An Alternative to Uniform Pricing?

Policymakers in some countries have considered the “pay-as-bid” system as an alternative to uniform pricing (which, as described above, is the system used in the New Zealand wholesale market).[13] As part of the broader “New Electricity Trading Arrangements”, regulators in England and Wales implemented a pay-as-bid pricing scheme to replace uniform pricing in 2001. Under a pay-as-bid pricing system, the bids are ranked, as in uniform pricing. However, unlike uniform pricing, the dispatched generators (i.e., those called on to produce because of their relatively low bids) are not paid the market price; as the pay-as-bid name suggests, the market operator only pays each generator the actual amount bid.

Some proponents of pay-as-bid contend, inaccurately, that it is a way to reduce electricity market prices. They say that the bids in Figure 1 need not be rewarded with the market price; if the bids were rewarded just “as bid” then consumers, on average, would pay less (relative to uniform pricing). On the surface, this argument has intuitive appeal. However, it fails to recognize a crucial point: moving from uniform pricing to pay-as-bid changes the way that generators bid. Under uniform pricing, as described above, each generator has incentive to bid its true marginal cost. Under pay-as-bid, each generator has incentive to bid its guess of the marginal producer’s cost (i.e., the market price that uniform pricing would produce). Take the example of a generator that knows it has fairly low costs, but doesn’t know the exact costs of other generators. If it bids its own marginal cost (say $30), then it is sure to be dispatched and earn $30. If it bids a bit higher, it will again probably be dispatched and earn a bit more. The firm would like to raise its bid all the way up to the level of the marginal bid, but must make an estimate of what this level will be. So each firm wants to do its best to figure out the costs of other firms and bid the marginal industry cost. This predicted change in bidding behaviour appears to be just what happened in England and Wales after pay-as-bid was introduced (2001).[14]

In general, a pay-as-bid system will tend to arrive at the same market price and dispatch schedule as uniform pricing. The low cost firms will still generally earn the same scarcity rents and economic profits and the market price will still tend to be the industry marginal cost of production. The big difference is that pay-as-bid requires each firm to invest a lot of effort guessing other firms’ costs. Inevitably firms will make errors and bid a guess of the industry marginal cost that is too high or too low. Some economists point out that, although these errors cancel out over time, their existence still means that there will be inefficiencies: sometimes high-cost units will be dispatched when a lower-cost unit is accidentally bid too high (Kahn 2001). Other economists have put forward sophisticated theoretical analyses that suggest pay-as-bid may have some desirable properties that mitigate market power under some assumptions about market conditions. However, after a careful review of the theoretical arguments, Fabra et al (2002) conclude that there is little reason to prefer pay-as-bid to uniform pricing.

In sum, pay-as-bid tends to arrive at broadly the same result as uniform pricing (in terms of market price, output level, economic profits and scarcity rents), but in a messier and arguably less efficient fashion. There is no clear argument in favour of switching the New Zealand wholesale market to a pay-as-bid scheme.