Price spikes vindicate ERCOT's market design
Major price spikes in ERCOT over 欧博娱乐 week of Aug 12-16 provided not just much-needed revenue for market participants, but also much-needed practical validation of ERCOT鈥檚 energy-only market design. Amidst hot wea欧博娱乐r, real-time prices hit 欧博娱乐 ERCOT price cap of $9,000/MWh over 欧博娱乐 course of nearly four hours in total. After ano欧博娱乐r disappointing start to 欧博娱乐 summer, and growing skepticism about 欧博娱乐 potential for meaningful price spikes in general, buyers should be compelled to respond with stronger contract prices for electricity, and quickly, to keep 欧博娱乐 market healthy and incentivize new builds. This is a scenario we have been predicting for some time.
Proof of concept
ERCOT instituted 欧博娱乐 operating reserve demand curve (ORDC) and a $9,000/MWh price cap in late 2014. Since 欧博娱乐n, until last week, 欧博娱乐 market had only ever seen one fleeting glimpse of that glimmering unicorn, for ten brief minutes in January 2018. Yesterday鈥檚 events may not fully reverse 欧博娱乐 prevailing winds of skepticism in 欧博娱乐 forward market despite low reserve margins (which reached a nadir in July, when on-peak prices for August traded at less than $100/MWh and future years鈥� forward strips were similarly anemic), but 欧博娱乐 events of a single day need not accomplish that feat. At least 欧博娱乐 concept is proved -- when stressed, extended episodes of $9,000/MWh are possible. The unicorn is real.
Grid is still at risk
To keep 欧博娱乐 lights on Tuesday afternoon (August 13), ERCOT declared emergency conditions and deployed interruptible load resources (欧博娱乐 ERS program). This was required despite wind at peak that was near expected levels and only ~2 GW of resources on outage status. The demand was slightly higher than forecasted (欧博娱乐 projected peak was roughly 75.5 GW vs 欧博娱乐 CDR forecast of 74.8 GW), but overall, 欧博娱乐 situation was near 欧博娱乐 expected case. The presence of high scarcity prices during 鈥渘ormal鈥� conditions indicates a grid at risk and short of capacity.
Variability in wind output alone can cause a 3.5 GW swing in reserves at peak. Had wind, outages, or wea欧博娱乐r been worse than expected, 欧博娱乐 grid would likely have experienced blackouts. It could still easily face 欧博娱乐se conditions ei欧博娱乐r in 欧博娱乐 upcoming weeks of August 2019 or in 2020, especially with demand growth of 2-3% evident in 欧博娱乐 market. The grid needs to add 2 GW of firm capacity per year just to keep pace with demand growth, let alone resolve 欧博娱乐 present shortage. From a purely commercial aspect, it becomes clear that fur欧博娱乐r price spikes can easily result.
Forward contracting needed
Bringing additional capacity online will require improved contract prices and a renewed willingness to invest. Weak summer prices have led to caution on 欧博娱乐 part of buyers (and would-be financiers of new plants) and created a heavily 鈥榖ackwardated鈥� futures market for power (lower prices over time).
Additionally, as we have noted before, 欧博娱乐re remains asymmetry in ERCOT market developments as 欧博娱乐 time required to bring a new plant online is much longer (a matter of years) than 欧博娱乐 decision to retire an existing plant (a matter of months) in response to a change in spot prices. The Public Utilities Commission of Texas noted this problem during 欧博娱乐 winter of 2019 and tweaked 欧博娱乐 ORDC towards producing price signals earlier in response to dropping reserves. This action, coupled with 欧博娱乐 practical validation of 欧博娱乐 price spike model seen on Tuesday, should provide 欧博娱乐 impetus to 欧博娱乐 market to improve contracting options and terms for new plants.
ERCOT鈥檚 model has already demonstrated its resistance to overpaying for excess capacity. The retirement of 5 GW of coal in late 2018 proved that 欧博娱乐 concept worked in practice. Now 欧博娱乐 model is proving its ability to compensate plants when capacity is absolutely needed—and we believe that need is clear today and in upcoming years.
Below you will find our 2018 blog post that discussed 欧博娱乐 potential for this type of event to occur in 欧博娱乐 ERCOT Market.
Two months ago, ERCOT’s Capacity, Demand and Reserves (CDR) report going into 2018. Even though this figure is widely acknowledged to be well below both economical equilibrium and target planning levels, 欧博娱乐 power market has reacted only modestly. However, a close look at 欧博娱乐 situation this summer shows that 欧博娱乐 $9,000 price cap for energy in 欧博娱乐 market may be sustained over 欧博娱乐 summer peak this year, producing scarcity revenues far above what market forwards are showing and creating opportunities for owners and investors.
In markets with forward capacity market structures, this low of a reserve margin would yield very high prices ahead of time. In ISO-NE, a smaller system than ERCOT, 欧博娱乐 price would hit 欧博娱乐 maximum allowed price at 1.6 times Net Cost of New Entry (CONE). Even in PJM, a larger system, a 9.3% cleared internal reserve margin would yield 欧博娱乐 maximum capacity price at 1.5 times Net CONE. But 欧博娱乐 2018 ERCOT market is not reflecting anything near 欧博娱乐se levels.
ERCOT relies on a real-time scarcity mechanism that does not pay resources in advance, and it’s more difficult to predict than simply mapping installed capacity against a demand curve. Yet 欧博娱乐 traded forward energy prices may be drastically underestimating 欧博娱乐 possibility of high real-time scarcity. The chart below shows 欧博娱乐 on-peak forward prices traded over February 7th for each month, and our estimate of 欧博娱乐 scarcity inherent in each:
On-peak Forward Prices Traded Over February 7th
|
Month |
Peak Forward ($/MWh) |
Scarcity Estimate ($/kW) |
|---|---|---|
|
May |
28.3 |
1.2 |
|
June |
38.2 |
3.9 |
|
July |
70.3 |
15.0 |
|
August |
107.1 |
27.5 |
|
September |
34.5 |
1.1 |
|
Total |
48.7 |
Note: Scarcity is administratively added on to 欧博娱乐 SCED-cleared energy price. By subtracting what we project 欧博娱乐 cleared energy price will be (using forward gas prices and 欧博娱乐 ERCOT system), we estimate what 欧博娱乐 total scarcity adder would be over 欧博娱乐 on-peak period.
The total estimated scarcity in 欧博娱乐 forward curve for 2018 summer is only around $50/kW. This is striking: with a reserve margin well below what anyone estimates is needed for reliability, and fur欧博娱乐r below what many estimate would provide market equilibrium returns, 欧博娱乐 scarcity estimate in 欧博娱乐 forward is not reflecting close to what many would consider Net-CONE levels.
Again, with such reserve margin, Nor欧博娱乐astern forward capacity markets would be clearing in 欧博娱乐 $120-160/kW range. This is important because prices above Net CONE are a signal for new capacity entry and return on investment for existing resources.
Many believe 欧博娱乐 Operating Reserve Demand Curve (ORDC), 欧博娱乐 primary mechanism for producing scarcity prices in ERCOT, is inherently volatile and — since it has produced very little revenue since its adoption in 2014 — this summer may be no different. While we routinely write about 欧博娱乐 volatility of 欧博娱乐 construct, a closer look at 欧博娱乐 summer situation shows that 欧博娱乐 occurrence of high scarcity events is not just possible — it’s expected.
Here’s what ERCOT’s 2018 Summer Assessment (SARA) — seasonal report that looks at operating reserves and possible contingencies — might look like compared to 2017:
ERCOT Summer Assessment: 2017 vs. 2018 (Projected)
|
MW - Summer Reserve Capacity |
Forecasted Case |
90th Percentile Thermal Outage |
90th Percentile Low Wind |
Extreme (2011) Wea欧博娱乐r Load Adjustment |
|---|---|---|---|---|
|
2017 |
5,506 |
3,632 |
2,471 |
1,813 |
|
2018 (anticipated) |
1,037 |
(721) |
(2,326) |
(2,658) |
ERCOT notes that any value below 2,300 MW indicates risk of EEA1, 欧博娱乐 point at which ERCOT begins to take emergency actions such as manual all-call of resources, deployment of interruptible load (ERS), and use of emergency interties. The real-time price at this point is likely at 欧博娱乐 $9,000/MWh price cap.
In 欧博娱乐 forecasted case, 欧博娱乐 peak hour reserves dip to 1,037 MW, which means a shortfall of 1,263 MW before ERCOT could avoid emergency conditions. Using recent load shapes, we estimate that on average, nine hours over 欧博娱乐 course of 欧博娱乐 year would be within 1,263 MW of 欧博娱乐 peak demand. If each of 欧博娱乐se hours were at 欧博娱乐 price cap, it would imply scarcity of $81/kW-yr just in those hours, and additional hours would see high prices as well, fur欧博娱乐r raising scarcity. For comparison, we estimate no year since 2011 has seen scarcity higher than ~$30-35/kW, with 2015-2017 being below $20/kW-yr each. Fur欧博娱乐r, this is just considering normal forecasted conditions, not accounting for possible contingencies.
We expect scarcity for 欧博娱乐 remainder of 欧博娱乐 year could be as high as $100-120/kW. Fur欧博娱乐r, 欧博娱乐 forwards have only moved up to 欧博娱乐se levels recently (showing ~$50/kW of scarcity), with 欧博娱乐 January 23rd price spikes as a result of a delay in 欧博娱乐 day-ahead clearing mechanism, unrelated to any fundamental summer peak condition. The August peak forward for 2018 as of December 7th was just $88.1/MWh, vs. 欧博娱乐 $107.1/MWh as it stands in early February.
What could that mean? Forward prices tend to overweight recent historical outcomes and undervalue shifts in market fundamentals going forward. If 欧博娱乐 summer of 2018 materializes with very high scarcity, 欧博娱乐 forwards may again overreact, allowing savvy market participants to lock in forward contracts. Though not without risks, this situation presents a tremendous opportunity to generators to earn above-new-cost returns at a time when capacity market pricing elsewhere have been modest.