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Transcript of VanKoten Bidding Behavior JRE 20 2008.12.12
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1. Introduction 3
2. Literature 6
3. The model 83.1 Assumptions 8
3.2 The second-price auction 113.3 The first price auction 163.4 Alternative models 20
4. The procurement auctions in New Jersey and Illinois. 23
5. Conclusion 26
6. Appendix 29
7. Parameter overview 38
8. Literature 39
XX. Figures and tables FOR QUICK NAVIGATION ONLY DELETE BEFORE RESUBMISSION 43
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Effects of vertical integrations on auction outcomes in the EU and US
electricity markets.*
Silvester van Koten**CERGE-EI
UNDER REVISION VERSION 12.12.2008
Abstract
With the deregulatory reforms in the electricity industry, production stages have been split up and are
performed typically by different companies that compete for inputs and/or customers in decentralized
markets. Often goods are sold by auction in such markets. As the extant EU and USA regulatory framework
allow integrated electricity holding companies to have ownership of firms active in generation, distribution
and transmission, these holding companies often own both the seller and one of the buyers in such
decentralized markets. A holding company that owns both a buyer (called the integrated buyer) and a seller
in an auction has distorted bidding incentives. Specifically, the holding company will make the integrated
buyer bid more aggressively to increase the auction revenue. As a result, the integrated buyer is more likely
to win the auction and the good is sold for a higher price. However, since the auction is now inefficient,
efficiency is decreased. Moreover, independent companies are less likely to win the auction, and, in any
case, pay a higher price.
Keywords: asymmetric auctions, bidding behavior, electricity markets, regulation, vertical integration.
JEL classification code: L43, L51, L94, L98, R39.
*I am grateful to Levent elik, Libor Duek, Dirk Engelmann, Peter Katuk, Jan Kmenta, Thomas-Olivier Lautier, Avner
Shaked, Sergey Slobodyan, the participants of the EEA-ESEM 2008 conference in Milano, the participants of the Econometric
Society Winter Meetings 2008 in Cambridge, and two anonymous referees of the Journal of Regulatory Economics for theirhelpful comments. Special thanks to Andreas Ortmann. I thank the REFGOV Integrated project funded by the 6th European
research framework programme, CIT3-513420, for financial support.**
Email:[email protected], [email protected].
CERGE-EI is a joint workplace of the Center for Economic Research and Graduate Education, Charles University in Prague,and the Economics Institute of Academy of Sciences of the Czech Republic.
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1. Introduction
Liberalization
The electricity supply industries in the USA and the EU are being reformed. In the past the production
stages in the electricity supply industry, most notably generation, transmission, and distribution,1
used to be
performed by Vertically Integrated Utilities (VIUs) that often were national or local monopoly producers of
electricity. Now, production stages have been split up and are performed typically by different
companies that compete for inputs and/or customers in decentralized markets.
In many such markets, competition is organized by running auctions, as auctions have, in theory,
features that have been judged highly desirable for electricity markets such as non-discrimination (the
highest bidder wins regardless his identity), efficiency (the bidder with the highest value makes the highest
bid and thus wins), and selling at efficient prices (prices that reflect the scarcity of a good).2
For example, in
the European Unions, the right for generators or suppliers to use capacity on cross-border transmission lines
is often allocated by explicit auction.3
In the USA, contracts for electricity supply by generators have been
awarded by procurement auctions, such as in New Jersey (Loxley and Salant, 2004; Reitzes, 2007) and
Illinois (Illinois Commerce Commission 2006; Negrete-Pincetic and Gross, 2007).
For the liberalization of the electricity supply industries to be successful, it is essential that such
decentralized markets are competitive. However, national markets are often dominated by large holding
companies, often the incumbent VIUs that own companies that are involved in different steps of the
electricity production process. As a result, in a market sometimes the seller and one of the buyers are owned
by the same holding company; I will refer to such buyers and the integrated buyer.
For example, in Illinois and New Jersey, distribution firms awarded contracts for electricity delivery in
procurement auctions to generator companies. Some of these generators where integrated buyers; they were
owned by a holding company that also owns the seller of the contracts.4
In the EU, the capacity on cross-
border transmission lines (also called interconnectors) is mostly sold by auction to generators (ETSO, 2006).
In many instances, one of the generators buying capacity is an integrated buyer; he is owned by a holding
1I focus on the three main production steps of generation, transmission, and distribution: generation is the production of
electricity in power plants, transmission is the transport of electricity over long distances, and distribution is the transport of
electricity over short distances, mostly to the final consumer.2
See for example Consentec (2004). However Joskow and Tirole (2003) argue that auctions result in prices that undervalue the
benefits of transmission line.3
In 2007 explicit auctions were used to allocate capacity for international transmission lines at 21 border crossings (Commission
of the European Communities, 2008b, p.30)4 See, for the case of New Jersey, http://bgs-auction.com, and, for the case of Illinois, Illinois Commerce Commission (2006, p.8).
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company that also owns the interconnector. For example in 2006 in 12 of the 27 EU member states, VIUs
that were involved in generation and/or distribution also owned the transmission and interconnector
networks.5
The typical pattern in such EU states is that a large dominant electricity generator, in which the
state has a majority stake, fully owns the transmission networks(see Commission of the European
Communities, 10.01.2007).
Legal unbundling
The holding company could have incentives to instruct the integrated seller to stifle competition by
selling only to the integrated buyer. Regulation in EU and USA aims to prevent integrated sellers from
discriminating against independent entrants by favoring integrated buyers. EU laws therefore mandate that
the integrated seller must be legally unbundled from the holding company (Directive 2003/54/EC and
Regulation 1228/2003).6
While the seller may still be fully owned by the holding company, the seller must
be a legally independent company with an autonomous management, and the holding company is not
allowed to give day-to-day instructions to the seller. Legal unbundling implies that the holding company
will not be able to make the seller discriminate against independent buyers in favor of the integrated buyer.
Auctions organized by such an integrated, but legally unbundled, seller are non-discriminatory in the sense
that the highest bidder wins, regardless of the identity or affiliation of the buyer.
USA laws mandate a comparable form of separation called functional unbundling that should
guarantee such non-discriminatory outcomes in auctions (FERC Order 888, P.21552). In the procurement
auctions in New Jersey and Illinois distributors selling electricity delivery contracts were not allowed to
own generators that could participate in the auction (Loxley and Salant, 2004; Illinois Commerce
Commission 2006; Negrete-Pincetic and Gross, 2007). However, it was allowed for distributors to be part of
a holding company that owned distributors and generators. This liberty did not go wasted; all four
distributors in New Jersey and both two distributors in Illinois were part of a holding company that also
owned a generator that participated in the auction.
5 VIUs own transmission networks, including the interconnectors, in the following countries: Austria, Belgium, Bulgaria, Cyprus,
Germany, Denmark, Estonia, France, Greece, Hungary, Ireland, and Luxembourg (Commission of the European Communities,2008b, p.38-39).6
Recently the European Commission has proposed new laws with a stricter requirements on unbundling. However, also in these
new laws VIUs would still be allowed to own generation and network activities, provided the network activities are legally
unbundled and operated by an independent System Operator (Commission of the European Communities, 19.9.2007, p.5).Access to the Network for Cross-Border Exchanges in Electricity (OJ 2003 L 176/1).
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While legal or functional unbundling might accomplish that the seller behave non-discriminatory,7
the
holding company is not restricted in changing the bidding behavior of its integrated buyer. I will argue that
the ownership of the seller gives the holding company incentives to make its integrated buyer bid more
aggressively in auctions. The intuition is that the price the integrated buyer pays for the good is not a net
cost to the holding company as (a part of) the payment returns to the holding company through its
ownership of the seller. The holding company will thus instruct the integrated buyer to adapt his bidding
behavior to consider the lower cost of bidding and bid more aggressively.
The holding company will order the integrated buyer to bid more aggressively only when the integrated
seller can keep a part of the profit of the auction and send it on to the holding company. This is the case
when the holding company is residual claimant of the income of the integrated seller; for example, the new
EU regulations allow the building of for-profit interconnectors (cross-border transmission lines), where the
owner can keep the full profits generated by auctions.8
Even when the income of the seller is regulated, the
seller is often allowed to keep at least a part of the increased profit due to cost reductions. Often regulation
allows transmission and distribution owners, in order to provide incentives to innovate and implement
efficiency gains, to keep a part of the profits. For example, if the regulated price for which a distributor
delivers electricity is fixed, then the distributor keeps the full gain of discounts he manages to obtain in the
buying process from electricity generators. In the paper I will assume that the seller can keep a certain
proportion of the profits. I refer to this portion as the (effective) ownership share and denote this by the
symbol K .9
The main driving question in this paper is if legal unbundling is a sufficient measure to assure a
competitive market where allocations and prices are non-discriminatory and efficient. This is an important
question; if legal unbundling puts independent buyers in a disadvantaged positionthen this makes it less
attractive for new, independent entrants to enter the energy market. This is highly relevant for EU electricity
generation markets: as national electricity generation markets in the EU are very concentrated,10
they need
7 There is evidence that legal separation is not a sufficient measure to guarantee non-discriminatory behavior of VIUs. For
example, in the EU the European Commission Competition DG (6.02.2006, p.144-148) found several concrete examples of
legally unbundled VIUs that curb competition through their combined ownership of generation and transmission or distribution
networks.8 While no merchant line has been built yet, it seems likely they will be built in the future; beginning 2007 the European
Commission had received two announcements of plans to built a merchant line (Commission of the European Communities,2008b, part 2, p.117)9
It is understood that the effective ownership share might be smaller than the stakes a buyer has in the seller due to regulation
or profit sharing with other parties.10 Efficient and non-discriminating outcomes in interconnector capacity auctions are indeed main objectives of the EuropeanCommission, especially as interconnection is seen as a means to increase competition in the highly concentrated markets for
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to attract new entrants to make the liberalization reforms successful.So far legal unbundling has been
regarded as a sufficient measure in the EU and the US. However, up till now the effect of integrated
ownership on bidding behavior and auction outcomes in electricity markets has not been studied. I formulate
my research question as follows:
What is the effect of a buyer having an ownership share in the seller on auction outcomes under legal
unbundling? Specifically, are the auction outcomes still efficient and non-discriminating?
To answer this question I choose to model a very simple set-up with two bidders that have private values
that are independently and uniformly distributed.11
I also assume that the good on sale is sold in one piece,
and not in many divisible units. This simplification allows me to derive explicit solutions that enable
efficiency comparisons. The results from this simplified model give a suggestive answer to the effects of
unified ownership of buyer and seller in auctions.
The remainder of this paper is organized as follows. In the next section I will describe the setup of my
model, and discuss its connection to the literature on legal separation and toehold auctions. Then I analyze
the first- and second prize formats of the main model and the efficiency implications. To show the limits
and robustness of the effect of unified ownership, I also present models that employ the same setting, but
under different assumptions. I then present empirical data on the procurement auctions in Illinois and New
Jersey where the one of the effects predicted in the model, discrimination of independent buyers, seems to
have occurred.
2. Literature
On legal unbundling
The effect of legal separation has been studied in three earlier papers : Hffler and Kranz (2007a), Hffler
and Kranz (2007b), and Cremer, Crmer and De Donder (2006). Hffler and Kranz (2007a) claim that legal
unbundling can have superior qualities over ownership unbundling. Hffler and Kranz (2007a) model
electricity generation by enabling foreign generators to access to such markets (Consentec, 2004, p.I). National markets for
generation in the EU are indeed highly concentrated; in 2006, out of 20 EU member states, 7 were highly concentrated (HHIbetween 1800 and 5000), and 8, among which Belgium and France, were very highly concentrated (HHI above 5000)
(Commission of the European Communities, 2008b, p.11).11
The bidders might have in addition to their private value a publicly known value component that is identical (common) for both
bidders. As long this common value component is identical and publicly known, such a value component does not affect theanalysis.
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competition between generators that buy transmission capacity for a fixed, regulated rate from a
transmission company to transport their electricity to consumers. The capacity on the transmission network
is unlimited in the relevant range. The transmission company is owned by one of the generators. Hffler and
Kranz (2007a) compare market outcomes for legal unbundling, full integration (where the generator can
give the transmission company instructions), and ownership unbundling. They show that the output of
generators is weakly higher under legal unbundling than under full integration or ownership unbundling,
and include an example of duopolistic price competition where the output is strictly higher. Hffler and
Kranz (2007b) extend the results of their earlier paper (2007a) by considering partial ownership and
imperfect legal unbundling.
My model resembles that of Hffler and Kranz (2007a); the regulated transmission company in their
model is an integrated seller, and the generator that owns the transmission company is the integrated buyer.
The main difference is that Hffler and Kranz (2007a) assume that the transmission company has an
unlimited capacity and has a vested interest to sell as much as possible of the capacity. The auctions I study
have a limited capacity (such as a limited supply of interconnection capacity or a limited supply of
electricity contracts in procurement auctions). In this setting, my model leads to conclusions opposite to
those of Hffler and Kranz (2007a): auction outcomes under legal unbundling are worse in terms of
competition and efficiency than under ownership unbundling.
Cremer et al. (2006) study the effects of legal unbundling of the buyer: in their model a downstream
firm (a buyer) is restricted to maximize his own (buyer) profit. This is different from my model where the
seller is the one who is legally unbundled and thus restricted to maximize his own profit (the auction
revenue), while the buyer is the one who can be instructed by the holding company to behave in ways that
do not maximize the buyer profit (but the total profit of the holding company).12
On toehold auctions
In the model setup, it will become clear that auctions with an integrated seller and an integrated buyer
are mathematically identical with so-called toehold auctions. Toehold auctions have been analyzed mostly
in the context of financial takeovers, where two buyers compete to buy a company and one or both buyers
already own, by holding shares, a fraction of the company (Bulow, Huang and Klemperer, 1999; Burkart,
1995; Ettinger, 2002). The fraction of the company owned by the potential buyer(s) is called a toehold.
12Hffler and Kranz (2007a) call the form of separation where the buyer is unbundled: reverse unbundling. I analyze a regime
that combines the regimes of legal unbundling andreverse unbundling in VanKoten (2007), and show that auction outcomesunder such a regime are still inferior to auction outcomes under ownership unbundling.
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Burkart (1995) analyzed second-price private value toehold auction and finds that the bidding function
of the bidder with a toehold becomes more aggressive for larger toeholds, while the bidding function of the
bidder without a toehold is unaffected. Ettinger (2002) compares first-price and second-price auctions with
symmetrical toeholds and notes that, for strictly positive toeholds, the revenue equivalence theorem doesnt
hold. Bulow et al. (1999) analyze common value toehold auctions, where both bidders can have a toehold
(and at least one bidder a strictly positive toehold) and show that the bidder with a larger toehold has a much
larger probability of winning the auction. Bulow et al. (1999) also show that the winning price is
dramatically affected by the toeholds.
As Burkart (1995) uses very general assumptions, he cannot make an analysis of the effect of a toehold
on efficiency, I use his results to determine, under more restrictive assumptions, the effects on competition
and efficiency for second-price auctions. I then generalize this model for an arbitrary number of bidders. I
further use models of Ettinger (2002) and Bulow, Huang and Klemperer, 1999, to asses the effects under
slightly different assumptions. As first-price toehold auctions have not been analyzed before, I present a
general result for first-price auctions with two bidders, one of which an integrated buyer that fully owns the
integrated seller. Under more restrictive assumptions, I numerically solve such first-price auctions with
partial ownership, and I show that the revenue equivalence theorem doesnt hold in such auctions. As a
default case I also present a model without uncertainty.
3. The model
3.1 Assumptions
In the main applications for my model, a generator competes to obtain a good, service or contract, such
as capacity on an interconnector or a contract for electricity supply, which it needs to be able to perform a
profitable transaction. The profitability of the transaction depends especially on the costs of generating
electricity. I will assume that the cost of generating electricity differs among the buyers.13
This implies that
13The value of the good to a generator is dependent on the costs of generating electricity. As a generator does not know the costof his competitors, he treats it as a random variable, drawn from a distribution that for sake of simplicity I will assume to be
uniform. The random costs drive the dynamics of the bidding behavior. In electricity generation, there is also a common cost
component, mainly gas or oil prices. I assume that the size of these common cost components are common knowledge and that
they are identical for both generators. As a result, these common cost components are inconsequential for the bidding behavior;this is determined by the unknown private value factors. (MORE EXPLANATION OR IS OK SO? Like:
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the buyers value the good on auction differently.
For example, when bidding for transmission capacity on an interconnector, the value of the good for sale
is the profit that could be made by selling electricity abroad. This profit is equal to the difference between
the price abroad and the costs of the generator.14 When generators compete for an electricity supply contract
in procurement auctions, the generators actually place as bids the price they will charge for the electricity
supply and the lowest price wins (Loxley and Salant, 2004). For ease of modeling I will transform such a
procurement auction, without loss of generality, into an equivalent discount auction where a given
electricity supply price is set and the generators make bids that represent the discount they will offer on the
price. In such a discount auction the highest bidder wins. For a generator the (private) value of the contract
is equal to the set electricity supply price minus the (private) cost of electricity generation. For example, a
bidder with low costs of electricity generation has thus a high value for the contract, and will be willing to
bid high discounts in the discount auction. The high discount bid in the discount auction translates to a low
bid (which reflects the price for which the bidder is willing to supply electricity) in the procurement auction.
I will assume that a buyer knows his own value, but not the value of the competing buyer. In my model
this implies that a buyer does not know his competitors marginal cost of producing electricity (except for a
common, identical cost factor such as gas or oil prices). In older models stemming from the time electricity
generator markets were tightly regulated, it was usual practice to assume that marginal costs are common
knowledge, however, since the electricity industry has become competitive, information on the cost
structure of electricity generation has strategic value and is therefore carefully guarded (Lautier, 2001,
p.34). Parisio and Bosco (2003, p. 8) add: generators frequently belongto multi-utilities providingsimilar
services often characterized by scope and scale economies (Fraquelli et al., 2004, amongothers). The cost
ofgeneration therefore can vary across firms because firms can exploit production diversities in ways that
are not perfectly observable by competitors. Parisio and Bosco (2003, p. 8). In this line of thought,
_ a _ a_ a _ a
[ ; ] Pr [Y wins;b] Pr [Y looses;b]
[ ; ] Pr [Y wins;b] ( Pr [Y looses;b]
[ ; ] Pr [Y wins;b] (
(1 ) [payment|Ywins;b] [payment|Y looses;b]
(1 ) [ payment|Ywins;b] [ payment|Y looses;b]
(1 ) [
b v v
b v R v
b v R v
E E
E R E R
E
T
T
T
K K
K K
K
!
!
!
_ a _ a _ a _ a
Pr[Y wins;b])
[ ; ] Pr [Y wins;b] ( Pr [Y wins;b])
[ ; ] [ ; ]
[ ; ] [ ; ]
payment|Ywins;b] (1 [ payment|Y looses;b]
(1 ) [payment|Ywins;b] (1 [payment|Y looses;b]b v R v
b v b v
d b v d b v
R E R
R E R E
R
db db
T
T T
T T
K
K K
K
!
!
!
14 In line with the empirical evidence, I assume that, as transmission capacity is fixed and small relative to the total demand,buyers cannot influence the final price in the distant location (see e.g. Consentec, 2004).
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competitors can only make an estimate of each others marginal costs. While earlier literature assume that
the cost of generating electricity by a generator is publicly known to all its competitors (Green and
Newbery, 1992; von der Fehr and Harbord, 1993), I find the arguments of Lautier (2001) and Parisio and
Bosco (2003) the most compelling, and I therefore assume that there is uncertainty about the competitors
costs. However, for completeness I also consider a deterministic configuration, where generators know the
costs of electricity generation for competitors.15
I model the competition of the two generator as two risk-neutral bidders who have private values that are
independently and uniformly distributed on ? A0,1 . Both bidders are thus, at the outset, symmetrical; they
have identical, independent value distributions. I assume that the good on sale is sold as one indivisible
good.16
As usual in auctions, the highest bidder wins the good, which reflects that the integrated seller does
not favor the integrated buyer and thus the legal separation of the integrated seller is working as intended by
the regulators.
One of the bidders is an integrated buyer; a holding company fully owns the integrated buyer and (a part
of) the integrated seller. I denote with parameter 1k the proportion of the integrated seller that the holding
company owns. I denote with parameter 2k the proportion of the auction revenue, which the integrated
seller can retain. For example, when the integrated seller is unregulated, he can keep all of the auction
revenue and2
1k ! . When the integrated seller is regulated, he can often still retain a part of the profit due
to incentive regulation (and possibly by creative accounting), and thus20 1k e . The relevant parameter in
the model is the proportion of the auction revenue that is received by the holding company, which I denote
by 1 2k kK ! .
I assume that the values of both buyers are independently and uniformly distributed on ? A0,1 . At the
outset, the buyers are therefore symmetrical. Given his value realization, the integrated buyerY chooses his
optimal bid,Y
b . In line with the literature, I assume that there exists a differentiable, strictly increasing
bidding strategy [ ]Y
b that maps the integrated buyers realized value ? A0,1Yv into his bid [ ]Y Yb v . The
bidding strategy [ ]Yb has an inverse [ ]y such that ? A[ ]Yy b v v! . Analogously, the optimal bid of the
independent buyer X, Xb , is determined by her bidding strategy [ ]Xb that maps her realized value
15I thank this suggestion to an anonymous referee.
16 While transmission capacity and electricity supply procurement auctions are usually multi-unit auctions, I restrict my focus tosingle-unit auctions to simplify the analysis and focus on the effect of integrated ownership.
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? A0,1Xv into her bid [ ]X Xb v . The s
trategy [ ]X
b has an inverse [ ]x , such that ? A[ ]Xx b v v! . Using these assumptions, the following lemma
holds (Krishna, 2002).
Lemma 1: The integrated buyerY wins (looses) the auction with bid b if [ ]X
v x b ( [ ]X
v x b" ), which has
probability [ ]x b ( 1 [ ]x b ) for the uniform distribution.
Proof: Ywins the auction if his bid b is larger than the bid ofX, [ ]X X
b v , thus when [ ]X X
b v b . Applying
the inverse biddingfunction [ ]x on both sides of the equation gives ? A ? A1X Xv b b x b
| . When values are
uniformly distributed, the probability of ? AXv x b is equal to [ ]x b . The argument forYloosingthe auction
is symmetrical (Krishna, 2002).
3.2 The second-price auction
For second price auctions17
with two buyers, an independent buyer and an integrated buyerY who owns a
share of the seller, where values are independently and identically distributed with a twice continuously
differentiable distribution function G(.) that satisfies the monotone hazard rate condition, Burkart (1995)
gives characterizations of the bidding functions of X and Y:
1 ( )
( )
Y
Y Y
Y
G bb v
g bK
! ,
X Xb v! .
Burkart (1995) shows that Y overbids his valuation. The amount of overbidding increases in the ownership
share K and decreases in the valueY
v . The intuition for this is as following (Burkart, 1995). When Y looses
the auction, Y is not indifferent to the price for which transmission is sold as Y receives the toehold times
his bid,Y
bK , when loosing. By bidding higher than his value but lower than the value of X,Y Y X
v b v , Y
has an increased gain in loosing the auction. However, when Y bids higher than X while the value of X is
higher than Y,Y X Y
v v b , the resulting profit ofY (winning the auction for a high price) is lower than
when he bids his true value (loosing the auction). The optimal amount of overbidding balances these two
opposite effects on profits. The gain of loosing with a higher bid is increasing in the toehold K , hence Y
17 In the second price auction the highest buyer wins and pays the bid of the second highest bid.
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overbids more for a higher K . The probability of winning is increasing in the value ofY, and therefore the
overbidding ofY is decreasing in his valueY
v . Furthermore Burkart (1995) shows that an inefficient
allocation happens with a positive probability and that the expected profit ofY increases with the size of
ownership.
The rather general assumptions under which Burkart (1995) analyzes the problem, do not allow him to
give an estimate of the size of the effects of integrated ownership. For this reason I explicitly determine
efficiency and competition effects under the assumption that the values of X and Y are identically,
independently, and uniformly distributed on [0,1], an assumption that can be thought of as a reasonable
approximation of reality. The bidding functions of X and Y then simplify to:
(1 )
1
YY Y
vb v K
K
!
,
X Xb v! .
The overbidding ofY is now given by the explicit term,(1 )
1
YvKK
, and the same intuition as explained
above for the general case applies
Figure 1. The bidding function of buyer Y in second-price auctions
Figure 1 illustrates the bidding by the integrated buyer and the independent buyer. Because of his
ownership holding in the seller, the integrated buyerY bids more aggressively. This has several interesting
effects, summarized in proposition 4.
Proposition 1:As the ownership share K increases, a) the price of the good on auctiongiven by the
auction revenue increases, b) the probability to win for the integrated buyerYincreases while that for
buyerXfalls, c) the strategic profit of the integrated buyerYincreases, and d) total efficiency falls.18
Proof: See appendix.
The intuition for proposition 4 is as follows: Ad. a) The price of transmission capacity increases as the
losing bid ofY is higher, and hence X pays more for the good. When Y wins, Y either pays the same (Y
18 The effects are all described by ex-ante expectedmeasures (before bidding and before concrete values have been realized).
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would have won with or without the ownership share) orY pays more (Y would have lost without the
ownership share). Ad. b) The probability ofY winning the auction is higher as Y bids more aggressively
than X. Consequently, the probability of X winning the auction falls. Ad. c) The strategic profit of generator
Y increases as Y changes his bid, while the old one is still available. As there is a unique optimal bid, this
argument reveals that Y must be better off with his new bid. Ad. d) Total efficiency falls as the auction is
now asymmetric and therefore inefficient. While Y has the same value distribution as X, Y now wins in
some cases when he does not have the highest value for the good, because Y now bids more aggressively
than X.
Figure 2. Effects of ownership share on outcomes in second-price auction .
Figure 2 shows the effect of ownership share on auction outcomes relative to the case with no ownership
share. There is a considerable efficiency loss19, up to 6.25% for full ownership. The gain for the VIU, given
by the strategic profit20
is also considerable; a VIU can, by bidding more aggressively, increase its profit
with up to 16.7% for full ownership. The price of the good is strongly affected; it can increase with up to
37.5% for full ownership. However, this might also be considered a positive effect in the case of
transmission line capacity auctions; Joskow and Tirole (2003) show that in general auction revenues are too
low to incite the building of an efficient amount of merchant transmission lines. This is what we see in this
model as well; the expected value of the transmission line, which is equal to the price difference between
the locations connected by the transmission, is equal to 23
, but the expected auction revenue is 13
. To have
an efficient level, the auction revenue should increase with 100%, and the 37.5% we observe under full
ownership is therefore a considerable step closer to its optimal value. Also in procurement auctions this
could be seen as a positive effect, as then the price paid reflects the discount generators are giving to the
distributor that buys electricity. An increase in the price means that the generator gives a larger discount
than without ownership integration; electricity is thus bought by the distributor at a lower price.
However, ownership integration creates strong discrimination against independent generators favoring
the VIU is a negative effect. As can be seen in Figure ownership integration increases the expected
19The efficiency loss percentage is calculated as
? A ? A
? A
0
0
W W
W
K, which is equal to
2
2
25
1
K
K.
20 The strategic profit percentage is calculated asYStrategic
YPassive
T
T.
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probability for the integrated generator to win the auction with up to 50%.21
Also at low levels of ownership
integration discrimination is considerable; even with a an effective ownership share of only 10%, the
independent generator already has a 10% higher expected probability to win the auction. This violates one
of the key principles which the EU intends to apply to the electricity markets : creating fair competition in
electricity generation. Moreover, the fact that ownership integration creates strong discrimination against
independent generators might discourage investment into generation by independent investors and thus lead
to a lower, suboptimal, level of competition. The dynamic cost of such a suboptimally low level of
competition are not determined here, but are likely to be considerable.
Auction with n independent buyers
An interesting question for policy is to what extend the above analysis generalizes to auctions with more
than one competing independent buyer; in many countries in the EU and the USA there are several
independent buyers in transmission and procurement auctions. When the integrated buyerY faces n
independent buyers, has value v for the good on auction, and makes bid b, then his expected profit is given
by:
( )
nd
th th
2
[ ; ] Pr [ wins] ( (1 ) E[the highest bid from buyers| wins])
Pr[ has the 2 highest bid]
Pr[ has the i highest bid] E[the2nd highestbid from buyers| has the i highest bid]
n
Y
n
i
b v Y v n Y
Y b
Y n i Y
T K
K
K!
!
The expression in the first line gives the part of the profit when Y wins; in that case Y receives his value vminus the money he must pay that doesnt go to the integrated seller, this is equal to 1 K times the highest
expected bid from the n competing independent buyers. The expression in the second line gives the part of
the auction revenue Y receives when he has the 2nd
highest bid. In this case, Y sets the price to be paid by
the winner of the auction; Y thus receives the effective ownership share, K , times his bid b. The expression
in the third line gives the expression when Y has a bid lower than the 2nd
highest bid and thus does not set
the price. When Y has the ith
highest bid (with 2 i ne e ), the expected payment by the winner is the 2nd
highest bid from the (n-i) bidders that have a higher bid than Y. The total expected profit forY in this case
is thus his effective ownership share, K , times the summation of the probability ofY having the ith highest
21 In the model with two buyers, this implies that the integrated buyer is expected to win three times more often (75%) than theindependent buyer (25%).
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bid times the expected 2nd
highest bid from the (n-i) bidders.
The effect of having more independent buyers participating in the auction on the bidding function of the
integrated buyerY is not immediately clear. On the one hand, more buyers lowers the risk for the integrated
buyerY to win the auction with a bid higher than his value (the first line in the equation), and thus gives Y
an incentive to bid more aggressive. On the other hand, having more independent buyers lowers the
probability that Y will be setting the price by having the 2nd
highest bid (the second line in the equation),
and thus gives Y an incentive to bid less aggressive. Interestingly, for values being independent and
uniformly distributed on [0,1] the two opposite effects cancel out, and the integrated buyerY bids the same
as in an auction with 1 competing independent buyer:
Proposition 2:For any 1n u , in a second-price auction with n+1 bidders, n independent bidders and one
integrated bidder who receives a share K of the auction revenue, where values are distributed
independently and uniformly on [0,1], the independent bidders bid their value, and the integrated bidder,
bids(1 )
1
YY Y
vb v K
K
!
.
Proof:See appendix.
It is intuitive that the efficiency loss becomes smaller when the number of competing bidders goes up.
Interestingly, the discrimination effect keeps rather strong even for a high number of competing bidders.
Proposition 3:For any 1n u , in a second-price auction with n+1 bidders, n independent bidders and one
integrated bidder who receives a share K of the auction revenue, where values are distributed
independently and uniformly on [0,1], the integrated bidder has a higher expected probability of winning
the auction. The percentage increase in the expected probability of winninggoes to 100K % when n goes to
infinity.
Proof: See appendix.
Figure 3 gives a graphical illustration of the remarkable strength of the discrimination effect of integratedownership. The left graph shows the relative increase in expected probability of winning, which increases
with the number of competing bidders. The right graph shows the negative effect that each independent
bidder experiences. As we have seen before, a single independent bidder has a probability of winning 50%
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less for full ownership. Each competing independent bidder has, with full integrated ownership, a
probability of winning 37.5% less with two competing independent bidders. Even with three competing
independent bidders, which is a rather generous assumptions as the markets for electricity generation are
rather concentrated in the EU,22 each of them experiences a decrease in the probability of winning of 29%
for full integrated ownership. Even for low effective ownership shares the discrimination effect is rather
strong; for example when 0.15K ! , each independent buyer experiences a decrease in the probability of
winning between 5% (with 3 competing independent buyers) and 13% (with 1 competing independent
buyer)
Figure 3: Effects on discrimination with several independent buyers in second-price auctions
3.3 The first price auction
In this section, I will analyze the effect of the integrated buyerY owning a part of the integrated seller in
first price auctions.23 When Y fully owns the integrated seller in first price auctions, a general result can be
established.
Proposition 4: When the values ofXandY,X
v andY
v , are independently distributed without any further
restrictions on the possible distribution, then when the integrated buyerYhas toehold 1K ! , Ybids in a
first-price auction his own value.
Proof: When 1K ! , Yreceives the full amount of any bid paid. Therefore Ydoes not have to take bidding
costs into account and has a lower bound on the expected profit of min[ , ]Y X
v b . Now an ar gument similar to
that for truthful biddingin second-price auctions applies. Suppose Yhas valueY
v . IfYmakes a bid lower
than his valueY Y
b v , then with a positive probabilityXwins with a bid,X
b ,which is higher than the bid of
Ybut lower than the value ofY,Y X Y
b b v . In this case Ycan guarantee himself a higher profit at no costs
by biddinghis value,Y Y
b v! . A similar argument establishes thatYwill not make a bid higher than his
22For example, in a survey of the European Commission the average share in total generation of the largest generator in 2006was, for the 18 countries that reported, 61%22 (Eurostat)
23 In a first price auction the highest buyer wins and pays his own bid.
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value. Hence, YbidsY Y
b v! and has an expected profit of max[ , ]Y X
v b .
Corollary 1:A buyer in a first-price auction who receives the auction revenue in full bids as a buyer (who
does not receive the auction revenue) in a second-price auction. This is true for any independently
distribution of values and for any number of competingbidders as longas these bidders are not
beneficiaries of (a part of) the auction revenue.
The Corollary follows from the fact that the equilibrium bidding function in second-price auctions is
bidding the own value and from the fact that the proof above does not depend on the distribution of Y or X,
nor on the number of competing bidders. DELETE? OR IS INTERESTING FACT?
To further analyze the bidding functions of X and Y, I assume that the values of X and Y, ,X Yv v are
independently and uniformly distributed on [0,1].
Following lemma 1, Y wins the auction with bidY
b for value realizations ? AX Yv x b and looses for value
realizations ? AX Yv x b" . The expected compound profit ofY can thus be calculated by integrating over all
possible value realizations of X;
1) ? A ? A
? A
1
0
Y
Y
x bY
Compound Y Y Y Y X X X x b
b v b b dv b dvT K K!
The first integral is the expected profit when Y wins; the profit ofY is equal to the value of transmission
minus his bid plus the fraction of his bid that he actually pays to himself, K times his bid. The second
integral is the expected profit when Y looses; the profit ofY is then equal to the share of the payment by the
winner of the auction, K times the winning bid. Solving the first integral and substituting [ ]X X
v x b| in the
second integral and integrating by parts results in,
2) ? A ? A 1 [ ] [ ]Y
bY
Compound Y Y Y Y Y Y b
b x b v b b b x b x d T K K F F ! ,
where b is the maximum bid.
To determine the first order condition for profit maximization forY, differentiate equation 2) with respect to
Yb , set it equal to zero and substitute [ ]y b for
Yv :
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3) ( [ ] ) '[ ] (1 ) [ ]y b b x b x bK ! .
The profit maximization problem for X is identical to that forY with the ownership share set to zero, 0K ! ,
therefore the first order condition for profit maximization for X is:
4) ( [ ] ) [ ] [ ]x b b y b y bd ! .
Under no ownership of the seller, when 0K ! , the problem is symmetrical for X and Y and both have
bidding function 12b v! . Under full ownership, when 1K ! , Y bids his value, and thus, using 4), X bid is
given by 12X Xb v! . The more aggressive bidding ofY has several interesting effects on the profits of X and
Y and on efficiency. Interesting indicators are the compound, the passive and the strategic24
profits ofY.
The compound profit ofY consists of the transmission auction profit and the generation profit together.
Proposition 2 summarizes the main effects.
Proposition 5: When integrated buyerYhas full ownership, 1K ! , then relative to the case of no
ownership 0K ! : a) the price of the good on auction given by the auction revenue is higher, b) the
probability to win forYis higher while that forXis lower, c) the strategic profit of buyerYis higher, and d)
total efficiency is lower.25
Proof: See appendix.
Quantitatively, when Y has full ownership of the integrated seller, the auction revenue increases with 62.5%
from 13
to 1324
, the probability of winning forY increases from 50% to 75%, the probability of winning for X
falls to 25%, the strategic profit increases from 0 to 124
, and efficiency falls with 4.2% from 23
to 1524
.
Corollary 2:Revenue equivalence between first and second-price auctions does not hold.
24 The compound profit ofY, the profit of the transmission auction and the generation together, is influenced by the ownership
share K has a direct and a strategic effect on the compound profit. The direct effect translates into what I will refer to as the
passive profit and is due to the fact that Y receives proportion K of the auction revenue. The passive profit is the profit that Y
would receive when he owns the proportion K , but bids as i f his ownership share was zero. The strategic effect translates into
what I will refer to as the strategic profit and is due to Y changing his bidding schedule. The strategic profit can be found by
subtracting the passive profit from the compound profit.25 The effects are all described by ex-ante expectedmeasures (before bidding and before concrete values have been realized).
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Proof: Usingthe above biddingfunction the auction revenue can be calculated to be equal to 1124 for the
case of full ownership. In section 3.1 I found that the auction revenue in a first-price auction is equal to 1324
for the case of full ownership.
Outcomes for :0 1K K lie in between the extremes of no ownership, 0K ! , and full ownership,
1K ! . Equations 3) and 4) can be solved numerically for [ ]x b and [ ]y b for : 0 1K K .26 Figure 3
therefore shows numerical approximations of the bidding functions for 0 1K together with the highest
bid b and the bidding function for 0K ! and 1K ! .27
Figure 4: the bidding functions for independent buyer X and integrated buyer Y in first-price
auctions.
The bidding functions in Figure 4 demonstrate that an increased ownership share in the seller results in
the integrated buyerY bidding more aggressively. Y maximizes profits given by
Pr[ wins | ] ( (1 ) ) Pr [ looses | ] ( )Y Y Y Y X
Y b v b Y b bK K . A positive ownership share, 0K " , increases the
gain of winning, (1 )Y Yv bK . This gives Y the incentive to sacrifice a part of this gain, by bidding
stronger, to increase his probability of winning. This incentive is partly countered by the income Y earns
when he looses; the ownership share times the bid of X,X
bK .28 All in all, Y bids stronger.
26To my best knowledge there exists no explicit analytical solution for the bidding function in first-price auctions with
: 0 1K K . Proposition 6 in the appendix lays out the necessary restrictions that the bidding strategies must fulfill.27
Note that there is a discontinuity at 1K ! . If and only if 1K ! , then biddingY Y
b v! is a weakly dominant strategy forY.
Suppose 1K H! (for small 0H " ), then if X sticks with her strategy 12X X
b v! , then Y would never bid more than 12
I (for
small 0I " ). At 12Y
v I! there would be a mass point which in turn would create an incentive for X to try to overbid it
whenever her value is larger ( 12X
v I" ). Therefore, once 1K , biddingY Y
b v! cannot be an equilibrium strategy forY. For
an equilibrium in pure strategies to exists at all, the bidding functions of X and Y must have the same bid for 1Y X
v v! ! . This is
the case in the strategies shown in Figure 3; there are no mass points, and the density ofYs bids is continuous, excluding the
possibility for X to improve her profits by deviating from her strategy. This implies that the maximum bid b converges to 1 when
the ownership share K goes to 1.28
Compare the bidding ofY with the much stronger bidding of a comparable buyerY in Van Koten (2007), where Y is a
subsidiary of a holding company and the pay-off ofY is given by' ' '
Pr[ ' wins | ] ( (1 ) )Y Y Y
Y b v bK , while 0 1Ke e is a
parameter set by the holding company in order to strategically delegates decision powers to Y. When Y looses he has noearnings and he bids stronger than buyerY in the present paper.
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The stronger bidding ofY lowers the profits of X, Pr[ | ] ( ) X X X
X wins b v b , by lowering the
probability of X to win the auction. This gives X the incentive to sacrifice a part of her earnings, by bidding
stronger, to increase her probability of winning. The relevant effects are, firstly, that there is a negative
efficiency effect; the ownership share makes the auction inefficient. The loss can be as large as 4.2% for full
ownership. Secondly, there is a discrimination effect; the independent generator, who has thesame value
distribution as the allied generator, has a lower probability of getting access to the transmission, which can
be as low as 25% for full ownership. Thirdly, there is a strong price distortion effect; transmission capacity
will be sold for a higher price. The increase in price can be up to 62.5% for full ownership.
3.4 Alternative models
In this section I analyze two alternative cases that might be relevant in electricity markets. The cases are
very similar to the setup I analyzed before, but make different assumptions concerning information. In the
first case I assume that there is no uncertainty; generators know the exact value of their competitors. In the
second case I assume that generators have the same value for the good on auction, but dont know this
value; they only have available an estimate of this value. This case can be modeled as a (unknown) common
value auction.
No uncertainty
While I assumed that generators have private information about their values (allowing a common value
factor that is publicly known), as they have to make an estimate that is subject to error, it could be useful to
look at an idealized situation where generators can estimate the exact value of their competitor without
error. It is shown that in such an ideal case of perfect information, most of the effects found before
disappear; there is no inefficiency and the probability of the independent buyer to win is not negatively
affected. Due to the fact that such a model has a continuum of Nash-equilibriums, the effect on the expected
price cannot be determined.
For generality, I assume that both buyers may have an ownership share; buyerY has ownership share
: 0 1Y Y
K Ke e and X has ownership share : 0 1X XK Ke e . To guarantee the existence of Nash-equilibriums,
I make the assumption that if both buyers make the same bid, then the auction then is won by the buyer withthe highest value (and in case of equal values the winner is chosen at random).
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Proposition 7:When a buyerYwith ownership share : 0 1Y Y
K Ke e and valueY
v , and a buyerXwith
ownership share : 0 1X X
K Ke e and valueX
v , are competingin an auction and the values are common
knowledge, then there exists a continuum of Nash-equilibriums. WhenX Yv v , then Ybids Yb p! andX
bidsX
b p! with [ , ]X Y
p v v . Ywins and earns both in first-price and second-price auctions
(1 )Y Y Yv pT K! . Xlooses and earns X XpT K! . In case X Yv v" , the Nash-equilibriums can be
expressed symmetrically.
Proof: When the price for transmission is equal to p, then a buyer with ownership share K and value v
receives when winning (1 )v p v p pK K ! and when loosing pK . From the relationship
p v v p p pK K " it follows that when the price is lower (higher) than his value, the buyer prefers to
win (loose) the auction and receive v p pK ( pK ).
There is a continuum of Nash equilibriums, in all of which the buyer with the highest value wins the
auction; all Nash equilibriums are thus efficient. However, because of the multiplicity of equilibriums it is
not clear which equilibrium will be chosen, and neither is it clear whether the buyers will be able to
coordinate on a Nash equilibrium. To determine the effects on efficiency, competition and price, further
assumptions must be made on how buyers set their bid or possibly bargain. I assume that the buyers are able
to coordinate on a Nash equilibrium. This implies that the auction is efficient, as all Nash equilibriums in
this auction are efficient. Furthermore, as the buyer with the highest value wins the auction, both buyers
have equal probability to win the auction; 50% each, which indicates that there is no discrimination againstthe independent buyer concerning winning the auction. However, it is possible that an independent buyer,
without an ownership share, earns less profit than an integrated buyer. For example, imagine that when the
value of the independent buyer is the higher (lower), the Nash equilibrium with the higher (lower) price is
selected. In that case the independent buyer earns zero profits, while the independent buyer earns positive
profits. Such a result would discourage investment in new independent generation. Stronger assumptions
would be needed to determine the precise effects. The price of the good on auction, as reflected by the
auction revenue, will be between the lowest and the highest value, which means that the price is weakly
higher compared to an auction where values are not common knowledge and no buyer has an ownership
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share.29
As explained before, a higher price can be interpreted as a positive effect as the resulting price in an
auction is lower than the value of the good.
The case of no uncertainty thus shows that with complete information, the negative effects are likely less
pronounced for integrated ownership of generation and transmission. To determine the precise effects more
structure needs to be added to the model. It is however clear that when information is complete, integrated
ownership seller does not result in inefficient allocations, and neither is the independent buyer disfavored in
winning the auction, while it is unclear whether the independent buyer possibly earns less profits.
Unknown common values
While I allowed in my model for an identical common value component in the valuations of the bidders,
I assumed that this component is common knowledge to both two buyers, thus preventing this component to
affect bidding strategies; these are determined by the unknown private value factor. A setup without a
private value factor and where the size of the common value component is unknown to both buyers, can bemodeled as a common value auction. Bulow et al. (1999) model such common value auctions where buyers
own a share of the seller. Both buyers have the same value for the good on auction, but the exact value of
the good is only known with certainty after a buyer has won the auction. Both buyers have private
information (called a signal) that allows them to make an estimate of the value of the good.30
From the
results of Bulow et al. (1999) for the case where only one buyer, the integrated buyer, has an effective
ownership share, and under additional assumptions similar to the ones I use in my model, signals are
uniformly distributed on [0,1], and the common value component is equal to the average of the signals,
similar conclusions to the ones in my model can be drawn.
While efficiency is not an issue in such a common value auction by definition (the good has the
same value for each buyer), ownership integration has, like in my model, a strong discrimination effect
(against the independent buyer) and an upwards effect on prices. Under the mentioned additional
29It is a standard result that in an auction with two buyers, where values are not common knowledge and no buyer has an
ownership share, the expected price is the lower of the two values (see for example Krishna, 2002).30
Such an analysis might be relevant for the electricity markets. For example, generators that have the same costs in producing
electricity might both need transmission capacity to sell electricity in a distant location. The exact price the generators will receive
in the distant location is not certain, and each generator makes an estimate of this price given his private information. The value oftransmission capacity to the distant location is then the same for both generators, but each has a different estimate of this value.
This situation can be translated into the model of Bulow et al. (1999). A similar situation could be in the case of procurement
auctions. Negrete-Pincetic and Gross (2007) argue that there was to a high extend uncertainty over the value of the contracts on
sale in Illinois in 2006. If the value of the contracts was indeed uncertain, and if generators had more or less the same cost ofproducing electricity, then the auction could be modeled by a common value auction, as done in Bulow et al. (1999).
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assumptions the probability of winning of the independent buyer is1
[ ]2
IP X winsKK
!
in first-price, and
[ ] 0IIP Y wins ! in second-price auctions. The discrimination effect is thus stronger in such common value
auctions; the probability of winning for the independent buyer in second-price auctions iszero, even if the
integrated buyer has only a small effective ownership share, and in first-price auctions goes to zero when the
effective ownership share ofY goes to one. The expected price of the good on auction when the integrated
buyer has a strictly positive, but possible very small, effective ownership share cannot be compared with the
price when the integrated buyer has no effective ownership share. In the latter case such a common value
auction has a multiplicity of equilibriums (Bulow et al., 1999). However, it can be determined that the
expected price is increasing in the ownership share of the integrated buyer; the expected auction revenue in
second-price auctions lies in between 0, when the ownership share K approaches zero, and 34
for full
ownership (Bulow et al., 1999), and in first-price auctions in between 13
, when the ownership share K
approaches zero, and 58
for full ownership.31
The model of Bulow et al. (1999) show that integrated ownership has similar effects on competition
as my model, while efficiency is by definition not an issue and the effect on expected price cannot be
determined due to indetermination of the model when the integrated buyer has no ownership share.
4. The procurement auctions in New Jersey and Illinois.
The procurement auctions held in New Jersey from 2002 till 2008 and in Illinois in 2006 are
examples of cases where distributors and generators figured as integrated sellers and buyers. In 2002, New
Jersey organized its first procurement auction where distribution companies sold one-year forward contracts
to ensure the electricity needs of their default service customers for a one-year period (Loxley & Salant
2004).32
The contracts were sold in procurement auctions as fixed percentages of load, called tranches. All
31The expected auction revenue in second-price auctions is equal to
2 1( )
4 4
IIm
KK K
K
!
, which lies in between 0, when the
ownership share K approaches zero, and3
4 for full ownership (Bulow et al., 1999). Using the functions in Bulow et al. (1999)with the additional assumptions mentioned above the expected auction revenue in first-price auctions can be shown to be equal to
32
1 1
2 2
1
(12 8 ) Gamma[ ] (3 )(2 ) Gamma[ ]1 1 1( )
2 6 2 6 7 2 (1 )(3 2 ) Gamma[3 ]
Ij j
mj j
K
K K
K
KK
K K K
!
.
32 See also http://bgs-auction.com.
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four distribution companies selling contracts, Public Service Gas & Electric Company (PSE&G), Jersey
Central Power & Light Company (JCP&L), Atlantic City Electricity Company (ACE) and Rockland
Electric Company (RECO), were integrated sellers; they were owned by holding companies that also owned
generation companies. In the procurement auction in Illinois in 2006 electricity supply contracts were, like
in New Jersey, sold in tranches (Negrete-Pincetic and Gross, 2007). Both the two distributors involved,
Ameren and ComEd, were integrated sellers as they were owned by holding companies that owned
generators that were bidding in the auction. Table 1 gives an overview of the distributors and their
integrated generators in New Jersey and Illinois.
Table 1: Distributors and their integrated generators in New Jersey and Illinois
The auctions ran in New Jersey and Illinois were, as they were multi-unit auctions and had more
than two bidders, more complicated than the auctions I modeled in this paper. A more detailed treatment ofthe auctions can be found in Negrete-Pincetic and Gross (2007) for the Illinois auctions, and in Loxley &
Salant (2004) and on http://bgs-auction.com for the New Jersey auctions. However, it is likely that the logic
in the theoretical cases treated in this paper carries over to more complicated settings. The models then
predict that non-discrimination is violated and that integrated buyers have a higher chance to win an auction
than independent buyers. A buyer will thus be more likely to win auctions when the seller and the buyer are
owned by the same holding company (they have the same affiliation), then when the seller and buyer are
owned by different holding companies (they have different affiliation). In the case of the auctions in New
Jersey and Illinois, an integrated generator is expected to acquire more tranches of his own integrated
distributor.
The raw data suggest that this might be the case; Table 2 shows the percentages of tranches won by
the generator integrated with ACE (Connective) in the auctions over 2002-2008, for the different products.
As my model suggests, the average percentage of tranches Connective won of ACE is higher than those won
of other distributors. In addition, Connective, from 2004 on, only aquired tranches from his integrated
distributor ACE, which suggests that Connective learned over time about the strategic advantage it has in
auctions for traches of ACE.
Table 2: Tranches won by the generator integrated to ACE (Connective)
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To test if bidders with affiliation did indeed have an advantage in the BGS auctions, I compare the
(unweighted) average proportion of tranches won in auctions over 2002 till 2006 among the four integrated
generators. If affiliation has no effect, then an integrated generator should win, on average, equal
proportions for the different distributors. If affiliation brings an advantage, then the average proportion of
tranches won should be higher for a generator when the distributor has the same affiliation, then when the
distributor has a different affiliation. For example, a generator integrated to ACE should have a higher
proportion of contracts won for supply to ACE than for supply to JCP&L, PSE&G, or RECO.
Table 3: Results of the New Jersey BGS auctions over 2002-2006
In Table 3 in column no.1 I have shown the average percentages of the load (called tranches) won in
the New Jersey BGS auctions from 2002 till 2008 by the generators with the same affiliation as one of the
distributors. Numbers in bold are the percentages won when the generator and the seller had the same
affiliation. In column no.2, I have depicted the averages of the percentages won in auctions by the three
generators that have a different affiliation than the generator in the row. For example, the generator
affiliated with ACE, won over the auctions from 2002 till 2008 an average of 8,1% of the tranches of ACE,
which is higher than the average percentage of tranches he won of any of the other distributors (JCP&L,
PSE&G and RECO). Table 3 shows that percentages won by integrated generators (the bold numbers in the
first column) are higher than the average percentage won by generators with another affiliation (the second
column). The percentage of tranches won by the generator affiliated with RECO is significant.33
Table 4: Results of the Illinois auctions in 2006
Table 4 shows the average percentages of the tranches won in the Illinois auctions by the generators
with the same affiliation as one of the distributors. Numbers in bold are the percentages won when the
generator and the seller had the same affiliation. Also here the average percentage of tranches won from a
distributor is higher when the generator has the same affiliation.
For a more rigorous test, I ran separately for Illinois and in New Jersey regressions with Won, the
proportion of tranches won in auctions for the integrated generators, as dependent variable. As independent
33I compared the average of tranches of RECO won by the generator affiliated with RECO (Consolidated Edison Energy, Inc.)
with the average of tranches this generator won with the other distributors using a t-test with pooled variance. I did the same testfor the other generators, but most of them had a low significance (round 0.2 ~ 0.3).
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variable I used indicator variableIntegrated, which takes value 1 (0) if the proportion won by the generator
was with an integrated (non-integrated) distributor. As the auctions in New Jersey took place over 2002 till
2008, I also included variable Year, indicating the year the auction took place. The theory presented in this
paper suggests that an integrated buyer will bid more aggressively in an auction and thus have a higher
probability of winning the auction; the variableIntegratedshould thus have a positive effect on the
proportion won. Table shows that in regressions with the proportion won as a dependent variable, the
coefficient onIntegratedis indeed positive and significant, both in Illinois and in New Jersey.34
Table 5: Percentage of tranches won in auctions regressed onIntegrated.
My analysis in the procurement auctions in Illinois and New Jersey shows that generators obtained
higher shares of contracts for supply, called tranches, for integrated than for non-integrated distributors.
This conforms to the intuitions developed in the theoretical models in this paper. However, an alternativeexplanation would be that there are other advantages for a generator to supply to an integrated distributor.
For example, a generator might receive information of his integrated generator which enables him to better
forecast the needed supply and thus save costs. In addition, for the theoretical models in this paper to apply,
it must be the case that the distributor at least partly benefits from the auction revenues, and that a part of the
benefit is passed on to the owner, the holding company. A more extensive study could control for such
alternative explanations.
5. Conclusion
My analyses suggest that the integrated ownership of a buyer and seller has negative effects on auction
outcomes under imperfect information. A holding company that owns both a buyer (the integrated buyer)
and (a share of) the seller, has incentives to make the integrated buyer bid more aggressively. Consequently,
the probability of winning for the integrated buyer increases at the expense of an independent buyer, thus
curbing competition. This increases the profits of the integrated buyer, while causing efficiency losses. The
aggressive bidding also drives up the price of the good on auction. This price effect can be interpreted as
positive: in transmission auctions the transmission capacity, which is generally underpriced, is then priced
slightly closer to its value, and in procurement auctions the distributor can buy electricity for a lower price.
34As a robustness test I included several sets of dummy variables in the regression. I included dummies for different products
(contracts for different duration and pricing), for years, and for generators, but the significance of the variableAffiliatedwasvirtually not influenced. See Table A in the Appendix for the regression models including the dummies.
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Additional analyses shows that the negative effects only occur under imperfect information; when the
buyers valuations for the good are common knowledge, the allocations that result from the auction are no
longer discriminatory and inefficient.
These results should be of interest to regulators of the EU and USA electricity industries. In the EU
regulators addressed the issue of underinvestment in capacity by allowing unregulated for-profit building of
transmission lines. In such a setting, a VIU might be tempted and in fact is likely, as I have shown above
not to allocate transmission capacity in a non-discriminatory and efficient manner. Most notably auctions
lose their favorable features (non-discriminatory, market-based and efficient). As a result, the competitive
effect of new connection lines in the merchant model is smaller under legal unbundling than under
ownership unbundling. This questions the claim of Brunekreeft et al (2006) that ownership restrictions are
not much of a concern, as they assume that the owner will want to keep competitive pressure between the
generators. My model shows that this is not the case as long as only legal unbundling is applied.
This is highly relevant for EU electricity generation markets : as national electricity generation markets
in the EU are very concentrated,35
they need to attract new entrants to make the liberalization reforms
successful. Furthermore, the holding company owning the integrated seller is advantaged, and because the
holding company is often the (former monopoly) incumbent who typically still holds a dominant position in
the electricity supply industry, this does not facilitate competition.
In the USA contracts for electricity supply have been sold in procurement auctions. The distributors who
were selling the auctions were owned by companies that also owned generators that participated in the
auction. Such auctions are likely not fair integrated generators have a higher probability to win auctions.
Indeed my empirical analysis showed that integrated generators indeed obtained significantly more contracts
from integrated distributors than from other ones. This might affect efficiency negatively and discourage
new entrants. However, a positive static effect is that the aggressive bidding of integrated generators makes
the electricity cheaper for distributors, and consumers are likely to benefit from this.
There are a few possible solutions to remedy the negative results found in this analysis. Firstly,
regulators could aim their efforts at preventing that auction revenues benefit the VIU that owns distribution
or transmission networks. This would, if successful, reduce the effective ownership share to zero and thus
take away the basis for the advantaged position of the integrated generator. Enforcing ownership unbundling
would effectively achieve this goal. Alternatively, given the strong resistance against ownership unbundling
35In 2006, 20 regulators submitted data on the concentration of electricity generation in EU member states. Out of these 20, 7
countries were highly concentrated (HHI between 1800 and 5000), and 8 countries, among which Belgium and France, were veryhighly concentrated (HHI above 5000) (Commission of the European Communities, 2008b, p.11).
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both in the EU and the USA, regulators could try to achieve this goal by means of strict regulation without
ownership unbundling, for example by using rate of return regulation for transmission and distribution
networks. However, rate of return regulation has long been known to lead to welfare losses (Averch and
Johnson, 1962). To give a network owner incentives to run the network efficiently and to add new capacity
usually a form of incentive regulation is used that allows a network owner to keep a part of the generated
profit. Moreover, preventing transmission owners from benefiting from the generated profits goes against
the EU policy of allowing the merchant (for-profit) building of new transmission lines. In addition, there is
evidence that it might be difficult in practice to regulate the auction revenues of the VIU; regulators in the
EU have not been successful in enforcing the prescribed use of auction revenues for transmission lines.
While EU regulations state that auction revenues of international transmission lines (interconnections)
should be spend on infrastructure projects in full, an energy inquiry by the European Commission that took
a sample of 10 transmission owners reported that, over the years 2001-2005, a mere 20% of the auction
revenues were spend on such projects (Commission of the European Communities, 2007, p.179).
Secondly, an independent generator could be awarded or sold an ownership share such that both
generators end up with equal shares.36
Ettinger (2002) has analyzed unique symmetric equilibriums for first-
price and second-price auctions with two buyers who have symmetrical shares of ownership in the seller
(called toeholds) under the assumption of private, independently distributed values. 37 In a symmetrical
equilibrium exists by definition no discrimination effect, hence the buyer with the highest value wins, which
implies there is no efficiency loss as I found in my model. Moreover, the positive effect of integrated
ownership, a price closer to the optimum is strengthened; using the solutions for the bidding functions of
Ettinger (2002), and assuming that values are uniformly distributed as in my model, it is easy to show that
when the price increases in the ownership shares. When both buyers own the maximum possible ownership
share, the increase in expected prices is 33% in first-price auctions, and 67% in second-price auction.
Giving equal shares thus provides a solution. It requires the regulator to have the authority to mandate the
VIU to sell shares in the transmission line to new independent generators. Moreover, implementation of
such a measure brings up many practical questions, such as on what legal basis should regulators be allowed
to take away ownership shares from the incumbent and for what compensation? And should ownership
shares be only given to participating buyers or also topotentiallyparticipating buyers? Giving buyers
symmetrical shares therefore does not seem a practical solution in most cases.
36A form of such co-ownership structure is used in Finland for the transmission network Fingrid (REF!)
37 Ettinger (2002) finds that also with symmetrical ownership shares revenue equivalence between the first-price and second-priceauction does not hold.
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Thirdly, a possible remedy is to mandate the VIU to legally separate not only the integrated seller, but
also the integrated buyer. This is the form of legal unbundling that Cremer et al. (2006) consider, and for
which Hffler and Kranz (2007a) coined the term reverse unbundling. By implementing the same sort of
legal unbundling for the integrated buyer, the holding company is no longer able to give the integrated buyer
day-to-day instructions. Also, the integrated buyer is not allowed to receive take revenues of the integrated
seller or the holding company in account; it is usual that in a legally unbundled firm managers are not
allowed to receive bonuses contingent on results of the holding company.38
I take up this question in Van
Koten (2007), and show that auction outcomes are still negatively affected on the same dimensions as in this
paper, even though slightly less pronounced. Legal unbundling of the integrated buyer is therefore not a
sufficient measure.
The solution most in line with economic logic is to mandate ownership unbundling for distribution and
transmission networks. When buyers have no ownership shares in sellers, auctions are efficient and non-
discriminatory.
6. Appendix
Proposition 1:As the ownership share K increases, a) the price of the good on auctiongiven by the
auction revenue increases, b) the probability to win for the integrated buyerYincreases while that for
buyerXfalls, c) the strategic profit of the integrated buyerYincreases, and d) total efficiency falls.39
Proof: The probability forYto win the auction is given by 12[ ]2(1 )
Y winspK
KK
!
, which is increasingin
K, and thus the probability ofXwinningthe auction is decreasingin K . The above expression can be found
by usingthe Lemma 1 (page 11) and the second-price auction biddingfunctions forXandY(page 11). Y
with a realized value ofY
v wins with probability ? A[ ; ] [ ; ]1
Y wins YY Y Y
vp v x b v
KK K
K
! !
. The expected
proportion of auctions that is won by Ycan be found by integrating [ ; ]Y winsY
p v K over the realizations ofY
v :
1
0[ ] [ ; ]Y wins Y wins
Y Yp p v dvK K!
38For example, managers in legal unbundled transmission companies are not allowed to receive bonuses contingent on results of
the holding company (Directive 2003/54/EC, article 10, section 2b, and Commission of the European Communities, 16.01.2004,
p.8).39 The effects are all described by ex-ante expectedmeasures (before bidding and before concrete values have been realized).
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1
0 1
Y
Y
vdv
K
K
!
12 1
21 2(1 )
K KK K
! !
.
a) The price of the good on auctiongiven by the auction revenue increases
Proof: The auction revenue is given by ? A 2
1 (2 )
3 6 1m
K KK
K
!
, which is increasingin the ownership
share K . The auction revenue ( ? Am K ) can be found by calculatingthe expected payment of each bidder
(( ? AYm K and ? AXm K ) and add these up.
? A ? A ? AY Xm m mK K K!
? A1 1
01
| |YWINS XWINSx x y y Y X Y X
P E b b b dv P E b b b dvKK
! " -
1 1
01
| 1 |1 1 1
y y Yx x y X Y X X
v v vE v v dv v E b v dvK
K
K K KK K
K K K
! " - -
2
1 1
01
11 | 1
2 1 1
y Yy X Y X X
v vdv v E v v dvK
K
K KK K K K
K K
! -
2
12
1
11
1+3 3 2116 1
X
X X
v
v dvKK
K K KK K K K KK
!
12 2 22 1
3
2
1
(1 )1+3 3
2( 1)6 1
X Xv v
K
K
K KK KKK
! -
2
2 2
1+3 3 1 3
6 1 6 1
K K K
K K
!
21 (2 )3 6 1
K KK! .
c) The strategic profit of the integrated buyer Y increases
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Proof:The strategic profit ofYis given by ? A
2
6 1
Y
Strategic
KT K
K!
, which is increasingin the ownership
share K . The strategic profit is defined as the extra profitYcan earn by consideringhis ownership
share K when choosinghis biddingfunction. This is equal to
? A ? A ? A ? A ? A 0 0Y Y YStrategic Generator Generator m mT K T K T K K! . The strategic profit is the sum of the effects ofstrategic biddingon the generator profit (negative) and the auction revenue (positive) times the
ownership share K .
The generation profit ofYis equal to ? A
2
16 2
6 1
Y
Generation
KT K
K!
. It can be derived by multiplyingthe
probability of winningtimes the generation profit and integratingthe resultingexpression over the
possible value realizations:
? A ? A 1
0|Y YWINSGenerator Y X X Y Y P v E b b b dvT K !
1
0|
1 1
Y YY X X Y
v vv E v v dv
K KK K
! -
1120 1 1
Y Y
Y Y
v vv dv
K K
K K
!
12 3 2 3 21 1 1
2 3 3 2
01 2( 1)
Y Y Y Y Y
v v v v vK K K
K K
! -
21+2
6 1
K
K!
2
16 2
6 1
K
K!
.
Usingthe expressions for the generator profit and the auction revenue, the strategic profit can be
determined:
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? A ? A ? A ? A ? A
2
1 1
6 2 6 2
2
2 2
2
0 0
1 (2 ) 1
3 36 1 6 1
(2 )
6 1 6 1
6 1
Y Y Y
Strategic Generator Generatorm mT K T K T K K
K K KK
K K
K K K
KK K
K
K
!
!
!
!
d) Total efficiency falls.
Proof:Efficiency is given by ? A
2
2
2
3 6 1W
KK
K!
, which is strictly decreasingin the ownership share
K . Efficiency can be found by addingthe profits ofXandYwith the auction revenue;
? A ? A ? A ? AY XW mK T K T K K! .
The profit ofX, ? A 21
6( 1)
XT K
K!
, can be found by multiplyingthe probability of winningtimes the
profit and to integrate the resultingexpression over the possible value realizations.
? A ? A 1
1
|X X WINS X Y X Y X
P v E b b b dvKK
T K
!
? A1
1
[ ] |1
Y X X X Y X X
vy b v v E b v dvK
K
K
K
! " -
1
1
1 | 11
X X Y X X
vv v E v v dvK
K
KK K K K
K
! -
1
1
11
211
X
X X X
vv v dvK
K
K K KK K
K
!
21
21
2
1
(1 )2( 1)
X X X v v dvK
K
KK KK
! -
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12
3 21 16 2
1
(1 )2( 1)
X
X X
vv v
KK
KK K
K