Avoiding Overpriced Risk Management: Exploring the Cyber Auction Alternative

Should an LDC procure electricity hedge products by using an Internet-based auction?

We propose that local distribution companies (LDCs) should use an Internet-based auction to procure inactively traded products, because the auction is a superior alternative to common procurement methods, such as bilateral negotiation and request for offers (RFO). Supporting our proposal is the empirical evidence from two auctions recently held by a municipal utility in Florida. The auction results show that an Internet-based auction can yield competitive price offers from prospective sellers, achieve cost savings when compared to an LDC's benchmark for price reasonableness, reduce the time required for transaction consummation, and provide documentation that can withstand close scrutiny by an LDC's management and regulators.

As part of their regulatory mandate, LDCs are required to supply electricity, upon demand, to their customers. An LDC has three basic options for acquiring that electricity: (1) generation through its own plants; (2) spot-market purchases; and (3) fixed-price forward contracts and call options. The LDC can satisfy some of its anticipated future requirements through forward contracts and call options to help it better manage the electricity procurement-cost risk that stems from spot-price volatility. By buying forwards and options, an LDC may be able to avoid the potentially disastrous financial consequences of over-reliance on volatile spot markets, which were so dramatically evidenced by the April 2001 bankruptcy of Pacific Gas and Electric Co.