Pay-as-Clear vs. Pay-as-Bid in Power Trading

Definition

Pay-as-Clear

Pay-as-Clear is a pricing mechanism commonly used for auctions of homogeneous goods, such as commodities, shares (e.g., emissions), or electricity. In this process, a uniform price applies to all buyers and sellers at the conclusion of the auction, regardless of the bids they initially submitted or accepted. This is why it's also referred to as uniform pricing.

The price is determined by accepting bids until supply and demand are identical, i.e. the market is cleared. In practice, bids are usually accepted until a set quantity of the good has been auctioned off. In sales auctions, the highest price accepted then applies; while in purchase or procurement auctions, the lowest price awarded applies.

Even if the quantity of electricity to be auctioned in wholesale trading is not fixed in advance, electricity auctions—such as those on the European Power Exchange (EPEX)— effectively function like sales auctions. Firstly, the bids are awarded in ascending order. Secondly, even if there are a few large consumers who base their consumption partly on the price of electricity, all other consumers consume or buy as much electricity as they need - regardless of how much it costs. Thus, demand behaves as if it were perfectly elastic, effectively acting like a predetermined quantity.

Pay-as-Bid

In Pay-as-Bid auctions, each buyer and seller is paid the price they specified in their successful bid. This means that prices below the highest bid are possible at sales auctions - at least in theory - and prices above the lowest bid at purchase or procurement auctions. You can find out why things often turn out differently below.

Controversies surrounding Auction modes on the German electricity market

In the course of the natural gas crisis in connection with the war in Ukraine, numerous politicians spoke out in favour of switching from pay-as-clear auctions on German and other European electricity markets to pay-as-bid auctions. Their theory was that this would lower average wholesale prices for electricity and therefore also consumer prices.

Advantages and Disadvantages of Pay-as-Clear Auctions

High market transparency, low transaction costs

The Pay-as-Clear process ensures high market transparency and low transaction costs for all trading partners. Sellers have no incentive to bid above their reserve price, as the only outcome would be exiting the auction without selling anything. Therefore, their bids will be close to their own marginal costs. The same applies to the buyers, who have no advantage in specifying a lower willingness to pay than their actual limit, as this will not push the price down. After all, suppliers offer the electricity at their marginal costs and would not produce at a lower price. This creates fully transparent price signals for both sides.

At the same time, Pay-as-Clear incentivises producers to invest in efficiency in order to be able to sell electricity as often as possible and at the highest margins.

More Volatile Electricity Prices as a Price Signal to Consumers?

The high volatility of wholesale electricity prices is sometimes cited as an argument against Pay-as-Clear auctions. In fact, day-ahead prices can multiply from one hour to the next if a power plant with higher marginal costs is required to cover demand. This was particularly evident during the gas crisis in 2022. However, prices on continuous intraday markets, which also use pay-as-bid pricing, tend to be even more volatile.

That said, volatility can incentivize consumers to increase electricity consumption when cheap electricity is available, as no expensive raw materials are needed to meet demand. This requires passing the volatility on to consumers. From 2025, large consumers in Germany will be required to have dynamic tariffs linking consumer prices to the electricity exchange price. The smart meters required for this are to be the general standard by 2032.

Lack of regional incentives

In Germany, uniform pricing is sometimes viewed as regionally unfair, as the low production costs of wind power in northern Germany often benefit industrial companies in the south. Meanwhile, the combination of high electricity consumption and low wind and solar capacity in southern Germany often leads to higher electricity prices, which then also apply to northern Germany. As a result, calls for a division of the country into several electricity price zones have become louder in recent years.

The high excess profits made by the already subsidised operators of wind and solar parks during the gas price crisis have also aroused the displeasure of electricity customers and politicians.

Advantages and disadvantages of Pay-as-Bid auctions

Lower Average Prices Possible in the Short Term

In Pay-as-Bid auctions, generators with low marginal costs could theoretically be paid lower prices. The (false) idea is that this would reduce costs, as each power plant would only be remunerated according to its own marginal costs and not according to the marginal costs of the last (marginal) power plant on the market. In theory, this could lower the average exchange electricity price and thus the consumer price.

Greater Cannibalisation of Renewables

Wind and solar parks, whose primary energy sources are free, have the lowest marginal costs, close to zero. However, if operators sell this electricity at marginal cost, they would not generate enough revenue to cover other operating costs (e.g., personnel) or their investment costs (setting up the power plant). This would contribute to the cannibalisation effect of renewables, reduce the attractiveness of further investments in these generation technologies and consequently drastically increase their need for subsidies.

Low Market Transparency, High Transaction Costs

In Pay-as-Bid auctions, electricity buyers benefit from knowing how much they can negotiate prices down. For producers, it is important to find out how high they can drive their prices before a competitor wins the bid. This creates an incentive to conceal cost structures and bidding strategies, reducing the already low market transparency. Market participants in Pay-as-Bid auctions often attempt to guess the clearing price to maximize margins. Since such guesswork is rarely accurate, inefficiencies are almost inevitable.

From a business point of view, it would still make sense to invest capital and labour in the procurement of information on the one hand and its concealment on the other, even though this significantly increases one's own transaction costs.

Higher Electricity Prices in the Long Term Due to Misallocation?

From an economic point of view, this behaviour would mean a misallocation. On the one hand, because guessing the market-clearing price can be missed. Secondly, because the increased transaction costs tie up resources that could have been made available for innovation or efficiency improvements.

In the medium to long term, electricity prices could even be higher if they were determined by Pay-as-Bid auctions.

Do Pay-as-Clear and Pay-as-Bid Lead to the Same Price?

Whether electricity prices are actually lower in Pay-as-Bid auctions than in Pay-as-Clear auctions is a controversial issue. According to the German Association of Energy and Water Industries (BDEW), "Theoretically, Pay-as-Bid and Pay-as-Clear auctions should lead to similar results." Economist Lion Hirth from the Hertie School also reaches the same conclusion.

The reason for this is marginal pricing. This market-based mechanism means that the market price is automatically based on the highest successful bid - whether it is determined in a Pay-as-Clear auction or not. This is demonstrated, for instance, by the almost standardised global commodity prices for crude oil, gold, wheat and lithium.

Example of a Market with Pay-as-Bid Auctions

Starting point

The inhabitants of a small island without a mainland connection obtain their electricity from Mrs. Miner, who operates a modern gas turbine with a capacity of 1 MW. If more electricity is needed, Mr. Pitman fires up his old diesel generator. Ms. Miner's marginal costs are 9 thalers, but she knows that Mr. Pitman has to take 11 thalers for his electricity to generate one kilowatt hour (MWh) without loss, so she charges 10 thalers.

As the island becomes increasingly popular with tourists, Mr. Farmer realizes that the two power plants will no longer be enough to supply the residents and tourists. Therefore, he erects a 2.4 MW wind turbine on his property. Mr. Farmer is not a profit-oriented person. He only charges the islanders 2 thalers per MWh. This is just enough to cover the maintenance costs and pay off the loan he took out for the investment over the 25-year term.

The long term

Ms. Merchant observes all of this with great interest and inquires about the cost of a wind turbine. She calculates that Mr. Farmer earns so much at weekends that he will have paid off his wind turbine in about eight years.

Resourceful woman that she is, she decides to erect a wind turbine herself and take Mr. Farmer's profits. She realizes that there will be more days when the island will rely solely on wind power. However, she has secured a very favorable loan, giving her marginal costs of only 1 thaler. As a result, she will sell her electricity before Mr. Farmer and almost always at 2 thalers, since her turbine is too small to meet the island's total consumption.

The customers are happy because their electricity price is more often only 2 thalers. Ms. Miner can also live with it because she can now charge 11 thalers per kWh. Mr. Pitman is pleased that he no longer has to start up his old, smelly generator, and would only do so if Ms. Miner tried to charge more than 11 thalers. Even Mr. Farmer is satisfied, as he calculates that, with the high weekend earnings, both wind turbines will be profitable after about 20 years.

Overview: Pros and Cons of Pay-as-Clear and Pay-as-Bid