What electricity prices can (and cannot) do in the real world of energy markets

At the heart of the Texas blackout is a myopic faith in the price signal. It may work well under a wide range of market conditions, including intense summer heat. But it badly undervalues the kind of massive, long-duration loss of supply we experienced last month

Control room at ERCOT, the operator of Texas’ troubled power grid
Photo: ERCOT corporate image

The “what” is pretty clear. The “why” will take a little longer.

The “what,” of course is that last month Texas’ electric power grid failed spectacularly in the face of a winter storm of unprecedented intensity, duration and geographic breadth (at least, for Texas). The most serious failures occurred in the part of the electric grid managed by the Electric Reliability Council of Texas, or ERCOT, which covers most (but not all) of the state. Almost 50 percent of the power generation that ERCOT expected to be available during the storm was not, forcing massive controlled outages that left millions of Texans without power, many for the better part of a week, taking lives and imposing enormous economic and other costs on Texans.

All of which left everyone asking, “why?”

Some Texas government officials blamed frozen wind turbines. But it quickly became clear that all of the technologies on which ERCOT had been depending failed, for different storm-related reasons, but at roughly similar rates.

The more interesting and important question is how much blame should be allocated to ERCOT’s electricity market structure, which is much more reliant on price signals to provide affordable, reliable service than those of other electricity markets.

Markets, regulation and faith

As many readers probably know, more than two decades ago some parts of the United States moved away from traditional, vertically-integrated monopoly utilities to a system of competition and market pricing for power. The ERCOT grid, California, the Northeastern United States, and the middle Atlantic region all made this transition. Each of these so-called “organized power markets“ has its own particular market design.

Market designers and overseers have long worried openly about the ability of these markets to incentivize sufficient generation to keep the lights on during emergencies—particularly after California’s market experienced its own spectacular collapse in 2001. The old regulatory system provided electric utilities with a powerful incentive to invest in reserve capacity by guaranteeing a positive return on that investment. Under pure energy price competition, that incentive is absent.

Consequently, most of these regional competitive power markets employ regulatory devices that compensate generators to be available as reserves, months or years in the future. But ERCOT does not. Instead, it relies on wholesale electricity prices that can rise as high as $9,000 per megawatt hour (mwh), about 300 times the usual price and four times higher cap than price caps in other markets.

After briefly falling below its reserves target a few years ago, ERCOT has tinkered with its pricing formula, but has never joined other competitive wholesale markets in paying for future capacity. Other competitive markets tinker with their capacity incentives too. All this tinkering with pricing rules in competitive markets belies an awareness that the efficiency of textbook markets may not always manifest in real world electricity markets. I was not alone when I expressed this concern back in 2008:

[T]he amount of time and resources devoted to creating these various incentives testifies to the market’s own failure to provide the right incentives, at least in some places. Is this merely a symptom of the immaturity of these markets … [or] is this an indication of some deeper incompatibility between economic theory and energy markets?

But until last month the ERCOT market had been performing well, despite declining reserves. Proponents of green energy liked it because the market design is friendly to wind and solar power. Wind and solar are now the cheapest forms of utility-scale generation. So by putting a premium on price competition and offering few regulatory barriers to entry, the ERCOT market design helped stimulate the Texas renewable energy boom. And prior to last month’s unusual storm, the ERCOT system had been keeping the lights on. Last August, when both California and Texas experienced sharp, weather-related spikes in demand, the ERCOT market avoided the rolling outages that California was forced to impose.

So what went wrong?

You can’t price everything

So, the idea is that ERCOT generators will want to capitalize on those $9,000/mwh prices by providing power during times of scarcity, like they did last summer. But during last month’s crisis they did not, and could not. Some plant components failed in the cold. And for many natural gas-fired plants there was no natural gas to be found because the storm interrupted gas supplies; those natural gas-fired generators that could find gas had to pay as much as 100 times the usual price because gas was scarce.

The resulting spikes in wholesale prices will mean bankruptcies and financial stress for retailers of gas and power, and ultimately for ratepayers. ERCOT market designers assumed that retailers would protect themselves against price risk by purchasing insurance against unacceptably high purchase prices. However, most probably did not foresee the need to hedge the risk of hyper-inflated power and gas prices for days at a time.

When all is said and done, the fallout from this failure will be huge:  tens or hundreds of deaths, billions of dollars of quantifiable economic losses, and immeasurable emotional and psychic costs.

At the heart of the problem is a myopic faith in the price signal, the logic of which goes like this.

If the ERCOT price cap reflects the value consumers place on lost service (as is the intent), last month’s high energy prices apparently weren’t high enough to induce sellers of power to weatherize their plants in order to capture the windfall. Therefore, ratepayers must not be willing to pay enough to avoid an outage like the one last month.

But willingness to pay is not value. Most of us would pay whatever we have to avoid a life-threatening loss of warmth during an extended cold snap. But our ability to pay varies widely. Do the poor value that missing energy less than the rich? Of course not. 

Furthermore, if the price cap represents a fair estimate of the ratepayers’ aggregate willingness to pay, it almost certainly was never intended to estimate the value to consumers of avoiding the loss of heat for days on end during an extended cold snap.

The ERCOT market may work well under a wide range of market conditions, including intense summer heat. But it badly undervalues the kind of massive, long-duration loss of supply we experienced last month.

Only regulation can provide an adequate response to that problem.

The coming weeks and months will see a lot of debate over the wisdom of requiring investments to winterize the ERCOT grid and the natural gas system, better gas-power market coordination, and the value of building better connections to the interstate grid. If the policy discussion simply reverts back to tinkering with price formation as the solution, that will be a mistake that will bite Texans again in the (unpredictable) future.

The purpose of public utility regulation is not to “make markets work” or solely to “get prices right.” It is to provide customers with affordable, reliable electric service. We depend upon regulators, not just well-designed markets, to fulfill that objective.

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