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The Most Effective Way

Market prices send investors clear signals to invest in the most efficient means for producing electricity.

Fortnightly Magazine - October 2006

will receive. Doing otherwise would leave money on the table.

A generator’s strategy when forming its offer will focus on its estimate of the market price. To maximize revenues, its offer must be low enough to be accept-ed, but as close as possible to the highest offer accepted. The result will be market prices similar to the uniform-clearing-price market.

Uniform Clearing Price Encourages Efficiency

Although theory suggests that prices will be similar under both systems, in the real world the uniform-clearing-price system actually imposes more discipline on pricing.

Under the pay-as-offered system, financial success depends more on producing the most accurate forecast of prices rather than on operating more efficiently. Pay-as-offered rewards the best forecasters. Smaller generators and new producers are disadvantaged because they may not have the resources needed to most accurately forecast prices.

Under the uniform-clearing-price system, financial success depends on efficient operations. The lowest-cost, most efficient generators receive the greatest reward. As a result, the system encourages construction of efficient generation. Eventually, the efficient new generation will displace more costly generating units. If a generating company attempts to exercise market power and force prices higher than at a competitive level, smaller market participants, which receive the same price, would be encouraged to build new generation and enter the market.

Real-world experience demonstrates that the uniform-clearing-price system does not “unfairly” reward generators that use lower-cost fuels, such as coal-fired steam generation plants, compared with plants using higher-cost fuels, such as natural-gas fired plants. In the market operated by PJM Interconnection, coal-fired generators set the market clearing price most of the time. For example, in 2005 generation units using coal set the market price 62 percent of the time. As a group, coal-fired generation had the opportunity to try to recover their fixed costs and to earn a profit in the remaining 38 percent of the time—when units using natural gas or petroleum set the price. Again, if a pay-as-offered system had been in use, coal-fired generators would have had a strong incentive to offer power at the highest prices all the time to recover all of their costs.

Competitive results under the uniform-clearing-price system have resulted in lower markups. The average markup of marginal units has declined as fuel costs have risen. For example, in PJM, marginal combustion turbines’ average annual markup decreased from 16 percent in 2004 to 6.5 percent in 2005. For steam units, it declined from 5 percent in 2004 to a negative 1.7 percent in 2005.

Under traditional rate regulation, building new generation increases rates as recovery of the capital investment and other fixed costs are added to rates. Rates are set to allow generators to recover all of their costs and earn a profit. Since markets opened, about 16,000 MW of new generation have been added to the PJM region, all of the generation built at investors’ risk rather than ratepayers. The PJM Market Monitoring Unit has calculated the annual levelized fixed costs (or revenue requirements, in regulatory terminology) for new combustion turbines, combined-cycle, and coal-fired plants at, respectively, $72,207/MW, $93,549/MW, and $208,247/MW. For illustrative