What Does Pricing Tell Us About What Happened to Texas’s Power Grid?

A series of major winter storms in February led to a crisis for Texas’s electrical power system. In short, the system failed to produce sufficient power, resulting in lacks in electricity and power that affected more than 4.5 million homes and businesses. At least 70 people died as a result of the storm, and many customers have faced surprise electricity bills in the tens of thousands of dollars.

Questions and accusations have swirled about how Texas’s uniquely isolated and deregulated power grid may have contributed to this catastrophe. While a full analysis of the system is both out of scope for this article and above my pay grade, I wanted to take a look at some of the pricing and incentive dynamics that came into play and what we can learn from them.

First, what exactly is going on with Texas’s electricity market?

The Situation

Texas’s deregulated electricity production means that customers in many cities, such as Houston and Dallas, can choose to receive their power from different retail electric companies. These retailers purchase power from the power producers.

Power prices increase during high demand, which is supposed to incentivize power plants to provide more electricity to the market. There is a wholesale market price cap of $9,000 per megawatt hour set by the state. The average price was $21.28 in 2020, according to the Electric Reliability Council of Texas (ERCOT).

Some retailers offer variable rate plans, which are tied to wholesale prices. While these plans can offer low rates under normalcy, the rates increase if wholesale rates do.

You may see where this is going.

When demand spiked during the storm, prices quickly surged to hit the $9,000 per megawatt hour cap. The goal of the high price is both to increase supply and decrease demand. However, supply was already strangled by cold weather and inadequate winterization, which took many plants offline, regardless of whether they were wind, coal, natural gas, or even nuclear. And there is only so much an individual can decrease demand for life-saving electricity during a storm of the decade, so usage remained astronomical.

The upshot? Citizens with variable rate plans have seen charges in the tens of thousands of dollars for a few days’ worth of electricity.

The finger pointing was quick. The Texas attorney general blamed retail. Retailers blamed wholesale. Independent monitors blamed the utility commission. The utility commission is declining to intervene retroactively. Politicians blamed user error while wondering whether their market setup is all it’s cracked up to be:

“Going forward, people need to read fine print in these kinds of bills,” said Lieutenant Governor Dan Patrick. “We may even end that type of variable plan because people were surprised.”

While I’m not going to solve this, I do think we can identify some fundamental issues with how pricing and incentives were applied.

Customer Knowledge

Texas is one of the few states with variable rate plans. While it can be argued that customers should have, as Patrick said above, read the fine print, customers clearly didn’t fully internalize what these plans could mean to their monthly bill.

In the earlier days of Uber when customers were still getting accustomed to surge pricing, there were some horror stories of riders who faced unexpectedly huge charges. Uber, knowing that customers have alternatives to its service, had to work hard to bring back trust, even if at some level its customers should have “read the fine print.”

The Texas retailers that survive will have to act in a similar fashion, because customers have choice. It is the role of the market creators, however, to ensure that the right transparency and rules are place for both customers and producers.

Similarly, it is your company’s job to make sure its customers understand the details of your arrangements. Very few companies can afford to disorient their customers for long without suffering blowback.

Incentives

Power producers and the utility commission do not face similar commercial pressures. That might be a reason that their response has been so muted. Public officials, who do face electoral pressures, on the other hand, have been vocal in the aftermath.

The depth of the storm meant that many plants couldn’t fire up, even if they wanted to. It appears that regulations and/or incentives for power producers were inadequate to create the proper level of winterization that would help in such storms. As Dallas County Judge Clay Jenkins put it, “[The Governor] consciously chose to do rock-bottom prices…so much so that it was at the expense of reliability for residential customers and all of us in extreme weather.”

As the Wall Street Journal explains:

Texas has what is known as an “energy only” market. Producers are paid only for the power they generate. If they were paid to be on standby for all weather conditions, that would encourage investments to ensure they are ready to go, electricity-market veterans say.

If you don’t lose customers when you provide bad service, the incentive will be to shirk. Even catastrophic events must be planned for. Utilities that provide necessary services need to be even more supported.

Incentives functioned improperly on the demand side, as well. While customers may have had an incentive to reduce power usage, many simply could not. Electricity for heating is a life-or-death necessity during a winter storm. Therefore, the incentive cannot really function as designed; electricity demand will skyrocket regardless. Implementing high surge pricing will have the regressive effect of most hurting those who do not have an alternative to using their electricity.

To induce the right customer behavior, customers must both know the rules of the game and also have the ability to change their actions. Neither were reasonably the case here.

For companies, customers must understand your price variance policy (i.e., discounts and rebates) in order to take advantage of them. If you are using price variance policy to incentivize certain customer behaviors (and you should be), the incentives must be communicated and actionable to have their intended effects.

Market Organization

The proliferation of market actors in the deregulated market is supposed to increase choice and lower prices for customers. But did it?

Texas does have low electricity prices compared to much of the United States (about 8% lower than the nationwide average). But an analysis by the Wall Street Journal showed that Texas residents who have choice in retail actually pay 13% higher than the nationwide rate, meaning bills in Texas were $28 billion higher than they would have been without retail options.

The expected benefits of competition appear to have become negative, perhaps due to industry consolidation. Perhaps the state regulated prices are in some sense too low, but then you would expect customers to get more for their money via retail shops instead of both paying too much and getting worse outcomes.

What I draw from this is that reality doesn’t always match theory from Economics 101. If pricing strategy were a simple matter of finding the equilibrium price or where MR = MC, our lives would be a lot simpler. But, in reality, most companies are not operating in industries or scenarios that conform to such theory. Pricing is a wicked problem and details matter.