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Pay-as-Bid vs. Uniform Pricing

Discriminatory auctions promote strategic bidding and market manipulation.

Fortnightly Magazine - March 2008

to produce power as efficiently as possible given the generating and other resources that already exist in the system, there is still the critical question of whether the market system provides the incentives for development of the most efficient generation, transmission and demand-side infrastructure. Achieving long-run, dynamic efficiency thus requires developing the right amount and type of resources, such as generation facilities, in the right locations. To create this infrastructure, the system must create price signals that encourage the right incremental investment. It also must provide incentives that promote a competitive market structure, and provide sufficient confidence that the system of pricing and compensation for power production will afford a reasonable opportunity for investment recovery given the capital intensity of, and multi-year lead times for, plant construction.

A major objective of industry restructuring has been to improve the price signals for efficient investment, along with improving the incentives for cost-effective implementation of investments (and cost-effective investments in existing plant operations). In principle, differences in the potential level of static and dynamic efficiency emerge for each of these regulatory models (as illustrated conceptually in Figure 1) .

Setting aside the question of whether restructuring has increased electric-market efficiency, several important factors influence an analysis of auction-design alternatives. 7 First, there is an important difference in how investors are compensated under the new RTO markets. While independent power producers (IPP) in RTO markets rely upon revenues from energy, ancillary services and evolving capacity markets, they do not—unlike generators under cost-of-service regulation—receive compensation for fixed costs (including return on investment) through rate base or through depreciation charges in base rates. 8 Second, the price signals created by alternative auction approaches yield important consequences for the efficiency of resulting investment incentives. Uniform-price auctions develop these price signals differently than pay-as-bid auctions do.

How, then, do these such differently structured wholesale markets provide for supporting a power plant’s combined investment and operating costs? Does one overpay suppliers compared to another? These questions can be answered by comparing single-clearing-price auctions and pay-as-bid auctions, and considering the implications for prices and investment.

No Significant Effect

Pay-as-bid auctions are unlikely to have any significant effect on market prices for electricity, and more likely than not will raise prices rather than lower them.

To compare auction models, it’s easiest to start with a uniform-price auction. Suppliers bidding in a competitive uniform auction have the incentive to bid their opportunity cost of selling electricity into the RTO market, which could reflect the cost of producing electricity or the lost opportunity to sell electricity at another time or into another market. A supplier’s bidding alternatives for an individual plant illustrate this incentive to bid at cost. Bidding above costs decreases the likelihood the plant will be selected to supply electricity, without affecting the price they will receive, while plant owners might lose money if they bid below their marginal costs. Bids may be affected by the opportunity to raise prices for other plants owned by the supplier, but that doesn’t dramatically change the intuitive conclusion. In a pay-as-bid auction, suppliers who would bid