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Discriminatory auctions promote strategic bidding and market manipulation.
Electricity prices are rising. These price increases coincide with policy changes in many parts of the country that introduced into the electric industry greater reliance on market forces. Although today’s electricity prices still are relatively low in historical terms (about two-thirds of their 1980s levels when adjusted for inflation 1) and rising electricity prices have been largely the result of movements in global markets for fossil fuels, these price increases nonetheless have placed pressure on policy makers in a number of recently restructured electricity markets to question whether power prices have increased due to the design of competitive markets. Some observers have begun to push for redesign of market rules or even a return to elements of traditional cost-of-service regulation in the electric industry. 2
Among the proposed reforms are changes to the design of auction processes used in various wholesale electricity markets. These auctions involve offers to supply (and, possibly, bids to buy) power. The auction determines the identity of the winners—those competitive suppliers selected to supply power in any given time period—along with the price and other terms of the power sale. Typically, the buyer is some entity with responsibility to supply power to end-use consumers of electricity. Notable examples of such auctions in the power industry are the organized 3 energy and capacity markets administered by various regional transmission organizations (RTOs). In addition, in some states with retail choice, distribution utilities have used auctions to obtain power supplies for their basic-service customers.
In response to rising prices in some of these markets, some observers advocate a switch from uniform-price auctions (also called single clearing price markets), relied on almost exclusively in all organized wholesale power markets in the United States, to pay-as-bid auctions. 4 These alternatives differ in the way the price awarded to winning suppliers is determined. Under uniform-price auctions, all suppliers receive the same market-clearing price, set at the offer price of the most (or nearly most) expensive resource chosen to provide supply. In contrast, in a pay-as-bid auction, prices paid to winning suppliers are based on their actual bids, rather than the bid of the highest priced supplier. For this reason, pay-as-bid auctions also are known as “discriminatory auctions” because they pay winners a different price tied to the specific prices they offer into the auction.At first blush, the intuitive appeal of a pay-as-bid auction is obvious. Why pay a higher price to a supplier than the price at which he or she offers to sell the product? Wouldn’t doing so simply impose higher-than-necessary costs on the buyer—and by extension, to the consumer? Wouldn’t switching to a pay-as-bid