Jay Zarnikau, C.K. Woo, and Ross Baldick have examined whether the shift from a zonal to nodal market design in the ERCOT power market had a noticeable effect on electric energy prices. The resulting article, published in the Journal of Regulatory Economics, and this post may be a bit geekier than we usually get around here. I’ll try to tone it down and explain the ERCOT change and the effect on prices as clearly as I can.
The topic is important because the shift from zonal to nodal market structure was controversial, complicated, expensive, and took longer than expected. Problems had emerged shortly after launch of the initial zonal-based market and the nodal approach was offered as a solution. Some market participants had their doubts, but rather quickly ERCOT began the move to a nodal design. Note that phrasing: “rather quickly ERCOT began the move.” It took several years for ERCOT to actually complete the process.
In part the shift was promoted as a more efficient way to run the market. Zarnikau, Woo, and Baldick looked at the effect on prices as one way to assess whether or not the resulting market has worked more efficiently. They conclude energy prices are about 2 percent lower because of the nodal market design.
Don’t get hung up on the 2 percent number itself, but think of the shift as having a modest downward pressure on prices.
The result is consistent with an understanding one would gain from the study of power systems engineering as well as with what power system simulations showed. The point of the Zarnikau et al. study was to investigate whether data analysis after the fact supported expectations offered by theory and simulation. Because there is no better empirical study (so far as I am aware) and because their results are consistent with well-founded expectations, I have no reason to doubt their result. I will contest one interpretation they offer concerning the current resource adequacy debate in Texas.
Some background (which beginners should read and others can skip).
The delivery of electric energy to consumers is a joint effort between the generators that create the power and the wires that bring it to the consumer. The wires part of the system are not simple links between generators and consumers, but rather complicated network of wires in which consumers and generators are connected in multiple ways. The added flexibility that comes with networking helps the system work more reliably and at lower cost.
The network also comes with a big coordination problem, too. Power flows on the network are not individually controllable. With many generators producing power for many consumers, parts of the power grid may become overloaded. One key job of the power system operator is to watch the power flows on the electric grid and intervene as needed to prevent a transmission line from being overloaded. The intervention generally takes the form of directing a generator (or generators) contributing to the potential overload to reduce output and directing other generators to increase output. In areas outside of regional system operators, this function is done on a piecemeal basis as problems arise. A significant benefit coming from full-scale regional power markets integrated with system operations (such as ERCOT in Texas after the switch to a nodal market and in other similar ISO/RTO markets) is that such coordination can be done in advance, with more information, mostly automatically, and more efficiently than piecemeal adjustments.
Described in simpler terms, the regional power system operator helps generators and consumers coordinate use of the power grid in the effort to efficiently satisfy consumer demands for electric energy. A zonal market design, like ERCOT started with, did minimal advance coordination. The nodal market design and related changes implemented by ERCOT allowed the market to do more sophisticated and efficient coordination of grid use.
About data challenges.
In order to assess the effects on prices, the authors couldn’t simply average prices before and after the December 1, 2010 change in the market. The power system is a dynamic thing, and many other factors known to affect electric power prices changed between the two periods. Most significantly, natural gas prices were much lower on average after the market change than during the years before. Other changes include growing consumer load, higher offer caps, and increasing amounts of wind energy capacity. In addition, the prices are generated by the system has been changed, making simple before and after comparisons insufficient. For example, rather than four zonal prices produced every 15 minutes, the nodal market yields thousands of prices every 5 minutes.
One potentially significant data-related decision was a choice to omit “outliers,” prices that were substantially higher or lower than usual. The authors explain that extreme price spikes were much more frequent in 2011, after the change, but largely due to the summer of 2011 being among the hottest on record. At the same time the offer caps had been increased, so that prices spiked higher than they could have before, but not because of the zonal-to-nodal market shift. Omitting outliers reduces the impact of these otherwise confounding changes and should produce a better sense of the effect of the market change during more normal conditions.
Their conclusion and a mistaken interpretation.
Zarnikau, Woo, and Baldick conducted their price analysis on four ERCOT sub-regions separately so as to see if the change had differing impacts resulting from the changeover. The West zone stood out in the analysis, largely because that zone has seen the most significant other changes in the power system. The two main changes: continued sizable wind energy capacity additions in the zone, and more substantially, dramatic electrical load growth in the region due to the recent oil and gas drilling boom in west Texas. Because the West results were a bit flaky, they based their conclusions on results from the other three zones. Across a number of minor variations in specifications, the authors found a price suppression effect ranging from 1.3 and 3.3 percent, the load-weighted average of which is right around 2 percent.
So far, so good.
But next they offered what is surely a misinterpretation of their results. They wrote:
[T]he reduction in wholesale prices from the implementation of the nodal market might be viewed by some as a concern. In recent years, low natural gas prices and increased wind farm generation have also reduced electricity prices in ERCOT which has, in turn, impaired the economics of power plant construction. … It appears as though the nodal market’s design may have contributed to the drop in prices that the PUCT has now sought to reverse.
Strictly speaking, the goal of the Public Utility Commission of Texas hasn’t been to reverse the drop in prices, but to ensure sufficient investment in supply resources to reliably meet projected future demand. Lower prices appear to be offer smaller investment incentives than higher prices, but there is a subtle factor in play.
The real incentive to investment isn’t higher prices, it is higher profits. Remember, one of the most important reasons to make the switch from a zonal to a nodal market is that the nodal market is supposed to operate more efficiently. Zarnikau, Woo, and Baldick notice that marginal heat rates declined after the shift, evidence consistent with more efficient operations. The efficiency gain suggests generators are operating at an overall lower cost, which means even with lower prices generator profits could be higher now than they would have been. It all depends on whether the drop in cost was larger or smaller than the drop in prices.
The cost and profit changes will be somewhat different for generators depending on where they are located, what fuel they use, and how they typically operated. I’ll hazard the guess that relatively efficient natural gas plants have seen their profits increased a bit whereas less efficient gas plants, nuclear plants, and coal plants have likely seen profits fall a little.
FULL CITE: Zarnikau, J., C. K. Woo, and R. Baldick. “Did the introduction of a nodal market structure impact wholesale electricity prices in the Texas (ERCOT) market?.”Journal of Regulatory Economics 45.2 (2014): 194-208.
Here is a link to a non-gated preliminary version if you don’t have direct access to the Journal of Regulatory Economics.
AN ASIDE: One modest irony out of Texas–the multi-billion dollar CREZ transmission line expansion, mostly intended to support delivery of wind energy from West Texas into the rest of the state, has turned out to be used more to support the import of power from elsewhere in the state to meet the demands of a rapidly growing Permian Basin-based oil and gas industry.