Hard Price Caps

Regulators impose a maximum price that buyers (utilities or ISOs) can pay generators. This is a form of monopsony power. Typically generators are not required to sell.

• It is hard to determine the appropriate price cap that provides a balance of cost reduction and incentives for entry. Application must extend to the entire regional market.

• A requirement is effective enforcement to ensure that generators cannot sell elsewhere or for more than the nominal price cap. No "out-of-market" purchases.

 • Enforcement requires involuntary demand curtailment when supplies are tight.

• Operating incentives at the margin provide the wrong signals for supply and demand.

• Experiences in natural gas and oil indicate that price caps soon create many new problems, as enforcement becomes more difficult and more bureaucratic.

• If the price cap is too low, there is no natural transition to a workably competitive market. P Q Demand MC Max Capacity qc pc Mitigating Market Power: Price Caps pc ~ MC Price Cap 19 ELECTRICITY MAR

Pay-as-Bid Auction. A uniform price electricity market pays everyone the market-clearing price. The pay-as-bid auction pays not the market price but the amount bid.

• Under a uniform price auction, the incentive for price taking bidders is to bid the opportunity cost. The resulting price is above most bids.

 • Under the pay-as-bid approach, the incentive for all bidders is to bid the greater of the expected market-clearing price or the opportunity cost.

• Theory predicts and experience demonstrates that the prices paid do not greatly differ on average, but real costs can be higher under the pay-as-bid approach.

• Pay-as bid problems are especially compounded in the case of electricity.

1. Locational differences in opportunity costs and market clearing prices.

 2. Multi-part cost structure with start up, no load and energy costs.

3. Ancillary services for spin, regulation and reactive power.

• Pay-as-bid systems have appeared most prominently in California, and compounded the problems in the Summer 2000. Similar difficulties and bureaucratic responses can be seen in the forthcoming New Electric Trading Arrangements in England and Wales.

Soft Price Caps. A default price cap on all transactions, combined with the possibility of being paid more subject to a regulatory determination that the higher bid was justified by cost considerations. There is no requirement for generators to sell.

 • A default hard price cap with a pay-as-bid auction above the default price level.

• The details of cost justification determine the impact of the "soft' cap. If costs must be demonstrated, it is a return to cost-ofservice regulation without the requirement to sell or the guarantees to generators. If opportunity costs are excluded, it is "bid-as-told." If virtually any bids accepted, it like an expensive "pay-as-bid" auction.

• The California experience was that imposition of a soft price cap raised current and forward electricity prices.

 • Enforcement remains a key issue. Sales outside the region or "out-of-market" can undermine any benefits.

Bid Caps. (e.g., FERC California Order of April 26, 2001) Generators have a forward obligation to offer production at no more than a predetermined bid cap. Actual production compensated at the market-clearing price.

• Distinguishes between monopoly rents and scarcity rents.

• Generator has an obligation to offer at least the designated amount. Bids for additional quantities are unregulated.

 • Provides the right incentives for supply and demand, for entry and operations.

• If high prices caused by withholding, the bid cap will lower market clearing price. If high prices caused by scarcity, bid cap will produce high prices.

 • The information burden is greater than for price caps but less than for cost-ofservice regulation.

• Bid caps are generator specific and compatible with a gradual transition to a workably competitive market.