A Misguided Criticism Of Texas Electricity Deregulation

Lynne Kiesling

In a Wall Street Journal article on Friday titled “Texas Electricity Deregulation Hasn’t Aided Small Power Users,” Rebecca Smith suggests that small customers in Texas are not benefitting from electricity restructuring because the fuel price pass-through has led to higher prices:

Deregulated power companies operating in their former monopoly territories were forced to continue offering quasi-regulated prices — the so-called “price to beat” — until 2007, even as competitors could come onto their turf and offer lower prices. Still, state regulators gave them the ability to peg the price of the electricity they sell to their traditional customers to the price of natural gas, which has been rising sharply. Mr. Zarnikau says the formula actually exaggerates the effect of gas prices, though. The reason: gas is used to generate about half the electricity produced in Texas, but the formula treats it as if it were the sole source.

The Zarnikau study, to which I have as yet been unable to find a link online or through the university library, suggests that the average price per kilowatt hour for small customers who have stayed with their incumbent utilities has risen 43% between January 2002 and October 2004. I did find a January 2005 Energy Policy article in which he provides a good analysis of the chronology of Texas restructuring, but it does not include this number or the data to calculate it.

What drives these critiques is the combination of the “price to beat” mechanism and the fuel cost pass-through. The price to beat is a tool for preventing incumbent utilities from pricing to achieve entry deterrence, by stipulating that over the first few years they cannot charge a price lower than the price to beat. This price leaves enough margin to attract competing suppliers. The fuel cost pass through allows retailers to charge more when the price of the electricity they are buying and reselling goes up, because it allows the price to beat to be adjusted to reflect rising fuel costs. This mechanism helps keep both the incumbent utilities and the entrant retailers solvent (unlike the bankruptcy fiasco in California in 2001).

Ms. Smith’s claim, following Mr. Zarnikau, that the cost pass-through exaggerates the effects of natural gas prices is incorrect and based on faulty economic reasoning. The important point is not that the pass-through allows generators to earn higher prices from selling non-natural-gas-generated power. The important point is that for a very long portion of the supply curve, the marginal units are going to be natural-gas-fired. Thus the market-clearing price for power in the Texas wholesale markets will be almost entirely determined by the price of natural gas. It’s the margin, not the share, that matters for determining the price of wholesale power that retailers have to pay, and in Texas natural gas is the marginal fuel most of the time. That’s why the fuel cost pass-through makes sense and is fair to both the incumbent and the entrants.

But is it fair to customers? Here Ms. Smith fails to ask the correct “compared to what?” question. Let’s take as given that 43% average increase in the price to beat over two years. According to the EIA’s Natural Gas Investigator, between January 2002 and October 2004, Texas city gate natural gas prices rose by 66.5%. That means that much, but not all, of the fuel cost increase has been passed on to customers. By just looking at the absolute price increase, Ms. Smith has failed to pose the correct counterfactual, which is: how much would regulated rates have gone up in response to a 66.5% increase in natural gas prices? Given regulatory lag and other political machinations that affect regulated rates, this counterfactual is challenging. But I suggest that you can’t condemn the fuel cost pass-through on its face the way Smith and Zarnikau seem to be doing.

A recent Texas PUC report on electric competition provides data pointing at that counterfactual. For example, Figure 11 on p. 55

demonstrates that the lowest competitive offer remains lower than the regulated rates that were in effect in December 2001 in all service areas. While the rates in December 2001 included fuel surcharges for past under-recovered fuel expenses, this further suggests that competitive forces can be more effective than regulation in establishing competitive prices.

Figure 10 in the same report shows that the average competitive offer is consistently below the price to beat. The report also points out that the number of retail electric products has increased since 2002; these products include such offerings as green power, which cost more to produce and also sell at a higher price to consumers, but people are free to choose them. Ms. Smith’s article neglects to mention the benefits of increased diversity for those who choose to take advantage of it.

Furthermore, Ms. Smith is naive in believing the complaints that residential customers don’t have enough access to aggregators:

Large energy users have switched suppliers in droves, but small consumers have had fewer choices and only one in five residential consumers has changed providers. The rising “price to beat” also gives competitors room to increase their prices. Consumer advocates believe the fuel adjustment is unfair but “we’ve been unsuccessful in the courts so far,” says Clarence Johnson, director of regulatory analysis for the Office of Public Utility Counsel in Austin. Now they are pushing for a state law that would make it easier for small consumers to band together and buy bulk power; TXU is fighting them.

If you go to the Texas PUC aggregator page, you’ll see a link to a java pop-up with a list of residential aggregators. There are about 44 aggregators serving residential customers in various parts of the state. Instead of credulously believing that their aggregation services are not valuable, Ms. Smith would provide a useful service if she analyzed aggregation in more detail to see if some improvements are possible.

Ms. Smith seems to be decrying the fact that not many small customers have switched. I suggest to her that, given the diversity of choice and the lower prices that they could enjoy if they did switch, their decisions not to switch indicate that they prioritize those choices lower than other things that they are doing in their lives. I also suggest that no one is in a better position to evaluate the pros and cons of switching than the individuals themselves.