Hayek’s knowledge problem as an issue in electric power market design

Michael Giberson

Recently the Brattle Group submitted a study of resource adequacy issues within the ERCOT power system and the policy options available to ERCOT and the PUC of Texas, the regulatory authority overseeing the ERCOT system. As the Brattle report points out, ERCOT has so far stuck with a so-called “energy-only” market design while the other RTO markets have implemented some form of capacity markets to help assure the market will be adequately supplied with generating resources.

The Brattle report is available from the ERCOT website. The PUCT is taking comments on the report in Project No. 40480, “Commission Proceeding Regarding Policy Options on Resource Adequacy.” A workshop will be held to discuss the Brattle recommendations on July 27, 2012 at the PUCT offices in Austin.

BP Energy Company finds Hayek’s knowledge problem as a key issue in electric power market design. After quoting a segment from “The Use of Knowledge in Society,” BP Energy Company writes:

Hayek’s “Knowledge Problem” and its optimal solution – decentralized commercial markets – provide the best lens for regulators to see the fundamental issue in electricity market design in response to rapid technological change and increasingly diverse groups of willingly innovative buyers and sellers. As the procurement and use of electricity cross a complexity threshold, as a few customer classes are transformed into a multitude of individual market participants, electricity market design needs to move away from centralized planning to a decentralized procurement of resources, to be both sustainable and efficient in meeting the resource adequacy objectives for the bulk power system and society at large.

The unwieldy process of centralized procurement of resources in the organized markets within the Eastern Interconnection is not proving to be a healthy evolution for electricity markets; instead, these interventions have greatly interfered with the natural development of networks among market participants that can lead to a healthier market ecosystem. Utility economist Kenneth Rose, in a recent working paper that highlights the continuing problems of centralized procurement in the capacity mechanisms in the Eastern Interconnect, reprises the “Knowledge Problem” in the following analysis:

“…. They (RTOs and regulators) are attempting to create a final product market for something that is merely one input of many that are needed to generate electricity.

This may explain why the capacity construct that the RTOs are using has become so complex. Every aspect of the capacity market design has to be redesigned and readjusted to fit changing conditions, rather than allowing the market participants to adjust to market information over time, as happens generally in competitive markets…..

The complex mechanism of capacity markets is not self-sustaining since the RTOs and regulators will need to continuously update and fix the apparatus as conditions change…. A truly competitive market, in contrast, changes as circumstances change, without the stakeholders having to agree on changes and without the regulator having to insert its judgment by choosing and approving what it thinks will work. “

The result is that to date, regulators, not market participants, procure virtually all of new resources. Some of those resources, especially “demand resources,” are poorly designed and have questionable value. Incumbent technologies and business practices are favored over innovative ones, to the ultimate detriment of consumers and local businesses.

As might be obvious by the name of this blog, we at KP find Hayek’s identification of the knowledge problem a key discovery in the long history of the study of markets. It is no surprise that efforts to manage the growth of markets run up against knowledge problem issues, and regulators and other market designers would be wise to consider its significance.

NOTES: Hayek’s article, “The Use of Knowledge in Society,” was published in the American Economic Review (September 1945) (ungated here and here). Rose’s report is “An Examination of RTO Capacity Markets,” IPU Working Paper No. 2011-4, Michigan State University (September 2011). I mentioned the Brattle report on ERCOT resource adequacy issues in this earlier post, see also this earlier post on capacity market issues.

Competitive power market in Texas faces supply concerns. Now what?

Michael Giberson

The question troubling some folks in Texas’s competitive power market: Will Texas consumers want to consume more electric power than suppliers are able to supply? A resource adequacy review by ERCOT, the power system and market operator for most of the state, suggests that consumer demand may outstrip resources available as early as 2014. ERCOT officials have also warned that extreme temperatures this summer could result in reliability concerns, though the most recent review reveals resources will likely be adequate.

The longer-term resource review has attracted a number of media reports, including this morning’s story by Rebecca Smith in the Wall Street Journal, “Power Shortage Vexes Texas: Report Urges Price Increase to Spur Industry to Build More Generating Plants.” See links to other stories at the end of this post.

The “report urging price increases” is that of the Brattle Group, “ERCOT Investment Incentives and Resource Adequacy,” June 1, 2012. ERCOT asked Brattle to study generator investment criteria, the connections between incentives, investments, and resource adequacy, and policy options to support resource adequacy. The Brattle report will bear further study, but for now a few comments about it and the WSJ article.

The newspaper story, following the main thrust of ERCOT’s request and therefore the main part of Brattle’s response, is focused almost entirely on price incentives to potential investors in additional generation resources. The story mentions several of the relevant factors: demand growth, low power prices due to low natural gas prices, ERCOT’s “energy-only” market design, and the lack of significant connections to neighboring grids. The rest of the story plays out as expected: generators say the current offer cap is too low and consumer representatives express horror at the prospect of paying extreme prices to generators who might refuse to expand.  The story entirely misses the possibility that consumers are not complete idiots willing to sit idly by in their air-conditioned palaces and pay 100 times the usual power prices.

Consumers have two easy ways of avoiding any potential $9,000 MWh price: (1) have a fixed price contract with a retailer or (2) simply cut power consumption during pricing peaks. Few consumers actually paid $3,000 MWh last year during February 2011’s few hours of rolling blackouts or the summer’s infrequent emergency conditions. Instead what happened in February and summer 2011 is that retailers who did not secure all of the power their customers wanted by short- or long-term contracts ended up paying the $3,000 price (but just for the additional supplies they needed) AND power generators under contract to supply power who found themselves unable to meet their commitments also ended up paying the $3,000 price (for any committed capacity that they could not deliver). The market risks are divided up between retailers and generators and very little of it is pushed out directly onto the consumer.

Obviously, whatever risks generators take on will be reflected in the prices they’ll seek in contracts with retailers, and whatever risks retailers take on will be reflected in the prices that retailers offer to consumers. But competition among generators to contract with retailers and competition among retailers to sell to consumers should work to do well one thing that the usual rate-regulated monopoly power systems do poorly: competition should shift risks onto the market participant who can most efficiently manage the risks. Consumers typically are not the best able to handle the risks, so competitive markets usually won’t stick them with the risks.

The Brattle report makes a couple of additional valuable points. First, the study assumes only the current level of demand response activity, but additional price-responsiveness on the consumer side of the market would provide additional resource adequacy support. Second, the “1-in-10″ reliability standard typically employed in power systems reliability analyses has rarely been studied from an economic standpoint. The report suggests that overall reliability of delivered power to consumers could be improved and costs reduced by shifting some of the expense away from the bulk power system and toward distribution systems.

So far as I have noticed, the report itself doesn’t recommend a particular policy course, but simply reports on some of the likely advantages and disadvantages of several resource adequacy policy options. The Brattle press release accompanying the report does, however, indicate a clear preference for adding a centralized forward capacity market (similar to that employed by PJM; though note not everyone is happy with PJM’s capacity market).

One last bit of perspective. It is the goal of a resource adequacy study to be excessively cautious. Things probably will not turn out as bad as projected, in part because suppliers, retailers, and consumers will continue to adjust to changing conditions.  But things could be as bad as projected, and that is exactly what the study is intended to highlight.

RELATED:

NOTE: Prices above are all quoted in $ per Megawatt Hour (MWh), a typical price metric for wholesale markets, but consumer bills are usually quoted in cents per kilowatt hour (kwh). Typical wholesale prices in ERCOT have been running between $20 and $50 MWh, the equivalent of between 2 and 5 cents kwh. Typical consumer prices in ERCOT range between 8 and 14 cents kwh. The $3,000 MWh price cap is equal to $3 kwh (so $9,000 MWh is the same as $9 kwh or about 100 times  typical retail prices).

Pat Wood: The Texas Tribune Interview

Michael Giberson

Pat Wood, the former FERC chairman and former Texas PUC chairman, was interviewed recently by The Texas Tribune. Wood is surely one of KP‘s favorite ex-regulators, so of course we’re linking to the interview. Here’s just one bit:

Wood: … There is also a lot that can be done, particularly on the energy demand side. By that I mean more aggressive conservation programs where you let market signals encourage customers that have the ability to shut down for a certain small amount of hours in the day to get paid to do so.

TT: Do you mean even individual consumers can potentially do more — or be helped to do more — to save energy?

Wood: They could, but if you went from the current penetration we have today, which is focused on the largest customers, to then focus on the medium-sized customers  — and by that I mean grocery stores, shopping centers, Target, customers like that — you can pick up a whole lot more responsive load before you need to get to the residential customer. The residential customers comprise about 40 percent of the [electrical] load at peak. Industrial and commercial are each about 30 percent. That’s a lot of lower-hanging fruit to pick before you get to residential.

And in discussing this, I’m not saying that Target would have to bid to shut down a store to get paid; it would maybe curtail 20 percent of its demand from 4 to 6 pm [when electricity usage peaks].

This capacity tightening may force that day to come sooner rather than later, which I think is a great thing for Texas, to latch onto this smart-grid investment that we’ve been making statewide over the past couple of years into a level of demand responsiveness that really moves our grid to 21st century capability well ahead of the other states.

Wood also addresses the lack of incentives to build new plants in Texas, the prospects for wind and solar in the state, energy storage, and among other things the role of the Public Utility Commission after the state “moved the dial from 10 to 4 in terms of regulation.”

Pat Wood joins the ranks of energy bloggers

Michael Giberson

The Houston Chronicle has added another voice to its roster of energy bloggers: Pat Wood III.  Wood is former chairman of the Federal Energy Regulatory Commission and before that chairman of the Public Utility Commission of Texas (though around here they usually list those two items the other way.  In order of importance, you know).

The blog, Wood on the Wires, is subtitled “Energy infrastructure with Pat Wood.”  As the Chronicle’s NewsWatch: Energy blog says in its introduction, “His inaugural post shows a bit of the humor that anyone who knows Pat is sure to recognize.”

Tres Amigas wants to take cheap electric power away from hard-working Texas families

Michael Giberson

I spent the middle of last week in Austin at the University of Texas-Law conference on wind, solar and geothermal energy law, and as a side bonus got to hear some informal, Austin-based commentary on the Tres Amigas proposal to interconnect the Eastern, Western, and Texas electric grids. It will give you some idea of the thinking in the state capital that I heard the term “Dos Amigas” used more than a few times.

During the pre-conference “fundamentals” discussion, in response to a question that asked whether stronger transmission links to other states would help accommodate added growth in Texas wind power, a current member of the Public Utility Commission of Texas arose from the audience, climbed onto the dais, and took the microphone to say, among other things, “ERCOT is just fine the way it is.” The other main point of his comment was to suggest that the Southwest Power Pool, which has long covered the wind resource rich Texas Panhandle (with relatively weak links elsewhere, but a plan to beef up those links), would ably serve to sell the wind resource out of state while not compromising ERCOT’s jurisdictional status with respect to the feds.

Later in the conference a speaker offered a Texas policymaker’s view: ERCOT has its well-regarded CREZ plan to spend $5 billion on transmission enhancements primarily intended to allow wind generation in far west Texas, central west Texas, and the Texas panhandle to be delivered downstate to consumers in the Dallas, Houston, Austin, and San Antonio regions. If those lines link to Tres Amigas, then the prospect arises that consumers elsewhere will – in effect – “drink our milkshake.” Texas policymakers don’t want other consumers to drink our milkshake, especially after ERCOT consumers spend $5 billion to build there own transmission “straw” into the Panhandle region.  (Yeah, I watched “There Will Be Blood” a week or so ago, hence the milkshake and straw references. The presenter did not use this language.)

Peter Behr, writing for ClimateWire, has a more journalistic report on the debate over Tres Amigas. Behr reports that Occidental Petroleum – a large power consumer within the ERCOT region – has actively opposed the Tres Amigas project in filings at FERC, as has the Texas Industrial Energy Consumers. I haven’t read their filings, but apparently they believe ERCOT power prices will be higher on average with Tres Amigas than without, and as consumers they prefer lower prices.

In my opinion, however, they are more likely to get slightly lower (and somewhat less volatile) prices with better links to the rest of the grid.  That’s the way market expansion usually works.

Tres Amigas posts its FERC filings and related documents on its website. Here are links to a couple of the opposing views filed at FERC.  The “Supplemental Protest of Occidental…” includes the expert witness testimony that Behr discusses in his story:

Not all Texas policymakers oppose Tres Amigas. Member of Congress Randy Neugebauer (R-TX) sent FERC a letter indicating the project would encourage investment in renewable power and urging the Commission to give the project a “fair and deliberate view.”  And, as the ClimateWire story suggests, developers aiming to exploit the extensive power generation potential of the region are strongly behind the project.

Consumer protection in the Texas retail power market, part 2

Michael Giberson

The Dallas Morning News is back with the second half of its investigative report into consumer protection problems in the Texas retail power marketIn this article the DMN focuses on the owner of Freedom Power, one company serving the prepaid power segment of the Texas retail market. (Yesterday I commented on part one of the story.)

The story reveals that Ken Weaver, when he became the owner of Freedom Power, lied about his past on state licensing documents.  Among the problems: failing to disclose his felony record and prison time, claiming college degrees he didn’t earn, and reporting a three-sport varsity career as an undergrad.  State officials said that the felony convictions may not have disqualified Weaver from receiving a license (though presumably extensive lying on the licensing application is a problem).  The story suggests, reasonably I might add, that any checking into the background of potential licensees would have revealed the deceptions.

Of course just because Weaver lied to state licensing officials doesn’t make the company he bought a bad apple, right?  Well, the DMN reported:

For some, the consequences were painful.

Weaver’s Freedom Power developed a track record of cutting power to customers in midsummer, despite a state-imposed moratorium on cutoffs during a heat emergency. It also compiled the highest rate of consumer complaints in Texas and one of the highest rates of rule violations of any electricity provider in the state.

The Public Utility Commission, which is supposed to protect consumers in the deregulated market, ultimately fined Weaver’s company $21,050 for a few electrical cutoffs. But it took no other action even after The Dallas Morning News informed it of Weaver’s criminal history and false statements his company made in filings to the commission.

I don’t know whether the $21,000 fine is comparable to fines assessed to other companies with similar violations, if any, but this story is pretty thin on actual consumer harm.  The single consumer harm mentioned is the midsummer loss of power during a state-imposed moratorium on cutoffs. (Yesterday I commented on the likely consequences for prepaid customer rates of forcing retailers to be charities during emergencies.)

Yes, Weaver lied on his licensing application and generally seems to mix business with a great deal of self-promoting fiction, and his fast-and-loose play with the facts may be tied to those record-setting number of consumer complaints, but the story does not document that connection. After reading the article, I wouldn’t trust Weaver with my money nor would I sign up as a customer to one of his businesses, but it doesn’t look like he set out to defraud his consumers.  Instead, it looks like he has tried to run a business.

Despite the evidence, in both the first and second half of the report, of problems in licensing review and weak efforts put into consumer protection at the PUC of Texas, the reporters came up with little direct evidence of harm to consumers due to these problems.

Texas regulators choose companies to build transmission to reach wind power

Michael Giberson

On Thursday, Texas utility regulators selected nine companies to build portions of the nearly $5 billion-worth of transmission to better connect existing and anticipated generating resources in the western part of the state to the large consumer load centers in the east, central and southeast parts of the state.  (Most of those existing and anticipated generators are wind powered, but so far as I know nothing in the rules would prevent a company from building a coal plant in west texas and getting access to the grid.)

This map posted on the PUCT website shows the approximate assignment of lines to companies.  Note that one project in the McCamey area was assigned to STEC, but is not shown on the map. Click on the image for a larger view.

PUCT_CREZ_Transmission_Award_Map_2009_Jan_29

In the Fort Worth Star-Telegram, Jim Fuquay reports:

On Thursday, the Public Utility Commission of Texas identified nine organizations to build various segments of about 2,400 miles of power lines in the nearly $5 billion project. Transmission capacity now barely covers half of the state’s 8,000 megawatts of wind power, leading to curtailments among wind farms roughly half the days of the year.

Still, wind provided nearly 5 percent of the state’s electricity last year, the operator of the state’s biggest electric grid reported last week.

While you may wonder about the companies abilities to finance $5 billion in spending, Fuquay quotes Jim Owen at the Edison Electric Institute as pointing out that regulated transmission lines should be able to secure financing.

“Utilities are hugely capital-intensive,” Owen said, adding that speculative power-generation projects are running into roadblocks. “But if you have a regulated revenue stream, it helps significantly with the financing.”

Ah yes, the pleasures of doing business with captive consumers.  The consumers have to rely on the wisdom of the regulators to keep a check on regulated utilities. It is often also worthwhile for consumers to keep an eye on regulators.

In this particular case, while I haven’t looked at the underlying analyses too carefully, I think if you assume state and federal incentives for renewable power development continue, then the transmission additions makes sense for consumers.  Captive consumers throughout ERCOT will see an increase in the “wires” part of their bills to repay the expense of building the transmission, but these same consumers are likely to see more than offsetting reductions in the cost of buying power.

Notes: Related stories appeared in the Dallas Morning News, Reuters, and Greentech Media. You can find the map displayed above (and much, much more) via the PUCT Interchange site.  Click the “Login” button at the top right; on the next screen enter the control number 35665, and click “Search Now”; scroll down, the map is item #1274.

Even in Texas competition between electric wires companies is prohibited, except in Lubbock

Michael Giberson

Power to The Woodlands, Texas, a little north of Houston, is delivered by two different companies. Depending on which neighborhood you live in, either your power comes via CenterPoint Energy or it comes via Entergy Texas.  After power outages caused by Hurricane Ike, it took up to a week longer for power to be restored to the CenterPoint Energy neighborhoods than the Entergy Texas neighborhoods, and that prompted some interest in having service to the community integrated under Entergy Texas.

NewsWatch: Energy highlights a Houston Chronicle story that reports the response from the Public Utility Commission of Texas.  In brief, the move is not impossible, but the barriers are substantial. The Chronicle quotes Barry Smitherman, chairman of the PUCT, from a letter to the town: “Essentially, there is a high statutory standard that must be met before a service territory can be transferred ….”

NewsWatch: Energy provides this summary of the regulatory barriers:

  • CenterPoint holds the certificate of convenience and necessity for Sterling Ridge and Creekside Park, which gives exclusive rights to provide electricity in those areas.
  • A certificate of convenience and necessity can only be revoked if the company no longer provide power service in that area.
  • Multiple [certificates of convenience and necessity] are not permitted in any given area.

While there would be some expense involved in actually disconnecting from one system and connecting to the other, the expense is not the problem.  The key barriers are all matters of public policy.

Interestingly, in my new hometown of Lubbock, Texas, competition between distribution companies has long been the norm.  I don’t know if overlapping certificates of convenience and necessity have been issued.  More likely, the arrangement was grandfathered in when the state regulatory commission was established. But the Lubbock example suggests another approach for The Woodlands: don’t switch from one to the other, allow both.

Lubbock Power & Light explains the history of competition as one in which early city commissioners were unhappy with the local privately-provided electric power service, and so authorized the build of a municipal generator.  I suspect typically in such cases the municipal government would acquire the local distribution equipment from the displaced private owner, but the Lubbock government refused offers from Texas Utilities to transfer the existing Lubbock distribution system.  And so, according to LP&L:

Today, the vast majority of Lubbock remains dual-certified and customers still have a choice of electric utility providers. Customers whose account balances are current are allowed to switch from one company to the other at their discretion. The competition for the electric dollar in Lubbock has resulted in some of the lowest electricity costs in the state of Texas and in the nation. Another major benefit of competition is that customers enjoy increased levels of customer service than would be found in cities this size with only one electric provider.

In the past six months we have switched from one utility to the other exactly once.  So far my current provider hasn’t given me a good reason to go back, but it is nice to know that I could if I wanted too.

A 1981 story in Reason magazine tells the story of power competition in Lubbock, noting for example:

In Lubbock, … the city fathers wrote into the city charter that any change in the competition between Lubbock Power & Light and Southwestern Public Service Company must be approved by three-fourths of the registered voters. Nowhere in the country do three-fourths of the registered voters even vote, much less agree!

The Reason article then digs into the research of economists like Greg Jarrell and Walter Primeaux, among others. Jarrell’s research into the emergence of public utility regulation of electric power turned up some surprises:

In fact, Jarrell discovered, the first states to come around to regulation were those whose utility rates had been much lower (by an amazing 46 percent) than those of late-regulating states. Profits, too, were lower (by 38 percent) and output was higher (by 23 percent). In short, it appeared that regulation was sought most avidly precisely in those states with the least monopolistic utilities, those least able to manipulate output and prices. This finding bore out the suspicion that it was the utilities themselves that wanted regulation, to protect themselves from competition.

Further confirmation came from Jarrell’s second finding. After five years of state regulation, he discovered, the utilities’ prices and profits had both increased, while electricity output fell. Regulation was creating the very monopolistic results the public was told it would counteract!

After a student tipped Primeaux in 1968 to electric utility competition in Lubbock, Primeaux started researching the topic:

Among Primeaux’s discoveries was the fact that electric utility competition seemed to be dying out. By 1972 the number of cities with competition had dropped from 49 to 35. And today Primeaux’s tally reveals only 23 competitive cities.

Turning his research to the cause of this demise, he found that the opponents of competition were not consumers in the area but regulatory officials committed to its elimination on theoretical grounds. Like their predecessors, public utility regulators remain convinced that electric utilities constitute a natural monopoly and should therefore be subject to rate-of-return regulation.

(Yes, Virginia, economic theories are performative, and not just Black, Scholes and Merton.)

The prospects for The Woodlands are complicated by the fact that CenterPoint Energy is part of the ERCOT system, while Entergy Texas is part of the Eastern Interconnection.  Entergy Texas has been seeking to join ERCOT for a few years, but that isn’t likely to happen soon, and may not happen at all.

But even with that additional layer of technical complexity, the main barrier to wires-level competition for The Woodlands is Texas state regulatory policy.  Some folks in The Woodlands want to switch distribution utilities.  The state of Texas, which otherwise has some of the most pro-competitive retail power policies in the United States, prohibits such switches.  Texas could, and should, allow consumers in The Woodlands the power to choose their own electric distribution company.