What Happened with Texas Power Markets? An Economics Explainer

For many of us Texans, the intense winter storms of the past week were a major life disruptor. As a Houstonite myself, the days of power outages, limited access to clean drinking water and spotty internet service harkened back to the types of disaster scenarios typical during hurricane season. Of course, there were also differences. Extreme winter storms are not the norm, unlike hurricanes, making it difficult for residents to prepare and impacts were felt well beyond coastal regions. Every major Texas city - Houston, Austin, San Antonio and Dallas - all faced a head on collision with mother nature at the same time. While the debate around whether this type of extreme cold weather will become more of a normality for Texas as climate change continues to impact regional weather patterns, one outcome was clear, the Texas power grid was ill-equipped to handle the duality of record low temperatures and a spike in demand.

Source: EIA

How is the Texas power grid structured?

Before moving forward on the causes of the immense failure of the Texas power grid, it is important to establish how the grid actually functions. The Texas power market is divided into two parts, generation and distribution.

The generation portion of the market involves any entity that is producing power, either via fossil fuels, nuclear or renewables that then sells that power into the market. The process of selling into the grid involves a day-ahead and real-time market. The day-ahead market is just that, a market in which power producers sell forward electricity output for next day demand. This day-ahead market represents some 95% of total electricity output and is forecasted by ERCOT (I'll come back to this entity in a bit). The real-time market is utilized to fill the shortfalls in output from the day ahead market, typically due to small demand forecasting errors.

The distribution portion of the market involves the actual transmission of produced power, i.e. the power lines, transformers and other gear that is required to feed electricity into a home, retail establishment or other industrial facility.

In a "traditional" regulated power market, the generation and distribution entities are the same firm and thus, hold a monopoly position over the market. This is also known as vertical integration and customer choice is ultimately limited to a single provider. This monopoly is closely regulated by the state - prices are monitored to insure a "fair" return for the firm while also insuring that consumers are not charged exorbitant rates. If the vertically integrated firm wants to make an investment in new generating capacity, there are strict requirements that must be met because the ultimate risk of this capacity expansion will be passed on to downstream customers.

Texas is not a "traditional" regulated power market. Instead, Texas separates generation and distribution. For example, as Houstonite, I might purchase my power from Reliant Energy and yet this power is distributed via Centerpoint Energy, which handles transmission within the city. In most of the parts of the state, this means customers have the choice to choose an electricity supplier who might or might not be the actual generator (i.e. a supplier could purchase power from a generator and resell to customers). Oftentimes, suppliers are a parent or child company of a given generator. The ultimate risk of new capacity falls on generators under this market structure. The distributor remains a regulated monopoly even in the deregulated market that exists in Texas (i.e. it would be inefficient to have more than one company building power lines through a city).

Note that the Texas market structure is not true across every part of the state. Cities like San Antonio (CPS Energy) have decided to remain vertically integrated, but these regulated monopolies remain subservient to ERCOT and will often tap the broader grid to meet demand shortfalls or meet power mix generation goals (i.e. more renewables or gas and less coal).

ERCOT, also known as the Electricity Reliability Council of Texas, is tasked with connecting the generation and distribution portions of the power market, insuring the reliability of the grid and forecasting forward demand. ERCOT is one of several RTOs (regional transmission organization) that exists within the United States and Canada. ERCOT also handles the day ahead and real time pricing auctions that generators sell into by conducting a bid-in system in which those with the lowest bids get first priority to provide power.

Regional Transmission Organization Map

There are problems with deregulation

In theory, deregulation is a great idea. Shift the risk of investment to the firm and allow competition, whether than a central planner, to determine market prices. Most of the time, this is a correct assumption. Unfortunately, deregulation tends to lead to under-investment, which can cause problems when additional capacity is needed in times of extreme demand. The incentive for a power generator to risk building a new power plant inherently implies lower bid-in prices given the increase in supply. Furthermore, ERCOT limits how high prices can go ($9,000/mwh) in times of peak demand, thus limiting the gains of generators further.

In the drive to deregulate in the early-2000's, requirements were also done away with to maintain a capacity market. Under a capacity market, power generators bid into a secondary market that insures generators are ready and available to operate if needed, even if the likelihood of utilizing said capacity is low. In other words, generators receive payments as a reward for being ready and able to come online if needed.

Of course, one should not walk away in the belief that a regulated market is flawless. Remember that in such a system, the vertically integrated firm must petition the state to add generating capacity. If the state agrees, but the project ends up running over budget or is never completed, the cost is ultimately bore by the end-consumer. This is not the case in a deregulated market, in which the generator bears the risk of new investments. Under a regulated system, the state regulator might also incorrectly forecast forward demand when planning for the construction of new capacity or incorrectly give too high a percentage return to the regulated monopoly, both of which arbitrarily drive up prices.

Ultimately, deregulation has led to a multi-years underinvestment in the Texas power grid, especially across thermal sources (non-renewables). Generators have been unwilling to absorb the risk of significant new capacity investment given high costs and the lack of a guaranteed "fair" return. The lack of a capacity market is also a contributing factor. The winter weather event and subsequent failure across much of the Texas grid is the ultimate outcome of this under-investment.

Renewables present a challenge

Over the past half decade, ERCOT has come to rely heavily on wind as a vital source of power for the grid. In 2019, wind accounted for some 20% of total Texas power generation, doubling from levels in 2011. Much of this has come as a result of subsidization that has improved the economics of such projects that have a huge upfront cost, but are very cheap to operate. This has tended to shift investment away from traditional fossil fuel projects (especially natural gas) and towards wind power. It is very difficult for alternatives to compete with an energy source that has a subsidized startup cost and yet is relatively cheap to operate once up and running.

The problem is that renewables, such as wind, cannot be brought on- and offline as needed to meet demand (unlike a natural gas turbine). The wind will blow and the sun will shine as dictated by climate, seasonal and weather patterns, not consumer demand. While it is certainly true that the failure of wind turbines in West Texas were not the sole cause of power outages through the winter storm event, wind subsidization has certainly drawn dollars away from alternatives. Between 2006 and 2019, some $15.9 billion in subsidies was made available to help in the construction of wind energy. The benefits of renewables, which are indeed far reaching, will need to be weighed against the need to insure supply can meet demand at any point in time.

Other factors that played a role in outages

Problems began to surface on Sunday night, February 14th when Texas power usage pushed to near record-high levels only ever seen in the hottest of Texas summers. The spike in demand aligned with several factors:

  1. The availability of natural gas feedstocks tightened considerably, limiting the ability of gas turbine capacity to come online and meet demand. There was quite literally no natural gas supply available in many areas of the midcontinent. Many pipeline operators and upstream producers also reported operational issues, limiting the flow of natural gas to demand centers.

  2. The lack of capacity winterization caused renewables, coal, natural gas and nuclear plants to go offline (or they where already unavailable for use due to normal seasonal maintenance and/or the lack of a capacity market). Many generators originally decided not to undergo such winterization procedures as recommended by ERCOT (although not required), likely due to the cost of doing so. On Tuesday, of the 45,000 mw that were offline, 29,000 mw was attributable to thermal (non-renewable) and the rest due to installed wind. This is not a story of fossil fuels vs. renewables, everything failed.

  3. ERCOT was unable to pull power from other parts of the United States. The RTO does not share interconnects with the Eastern connection (which links suppliers and customers east of the Rockies) or the Western connection (which links suppliers and customers west of the Rockies). ERCOT values it's regulatory independence from FERC (Federal Energy Regulatory Commission) but doing so clearly comes at a cost, as evidenced through the winter storm.

What about solutions? There are many possibilities. I'm not convinced that a fully regulated market is the answer. Nonetheless, the state of Texas will need to find ways to incentivize more investment in the grid. The creation of a capacity market would be a solid first step. Submitting to FERC authority in order to enjoy interconnections with the rest of the United States would also help to ease concerns of supply. Requiring winterization of equipment, including pipelines, would certainly go a long way too.

This topic is deep and wide ranging. The challenge is keeping this sort of writeup within the bounds of a general readership. I'd love to hear the thoughts/recommendations/solutions/critiques from others on this issue.

Source: ERCOT