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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
  • important input to each seller's own assessment of how low its offer must go to win the auction. Similarly, binding offers provide the buyer with the confidence that the winning offer is indeed obtainable at the conclusion of the auction.
  • The auctioneer assists the LDC in setting an objective price benchmark, undisclosed to auction participants, against which all offers may be considered.
  • The auctioneer discloses the upfront and clear criteria for selecting a winning offer. If sellers know the criteria, they can control their fate and are likely to make their best offers.

Having completed the key preparatory steps, the auctioneer assists the LDC in implementing an Internet-based multi-round auction:

Round 1: Initial offering (e.g., 30 minutes). In Round 1, all pre-qualified sellers submit their initial anonymous offers on the auctioneer's Web site. Only the lowest prevailing offer is observable, thereby allowing the participants to assess the extent of price competition. During Round 1, pre-qualified sellers may revise their initial offers. Revised offers must be lower than that seller's previous offer but do not have to beat the lowest prevailing offer. The revised offers are not required to beat the lowest prevailing offer so as to ensure multiple offers and seller participation. Receiving multiple offers approximates the results from an RFO process, and the range of offers informs the LDC if the auction is in fact superior to the RFO. The lowest offer at the conclusion of Round 1 sets the prevailing best offer at the beginning of Round 2.

Round 2: Open offering (e.g., 15 minutes, with possible 5-minute extensions). In Round 2, each seller can see the prevailing best offer and submit new price offers. A new price offer must improve on the prevailing best offer to be valid. The auctioneer updates and posts the prevailing best offer in real time.

A valid offer arriving in the last remaining five minutes automatically extends Round 2 by five minutes. Round 2 closes at the later of the scheduled time or after five minutes of no bidding activity. The auctioneer then identifies the sellers with the lowest price offers as the finalists for Round 3.

Round 3: Best and final sealed offering. In Round 3, the auctioneer invites the three sellers with the lowest offer prices in Round 2 to submit their best and final offers. Each seller's offer is "sealed," unobservable to the other two sellers. Each seller's sealed offer must not exceed the seller's own prior offers in Round 2. By not requiring each seller's sealed offer to beat the lowest offer found at the end of Round 2, the LDC has two "backup" offers in the unlikely event that the winner with the lowest sealed offer in Round 3 withdraws (despite the risk of legal actions by the LDC). As Round 3 creates uncertainty of losing, it mitigates collusion and induces further price reductions.

Case Study: Municipal Locks in Risk Management in Four Hours

The auctions were held on the behalf of the Utilities Commission, city of New Smyrna Beach (UCNSB), a municipal utility located on Florida's north/central east