So far, no electricity market is able to completely avoid blackouts due to insufficient capacity. That means some mechanism must decide the extent of blackouts that will be accepted.
There are two ways to control the quantity of capacity the market will build — by regulating prices or by regulating the quantity of capacity purchased in a capacity auction. Texas has chosen to regulate prices. This means it has no capacity auction, so it operates as an “energy-only market.”
The Texas Price-Spike Approach
According to Peter Cramton, who was vice-chair of ERCOT (very briefly) at the time of the blackout,
“There is one number, in all this, that is the most important number, and that’s $9,000 — that’s the value of lost load [VoLL].”
This is absolutely correct. As he also points out, a 1 GW generator selling into the spot market during the 4.3-day blackout would have earned $1 billion. Clearly, that $9,000 price provides the signal that controls investment.
No, Texas doesn’t use pure VoLL. That would mean the price would stay quite low until there was a blackout and then jump to VoLL until it was over. Instead, they ramp the price up to VoLL as the chance of a blackout gets more likely. But that ramping curve is strictly proportional to VoLL, so the entire investment incentive depends on VoLL and the super-high price spike of VoLL pricing is only spread out a little. I’ll call this TX-VoLL pricing.
Risk is Costly and Well … Risky
In theory (by which we always mean over-simplified theory) this should work almost perfectly. But what that theory ignores is risk. (It also ignores market-power problems but risk will explain enough.)
When the bulk of the incentive to build extra capacity for reliability is provided by a price spike that is expected to arrive every 10 or 20 years more or less, and which will then pay for your entire plant, that’s an extremely risky proposition. So much risk will command a large risk premium, which will be expensive for consumers.
Even worse, we have little idea of how investor psychology will operate in such a risky environment. Especially considering that an investor must guess how other investors will react. If too many take the bait, they will prevent the blackout and price spike they are depending on. So investors must contend with two huge sources of risk — rare and unpredictable acts of nature and unpredictable future investments by other investors.
There’s an Alternative
Instead of regulating the price and hoping for the best with fingers crossed, there is a safer alternative. Let the engineers, who have always solved this problem continue to tell us how much capacity is needed, and then buy that capacity in a competitive auction. This is the capacity market approach.
My next post on Texas will discuss how the safe approach has been blocked from consideration in Texas.