risk is intuitively appealing and economically reasonable. Knowing what to buy, however, does not guarantee least-cost implementation, because the forward-contract price or option premium quoted by a prospective seller may not be the "best deal" that the LDC could have obtained.

If the LDC's desired purchase is a standardized forward contract with delivery at a major hub, the LDC can simply buy from the actively traded forward market with many competing sellers. The forward contract of the LDC's interest, however, often deviates from a standardized contract. Common deviations include: (a) a delivery point different from a major hub; (b) a contract period longer than the next month; (c) a daily delivery pattern that differs from the standard (6x16) specification; (d) a less-than-100 percent delivery rate for a given megawatt size; and (e) a megawatt size that is not a multiple of 50 MW.

Trading for non-standardized contracts is thin to non-existent. As a result, the LDC may not easily receive a competitive price quote for non-standardized contracts without using an auction. The same holds true for other inactively traded products such as call options.

Commonly Used Procurement Methods for Inactively Traded Products

An LDC can procure actively traded standardized products with confidence from brokers and electronic exchanges (e.g., Automatic Power Exchange and Intercontinental Exchange). With broker assistance, the LDC may rely on bilateral negotiation to procure inactively traded products. However, it is unlikely that bilateral negotiation will yield the best deal for the buyer because "the value of negotiation skill is small relative to the value of additional competition." 1

Even if the LDC can contact many prospective sellers, the negotiation

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