Reforming Texas Electricity Markets

July 5, 2013

In the United States and around the world, electricity restructuring is converting regulated monopolies into market regimes. The characteristics of those markets, however, are critical determinants of their performance and remain the subjects of active policy debate. One important issue is whether electricity markets can -- without government intervention -- provide adequate generation to reliably power society's needs, say Andrew N. Kleit, professor of energy and environment economist at Pennsylvania State University, and Robert J. Michaels, professor of economics at California State University, Fullerton.

  • Advocates of intervention believe that competitive markets for energy should include additional payments to firms for having reserve generation capacity beyond what ordinary electricity rates would incentivize. Critics of this idea see such "capacity payments" as unnecessary subsidies to electricity producers.
  • Most U.S. regional transmission operators, including the Pennsylvania-New Jersey-Maryland Interconnection and the New York Independent System Operator, operate capacity markets.
  • In California, state regulators impose "resource adequacy" requirements on utilities, but do not directly operate markets.

Kleit and Michaels review the rationales for capacity markets recently proposed for the Electricity Reliability Council of Texas (ERCOT). Some have argued that low levels of investment in generation on ERCOT are reducing reserve margins to levels that threaten reliability. Others believe that ERCOT's "energy-only" regime can suffice to incentivize adequate investment.

An examination of ERCOT's current state does not provide coherent support for capacity market advocates.

  • The 2011-2012 capacity shortfalls cited by ERCOT critics are largely idiosyncratic -- the results of unusual political, regulatory and weather events.
  • In many years, a highly conservative three- or five-year projection would show ERCOT falling dangerously short of reserves, but market forces have invariably succeeded in restoring their generation adequacy.
  • Claims by critics that investment is persistently unprofitable in ERCOT's energy-only markets rest on a regulator-determined formula (Peaker Net Margin) whose definition is restricted to only a subset of all potential revenues.

Two remaining barriers to efficiency and reliability are in the process of falling. The first is the set of rules that lower market prices during peak periods when they should be raised. The second is demand management that has yet to grow the institutions and attain the scale that would make it truly symmetric with supply in setting prices. These problems, however, do not stem from any inherent flaws that render energy markets incapable of functioning efficiently and properly without capacity markets.

Source: Andrew N. Kleit and Robert J. Michaels, "Reforming Texas Electricity Markets," Regulation Magazine, Summer 2013.


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