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Management in Practice

Why the Texas Power Market Failed

Ed Hirs ’81, an energy economist and a University of Houston Energy Fellow, is a longtime observer of the Texas power sector as a researcher, entrepreneur, and public commentator. He says the February 2021 energy crisis exposed longstanding, fatal flaws in the state’s energy market design and oversight.

Workers repair a power line in Austin, Texas, on February 18, 2021. Photo: Thomas Ryan Allison/Bloomberg via Getty Images.

Workers repair a power line in Austin, Texas, on February 18, 2021. Photo: Thomas Ryan Allison/Bloomberg via Getty Images.

Q: In February, millions of homes in Texas were left without power for several days. What happened?

On the night of February 14, when the cold dipped into the very southernmost parts of Texas and people switched on their heat, the grid began to deteriorate. Power generators tried to fire up their plants, but many couldn’t get them going.

In Texas everybody knows that every power plant will be needed for the August peak, which is somewhere around 75 gigawatts. Through the rest of the year, only about 45 gigawatts of load is required, on average. That means 30 gigawatts of load sits on the bench not earning any money, so many plants just shut down.

After a similar storm in 2011, generators were encouraged to winterize, but they don’t receive payment to offset the costs, so many didn’t do it. Things that are routine in Wyoming, Colorado, Kansas, and Buffalo, New York, weren’t done, which meant in Texas the same equipment couldn’t be brought online when it was needed.

This was exacerbated by the rolling blackouts that the Electric Reliability Council of Texas, better known as ERCOT, started imposing to avoid losing the entire grid. The first users to lose power are industrial users. In that category we include natural gas compression units around the state. Without the natural gas delivery infrastructure, some generators no longer had fuel.

The energy grid is a system, and very few people think in terms of second-order and third-order conditions. But this cascade of failures was going to happen at some point; it just needed a stressor to kick the legs out from under it.

Q: You’ve described the grid as antiquated and the generation capacity as needing upgrading, but you point to the Texas power market itself as the true cause of the crisis?

Yes. Fundamentally, the difference between the Texas market and other energy markets across the U.S. is that it’s an electricity-only market. There is no capacity market paying generators to ensure there will be enough power to meet peak demand. The generators only make money when they’re delivering electrons into the grid.

An electricity-only market is the same as the New York Yankees only paying the players who take the field. If the guys on the bench aren’t paid unless they play, they’ll eventually be bidding to play for less and less just to be able to feed themselves.

“Over the last 10 years, the revenues collected by the generators were less than the cost of providing the electricity. That is not going to produce a reliable system.”

That’s what we have in the Texas energy market. Over the last 10 years, the revenues collected by the generators were less than the cost of providing the electricity. That is not going to produce a reliable system.

With this model, the generators don’t add investment because they can’t get paid for it. In fact, if they added generation units, all they would be doing is ensuring that the price would stay low. There’s been no incentive to add generation, even though demand in the state has continued to grow through inbound population and inbound industry.

Given an electricity-only market with an average wholesale price less than the average total cost to produce the power, a lack of reinvestment, and the fact that nobody winterized their plants because they expect temperate winters in Texas, this disaster was inevitable.

In 2011, a polar vortex got into North Texas and caused numerous blackouts. ERCOT’s blackout of the Dallas Medical Center tragically led to the death of a number of patients, though the blackout people remember is Arlington Stadium before the Super Bowl.

Before that, in 1989, Houston had several days of single-digit temperatures, which broke the grid and other infrastructure. These are not one-in-a-hundred-years storms. These are more like one-in-ten-years storms. The recommendations made post-2011 grid failure to winterize the plants had no teeth because ERCOT has no enforcement ability.

Q: What does ERCOT do?

ERCOT directs the flow of electrons around the grid the way an air traffic controller manages aircraft. It also serves as the clearinghouse, market maker, and principal buying agent for electricity on behalf of consumers.

You can watch the ERCOT market online. Generators can bid into the day-ahead market or provide electricity real time. Prices change at different nodes across the grid depending on where there’s demand, congestion, or a unit that’s out.

Prices range from negative $30 per megawatt-hour—negative because it’s non-economic for some of these plants to ramp down and negative because of production tax credits that are still being used by wind generation—up to $9,000 per megawatt-hour at the cap. During the crisis week of February 14, some of the ancillary prices jumped to $25,000 a megawatt-hour. Imagine the $25 per kilowatt-hour bill on your house. That would be quite extraordinary. [Editor’s note: the average household in Texas uses 1,176 kWh a month.]

The value of electricity is not in the cost of producing it. The value is in what it allows us to do. Texans were introduced to the concept of opportunity cost when dozens of people died and $140 billion in losses was wrought across the state—$50 billion from ERCOT charges and an estimated $90 billion in property and casualty losses.

Q: How did this market structure come to be?

The Texas energy market is a vertically disintegrated utility system. The old model had everything from power generation to the wires to the meter all integrated into one company that was regulated such that the utility earned a return on capital.

In the United States, the utilities have pretty well been regulated and governed for the public interest since the 1930s by the Federal Power Act and the Federal Power Administration, which became the Federal Energy Regulatory Commission—FERC. Texas, in the ’30s, opted to keep its grid separate and outside of the federal authority, so FERC still doesn’t have oversight in Texas.

During the Roosevelt administration, Texas’s independence was welcomed. Texas was essentially its own industrial powerhouse. Leading into World War II, Texas started building natural gas pipelines to the northeast. In that framework, with plentiful oil, natural gas, and coal, the Texas grid expanded dramatically. Things rocked along. And while there wasn’t federal oversight, within the state the power sector was still regulated vertically.

In the mid-’70s, under the Ford and Carter administrations, there was a push for deregulation of industries. In the ’80s, electric utilities were deregulated in Australia; folks took notice in Houston. Enron, which had commoditized natural gas trading, began to look at electricity. They became a leading proponent of deregulating electric markets.

The first to try it was California. Assembly Bill 1890 began the process of disintegrating the vertical utilities—separating the generation, the transmission, and the local distribution companies, even setting up resellers of electricity so that the customer could choose among different resellers. The changes were implemented in 1996, then careened to an incredible and well-known failure in 2000 and 2001.

Enron had also been talking to then Governor George W. Bush in the late ’90s. By the time Texas implemented its electricity-only market, Governor Bush was President Bush, and Rick Perry was Texas’s governor.

Q: Why not use a capacity market?

The siren song from Enron was that Texas had overbuilt its generation capacity. In a vertically integrated, vertically regulated utility, the only way to make more money was to build a bigger plant, so there was an impetus to build ever-larger physical plants to obtain larger and larger rate bases.

In the ’60s, ’70s and early ’80s, hearings before public service commissions were all about the rate base. Utilities would try to argue for every possible reason to expand the rate base. Public utility commissioners would try to limit the expansions. But they wound up building the system to a very high standard of reliability.

As one of the principles of intro to microeconomics will tell you, you begin to hit a point of diminishing returns. Getting that last 1% of reliability costs almost as much as the first 98%. Sharp MBAs at Enron and other places had figured this out. They went to Governor Bush and said, “We can cut costs here. We will save people money.” And the craven politicians fell for it.

Q: Did consumers get better rates?

Actually, no. They didn’t. L. M. Sixel, a journalist at the Houston Chronicle, has done a series over several years looking at ERCOT. She showed that ERCOT was not providing the consumers of Texas with cheap electricity as advertised. Other markets, especially in states that are vertically regulated, had cheaper bills. The Wall Street Journal recently reiterated the point, noting consumers have paid $28 billion more since 2004 than they would have without the deregulation.

Part of that is market design. Part is how the market has been managed. The incentives are misaligned. Let me take you to the point where governance and game theory play in. As generation companies watch the Texas market, minute by minute, they can force it into a tight squeeze, every once in a while, by withdrawing generation and watching the price spike. If they have eight generation plants and pull back two, then the other six would benefit from a higher price. They could also do this and set off trades on the financial markets.

Under FERC rules, this sort of behavior is illegal. But under Texas rules, there are no conflicts of interest. The series in the Chronicle highlighted several instances where the Texas market has been gamed. In particular, in 2014, one of the generators took basically $300 million off the top of the market.

Q: You described Texas’s energy market as vertically disintegrated. Is it truly deregulated?

No. It’s just regulated differently. If I eliminated the speed limit on I-91 through New Haven, I could say, “I have totally deregulated I-91.” But that doesn’t mean cars aren’t still constrained by entrances, exits, and the condition of the road. Drivers may be allowed to drive at 120 miles an hour, but good luck trying it during a polar vortex blizzard.

[Former Yale SOM dean] Paul MacAvoy detailed this in his book The Unsustainable Cost of Partial Deregulation. If you deregulate one portion of the market, you create bottlenecks and strictures at other points. In his analysis of partial deregulation of electric utilities and transmission lines he details the dislocations that occur. For example, electricity in Connecticut might sell for three and a half cents per kilowatt-hour wholesale, whereas right across the border in Massachusetts it’s nine and a half cents. Or natural gas enters the pipeline at the Waha Hub in West Texas near the Permian Basinat $2.50 per MCF [thousand cubic feet] and exits in southern California at $12.50. These types of dislocations run counter to public interest.

“Milton Friedman said there’s no such thing as a free lunch. The guys at Enron offered Governor George W. Bush a free lunch. And Texans are now paying for it.”

In an exchange I’ve had with [Yale economist] William Nordhaus about this crisis in Texas, he described it as a case of the market fundamentalism running into reality. It’s worth keeping in mind: Milton Friedman, the free market proponent, also said there’s no such thing as a free lunch. The guys at Enron offered Governor George W. Bush a free lunch. And Texans are now paying for it.

Q: So how do you fix it?

The short answer is, spend some money, and it’s going to be money that either the consumer or the taxpayer is going to have to come up with. We need to provide a financial incentive or the financial wherewithal for generators to harden the grid and make it resilient, not just for winter events but for the normal, run-of-the-mill hurricanes and heat waves.

The legislature is going to have to pass some laws. The idea of further government intervention is of course causing heads to spin in Austin, if not absolutely explode. It’s a little early to see how it’s going to shake out, but even the governor said that we’re going to make sure that these plants are paid to winterize.

Free market true believers have taken over the Texas legislature and the executive mansion now for three administrations over 20-plus years. In my view, the mantra of free markets has become a cop-out to avoid doing critical analysis. Their thinking is something along the lines of, “I don’t have to do the work to figure this out; the free market will do it for me.” It’s feckless to dodge understanding the market and the systems these legislators and executives are responsible for.

Q: What would you do with ERCOT?

My recommendation would be to separate ERCOT’s two functions. Moving the electrons around the grid optimally, of course, needs to be done. But combining that with the market-making function that controls the financial incentives causes a conflict.

As it stands, ERCOT effectively has no oversight and no accountability. The Public Utility Commission, which theoretically oversees ERCOT, is essentially the same; the governor can ask for resignations of commissioners, but there’s no other way to enforce good behavior.

Q: Could Texas copy a market structure being used elsewhere?

Each state and region has a unique model with its own benefits and costs. I fully expect the legislature to consider the expedient approach, which would be to install a capacity market with some carrots and sticks attached. But that’s not going to solve the problem of the lack of investment in the Texas grid.

Lots of folks have said being part of the western interconnect or the eastern interconnect would have saved Texas. There wasn’t enough power available to make up for the 30 gigawatts we were missing during the crisis. And quite frankly, who would want to have a weak link? Texas’s market and infrastructure are not up to snuff. We would potentially take everybody down.

There could be a push to vertically reintegrate and reregulate the Texas grid, really as a matter of national security. During hearings, in front of the legislature, it was disclosed that the grid was four minutes away from complete shutdown. To reenergize an electric grid from complete shutdown is called a black start. It’s likely Texas would need weeks or months to restore power from a black start.

That indicates the incredible weakness of the Texas grid. After the massive blackout in the Northeast in 2003, it was partially restored in a matter of hours and fully functional in 48 hours. With the 2011 blackout in the Southwest and Southern California, power was back in about 12 hours. Those grids came back from a black start. Texas’s grid is so disjointed. It’s a horrible strategic vulnerability that nobody’s addressed.

Q: That sounds like a reason for people in other parts of the country to care about what’s going on in Texas.

Absolutely. Texas is one of the main economic engines of this nation. Whether you like the politics or not, if we lose the grid in Texas for weeks, it would be a huge, strategic vulnerability for the entire nation. Millions of people without power, without water. It would be like New Orleans post-Katrina. Everything would break down. If the nation has to turn its eyes inward for a disaster here in Texas, that would leave us vulnerable to all sorts of bad actors. This is a real, serious issue.

This is not a red or blue issue. Electrons don’t know if they’re red or blue. This is smart versus stupid. This is a matter of public interest and it’s a matter of commercial interest. Nobody is going to want to move to Texas if you can’t keep the lights on.

Tesla is building a huge plant in Texas. It’s a black eye when Elon Musk tweets about the lack of reliable electricity. Samsung is currently considering building a huge chip plant in Texas. This is unlikely to go into the plus column.

Fixing the power sector in Texas is complicated. The system is interrelated and multidimensional. There are first-order, second-order, and third-order effects. Everything changes over time. It hurts people’s brains to think through these things. But getting it right is a matter of public interest. As Kingman Brewster, the former president of Yale, said, “There has to be something below the bottom line.”

Q: You mentioned that time is a factor shaping this complex system. Has climate change factored into planning for the grid?

Not yet. The legislature and the executive in Texas are climate deniers. They have the free-market mantras and they have the climate-denying mantras.

Q: How likely is a fix in the next few years?

If nothing’s done with the Texas grid, we will have another disaster, perhaps as soon as August. It’s clear that the leaders of the Texas legislature and the governor and lieutenant governor don’t have a grasp of the situation. It’s also quite clear that the federal authorities don’t have a grasp of it either. Because Texas is separate and not regulated by FERC, they really haven’t paid attention to it. But I’m an optimist; 2022 is an election year. Maybe a candidate or two steps up and starts thinking about the welfare of the state.