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New auction rules will govern the way California consumers buy power from newly-deregulated utility companies
Stanford Business School —Economist Robert Wilson has a knack for turning abstract theory into practical solutions. When California takes the bold step of deregulating its electric power industry in January, it will be Wilson's carefully crafted auction rules that will govern the way consumers get their power.
What is widely referred to as deregulation—an industry restructuring with light-handed state and federal oversight—will force California's largest utilities to sell their power plants, much as AT&T had to spin off the Baby Bells more than a decade ago. Fam iliar firms like Pacific Gas & Electric will continue to operate, but they will function more as distributors than as generators of power. Other distributors and generators are expected to join the fray, creating a lively, competitive market for power. "There will be an entirely new regime in which power is traded in an open market," says Wilson, the Atholl McBean Professor of Economics at the Stanford Graduate School of Business.
Yes, that will mean annoying dinnertime phone calls from telemarketers trying to get consumers to switch to a new power plan or distributor. But the expected result, once the new system is fully under way in about five years, will be cheaper electricity for consumers, who can choose when and where to buy their power. Such freedoms will let consumers run the air conditioner or washing machine at cheaper, off-peak hours of power usage.
What is driving these changes? It's the high price of electricity, says Wilson. The average price of power is 11 cents a kilowatt hour, but the wholesale price is 2 cents. Up to 6 cents of the difference pays off debt incurred in the 1970s to construct now-obsolete generators. Selling off these plants and paying off the debt will result in lower prices. "Five years from now, the retail price of power is going to be about half of what it is now," explains Wilson.
Wilson's auction rules will manage the trading of power through the Power Exchange, a computerized commodities market where producers will sell their power. Distributors will bid hourly each day to purchase power that they will package into retail purchase plans for consumers. Big industrial customers will be able to buy power directly from suppliers.
Wilson began working on the California power auction a year ago as an advisor to the California Trust for Power Industry Restructuring, which was set up by the state to implement deregulation. The trust's objective was to devise a system that would promote active trading in the market and ensure that the lowest-cost producers prevail. Prices need to be arrived at quickly during the auction and have to be based on real costs rather than on strategic bidding aimed at grabbing market share.
Whether deregulation of this $20 billion industry works hinges to a large degree on Wilson's plan, which contains two key rules. First, power sellers cannot increase offer prices during the auction. Second, and most important, a seller loses the chance to cut its price if it does not beat a market price lower than its previous bid. The idea is to drive prices down as far as costs will allow. Bidders can't swoop in at the end with a lowball bid. Experiments have shown that these rules will force prices to move down in an orderly fashion to a level that represents real costs.
Wilson is no stranger to auction theory. Working with Stanford economist Paul Milgrom, Wilson developed rules for the FCC's auction of spectrum rights for wireless communications in 1995. The auctions raised $23 billion for the U.S. Treasury. In the 1970s, he helped the Interior Department develop auctions for offshore oil leasing, and he has designed other auctions for petrochemicals, telecommunications services, and power plants.
Wilson's auction system rests on complex aspects of game theory, but the fundamental concepts are simple and came to him while he lay in bed one morning. "This was a problem where formulas wouldn't help," says Wilson. "I had to meditate on it." After he developed the auction plan, simulations conducted by Charles Plott of the California Institute of Technology tested it and proved it could work. Thanks to Wilson's ability to apply highly technical knowledge to a real life-problem, consumers should eventually enjoy lower utility bills. — by Barbara Buell
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