The Most Effective Way


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

Fortnightly Magazine - October 2006

Higher electricity prices have drawn sharp attention to the design of organized wholesale electricity markets—particularly to areas where residential customers’ rates will increase because multi-year rate freezes are ending.

Rising costs for the fuel used to generate electricity have driven wholesale electricity prices higher. The price of natural gas has increased dramatically, although oil and coal prices also are higher than they were two years ago. These underlying fuel-cost increases would have pushed up electricity prices no matter how prices were set.

Nevertheless, because of higher electricity prices, some suggest changing the way that markets set wholesale electricity prices, or doing away with competitive markets entirely and returning to government regulation of prices. They say that the design of the markets exaggerates the effects of natural-gas price increases and unfairly rewards generators that use lower-cost fuels.

Organized Markets Promote Efficiency

A market-based system provides the best investment and performance incentives. Market prices send investors clear price signals to invest in the most efficient means for producing electricity. Plant operators have the financial incentive to operate and maintain power plants effectively and at the lowest cost possible. Investment and operating decisions are made at the investors’ own risk and potential for reward.

Spot markets send instantaneous price signals to producers and consumers about the need for additional power supplies or for conservation. Spot-market prices are volatile because they instantly reflect real-world conditions. The volatility of spot markets creates risk of profit or price changes. Typically, long-term contracts provide a means to reduce the risk. Long-term contracts do not reduce prices or increase profits; they create more stable prices and profits by reducing the amount of fluctuation.

Regulation Stabilizes Prices At the Cost of Efficiency

Regulation (the fixing of prices by the government) tends to reduce the risk of profit or price changes. Profits to investors remain fairly stable regardless of investment decisions or operating efficiency. Consumers have less risk of price shocks. Regulated price changes are slower than price changes in a market-based system, both because of the slowness of the regulatory process and because the process tends to look at historical rather than current costs.

Under government regulation, costs tend to be higher than they would have to be because there is little incentive for efficiency. In fact, the traditional regulation system by its design encourages inefficient investment in generation facilities. Under regulation, the predominant way a utility can increase its profits is to increase the amount of money it invests in facilities that are paid for by customers. Because regulation is backward looking, producers and consumers receive incorrect price signals about the need for conservation or for investment in additional generation. The risks of investments or operating performance are borne largely by consumers.

Indeed, it was the failures of the regulatory system that led to the calls for competition. How soon we have forgotten nuclear power plants being brought into rates at a cost of $5,000/kW, PURPA contracts with prices per kilowatt-hour (set by regulators) at twice the competitive cost of electricity, and wide disparities among utilities in the costs of construction and the operating performance of power plants.

Uniform Clearing Price: The Worldwide Standard

In the United States and most of the rest of the world, organized wholesale electricity markets set a uniform clearing price. Generators submit offers to a market administrator to supply a quantity of electricity at a certain price. The market administrator accepts offers beginning with the lowest-cost units, then moving to higher-cost units until the supply of electricity matches the demand. All generators are paid the same price, which is set by the offer from the last unit (the highest-priced unit) accepted to supply electricity. A lower-cost coal, nuclear, or hydroelectric generator thus could be paid the same price as a more expensive natural-gas-fired generator.

To remedy current high electricity prices, some say generators should be paid only their actual offers. The uniform-clearing-price market supposedly pays too much for electricity because it sets a price for all equal to the highest-priced unit called on. Under the proposed alternative—the “pay-as-offered” market—when a generator’s offer is accepted, it would be paid only the price it offered. The expectation is that a pay-as-offered market would result in lower prices.

However, a pay-as-offered system does not result in lower prices than a uniform-clearing-price market. Economic theory, economic models, and real-world experience support this conclusion. Over the long term, both systems will produce similar prices.

Pay-as-Offered’s Attraction Based on False Assumption

The seeming benefit of a pay-as-offered system is based on the assumption that generators’ bidding strategies would remain the same in a different market. However, that assumption is false. Lower-cost generators simply will raise their supply offers to increase their revenues.

A uniform-clearing-price market, the most common wholesale electricity market, encourages generators to offer their electricity at their “margin,” their breakeven point for variable costs.

If Generator A’s offer is accepted and sets the clearing price, the generator will do no worse than recover its variable costs of running. If another, higher offer also is accepted, the clearing price will be higher. Now, Generator A recovers its variable costs and some of its fixed costs. A generator’s bidding strategy focuses on its own costs. A generator recovers its fixed costs, such as labor, debt service, depreciation, and decommissioning costs, and earns a profit only when a higher-priced generator sets the market-clearing price.

On the other hand, a pay-as-bid market encourages generators to offer their electricity at the expected market price. Knowing they will be paid only the price they offer, generators must offer a price high enough to recover both fixed and variable costs. If Generator A believes that the offers of other, higher-cost generators will be accepted, Generator A will offer its electricity at a price close to the highest offer it expects the market 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 purposes, if we assume that all of the new generation was natural-gas-fired combined-cycle (most of i t was), under traditional regulation, the aggregate of wholesale rate increases to support the revenue requirements for these new units can be estimated to be at least $1.5 billion per year for wholesale power.

Illusions and Proven Realities

In short, the uniform-clearing-price market, used by PJM Interconnection and nearly the entire world’s other organized wholesale electricity markets, provides a built-in mechanism to produce the lowest competitive prices. At best, a pay-as-offered system would produce only similar prices. In the process, uniform-clearing markets shift the burden of performance risks off the ratepayers’ shoulders, and onto investors’.

The appeal of a pay-as-offered system is illusionary and based on false assumptions. Traditional regulation can force prices lower artificially in the short term only, and at the expense of higher longer-term prices, because of inherent inefficiencies in the regulatory system. Wholesale competition works; it produces fair, efficient prices that send appropriate signals to market participants.