The Reverse Auction Con
ArchPundit
Rich points out the reverse auction for power was a system to screw consumers and he’s exactly right. I discussed some of the larger issues the other day, but the reverse auction is an essential cause of the breakdown as to why a ‘deregulated’ system failed miserably for consumers.
Part of the initial energy deregulation plan for Illinois was to divide the production of power from the distribution of power. In this way consumers could choose the producer of power based on price or preferences over how the power is produced. Some, certainly not all, environmentalists including me in general agree with the concept because if people can buy power that is produced through green processes, the investment in green power research and development should dramatically increase.
The challenge though is to find a way to encourage more producers so there is effective competition. When you start off with one power company in a single area, competition takes time to develop. Making that more difficult is the issue that since there was a rate cap on residential power, there was little incentive to invest until the rates were set by the market. I discussed this in the last post.
The danger of deregulation in the example of California was averted by allowing medium term contracts to be developed for power. In California, requiring the spot market to determine pricing to the distributors meant producers could and did game the system. The notorious tapes of Enron traders asking facilities to shut down to create great demand on the spot market caused prices to increase dramatically and artificially while also causing too little supply. Hourly rates were also allowed, but the volatility by having a medium term contract was kept to a reasonable level.
The decision on a specific mechanism was left to the Illinois Commerce Commission. And it is the commission that made the really stupid idea of relying upon a reverse auction where providers were sought out and asked to bid on the amount of power they were willing to provide at a given price with the auction concluding at the price in which the amount of power matched the amount provided–theoretically the market clearing price.
At the same time, power utilities had to divide themselves up–with producers being separated from distributors. This meant that the same corporation could not do both tasks in Illinois, but it did not stop two corporations owned by the samed entity from existing so Ameren simply had to split itself into two companies owned by a larger holding company. The same with ComEd/Exelon.
IOW, while there is a legal distinction between the companies that are providing the power and distributing the power, there is little distinction in terms of incentives. Both seek to maximize profit to the same shareholders.
Could you still create a system that would provide low prices even with the same parent company? Probably and of all people, Arthur Laffer and Patrick Giordano made the case in 2005:
ComEd is a wholly owned subsidiary of the Exelon Corp., which also owns Exelon Generation. Exelon Generation is a huge generator of electricity derived primarily from nuclear power plants once owned by ComEd and then transferred to Exelon Generation. It’s all quite incestuous and confusing but nonetheless important to understand: ComEd is owned by the same company that owns Exelon Generation. Exelon Generation is the principal supplier of electricity to ComEd, which no longer owns any generating plants. It is obviously in ComEd’s interest to have Exelon Generation make as much money as possible. For ComEd’s auction proposal or any other proposal to go forward, the Illinois Commerce Commission must approve. An administrative law judge who has heard oral testimony and read briefs will issue a proposed order soon. The ICC is expected to make a final decision in January.
ComEd’s proposed auction would start by setting a very high purchase price for electricity and then asking all qualified electricity suppliers how much they would be willing to supply at that very high price. With a high enough price, far more than 100% of ComEd’s need would be offered by potential suppliers. The price is then allowed to decline in discrete amounts (a “reverse” auction) until a price is found at which the total amount offered by all suppliers is equal to ComEd’s need.
In ComEd’s proposal the auction is halted at the so-called market-clearing price and all sellers receive that same uniform price–even those suppliers, like Exelon Generation, that might have been willing to sell at lower prices because their generation costs are very low.
Significantly, under ComEd’s proposal all bidders would be told how much energy other bidders are willing to supply at each price as the auction proceeds. ComEd spokespeople describe this as transparency. But to us, it is simply an inducement for the suppliers to collude.
ComEd’s proposal makes sense from its perspective. Higher prices for electricity supply directly benefit Exelon Generation, and thereby the parent company of both ComEd and Exelon Generation. Any proposal by ComEd that didn’t benefit Exelon Generation disproportionately would be a breach of Exelon Corp.’s fiduciary duty to its shareholders.ComEd’s “uniform price” approach, however, violates a basic tenet of public policy: providing the lowest prices for consumers. Stopping the auction when the amount offered equals the amount needed starts at the wrong end of the supply curve. Meanwhile, showing each bidder all the other bids encourages implicit collusion. You don’t have to be an industry expert to predict that ComEd’s approach will result in consumer prices well above those reached in a truly free market. ComEd’s proposal is particularly objectionable in Illinois because utility consumers long ago paid to build the nuclear plants now owned by Exelon Generation.
It would be much better to let the market operate freely under a “pay as bid” reverse auction, instead of the “uniform price” auction ComEd proposed. A pay-as-bid approach allows suppliers to continue to bid in the auction until no bidder is left willing to supply electricity at lower prices.
Under such an approach, some bidders could not afford to lose out on any sales because most of their costs are fixed and there is substantial excess generating capacity in the Illinois market. Therefore, they would continue to offer supply at ever-lower prices in order to guarantee full sales. This way, bidders with generating plants that produce low-cost electricity (read Exelon Generation) would bid much closer to their costs of production in order to ensure success in the auction.
And obviously, bids would have to be kept private so no one could game the auction. Under this approach, Exelon Generation would still come out ahead because its costs of production are low, but consumers would benefit as well through lower electricity charges. This method would best facilitate real electricity competition.
And of course, the price of electricity doesn’t really effect ComEd as a distributor since it’s only passing along the prices.
There’s another short term aspect as well. There are limited numbers of power producers and suppliers in the region–some of the suppliers aren’t producers, but actually brokers such as Constellation Energy which won the second most number of tranches in the Ameren area next only to Ameren’s production unit and a significant number of tranches in the ComEd area. Yet, Constellation has limited production capability in the region making. And here I don’t have the expertise in the industry to know who they are buying from. Given several of the smaller providers have little in the way of generation capability, I have a question as to whether much of the power outside of what the generation companies tied to the distribution companies is simply repackaged from the generation companies that are tied to ComEd and Ameren. If this is the case, the actual competition is far more rigged than it already appears to be.
There’s a significant distinction between one being pro-market and one being pro-business. The reverse auction was pro-business, but anti-market as it will retard the ability for further competition to grow in the area and provide higher prices for consumers.