Deregulation in Texas Electricity Market

Electricity deregulation in Texas was the result of the coming into force of Texas Senate Bill 7 on January 1, 2002. According to the law, deregulation is to be phased in over several years.

As a result, most Texas power customers (those served by a company not owned by a municipality or a utility cooperative)can choose their electricity service from a variety of "Retail Electric Providers" (REPs) which includes the incumbent utility (usually a subsidiary thereof). The incumbent utility in the area still owns and maintains the local power lines (and is the company to call in the event of a power outage) and is not subject to deregulation. Customers served by cooperatives or municipal utilities can choose an alternate REP only if the utility has "opted in" to deregulation; to date, only the area served by the Nueces Electric Cooperative has chosen to opt in.

Since 2002, approximately 85% of commercial and industrial customers in Texas had switched power providers at least once. Approximately 40% of residential customers in deregulated areas of the state have switched from the former incumbent provider to a competitive REP.

Background
The state of Texas is the largest electricity market in the United States; Texas also ranks as the 11th largest worldwide market, falling between Great Britain and Spain in terms of annual consumption.

System
The law designated the Electric Reliability Council of Texas (ERCOT) would have the authority to oversee grid reliability and operations so as to ensure no particular buyer or seller would gain an unfair advantage in the marketplace.

"Aggregators" are legal entities that join together two or more customers for the purpose of purchasing electricity at reduced rates. Although there are almost 200 aggregators registered with the Public Utility Commission, perhaps only 25 or so are still active in terms of acquiring and managing customers.

The "price to beat"
Included within SB7 was a regulated rate concept governing the pricing behavior of the ex-utility providers known as the "Price To Beat" or PTB.

In typical economic theory, prices are optimally determined in a fair and transparent market, and not by a political or academic body. In Texas's deregulation, one concern with setting prices in the market right away was that incumbent electricity providers would undercut the prices of new entrants, preventing enough competition and creating a continuation of the existing monopoly of providers. Thus, the SB7 bill introduced a phase-in period during which a price floor would be established (for incumbent electricity companies) to prevent this predatory practice from occurring, allowing new market entrants to become established. New market entrants could charge a price below the Price to Beat, but incumbents could not. This period was to last from 2002 to January 1, 2007.

How is the Price to Beat established?
In order to incentivize participation in the Texas market, the Price to Beat would have to be high enough to allow for a modest profit by new entrants. Thus, it had to be above the cost of inputs such as natural gas and coal. For example, a PTB price that is fixed at the actual wholesale procurement price of electricity does not give potential entrants margin to compete against incumbent utilities. Second, the Price to Beat would have to be reasonably low, to enable as many customers as possible to continue to enjoy electricity during the transition period.

Competition and entry of new firms
There is often confusion about the relationship between deregulation, competition, profits, and how pricing is decided. Electric utilities were originally created because of the concern that there would be little competition among electricity providers, and thus there would be monopoly pricing. In the years since that era, some legislators in Texas came to believe that competition could operate where previously it was thought that it could not. For example, in 1999 Governor George W. Bush stated that, "competition in the electric industry will benefit Texans by reducing monthly rates and offering consumers more choices."[2] This belief led to deregulation in Texas.

The original fear was that because of the large capital requirements for things like power plants, only one company would typically have enough capital to create and own the plants; thus, with no choices of other providers, consumers would be stuck with monopoly prices. In today's world, the opposite is true: there is plentiful capital to be invested, and often numerous plants are proposed (by competing companies) to fulfill the same or similar needs, even to prepare to meet future needs. The existence of efficient capital (debt and equity) markets enables new entrants to raise money and begin construction on power plants where a future need has been identified.

Energy industry representatives argue that deregulation in Texas will correct a bottleneck in electricity supply and point out the 2003 North America blackout and the California electricity crisis as examples of problems that, they argue, could not arise in a mature deregulated electricity market.

What is notable about profitable versus rate-controlled utilities?
If deregulation in Texas leads to profitable rates, the building of new capacity, and the eventual creation of buffer capacity that would make blackouts unlikely, why couldn't society achieve this without having to pay profits to electricity firms?

If a provider receives its funding from private sources, it has to make a reasonable return (profit), or that funding will go fund something else. If a provider that receives private funding cannot charge market rates that reflect its costs, it may not be able to pay the needed return, and its funding will dry up. Conversely, if a utility instead agrees to charge below-market rates, it either a) cannot compete with a utility that can afford to build better plants to satisfy demand, or b) it must raise money via taxes rather than from the market to invest in new plants.

Previous utility economic theory posed a problem with unregulated rates: there will not be enough competition to keep rates reasonable, because of the capital costs. Modern economists generally agree on the presence of competition where it was previously considered impossible.

Deregulation has enabled entry of new firms
Since 2002, other companies such as Constellation Energy and FPL Group have entered the ERCOT market for the purpose of gaining market share.

More than 60 startup firms have been formed specifically for the Texas electricity market, split almost equally among commercial-usage focused firms and residential-usage firms.

What about the price issues?
Many have focused on the recent rise in Texas electricity prices as a reason to reject deregulation; after all, the claim was that deregulation would help consumers and lower prices. What is less commonly considered is that deregulation, by enabling new entrants and competition, probably has restrained prices better than the alternative.

For example, according to a commentary website, while prices to customers increased 43% from 2002 to 2004, the costs of inputs (e.g. natural gas) rose faster, by 63%, showing that not all increases have been borne by consumers [4]. In economics circles, a lot of discussion revolves around how prices are passed on down a value chain, from producers to intermediaries to consumers. To economists who study price elasticity and competition, the above statistic implies that competition is preventing producers from passing on the full costs of the increases in their inputs.

Additionally, by enticing the construction of massive new capacity (if this is permitted politically), it is clear that Texas's electricity markets will experience more rigorous competition on price.

A note on why natural gas prices are used instead of coal prices
When commentators complain that Texas electricity companies are unfairly basing their prices on natural gas prices, this is because there are not enough coal (cheaper) power plants to satisfy demand. To clear the market properly (that is, satisfy everyone), the price must be set at the marginal price, or the price of bringing online the temporary supply of the expensive natural gas-powered plants. See example below:

In basic economics the "clearing" price of any commodity is determined by the marginal price, or the price of the last item to be sold if they are all to be sold. Example: Suppose your sandwich shop has enough cheap lettuce for 5 sandwiches (cost: $1 apiece) and enough expensive lettuce (held on reserve, just in case) for 5 sandwiches (cost: $3 apiece). The rest of each sandwich costs $3, and typically you only sell the cheap lettuce sandwiches for $5, a $1 profit. Now 10 customers come in the door at the same time, a new record. You have not written the price of a sandwich yet on the board. What price should you set?

Your sandwich shop will go out of business setting it at $5, because it will have to make no profit on the sandwiches, leaving nothing left over for maintaining or improving the shop (a capital expense - need excess capital for this). If it tries to sell some at $5 and some at $7, the $7 customers will be angry - because the expensive, reserve lettuce is no different from them, no added value. And the $7 customers look unfairly at the $5 customers. (This is analogous to trying to sell some customers expensive electricity generated by the natural gas turbines and selling to the other customers cheaper electricity - electricity is electricity to the customer.)

The sandwich shop must price all the sandwiches at the marginal price that enables him to make a profit on his expensive sandwiches, by setting the price at $7 (a profit of $1 with the expensive lettuce).

For the same reason, that expensive natural gas power plants are necessary to supply the growing demand, current Texas electric companies must set their prices at the price dictated by natural gas production, even though some of their electricity comes from cheaper coal plants.

What will basing the price on natural gas prices do in the longer term?
By selling coal-generated power at the higher price of natural gas-generated power, Texas electric companies are reaping profits - but not for long. Everyone in the system knows about this profit, and profit invites imitators to build more coal plants to try to take some of the profit. After enough coal plants are built, suddenly demand can be entirely met with coal plants - and the marginal price is no longer set by the natural gas plants. Thus, the profit incentive of the market pricing causes three things to happen:

The profit causes investment (not because profit is always invested, but because others want to obtain the profit available at the market-clearing price)
The new investment causes an increase in capacity (which is what customers are communicating when they are paying more for the expensive electricity)
The increase in capacity solves two social problems simultaneiously: it lowers prices again, and it enables more people to enjoy inexpensive electricity than could enjoy it prior to investment

The type of deregulation that has been passed in Texas allows the above socially-optimal cycle to occur, for the reasons mentioned earlier. As mentioned above, we are already seeing signs confirming that such investment and competition is already occurring in Texas.

http://en.wikipedia.org/wiki/Deregulation_of_the_Texas_electricity_market

Deregulation in Texas