Sunday, June 10, 2012

Texas Electricity Market: Is the Invisible Hand Fumbling?

Electricity is neither a Giffen good nor a Veblen good but it still violates the law of demand. This was reinforced last summer in Texas, the hottest on record, when wholesale electricity prices reached nearly 30 times the normal price with no appreciable dent in demand. The Electric Reliability Council of Texas, the wholesale market operator, scrambled to procure the necessary capacity to keep Texans’ air-conditioners humming and barely avoided having to impose rolling blackouts. It could do so because “reserve margins” (electric sector jargon for excess capacity) in Texas at the time were adequate to avoid any shortfall in supply. Signs now point to reserve margins being in decline. If current trends continue, by 2016 the region’s reserve margin will be less than half its current reliability target of 13.8 percent (of total peak demand). What can Texas do to reverse this trend?

That question leads to what may arguably be the most difficult challenge in the design of wholesale electricity markets: ensuring long term resource adequacy. If electricity markets were perfectly competitive, the need for resource adequacy would be moot. Consumers would adjust their electricity demand while investments would flow to new power plants in response to price signals from the market. No extra capacity would be necessary to meet peak demands.  

But electricity markets are not perfect. One reason is that consumers are largely insulated from signals sent by fluctuating prices. Limitations of current technology make it difficult to transmit price signals in real-time to consumers to evoke demand-side responses. As a result they pay flat rates for electricity, even as wholesale prices rise sharply during peak hours and on extremely hot days. This creates ideal conditions for demand spikes, which, because of the electric grid’s unique nature, must be evenly balanced with an adequate supply of generating resources or widespread blackouts may ensue.

Since occurrences of peak demand for electricity are largely at the mercy of the weather, market operators struggle to foresee the extent of each and every demand spike. They must adopt an acceptable level of reliability (the industry standard for loss-of-load expectation, LOLE, is “one day of firm load shed in 10 years”) and institute appropriate market policies to attract the corresponding level of investment in new generating plants. The purpose of such policy is to reward investors with adequate returns on their investments commensurate with perceived risks. But policy must also balance the benefits of resource adequacy against the ability of resource suppliers to exercise market power during periods of peak demand or scarcity. Because consumers are not able to alter their behavior in the face of rising demand and wholesale prices, suppliers can withhold capacity causing prices to soar and take higher profits. The means to striking this balance in nearly every wholesale electricity market is a cap on the level to which electricity prices are allowed to rise.

That creates the “missing revenues” problem. The trouble with price caps is that they are a blunt instrument. During times of high demand price caps significantly curtail the revenues that power plants can earn. For existing plants this means not recovering their fixed costs fully, which may lead to their retirement. Limited revenue potential also discourages investment in new power plants. Over time, the net result of a price cap is a reduced level of generating resources that matches the total revenue available. Texas’s declining resource reserve margins are an effect of the “missing revenues” problem going uncorrected.

There are two ways to rectify things without completely forgoing the balancing benefits of a price cap. One is to partially rollback the price cap by raising it somewhat. This is where Texas appears to be headed.  A partial rollback, however, may not bring all the intended benefits because investors and existing plant owners must still rely on energy prices hitting scarcity levels for a minimum number of hours. And because they would be subject to the weather and other unpredictable events, cash flow projections would be harder to model and more volatile. According to the Brattle Group, a consultancy, even with higher price caps, an energy-only market (ie, one that relies solely on wholesale electricity prices) will not be able to sustain Texas’s current electric grid reliability target with any degree of certainty.

A more economically certain option would be to put in place a capacity market. Capacity markets seek to provide generators with the “missing revenues” separately and outside of the energy market. Generators are made whole by paying them the difference in revenues that they would receive if energy market prices could rise to properly reflect their value during scarcity. One of the key differences between raising the energy market price cap and a capacity market based approach is that with the latter the reserve margin target is determined administratively, not by the market. It is this target that drives the revenues paid out by the capacity market. This makes the reserve margin target an independent, not a dependent, variable. The result is a higher level of reliability achieved at a lower cost to consumers and lower investment risk to investors.

Neither the lifting of price caps nor capacity markets are substitutes for a smart grid that allows real time dissemination of electricity price signals to end consumers. But until we get there consumers will still want a reliable supply of electricity to cool them in the summer and investors will look for certainty that they will earn decent returns on their investments. Capacity markets provide both. Texas should adopt it.

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