Virtual Bids, Convergence Bids, and How They Work

Originally posted here.

In deregulated, open energy markets, utilizing day-ahead electricity sales comes with the goal to ensure those markets operate as efficiently as possible, ensuring that predicted demand is matched with the most affordable and dispatchable energy supply. In order to accomplish this, the independent system operators (ISOs) and regional transmission organizations (RTOs) will often tap into tools known as virtual bids or convergence bids.

For any stakeholders operating outside the electric power industry or for professionals just getting started in energy brokerage, these types of transactions can be tricky to understand because they largely don’t mirror how markets in other industries tend to work. However, these virtual and convergence bidding systems represent a clever and advantageous tool for the energy broker and their customers alike, and understanding how they work is the best way to ensure individual transactions have maximum efficiency as well.

Defining Virtual Bids and Convergence Bids

At a high level, virtual transactions (which include virtual bids and convergence bids) are simply financial contracts awarded based on day-ahead energy prices, but where the actual settled price is dictated by the real-time market during the time of delivery. Putting it succinctly:

Virtual bids are financial instruments that allow market participants to take financial positions in the Day-Ahead market that are automatically reversed/closed in the Real-Time market.

Convergence bidding is simply another name sometimes used for the same financial instrument and process, but with a name that indicates directly how the goal is converging towards the optimal price. Energy brokers will recognize that there isn’t a specific definition difference between ‘convergence bids’ and ‘virtual bids,’ but rather different ISOs/RTOs refer to them using these different terms with slight nuances in how each individual market sets the rules and guidance behind them.

Regardless of the term used of the specific conventions adopted by a regional energy market, virtual bids refer to two main types:

- INCs, which is the shorthand used for incremental offers, operate like generation offers but appear as virtual generation

- DECs, which is the short hand used for decremental bids, focus instead on the other side of the coin and operate as demand bids.

Another way to break down and understand difference between INCs and DECs is outlined thusly by the California Independent System Operator (CAISO): INCs are the bids to sell at day-ahead prices but buy at real-time prices the next day (and thus look like dispatchable supply) while DECs are bids to buy at day-ahead prices and sell at the next day’s real-time price, operating as price sensitive demand.

Understanding the financial mechanisms in this way highlights how these virtual bids are a theoretical arbitrage of sorts, but with the key difference that they don’t require the participant to physically move the energy and store it (which of course costs money and leads to a percentage of energy loss). Instead, this financial mechanism completes the arbitrage ‘virtually’ in order to even out the markets in a way that benefits the grid. No physical energy is delivered or consumed, but the numbers and money are adjusted for the sake of market efficiency. Having this all happen in the digital space rather than with physical energy is why it can be hard to understand virtual bids, but those characteristics are also the very essence of what makes them efficient and beneficial.

What’s the Point?

The goal of both INCs and DECs is to allow market participants to seek out the best opportunities for profit, bidding through arbitrage or speculation in a way that’s designed to deliver the most affordable power to the final customers. As with many economic models, the goal of these virtual bids is to increase competition on the market, which naturally brings prices lower to their natural settling point while providing pressure to the markets for the market to stay liquid. These goals are all accomplished while keeping the grid humming as smoothly as possible via efficient dispatch of power generation exactly where and when they’re needed.

At first glance, these virtual bids may sound like complexity without actual real-world benefit, but in fact they represent an essential component of the efficient energy market toolbox. Specifically, virtual bids are meant to improve overall market efficiency, mitigate market power, fine tune prices to be the most representative and fair as possible, hedge the risk associated with a purely real-time market, and even price in that hedging of risk. Overall, these mechanisms serve to lower costs thanks to additional day-ahead commitments while minimizing (or converging) the differences between day-ahead and real-time prices. The efficient allocation of funds, therefore, allows the physical grid to operate more stable, predictably, and efficiently.

Indeed, studies have shown that the introduction of virtual bids into a system for the first time delivered on the promised price convergence, signaling the effective transition to more efficient markets. CAISO specifically provides great resources that walk through examples with easy to understand numbers that illustrate why participants would engage in virtual bidding, how it impacts their profit, risk, and the grid as a whole.

The use of virtual bids is not without its detractors, with arguments against the system ranging from the asymmetry in the settlement treatment of different types of virtual bids to the trouble with virtual transactions potentially being used for profiting without providing real value or benefit to the system a whole to the idea that virtual bids erroneously tries to apply commodity-based economic theory in the unique non-commodity wholesale electricity markets. These issues all draw out continued debate among market regulators, government officials, and energy experts. But to date, these virtual bidding processes retain a key role in some of the largest U.S. energy markets, including: PJM, CAISO, and ISO New England, and all other independent U.S. system operator markets (indeed, FERC requires convergence/virtual bidding as a mechanism).

That said, the landscape of energy markets is ever-evolving and being put under the microscope, such as CAISO suspending convergence bidding during times of record heat waves in 2020 and PJM regularly reviewing and evaluating if and how virtual bidding is accomplishing its intended goals. For energy brokers, knowing the specifics of the virtual bid process in each RTO/ISO and how to use that to get customers the best possible prices is critical. BrokerX will continue to keep you up to date on how the markets evolve and what the optimal strategies are for you and your customer.