By Ed Hirs, Energy Economist, College of Liberal Arts and Social Sciences
The low electricity prices enjoyed by most Texas consumers can’t last forever. To understand why, you need first to understand a bit about the pricing structure in the Texas electricity market.
Under the supervision of the Texas Public Utility Commission, a co-op called the Electricity Reliability Council of Texas (ERCOT) sets the structure for the Texas electricity market. For a long time, ERCOT has used a model under which companies that generate electricity are paid only for the electricity they generate.
When electricity is plentiful, competitive pressure dictates that the price a generator can charge will be little more than the cost of generation. Only during times of electricity shortage can producers charge enough to enable them to invest in new plants and equipment. When shortages are rare, as is currently the case, very little capital can be accumulated to provide the financing for future growth.
Every electricity market has its own challenges. The situation in Texas came into stark relief when ERCOT’s independent market monitor, in its July 15, 2015, annual report on the state of the energy market in Texas, noted that electricity prices in 2014 could not have provided sufficient capital for any generating company to invest in current generating technology without losing money, or “incurring negative cash flow” in accounting terms. The report excluded any comment on wind generation, which has expanded rapidly due to federal subsidies but which faces additional costs of transmission and storage. That is, when they are needed most, wind resources are not reliably present.
Electricity shortages are usually quite temporary. They may come from a spike in demand, such as a record heat wave, or a reduction in capacity, which might happen, for example, when a number of large plants go offline at the same time.
Relying on temporary shortages to provide the revenue needed to finance long-term capital projects is a risky business for generating companies. It is safer simply to sit back, make a modest profit, and let someone else take the risk that there will be enough shortages to finance their projects.
If someone else overestimates the revenue from temporary shortages, they will go broke. Then they will have to sell their existing generation facilities to the buyers who sat on the sidelines the longest and built up the largest piles of cash.
In this scenario, a few risk-taking companies will succeed, while others will fail. Since success provides only incremental growth and failure results in the end of the company, most companies will sensibly leave the risk-taking to others, continue to build their cash hoards and wait for the inevitable failures.
Growth for the safe players will come more slowly than for the risk-takers, but they won’t suffer the consequences a “bet the company” player faces in the event of a miscalculation.
So ERCOT’s structure practically ensures that at some time in the future, after the number of “bet the company” players has grown too small, capital investment will lag behind the growth in demand that inevitably comes from continuing population growth in Texas.
That’s when the public will clamor for more generating capacity, but it may be too late.
No one generating company will have enough cash to take on the cost of constructing significant new capacity. A company that wants to go it alone will leverage itself through borrowing, taking on the risk that the new capacity may not be needed at the exact time the new plant comes on line.
A more sensible approach might be to form a consortium with other cash-rich generators to build plants on a joint-venture basis. This reduces the risk that a host of companies will engage in projects due to come online at about the same time, with the winner being the one who gets to market fastest, while those who lag behind find themselves with half-finished plants that no longer make economic sense to complete.