Price spikes vindicate ERCOT's market design

Major price spikes in ERCOT over the week of Aug 12-16 provided not just much-needed revenue for market participants, but also much-needed practical validation of ERCOT’s energy-only market design. Amidst hot weather, real-time prices hit the ERCOT price cap of $9,000/MWh over the course of nearly four hours in total. After another disappointing start to the summer, and growing skepticism about the potential for meaningful price spikes in general, buyers should be compelled to respond with stronger contract prices for electricity, and quickly, to keep the market healthy and incentivize new builds. This is a scenario we have been predicting for some time.

Proof of concept

ERCOT instituted the operating reserve demand curve (ORDC) and a $9,000/MWh price cap in late 2014. Since then, until last week, the market had only ever seen one fleeting glimpse of that glimmering unicorn, for ten brief minutes in January 2018. Yesterday’s events may not fully reverse the prevailing winds of skepticism in the forward market despite low reserve margins (which reached a nadir in July, when on-peak prices for August traded at less than $100/MWh and future years’ forward strips were similarly anemic), but the events of a single day need not accomplish that feat. At least the concept is proved -- when stressed, extended episodes of $9,000/MWh are possible. The unicorn is real.

Grid is still at risk

To keep the lights on Tuesday afternoon (August 13), ERCOT declared emergency conditions and deployed interruptible load resources (the ERS program). This was required despite wind at peak that was near expected levels and only ~2 GW of resources on outage status. The demand was slightly higher than forecasted (the projected peak was roughly 75.5 GW vs the CDR forecast of 74.8 GW), but overall, the situation was near the expected case. The presence of high scarcity prices during “normal” conditions indicates a grid at risk and short of capacity.

Variability in wind output alone can cause a 3.5 GW swing in reserves at peak. Had wind, outages, or weather been worse than expected, the grid would likely have experienced blackouts. It could still easily face these conditions either in the upcoming weeks of August 2019 or in 2020, especially with demand growth of 2-3% evident in the market. The grid needs to add 2 GW of firm capacity per year just to keep pace with demand growth, let alone resolve the present shortage. From a purely commercial aspect, it becomes clear that further price spikes can easily result.

Forward contracting needed

Bringing additional capacity online will require improved contract prices and a renewed willingness to invest. Weak summer prices have led to caution on the part of buyers (and would-be financiers of new plants) and created a heavily ‘backwardated’ futures market for power (lower prices over time).

Additionally, as we have noted before, there remains asymmetry in ERCOT market developments as the time required to bring a new plant online is much longer (a matter of years) than the decision to retire an existing plant (a matter of months) in response to a change in spot prices. The Public Utilities Commission of Texas noted this problem during the winter of 2019 and tweaked the ORDC towards producing price signals earlier in response to dropping reserves. This action, coupled with the practical validation of the price spike model seen on Tuesday, should provide the impetus to the market to improve contracting options and terms for new plants.

ERCOT’s model has already demonstrated its resistance to overpaying for excess capacity. The retirement of 5 GW of coal in late 2018 proved that the concept worked in practice. Now the model is proving its ability to compensate plants when capacity is absolutely needed—and we believe that need is clear today and in upcoming years.

Below you will find our 2018 blog post that discussed the potential for this type of event to occur in the ERCOT Market.

Two months ago, ERCOT’s Capacity, Demand and Reserves (CDR) report projected a reserve margin of just 9.3 percent going into 2018. Even though this figure is widely acknowledged to be well below both economical equilibrium and target planning levels, the power market has reacted only modestly. However, a close look at the situation this summer shows that the $9,000 price cap for energy in the market may be sustained over the summer peak this year, producing scarcity revenues far above what market forwards are showing and creating opportunities for owners and investors.