Every year, Potomac Economics, publishes Independent Market Monitoring (IMM) reports for multiple electricity wholesale markets. The annual reports provide a competitive assessment of such markets. Over the past several years, the IMM has consistently found that the ERCOT markets are generally competitive and functioning well, although the IMM has always suggested market enhancements. In the 2012 State of the Market Report, there was significant emphasis in discussing one of the largest challenges facing the ERCOT market—future resource adequacy. While resource adequacy presents a challenge to ERCOT as the grid operator, it provides opportunities for end users to participate in Demand Response programs as part of a comprehensive risk management strategy.
What Is Resource Adequacy and Why It Matters
Simply put, resource adequacy means that sufficient generation exists to meet the projected peak demand for the ERCOT system. ERCOT is one of the few energy only markets in the world, meaning that generators can only make money for energy they produce. In other words, in ERCOT there is no “capacity payment” for simply being available to provide energy whether they are called upon or not. In evaluating market performance, one of the key metrics employed by the IMM is the evaluation of “net revenue”. This metric measures the total revenue that can be earned by a new power plant less its variable production costs. In other words, it is the revenue in excess of operating costs that is available to recover the unit’s fixed and capital costs. For the past 5 years, the IMM has determined that net revenue was insufficient to support new investment in generation in ERCOT. As the IMM noted, “Regardless of the means by which revenues are produced in a wholesale electricity market, it is fundamental that investment will only occur when the total net revenues expected by the investor are greater than its entry costs (including profit on its investment.)” In other words, over the past five years, the energy only revenue, adjusted for anomalies, such as the exceptionally hot weather in 2011, has not been enough to support new investment in generation in the ERCOT market.
Since the net revenue has been insufficient to support new investment in ERCOT, few traditional power plants that provide significant additions to the reserve margin have been built. From a practical perspective, this means that the availability of surplus generation over projected peak demand has decreased. This increases the risk of extremely high prices in the Real Time and Day Ahead Markets in ERCOT as well as the probability of energy emergency events and perhaps rolling blackouts.
While adding generation capacity is one method available to maintain adequate electricity supplies, consumers also have the ability to provide additional grid reliability through demand response programs. The following graph illustrates that loads acting as resources (in other words, load shedding to reduce demand) have replaced noticeable amounts of generation resources and provided Responsive Reserves, which are a critical service for ensuring reliability. In April 2012, ERCOT increased the limit of load resources providing responsive reserves from 1,150MW to 1,400MW. It only took a few months for load resources to reach this level on a consistent basis.
Source: ERCOT 2012 Stae of the Market Report at 92.
What the Resource Adequacy Issue Means for Energy Risk Management
From the end-users perspective, discussions about resource adequacy may seem esoteric. However, they play a critical role in understanding an evaluating energy risk management strategies. For instance, as the spread between available generation resources and peak demand decrease, the value of energy increases, following the simple laws of supply and demand. As part of an energy risk management strategy, this means that there is potential increased exposure to high prices. Given that the IMM has consistently found that net revenues are insufficient to support new generation, the spread between supply and demand is likely to continue to tighten. The chart below, from the IMM, shows that reserve margins drop below the 13.75% Target level in ERCOT after 2014. As part of a forward energy risk management strategy, the need for a proactive approach is critical to capitalize on market incentives and opportunities.
As reserve margins in ERCOT shrink past 2014, heat rates have edged higher to reflect the tightening of the supply/demand balance. Likewise, ERCOT and the PUCT have taken measures to improve supply shortage pricing to send efficient market price signals to incentivize investors to develop new generation in ERCOT’s territory. Not only will the generators profit from supply shortage price signals, but also the value of demand response participation should increase as energy prices climb. A comprehensive energy procurement strategy will evaluate the benefits of participating in demand response as well as how to manage forward price risk.
While the IMM report found that the ERCOT market was generally competitive in 2012, an interesting aspect of this latest report revolved around the resource adequacy issues facing ERCOT. As an energy only market, generators are only paid when they produce energy, meaning that energy prices have to be high enough for generation owners to cover their costs and return on investment. With net revenues being insufficient over the past 5 years to cover the costs and profit of new generation, supply has not kept up with demand. As this gap between supply and demand continues to shrink, there is more upside risk on forward prices. In an energy only market, the main source of revenues for generators is the net revenue during periods of supply shortage.
As part of a comprehensive energy risk management strategy, understanding the importance and implications of resource adequacy, allows the end use customer to evaluate risks and capture opportunities. In addition, a well-conceived and executed strategy will look at the benefits of participating in demand response programs, especially since shrinking reserve margins should put upward pressure on power prices and ancillary services.