- Texas is struggling with inadequate future power supply, and has been forced to rethink market design.
- Direct impact on companies with power assets in Texas - potentially dynamic value for merchant power assets.
- Many other jurisdictions will take lessons from Texas' challenges and modified market design.
By Elias Hinckley and Clair Austin
Texas both produces and consumes more energy than any state in the U.S. It controls one-quarter of U.S. proven oil reserves. Energy companies looking to grow or to establish a U.S. presence set up operations in Texas. The primary electricity transmission system in Texas is independent of the rest of the country (a long-time source of pride). The Electric Reliability Council of Texas, or ERCOT, is responsible for regulating the generation and supply of power to 85% of the state, except the extreme eastern and western portions.
1) Texas electric demand is huge and growing. Texas produces and consumes more electricity than any state in the U.S. Population growth is booming, and the nearly 26 million residents have a growing demand for power, as does the petrochemical and energy industries that has made up most of the state's relatively rapid job growth.
2) EPA regulations are coming at a difficult time for power systems operators. For ERCOT, greenhouse gas emissions and mercury regulations for power plants are turning aging inefficient power infrastructure that is already expensive to operate into economically unviable dinosaurs. The state government and industry groups have struggled with the EPA for some time, and the Texas state legislature voted to have the state Department of Environmental Quality take over the permitting process for new power plants.
3) Texas's power system is a deregulated market, and inconsistency brings inefficiency. There is no certainty for long-term pricing contracts for new developers under the current system, and in Texas' energy-only market, power providers are not paid for their capacity or for remaining online in case of emergency. The decision to build more generation capacity is based on potential economic consequences rather than regulatory forecasting (which provides security for investors), and drawing in investors without long-term revenue certainty is extremely challenging.
4) The fracking boom is producing energy, but also straining resources. Low fuel prices lower the apparent cost for new gas generation, but those same low prices pull down electricity prices in the current market, lowering revenue for a new generating facility, and energy companies have not been motivated to build new power plants. Fracking is energy intensive, adding to the growing demand for power and it is also a tremendous stress on water resources.
5) Drought and the energy industry's huge demand for water has run some communities dry. During each of the summers of the past few years, droughts in Texas have threatened energy capacity shortages. Investors and lenders are demanding that developers of new gas generation are able to show adequate water availability throughout the life of a new plant, which increases costs and slows development.
The fundamental challenge of a closed system is that it must meet its own needs, and that has not happened. There are increasing concerns about rolling blackouts in America's "energy capital." NRG Energy (NYSE:NRG) reported that by 2016, Texas could experience four rolling blackouts a year, and strongly recommended that the state build more power generation reserves to improve grid reliability.
Old and inefficient power plants are being fired back up to meet demand peaks, which is an inefficient use of inefficient technology and is unreliable. The transmission system is outdated. Financial obstacles like the bankruptcy of Energy Future Holdings (and all the associated fallout) - which controls the largest retail utility and the largest power generation fleet in the state - overhang any possible solution. All these challenges combined with growing electricity demand amount to a potentially serious problem.
Obviously, for anyone living in or doing business in Texas, the potential for a breakdown in electric reliability is a very serious concern. Systemic disruptions in the energy sector are dangerous, and can also cause serious and lasting economic damage. Simply the threat of unreliable supply and potential power failures reduce incentives to invest in Texas industries.
Much Bigger than Texas
Texas's power problems are about much more than Texas. The obvious concern is that the direct economic implications could be much wider than just Texas. The state represents a huge portion of U.S. economic activity, and is a vital part of our national energy strategy. Perhaps more important than the direct economic considerations is that the fight over EPA regulations may be defined by the battles in Texas. Similarly, how the lack of long-term power price certainty is resolved (allowing adequate financing to support necessary new generation projects) will cause ripples throughout US power markets.
Texas's larger utilities like NRG Energy are taking action primarily on the demand side, installing smart meters and using pricing mechanisms to "shed" customers during times of peak energy demand. In fact, ERCOT's emergency response service is credited (along with some fortuitous timing of very high wind power output) with avoiding blackouts during the Polar Vortex this winter. ERCOT is planning to raise the System Wide Offer Cap, or the total amount of money energy service providers can make during peak demand times, to $9000 per megawatt hour by the summer of 2015. Increasing this cap on wholesale power prices is intended to attract greater investment, and Texas utilities will combine these price increases with other efforts to shed peak load demand.
On the supply side, ERCOT is currently overhauling their power forecasting methods to better predict when they may need to bring more power generation capacity online. The Federal Energy Regulatory Commission's (FERC) recent order 764, requiring that utilities and other power generation sources report power capacity in 15-minute increments, will push ERCOT in the direction of more flexibility and enable it to predict when demand will reach emergency levels. Developing a capacity market, which is used in many other power markets, is a possibility. In many ways, capacity markets are still maturing, so a new take on capacity market design could have broader consequences.
ERCOT recently hit a record for wind power generation, reaching over 10,000 MW and 30% of total power generation. In Texas, as across the country, energy storage will be an important means of guaranteeing energy supply while supporting a renewable energy infrastructure. The largest battery storage facility is located in Texas, and ERCOT is working with the Energy Storage Association on plans to redesign the energy storage infrastructure.
Electric Vehicles are increasing in popularity across Texas; because of deregulation, electric utilities within ERCOT can charge EVs directly at power stations as a secondary income source. Utilities also value the power demand from charging stations as a way of offsetting the variability of wind power generation.
The state may also end its independence and isolation. While ERCOT's independence may be a source of pride, it is running up against the limitations of a contained system. Significant emergency power was imported from Mexico during the Polar Vortex. Tres Amigas SuperStation, which will connect the Texas Interconnection to the Eastern and Western Interconnections, is designed to reduce transmission bottlenecks, and may help the state meet its power needs and provide a larger market for Texas's wind power generation.
The independent power business has always been a tricky market, and especially so where investment has been based on merchant power. As it becomes clear that there will be at least shortfalls in spare capacity, if not outright supply shortfalls, the market for power generation in ERCOT, especially for dispatchable power generation, could be quite lucrative. Merchant power plant development has increasingly become the domain of private equity-backed enterprises (e.g., Panda Power Funds, FGE Power), and a number of large private equity firms (with mixed results - the failure of the KKR (NYSE:KKR), TPG and Goldman Sachs (NYSE:GS) led investment into Energy Future Holdings being one example) have bought into the Texas generation market. While access to these private deals is limited, publicly traded companies that have significant dispatchable assets in the Texas wholesale power market include Calpine (NYSE:CPN), NRG, Exelon (NYSE:EXC) and NextEra (NYSE:NEE) (though NextEra's portfolio is heavily wind-biased).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.