When you hear the word “auction”, the first thing you might probably think of are names like Sotheby’s or Christie’s, two auction houses that are particularly well known for selling art. For example, Christie’s auctioned Leonardo da Vinci’s painting “Salvator Mundi” in 2017 for a record price of 450 million US dollars. Obviously, these auctions have the objective of generating the highest possible revenue for the seller. However, there are numerous examples, where revenue maximisation is not the main motive of an auction. But let’s look at some basics first.
A brief introduction to auction theory
In auction theory, we as game theorists distinguish between private-value and common-value auctions. The auction of a painting is a typical example of a private-value auction, where bidders have different preferences for the same auction item and each bidder knows exactly his or her own valuation of the auction item during the bidding process.
In contrast to that, the value of an auction item in a common-value auction is unknown to the bidders, but to a large extent identical for them. They typically only have an individual estimate of the true value which is subject to uncertainty. Examples of common-value “objects” are oilfields, telecommunication spectrum or – as in a very recent case – wind farms.
Why auctioneers should consider the winner’s curse
A phenomenon that often occurs in connection with common-value auctions is the so-called “winner’s curse”. This means that the auctioned object is worth less than the highest price paid and was therefore significantly overestimated by the (too optimistic) winner of the auction. Auctioneers usually try to avoid the risk of the winner’s curse for at least two reasons. On the one hand, they fear a reduced revenue if experienced bidders bid more defensively in anticipation of a winner’s curse risk. On the other hand, they don’t want bidders to overpay or, even worse, go bankrupt because they suffered from the winner’s curse.
Take the example of Germany`s UMTS spectrum auction in summer 2000: The government raised a whopping 100 billion DM by auctioning off spectrum bands that telecommunication providers needed to build their 3G networks at the time. While the unexpectedly high revenues were initially celebrated, disillusionment soon set in. Two of the auction winners later had to give up, and the telecommunication giants also had to cope with the high license fees for a long time. Network expansion progressed much more slowly than planned because there was simply no money for investment and bidders tried to retrieve payments via tax deductions.
Auction rules need to be fit for purpose
Undoubtedly, for many auctions, revenue maximisation will be the driving motive. However, if a government or regulatory authority designs an auction for public assets, the question is (if there are not additional or even superior objectives that need to be accounted for) can they ensure a functional, competitive market structure, fast innovation, efficient implementation, or broad coverage, to name only a few considerations. This can be achieved by setting the rules accordingly, examples ranging from ensuring a particular number of winners, preserving particular lots for smaller challengers, and establishing a common cost for the winners via a uniform pricing mechanism. In the case of wind farms, one would expect that ensuring a functional market for renewable and sustainable energies would be a supreme goal. This raises the question whether this was indeed accomplished in Great Britain recently, where the government auctioned off the rights to develop offshore wind farms with a capacity of almost 8 GW. Nothing striking so far.
BP`s role in the British offshore wind farm auction 2021
It was striking, however, that BP, together with its co-operation partner EnBW, bid twice as much per megawatt and year as the established wind company, RWE Renewables. Reading the bids, this could mean that newcomer BP and its partner EnBW believe they can implement the project much faster or value the particular locations significantly higher than RWE, who have already built an offshore park on the east coast of Britain and should actually have more synergies. But it is also likely to be interpreted that RWE anticipated the winner’s curse and built substantial risk buffers into its bids.
We cannot look into the minds of the decision makers at BP and EnBW, but the counter thesis to the winner’s curse could be that they are not inexperienced in auction matters and have strong offshore experience. Even if BP and EnBW are financially strong and have a large strategic interest to enter the British wind farm market, the sheer difference in the bids remains striking. Looking at the outcome from a different angle, such an award is a beacon project. It has a strong signal effect on future electricity prices in and outside the UK. One might also argue that the more expensive offshore wind farms are, the longer it may take to construct them, and the longer companies like BP can continue to sell their fossil fuels.
Setting the auction rules correctly is crucial for achieving your goals
Whether or not BP bid too much – due to inexperience, strategic value to jump the green energy bandwagon, or other motives – only the future will tell. Either way, if you are in the position to set the rules of an auction, be it for public or private tenders, you need to bear in mind which goal you want to achieve and if the designed rules serve the right purpose. If the authorities were mainly interested in generating as much revenue as possible and building a golden bridge for a British fossil fuel giant into the world of renewable energies, then one has to say: “hats off”! But in times when climate protection is at stake, an award for something with such an immense public interest should ensure that the market for renewable energies flourishes instead of becoming structurally burdened and potentially massively subsidised for years to come. In any case, the auction rules of British authorities will probably neither go down in history as “Salvator Mundi”, nor are they likely to bring a wind of change into the market for renewable energies.
If you’d like to get more insights on how game theorists evaluate auctions in markets for electricity and renewable energies, check out one of our latest podcast episodes:
Why cheaper isn’t always better – the effect of zero prices in the electricity market | With Robert Idel
Sources & further reading:
- The Winner’s Curse: Paradoxes and Anomalies of Economic Life | Thaler, Richard
- Using and abusing economic theory | Klemperer, Paul
- Title image Norbert Pietsch on Pixabay