Is There an Texas Electricity Market Bubble?

Posted on Posted in Consumer Advocacy, PUC/ERCOT, Texas Electricity, Texas Electricity News

I’ve written before about my concerns about how Texas electricity companies are selling electricity plans at a loss, and I’ve written before about my thoughts on electricity companies potentially going out of business during summer months. Now, I’d like to take a look at something based on both of those concerns combining to cause what would be a huge market shakeup, and have a huge effect on Texas electricity customers. There’s a lot of moving parts here, so lets do a quick outline to check out the forces at work creating what can only be described as a bubble in the electricity market. Much like the real-estate bubble, there’s more than one thing at play here.

The Increased Market Cap

When the PUC raised the market cap last summer, it had the expected cause of raising the price of wholesale electricity during the summer months. Their idea was that this might “guarantee” profits for electricity generators, and thus encourage more generation. Of course, the extra investment in generation hasn’t happened yet, but this summer we’ll be looking at a dramatic increase in wholesale pricing, which means we’ll be looking at higher electricity prices for retail customers as well. Basically, the cost of buying electricity through the summer months is going to be more expensive than ever before this summer (and every summer to come), and these prices will inevitably be passed to the customers, although we haven’t seen that yet. More on that in a bit.

Companies Selling at a Loss

Another major factor, which I’ve also written about extensively, is some companies selling at a loss. Companies like NRG/Pennywise Power are currently selling electricity at a rate that is a net loss to the company. There are a number of reasons why NRG and other companies might be doing it, but what can’t be argued is the effect that it has on the rest of the electricity market. By setting prices at a loss, it forces many other companies to try and keep their prices as low as possible, or else risk becoming a non-factor in the market. It prevents smaller companies from gaining any market share, or worse forces smaller and even established companies with less funds and security to gamble and take risks in an effort to grow or maintain their business. This leads us to the last major factor in an electricity market bubble.

The Prevalence of Risk in the Marketplace

The way REPs evaluate risk is changing in the state of Texas. Typically risk is centered around 2 factors: A) Unertaintly in how much electricity will be used by consumers B) Uncertainty of wholesale costs. To manage this, REPs mix forecasting expected usage and locking in secure electricity purchases at wholesale prices. But this doesn’t prevent wild fluctuations from day to day, and sometimes hour to hour.

Normally that is fine, but the raising of the market cap last summer but the PUC, coupled with some REPs selling residential electricity below cost is trimming the margins to zero (or negative) for REPs attempting to stay competitive. And this is forcing many REPs to change their strategy…or in other words to gamble more with spot market pricing as opposed to locking in long term wholesale electricity purchases. If it is costing REPs 400% to buy electricity for their customers when summer months are included, which is the case now thanks to the market cap increase, the temptation to gamble is going to be very strong for a lot of REPs.

By taking on more risk to save money, the trouble starts during hot weather days where the grid is strained and there would be threats of rolling blackouts.There were a couple days like this last summer, but nothing truly frightening. However, two summers ago, when the temperatures across Texas averaged over hundred degrees for a month, there were several handfuls of days like that. And on days like that, prices on the spot market jump from $30 to $4500 (with the new rules) per unit. That’s a price increase of 150% per unit (units are 15 minutes). What happens if you’re and REP buying 25% of your customer load on the spot market on days like that? Lets say you’re a company with 40,000 customers, which means you need 40 megawatts of electricity to power all of your customers for one hour. And lets say you’re buying 25% of that on the spot market. So 10 Megawatts, every hour, every day. Well, when prices shoot up during the superpeak hours during an emergency (3-7 pm), a company 10 megawatts in the hole is suddenly facing a situation where they’re burning through and extra $125-150k an HOUR over expected costs. So they’d be eating about $500k dollars a day in unexpected costs. Now imagine if a company is leveraging more than 25% (although this would likely only be much smaller providers). Also consider this: Currently a licensed Texas Retail Electricity Provider is only required to keep 500k dollars in cash reserves on hand at any time. In a situation like what I described above a company could burn through their entire cash reserve in the span on 4 hours on one bad day. What happens if this happens 3 days in a row (these events are often stacked in clusters of hot days)? Or such as two summers ago, where it seemed it happened several times a week for an entire month?

And to be perfectly honest, I’m actually low-balling the $500k cash requirement. The truth is, that every quarter if an REP grows their customer base, or their usage, the amount of dead money they have to have on hand in cash also increases. So that even further increases the amount of cash an REP has to have on hand at all times, depending on their size, which could arguably make them even more vulnerable to any massive hits to their cash reserves like the ones I described above.

Credit Agencies and ERCOT

This is where credit agencies come into play. As I wrote in my article in 2011 where I predicted some REPs might go out of business, I believe one of the reasons no companies did exit the market was because of their deals with their credit agencies. Basically, the companies with whom an REP has partnered to buy their electricity also can extend the credit to an REP that might have come short of cash. The reason they might do this is because long term, at least the credit agency might have a chance to recoup their investment. I believe a number of credit agencies might have floated some REPs during the summer heatwave of 2011 after some of them got hit by the overages I laid out at the beginning of this article.
The other thing to consider is that to avoid having massive bankruptcies hit their electricity market, ERCOT might have relaxed some of their credit requirements for certain REPs, or extended their payment arrangements. If that is the case, then ERCOT is actually operating like an insurance agency or a hedge against the actual forces of the market. And if so, this is a terrible, terrible turn of events.If ERCOT is functioning like a hedge, it encourages companies to take on a greater amount of risk in their trading because ERCOT will bend the rules to avoid them from facing the consequences of market forces. It encourages bad behavior, and also disrupts the natural market forces that need to exist to keep the Texas electricity market functional. While the perception might initially look bad if half a dozen REPs went out of business because their risk was too great, the reality is that this would probably be a good thing. The  market would be functioning properly, REPs that took on too much risk would exit the market, and there’s an excellent chance prices would normalize and REPs would no longer be selling at below margin to acquire customers and/or stymie the competition. The risk would return to safe levels in the portfolios of the remaining competition, and at the end of the day the Texas electricity market would actually be stronger.

Final Thoughts

No matter how you slice it, right now the Texas electricity market isn’t functioning in a very healthy manner. It’s impossible to argue that the way some REPs are selling below margin is healthy, much less smart, behavior. Throw in the possibility (dare I say likelihood?), that some of the REPs in the market are maintaining too much risk in their portfolio (and possibly not making enough cash on their existing customer base), and you’ve got the makings of a legitimate Texas electricity market bubble. And if ERCOT is extending payment and credit requirements, it matches the model of a market bubble right down to a government agency working to protect and bail out any companies who are making bad business decisions. Like any troubled market, Texas electricity could use a purge and a reset to normalcy for the long term health of the marketplace. Finger’s crossed that if some companies selling below margin and taking on to much risk fall upon hard times this summer, nothing stands in the way of them exiting the market.

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