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Pay-as-Bid vs. Uniform Pricing

Discriminatory auctions promote strategic bidding and market manipulation.

Fortnightly Magazine - March 2008

risks for consumer budgets.

Efficiency Implications

A switch to a pay-as-bid auction, while having little impact on prices—and consumer payments—in wholesale electricity markets, likely would have an adverse impact on efficiency of economic plant dispatch. Uniform-price auctions generally achieve efficient economic dispatch. Because of the tendency for plant owners to bid in relation to their marginal costs, the order of plants based on supplier bids is the same order as that based on marginal costs (see Figure 2) .

Under a pay-as-bid auction, suppliers’ bids reflect their estimates of expected market prices, not marginal costs. However, because supplier forecasts are likely to differ due to a range of factors unrelated to the underlying costs of generating electricity, the plants with the lowest bids may not reflect the plants with the lowest production costs. For example, a plant with low variable costs and an overly optimistic forecast of clearing prices inadvertently may bid above the eventual market-clearing price. As a result, this low-cost plant would not be selected to supply electricity while other plants with higher costs would be chosen and dispatched.

Figure 2(1B) illustrates this inefficiency: The lowest cost plant (Plant A) is not a winning bidder and does not supply electricity because its price forecast (and its offer price) was above that of the eventual market-clearing plant (Plant F). In its place, higher cost plants—Plant E and a portion of Plants F—are run that would not run on economic merit alone. Consumers pay no less in this example, but society’s resources have been used less efficiently than under uniform-pricing (Figure 2-1A) , where only the least-cost resources are selected to generate power. While not costing consumers in the short-run, such inefficient use of resources eventually will lead to higher consumer costs in the long-run.

Given unique circumstances in electricity markets that greatly increase the complexity and uncertainty of price forecasting, differences between supplier forecasts may be large. Bidders interact in a repeated bidding environment, involving multiple markets that are inter-related over time, space and across commodities, including markets for generation, transmission, capacity, emission allowances, and ancillary services. Idiosyncrasies in power production, such as the start-up costs, create interactions between an individual supplier’s bid across the day or week. Because electricity cannot be stored, unanticipated shifts in supply, demand, or the operations of other suppliers dramatically can shift prices from day to day, or even hour to hour.

These dispatch problems that may be introduced by pay-as-bid auctions were not present under the traditional cost-of-service model. In fact, as long as data provided by the vertically- regulated utility were accurate, power pools were designed to minimize costs across utility service areas, and all suppliers had non-discriminatory access to transmission, the traditional cost-of-service model did a fairly good job of minimizing overall power production costs, at least for the generating resources available to the dispatcher—typically those in the supply mix of the utility.

Pay-as-bid auctions also might affect incentives for investment in new generation facilities. For example, additional market forecasting costs, necessary to compete in a pay-as-bid market, might reduce incentives for investment