After all, what’s $29 billion between friends?
- Mar 8, 2021 3:02 pm GMT
It now looks like the financial storm that resulted from the meteorological storm in Texas three weeks ago has turned into an absolutely huge cluster you-know-what. For those of you who aren’t keeping score at home, here’s my take on the situation. You might want to read my previous post on this subject, since I’m building on what I said there.
1. The bitter cold that came to Texas over the Valentine’s Day weekend caused a perfect financial storm: Demand for electric power soared because most people in Texas heat their homes with electricity, while at the same time supply was severely constrained because so much generation was put out of service.
2. Monday, Feb. 15 was the Day from Hell in which ERCOT, the Texas grid operator, had to order large-scale outages in order to keep the system from being completely overwhelmed (which would have resulted in long-term damage to a lot of big generation – meaning probably many months of outages after that).
3. At the same time, the wholesale market price for power jumped from its normal level of around $20 per megawatt-hour to $1,200 per MWH. That alone was pretty bad. Unless you compare it to what happened next.
4. The Texas Public Utility Commission was meeting at the same time. Being all very knowledgeable about the basic principles of microeconomics (although not much more than that, it seems), they concluded that the fact that the market price was “only” $1,200 – while at the same time a lot of people were sitting in cold homes and couldn’t get power no matter how much they would have been willing to pay – meant only one thing: The price was being artificially constrained by the fact that so much demand was being curtailed (load was being shed, in power industry terms). They decided the best thing they could do would be to raise the maximum price to $9,000 (the highest price allowable) – a more than seven-fold increase.
5. And they were absolutely right – at least as far as their Microeconomics 101 course went. If not all demand is being satisfied (i.e. some people can’t buy the commodity at any price), this normally means that the true market price is higher than the apparent market price (namely, the $1200 price at the time). The way you clear the market in such a situation, according to a highly simplified view of microeconomics, is you allow the price to rise to the level at which quantity demanded will fall, because people decide they don’t need the commodity badly enough to pay the higher price. At the same time, quantity supplied will increase, because suppliers who didn’t think they could make money at the old price realize that they can at the new price. Quantity supplied will equal quantity demanded, markets will clear, and we’ll all live happily ever after.
6. Unfortunately, those PUC members never took Micro 102. If they’d done that, they might have learned:
a. When supply is constrained by non-economic factors (such as the effect of cold weather on generation facilities which aren’t prepared for it), it doesn’t matter how high you make the price – you’re not going to get any more supply. That was certainly the case in Texas on Feb. 15.
b. The end consumers of electric power (i.e. Joe and Jane Consumer) would never be willing to pay the $1,000+/day prices that would have been required to clear the market anyway. My guess is even at $300/day, most consumers would prefer to endure some cold, rather than start to cut into their life savings. In other words, the $1200 price was probably pretty close to the true market price. It was certainly a lot closer than $9,000 was.
7. So the PUC was clearly wrong in basing their decision to raise the price on the fact that ERCOT had ordered so much demand to be curtailed. But anyone with half a brain (a commodity evidently in short supply at that time and place) should have at least realized that the rationale for that high price would go away once the curtailments ended. On the 18th (Thursday), ERCOT stopped ordering curtailments (although because a number of utilities were still struggling to meet demand, there were still lots of people without power). Yet they didn’t lower the price by a nickel until Friday, even though the market price returned to normal by Thursday. To quote a Wall Street Journal article from March 4, “On Feb. 18 at 5:30 p.m., for instance, the market price of electricity was $22 per megawatt hour—and the utility commission’s additional price on top of the real-time market price, as imposed by Ercot, was $8,979 per hour.”
8. So the good news is that by Thursday, ERCOT was no longer imposing a price that was seven times the market price. The bad news is that they were imposing a price that was 409 times the market price. In other words, they made the PUC’s original decision much worse than it already was.
9. Let’s fast forward to last Thursday morning. The WSJ, in the article I just linked, pointed out that a market monitor who had been hired by the PUC said that the market price should have been restored – according to the PUC’s rules - on Thursday, when ERCOT stopped ordering curtailments. The Financial Times also had a good article that touched on other aspects of this story (thanks to my college roommate Dave Reed for forwarding me that link). That was 33 hours before the market price was actually restored. They said that the $16 billion surplus in receipts that was generated (pun intended) during those 33 hours should be returned to the entities that paid it (and ultimately, hopefully, to the end consumers whose huge bills funded it).
10. The tone of both the WSJ and FT articles was something like “Here’s a sensible proposal that won’t make everything right, but it will at least help some of the victims of this mess.” Neither article quoted anybody who didn’t believe that the PUC would take their advice and order the $16 billion to be refunded.
11. So I was very surprised to read in the WSJ on Saturday morning that, while the PUC (now down to just two members, since the chairwoman resigned two weeks ago, and deservedly so. The ERCOT CEO was fired last week, although he’s still on the job for 60 days) hadn’t made a final decision on this idea, they’re currently very much leaning against it. The new chairman worded their reasoning very succinctly: “It is impossible to unscramble this sort of egg”.
12. And indeed he’s right. This isn’t a case of having a bunch of suppliers on one side, who are sitting on this huge hoard of accounts receivable, and a vast, unwashed (since they haven’t been able to take showers because their pipes broke) mass of consumers on the other side, who are facing huge bills. Instead, there are all sorts of nuances to the story. Here are a few:
a. A lot of power suppliers are themselves the biggest victims. That’s because they were under contract to deliver power during the crisis, but since their plants (or wind turbines) weren’t operational, they had to go to the spot market for their obligations – meaning they were paying $9,000/MWH for the power they were delivering, vs. earning maybe $25/MWH in normal times. The big power producer Vistra said they lost over $1 billion in the crisis. Exelon’s generation arm lost more than $500 million; Exelon then decided to pull out of the Texas market altogether. And Brazos electric cooperative, the largest cooperative in Texas, declared bankruptcy two weeks ago, because they had to pay such high prices to deliver on their obligations to their customers (who are also their members).
b. Prices in the natural gas market also spiked by huge amounts during the crisis. As in the power market itself, this was due both to supply constraints (most gas wellheads were no better protected against the cold weather than the power plants were. And because it’s usually not necessary, gas pipeline companies in Texas don’t normally take all of the moisture out of the gas before putting it in the pipe, as happens in colder climes. Thus, many of the gas pipelines froze), and to demand spiking (because the gas generation plants that were still working were demanding as much gas as possible, as their owners tried to make all the hay they could while the sun shone). But this meant that a gas plant owner who was being paid an astronomical price for the power they were producing was also paying an astronomical price for the gas they used to produce that power. So if just the power price was rolled back but not the gas price, they would be in a deep financial hole.
c. Large purchasers of power (manufacturing plants, utilities that don’t generate the power they distribute, municipal utilities that don’t generate much if any power themselves, etc) will often (or even usually) hedge their purchases on the futures market – meaning they essentially buy the power they will need in advance at an agreed price (and it’s certain that the futures price, since it was probably set months ago, was much closer to $20/MWH than $9,000). So the big bills those purchasers received a couple weeks ago would be paid by the speculators on the other side of the contract; those purchasers just had to pay the much lower cost of the contract.[i]
d. On the other hand, the speculators would have lost a ton of money. Normally, they would just blame themselves for the losses, since obviously when you play that game you have to be prepared to lose as well as win. However, if some of the charges get reversed as suggested, it’s just about certain that the speculators are going to want some of that for themselves. And it’s likely that the power futures exchanges (the largest of which by far is the Intercontinental Exchange in Chicago) have rules allowing those funds to be recouped from the buyers of the contracts.
e. But the problem is that the large purchasers who bought futures contracts wouldn’t receive any funds if ERCOT ordered the power producers to cancel their big bills to consumers; they just wouldn’t have to pay more than the price of the futures contracts they bought. Yet now they would be hit with an order from the futures exchange to reimburse the speculators. They might in turn go to the power producers for reimbursement, but the producers will likely argue that, since they’ve been ordered to return whatever payments they received at the high rate, they certainly shouldn’t be ordered to reimburse their customers for the fact that they hedged their purchases.
f. In other words, it’s likely the large purchasers will be caught in a really tough legal fight with the futures exchanges, of which the outcome will be far from certain.
And that last statement pretty well sums up the electric power forecast for Texas in the coming years: Massive lawsuits and political fights. Ultimately, I’m guessing there will be some sort of huge settlement that won’t make anybody whole, but will put most of the cost on – you guessed it – Texas citizens, in the form of higher taxes and high power bills. I certainly hope they’ll decide that changes need to be made to keep this from happening again.
One other thing: You may have noticed the title of this post refers to $29 billion, but the amount that is being talked about for a refund is $16 billion. The market monitor decided that the original PUC decision to raise the maximum rate to $9,000/MWH was made according to the PUC’s rules, and continued to be so until Thursday, when the fact that ERCOT ended demand curtailments meant the price should have reverted to the market price of about $22/MWH (Note: The fact that the PUC had to pay somebody to point this out to them is incredible in itself). The $16 billion is just the extra cost for 33 hours from Thursday into Friday.
But as I hope I’ve shown, if the PUC had just applied some common sense on Monday the 15th, they would have realized there was no case for trying to make the rate go higher than the market rate, which at $1,200 was certainly high enough to induce whatever remaining supply might have been sitting on the sidelines. I read somewhere that, over the entire Monday-Friday period, the difference between the actual price ($9,000) and the market price led to $29 billion in unnecessary charges (i.e. if the PUC had just left the actual price at the market price, power purchasers would have saved $29 billion compared to the bills they actually received).
Given the recklessness and incompetence that the PUC exhibited in boosting the price far higher than what the market said it should be on Monday, and the terminal cluelessness exhibited by ERCOT in keeping the actual price at that level through Friday (remember, the $9,000 was the maximum allowed. The PUC didn’t order ERCOT to set the price at that level. I doubt they had that power, anyway), I think the entire $29 billion should be reversed. Of course, that makes a huge legal mess even worse. But expecting some power buyers to simply eat the $13 billion unjustified extra cost for Monday-Thursday isn’t exactly a solution, either. Get everything on the table and treat everyone equally poorly. And remember the people who got you into this mess the next time you go to the polls.
Any opinions expressed in this blog post are strictly mine and are not necessarily shared by any of the clients of Tom Alrich LLC. If you would like to comment on what you have read here, I would love to hear from you. Please email me at email@example.com.
[i] This assumes the purchasers were 100% hedged, meaning they’d bought futures contracts covering their entire needs. Since that’s not the usual practice (after all, there’s certainly a cost associated with buying futures contracts), these purchasers almost certainly faced large power tabs for the week of Feb. 14; but those were much lower than they would have been if they hadn’t hedged at all.
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