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Pay-as-Bid vs. Uniform Pricing

Discriminatory auctions promote strategic bidding and market manipulation.

Fortnightly Magazine - March 2008

their marginal costs under the uniform price auction instead bid based on their individual forecasts of the market clearing price.

While suppliers’ changes in bidding strategy leads to a set of offers that are higher overall, it is not immediately apparent whether the price level is affected by the auction choice. In fact, most analyses suggest that, under competitive conditions, market prices are unlikely to differ materially between uniform-price and pay-as-bid auction formats (see Figure 2) . While small differences may emerge due to factors particular to the market setting, structure, and design, economic analysis fails to support the conclusion that a pay-as-bid auction will lower overall prices.

Even so, many observers point to the potentially large differences between supplier bids and prices in a single-clearing-price auction as an inherent flaw in that market design (if not in wholesale markets themselves) resulting in excess payments to suppliers. Many observers view these payments as profits, and see these margins as unacceptably high for the suppliers with low marginal costs.

This viewpoint entirely overlooks the fact that in this market design, the margin is part of the compensation to suppliers to recover their fixed costs—that is, all those “other” but real expenses necessary to recoup the investment made to construct the power plant, to employ people to work in it, and maintain and operate it in safe working order. Because these expenses typically do not vary with the output of the plant, they are not a part of the marginal costs that figure into an economically rational bid in a market with a single-clearing price auction. While such fixed costs are collected in rates under traditional cost-of-service regulation—through return on investment in utility rate base, depreciation expenses, labor expenses, and so forth—the mechanisms for fixed capacity payments in some of today’s RTO markets clearly are not intended to fully cover these fixed costs. Instead, they are intended to make up for the fact that revenue streams from current energy markets—even given the current margins—provide insufficient income needed to support new generation investment (the missing-money problem).

Thus, limiting supplier payments to their variable generation costs would erode further investment incentives and thus exacerbate concerns about resource adequacy with risks for security of supply and increases in opportunities for market withholding. Further, changes in supplier-bidding strategy under a pay-as-bid auction would foil efforts to limit payments to them. Thus, a switch to a pay-as-bid auction does little to address concerns about either the affordability of electricity rates or the reliability of power supplies. The hoped-for outcomes are illusory.

Some analysts have suggested the pay-as-bid approach may reduce short-term price volatility compared to a uniform-price approach. But while a pay-as-bid approach may reduce short-term volatility—that is, volatility across hours or days—such volatility can be hedged through financial instruments. And that volatility even might promote investment in peaking technologies that rely upon price spikes in a few hours to justify initial capital investments. However, pay-as-bid auctions offer no panacea for reducing longer to medium-term price uncertainties that may act as a deterrent to new generation investments or raise