The Computer-Based Laboratory From Experiment to Application

Electronic trading (now commonly known as e-commerce) in the experimental
laboratory began at the University of Arizona in 1976 when Arlington Williams
(1980) conducted the initial experiments testing the first electronic “double
auction” trading system that he had programmed on the Plato operating system.
The term “double auction” refers to the oral bid-ask sequential trading system
in use since the 19th century for stock and commodity trading on the organized
exchanges. This system of trading has been used in economics experiments since
mid-century, and is extremely robust in yielding convergence to competitive
equilibrium outcomes (Smith 1962, 1982). Since information on what buyers are
willing to pay and sellers are willing to accept is dispersed and strictly private
in these experiments, the convergence results have been interpreted (Smith,
1982b) as supporting Hayek’s thesis “… that the most significant fact about
this (price) system is the economy of knowledge with which it operates, or how
little the individual participants need to know in order to be able to take
the right action” (Hayek, 1945, pp 526-527).

As with all first efforts at automation, the software developed by Williams
allowed double auction trading experiments that had previously kept manual records
of oral bids, asks and trades to be computerized.¹ That
is, it facilitated real-time public display of participant messages, recording
of data, and greater experimental control of a process defined by pre-existing
tech nology. It did not modify that technology in fundamental ways. This event
unleashed a discovery process commonplace in the history of institutional change:
the joining of a new technology to an incumbent institution causes entirely
new, heretofore unimaginable institutions to be created spontaneously as individuals
are motivated to initiate procedural changes in the light of the new technology.
Electronic exchange makes it possible to vastly reduce transactions cost —
the time and search costs required to match buyers and sellers and to negotiate
trades, including agreements to supply transportation and other support services.
More subtly, it enabled this matching to occur on vastly more complicated message
spaces and allowed optimization and other processing algorithms to be applied
to messages, facilitating efficient trades among agents that had been too costly
to be consummated with older technologies. Moreover, resource allocation problems
thought to require hierarchical command and control forms of coordination, as
in regulated pipeline and electric power networks, became easily susceptible
to self-regulation by entirely new decentralized pricing and property right
regimes. Coordination economies in complex networks could be achieved at low
transactions cost by independent agents, with dispersed information, and integrated
by a computerized market mechanism.

This realization then laid the basis for a new class of experiments in which
the laboratory is used to test-bed proposed new market mechanisms, enabling
a better understanding of how such mechanisms might function in the field, and
to create a demonstration and training tool for potential participants and practitioners
who become part of the “proving” process. Of course, once adopted, this modification
and proving process continues in light of field experience. We provide a short
history of the application of the conception of smart computer-assisted markets
to the design of electricity markets in the United States and abroad.

The Privatization/Deregulation² Movement:

The Arizona Utility Study

In 1984 the Arizona Corporation Commission contracted with the University of Arizona
experi mental economics group to study alternatives to rate-of- return regulation
of the utilities, with particular emphasis on electric power. The study consisted
of two parts: incentive regulation (Cox and Isaac, 1986) and deregulation (Rassenti
and Smith, 1986. Also see Block et al., 1985). Only the second part will be discussed
here, since this was the study that led to a long and continuing research program,
encouraged by the privatization/decentralization movement abroad, and most recently
in the United States.

Recommendations

The deregulation portion of the study led to many detailed recommendations
that can be briefly summarized in the following key points (see Rassenti and
Smith, 1986):

1. The energy (generation) and wires (transmission and distribution) businesses
would be separated, with generator plants (gencos) spun off from parent-integrated
utilities through the issue of separate ownership shares to form independent
companies.

2. An economic dispatch center would be formed that would operate a computerized
spot auction market for determining prices and allocations based upon hourly
location- (node-) specific offer price schedules submitted by gencos. The spot
market would be constituted so as to facilitate and incentivize the eventual
inclusion of demand-side bidding by discos (distribution companies and any other
commercial and industrial bulk or wholesale buyers). Thus, ultimately and ideally,
prices would be determined in an hourly two-sided auction in which discos would
submit location-specific bids to buy energy delivered to their location just
as gencos would submit offers to inject energy at their respective locations
on the grid.

3. Discos and transcos (transmission companies) would not be protected by exclusive
franchise permits, and would be subjected to the price discipline of potential,
if not actual, entry.

4. Important functions of existing institutions would be preserved but operate
through a computerized spot market bidding mechanism based on decentralized
ownership of gencos. By “existing institutions” we referred to optimization
— historically, computerized dispatch based on the engineering cost characteristics
of generators and the network of integrated utilities — joint ownership
by utilities of shared transmission capacity, and power pooling rules for security
(spinning) reserves. In the proposed competitive re-organization, optimization
algorithms would not be applied to production and transmission “cost” as in
the regulated, hierarchical, integrated utility, but to the offer supply schedules
and bid demand schedules submitted to the computer- dispatch center. The algorithms
would maximize the gains from exchange (rather than minimize engineering cost
as under regulation) in response to the real-time decisions of all buyers and
sellers in the wholesale market. This specification was motivated by the recognition
that: (a) supply cost is subjective and measured by the willingness to accept
payment for energy produced on location; and (b) demand is subjective and measured
by the willingness to pay for delivered energy, where both types of information
express the particular real-time circumstances of individuals.

Coordination was a consequence of a new form of property rights: Rules for processing
messages generated by decentralized agents were themselves empowered by rights
to choose offers and bids, and contingency rules for accepting offers and bids
were based on their merit order (higher bids and lower offers had priority in
the rank ordering of bids and of offers). But importantly, the rules were qualified
by technical and security constraints that were essential if each agent were
to bear the true opportunity cost that the agent imposed on all others. The
term “property rights” as we shall use it, provides a guarantee that allows
action within the guidelines defined by the right. Such guarantees are against
arbitrary reprisal, in that they restrict punitive strategies that can be levied
against actions taken by the rights holder. Such guarantees provide only limited
certainty of protection. Most specifically, property rights, as a guarantee
that allow action, do not guarantee outcomes, since outcomes depend upon the
property rights of others. In electricity markets, as we shall see, outcomes
also depend upon global constraints affecting local outcomes that must be honored
if the system is to be efficient, dynamically stable, and to incentivize the
direction and level of capital investment.

Defining Competitively-Ruled Property Rights to
Unique “Monopolistic” Facilities

It was the ACC project that alerted us to the existence of “co-tenancy contracts”
for the joint ownership and operation of some large generation and transmission
facilities. For us this was an illuminating empirical discovery, since this
institution, that we modified with competitive property right rules, offered
the potential to render the concept of natural monopoly null and void.

Thus, suppose a city demand center can be adequately served by a unique physical
facility such as a pipeline or transmission line. Under American-style regulation
it is decreed that an exclusive franchise will be awarded to a single owner
of the facility, whose price will be set so as to regulate the owner’s rate
of return on investment. Alternatively, in our proposed competitively-ruled
joint ownership property right regime it is decreed that the facility must have
two or more co-owners, each having an agreed share of the rights to the capacity
of the facility (in practice a common co-tenancy contract rule is for each co-tenant
to receive capacity rights in proportion to his contribution to capital cost).
Two additional competitive rules would allow rights to be freely traded, leased
or rented, and new rights to be created by agreement to invest in capacity expansion
by any subset of the co-owners, through unilateral action by any co-owner, or
by outsiders if the existing owners resist expansion to meet increased demand.

Figure 1 – Efficiency with experienced subjects

In historical practice, co-tenancy contracts had prohibited sale by individual
rights holders without the consent of the other co-tenants, and capacity expansion
was allowed to occur only by joint agreement. The proposed new property rights
structure creates multiple rights holders to compete in marketing downstream
services utilizing the unique facility, and encourages new investment in response
to increased demand. Subsequent to the ACC study, new research uncovered other
examples of co-tenancy contracts, a common one being the joint ownership of
specialized printing facilities by a consortium of newspapers in a city. Clearly,
who prints the newspapers is a production issue potentially separable from the
competition of newspapers for subscribers and advertising services.

The courts repeatedly affirmed this principle when such co- tenancy contracts
attempted to include marketing and pricing conditions in what was ostensibly
a shared production agreement (Reynolds, 1990). Thus, our conception of a joint-venture
property right regime had already been well-articulated in court cases involving
newspapers. There was no new principle — only the question of how it might
be reformulated for application to network industries.

This model of co-tenancy as an instrument of competition was further elaborated
in Smith (1988, 1993), and tested experi mentally in the context of a natural
gas pipeline network funded by the Federal Energy Regulatory Commission (Rassenti,
Reynolds and Smith, 1994). But such discussions are far from culminating in
a completed instrument and many practical implementation difficulties remain.

Aftermath of the Arizona Study

By 1985, when the study report was filed and presentations made to the ACC,
the political composition of the Commission had altered, and the immediate impact
of the recommendation for deregulation on Arizona policy was nil. By the time
our final report was completed the Commission was composed of newly elected
office holders who considered our proposal to be impractical, idealistic and
politically infeasible. Of course, the Commission’s actions made the last claim
a self-fulfilling truth. Unknown to us at the time, subsequent developments
would reveal that this experience was a minor battle in a wider war for institutional
change that would begin abroad but would ultimately spread to the United States,
albeit with less success.

Contrary to the position of the new commission, we considered our proposal eminently
feasible in the electronic age, though in need of far more fundamental research,
and resolved to undertake controlled experimental studies of various issues
in the deregulation debate. Progress on this objective, however, was slow due
to inadequate funding, and the fact that the cost of software development for
the laboratory study of electronic trading in the context of electric networks
was higher than for traditional forms of experimental research.

Nevertheless, by 1987 we had conducted several pilot experiments in a six-node
electric power network with three fixed, inelastic nodal demand centers, and
nine GENCOs (described in Rassenti and Smith, 1986). The GENCOs, located at
various nodes, submitted sealed-offer price schedules each trading period to
supply power over transmission lines whose energy losses were proportional to
the square of energy injected. A valuable lesson from this unpublished research
was the ease with which GENCOs could push up prices against inelastic demands
by bulk buyers using a mechanism that did not permit demand-side bidding to
implement consumer willingness to have deliveries interrupted conditional on
price. This was our first brush with the important principle that competition
is compromised in supply-side auctions in which buyers are passive and are unable
through the mechanism to enter demand-side bid schedules. The California electricity
market is now experiencing this principle in spades, but it was foreshadowed
in the experience with U.K. privatization, and in other spot markets abroad
and in the United States. We report experiments below that provide a rigorous
demonstration that when the spot auction mechanism in common use around the
world is supplemented by demand-side bidding it provides a property right regime
that is a remarkably effective antitrust remedy.

Domestically, through the 1980s and into the 1990s, electric power would remain
subject to American-style rate-of-return regulation, while abroad, government-owned
electric (and other) utilities were under political pressure to explore the
use of markets for the management of electrical energy allocations. Industry
performance was seen as abysmal in the 1980s, causing some countries (e.g. the
United Kingdom, New Zealand) to think the unthinkable: decentralization might
be preferable to either government planning or direct regulation.

The United States

Background

The deregulation of electricity did not impact the United States until privatization/decentralization
reform was well advanced abroad. Viewed from the perspective of those of us
interested in market design for deregulation, the U.S. experience has been disappointing,
and the design details heavily politicized. At the start, the industry strongly
opposed deregulation. Nothing new here; the same was predominantly true for
airline, gas, railroad and trucking deregulation. But with electricity, there
was the need for state or regional collective agreement on how the industry
would be restructured, and what rules would govern market operation, since there
was clear need for computer coordination of generator loads to meet instantaneous
demand on highly interconnected networks. For example, there was need for such
agreement in the deregulated airline industry. The routes no longer had to be
certificated, the industry was regulated by free entry and exit, and what emerged
spontaneously in response to the demand for frequent low-cost service was the
hub-and-spoke structure that was anticipated and deliberately planned by no
one.

When we finished our ACC report in 1985, the industry had argued that deregulation
was not technically feasible, but that proposition had been shot down all over
the world by decentralization programs, none of which had followed American-style
rate-of-return regulation. There were various forms of “light- handed” regulation,
such as price caps on charges for the “wires” business (high-voltage transmission
or local low-voltage distribution), but energy was being priced competitively,
limited only by technology and the state of learning. No one abroad wanted to
use the American model, which was perceived to be broken just as badly as the
state-owned or dominated models that were being reformed.

Once the writing was on the wall, the utilities focused not on questions of
market design and efficient spot markets, but on lobbying for fixed new monthly
charges to cover their alleged “stranded costs.” This was price design for revenue
protection, not market design for efficiency. Most economists seemed to accept
the need for such compensation, either because it was “fair” for utilities to
recover the cost of investments made in good faith under a regulatory regime
that was being replaced (Baumol and Sidak, 1995), or because it was considered
the politicalprice to be paid for utility support for deregulation (Block and
Leonard, 1998).

Since the utilities were already privately owned and had long engaged in bilateral
economy energy exchanges, and energy marketers, or intermediaries, had emerged
to facilitate such contracts, there was opposition to the very idea of an open
spot market. Bilateral interests wanted to report only origin and destination
flows to schedulers, with prices remaining proprietary. Ironically, the bilateral
special interest groups had been fostered by legislation intended to move the
industry toward market liberalization: the Public Utility Regulatory Policies
Act of 1978, and the Energy Policy Act of 1992. These initiatives were designed
to facilitate transmission access by independent power producers as a step toward
fostering the development of wholesale power markets. Bear in mind that such
access was being opposed by some utilities, and federal action was seen as necessary.
The bilateral trading model was promoted, partly because of its perceived success
in reforming the gas industry, but also because gas marketing intermediaries
wanted to expand into electrical energy markets. California followed the bilateral
model in restructuring electricity. We long regarded this model as misguided;
bilateral bargaining in the electronic age could not provide the foundation
for an efficient market model of interdependent (pipeline or transmission) networks.³
California did, however, require the investor-owner utilitie

s to be processed through the CalPX (their open spot market exchange), but
these demand quantity bids were “at market” (the supply-side asking price that
clears the market); they were not price-contingent bids implemented by interruptible
service contracts.

Thus, in California and elsewhere, the new “wires” utilities succeeded in
instituting new fixed monthly charges to cover their stranded costs, and fixed
per unit energy charges for retail customers. But no one was preparing for and
investing in the technology for demand-side bidding as an instrument to discipline
prices in the hourly spot market and to provide incentives for users to reduce
demand or switch their time-of-day consumption from higher- to lower-cost periods.
Imagine the consequences to the airlines and all of their passengers if, in
order to be licensed, airlines were required to charge all passengers an identical
regulated monthly access fee and a fixed price per mile traveled, independent
of flight destination, time of day, time of week, season or holidays, and independent
of the flier’s willingness to pay!

Figure 2 illustrates a typical 24-hour period of price variation on the CalPX.
Since most of the power was either traded via bilateral contracts at secret
prices, and not part of the spot market, or through the PX as bids “at market,”
demand was not price-responsive. Observe in Figure 2 that the peak demand and
most of the “shoulder” transition demand (between peak and off-peak) are at
prices above 10 cents per kilowatt ($100 per megawatt), and are therefore far
in excess of what local distributors collect from their residential customers.
There are numerous other examples of on-peak price spikes of up to 10 or more
times the normal energy prices (in the $25-$30 per megawatt range. See the Bloomberg
Daily Power Report Online (Summer 1999) for a report on sharp price spikes in
the Midwest and South). These price differences imply an enormous rate of return
on investment in contracts for voluntary selective interruption of energy deliveries,
with gains shared by both the distributor and its customers.

Figure 2 – California PX Prices: June, 26-30 2000

Demand-Side Bidding Controls Market Power and Price Spikes

Earlier experimental market research cited above used demand-side bidding
and we observed very competitive results. New experiments study this issue much
more systematically in the design reported by Rassenti, Smith and Wilson (2000)
comparing prices with and without demand-side bidding. Bulk buyers submit discretionary
bid steps reflecting the prices above which they are prepared to reduce demand
by invoking their contracts for interrupting deliveries. It is important in
a competitive electricity market that bulk energy providers contract for discretionary
interruption of (suitably compensated) consumers. Why? Because then their bids
in the wholesale market cannot be known with certainty by the supply-side bidders,
and demand-side bidding can better deter supply-side market power.

The problem created by inadequate price-responsive demand in a supply-side-dominated
auction can be illustrated with the chart shown in Figure 2. In such a market,
the clearing price is sensitive to the asking prices submitted by peaking generators
in short supply, especially near peaks in demand. Thus, in Figure 2, the price
is $15 per MW with demand 7,700 MW, but if demand had been 8000 MW, the spot
price would have been $45 per MW, and at a demand level of 9,000 MW, the price
would have been indeterminate, forcing the dispatch center to use security reserves
or to involuntarily interrupt customers.

Unquestionably, many consumers would have been prepared to reduce demand to
avoid such a price spike, provided that they had been given the opportunity
and incentives commensurate with the savings. In the United States, are such
conditions to be judged a problem in supply-side market power, or is it an institutional
and incentive failure of the market mechanism to implement responsive demand?
The tendency is to blame market power, although in other industries — hotel
accommodations or airline seat pricing, where the product also is non-storable
— demand responds strongly to time-variable competitive prices.

Implications for Electricity Deregulation in the United States

The computerization of laboratory market experiments using profit-motivated
human subjects in the 1970s unexpectedly revolutionized our thinking about the
purpose and uses of experiments. In particular, we soon came to recognize that
the laboratory could be used to test-bed new electronic trading systems for
application to industries traditionally perceived as requiring hierarchical
organization and government regulation to achieve proper coordination and control
over the resulting legally franchised monopolies. Electricity was a prime example,
and we attempted to use our first experience with what we called “smart computer-assisted
markets” to inform Arizona’s cautious and tentative interest in restructuring
its electrical industry to rely on markets to regulate the energy segment of
the industry. Failing at the time to influence policy, our effort was not ignored
abroad, and we participated as consultants in developing proposals and the use
of experiments to help inform some of the key research issues in decentralization,
and to serve as a hands-on training tool for those managing the transition.
Decentralization required the creation of new property rights: a governance
structure and efficient pricing for the grid, generator entry and exit rules,
market rules governing messages and contracts in the context of computer-controlled
coordination, optimization and communication, but with all outcomes driven by
the decisions of dispersed agents whose circumstances of time and place were
reflected in market bids to buy or offers to sell.

In the United States, the industry was already privatized but was subject to
centralized state and national price regulation based on a “fair” return on
investment. With the proposed deregulation of electric utility prices and consumption,
each state or region needed to develop a plan for restructuring their industry
and specifying the auction market rules for determining the real-time wholesale
price of energy. Without exception, the resulting market designs, hammered out
by regulators, consultants, industry representatives and various power-marketing
intermediaries, all employed supply-side bidding mechanisms for the hourly spot
market. These spot markets were supplemented with wide-ranging freedom for power
users, producers and intermediaries to engage in a variety of bilateral contracts
outside of direct price discipline by the spot market. For the spot market this
supply-side emphasis meant that any user, regardless of the individual circumstances
of that consumer’s need for an uninterruptible flow of energy, would be guaranteed
that this demand would be served. Bilateral contractors could agree to allow
various degrees of firmness of demand to impinge on contract terms. But in this
longer-term contract, market prices are negotiated and secret, and are not subject
to the direct real-time constraints on opportunity cost provided by the spot
market.

The “must-serve” demand policy in the spot market was inherited from a rigid
regulatory regime that politicized the reliability of electricity flows to all
consumers, whatever the cost. This cost was collectivized by averaging it across
all users regardless of individual consumer differences in willingness-to-pay
for keeping the lights on. The local utility was expected to maintain service,
or restore it quickly, even in inclement weather, spreading the cost of this
super-reliability thinly over all customers. This cost included the maintenance
of substantial reserves in generation and transmission capacity. Thus system
reliability and the capacity to satisfy all retail demand were exclusively a
supply-side adjustment problem. In providing this superior service to all, the
supply-side was always justified in claiming 100 percent cost recovery plus
a fair profit. The consequence of this supply-side mindset was uncontrolled
cost creep that increased to a gallop and ultimately became part of the political
outcry for deregulation. Implicitly, however, the process of deregulation assumed
that this built-in supply-side bias did not require fundamental rethinking when
it came time to design spot markets for the new world of competition. As always
in market institutions, the devil was in the details.

Beginning three years ago in Midwestern and Eastern markets, peak prices hit
short-run levels of 100 or more times the normal price level of $20-$30 per
megawatt hour. This was the predictable direct consequence of completely unresponsive
spot demand impinging on responsive discretionary (bid) supply. More recently
the California spot market has been plagued by exorbitant increases in prices
as illustrated in Figure 2. This has led to political action to impose price
caps on this market, which, of course, can only discourage a positive supply
response to the shortages. The move to replace American-style regulation with
what may become known as American-style deregulation is in danger of being derailed
by these interventions.

Controlled comparisons between markets with and without demand-side bidding,
in which only 16 percent of peak demand can be voluntarily interrupted, show
that demand-side bidding can dramatically lower both the level of prices and
their volatility. The public policy implications are evident: wholesale spot
markets need to be strengthened institutionally by making explicit provision
for demand-side bidding. Distributors need to incentivize more of their customers
to accept contracts for voluntary power interruptions, or use time-of-day meters
and load-control systems to manage their own price response. Industrial and
commercial buyers who already have the capacity to handle interruptible energy
supply, but who contract outside the spot market, need adequate incentives to
participate in the spot market where their more responsive demands can impact
public prices. Distributors stand to gain by interrupting demand sufficiently
to avoid paying higher peak and shoulder spot prices, and these savings can
be used to pass on incentive discounts to customers whose demand, or portions
of it, can be reduced or delayed to off-peak periods when supply capacity is
ample. In California, news reports indicate that distributors have lost some
$10 billion buying high (Figure 2) and selling at vastly lower residential rates.

The technology and capacity for implementing such a policy already exists and
can be expanded. This policy recognizes that adjustment to the daily, weekly
and seasonal variation in demand, and to the need to provide adequate security
reserves, is as much a demand-side problem as it is a supply-side problem. The
history of regulation has created an institutional environment that sees such
adjustment as exclusively a supply responsibility, and views prices as an ex
post means of cost recovery. The result is an inefficient, costly and inflexible
system that has produced the recent price shocks and involuntary disruption
of energy flows. Demand-side bidding and price feedback, coupled with the supporting
interruptible-service incentive contracts, can eliminate unjustified price volatility
and price increases and reduce the need for reserve supplies of generator and
transmission capacity.

Acknowledgements

We want to recognize the influence and support of many people and organizations
who made possible the research program on which this paper is based: the Arizona
Corporation Commission (Commissioners Richard Kimball, Junius Hoffman, and Marianne
Jennings) who in 1984 had the vision to fund our first efforts to study electricity
deregulation.

Footnotes

1 Williams (1980) reports comparisons of the oral and electronic
auctions. He found that oral auctions converged more rapidly for inexperienced
subjects, but for experienced subjects (one previous session) the two systems
were indistinguishable.
2 We use the term “privatization” to describe generically the process of reform
of foreign government command forms of organization of the electric industry.
In all cases major components of the industry have not had their ownership transferred
from public to private entities. Reform has focused on the use of decentralized
spot and futures markets to provide price signals to improve the short and longer
term management of the industry. The term “deregulation” applies to electricity
reform in the United States, where 50 states and one federal regulatory body
have regulated an industry already predominantly owned privately, but not decentralized
except through recent reforms in some regional transmission systems that are
still very much in transition.
3 For a critique of this trend see Smith (1987, 1996), and for studies of smart
computer-assisted markets in gas pipeline networks see McCabe, Rassenti and
Smith (1989, 1990), and Rassenti, Reynolds and Smith (1994).

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