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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

coast. Interconnected to Florida Power & Light Co. (FPL) and Florida Power Corp. (FPC), UCNSB has 64 MW of its own relatively inefficient generation. With an annual peak of approximately 91 MW, the UCNSB had historically been buying partial requirements service from FPL or FPC and the remainder of its requirements from the spot market.

Table 1 describes the two non-standardized hedge products desired by UCNSB: (1) one-month non-firm fixed-price forward energy with varying megawatt-size; and (2) three-month 10-MW call option with a $150/MWh strike price and a limited number of exercisable calls. The call option in (2) is substantially out-of-the-money based on an estimate of marginal generation cost of below $45/MWh (=forward gas price (~$4.5/MMBtu) x marginal heat rate (~10 MMBtu/MWh) ˜ $45/MWh).

The two auctions were conducted shortly before delivery. This ensures that UCNSB was buying at prices that were reflective of the most recent market conditions and expectations.

Table 1 shows that both auctions produced final price offers below the buyers' price benchmarks and yielded net cost savings.

Figure 1 portrays the time path of the price offers received in the forward non-firm energy auction. It shows a rapid decline in price offers in Rounds 1 and 2, with further price-cutting in Round 3.

Figure 2 is the time path of the auction's price offers for the call option. It shows more active bidding than the time path in Figure 1. We attribute the high bidding activity to the almost certain profitability of selling a covered call option by sellers with surplus generation. If the option is not exercised, the seller earns the premium. Even if the option is exercised, the strike price of $150/MWh is sufficiently high such that it should still exceed the seller's marginal generation cost.

Both figures indicate the absence of last-minute bidding whose strategic value was largely eliminated by the time extension feature of the auctions. They also provide time-stamped transparent records that can withstand close scrutiny by a third party (e.g., a board of directors, an industrial firm's senior management, or an LDC's regulators).

Given the attractive price offers, UCNSB signed the forward non-firm energy contract and the call option contract. Both took under four hours from the first offer submitted in Round 1 to UCNSB's contract execution. This is much shorter than the seven to 10 days required when using the typical RFO process. This shows the time-efficiency of an Internet-based auction.

  1. Bulow, J and Klemperer, P (1996) "Auctions Versus Negotiations" American Economic Review 86 (1) 180-194.
  2. Cameron, L J., Cramton, P and Wilson, R (1997) '"Using Auctions to Divest Generation Assets," Electricity Journal 10 (10) 22-31.
  3. Klemperer, P (2002) "What Really Matters in Auction Design," Journal of Economic Perspectives 16 (1) 169-189.
  4. Roth, A and Ockenfels, A (2002) "Last-minute Bidding and the Rules for Ending Second-price Auctions: Evidence from eBay and Amazon Auctions on the Internet," American Economic Review 92 (4) 1093-1103.

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