How electricity auctions are rigged to favor industry

The latest major electricity auction demonstrates yet again how the industry, with help from Wall Street financial engineers, is gaming power markets, forcing customers to pay higher prices. You would not know that, however, from most news reports mentioning the auction.

Absent disclosures by the secretive markets, investigation and reform, you should expect your monthly electricity bill to rise sharply in the next few years as electricity industry investors reap outsize profits.

The auction last week was not for electricity itself, but for promises to maintain the capacity to generate power in future years. The so-called capacity auction was conducted by PJM, the electricity market in 11 states serving 61 million people from New Jersey to Illinois.

Exelon informed investors that two Illinois nuclear plants and one New Jersey plant filed losing bids. The bids for these plants were higher than bids filed by other power plants owned by Exelon and other companies to provide the amount of generating capacity that PJM says will be needed for the 12 months beginning June 1, 2017.

PJM is a secretive market that does not disclose bid details even after an auction. But a list of all Exelon plants in the PJM area indicates that the losing bids affected just 17 percent of its generating capacity.

The capacity market is a so-called single-price or clearing-price auction. The highest bid needed to ensure capacity wins, with all those who bid less also getting the highest price. Those who bid above that price, like the two Exelon nuclear plants, get nothing.

Exelon alerted stock traders to these losing bids. When the markets opened on Tuesday, its share price jumped up, closing at 3.6 percent higher than on the previous trading day.

Why would losing bids make the stock price go up?

Strange as it may seem, Exelon stands to make a lot more money because it made losing bids for about one-sixth of its generating capacity. The reason is that it will collect much bigger revenues on the 83 percent of its plants that filed winning bids. Therein lies one of the many problems with the electricity market rules.

Exelon will get almost exactly double the capacity market payments than if it had placed winning bids for its entire fleet of generating plants, utility rate consultant Paul Chernick estimates.

While electricity markets are incredibly complex and technical, the math here is simple. Keep in mind that complexity in markets, as in government rules, tends to benefit connivers, as I teach my students at Syracuse University College of Law.

PJM’s market is further complicated by its signaling to energy producers how much extra profit they can earn by strategically withholding capacity through high bids. PJM does this by drafting what economists call a demand curve, not from actual market prices but from its own estimates. The effect is to help owners of multiple power plants strategically bid to maximize their revenues, which results in higher costs for customers.

The current PJM base capacity price is $59 per unit of electricity per day. The new PJM auction doubles the price, to $120.

Had Exelon not priced its two Illinois plants out of the market, Chernick estimated, the price would have fallen to $50. Those two plants provide less than 3 percent of total capacity PJM says it needs, illustrating how even tiny differences in capacity can have a huge impact on prices.

The math is simple: collecting $120 for 83 percent of your fleet of electric power plants produces 99 percent more revenue than getting $50 for 100 percent of the fleet.  

That extra revenue, by the way, is almost pure profit.

The capacity markets operate independently of spot markets — the markets to meet immediate demand, for the next few minutes or hours. This means that power plant owners can collect millions of dollars just for maintaining a plant’s capacity in case it is needed. Then, if power is needed, the owners can in addition collect the often huge sums charged in the spot market. 

To understand capacity markets, imagine you own a hotel. Now imagine the government paid you a fee to keep some rooms empty just in case traveling government officials needed those rooms.

Say you charge on average $100 a night for rooms and in the hotel capacity market you can collect $50 a day to hold these rooms in reserve. The fee to hold these rooms ready comes to $18,250 for the year, but had you sold the rooms every night of the year you would have collected twice as much money.

Here is the best part of the capacity market concept: When those rooms are actually needed, you get to charge whatever price the spot market sets. Since the times those rooms are needed are likely to be peak demand times — say, when a big convention is in town — the actual price the government will pay you to use the room might be $3,000.

Collect that $3,000 for just seven nights and your total revenue will be greater than if you took the risk that you could sell the rooms every night at your average rate.

So even if the rooms remained empty almost all of the time, the huge markups for the peak demand nights when they were used could mean much higher profits than you’d make if you did not get paid to hold any rooms in reserve. 

Allegations of price manipulation continue to plague the electricity markets, which each employ market monitors to look for manipulations. But the markets put these monitors on tight leashes and in some cases impose restrictions that amount to blinders so no one officially notices what is going on.

Strange is the market that by design favors higher prices rather than lower ones. After all, competitive markets are supposed to result in pressure to lower prices. But the electricity markets, whose original rules were drafted by Enron, are designed to generate higher prices.  

Financial engineers are already at work reducing electricity supply in New England, as I reported in my column earlier this month. Energy Capital Partners, a firm with close ties to Goldman Sachs, moved to close the second largest power plant in New England just five weeks after buying it for several hundred million dollars because the plant was worth much more shut down than generating power. In electricity markets, this is known as “economic withholding.”  

The owner of a single power plant cannot play such games and drive up prices artificially. But owners of fleets of power plants can. And by learning from bids placed by others, they can drive up prices near the level that an unregulated monopolist can charge, experiments at Carnegie Mellon University and others have shown. I explain this in detail in my 2007 book “Free Lunch.” Actual pricing records also document this.

The market monitors are supposed to spot such misconduct and block it. But as Professor Darren Bush, who teaches the laws of competition at the University of Houston law school, has noted, the restrictions placed on them mean that “many types of market power exercises are undetectable.”

What’s worse, the punishments for exercising market power are so weak that they encourage misconduct. Bush asks his law students the following question to focus their minds on the role of enforcement and punishment in promoting honesty: “If the only penalty for stealing your laptop was having to give it back, how many laptops do you think would be stolen?”

That is what we are seeing in the electricity markets — rules that incentivize bad behavior.

In this case, journalists bought the fantasy story that Exelon would suffer because it filed losing bids for its Byron and Quad Cities nuclear power plants, thus obscuring yet another scheme to drive up electricity prices. The reality is that Exelon gained by its losing bids, which in turn explains why the stock market instantly pushed up Exelon’s stock price on Tuesday.