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Letters to the Editor / Corrections & Clarifications

Fortnightly Magazine - November 1 2003

Letters to the Editor / Corrections & Clarifications

To the Editor:

In a letter to the Oct. 1, 2003, , a letter from Lewis Evans and Kevin Counsell claims that a "pay-as-bid" day-ahead market would produce prices comparable to real-time prices even if loads understated their demand day-ahead, eliminating the incentive to underschedule (as allegedly happened in California).

In fact, a uniform-price day-ahead auction should produce the same effect. Evans and Counsell state that in a day-ahead market bidders will attempt to "guess the market-clearing price" and bid close to it. On the other hand, auction theory predicts that in a second-price auction suppliers will bid their costs. The important point is the correct definition of cost.

Suppose that a generator has an operating cost of $20/MWh, and anticipates the real-time price will be $40/MWh. In a second-price real-time market that generator will bid $20/MWh. But for the purposes of bidding into the day-ahead market, which will reliably be followed by an opportunity to sell into the real-time market, that generator's cost is the $40/MWh in real-time revenue it forgos by placing power into the day-ahead auction instead-its opportunity cost. (In reality, the bid would be modified to account for the uncertainty in the prediction of real-time prices.)

This means that bidding behavior in a day-ahead second-price auction should be the same as in a pay-as-bid day-ahead auction, as long as it is not the last opportunity to transact. So why then should purchasers still be able to play a demand understatement game, as they allegedly did in the California ISO markets?

1) Absent all considerations of costs and bids, an ISO that operates a real-time market may consider that it has a responsibility to keep real-time prices low by, for example, requiring that bids reflect only variable costs with no fixed cost recovery. In that case the opportunity cost seen by day-ahead bidders will be below their operating costs, so they bid operating costs. The real-time price will be reliably below the day-ahead price, and load-serving entities will seek to shift load into real time.

2) Purchasers may feel some political or regulatory constraint against bidding opportunity costs. We have seen occasions where regulators or case participants imply that any bidding above operating costs is market manipulation.

Political and regulatory constraints can create the opportunity for multiple gaming behaviors that aren't always labeled as such. Labels, and their connotations, are key. "Virtual bidding," for example, is nothing other than a short sale, but "short selling" has acquired an odor of illegitimacy. But physical storage will not bring electricity forward and physical markets into balance. That role must be played by short sales, opportunity-cost bidding, and similar trading arbitrages. The designers of the California markets relied heavily on the anticipated use of these tactics, which were later categorized as games and market manipulation, and which constituted most of the smoke in the famous Enron "smoking gun" memos.

To the Editor:

John Sillin's commentary ("The Blackout of 2003: Why We Fell Into the Heart of Darkness," Sept. 15, 2003) on "the management and