Auctions as an allocation tool – how auctions can be tailored to reduce uncertainty

Norway is in the process of opening up for establishment of offshore wind production. One option is the use of auctions to allocate exclusive rights for this purpose. Industry players have raised concerns in particular due to uncertain prerequisites for these auctions. In this article, we point out that uncertainty might be mitigated by tailoring the auctions, and we give examples on how uncertainty can be reduced.

An auction is an allocation tool – a mechanism to efficiently allocate limited goods and services. There are numerous different types and sub-types of auctions, and each of these can also be tailored specifically. Four basic auction formats are: first-price sealed-bid auction, second-price sealed-bid auction, open ascending-bid auctions and open descending-bid auctions.

Most auctions are based on these basic formats, and all auction theory is in essence economic game theory.

Authorities worldwide increasingly use auctions to allocate limited exclusive rights, such as licences on a wide variety of areas. Internationally, probably the most common rights to allocate using auctions are spectrum licences. In Norway, also milk quotas for farmers and salmon fish farming licences are examples of exclusive rights auctioned out by the authorities.

When authorities design auctions, they normally engage auction experts to tailor the auction format to the specific case and also to provide the auction software since most such auctions are digital and web-based. The most important elements from the auction format is regulated in an auction regulation. Further details are often set out in detailed auction rules. Combined with other relevant information material to bidders, these elements form the frame and content of the auction.

Concerns raised by industry players

The Norwegian Ministry of Petroleum and Energy (the Ministry) is currently in the process of further developing the legal framework for offshore wind production in Norwegian sea areas. In awarding projects, they can decide whether to use auctions, or an assessment of applicants using objective and non-discriminatory terms, or a combination of these two allocation methods. For Sørlige Nordsjø II, the Ministry has suggested that allocation of an exclusive right to conduct a project specific impact assessment of potential offshore wind energy production, and to later apply for a licence to operate, can be decided using auctions. A public hearing was conducted this summer, and the Ministry is currently assessing the input from the consultation.

In the consultation, several industry players argued against the use of a quantitative allocation method such as an auction, in particular when the framework conditions are as uncertain as they are today. As an example, the future technological requirements, but also key infrastructural aspects such as physical market access, may influence the energy price and thus the potential income from the specific offshore wind activity. Furthermore, uncertainty related to the government’s ambitions for future development in the field of offshore wind, and also the pace of this and future allocation processes, were highlighted as concerns by the industry in the consultation.

To an extent the concerns raised are also that an auction can have a too narrow perspective, focusing too much on maximising the government’s profit – and by doing so limiting the variety of industry players. From society’s and authorities’ point of view, maximising profit from an allocation process is often not their only goal. In most cases there are also other, goals that have to be taken into consideration when designing and deciding upon an allocation tool.

How can uncertainty be mitigated and goals met?

An auction for offshore wind production – now in the relatively near future – may be encumbered with uncertainty which may affect the estimated future income for the production, and thus the market price of the exclusive rights in the auction. An important question drawing up and constructing the allocation process is how risk can be reduced prior to the process and how the allocation process itself – including the auction format – can mitigate at least some of the remaining uncertainty, and ensure that the authorities’ goals for the allocation are met.

Some of the risks can be reduced by authorities prior to the auction. This seems to be what the Ministry is planning for. For example, it seems that Statnett (a Norwegian government owned power system operator) will give at least some more clarity to potential applicants/bidders in relation to physical market access and questions related to infrastructure in the coming period leading up to an auction.

In any event, there will be a pre-qualification of potential bidders. In the consultation, the Ministry indicated a pre-qualification setting minimum criteria related to technical competence and financial strength. Another way to organise the allocation process could be to increase the degree of qualitative criteria in the pre-qualification assessment. This increases the Ministry’s possibilities to use their discretion to ensure that relevant goals of the allocation process are met.

Also the auction format itself can contribute to mitigate uncertainty and ensure the authorities’ various goals are met. For example, the choice of auction format can be of importance to what degree the auction has a price accelerating effect. Auction experts will be able to give relevant input. However, also more specific elements can be effective tools. The authorities can set a reserve price for the auction, providing a starting point price level. Another tool is to give bidders indications of the demand at different price levels during the auction. Both of these elements can help reduce the strategic and tactical complexity of the auction – creating a more level playing field – and give bidders greater confidence in how bids of the individual bidder relate to the development of the market price during the auction.

Conclusion

As demonstrated above, an auction can be tailored to meet a set of goals – also other than maximising profit for the government, but this requires expertise. Our recommendation to the Ministry is first to use sufficient time on the design of the allocation process. Second, we recommend engaging auction experts who can prepare the auction. This entails both the theoretic auction format, and offering suitable software solutions that allows the auction to be conducted in a good way according to the auction rules and regulations.

Depending on the strategic and tactical complexity of the auction format, potential bidders should also seek assistance from auction experts and lawyers in order to prepare for the auction. For example, an auction where there is uncertainty related to the valuation of the exclusive rights, and where little information on the demand is shared, may be particularly strategically and tactically complex. It will be time well spent actually understanding the dynamics of the auction.

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