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Energy Risk & Market

Fortnightly Magazine - March 2005


Energy Risk & Markets

Default Retail Supply:

New Jersey's recent basic generation service auction shows how ignoring the many sources of risk can be financially ruinous.

Bidding at last year's basic generation service (BGS) auction in New Jersey was generally found to be extremely aggressive as many merchant energy providers watched in amazement as the bid prices continued to fall during the course of the auction. Many speculated on the reasons for the low bid prices-was it a thirst for market share no matter what the cost? Was it a sophisticated application of bidder-specific risk profiles? Or was it simply poor modeling? This article describes the sources of risk inherent in load-following deals (such as temperature and price variations, etc.) and how these risks can impact resulting bids in such auctions, which are a relatively new phenomenon. In fact, several states around the country such as Illinois, Ohio, California and Maryland either experimented with such an auction structure or are proposing similar structures for the immediate future.

In the case of New Jersey, the state implemented retail choice in 1998, adopting a four-year transition period. During the first three years of the transition, New Jersey's electricity distribution companies (EDCs) 1 supplied those customers that did not switch to competitive providers using pre-established rates or rate-making processes. During the fourth year of the transition (2002-2003), the EDCs jointly proposed an auction where suppliers competed to supply BGS.

An essential goal of this auction process is to provide full-requirements BGS to customers at a cost consistent with market conditions. A second important goal is to further the transition in New Jersey by providing an opportunity for energy trading and marketing companies to compete in the auction by aggregating the supply of wholesale products and providing price-risk management services.

The state's four EDCs participate in this auction process, whereby portions of their load requirements are divided into individual tranches upon which suppliers may bid during the auction for the right to serve over terms of 1 or 3 years.

The BGS-Full Price (FP) auction, which is known as a clock auction, is designed to solicit offers for the supply of full-requirements tranches for smaller commercial and residential customers for each of the four EDCs. The initial round of an auction begins with the posting of a starting price. 2 During the bidding phase(s) of an auction, the auction manager will announce prices. After the bidding phase for a given round, if the number of tranches bid is greater than the number of tranches needed for a given product, 3 the auction manager will reduce the price of a tranche by a given decrement (0.5-5.0%) and a new bidding phase begins. At the end of each round, participants may reduce the number of tranches bid. The auction continues until the total number of subscribed tranches falls to the point where it equals the number needed. When the auction ends, those bidders holding tranches at prices of the final round are the auction winners.

Suppliers under load contingent arrangements such as those for