27.10.05

ROUND AND ROUND ON REVERSE AUCTIONS. The University's National Public Radio news affiliate has made available all three interviews addressing the Commonwealth Edison rate increase and the reverse auction for the procurement of supply. The first interview features Dave Kolata, executive director of Illinois's Citizens Utilities Board. Next out is Commonwealth Edison's Vice President of Energy Acquisition, Arlene Juracek. This morning was my turn. The news director was kind enough to run the local feature in its time slot, rather than cut away to the announcement that Supreme Court nominee Harriet Miers had withdrawn her nomination.

A seven minute interview is not a lot of time to communicate information. The producer's judgement was that the comparisons I drew between Priceline.com as a reverse auction and the joys of procuring pizzas would be the most accessible to a general audience. Herewith a quick synopsis of the other topic we chatted about.

1. Deregulation and fragmentation of formerly vertically integrated natural monopolies makes some sense. Although it seems a bit jarring to be undoing a power system in which one company generates, transmits, and distributes the electricity, there is ample economic research confirming that economies of scale do not persist at the largest generating stations in service. A system in which distribution companies purchase power from competing generating companies with the interstate transmission supervised by the Federal Energy Regulatory Commission and the local distribution supervised by the state public service commission introduces competition where competition is practicable while preserving regulation of the natural monopoly components by the proper federal and state commissions. I mentioned natural gas as a useful analogy, with a bit of history best summarized as The Regulation-Induced Shortage of Natural Gas. The breakup of the Bell System also provides useful lessons in introducing competition where previously there was none. Put simply, had regulatory commissions worked the way Bob LaFollette and Richard T. Ely envisioned, there might be no interest in deregulation and restructuring. But experience uncovered a number of problems LaFollette and Ely did not anticipate.

2. The reverse auction is a useful tool for getting the low-opportunity cost producers to reveal themselves. (One snippet that didn't make it onto radio included an "if any students are listening, this is disclosing your comparative advantages.") But the nature of the contract is important. I came up with the pizza metaphor after reading a statement by the New Jersey Ratepayer Advocate (think of a guardian ad litem for the householder too busy or too put off to read all the filings before the commission.)
The power is to be procured in 180 "slices" of 100 megawatts each. If the auction works as intended, the price for the 100-megawatt slices will drop until there are no longer enough bidders to supply all of the electricity needed.
Doesn't that sound like 30 pizzas? (Better cut it into six slices. I'm not hungry enough to eat eight.) But not all megawatt-years(?) are identical. Some of these slices will be for base-load capacity. The power grid analogue of your basic cheese and sausage pizza is a coal-fired or nuclear steam-turbine station that can spin lots of power onto the grid, relatively cheaply, day in and day out. It's not the kind of thing you can turn on or off quickly, and if you're going to take it off-line for maintenance, you'd best have something ready to replace its power when you do that. These units, however, are not so helpful on those hot days when all the air conditioners are running constantly, or on those cold days when all the baseboard heating units turn on at the same time. Something a bit more expensive to run but easier to turn on or off to meet that peak-load is in order here. Put a slice of pineapple and an anchovy on half of one slice on a six-slice cheese and sausage pizza.

The idea of procuring most of the power supply in advance is to avoid the situation California's system operator ran into a few years ago, when forecast load was for a lot of baseboard units to kick in, and a few owners of generating capacity easily turned on recognized that they could extract a lot of rent from a system operator desperate that the system not fail from an overload. The New Jersey system, on the other hand, appears to commingle the base-load and the peak-load procurement in one price per slice. One of my observations that didn't make the final cut was that such pricing might benefit Exelon with payments as-if the company is being paid to make some slices of pineapple-anchovy-sausage-and cheese when it is making only cheese and sausage. Exelon's private information about northern Illinois load patterns did make the cut.

3. Despite those potential difficulties, the reverse-auction approach has some promise. It spares Edison's load managers the exposure to hold-up that Californians faced, an exposure that would have been present even without the abuse of the system committed by some power traders at Enron. It introduces competitive bidding for long-term contracts, something a bit more flexible than the Demsetz auction of the right to operate the vertically integrated monopoly. The compromise the commission, the power companies, and the intervenors have yet to work out is one of specifying the auctions in such a way that providers of base-load power face different incentives from providers of reserve power, such that base-load providers do not receive a blended price in excess of their opportunity costs, and reserve providers are not discouraged from participating because that blended price is below their opportunity costs.

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