Electricity Primer - The Basics of Power and Competitive Markets
How Wholesale Electricity Prices Are Set
ISO/RTOs use a uniform (or single) clearing price auction in which electricity generators place bids with an independent market administrator for a particular time period. The independent administrator then dispatches the generators from lowest to highest bids until all power demand is met. Each generator that is dispatched is then paid the same price as what was paid to the last unit of electricity needed to meet total demand.
Uniform price auctions are used for the "spot" (or real-time) markets of all federally approved and independently run regional electricity markets. In practice, the spot market is used to serve only a portion of demand. Like a mutual fund, retail electricity suppliers serve their customers through a diverse portfolio of long-, medium- and short-term contracts, as well as the spot market.
The uniform clearing price auction drives generators to reduce their operating costs so that their bids can be lower and, hence, will be accepted - the generators that set the clearing price, and therefore meet the last increment of demand, earn little or no contribution to their fixed costs. The lower cost generators in turn are able to recover some of their long-term debt and other expenses under this auction design.
Because the last increment of demand set the clearing price, an explicit price signal to conserve electricity is established. For certain customers who can reduce their demand, a price incentive can be transparently seen.
By contrast, under a pay-as-bid auction design, the selection process for which generators will run at a given time is the same as in a uniform clearing price construct with the difference being that each auction winner is paid exactly what it bid - a significant distinction.
In a pay-as-bid auction, generators will roll all their costs into a single bid and attempt to guess what the highest price selected will be, and then bid to match it. Inevitably, some lower cost generators will bid too high - because all generators will be bidding above their operating costs, market transparency is lost and the risk of manipulation is raised.
For these simple reasons, economists - and some critics2 - agree that uniform clearing price auctions generally result in lower prices for consumers than pay-as-bid auctions.3
2 Lester Lave of Carnegie Mellon University and Kenneth Rose of Michigan State University speaking at the American Public Power Association's "Assessing Restructured Electricity Markets" Symposium, Feb. 5, 2007 in Washington, DC.
3 "Pricing in the California Power Exchange Electricity Market: Should California Switch from Uniform Pricing to Pay-as-Bid Pricing?" Peter Cramton, Alfred E. Kahn, Robert H. Porter, and Richard D. Tabors, Blue Ribbon Panel Report, California Power Exchange, January 2001.