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The Most Effective Way
Market prices send investors clear signals to invest in the most efficient means for producing electricity.
was the failures of the regulatory system that led to the calls for competition. How soon we have forgotten nuclear power plants being brought into rates at a cost of $5,000/kW, PURPA contracts with prices per kilowatt-hour (set by regulators) at twice the competitive cost of electricity, and wide disparities among utilities in the costs of construction and the operating performance of power plants.
Uniform Clearing Price: The Worldwide Standard
In the United States and most of the rest of the world, organized wholesale electricity markets set a uniform clearing price. Generators submit offers to a market administrator to supply a quantity of electricity at a certain price. The market administrator accepts offers beginning with the lowest-cost units, then moving to higher-cost units until the supply of electricity matches the demand. All generators are paid the same price, which is set by the offer from the last unit (the highest-priced unit) accepted to supply electricity. A lower-cost coal, nuclear, or hydroelectric generator thus could be paid the same price as a more expensive natural-gas-fired generator.
To remedy current high electricity prices, some say generators should be paid only their actual offers. The uniform-clearing-price market supposedly pays too much for electricity because it sets a price for all equal to the highest-priced unit called on. Under the proposed alternative—the “pay-as-offered” market—when a generator’s offer is accepted, it would be paid only the price it offered. The expectation is that a pay-as-offered market would result in lower prices.
However, a pay-as-offered system does not result in lower prices than a uniform-clearing-price market. Economic theory, economic models, and real-world experience support this conclusion. Over the long term, both systems will produce similar prices.
Pay-as-Offered’s Attraction Based on False Assumption
The seeming benefit of a pay-as-offered system is based on the assumption that generators’ bidding strategies would remain the same in a different market. However, that assumption is false. Lower-cost generators simply will raise their supply offers to increase their revenues.
A uniform-clearing-price market, the most common wholesale electricity market, encourages generators to offer their electricity at their “margin,” their breakeven point for variable costs.
If Generator A’s offer is accepted and sets the clearing price, the generator will do no worse than recover its variable costs of running. If another, higher offer also is accepted, the clearing price will be higher. Now, Generator A recovers its variable costs and some of its fixed costs. A generator’s bidding strategy focuses on its own costs. A generator recovers its fixed costs, such as labor, debt service, depreciation, and decommissioning costs, and earns a profit only when a higher-priced generator sets the market-clearing price.
On the other hand, a pay-as-bid market encourages generators to offer their electricity at the expected market price. Knowing they will be paid only the price they offer, generators must offer a price high enough to recover both fixed and variable costs. If Generator A believes that the offers of other, higher-cost generators will be accepted, Generator A will offer its electricity at a price close to the highest offer it expects the market