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Scarcity Pricing: Near-Term Pain, Long-Term Gain

With summer on the horizon, it’s a good time to talk about scarcity pricing — a hot topic last year when real-time wholesale power prices in Texas hit a $9,000 per megawatt-hour (MWh) cap multiple times over a three-day stretch.

Generally, wholesale power prices are driven by supply and demand. Prices go up when limited power supplies are used to meet growing demand.

Picture a hot, humid day. The Electric Reliability Council of Texas (ERCOT), which operates the grid and power markets in nearly all of the state, must call on all available resources to meet soaring electricity demand on those days. Typically, ERCOT will need to ask less efficient and more expensive power plants to run, helping drive up prices in those periods.

ERCOT also uses an “operating reserve demand curve” mechanism, or ORDC, in its markets to help make sure Texas has enough power supplies to avoid blackouts. The ORDC gives an extra boost to prices when real-time electricity reserves grow short. The ORDC partly reflects an estimate of how much people would pay to avoid power outages.

Importantly, scarcity pricing provides an incentive for building new power plants and for existing generators to make sure their power plants are in shape to run when needed.

Before last summer, ERCOT’s $9,000/MWh price cap was hit only once since it was put in place in 2014. But in August, after a change in a key variable in the ORDC, the price cap was hit for four hours. 

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Warding Off Supply Shortages

That surge in prices hitting the cap was partly caused by a regulatory decision that was made to address concerns Texas was growing short on power supplies.

Last year, with ERCOT facing a shrinking reserve margin — the cushion between supply and demand — the Texas Public Utility Commission ordered the grid operator to tweak a key factor used to trigger the ORDC in an effort to encourage power companies to build generating facilities.

The change centers on how ERCOT calculates the probability that a lack of real-time power supply could lead to outages, or “loss of load.” ERCOT increased the standard deviation in the grid operator’s loss-of-load probability used to calculate the ORDC by 0.25% last year. It is set to increase by another 0.25% this year, which could lead to additional price volatility in the summer.

While the revised ORDC may lead to higher prices in the short-term, if new power plants are built as a result, power supplies should increase, leading to lower electricity prices and less volatility in the future.

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What's Ahead For This Summer?

With weather playing a major role in changes to real-time power prices, it’s hard to know what will happen this summer.

ERCOT went into last summer with an 8.6% reserve margin, well below the grid operator’s goal of a margin of at least 13.75%. Although margins were low, June and July were mild, and real-time prices were modest.

But temperatures jumped in August, the second hottest August ever, and ERCOT set a peak demand record on Aug. 12 of 74,666 MW. As a sign of what can happen when reserves are tight, real-time prices hit $6,500/MWh for a 15-minute period that day and averaged about $1,000/MWh for the afternoon.

On Aug. 13 and Aug. 15, real-time prices hit the $9,000/MWh cap multiple times and averaged $2,500/MWh in one afternoon and $2,900/MWh in the other.

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Taking the Long View

Looking ahead to the upcoming summer, ERCOT expects to have an additional 7,630 MW to meet its needs. The new power supplies are mainly renewable energy facilities and flexible natural gas-fired generators.

ERCOT estimates it will have a 10.6% reserve margin this summer, up two percentage points from last year, reflecting estimates for power plants coming online and an expected peak load of 76,696 MW driven by strong growth in West Texas and along the coast, where new industrial facilities are being built.

Overall, it appears ERCOT will have a higher reserve margin than last summer, but the grid operator also changed its ORDC calculation, making it more likely scarcity pricing will be triggered.

The bottom line is generating companies should respond to any higher prices this summer by building power plants, putting a damper on prices and volatility down the line.

In an era where power pricing can be volatile, it’s important for businesses to understand their energy costs and how to manage them. Determining the best approach requires a careful look at your operation and its energy needs. That’s what Priority Power Management does. If you’re interested in looking more deeply at how to prepare your business for summer, we’re happy to help as your trusted advisor. Give us a call!