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Texas Mandated Reserve Margin, Capacity Market Would Be Inconsistent With Governor's Competitiveness Council, State Energy Plan
Adopting a mandated reserve margin in Texas, and the attendant mandatory capacity obligation, would be inconsistent with the vision of Governor Rick Perry's Competitiveness Council and specifically the Competitiveness Council's State Energy Plan.
The Governor's Competitiveness Council, which released its State Energy Plan in July 2008, noted that, "Texas companies, competing in the global marketplace, also need adequate, reliable, and reasonably priced energy," and that, "Without access to such energy, the economic prosperity of Texas and its citizens is threatened."
"Texas is at a crossroads in planning its energy future. This Energy Plan proposes a road map to guide Texas toward a future with a reliable energy supply that is balanced and competitively priced. It further proposes to give residential customers the tools they need to better manage their energy consumption," the Competitiveness Council said in its 2008 Texas Energy Plan. There has been no update to the plan or similar comprehensive state energy strategy released by the Governor's office since the 2008 Competitiveness Council report.
It is important to remember the world in which the Competitiveness Council's State Energy Plan was developed.
Specifically, resource adequacy projections were just as dire -- if not more dire, than the current reserve margin projections.
The Competitiveness Council was formed in November 2007. In ERCOT's December 2007 Capacity, Demand, and Reserves (CDR) report, ERCOT was projecting a reserve margin below the minimum target (12.5% at that time) as soon as 2009, with a 2009 forecast reserve margin of 12.1%. More serious reserve margin violations were forecast for the out-years, specifically, in December 2007, ERCOT was forecasting a reserve margin of 11.2% in 2011, 10.5% in 2012, and 8.2% in 2013.
The Governor's Competitiveness Council's Texas State Energy Plan indeed notes the challenges faced by Texas with respect to resource adequacy, noting that, "Within its power region, ERCOT forecasts the peak demand will grow at approximately 2 percent per year between now and 2025, requiring a nearly 50 percent increase in installed generation capacity by that date, and a need for between 1,500 and 2,000 megawatts each year just to meet this growth and maintain adequate reserve margins."
Additionally, the Competitiveness Council also made note of the aging nature of Texas' generating capacity, one of the reasons that capacity market supporters now say a capacity market is needed.
The Competitiveness Council noted, "This additional capacity will be needed because the generation fleet in Texas is aging ... Approximately 10,000 megawatts of generation within ERCOT is currently over 40 years old, with many of the older units being located in major metropolitan areas. Over 40,000 megawatts of new capacity would be needed by 2017 and 75,000 megawatts by 2027 to meet the forecasted load growth of the state and to replace capacity over 40 years old. Even if older units stay online until they are 50 years old, 20,000 megawatts of additional new capacity will be needed by 2017 and almost 64,000 megawatts will be needed by 2027."
Additionally, while the Competitiveness Council was conducting its review, ERCOT was forced into emergency conditions in February 2008, due to a decline in wind generation and other outages, and narrowly avoided rotating outages. The Competitiveness Council specifically made note of this event and (as noted below) discussed the need for additional reserves, but did not view the February 2008 event as indicative of the need for a mandated reserve margin, or need for a minimum amount of installed capacity.
Despite the forecast of inadequate reserve margin, the sheer volume of new capacity needed to maintain pace with economic growth, and the challenges posed by Texas' aging capacity, nowhere in the Governor's Competitiveness Council's comprehensive State Energy Plan does the Council recommend that Texas abandon its market-based approach to resource adequacy in favor of a mandated, government-set reserve margin, or that Texas cease sole reliance on the energy-only market for resource adequacy.
Indeed, the Governor's Competitiveness Council instead notes that, "The market continues to add additional generation resources in order to meet these needs."
"As a result of the move to a competitive electric market, Texas has seen an explosion in investment in generation facilities, and is widely regarded as having one of the most successful electric markets in the world ... These competitive markets position Texas well to continue to meet the energy needs of a growing, vibrant state with efficient market-based solutions and investment," the Council said.
"Most importantly, the Texas competitive wholesale model is working to bring diverse new generation investment to the state and any new policies should do no harm through creating unnecessary regulatory and legislative intervention," the Council said
"Many experts and financial analysts view the competitive structure in Texas as a successful example of wholesale and retail competitive electric markets. The ERCOT market has experienced unprecedented investment in the generation sector since restructure [sic], all at the risk and expense of the generation developers. To the extent the owners of generation make decisions that ultimately turn out to be poor economic choices or operate their units in an inefficient manner, the owners bear the risk of foregone profit or an inadequate return on their investment," the Governor's Competitiveness Council said (emphasis added)
A capacity market would return risk to customers, who would be compelled to purchase a mix of resources in advance, likely three years in advance. Three years is a long time, and purchasing capacity ahead of time can make customers miss technological and price revolutions, and instead locks them into a sub-optimal capacity mix. Moreover, as noted below, the capacity market acts as a barrier to new entry by subsidizing only government-selected resources in the market, meaning that while the capacity commitment period may only be one year, the presence of a capacity market will continue to keep out new investment. Risk is thus placed back onto customers that the capacity mix they are compelled to procure three years out is no longer economic.
Meanwhile, the capacity market, under existing designs in the Northeast, removes operational performance risk from generators (generators no longer having to rely on, and thus be available for, scarcity pricing to recover fixed costs), placing such risk back on customers.
Given that the goal of the Competitiveness Council was to, "provide a road map for the governor, State Legislature, state agencies and industry leaders to enhance Texas’ competitive position in the global economy," and focused on, "challenges and opportunities facing Texas in a fast-paced global marketplace" and, "the needs of industries to ensure a prosperous future for the state’s economy and all Texans," the fact that, even as the Council recognized the need for vast amounts of new capacity to keep pace with economic development and replace aging infrastructure, there was absolutely zero mention of a need for a mandated reserve margin, or changes in market design to assure resource adequacy, speaks volumes.
Obviously, the Competitiveness Council, which was charged with a comprehensive review of every facet of Texas' energy policy, did not feel the lack of a mandated reserve margin put Texas at a disadvantage, either nationally or globally, in attracting businesses to Texas, contrary to what capacity owners now claim.
Indeed, one of the key recommendations from the Competitiveness Council was to, "offset the need for future capacity by expanding energy efficiency and demand-response programs," not forcibly compelling customers to subsidize the retention of existing capacity in hopes that it may also lead to incremental capacity additions (as occurs in the existing Northeast capacity markets).
The Competitiveness Council found that, "Texas has established a strong, competitive electric market." The Council said that all future changes to the current structure should be evaluated against the following core principles (all emphasis added):
• "State policy should continue to focus on providing reliable, competitively priced electric service to all customers by strengthening the competitive marketplace, by removing artificial barriers to competition, and by providing legal and regulatory stability within that market.
• State policy should not artificially impede investment in the electric sector by private companies. Doing so will hinder the development and adoption of new technologies.
• In enacting the recommendations in this plan, or in any proposed legislative or regulatory change, the state should be mindful of the costs such a change will impose on all residential, commercial, and industrial customers.
• The state should not create new mandates for any particular generation technology, as poorly crafted subsidies can have far-reaching and unintended consequences that may result in higher costs to consumers.
The Governor's Competitiveness Council's concern with the cost of electricity speaks for itself. Matters would like to note, as well, the Council's concern with artificial barriers to competition, and the market-distorting impacts of subsidies.
Centralized capacity markets are an artificial barrier to competition, and specifically, to new entry by capacity in the wholesale electric markets (their purported goal). As been explained exhaustively in the past by Matters, capacity markets act as a barrier to new capacity by having the government define an artificial product (installed capacity), and then meeting the need for this product through a tilted playing field -- clearing units with the lowest going forward fixed costs. By the very design of the capacity market, the units clearing the capacity market, and meaning those which receive subsidies from customers, will be existing, largely depreciated units, whose costs have already been sunk, and thus have low going-forward costs. While from the narrowest of viewpoints, this seems "competitive," it is not competitive when the impact on electric customers is considered.
Customers don't care which units have the lowest going forward fixed costs, because capacity is not the sole product customers buy. They also buy energy, and ancillaries, and often, the plants which produce these other products at the lowest cost are not the units with the lowest going forward fixed costs. Indeed, often times, the units which are cheapest to produce energy have the highest going forward fixed costs, because they are new, and their costs are not sunk yet. These new units have the latest efficiencies and innovations to produce the lowest-cost energy and ancillaries, but because of their high going-forward fixed costs, they can't get access to the market, because they can't clear the artificial barrier of the capacity market.
While nothing legally prevents a new unit from entering the energy market without a capacity payment, the capacity market, by design, creates barriers to such non-subsidized entry. Specifically, the capacity market, as Texas supporters of the capacity market are quick to tout as a benefit of the market, reduces "volatility" and by its very nature (if effective) reduces or eliminates scarcity pricing (as an installed reserve margin has now been met). As a result, new capacity owners seeking to enter the market without the capacity market subsidy have no avenue to recover their fixed costs, because there will be no scarcity pricing. The presence of a capacity market is, therefore, a barrier to new entry. New units are unlikely to clear the capacity market because of their higher going-forward fixed costs (even where their all-in energy rate would be lower for customers), but because the capacity market depresses energy market revenues, new units can't enter the market without clearing the capacity market.
Such market behavior is apparent in the RTOs with capacity markets, such as PJM, where existing capacity resources earned 93% of capacity revenues through 2011.
The reason Texas has seen the most new entry of any RTO in the country is because it doesn't have a capacity market creating an artificial barrier, and doesn't have customers subsidizing 50-year old, low-going-forward-fixed cost units at the expense of keeping out new entry by more efficient and reliable units.
While the Council's core principle of avoiding poorly crafted subsidies was specifically concerned with types of generator technology, it is equally applicable to imposing a capacity market on Texas customers, as capacity markets subsidize some resources at the expense of others. While it is true that any resource may "compete" for the capacity payment, the government-defined capacity product, which is not the result of the interaction of real buyers and sellers, makes clearing the market a fait accompli with certain resources which are given an unfair competitive advantage in serving the capacity product without any regard to whether these resources would be those that would be procured in a truly competitive market (one where customers select the resources, and would consider all-in energy, capacity and ancillary costs, plus any externalities considered by the customer).
The Competitiveness Council includes 37 recommendations in its Texas Energy Plan. Despite the noted challenges of resource adequacy, none of these recommendations is for a mandated reserve margin or capacity market.
In fact, the report repudiates a focus on installed capacity in one of its recommendations, as the Competitiveness Council recommends (emphasis added), "The PUC and ERCOT should study whether an additional operating reserve service to help manage the intermittency of wind energy or other alternative energy sources would be a cost-effective solution to more reliably integrating these energy resources to the grid. Such a service could be provided by quick-start natural gas units, demand-response by customers, or storage solutions."
Moreover, the Governor's Competitiveness Council warns against "centralized resource planning mechanisms and governmental dictates," which are hallmarks of a mandated reserve margin and capacity market.
"Many other states are addressing these challenges by adopting centralized resource planning mechanisms and governmental dictates for specific generation technologies. Such attempts inhibit market-based solutions and competitive pressures that are more likely to provide long-term efficiencies and innovation. In contrast, because the competitive marketplace in Texas is already providing a diverse mix of generation resources, this plan seeks to identify and remove regulatory, legal, informational, and economic barriers that thwart efficient market responses to the energy needs of the state," the Council said.
Rather than placing an emphasis on a command-and-control mandated reserve margin, the Governor's Competitiveness Council emphasizes customer empowerment, which is eliminated when a nonbypassable capacity tag is placed on customers to meet a government-set reserve margin.
"[A]ggressive DSM [demand-side management] and deployment of advanced meters
will empower customers to better manage their electricity consumption," the Council notes.
Note the emphasis on customer-empowered demand response, essentially price responsive demand, as opposed to command-and-control demand response procured through a government-run market (a contrast to claims a capacity market is needed to grow demand response).
"Texas should explore ways to cost-effectively reduce the rate of demand growth in the state," the Council said, as, "Texas is likely to benefit from additional energy efficiency and DSM that slow the rate of demand growth and shift energy usage to off-peak hours where existing capacity sits idle"
Again, the focus is not meeting a mandated reserve margin with forward procurements of capacity, but avoiding such purchases.
Among the Council's recommendations is, "The PUC should ensure that ERCOT incorporates the most cost-effective means of ensuring that all retail customers have the option to be settled on 15-minute interval data in order to receive the full benefits of changes in consumption behavior and generation from solar panels and other distributed sources" (emphasis added).
As previously noted, introduction of a capacity market robs customers of their ability to receive the full benefits of changes in consumption behavior. Under the capacity market, the customer is saddled with, for 12 months, a capacity tag, and changes that the customer makes to reduce their demand and lower costs are not seen by the customer immediately, reducing incentives for the customer to take such action.
The Council notes that, "all electricity customers are likely to see substantial increases in their electricity costs in the coming years, whether those cost drivers are increased natural gas prices or incremental capacity additions. The competitive retail market in ERCOT, however, will continue to allow customers and REPs to manage the changing cost factors and more quickly and efficiently respond to these market dynamics" (emphasis added).
Again, we see the Council concerned with customers' ability to respond to the costs from capacity additions. Inherent in this view is that customers will have the ability to hedge, or avoid, new capacity costs, through a variety of actions (forward contracting, demand reductions, load shifting, etc), and that retail electric providers will innovate solutions to meet customer needs. However, these options are eliminated when a government-set reserve margin and capacity tag are imposed on customers on a nonbypassable basis.
Capacity market supporters might claim that the world has changed since the Governor's Competitiveness Council State Energy Plan, and that market-altering events make the analysis by the Competitive Council inapplicable in today's world. We disagree.
We presume capacity market supporters would point to the Lehman Bros bankruptcy, and its impact on financing, as well as the shale gas revolution, as creating new challenges to building new capacity in an energy-only market that were not apparent when the Council developed its report.
While we don't deny the challenges presented by these new realities, it must also be remembered certain barriers to new capacity construction, or other challenges to a supply/demand balance, which the Council was aware of (but nevertheless rejected a mandated reserve margin and capacity market), are no longer applicable. Most notably, the Competitiveness Council observed the challenges to new capacity construction by the spiraling costs of various raw materials, due to, at the time, robust global economic growth. "[A]ll capacity additions are likely to be significantly more expensive than just a few years ago, due to rising fuel and capital costs," the Council noted.
Given current economic realities, this barrier to capacity construction has been severely reduced. Additionally, economic growth, while still strong in Texas, is obviously at a different place versus pre-recession, and, as has been noted by Commissioner Kenneth Anderson, even with current levels of economic growth, the old algorithmic link between load growth and economic growth is no longer apparent.
Moreover, we believe the fact that the world has changed so much since the Council's report compels continued reliance on the market, with risks placed on investors, to meet Texas' electric needs, instead of government trying to assume this obligation. As the Council's report shows, no one, neither government nor private investors, knows what the future holds for the electric industry, and revolutions can come from unlikely and unforeseen places, with such revolutions having a radical impact on those parties carrying the risk (investors, or customers, depending on market design).
Indeed, the conventional wisdom in the Council's report was that Texas needed to get natural gas off the margin for electricity production, and would benefit from additions of coal and nuclear plants. Now, gas is making those coal and nuclear plants uneconomic.
That's why the government should stay out of the electricity market, even when it comes to a mandated reserve margin, because the government should not be placing risks on ratepayers.
Imagine this likely scenario. What would have happened if, in 2006, Texas adopted a mandated reserve margin, and as a result, instituted a three-year forward capacity market. Texas would have been procuring capacity three years in advance based on robust economic growth forecasts, and robust levels of peak demand. As we all know, with the 2008 crash, demand fell (ERCOT's 2009 peak was about 5% below forecasts), and Texas would have severely over-procured and overpaid capacity. How much would this have cost Texas customers? Saddled with these exorbitant and uneconomic capacity costs -- the results of a government mis-forecast -- Texas businesses may not have been able to withstand the economic downturn. The "Texas miracle" may never have happened, because in 2006, in customers' "best interests," the government stepped into the market to "assure" reliability, because it was necessary for "economic development."
Finally, the Council's Energy Plan warns against re-regulation.
"The state should resist efforts to re-regulate the market and instead adopt the recommendations in this plan, while retaining the oversight of the PUC and ERCOT over the market."
"[E]very other area of the country, whether regulated or not, faces significant costs of adding new generation over the next two decades. Texas is light years ahead of these other regions in adding new generation and transmission capacity, and Texas’ competitive marketplace has placed the risk of substantial new capital additions in generation on the companies building these resources and not Texas customers. Reverting to a regulated market would subject Texans to substantial new costs without having a meaningful downward impact on the overall level of electricity prices," the Council said
While some proponents of a mandated reserve margin and capacity market claim that it is not re-regulation, this is an indefensible position. The Texas government currently has zero authority to compel ERCOT customers to meet a mandated reserve margin.
The fact that this mandated reserve margin would be met through "competitive" means is irrelevant. While pricing may not be regulated, the demand for installed capacity has now been regulated by the Texas government.
Any change to introduce a mandated reserve margin would, by definition, be re-regulating the market, by introducing regulation into an aspect of the market that is not currently subject to regulation. While there may be alleged policy reasons supporting this re-regulation (we do not concede those as appropriate by citing them), it must be recognized and called what it is. And it must be recognized that re-regulating the market through introduction of a mandated reserve margin would be contrary to the Governor's Competitiveness Council Texas Energy Plan.
Link to Governor's Competitiveness Council Texas Energy Plan
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September 20, 2013
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Reporting by Paul Ring • ring@energychoicematters.com
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