The Electric Reliability Council of Texas (ERCOT) is an independent system operator representing around 85 per cent of the electricity load in Texas. ERCOT is a leader in the development and advancement of competitive power markets in the United States, and has successfully delivered some of the nation’s lowest energy costs to consumers.

Unlike traditional integrated uti lity monopolies, competitive power markets like the one existing in ERCOT typically separate the ownership of transmission lines, generation assets and the retail sale of power to end consumers. The market created by ERCOT is designed to dispatch the lowest cost generators of energy and to give consumers the option to elect their retail electricity provider in order to receive energy at the lowest possible cost. The owners of the transmission and distribution lines are the only non-market participants (certain areas within ERCOT are served by cooperatives and municipal-owned electric utilities and are not subject to competition) in ERCOT’s areas of competitive choice, and the prices they are permitted to charge are regulated by the Public Utility Commission of Texas (PUCT).

As a result of its energy-only market design, ERCOT has been very successful at delivering low energy prices to consumers. Generators are paid market prices for the electricity they generate and for certain ancillary services they provide to the grid to maintain reliability. Only the lowest cost generators are dispatched to deliver energy and receive the market-clearing price. The ERCOT market does not include any fixed payments to generators for their plant’s generating capacity. The Texas Legislature and the PUCT believe strongly in letting the energy markets work to incentivise the construction of new generation. Adequate price signals should trigger construction of new generation, making fixed payments for capacity unnecessary.

This fundamental faith in the market is now being tested in Texas. Growth in demand is resulting in smaller reserves of generating capacity.

In spite of the recession, demand growth in the ERCOT market continues to exceed 2 per cent per year and is expected to continue to grow at this pace for the foreseeable future. On a quarterly basis, ERCOT publishes the Seasonal Assessment of Resource Adequacy (the SARA report). According to ERCOT, the SARA report is designed to provide an accurate assessment of near-term conditions. It is based on the most current available data on seasonal weather, the status of power plants and the impact of factors such as economic activity and the ongoing drought. The final SARA report for summer 2012 was released on 1 May. It estimates that under extreme load conditions with typical generator outages, adjusting for decreased demand owing to scarcity, there could be an approximately 260 MW shortfall in capacity this summer.

The issue facing ERCOT is one of resource adequacy. ERCOT needs more gas-fired power generation to meet peak demand during summer months. During the “shoulder” months of spring and fall, electricity demand in Texas is relatively low, owing to cooler temperatures. During the same period, windy conditions in West Texas result in more power being generated from wind. As a result of these factors, ERCOT has an abundance of generating capacity at these times. The summer, however, is a different story; demand for energy is at a peak and wind generation is at a low. The ERCOT system may lack sufficient demand-responsive power-generation resources, such as natural gas-fired power plants, to meet demand at peak periods.

The retail electricity market has evolved in a manner that makes this situation even worse. End customers typically sign agreements with their retail electricity providers lasting one to two years for a fixed dollar per kilowatt-hour rate. This means, despite resources becoming scarce and prices for electricity increasing, many end customers have no incentive to reduce their electricity consumption. Further, retail electric providers typically do not enter into long-term power purchase agreements with generators. Instead, they hedge their supply side pricing risk over the same time period as their customer contracts, i.e., one to two years. Generators typically need a power purchase or tolling agreement with a creditworthy counterparty covering 15 to 20 years in order to obtain debt and equity financing for new projects. The lack of a market for long-term power purchase and tolling agreements in ERCOT makes it very difficult for investors and lenders to commit capital to new power projects. In increasingly difficult financial markets, financial institutions need certainty that regular cash flows will be available to service debt, and equity investors want some assurance they will earn a return on their investment.

Given these circumstances, the challenge is in providing an adequate incentive for the construction of new demand-responsive generation capacity in ERCOT. Stakeholders have suggested the revision of some regulations put in place to protect consumers from abusive practices by generators.

System-Wide Offer Cap under

First is the System-Wide Offer Cap (SWOC) of US$3,000 per MWh. The SWOC is a price ceiling designed to limit price spikes during periods of reserve scarcity. It has been proposed that the SWOC be increased to allow scarcity rents to be collected by “peaker” power plants (units that run when demand is high).

On 12 April 2012, the PUCT approved two proposals to increase the SWOC to US$4,500, effective 1 August 2012, and increasing it gradually to US$9,000 per MWh by 1 June 2015, with a final decision on these adjustments anticipated this summer. Proponents of the adjustment to the SWOC think it is necessary because margins have been driven down by low offpeak power prices owing to low natural gas prices and low-cost energy injected into the system during off-peak times by wind energy projects. Lower off-peak margins mean that gas-fired power plants make the majority of their margin during peak periods during the hot summer months. Therefore, the price signals during summer peak demand must be high enough to justify the cost of building new gas-fired generation.

Peaker Net Margin

Second is the Peaker Net Margin (PNM) mechanism. The PNM mechanism sets a maximum amount of scarcity rent (currently US$175,000 per MW-year) at the SWOC that may be collected by a generator before the maximum price reverts to the Low System Offer Cap (LCAP) (currently US$500). The PNM ostensibly represents the cost of building new generation capacity. However, it has not been revised since 2006 and does not accurately represent the real, current cost of building new generation capacity. It has been suggested that both the PNM and the LCAP be revised upwards to further incentivise construction of new peaker power plants.

ERCOT has engaged a private consultant to study the potential solutions, a process that is due to be completed in early June. We wait to see if the upward revision of the SWOC, PNM and LCAP mechanisms will be enough to encourage the construction of new “merchant” generation (power plants without long-term power purchase agreements), or cause retail electric providers and others participating in ERCOT’s energy market to rethink their view on long-term power purchase agreements.