Models of supply functions competition with application to the network auctions

The role of different types of auction mechanisms in reducing electricity prices

Russia’s electricity system – a vast state monopoly – is undergoing dramatic changes involving privatisation of generating companies and creating an efficient mechanism of interaction between sellers and buyers of electricity.

The paper analyses the plan of electricity industry reform currently under discussion in Russia. A key feature of this plan involves the creation of independent generating companies and development of a competitive market. There are two main reasons for the impending reform. First, the traditional pricing method (costs of production plus profit) did not stimulate cost reduction and production efficiency. Second, the industry needs huge investments for restoration and modernisation of its production capacity and infrastructure.

The authors focus on the way in which electricity prices will be determined in the newly established market. Their study employs a game-theoretical methodology to assess the pros and cons of different auction mechanisms. They suggest that the method of "first-price auction" that is being proposed at the moment, may provide large generating companies with an opportunity to execute their market power. Due to imperfect competition, prices established in an auction that uses this method may substantially exceed a competitive equilibrium price.

Nowadays, with state monopoly in place, prices grow only moderately because the share of the deregulated market is rather small, and the price there is limited by prices in the regulated market. However, the authors expect that electricity prices will significantly increase with the adoption of the new system.

The paper suggests two ways of preventing a hike in electricity prices: maintaining government regulation, or employing an alternative market mechanism. The authors consider the first option to be ineffective in the long run and, instead, focus their analysis on the second proposal.

The paper recommends "Vickrey auction mechanism with reserve prices" as an alternative solution. Its main advantage is maximisation of the total welfare of all market participants (sellers and buyers) under assumptions of individually rational behaviour.

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Models of supply functions competition with application to the network auctions