TEXAS POWER CRISIS. MARKET OR REGULATORY FAILURES?

 

Viewed as independent countries California and Texas would both rank among the ten largest economies in the world. One Democrat and the other Republican, the feature they now have in common is failure to prevent extensive and disruptive interruptions to power supply – California in 2001 and Texas in February 2021. In both states near-catastrophic failures raise questions as to the viability of highly market-driven power systems, which contrast with the stability of more integrated models of the East Coast of the US, and internationally. The answers matter, not just for Texas, but for developed and developing economies everywhere.

In California, the new market structures had only recently been introduced. California had copied many features of the UK 1990 model, which had worked successfully, or at least without major mishap, for ten years. With the benefit of hindsight and a lot of analysis, there seems to be a reasonable consensus that the failures resulted from a combination of factors:

·         Weaknesses in the design of the new market structures

·         State regulatory authorities’ imposition of a price cap, which prevented the market working as it should, to reduce demand and increase supply.

·         Market abuse by Enron, notoriously exploiting the rules to gain large economic rents. Enron went on to become a major corporate scandal, but California was the setting for some of its most egregious wrongdoings.

The recent failures in Texas, celebrated as an example of liberalised market reform, are harder to explain. Unusual weather conditions may be a proximate cause but are hardly an adequate excuse for one of the wealthiest advanced economies in the world, in a liberalised power sector that has appeared to operate without serious mishap since the late 1990s. The other factor cited, the intermittency of wind, can be dismissed as a credible explanation; if relevant at all, it is a known risk that should have been easily managed in a well-functioning sector. We need to look further for adequate explanations of failure to provide reserve capacity.

Creating incentives for private operators to provide the level of reliability that the public want has always been a potential weakness of market-driven systems, usually resolved by the imposition of reserve margins, and financial incentives or penalties. Peter Cramton[1]  is Vice-Chair of ERCOT, the body that has coordinated the Texas power sector over this period, and has described[2] the approach taken to this problem in Texas. It is an administered scarcity price similar to that used in the 1990 UK reforms, which operated successfully up to the introduction of further changes in 2000.

A market in reliability

The Texas model, according to Cramton, sets out the rules to determine an administered scarcity price, in periods when there may be very high or peak demand or low supply.  In theory this should incentivise sufficient capacity (Q) at all times. The administered price aims to reflect the value of lost load (VOLL), and a high VOLL should in consequence result in high reserve margins for generating capacity. Texas sets a high value for VOLL. ^[3] Simple economics suggests high rewards will bring forward more than adequate supply.

One possible explanation for the current failure is simply that this scheme lacks credibility. If we look at these incentives for investors in potential reserve capacity, then the return on investment – the future revenue stream – may depend on achieving ultra-high prices in periods with an ultra-low probability of occurrence. This probabilistic estimate may indicate good “expected value” returns, but the very high chance of zero revenue is not attractive as a basis for large scale investments. Paradoxically the higher the value of VOLL, the rarer the occurrence of periods of scarcity and the less credible the projected revenue becomes. 

Closely linked is the matter of regulatory credibility: if prices need to go that high, as they must do to validate the investment in reserve capacity, and particularly if the price spikes impact on consumers, will the regulatory or political authorities really stand aside and let them happen? The 2001 California experience, at least as suggested in many accounts of that event, suggests otherwise.

What do UK market models tell us?

The UK used its own version of an administered scarcity price from 1990 up to 2000. Fortunately, this was a period with a legacy of surplus capacity, so the method was not subject to severe stress tests. It worked well but was also criticised for potentially allowing larger generators to exploit their market power. It was replaced in 2000 by trading arrangements which had no formal mechanism for capacity. It rapidly became apparent, however, that these would not incentivise new capacity, and would pose an increasing risk to reliability of supply. The UK moved gradually towards the establishment of capacity markets to supplement the new arrangements.

In practice this means that investment in new capacity does not depend on investors responding to market price signals and guessing future prices in the “energy only” electricity market.  Virtually all new UK generating capacity results either from government choices, long term contracts (nuclear plant), from feed in tariffs, or from capacity auctions.

If fixing prices (P) doesn’t work, try fixing quantities (Q)? P or Q?

Economists will be familiar with markets where the choice is to use price or quantity as the appropriate instrument of policy. A good illustration is the energy policy choice between a carbon tax (P) and setting emissions quotas (Q) which can traded. It is possible for the price and quantity outcomes to be the same under either regime, but the choice is important and is usually made on an empirical or pragmatic basis, of what is likely to work best or be more politically and socially acceptable. The UK approach, de facto, for reliability, is to concentrate on fixing Q.

In this context, capacity markets can fix Q if a central authority – government, regulator or utility – decides on the reserve margin and the reliability standard, and invites tenders to provide that capacity. This has the advantage of much more certainty that the reserve will be provided, but it places the onus on the central authority, not just to decide how much capacity but also, in practice, to determine the right technology mix, and to monitor delivery. It represents the abandonment of most of the tenets of a market fundamentalist approach to the power sector.

Regulation and Governance for the Power Sector

It is always tempting to read too much into a single event, when there will inevitably be multiple interpretations of what has happened, and rarely one simple explanation. Another focus will no doubt be on the general governance and regulatory arrangements in Texas, and the role of ERCOT (see below). However, the “standard model” of unbundled utilities, wholesale and retail competition, independent regulation and excessive reliance on markets, however flawed, must come under more scrutiny. Pioneered in the UK, promoted by the World Bank, the European Commission and others, it looks increasingly incapable of responding to today’s policy challenges, of which the climate emergency is just one.

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[1] Cramton is an academic economist, who has described and indeed promoted market-driven models for the power sector. He described the role of ERCOT and the power sector in Texas in a paper - Electricity Market Design - in the Oxford Review of Economic Policy.

[2] Oxford Review of Economic Policy, Volume 33, Issue 4, Winter 2017, Pages 589–612

[3] In Texas VOLL was set administratively at $9,000/MWh—367 times higher than the average energy price of $24.62/MWh in 2016.

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Additional Notes.

A regulatory issue. There is another feature of the power sector in Texas which is at odds with the “standard model” of liberalised markets and independent regulation. The Electric Reliability Council of Texas (ERCOT) effectively controls the functioning, in operational terms, of the Texas power system. It is an umbrella organisation, whose membership includes the utilities, generators and other stakeholders in the sector. It implicitly assumes responsibility for reliability and by its nature provides scope for formal or informal coordination within the sector. This might be interpreted as a quasi-regulatory role, violating one of the conventional principles of sound regulation, namely that the regulator should be independent of ownership and management.  There is an additional oversight from a Texas Public Utilities Commission, but it is unlikely this will have had the knowledge or expertise to probe ERCOT too closely, especially on technical issues

It is possible to argue that ERCOT also provides a vehicle for informal planning or informal guarantees for future investment, and that coordination and more rigorous planning disciplines, plus technical monitoring of capacity, should have been applied.  I would argue in this instance that it was reliance on a “market” mechanism that is the more likely prime cause of the failure.

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California. See for example Weare, Christopher (2003) The California Electricity Crisis: Causes and Policy Options  ISBN 1-58213-064-7;

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There is another important alternative to administered scarcity prices. It is to allow scarcity prices to be set in a market by consumer choices and consumer valuation of reliability, but that is generally seen as currently impractical, because consumers lack the technical capability to respond quickly to price or crisis signals. However increasing digitalisation, and concepts like differential reliability and supplier managed loads- see my tariffs paper - will take us in that direction in the future.