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Anatomy of Sealed-Bid Auctions

Bringing flexibility and efficiency to energy RFPs.

Fortnightly Magazine - June 2009

is more costly for the bidder to provide than the second tranche, 18 there’s no way for the bidder to reflect this cost difference in its bid. Thus, such a bidder is forced to increase the price at which it’s willing to provide the second tranche above its marginal cost to be sure to cover its marginal cost of supplying the first tranche (see Figure 1). 19 Basic economics tells us that pricing above marginal cost can lead to inefficiencies. 20

In contrast to the utilities in Maryland, PPL Electric’s RFP explicitly allows a bidder to submit a bid that is conditional on the number of tranches that the bidder is awarded. In PPL Electric’s RFP, bidders are asked to submit prices for each total number of tranches they’re willing to provide. For example, a supplier in this RFP might be willing to provide a maximum of five tranches. This bidder would have to provide five separate prices, i.e., a price for providing one tranche, two tranches, three tranches, four tranches, and five tranches. In this manner, the bidder’s bid is conditional on the number of tranches it’s awarded. If the first tranche is more costly for the bidder to provide than the second tranche, the bidder can reflect this cost difference in its bid by lowering the price of providing two tranches relative to one tranche. Such a bidder can offer prices at which it’s willing to provide each total number of tranches equal to its marginal cost (see Figure 2) .

The type of conditional bidding allowed under PPL Electric’s RFP clearly can increase efficiency compared to Maryland RFPs, but it requires a different auction clearing mechanism. With conditional bidding, determining the winning set of bids becomes more complex and, thus, identifying the winning bidders requires the auction manager to use a different solution technique. For the Maryland utilities, the process of identifying the winning bids is rather simple and straightforward. Bids are ranked from least expensive to most expensive. The utility purchases the least expensive tranches that fulfill the supply it was seeking to obtain.

For example, if the utility seeks to buy a total of five tranches, it purchases the five least expensive tranches (see Table 2) . For PPL Electric, the process of identifying the winning bids requires considering which combination of bids yields the desired number of tranches at the least cost. This process requires more computation than the simple ranking of bids necessary in Maryland because the cost of each combination must be assessed. For example, if the utility seeks to buy a total of five tranches, it must consider all combinations of five tranches that can be obtained from the available bidders’ bids in order to determine the unique set of low-cost suppliers (see Table 3) .

Conditional bidding gives rise to the need for a different solution technique like that used in PPL Electric’s RFP. Suppose the electric utility wants to buy a total of 10 tranches and that each bidder is willing to provide a maximum of five tranches. Under the