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Texas Should Reject a Capacity Market


By Tom Aldred, Executive Director. May 5, 2021



There have been numerous responses to the failures of Texas’ electric grid during the winter storm this past February. From changes to the governance of the Public Utility Commission (PUC) and the Electric Reliability Council of Texas (ERCOT), to measures aimed at requiring the weatherization of electric generating facilities, the Legislature has taken its responsibility seriously.


Several legislative proposals related to “capacity markets”, however, go too far and fundamentally misunderstand the root causes of the February grid failures. Put simply, capacity markets require electricity customers to pay for the capacity of the grid, while “energy only” markets require customers to pay for the electricity they use. From the perspective of the generators, in a capacity market they are paid for the generation capacity they offer, while in an energy-only market they are paid as they generate power on a day-to-day basis.


With respect to the February storm, generating capacity is not the clear culprit of the energy market’s failures. Lack of weatherization and preparedness for an extreme freeze played an outsized role. At one point, wind generation had fallen by 32%, coal generation dropped 13%, and national gas generation declined by 25%.[i] Those three sources are responsible for roughly 85% of the state’s electricity generation.[ii] One is no more to blame than the others because facilities using all of these key resources either froze or failed during a weather event that was unique and unanticipated.


Given these facts, it is unclear how a capacity market would guarantee that a repeat of the February 2021 outages cannot occur. As Frank A. Wolak, the Holbrook Working Professor of Commodity Price Studies in the Department of Economics at Stanford University explains in a paper entitled “What’s Wrong with Capacity Markets?”:


The major rationale for capacity markets in the United States appears to be a holdover from the vertically integrated regulated regime when capacity payments compensated generation units for their capital costs, because the regulatory process typically reimbursed unit owners for their variable operating costs … capacity payments look very much like subsidies to the construction of new generation capacity. Recall that they are payments made to generation unit owners for being available to produce electricity. The requirement to make these payments to owners of generation capacity can lead to over-investment in new generation capacity, which will reduce the spot price of electricity and increase the need for higher capacity payments in the future.[iii]


Put simply, in a normally functioning market, when supply is greater than demand, prices will come down. In a marketplace in which supply is forced to be greater that demand (i.e. a capacity market) prices will necessarily be higher than they would need to be, to the detriment of all consumers in the market. Indeed, ERCOT uses price signals to make sure that generators come online to meet demand. Demand peaks, prices go up, generators come online. In “The Texas Freeze: Why the Power Grid Failed,” Katherine Blunt and Russell Gold explain in the Wall Street Journal that:


Within the competitive Texas power market, there is a strong incentive for generators to keep costs down to recoup their investments. The rapid buildout of wind and solar power, which are now among the cheapest sources of electricity, have pushed prices even lower in recent years, making it more difficult for gas and coal plants to compete.[iv]


In other words, the expansion of renewable power generation may have come at the expense of grid reliability. The appropriate response to this is not to create a capacity market, but to ensure that the energy-only market can function appropriately without price signals being distorted by unreliable or heavily-subsidized generation sources. Weatherization and other reasonable efforts to ensure the future reliability of existing generation facilities are also reasonable approaches that should be supported. A capacity market is not.

[i] https://www.scientificamerican.com/article/why-the-deep-freeze-caused-texas-to-lose-power/ [ii] https://comptroller.texas.gov/economy/fiscal-notes/2020/august/ercot.php [iii] https://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.369.6388&rep=rep1&type=pdf [iv] https://www.wsj.com/articles/texas-freeze-power-grid-failure-electricity-market-incentives-11613777856