Why We Should Not Be Quick to Move Away from Single Clearing Price Auctions in RTO

Before explaining my conclusion, it is helpful to review how single-clearing price auctions work and why they are beneficial.

By Matt Estes

I read with interest Federal Energy Regulatory Commission (“FERC” or “Commission”) Commissioner Mark C. Christie’s recent article in the Energy Law Journal calling for the review of the markets administered by Regional Transmission Organizations (“RTOs”)—and raising questions regarding the continued use of single-clearing price auctions in those markets. Commissioner Christie asserts that it is “appropriate to consider whether single-clearing price mechanisms can still produce just and reasonable rates, which is, after all, what the Federal Power Act [(“FPA”)] requires.

Single-Clearing Price Auctions

Before explaining my conclusion, it is helpful to review how single-clearing price auctions work and why they are beneficial.  Commissioner Christie starts off on the right path by drawing on the useful description of these auctions provided in U.S. Supreme Court Justice Elena Kagan’s opinion for the Court in FERC v. Elec. Power Supply Association:[i] Operators accept the generators’ bids in order of cost (least expensive first) until they satisfy the [load serving entities’] total demand.  The price of the last unit of electricity purchased is then paid to every supplier whose bid was accepted, regardless of its actual offer . . . .  So, for example, suppose that at 9 a.m. on August 15 four plants serving Washington, D. C. can each produce some amount of electricity for, respectively, $10/unit, $20/unit,

$30/unit, and $40/unit.  And suppose that [load serving entities’] demand at that time and place is met after the operator accepts the three cheapest bids.  The first three generators would then all receive $30/unit.  That amount is (think back to Econ 101) the marginal cost—i.e., the added cost of meeting another unit of demand—which is the price an efficient market would produce.[i]

Justice Kagan does a good job here of explaining how a single-clearing price auction works and why that price represents the marginal price that would result from an efficient market.  But after quoting from this opinion, Commissioner Christie goes on to question why low-cost suppliers should receive a clearing price well above their offers.  He instead proposes consideration of alternative pricing mechanisms, such as “pay as offered” auctions or bilateral trading markets.  Commissioner Christie asserts that these alternative mechanisms would result in lower rates for consumers by reflecting the lower offers submitted by low-cost suppliers—offers that are not reflected in the rates resulting from single-clearing price auctions.[i]

But there is another important aspect of single-clearing price auctions that was not mentioned in Justice Kagan’s opinion because it was not relevant to the Court’s decision. Specifically, and as discussed in more detail below, the use of a single-clearing price auction incentivizes suppliers to submit offers that are lower than they would be under other pricing mechanisms.  Consequently, under the alternative pricing mechanisms that Commissioner Christie identifies for consideration, suppliers would not submit the low price offers he wants to capture for consumers.

This aspect of single-clearing price auctions can be illustrated by the hypothetical quoted above from Justice Kagan’s opinion, applied where a pay as offered price mechanism is employed (i.e., where each winning supplier is paid what it offers instead of the market-clearing price).  Suppose the prices of the units in her example represent each unit’s cost of production.  If the owners of the $10/unit and the $20/unit can predict that the system load will be greater than their combined output—and in fact it is not difficult in most markets to accurately project load levels to least a general degree—then their incentive will be to offer above their costs and just below what they believe the marginal offer price will be.  They know that the owners of the $30/unit and $40/unit likely will not offer below the costs of their units because otherwise they run the risk of having their offer accepted and being required to sell at a price that is below their cost.  Consequently, the owners of the lower-cost units will not offer their units at $10 or $20, but instead will offer at a price of $30, or even $40 if they project that the $40/unit will be required to serve load.[ii]

Failure of the owners of the lower cost units to offer above their costs and near the price they believe will be the price offered by the marginal price unit would result in the loss of revenues that would be readily available to them under the auction.  Generation owners are sophisticated profit-maximizing entities, and they simply will not offer into a pay as offered auction at prices well below the anticipated auction clearing price and thereby leave money on the table.  Nor will they agree to prices in a bilateral trading system that are well below the expected marginal price offered in the bilateral market.

If the owners of the lower cost units in Justice Kagan’s example correctly forecast load as requiring the dispatch of all three units in the example, and if they correctly determine that the third unit’s costs are $30, then they likewise will be incentivized to offer at $30 and, if the $30/unit offers at its costs, then the result will be exactly same as under a single-clearing price mechanism.  But unit costs are not made publicly available, and load forecasts can be incorrect.  If the owners of the units incorrectly forecast the load level or the costs of the marginal unit, then the total costs to consumers under a pay as offered auction structure could be even higher than under a single-clearing price mechanism (for example, if the owners of the $10 and $20 units offer at a price above $30).  By contrast, under a single-clearing price mechanism, none of the unit owners need to predict loads or their competitors’ costs to submit the most economically beneficial offer.  The owner of each unit can submit an offer at the cost of its unit, thereby ensuring that it will receive the price of the marginal offer, whether that is submitted by the $30/unit or the $40 unit.  And if the marginal offer price is below an owner’s costs, that owner will not be given an award and will not be forced to operate its unit at a loss.  Further, all units that are given awards will have costs at or below the costs of the marginal unit, and no unit with costs below the marginal unit will fail to receive an award.  Thus, under a single-clearing price mechanism, suppliers have an incentive to offer at their costs even when such costs are likely to be well below the market-clearing price.  But this incentive exists only if suppliers are awarded the market-clearing price. 

Of course, the discussion above is based on a simplified example and outcomes will be somewhat different in the complex RTO markets.  But it nevertheless remains true that low-cost sellers that offer into single-clearing price RTO auctions at prices well below the clearing price would not have the same economic incentive to do so under other possible pricing mechanisms.

Review of Single-Clearing Price Auctions Under FPA Section 206

FPA section 205(a) mandates that “[a]ll rates and charges” within the Commission’s jurisdiction, as well as “all rules and regulations” pertaining to those rates and charges, must be “just and reasonable.”[i]  In order to enforce this mandate, the Commission reviews proposed new rates and rate changes under section 205.  In addition, under FPA section 206, the Commission also reviews rates that were previously reviewed and allowed to go into effect under section 205—either in response to a complaint or sua sponte on its own motion.[ii]  Given Commissioner Christie’s call for the Commission to consider whether single-clearing price auctions continue to be just and reasonable,[iii] my comments focus on the analysis under FPA section 206.

Section 206 requires the Commission to follow a two-step process before requiring that a currently effective rate—such as the RTO rates established pursuant to single-clearing price auctions—be replaced by some other rate-setting mechanism.  First, the Commission must determine that the currently effective rate is no longer just and reasonable.  If it makes such a finding, the Commission then must determine the just and reasonable replacement rate.[iv]  My comments focus on this first step.

In his article, Commissioner Christie presents two principal concerns regarding single-clearing price auctions.  Both represent a valid concern regarding RTO markets that should be addressed in any Commission review of those markets.  But, in my view, neither of these reasons implicates the just and reasonableness of the use of single-clearing price auctions.

First, Commission Christie notes that RTO markets, especially capacity markets, impose several different requirements on offers and incorporate a number of assumptions, including assumptions about how much capacity is needed, the shape of the demand curve, and the cost of constructing a new unit that acts as a ceiling on the capacity price to be awarded at the auction.  From this, Commissioner Christie concludes that capacity markets “have never been true markets, but rather administrative constructs with some market characteristics.”[v]  He asserts that RTO capacity auctions represent an administrative planning exercise similar in nature to the integrated resource planning process followed by state Public Utility Commissions outside of RTOs.[vi]  “Just don’t pretend,” Commissioner Christie cautions, “that what’s at work in capacity markets is Adam Smith’s invisible hand efficiently allocating capital through a single-clearing price mechanism.”[vii]  And, based on his frequently repeated characterization of capacity auctions as “administrative constructs,” Commission Christie questions whether his criticisms of single-clearing price auctions can “be divorced from the question whether these markets were based on deregulation assumptions that may no longer be valid, if they ever were.”[viii]

Commissioner Christie is certainly correct that the various RTO markets incorporate several administrative assumptions and guidelines.  But very few, if any, existing markets of any type are completely free from regulation.  The stock and commodities exchanges, for example, are subject to extensive rules and regulations, including provisions to prevent market manipulation and the exercise of market power, which are the subjects of several rules governing RTO markets.  Further, Commissioner Christie suggests that states could require the procurement of capacity through “competitively-bid PPAs,”[ix] a process that certainly would be subject to many of the same assumptions and requirements as the RTO capacity auctions.  That these markets are perhaps less free than envisioned by Adam Smith does not mean that competitive forces are absent—or that economic principles are inapplicable.

And although it is certainly valid to question, as Commissioner Christie does, whether the rules governing the various RTO markets could be revised to include more appropriate parameters or even whether those markets should exist at all, I do not think that Commissioner Christie has presented a rationale that would support the conclusion that single-clearing price auctions are not just and reasonable.  Whether characterized as a competitive auction or an administrative construct, single clearing price auctions in RTO markets provide for the submission of offers to sell energy, capacity, and certain other products into market-based rate auctions.  And Commissioner Christie has presented no reason for us to question whether the use of single-clearing price auctions represents a just and reasonable way to derive the most efficient marginal price from the offers that are submitted for the products that are the subject of the auction.

Commissioner Christie’s second reason for questioning the continued reliance on single-clearing price auctions is based on his observations regarding the effect of subsidies on the RTO markets: 

State policies mandating that utilities must purchase power based on the type of generator or other attributes, other forms of state subsidies, such as zero emissions credits (ZECs), combined with lavish federal subsidies in the form of investment and production tax credits, undercut any continuing claim that capacity markets are simply procuring the lowest-cost capacity on an agnostic basis.[i]

Commissioner Christie quotes former Commissioner Tony Clark’s characterization of these subsidies as “more than a thumb on the scale of energy markets,” but rather “a twelve-ton dump truck.”[ii]  He also notes the difficulties of operating multi-state RTOs with divergent policies on subsidies and the intense disagreement over the need for minimum offer price rules to mitigate the effect of subsidies on auctions.

Commissioner Christie has identified what undoubtedly represents a difficult and controversial challenge faced by the electric industry today, which is how to integrate the large and fast-growing number of highly subsidized renewable resources into the electric grid while maintaining grid reliability.  But he follows his identification of this issue with a non-sequitur: “So what purpose is served by giving all sell offers the highest clearing price?  If their promises of future deliverables are based on their actual costs, discounted for subsidies, why shouldn’t each seller that clears simply get its offer price?”[i]

The answer is that, as explained above, under a pay as offered mechanism or a bilateral transaction mechanism, renewable resources will not offer at “their actual costs, discounted for subsidies.”  An RTO’s single-clearing price auction may represent an administrative construct imposed by the market operator, but marginal price theory is not.  Instead, it is an economic principle that has been observed to apply in countless markets and market structures.  Prices will tend to be set at or near the marginal price even without a single-clearing price mechanism.[ii] 

As Commissioner Christie observes, the problem raised by subsidies for renewable resources is that they may depress prices and thereby threaten the financial viability of dispatchable resources that are necessary for system reliability.[iii]  This is not a problem that can be fixed by eliminating single-clearing price auctions.  Yes, the prices set under single-clearing price auctions are affected by subsidies, but the presence in a market of large quantities of low-cost subsidized supply will suppress prices regardless of the market pricing mechanism employed. 

As I stated at the outset, Commissioner Christie has raised valid concerns about RTO markets, and he also has identified some interesting ways to address those concerns.  For example, I find his reference to the bifurcated market idea being pursued in Europe—which involves separate (single-clearing price) auctions for renewable and dispatchable resources[iv]—to be intriguing, although perhaps difficult to implement.  And it is absolutely necessary to address the current challenges in maintaining grid reliability.  But in doing so, we should focus on the problems that may be threatening the just and reasonableness of the RTO markets.  That threat does not come from single-clearing price auctions.

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