Efficiency in Deregulated Electricity Markets: Offer Cost Minimization vs. Payment Cost Minimization Auction

A payment cost minimization (PCM) auction has been proposed to solve the problem of inflated wholesale electricity prices. In the electricity industry, where even small changes in $/MW are worth tens of millions of dollars, it is highly important that policy makers have a good understanding of the tradeoffs and impacts of new institutional rules. In this paper we examine efficiency performance of the proposed PCM auction in contrast with the offer cost minimization (OCM) auction currently used by most independent system operators (ISOs) in the United States. For most of the analysis we concentrate on production efficiency, which is attained when a product is supplied to the market by the suppliers that have the smallest average total cost (ATC). An electricity market is efficient if there is no generator that could produce electricity cheaper than the chosen generators do. Production efficiency is desired because 1) it guarantees that market output is produced using the least-cost combination of inputs, thus resources are not wasted, 2) it also rewards the low-cost suppliers and provides the incentives to search for production techniques with even lower costs. [excerpt] Required Publisher's Statement Original version of the book is available from the publisher at: http://www.atiner.gr/docs/ 2007Roufagalas_CONT.htm This book chapter is available at The Cupola: Scholarship at Gettysburg College: http://cupola.gettysburg.edu/econfac/13 E f f i c i e n c y i n P e r e g u l a t e d E l e c t r i c i t y M a r k e t s ? O f f e r C o s t M i n i m i z a t i o n v s . P a y m e n t C o s t M i n i m i z a t i o n A u c t i o n Rimvydas Baltadounis, University of Connecticut, USA A payment cost minimization (PCM) auction has been proposed to solve the problem of inflated wholesale electricity prices. In the electricity industry, where even small changes in $/MW are worth tens of millions of dollars, it is highly important that policy makers have a good understanding of the tradeoffs and impacts of new institutional rules. In this paper we examine efficiency performance of the proposed PCM auction in contrast with the offer cost minimization (OCM) auction currently used by most independent system operators (ISOs) in the United States. For most of the analysis we concentrate on production efficiency, which is attained when a product is supplied to the market by the suppliers that have the smallest average total cost (ATC). An electricity market is efficient if there is no generator that could produce electricity cheaper than the chosen generators do. Production efficiency is desired because 1) it guarantees that market output is produced using the least-cost combination of inputs, thus resources are not wasted, 2) it also rewards the low-cost suppliers and provides the incentives to search for production techniques with even lower costs. Deregulated U.S. wholesale electricity markets (e.g. the day-ahead, hourahead, and real-time markets) operated by ISOs generally adopt an auction mechanism to select generation offers and demand bids for energy and ancillary services. In the day-ahead energy markets, all selected suppliers are paid at a uniform market clearing price (MCP), usually the price of the most expensive selected offer. Currently, most ISOs adopt the OCM auction by using the traditional unit commitment approach. It has been pointed out by Yan and Stem (2002) that this auction does not ensure the lowest procurement costs of electricity to consumers for a given set of offers. This motivated Luh et 1 For a bibliographical survey on the unit commitment problem see Padhy (2004).