Knowledge Problem

Michael Giberson

In economic theory, in lab experiments, in practice – pretty much generally speaking – it is well established in economics that a uniform clearing price auction works better than a pay-as-bid auction in cases such as the spot markets for power operated by the NYISO and ISO-New England (and every similar market in the United States, and most every other similar market internationally).

A week ago we discussed the recent argument to the contrary being tossed about in New York, and it appears that the pay-as-bid camp now has an advocate in neighboring Connecticut as well: the Attorney General. But in Connecticut the AG wants to go one better than a pay-as-bid pricing rule for ISO-New England (the regional power market operator in the Northeast), he wants to create a state power agency to supply power at cost to the state’s utilities.

According to an op-ed by the AG published in the New Haven Register:

A nonprofit, independent energy agency would lower prices by circumventing and short-circuiting irrational federal rules that ISO and FERC refuse to reform. The agency would do so by creating more supply — financing, building and buying power plants — that would sell power at cost to the utilities. It also would purchase power directly from generators, using its market power to negotiate lower rates and cutting out middlemen, such as hedge funds, investment banks and energy traders.

Finally, the authority would reduce costs by encouraging energy conservation and doing long-term planning for the state’s future power needs.

… An energy authority would neutralize FERC’s irrational rules by adding a big new player, acting in the public interest, that would use its market power and new plants to force down prices.

The “irrational federal rules that ISO and FERC refuse to reform” are rules in which, the AG said, the “highest, not the lowest, price sets the market.“ That formulation of the pricing rule omits an important detail – it is the highest accepted offer price that fixes the market price – not the highest offer price. I assume that the AG assumed the reader would grasp that point, but I make it explicit because that detail makes a big difference.

In a competitive market using a uniform clearing price paying the highest accepted offer, suppliers have strong incentives to bid near or at their marginal cost of production. When suppliers bid near their cost of production, then the market will naturally end up selecting the most efficient producers available to supply power. The market design also provides strong incentives to invest into the most efficient kinds of power plants. If the market is not competitive, then a uniform clearing price auction can enhance incentives to exercise market power, so these markets generally have extensive market power monitoring and mitigation schemes, too, for non-competitive periods.

In a competitive market using a pay-as-bid price rule, there are strong incentives for suppliers to bid at or just below their best guess at what the highest accepted market price will be. A low cost supplier that bids below the highest accepted market price is throwing away profit opportunities. The result is that the suppliers who guess (and so offer) the lowest prices get selected, not necessarily the low cost suppliers. In fact, as shown in economic experiments, (ungated version here) under pay-as-bid rules and competitive conditions, prices tend to drift as high as in uniform clearing price auctions with market power. (In the experiments cited, the researchers did not bother running the planned auctions under pay-as-bid rules and non-competitive conditions because the market performed so badly under pay-as-bid and competitive conditions it was clear that things could not get much worse.)

If prices under pay-as-bid do match uniform clearing price levels, then pay-as-bid will provide incentives to invest in the most efficient kinds of power plants. But, if the hopes and dreams for the pricing rule of pay-as-bid rule proponents come true:  suppliers bid their true costs, then incentives for investing in efficient plants are nearly eliminated.

There are a few other wrinkles in the comparison of pay-as-bid and uniform clearing price rules. In the testimony to the New York state assembly committee that I cited last week, David Patton summarized as follows:

While the pay-as-offered market design is superficially appealing, it would result in:

• Higher overall costs to consumers;
• Substantial inefficiencies in the operation of the system;
• Distortions in the incentives to invest in new generation and transmission assets;
• Additional costs that would harm relatively small suppliers; and
• Enhanced opportunities for suppliers to engage in market power abuses and manipulation.

Similarly, in a recent overview of the view of the issue by power systems engineer Ross Baldick, he said:

Despite the compelling reasons for using the single market-clearing price for electricity, alternative pricing rules are sometimes proposed. One such alternative proposal is “pay-as-bid,” where each accepted offer is paid its offer price. However, there is no empirical or experimental evidence that pay-as-bid or other alternatives would reduce prices significantly compared to a single market-clearing price design. In fact, some evidence suggests that pay-as-bid would increase prices compared to explicitly setting the single market-clearing price. Moreover, pay-as-bid has some significant drawbacks.

In a forward to Baldick’s study, prominent auction design economist Peter Cramton said, “the clearing-price auction maximizes gains from trade: consumption comes from demand with the highest values and production comes from supply with the lowest cost. This is perhaps the most celebrated result in economics.”

Eight years ago, a “blue ribbon panel” – Cramton along with Edward Kahn, Richard Tabors, and Robert Porter – addressed the same issue in California. Then, as now, the analysts came to the conclusion that uniform clearing price rules are better, and pay-as-bid would: forstall efficiencies expected from the market, introduce additional inefficiencies in operations, weaken competition, and impede investment in demand-side responsiveness.

Not good enough for the AG in Connecticut. He wants a new state power agency empowered to fight these market rules and their incentives for economic efficiency. While I subscribe to the conventional wisdom of economists on this issue – uniform clearing prices work best – every so often it is worthwhile for advocates of failed policies to give the failed policies another chance to fail again. And the more public and transparent the failure the better.

Efficient markets may serve as good examples, but sometimes it is even more educational to have a “horrible warning” to point to. I’m not an electric power ratepayer nor taxpayer in Connecticult; I say, “Go for it!”