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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

minimization requires fierce head-to-head competition among a reasonably large number of sellers (e.g., 6 to 20). This degree of competition may not occur when the LDC transacts with a seller via one-on-one negotiation. Even if the LDC can contact and negotiate with many sellers, the process is time-consuming and may not overcome the asymmetric information advantage enjoyed by sellers who transact more frequently than the LDC. Furthermore, sellers are less inclined to lower offer prices in bilateral negotiation than when directly faced with lower binding prices in an auction.

Active and aggressive bidding by sellers cannot occur without the transparency achieved when the auction rules are fixed in advance and applied to all sellers. An opaque design reduces the number of participating sellers and induces conservative bidding. An example of a transparent design is one that has the following properties: (a) clearly defined non-price terms of a forward contract (e.g., size, delivery point, delivery rate, contract period, etc.); (b) auction rules that govern offer submission, auction duration, and auction close; and (c) a simple selection rule such as "Subject to the LDC's benchmark for price reasonableness, the lowest price-offer wins."

A transparent design eliminates the post-auction allegation of biased winner selection. It also leads to transparent results with a detailed record that can withstand close scrutiny by a third party. For example, a regulator may audit the procurement decisions of LDCs. The regulatory audit includes a review of the procurement process and an examination of the procurement results.

Price discovery is important to both sellers and the LDC. When sellers can see the evolution of price offers, they can better infer the common price expectation relative to their own private costs. The availability of price information makes the sellers less inclined to bid conservatively so as to avoid the "winner's curse," thus promoting price competition. From the LDC's perspective, the auction helps uncover forward-contract prices that are otherwise unavailable or unreliable due to thin trading and other market imperfections (e.g., asymmetric information). This aids the LDC in making a better-informed purchase decision.

LDC Internet Auctions: The Process

To achieve the objectives of forward-price minimization, transparency, and price discovery, an independent auctioneer not affiliated with the auction participants performs a number of key preparatory steps prior to the auction date.

  • The auctioneer assists the LDC in clearly defining the product, including the characteristics of electricity to be delivered and the relevant terms and conditions. The auctioneer can solicit seller feedback as to the reasonableness or clarity of terms and conditions. Contract ambiguity can have two undesirable effects: (a) it can cause potential sellers to shade their offers; and (b) it can hinder contract enforcement by the LDC in case of seller non-performance.
  • The auctioneer assists the LDC in pre-qualifying sellers, so as to only include creditworthy sellers that have a strong interest in the auction. As part of the pre-qualification, the auctioneer requires sellers to contractually commit to the offers that they make in the auction. Binding offers inform all participating sellers that a price offer observed in the auction is "real," an