Chances are Texas businesses will increasingly hear the term “scarcity pricing” as concern grows about potential electricity price spikes this summer.
Company decision-makers should understand how scarcity pricing dynamics influence their energy contracts – especially if they are reviewing their energy position now, as experts advise, in preparation for what could be a wild ride.
Here’s a brief tutorial on scarcity pricing as set by the Electric Reliability Council of Texas (ERCOT), which oversees the Texas wholesale power market.
What is scarcity pricing?
Scarcity pricing is an economic term that refers to the price escalation that occurs when supply becomes tight in a commodity market. As demand edges close to supply limits, prices rise, reflecting the growing scarcity.
Potential exists for scarcity pricing in the ERCOT market this summer due to a combination of strong growth in electric consumption, the retirement of 4,700 MW of power plants and the lack of new generation entering the market. As a result, ERCOT predicts a historically low reserve margin, which is the cushion of power-generating capacity available when electricity demand is at its highest.
How high could prices rise this summer?
High prices are typically caused in two ways. First, prices can rise when demand increases and less efficient (i.e. more expensive) generation is needed to satisfy demand. The cost of generation increases dramatically when demand is very high and the least efficient generation in ERCOT is called upon. The price cap for the cost of generation (the highest price a generator can charge for electricity) has increased over the years from $3,000/MWh in 2011 to $9,000/MWh today. The chart below from ERCOT shows the history of price cap increases.
During periods of very high demand this summer, we could see the cost of generation at or near this price cap. This is the first way we can see scarcity pricing.
The second way we can see high prices this summer is through a pricing mechanism called the Operating Reserve Demand Curve (ORDC), which ERCOT put in place to ensure electricity prices accurately reflect shortage conditions. Instituted in 2014, the ORDC automatically increases the price of power as reserves get tighter. The ORDC adder activates when operating reserves decrease below 6,000 MW and continue to decline, with the maximum price adder applied when reserves drop to 2,000 MW.
This price adder reflects the “value of lost load” (VOLL) – the expected economic impact to customers if reserves draw down so low that ERCOT is forced to institute rolling blackouts. Loss of electric power is expensive, especially for businesses, if they must halt production, cease transactions and send home workers. As reserves drop, the probability of a load shed event increases, which is why the ORDC adder increases as reserves decrease.
ORDC is designed to let power prices rise to a point that averts this worst-case scenario by incentivizing power plant owners to run generators, including emergency resources. That price point, in ERCOT’s determination, is $9,000/MWh.
So when the ORDC activates – as it’s expected this summer – power prices can rise as high as $9,000/MWh, a significant leap from the average power price of $30-35/MWh over the last several summers (see chart below).
Increased risk
ERCOT has signaled in multiple reports the likelihood of tight supply this summer, most recently in the Seasonal Assessment of Resource Adequacy (SARA) for the ERCOT Region Summer 2018, released March 1. Given the strength of the Texas economy, the report anticipates a record-breaking peak demand of 72,710 MW, 1,600 MW higher than the all-time peak set in August 2016. ERCOT said in the report that it based this forecast on “normal weather” for years 2002-2016. Clearly, if the summer proves hotter, peak demand could be higher.
So, Texas electricity consumers face substantially more risk this summer as a result of high demand and low power supply. Officials are warning consumers to brace themselves. “We are going into a summer where people are going to be paying a lot, potentially paying a lot more,” said Brandy Marty Marquez, Public Utility Commissioner, as reported in the Houston Chronicle.
What’s the bottom line for businesses within ERCOT?
Those with power contracts indexed to real-time pricing face the greatest risk, since they will feel the direct impact of market volatility. Others with fixed-price contracts face less immediate exposure, although they may eventually be susceptible depending on when their contracts expire, thus finding themselves negotiating terms during a period of inflated pricing.
Fortunately, businesses still have time to position their supply agreements to prepare for the summer. “The most important thing is to plan now. Consult an energy expert to review your electricity contract and understand the risks associated with your current electricity plan,” said Scott Hart, Vice President of Commercial and Industrial, NRG. “We’re here to help businesses mitigate their risks by providing them our expertise and energy solutions to meet their needs.”
NRG Energy can help. With decades of market experience in electricity cost management, NRG invites its current customers – as well as other businesses in ERCOT – to get in touch and secure a strategy for the summer.
