August 25, 2012

Elizabeth Souder
Bloomberg Business Week

Aug. 25–It’s come to this: The Texas electrical grid operator’s ammunition for avoiding blackouts this summer is begging for conservation with cat videos.

Electricity companies haven’t built enough power plants to keep up with growing Texas demand, and there’s not enough time to build new plants before the state’s margin of excess generating capacity becomes dangerously thin. So the Electric Reliability Council of Texas made a dancing cat commercial encouraging conservation.

There is, however, time to build plants before Texas’ reserve of excess generating capacity vanishes. Regulators are debating changes to the electricity market to encourage power companies to build more generators. Trouble is, the changes will cost money or, like the cat videos, push people to use less juice.

"What is that right balance between investing in a lot of generation capacity that will mostly sit idle vs. having the right amount and not necessarily increase the prices too high?" said Gurcan Gulen, a research associate with the University of Texas Center for Energy Economics.

The commission is considering several approaches.

Allow wholesale market prices to skyrocket when electricity is scarce, creating an incentive for power plant owners to generate electricity during those crucial times. This approach is the least costly but doesn’t ensure adequate generation.

Create a market where power companies can trade future power generation capacity as a way to ensure Texas will have enough plants. This idea can be expensive, but reliability is more secure.

Find new ways for consumers to participate more directly in the wholesale market, so that spikes in electricity prices give consumers the financial incentive to shut things off. This is cheap but could take a long time to develop.

"We’re basically rolling the dice here," said state Sen. Leticia Van de Putte, D-San Antonio. She’s a member of the Business and Commerce committee that oversees the electricity industry.

Why gas prices matter

In Texas’ deregulated electricity market, power companies build plants with their own money and only get a profit when they sell the electricity. Natural gas prices tend to set wholesale power prices because Texas usually uses natural gas plants to meet consumer demand as it rises and falls throughout the day.

That situation worked nicely for the industry when natural gas prices were hitting all-time highs above $15 per British thermal unit a few years ago. But now, with natural gas below $3, developers say new plants are a bad investment.

Meanwhile, the Texas population and economy continue to grow, boosting demand for juice. Texas’ margin of excess generating capacity, known as the reserve margin, will shrink below ERCOT’s target of 13.75 percent by 2014, putting the state at greater risk of blackouts.

Two years isn’t enough time to build plants. Hence, ERCOT made cat videos. But there is time to build plants in the next decade, before the reserve margin hits zero.

Lifting the price cap

To get things moving, the Public Utility Commission raised the cap on wholesale prices this summer from $3,000 per megawatt hour to $4,500 and is considering lifting the cap to $9,000. PUC chairwoman Donna Nelson and other free-market regulators say a more mature market wouldn’t need caps at all.

A megawatt hour of electricity, which is about the amount a typical household uses in a month, usually costs, on average, $25 on the wholesale market. But when electricity becomes scarce and regulators must call on the oldest, most inefficient plants to fire up and meet demand, prices spike.

Allowing wholesale prices to rise extremely high, in theory, encourages people to build new power plants to capture that revenue. Along the way, however, consumers get dinged with volatile and sometimes high prices.

A report by University of Texas’ Center for Energy Economics shows that raising the price cap to $9,000 per megawatt hour would cause wholesale prices to rise around 9 percent during the next decade.

That’s still not high enough for power companies to build. Executives with NRG Energy, the second-largest power generator in the state, have said investors won’t get serious about new plants until average wholesale prices rise about 40 percent.
A report by the Brattle Group on how the PUC could address reliability says raising the wholesale price cap won’t get the reserve margin to the 13.75 percent target. That is, the higher prices do not buy the level of reliability regulators want.

So policymakers are debating whether the 13.75 percent target is good. While preventing outages costs money, allowing them can also be costly in terms of lost economic productivity.

"For me, reliability is paramount," chairwoman Nelson said. "I’ve said this many, many times. I want to hit that sweet spot where we have the reliability we need but we keep costs low."

Nelson, who was appointed by Gov. Rick Perry, said she favors the current market design with higher price caps. That’s because so far it has worked. Changing to a new type of market would be complicated and might not even help, she said.

State Sen. Kirk Watson, D-Austin, said regulators are too committed to a pure, free-market system that isn’t working.

"I think there have been some who, out of fear or dogma, have taken the position that if we say it isn’t working perfectly, somehow they’ll look like something less than free market," he said. He wants to see bigger ideas, bigger changes.

A capacity market

One big change commissioners are considering is creating a capacity market. Market participants could trade future generating capacity. That way, traders could respond to electricity shortages ahead of time.

This type of market allows power generators to get paid for keeping excess capacity for emergencies. (In Texas’ current market, idle power plants make no profit.)

NRG Energy chief operating officer Mauricio Gutierrez said on a conference call with analysts that, despite hiking the wholesale price cap, "there is still a gap to incentivize those new builds. And that missing money has to come from somewhere else, whether it’s a capacity market or some other form or type of resource adequacy program."

Many deregulated electricity markets already include a capacity market.

Problem is, requiring the market to keep excess capacity costs money, and ultimately consumers pay. It’s a "bad deal" for consumers, according to a study last year on capacity markets in the Northeast by Synapse Energy Economics Inc.

"High capacity prices in local markets have increased the profitability of incumbent generation at ratepayer expense, but have not led to significant investment in new power plants," the study says. Instead, the study shows, capacity markets have kept old plants running or prompted power companies to expand existing facilities.

Pricing programs

The real nut of the free-market problem is that most consumers don’t participate directly in the electricity market. There’s hardly a reason for people to use less electricity when prices spike.

Some industrial companies buy electricity wholesale and save money if they cut back when prices spike. But the average consumer sees no difference in the cost of doing a load of laundry at midnight, when wholesale electricity markets are low, or during a hot afternoon grid emergency, when prices hit the cap.

If household customers got stung with extremely high prices during shortages, people might seriously cut their use. That could make a big difference because about 70 percent of electricity use on hot summer afternoons is by households and small businesses that jack up their air conditioning.

Shrink usage by those customers, and you just might prevent shortages entirely without fooling with price caps, capacity markets or even new power plants.

"If that happens, regardless of what the price cap might be, we may never reach those price caps," said UT researcher Gulen.

Regulators are working to expand existing programs that allow large customers to cut back during grid emergencies. But they haven’t created a program for small users to do so.
A few retail electric providers offer pricing plans that charge more for power used during the day, and some even pay customers to cut electricity use during grid emergencies. Moving customers to these pricing plans takes time and education, and might not happen fast enough to avoid outages.

Part of the cat video strategy is to educate people about the value of conserving during the afternoon.

The PUC will hold a market design workshop Sept. 6. Nelson said she aims to have a market design plan in place by the end of the year.

She’s under pressure to get it done. If she doesn’t, the Legislature might step in when it meets next year.

"I don’t think anybody wants the lights to go out in Texas on their watch. So I’m depending on that to be a motivating factor for the agency that regulates, as well as policymakers," said Rep. Byron Cook, R-Corsicana.

"If we don’t feel comfortable that’s happening, come January I think we’ll take a pretty aggressive approach to it in the legislative session," said Cook, chairman of the State Affairs committee, which oversees the electricity industry.

Follow Elizabeth Souder on Twitter at @esouder.

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