The Case of Texas:

Lessons and Reflections

Expert Workshop – New Electricity Market – Challenges and Opportunities Jerusalem Jay Zarnikau Frontier Associates LLC

and

The University of Texas at Austin July 2014 1

Why Consider Texas as a Model?

 Texas is often cited as North America’s most successful restructured market  Vibrant competition at the retail level  The wholesale market functions fairly well  Texas has probably the most unregulated electricity market in North America  An “energy only market,” relying extensively on the forces of supply and demand to preserve reliability  There is very little regulation over retail prices and services  FERC policies are not very relevant to Texas, allowing the nation’s largest electricity generating state to do things differently from other U.S. States 2

Competition in the ERCOT (Electric Reliability Council of Texas) Market

 Wholesale competition gradually introduced over three decades:  Cogeneration was promoted in the 1980s, exceeding 8 GW by the end of the decade  This led to a lot of independent power production beginning in the late 1980s  Wholesale competition formally introduced in 1995, creating the first ISO  Retail competition introduced:  Legislation in 1999 requiring full customer choice by January 2002  Price-to-Beat (PTB) regulated transitional default pricing for customers who do not exercise their right to choice expired in January 2007 3

Impetus for Restructuring

   Large industrial energy consumers thought they could obtain access to cheaper power supplies.

Power marketers and independent power producers (e.g., Enron and Shell Oil) wanted to play a bigger role in the retail sector.

A booming economy led to relatively-high demand growth and new business opportunities.

  There is a general distrust of government in Texas. Thus, a reduced role for government regulation was considered to be attractive, particularly under Governor George W. Bush’s administration. High prices was

not

much of a driver, in contrast to other states. Nonetheless, it was often claimed that restructuring would reduce Texas’s electricity prices even further. 4

Attributes of the Wholesale Market

 The market is

unbundled

. Generation, transmission and distribution, and retail sales functions have been separated. Nonetheless,companies serving different functions may be under common ownership.  There is a mix of investor owned utilities (IOUs), municipally-owned systems, rural electric coops, and independent power producers (IPPs).

 The independent system operator (ISO) dispatches resources to maintain reliability and operates markets for energy and ancillary services  The wholesale market structure switched from “zonal” to “nodal” in December 2010.

 A Day-Ahead Market also introduced in December 2010.

5

The Restructured ERCOT Market

ERCOT Competitive Market Participants Qualified Scheduling Entity (QSE) Resource Power Marketer (Optional) Load Serving Entity (LSE) Aggregator (Optional) Transmission and Distribution Service Provider (TDSP) NOIEs (Municipality/Cooperative) Public Utility Commission of Texas (PUCT)

Legend

Key Information Flow Power Flow Non-Regulated Organization Regulated Organization 6

ERCOT Electricity Generation Mix

ERCOT Electricity Generation 2013

Nuclear 11.6% Coal 37.2% Wind 9.9% Hydro, Biomass, Other 0.9% Natural Gas 40.5% Source: ERCOT 7

Generation Additions in the Early Years

(Source: PUCT)

8

And, a Lot of Wind Power

(Source: PUCT)

Retailers are required to sell (or have credits for) a minimum percentage of renewable power. And there are federal tax breaks for renewables. es .

9

ERCOT Wind Capacity Installed and Future Projection

14,000 MW 12,000 10,000 8,000 6,000

Cumulative MW Installed Cumulative Planned (Signed Interconnection Agreement)

ERCOT Wind Installations by Year (as of September 30, 2012)

The data presented here is based upon the latest registration data provided to ERCOT by the resource owners and can change without notice. Any capacity changes will be reflected in current and subsequent years' totals. Scheduling delays will also be reflected in the planned projects as that information is received.

8,005 12,433 12,702 12,790 11,542 2,398 2,667 2,755 8,916 9,400 1,507 9,604 10,035

This chart now reflects planned units in calendar year of installation rather than installation by peak of year shown

4,785 4,000 2,000 0 2,875 816 977 1,173 1,385 1,854 116 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Source: ERCOT System Planning Monthly Status Report (September 2012). 10

ERCOT Competitive Renewable Energy Zones Transmission Projects

Source: PUCT web site at: http://www.texascrezprojects.com/projects.aspx

. 11

Yet, Possible Supply Shortages Ahead

Source: PUCT 12

Generation Market Share in ERCOT (As of December 2006)

All Other 25% TXU 23% Tenaska 5% Austin Energy 3% Calpine 7% CPS Energy 7% Exelon 3% FPL 6% NRG 17% LCRA 4% The ERCOT market probably has the highest supplier concentration among all of North America’s “competitive” wholesale markets.

14

Monthly Wholesale Prices Vary a Lot

Source: Potomac Economics (2012), page ii.

15

Volatile Prices

First graph is an example from August 2, 2011; Price caps are now $7,000/MWh and will increase to $9,000/MWh next summer. Prices may differ in different zones, as can be seen in the second graph

3500 3000 2500 2000 1500 1000 500 0 0 20 40 80 100 120

Balancing Energy Prices in Various Zones on June 3, 2008

$1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $0 -$200 15 145 315 445 615 745 915 1045 1215 1345 1515 1645 1815 1945 2115 2245

15-Minute Interval

Houston North Zone West Zone

Assessment of Wholesale Market Performance

    The ERCOT ISO has done an admirable job of preserving reliability.

There has been some “gaming” by generators to raise prices. Market rules have had to evolve to prevent manipulation of market prices.

Some generators have gone bankrupt, but this hasn’t affected the market much (aside from “credit” problems).

The original “zonal” market design had some problems. The new “nodal” market is working better.

  Fairly high market concentration in the generation sector has led to some market power concerns. Yet, concerns that prices are actually too low to attract new investment has led the Public Utility Commission of Texas to downplay such concerns. Long-term resource adequacy remains a concern. But the Texas Commission is addressing this by allowing wholesale price (really, offer) caps to increase and better scarcity pricing. Texas is reluctant to introduce a “capacity market.” 17

Retail Competition

     Over 100 Retail Electric Providers or ‘REPs’ are serving customers (including some industrial energy consumers that serve as their own REP).

Service areas of investor owned transmission and distribution utilities offer customer choice. Currently, there are 15 to 18 REPs serving residential customers in the larger service areas opened to competition. Three REPs have more than 500,000 customers. Eight REPs have more than 100,000 customers.

TEXAS Service Areas Offering Retail Competition TNMP TXU AEP-North TXU AEP-North TNMP CNP

Legend AEP – Texas Central Company (AEP-Central) AEP – Texas North Company (AEP-North) CenterPoint Energy (CNP) Texas Electric Utilities (TXU) Texas-New Mexico Power Company (TNMP)

AEP-Central TNMP

March 2003

18

There is Ease of Entry in the Retail Sector. As well as Acquisitions and Bankruptcies

Notable Bankruptcies of Texas Retail Electric Providers Retailer Date of Default on Obligations to ERCOT Number of Affected Retail Accounts

Texas Commercial Energy Utility Choice Electric Ampro Buy Energy Franklin Power Company Blu Power of Texas Hwy 3 MHP Sure Electric (Riverway Power Company) Pre-Buy Electric National Power Company Abacus Resource Energy EPCOT Electric March 6, 2003 2004 2006 2006 June 8, 2005 July 1, 2008 June 3, 2008 June 10, 2008 May 16, 2008 May 27, 2008 February 9, 2011 July 12, 2012 Unknown Unknown Unknown Unknown <3,000 2,092 12,222 6,202 8,400 15,163 7,743 5,736 Source: ERCOT web site, various News Releases at: http://www.ercot.com/news/press_releases/ . And, now the state’s largest retailer, TXU, filed for bankruptcy a month ago.

19

Residential Rates

20

Restructuring has increased the sensitivity of retail electricity prices to the price of natural gas (the marginal fuel)

0.12

0.1

0.08

0.06

0.04

0.02

0 0

Generation Price vs. Natural Gas Price

2 4 6 8

Natural Gas Price ($/MMBtu)

10 12 21

Demand Response

  U.S. FERC: “Demand response is essential in competitive markets, to assure the efficient interaction of supply and demand, as a check on supplier and locational market power, and as an opportunity for choice by wholesale and end-use customers.” As electricity markets are redesigned, stakeholders and policymakers are challenged with ensuring that consumers are presented with accurate price signals and the appropriate incentives to react to those prices.

 When the demand side is price responsive:  System operating and investment costs are reduced when energy consumers are encouraged to shift their consumption of electricity from high price periods to hours when electricity can be supplied to consumers at a lower cost.  Prices can go down for all consumers.

 Uneconomical price spikes can be reduced or avoided.  Market power can be held in check. 22

If we could just magically change this curve. . . .

2000 1500 1000 500 0 0 1000 2000 3000 4000

MWs

5000 6000 7000 8000 Bid Curve D D-250 D-500

    

Why Demand Curves are Nearly Vertical

Price caps, preventing prices  Until recently, the metering infrastructure didn’t provide from rising to sufficient levels.

utilities or retailers with the Most consumers face (and capability to price electricity want) flat fixed pre-determined differently during different 15 prices.

minute intervals or hours to Need to separately settle and smaller residential consumers. meter a price-responsive The older meters were only customer.

read once a month and the total Not easy to get price information.

consumption of electricity since the last meter read was all that could be determined.

Prices cannot be perfectly forecast.

24

   

Steps Taken to Add Some Slope to the Demand Curve

Prices will soon be allowed to go has high as $9,000 per MWh.

Implemented an Operating Reserve Demand Curve last month, to enhance scarcity pricing.

Transmission charges are based upon the consumer’s contribution to demand during four summer month peaks, providing a strong price signal during peaks.

Consumers can purchase energy on a spot market through a retail electric provider.    The design of the wholesale market settlements system rewards Load-Serving Entities who can reduce generation needs during high price periods (passive load response).

Texas invested over $2 Billion in advanced meters, so that we can at least measure how much energy is used by residential consumers during 15-minute intervals. “Loads in SCED 1.0” 25

Some Success in Promoting Demand Response in Texas

  We’ve been very successful in allowing “interruptible loads” to provide an operating reserve or ancillary service. (See next slide) We have an Emergency Response Service (ERS) to participating consumers (mainly, large industrials) reduce purchases of power when ERCOT has a reliability problem.

    Some transmission and distribution utilities (TDUs) offer “load management programs.” Some retailers offer special programs to encourage consumers to shift their consumption to off-peak periods.

Transmission prices encourage consumers to shift their consumption away from peak periods. Some large energy consumers buy power based on wholesale market prices.

Load Resources Providing Operating Reserves

  Large industrial energy consumers who can withstand occasional interruptions in their purchase of electricity with no advance notice can provide Responsive Reserves.

About one half of ERCOT’s requirements for Responsive Reserves is met by these interruptible service customers. Power plants provide the remainder.

   Offers to provide this service may be offered into an ERCOT administered market on a day ahead basis (or “self arranged”).

A drop in frequency or a verbal instruction from ERCOT triggers an interruption.

Over 1,400 MW of load provides an operating reserve.

Response to 4CP Transmission Prices

Estimated Average Demand Response During a 4CP in 2013 Demand Response from Energy Consumers Served at Transmission Voltage in Competitive Areas (regardless of their participation in formal programs) (1) Programs Implemented by NOIEs (2) Other Load Control Programs activated during a CP RTP and B&I Programs (incidental impacts during a CP) Rough Estimate of Other Response not otherwise accounted for (3) TOTAL Notes: (1) An historical baseline calculation yields an estimate of 251 MW. Regression analysis suggests a reduction of 201 MW on average over the past 5 years.

(2) Based on a review of savings estimates reported by NOIEs. We have been unsuccessful in independently confirming these estimates.

(3) This is a conservative estimate based on judgment, to account for response by industrials with IDRs served at a voltage other than transmission and industrials within NOIE service areas.

Total MW 250 200 Small Small 50 500 13

Response to a Price Spike

Estimated Demand Response During a Spike in Wholesale Energy Prices in 2013 (1,2) (For a Load Zone Settlement Point Price above $3,000/MWh) RTP and B&I Programs Customers with IDR Meters Customers with AMS Meters Rough Estimate of Other Response not otherwise accounted for (3) Load Control Programs Implemented by NOIEs Peak Load Rebate Programs TOTAL Notes: (1) There were very few price spikes in ERCOT in 2013 (see Appendix). Consequently, many programs were not activated and the estimates here do not reflect potential demand reduction.

(2) Methodology: Regression analysis.

(3) This is a conservative estimate based on judgment, to account for response by industrials within NOIE service areas. Total MW 180 50 2 200 0.5

432.5

22

Lessons Learned



A competitive generation market can be successfully operated

.  The information technologies, models, databases, and accounting systems necessary to coordinate, price, and account for wholesale power transactions involving numerous generation suppliers in a reliable manner are available.  Centralized ISOs or RTOs can preserve reliability as well as system operators at vertically-integrated utilities.  Further, there is some evidence that competitive generation markets have achieved efficiency gains.  The establishment of a competitive independent power production sector can shift certain market risks away from consumers, which may also provide benefits.  Yet, concerns regarding market power and long-term resource adequacy are tougher to solve in a competitive market. 30

Lessons Learned



Competition requires considerable centralized coordination

.  A misnomer, so called “deregulation,” involves substantial government involvement in the design of a market and continued regulatory oversight over many functions. 

Market monitoring is necessary

.  Until the perfect wholesale market can be designed – a market immune to games and loopholes, with vibrant demand response, and with perfect competition among suppliers – there will be some need for on-going oversight of supplier pricing behavior and operational decisions.

31

Lessons Learned



In wholesale markets, market power is often a problem, particularly if the traditional utility supplier continues to own and operate a considerable share of the generating capacity.

 Absent some policy restrictions, the incumbent utility providers are likely to hold some initial market power or an ability to raise and sustain market prices above the price levels that would be produced by a more competitive market.  The restructuring plans of some markets required forced divestiture of generation assets from the traditional utility supplier.  Other markets have placed limits on the quantity of generating capacity that can be owned and operated by a single entity.  The high costs of storing electricity, inelastic demand, barriers to market entry and transmission bottlenecks can further limit the number of generators available to supply electricity to a given area at a given time.  Consequently, it has been difficult for policy-makers to remove constraints and safeguards on price-setting in wholesale markets, resulting in price caps, constraints on bidding behavior, and market monitoring activities.

32

Lessons Learned



More attention must be paid to fostering the response of the demand side of electricity markets to changes in the cost of generating, transmitting, and delivering power to the consumer.

 Demand response is essential to success of competitive electricity markets.  In markets with relaxed regulatory oversight, demand response can be used to help constrain prices to economically efficient levels.  A small amount of demand response can yield significant reductions in wholesale electricity prices.  In the absence of either demand response or a high degree of competition among suppliers, wholesale price caps and aggressive market monitoring are necessary 33

Lessons Learned



Given the role of political processes in the design of markets, reforms tend to include many features that have nothing to do with fostering competition.

 A lot of social and environmental programs get added into the mix to make restructuring more palatable to those who are concerned about likely inequities.  Thus, it is quite common for restructuring policies to include goals for energy efficiency, renewable energy, low-income family assistance, and compensation to any party that might be adversely affected by the policy change. 34

Lessons Learned



There is no guarantee that restructuring will result in lower prices to consumers.

 Restructuring induces a fundamental reorganization of the industry and introduces expensive new activities and functions that are not required of vertically-integrated utilities.  Given the economies of scope traditionally associated with this industry, it does not necessarily follow that a non-integrated series of markets and regulated monopolies can meet consumers’ needs better than a vertically integrated utility.   However, high prices are not an inevitable consequence of restructuring. Market restructuring has tended to increase the sensitivity of retail electricity prices to changes in the price of natural gas, the marginal fuel used for generation in many regions. In contrast, price changes in regulated utility service areas tend to reflect the utilities’

average

fuel costs (as opposed to

marginal

wholesale power costs). Give me a forecast of gas prices, and I’ll tell you what market structure will have lower prices.

35

Lessons Learned



Efficiency benefits appear to be showing up at wholesale level, but are not obvious at the retail level

.  It is not yet clear whether the creation of a competitive retail sector adds sufficient value to the industry, relative to the increased costs and confusion associated with retail competition.  Retailers incur costs for customer recruitment activities and the market bears considerable costs in order to switch consumers between retailers and track which retailers are serving which consumers.

 Retail competition can leave consumers confused.

36

Lessons Learned



Innovation is occurring, but we are seeing a lot of innovation in re-regulated and traditional markets as well

.  In competitive retail markets, retailers seek to differentiate themselves based on pricing options (e.g., spot market pricing, new billing options, and hedging mechanisms) and added services (e.g., energy efficiency services and coupons for discounts on other products).  Yet, much of the innovation in pricing has been coming from California, a state where re-regulation was imposed.  And it has been difficult for retailers to provide consumers with new metering equipment, in-home networking equipment, load control capabilities, and other advanced equipment when there is a probability that the equipment will become stranded if the consumer switches to a different retailer in the future. 37

Lessons Learned



It is not clear how to ensure long-term resource adequacy

.  Monopoly providers of electricity have a responsibility for ensuring that adequate resources are available to meet the demand for electricity over the long run.   But in a competitive market with entry and exit, there is not a single generator or market participant to which such responsibility can be assigned. The approaches being tested range from the “energy-only” approach of letting the forces of supply and demand resolve the problem (in Australia and Texas) to requiring load-serving entities to hold a sufficient quantity of tradable capacity credits (in the New York, MISO, and PJM markets).  It is not yet clear whether either of these solutions will work.

38

Lessons Learned

 

IT requirements are enormous

.  The high degree of coordination required of competitive wholesale markets requires a daunting amount of information and data processing capability.  The failure to fully appreciate and implement the systems necessary to track “who is serving who” and billing information created chaos following the introduction of retail choice in Texas and other restructured retail markets.

There are stages in the evolution toward a competitive market

.     Competition is always introduced in stages, for good reason. Markets are designed, and flaws in the initial design must be recognized and corrected. Joskow refers to this as the “reform of the reforms.” As the market develops and competition becomes more prevalent, safeguards such as price caps may be relaxed.

39

Lessons Learned

 

Retail prices must be free to adjust to wholesale prices

.  Not only can pricing constraints place financial stress on a retailer, they prevent consumers from seeing the true cost of power.  Constraints on retail prices may remove any conservation signal from prices during high fuel costs or resource adequacy, resulting in over-consumption.

The need for both bilateral contracts and a spot market

.  California’s experience with a Power Exchange suggests that requiring all power to be bought and sold through a spot market introduces extreme volatility into markets. Load-serving entities are unable to hedge risks.  The Nordic market and others that are dominated by bilateral contracts, with a smaller real-time market to address imbalances and some form of a day-ahead market, tend to be more sustainable. 40

Lessons Learned

 

Ultimately, the fate of restructuring is in the hands of politicians and policy makers.

 The design of markets is a political process and some market participants have greater influence over the political process than others.  For electricity markets to succeed, policy makers must make long term commitments to policy directions.

There is no one single successful blueprint

.  Each region which has pursued restructuring has approached it with its own unique legacy infrastructure, needs, customer mix, and traditional regulatory or government policies. 41

Some of my papers on this topic. . .

          “The quest for competitive electricity markets,”

LBJ Journal of Public Affairs

, 2008.

“A review of efforts to restructure Texas’ electricity market,”

Energy Policy

, Vol. 33(1), 2005, pp. 15-25.

“Did the introduction of a nodal market structure impact wholesale electricity prices in the Texas (ERCOT) market?”

Journal of Regulatory Economics.

Vol. 45(2), 2014. With C.K. Woo and Ross Baldick.

“The response of large industrial energy consumers to four coincident peak (4CP) transmission charges in the Texas (ERCOT) market,”

Utilities Policy

. With Dan Thal.

“Texas electricity market: Getting better,”

Evolution of Global Electricity Markets: New paradigms, new challenges, new approaches

, ed. P. Sioshansi, Elsevier, 2013. With Parviz Adib and Ross Baldick.

“Demand participation in the restructured Electric Reliability Council of Texas market,”

Energy - the International Journal

. 2009.

“Aggregate consumer response to wholesale prices in the restructured Texas electricity market,”

Energy Economics

. Vol. 30(4), pp. 1798-1808, 2008. With Ian Hallett.

“Integrating demand response into restructured wholesale markets,” in

Competitive Electricity Markets: Design, Implementation, and Performance,

edited by F. P. Sioshansi, Elsevier, 2008. “Using demand response programs to provide operating reserves in wholesale power markets.”

US Energy Association’s Dialogue

, 2006.

“A look inside the most successful restructured electricity market in North America: Texas,”

IAEE 29th Annual International Energy Conference Proceedings

, Potsdam, Germany, 2006.