Public Utilities Reports

PUR Guide 2012 Fully Updated Version

Available NOW!
PUR Guide

This comprehensive self-study certification course is designed to teach the novice or pro everything they need to understand and succeed in every phase of the public utilities business.

Order Now

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

process is time-consuming with a non-transparent outcome. Furthermore, it is difficult to document every detail in a negotiation. As a result, the LDC may find itself defending a forward contract with an ex-ante fixed price that turns out to be much higher than the ex-post spot price.

Realizing the potential shortcomings of bilateral negotiations, the LDC may issue a request for offers (RFO) to solicit sealed offers from suppliers, followed by final negotiations. Commonly used by utilities for buying energy and capacity, this kind of RFO process is equivalent to a single-round sealed-offer auction.

However, a single-round sealed-offer auction has many potential shortcomings. 2 First, it may not inform the LDC of the best deal available from the auction participants. While negotiation improves the final offer, its outcome may still not be the result of the fierce head-to-head competition exemplified by an open-offer auction where sellers can continuously submit price quotes to outbid competitors.

Second, it does not afford each seller an immediate opportunity to revise its price to beat the offers from other sellers, as each seller must await the LDC's notification for negotiation. However, the notification may be a rejection of the seller's offer from further consideration by the LDC, without providing an opportunity to revise its price.

Third, a seller may be excessively cautious to avoid the "winner's curse" because it is unaware of other sellers' offers that reflect independent valuations of the forward contract in question. This is especially true for a non-standardized contract for which reliable market-price data do not exist due to thin or no trading.

Fourth, the final negotiation and its outcome have limited transparency and are subject to second guessing by an LDC's management and regulators. It is difficult to document every detail in a negotiation. As a result, the LDC may find itself defending a forward contract with an ex-ante fixed price that turns out to be much higher than the ex-post spot price.

Finally, the offer evaluation and final negotiation of the RFO process can be time-consuming, making its frequent use difficult for contracts with delivery beginning in the immediate future (e.g., one to two months from now). The time-consuming nature of an RFO also often results in a cost premium in the sellers' sealed offers to hold prices "open" for a relatively long period (e.g., 10 days), while an LDC evaluates proposals and conducts negotiations.

Internet-based Multi-round Auctions

To remedy the potential shortcomings of the typical RFO process, we propose an Internet-based multi-round auction design following a form of the Anglo-Dutch auction that "combines the best of both the [open-] and the sealed-bid worlds". 3 The design allows for a time extension that eliminates the potential advantage of last-minute bidding by a seller under an eBay-style auction with a fixed time deadline. "Bid sniping" is a likely cause of non-competitive quotes due to (a) inadequate time for other sellers to respond; (b) winning without revealing lower prices; and (c) avoidance of a price war with other auction participants. 4

The auction aims to effect price minimization, transparency, and price discovery. Price