The Lone Star State approaches electricity policy—among other things—a bit differently. The Texas system creates a unique set of investment incentives for power plant and demand-side resource developers. Combined with shifting market fundamentals, this structure has contributed to the best electric industry performance of any state in the past decade, while simultaneously retiring old polluting facilities and ushering in a new wave of clean energy development. More than 5,600 megawatts of fossil-fuel capacity will retire or mothball in the coming year, while 2,200 megawatts of natural gas, wind and solar look to come online this winter, along with growing prospects for energy storage.
Such economic shifts foreshadow political ones. In a recent GreenTechMedia podcast, the R Street Institute and the Environmental Defense Fund noted the possibility of green and pro-market interests converging around competitive electricity markets, with Texas as the model to emulate. Ironically, Texans’ “freest” market for electricity boasts a philosophy that directly contradicts the shockingly anti-competitive subsidies proposed by the U.S. Energy Department, led by none other than the former Texas governor who helped to develop the state’s successful policy. As such, the next couple of years of market and policy developments in Texas could have large implications for the state, but even larger ramifications for policy elsewhere.
States rely on either regulated monopolies or one of two market models to drive resource investment. Texas is the only state that relies exclusively on wholesale prices to spur investment in power plants. The Electric Reliability Council of Texas (ERCOT) uses an energy market that reflects the marginal cost to operate the grid and employs shortage (or “scarcity”) pricing that administratively sets prices above marginal cost when resource reserves run short.
Other deregulated, or “restructured,” states use capacity markets, which procure a minimum level of resource capacity, in addition to energy markets. Capacity markets supplement energy markets, providing additional revenue to signal investment decisions. States that retain the monopoly utility model rely on inefficient regulatory processes to determine investments. The “energy-only” Texas model, capacity markets and monopoly regulation have all proven capable of facilitating investment, but the economic implications of each differ markedly.
Prices in energy-only markets more accurately reflect system scarcity than capacity markets, especially when it comes to the duration of shortages. This may prove particularly advantageous as resources with time-varying output profiles—think variable resources like wind and solar and use-limited resources like energy storage—become more economical. At the same time, inexpensive natural gas and resources with no fuel costs push marginal costs down, forcing power plants to receive more of their total revenue from shortage pricing and exposing any vulnerabilities an energy-only market has with inaccurate price formation.
ERCOT does have some design flaws that affect price formation. These are currently under review by state regulators, raising the question of whether the weaknesses or virtues of the energy-only market will play out.
Thus far, the virtues are winning. ERCOT is capacity-long, and the net capacity decrease from forthcoming retirements and additions should put it close to the economically efficient reserve margin (i.e., the level that maximizes the benefits, minus the costs of electric reliability). Yet this level, which economists at the Brattle Group estimate at around 10 percent, falls below the 14 percent reserve target established by an archaic industry standard. That target is based on a standard industry practice that fails to weigh the costs and benefits of electric reliability, instead aiming for the likelihood of a reliability event occurring only once a decade (if you think that sounds arbitrary, you’re onto something). All told, while economists may be giddy with recent developments, alarmists and industry traditionalists will raise red flags.
Not only does the adjusted level of resources in ERCOT appear reasonable, but the retirements are consistent with economic fundamentals. They come as no surprise, though the simultaneous timing is a bit sudden. Profitability analysis of baseload resources suggest that the day to exit the market was fast approaching. Had this capacity retired prior to the summer of 2016, ERCOT would have triggered scarcity pricing instead of experiencing humdrum prices. This led analysts at ICF International to estimate that the retirements may be worth billions in 2018, with potential for levels of scarcity pricing not seen since 2011. If this occurs, it’ll provide insight into recent developments of price-responsive demand, an immensely important area for development in electricity markets.
Another interesting question is to what extent, in what form and in what location new resources will come online. Forward prices have risen since the retirement announcements, which provide the basis for resource valuation and investment decisions. ERCOT’s independent auditor and an economist on ERCOT’s board expressed optimism that this would signal entry of new resources, with the latter saying, “Now is the time for us to let the market work.”
Since the 2000s, natural gas generation dominated new construction, while wind saw strong gains in Texas. Continued gas and wind builds are expected, but supplanting this progress is an upsurge in the prospects for solar and energy storage. As costs and federal subsidies for renewables fall in parallel the next few years, Texas will offer the most useful laboratory to see how well renewables compete on their merits. At the same time, energy storage developers have their sights set on displacing gas-fired combustion turbines to meet peak power needs.
While Texas should see continued wind growth, the drivers and nature of those projects represent a new era for wind to compete on its merits and maximize its market contributions. In the past, nearly half of all revenues for some wind projects in Texas came from the federal production tax credit. But as the credit phases out, wind developers will obsess less with siting projects to maximize output (to maximize the subsidy value) and will more strongly consider market factors. These factors include locational energy pricing, as transmission congestion drives up the price and value for resources in “import-constrained” areas. This creates opportunities for wind growth in non-traditional locations, like coastal Texas, which fetch premium market prices.
The potential for large solar additions to contribute to ERCOT’s reliability needs—measured by solar’s effect on scarcity pricing—will prove a fascinating development. Solar output tends to align with scarcity conditions far more than wind – 82 percent for solar and 16 percent for wind, according to an ICF analysis. However, this diminishes rapidly with moderate levels of systemwide solar penetration, unlike wind, as analysts from the National Renewable Energy Laboratory to the Institute for Energy Research have noted. Thus, the long-term fate of deep solar expansion is very sensitive to cost-effective storage developments or alternative solar output methods. ERCOT’s base design is ideally suited to signal this value, but enhancements would help considerably.
In order for Texas to signal new entry and retirements efficiently, the modest-to-moderate flaws in ERCOT’s market design require correction. An excellent report by Bill Hogan and Susan Pope outline remedies that would improve price formation in ERCOT’s energy market and enhance transmission policy. This has spurred a thorough regulatory discussion likely to result in several changes to ERCOT’s market design.
ERCOT should enact reforms that enhance market efficiency, regardless of how they alter competitive relationships among technologies. For example, incorporating the cost of transmission-line losses in ERCOT’s energy market and using market-based policies for transmission planning, instead of socializing costs, would put resources to more productive uses but would disadvantage wind generation. Enhancing scarcity pricing and making it localized, instead of just systemwide, would further benefit market efficiency and improve prospects for energy storage, which can site near population centers that often experience localized scarcity.
All told, competitive electricity markets best serve our economic and environmental interests. Empowering markets spurs innovation and facilitates transitions to breakthrough technologies far more efficiently than the regulated monopoly model. With competitive markets like ERCOT driving costs down and clean energy investment up, a coalition of consumer, environmental and conservative interests have reinvigorated calls for electric competition outside Texas. Calls for state competitive reforms from Nevada to Florida need a role model. Meanwhile, tens of billions in cost overruns at several power plants in the Southeast provide a harsh déjà vu of the consequences of socializing risk under the monopoly model, leaving conservatives wondering why their red brethren in Texas have fared so well. And, of course, Texas provides learning value for federal policy.
While the anti-competitive Energy Department proposal has something for (almost) everyone to hate, the pro-competition Texas model has something for nearly everyone to love. The Sierra Club praised the beauty of ERCOT’s market leading to clean-energy development, while the conservative Texas Public Policy Foundation touts the market as the best place to decide the fate of generation fuels, not policy interventions that pick winners and losers. Greens and conservatives should closely monitor Texan developments, as they just might spark political convergence. This potential to align the conservative, consumer and green agendas is indeed energizing, and the workings of an unholy energy alliance have flashed in the wake of resistance to anti-competitive proposals at the state and federal levels.