Auctions are an interesting and potentially effective form of procuring electricity. If successfully designed and implemented, they may lead to far superior results than other selection methods since they increase transparency and foster competitiveness.
Bidders don’t raise their paddles in an electricity auction, and there’s no fast-talking man at a podium urging folks to act fast on a great deal. But the auction of electricity contracts is still an exciting event for many countries, especially for those just starting to introduce competition in the market. For governments that already use competitive procurement methods, these auctions can further enhance competition and ultimately reduce energy costs to the end-user.
Auctions can be used in countries with a wide range of sophistication in institutional and regulatory frameworks; in many cases, the benefits have offset the overall implementation costs. Auctions have also been used to procure energy contracts across a wide range of technologies, such as wind, biomass, solar photovoltaic or concentrated solar power, or even site-specific hydropower plants.
Although every case is different, successful auctions have similar results. Typically, they are able to:
- increase the transparency and competitive-ness of the procurement process, resulting in economically efficient outcomes that are difficult to challenge; and
- establish an objective, market-driven criterion for the thorny regulatory issue of pass-through of generation costs to a utility-franchised market.
Latin America is leading the introduction of auctions to promote competition in energy procurement and contract new capacity. Overall, about 30 energy auctions have been conducted in Brazil, Chile, Colombia, Panama, and Peru. Results have been satisfactory more often than not, in terms of attracting a large number of private players and ensuring lower costs for consumers.
From theory to practice
Moving from auction theory to real-life implementation is, however, not an easy task. Evidence from electricity auctions over the last few years makes it clear that to ensure success energy auctions must be built for purpose—taking into account the challenges and objectives of the host country. When this is not the case, there can be drawbacks.
Under an auction-based system, for example, an incentive is created for bidders to bid as low as possible in order to increase their chances of securing a contract. Recent experience from jurisdictions such as China and Brazil suggests that underbidding is widespread, and contract failure rates remain high, leading to slower growth. This requires the establishment of strict criteria for participation and severe penalties for non-compliance. Large countries like Brazil and South Africa have the resources and skills to design effective auction mechanisms, and smaller countries need support in designing equally effective auctions. Benefits far outweigh the initial set-up costs.
On a different level, auctions significantly increase the overall risk of renewable energy investments, as there is a relatively low likel-ihood that any individual project will receive a contract. Bidders must therefore put up significant sums in order to mount a bid at all, adding layers of transaction costs with little assurance that this risk will be rewarded with an actual contract to build.
Auctions for renewable power can work to expand the energy portfolio and push costs down.
This risk must then be reflected in the cost of capital, as both debt and equity providers will rightly identify increased contract and completion risks, and demand higher returns. These higher returns may well wipe out any gains derived from greater price efficiency.
If there is confidence that auctions are there to stay, as opposed to being a once-in-a-lifetime event, manufacturers may invest with confidence, even knowing that auctions may reduce margins for them. Manufacturers report that at least they know that there will be a sustainable market for them to sell their products.
Not bidding adieu
Despite these challenges, there is a great deal of potential for furthering the use of auctions in the power sector, even in small, unsophisticated markets. For example, they can be used as a mechanism to grant the use of water rights, thereby enabling the development of new hydropower sites. They can also be used to select preferred projects or to allocate long-term energy contracts competitively in multi-country power pools.
Multi-product, discriminatory price auctions are also potentially applicable to select small, modular units of emergency power generation. Two-sided auctions may entertain demand response, increasing competitiveness, reducing market power, and paving the way for a more energy-efficient economy.
As these examples show, auctions can be an efficient alternative to developing non-conventional sources of energy in emerging markets, as a substitute for or complement to the traditional feed-in tariff schemes. Despite the significant initial costs to set up functioning auctions, auctions for renewable power can expand the energy portfolio and push costs down.
This article was adapted from “Electricity Auctions: An Overview of Efficient Practices,” World Bank, 2011. Updated examples of electricity auctions have been included.