Econ 1101/1165—Reading 1

Auction Markets for Electricity in the United Kingdom

By Thomas J. Holmes, Dept. of Economics, University of Minnesota

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There are a variety of important markets throughout the world where exchange takes place through auctions. (E.g., government bonds, internet advertising, used cars, etc.) A discussion of how auctions work is a good way to start an economics class because the basic mechanism through which price is arrived at is relatively easy to understand. This reading discusses how a particular auction works.

The market is wholesale electricity in the United Kingdom. Before 1990, electric power in the UK was provided by a single firm that both produced and distributed power to consumers. (In economics, we say that such a firm is vertically-integrated, because the firm is at the beginning and the end of the production process.) The firm was a government monopoly, analogous to the way the Postal Service is a government monopoly here. In 1990, the industry was restructured to introduce competition into the market. The industry was privatized and firms began competing to sell electricity. There typically remained only a single power cable going into any particular building. But that cable would be connected to a power grid. The electricity flowing into the building could come from potentially numerous suppliers connected to the grid. With all these various firms connected to the grid, there needs to be some way of coordinating things so that the right amount of electricity is put into the grid, to ensure the lights go one when someone flips a switch. Since 1990, the UK has used auctions to coordinate production and to determine the wholesale price.

To explain how the auction works, we need to give a little background about the electricity market. The demand for electricity varies substantially throughout the day. The first figure below plots the total quantity of electricity demanded in the UK over the course of the day of Sept. 3, 2014. (This data is available on the web and the sources and details about the data are discussed below.) The horizontal axis is the hour of the day (according to a 24 hour clock). Notice that demand is lowest in the early morning when the lights are out and people tend to be sleeping. On this particular day demand was 25,000 MWh in the early morning hours. Then, after 5:00 a.m., demand began going up until it leveled off at approximately 37,000 MWh just after 8:00 a.m. Later in the evening (at 20:00 or 8:00 p.m.) demand began to head back down again.

Electricity Demand in Great Britain on Sept 3, 2014

(MegaWatt Hours by Time of Day)

Source: Initial Demand Out-Turn for 2014-09-03 as reported by www.bmreports.com

In the UK electricity market, each half-hour period in a day is considered a separate market with its own auction. Bidders submit a quantity that they are willing to sell or buy, as well as the price for which they are willing to engage in the transaction. Bid information is gathered together and a system price is determined for the particular half-hour period. The figure below reports price by time of day on September 3, 2014. (This is called the “reference price” and is reported by APX Power.) Notice that price was low in the early morning hours, at around £35 per MWh, and began to go up after 5:00 a.m. just as demand was increasing. Price hit a peak of £60 per MWh at both 17:00 and 20:00 (5:00 p.m. and 8:00 p.m.) before falling back below £40 by the end of the day. The price peaks at 17:00 and 20:00 matched the demand peaks at exactly the points in the day. But notice that price changed a lot more than demand was changing! This high degree of price volatility is common in wholesale electricity markets.

Reference Price of Electricity in Great Britain on Sept. 3, 2014

(British Pounds per MegaWatts Hour, by Time of Day)

Source: APX Power Reference Price for UK on 2014-09-03 as reported by www.bmreports.com

We will illustrate how wholesale electricity markets work in a simple example. It is common in these markets for there to be an entity in charge of the auction called the Independent System Operator, who takes the bids and determines the price that will clear the market. In our hypothetical example, let’s assume demand at 10:00 is projected to be 40.5 megawatts. Suppose the independent system operator receives the following bids to sell electricity.

Table 1

Example Bids Submitted for 10:00 (unsorted)

Bidder Name	Sell Price (£ per MHh)	Quantity Offered (MHh)
Power Gen	24.00	15
Smelly Coal Plant, Inc	28.18	10
Ye Old Time Electric	40.00	10
Big Nukes, Inc	10.00	20

The job of the independent system operator is to process the bid information to determine (1) which suppliers will produce and how much each produces and (2) the system price will be that each supplier will be paid. The first step in the process is to sort the bids from lowest to highest. Lower bidders are always in before higher bidders. The next step is to add up the cumulative quantity supplied as we go from the lowest to the highest bidders. The trick is to go down the supply list until there is enough supply to meet the demand (here 40.5 MWh). The system price is set to be the bid offered by the last bidder in. All suppliers with lower bids get paid the system price.

Let’s pretend we are the independent system operator. To process the bid information, it useful to set up a worksheet like this that sorts the bids from lowest to highest:

Table 2

Independent System Operator Worksheet

Bidder Name	Sell Price (£ per MHh)	Quantity Offered (MHh)	Cumulative Quantity Offered	Market Demand	Auction Result (amount sold)
Big Nukes, Inc	10.00	20	20	40.5	20
Power Gen	24.00	15	35	40.5	15
Smelly Coal Plant, Inc	28.18	10	45	40.5	5.5
Ye Old Time Electric	40.00	10	55	40.5	0

In order to get a cumulative quantity supplied big enough to meet the demand of 40.5, we need to go to the third bidder on the list, Smelly Coal Plant, Inc. (These cells are highlighted in yellow.) The system operator stops here and sets the system price to the £28.18 per MWh bid by Smelly Coal (the cell highlighted in blue). The two lowest bidders sell the entire quantities that they offer and they are paid the system price of £28.18. As the last one in, Smelly Coal sells only part of what it offers, in order to exactly match demand. Ye Old Time Electric doesn’t sell anything. But note that if the weather were hotter that day and more air conditioners were running, electricity demand would have been higher. If the increase in demand were big enough, Ye Old Time Electric would need to be brought in, raising the system price to £40.00. With a high bid like this, Ye Old Time Electric likely has an old inefficient plant. A costly-to-operate plant like this will generally operate only at periods of unusually high demand.

To see what is going on, it is also useful to plot the bids on a graph like below. We start by plotting the prices and cumulative quantities offered by the suppliers, (beginning with the lowest to the highest bidders). This is in blue in the figure below. The demand of 40.5 is in red. The intersection point determines the system price.

An auction like the one just described takes place for each of the half hour period of the day. Suppliers submit their bids on a daily basis. In the early morning when demand is low, the only suppliers that operate are the ones setting low bids like the bid of Big Nukes, Inc, and the system price is low. Later in the day when demand is high, the system price is high.

Other places around the world have followed the United Kingdom’s lead in deregulating wholesale electricity markets. For example, California has a wholesale electricity auction market that shares some of the features of the British market.