Game theory strategies minimized procurement costs in highly successful New Jersey auction for default energy services

New York, NY, July 11, 2002 — In February, New Jersey completed a successful market process to replace government agency allocation since electricity restructuring began in the U.S.

The Feb. 13 auction was the first ever application of the Simultaneous Descending Clock Auction (SDCA) for the procurement of power. While this was not the first auction for “default service” or “provider of last resort” obligations it was the first time that advanced principles of economic auction theory were successfully applied in the U.S. electricity sector, and is arguably one of the most successful applications of auction theory in any regulated industry.

This auction provided for the basis for the successful transition of basic generation services from a regulated environment to a market-based environment that recently delivers services at a competitive price, while at the same time assuring that New Jersey customers experience no rate “shocks.”

“Default service” is the energy supply service provided to those customers who are not being served by competitive “third-party” suppliers, and therefore must typically be provided (at least initially) by Electric Distribution Companies (EDCs) at rates that are both regulated and fixed for some period of time by the regulator.

Implementing a default service auction is an elaborate process that requires careful choreography. Utilities in other states, most notably California, have tried to organize similar efforts, but with less success.

Fulfilling default service obligations is among the most difficult problems faced in regulatory economics. “The ‘triple-threat’ of rate-caps, the ability of customers to switch back and forth, and extreme volatility in wholesale markets and prices, makes this problem a potential ‘lose-lose’ proposition for the EDC and creates the potential for conflict with the regulators as they strive to ensure ‘reasonable’ prices,” remarks Dr. David Salant, NERA Senior Vice President and New Jersey BGS auction designer.

The BGS auction began February 4 and ended February 13 of 2002. In that auction, the four New Jersey electric distribution companies (EDCs), Conectiv, GPU Energy, PSE&G and Rockland Electric secured one-year forward contracts for approximately 17,000 MW of forecast peak load at what are widely regarded as competitive and reasonable prices.

More than 20 bidders competed vigorously for the opportunity to serve the New Jersey BGS load. There were 15 winners. The total value of the auction exceeds $4 billion.

The challenge facing regulatory authorities is that they want to encourage competitive markets while at the same time there is a perceived need to protect customers from the price volatility that is typical in such markets. Improved markets and other opportunities for trading, such as the BGS auction, are integral parts of the solution as such markets allow all parties to observe market prices directly and result in more efficient allocations.

Dr. David Salant and Dr. Colin Loxley, Director of Resource Planning at PSE&G, have co-authored a paper in which they explain how the use of economic theory in designing the auction supported the Electric Discount and Energy Competition Act (EDECA) and the New Jersey Board of Public Utilities (BPU) mandate to use a competitive bidding process to meet their default or basic generation service commitments.

A copy of the paper in its entirety can be found on the NERA web site, www.nera.com.

Founded in 1961, NERA is a firm of consulting economists who understand how markets work. Our clients include corporations, governments, law firms, regulatory agencies, trade associations and international agencies. Our global team of 450 professionals operates in 16 offices across North and South America, Europe, Asia and Australia.

NERA is a Marsh & McLennan company. MMC (www.mmc.com) is a global professional services firm with annual revenues of $10 billion and approximately 58,000 employees providing analysis, advice and transactional capabilities to clients in over 100 countries.

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