Texas Should Think Again Before Rushing to Overhaul Its Electricity Markets
In February 2021, Winter Storm Uri killed hundreds of Texans and devastated the Texas electricity grid. In response, the Texas Legislature passed S.B. 3, a law aimed at shoring up the grid and preventing future blackouts. The law delegated much of the new policymaking to the Public Utility Commission of Texas (PUCT), the state agency that regulates Texas’s electric utilities. The PUCT has implemented many changes since then, including new weatherization requirements for power plants. The PUCT has also approved a first wave of changes to the Electric Reliability Council of Texas’s (ERCOT) wholesale electricity market (i.e., the electricity market that covers most of Texas).
Now the PUCT is considering a more fundamental overhaul of the ERCOT market: a so-called “reliability mechanism” to encourage the construction and retention of generation resources. The PUCT solicited comments on five variations of a reliability mechanism, each described in an accompanying report commissioned by the PUCT and prepared by Energy + Environmental Economics (E3), a consulting firm. The PUCT’s favored mechanism is the Performance Credit Mechanism (PCM), a policy that, according to E3, has never been implemented in any electricity market in the U.S. or around the world. Under the PCM, generators would earn credits by producing power during the highest-risk hours for the grid. Exactly which hours were the highest risk would be determined after the compliance period (a year or other interval to be determined) has concluded. The “load serving entities” that procure electricity for resale to consumers would need to purchase these credits based on their share of the overall energy consumption during the same highest-risk hours.
We submitted comments advising the PUCT that the agency should reconsider its objectives before adopting any of the proposed reliability mechanisms. In short, the agency hasn’t yet adequately diagnosed the problem that needs to be solved. The PCM and other proposed mechanisms are primarily intended to address insufficient investment in generation capacity. But it may be that ERCOT has a vulnerability to extreme cold or heat or both (i.e., a resilience problem) rather than a generation capacity problem. During Uri, blackouts were primarily caused by unplanned outages from freezing at power plants and lack of access to natural gas, not a general failure to have constructed sufficient generation resources.
If, after additional analysis, it turns out that ERCOT needs to better incentivize construction and retention of generation resources — what would be known as a “resource adequacy” problem — our comments provide four recommendations for how the PUCT could meet this challenge while minimizing costs for Texas consumers. Those recommendations are to:
(1) compensate generation resources according to the reliability value they provide to the grid regardless of technology type;
(2) set efficient penalties for non-performance;
(3) mitigate uncertainty for market participants; and
(4) carefully evaluate the potential for market power issues that could result from any new mechanism.
Does ERCOT Need a New Reliability Mechanism?
To understand our recommendations, it is helpful to start with some basics about how electricity markets incentivize investment in generation resources and why resource adequacy problems occur.
If electricity prices were to fluctuate purely according to the value of electricity provided at a given time and place on the grid, these prices alone could encourage adequate investment in generation. But, in ERCOT and other wholesale markets, electricity prices have artificial price caps that are designed to prevent abuses by firms with market power. These price caps (and other factors that may suppress market prices) discourage investment in generation resources because they prevent many societally beneficial investments from being sufficiently profitable. This problem is called the “missing money” problem because investors are missing some of the money that they would need to recoup their investments. Accordingly, some other investment incentive is needed to ensure resource adequacy.
Many wholesale markets in the U.S. address the missing money problem by creating separate capacity markets. In a capacity market, the owners of generation resources are paid for promising that their resources will be available to produce energy at certain times in the future. These payments are an additional stream of revenue beyond the revenue earned from selling electricity.
Texas, however, has addressed the missing money problem with its operating reserve demand curve (ORDC). The ORDC adds a premium to the price of energy when electricity supply is scarce relative to demand. This premium increases with scarcity. After Uri, one of the PUCT’s changes to the ERCOT market was a recalibration of the ORDC. Now, the premium kicks in earlier, with less acute levels of scarcity. But the maximum scarcity premium is also lower than before. While the first change ameliorates the missing money problem, the second exacerbates it. According to ERCOT, the net effect of these changes has been “higher price signals during periods of lower reserves” relative to previous ORDC policies.
Both the newly proposed PCM and the ORDC are designed to ensure resource adequacy. Before the PUCT adopts the PCM, it should first more carefully consider the extent to which the ORDC is incentivizing investment, especially given the recent changes. If the ORDC is already supplying investors with the missing money that they need to invest, then a second resource adequacy policy would be duplicative and wasteful. The analysis conducted by E3 doesn’t provide enough information to answer this question. For example, the analysis isn’t sufficiently forward-looking, focusing on outcomes only in the year 2026; investors plan over decades-long time horizons. Moreover, the consultants’ modeling fails to take into account how a variety of generation technologies could be added to the system to meet reliability standards. Instead, their model assumes that a single technology, combustion turbines, would be added to the system until resource adequacy is achieved.
In sum, before the PUCT rushes forward with a fundamental and first-of-its-kind overhaul to promote resource adequacy, it should better understand whether this problem has already been solved. It may be that ERCOT’s true problem is vulnerability to extreme weather, not resource adequacy.
How to Design an Efficient Reliability Mechanism
It may indeed be the case that ERCOT has a resource adequacy problem. If so, we identified four recommendations that the PUCT should follow when creating a mechanism to solve the missing money problem. These recommendations are derived from economic principles and would benefit consumers and investors by ensuring adequate investment in generation capacity at the lowest cost.
First, any payments for reliability should go to both non-dispatchable (e.g., solar) and dispatchable (e.g., natural gas) resources, in accordance with the reliability they add to the grid. Although PUCT Chairman Lake has floated the exclusion of payments to non-dispatchable resources within the PCM, that would only increase the price that Texas consumers would pay for reliability. Even though the amount of power that non-dispatchable resources provide cannot be adjusted at will, these resources contribute to reliability by providing energy during the highest-risk hours for the grid. Subsidizing reliability only from dispatchable resources would cause the procurement of a more expensive fleet of generation resources. It would also lead to a generation mix disproportionately composed of units that have relatively high operating costs, ultimately leading to higher energy prices.
Second, the penalty for failing to provide promised reliability under any mechanism should reflect the societal value of the lost reliability. When conditions are strained, there’s a higher probability that one additional megawatt of generation capacity will prevent a blackout event, implying greater reliability value for that capacity. When conditions are not strained, one megawatt of additional capacity may not have any effect on the stability of operations, meaning the additional capacity would have little reliability value. An ideal penalty would fluctuate with the changing value of reliability. It is difficult to evaluate the PCM’s penalty against this rule because the consultants’ report provides little detail on how this penalty would work.
Third, a reliability mechanism should reduce uncertainty, thereby reducing risk premia demanded by investors, and ultimately reducing costs to consumers. Investors make capacity-investment decisions based on expectations about future market outcomes. And they can be risk averse. Imagine that an investment has a 50% chance of earning $200 and a 50% chance of earning $0. Although the expected value of that investment would be $100, a risk-averse investor might value the investment at only $90 because of the high probability that it would lose all value. In that case, the risk premium — i.e., the difference between the expected return and the investor’s willingness to pay — would be $10. The same logic applies to investments in generation resources and the uncertainty caused by a new reliability mechanism.
Electricity markets are inherently risky due to fluctuations in prices over both short and long time horizons. A reliability mechanism that includes certain types of forward-contracting can mitigate this risk, thus reducing financing costs by reducing the risk premia for investment in new generation. The PCM design involves significant uncertainty surrounding the revenue from investing in generation resources. The unpredictability of which hours will be the highest-risk and exactly how high-risk those hours will be results in volatility in the settlement prices and quantities of performance credits. This uncertainty would likely lead to high risk premia for new investments in generation resources, which would be passed on to consumers in their electricity bills.
Fourth and finally, before launching an untested policy like the PCM, it is important to understand whether the design will be susceptible to market power exercise on behalf of market participants. In a typical energy market, a supplier with market power can elevate settlement prices by strategically withholding supply. Under the PCM, a supplier would not only be rewarded for the quantity of energy generated in real time, but also for the total available quantity that it has offered into energy and ancillary services markets during the high-risk hours. This additional reward may amplify a supplier’s incentive to withhold some supply during high-risk hours to induce both a higher energy-clearing price and a higher performance-credit settlement price.
The PUCT has invited a discussion of the details of various reliability mechanisms before answering the broader question of whether such a mechanism is needed in the first place (and whether the changes it has implemented under S.B. 3 would suffice to protect the Texas grid against future extreme weather events). If it does turn out that Texas has a resource adequacy problem, the PUCT, by following our recommendations, could ensure that Texans don’t overpay.
By Matt Lifson and Chris Holt.
