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ERCOT, and our Texas Electrical System, is not a free market.

Today, at Imagine Better Media, we are going through the history, structure, problems, and solutions to our Texas electrical grid.

In recent history, we've seen some significant failures and great successes from ERCOT. We all remember Snowmageddon, and none of us like the constant pleas from ERCOT to reduce our electricity consumption. On the other hand, the low prices and wealth of choices unique to Texas are fantastic.

So good, bad, and ugly, we are diving into the most electric part of Texas politics.

Electricity in Texas starts with ice companies in the late 1800s. They had power plants on site to run their condensers and sold excess electricity to surrounding houses and businesses.

In 1880, we got our first power plant in Galveston, TX. Small electric generators started popping up around the state as the demand for electricity grew. These generators built their own transmission lines to move and sell the electricity.

That wasn't the route everyone took, though. In 1891, Greenville, TX, built the state's first fully government-owned electrical system. The city owned the generation, transmission, and electric company.

It was so efficient and productive that the city of Greenville became a center for industry in the state. Oh, wait. It didn't.

These systems and similar systems are in the background of our whole story but aren't significant, so we won't focus on them.

The state's electric system grew in different ways over the next few years, with government and private industry filling all the roles in various ways.

In 1905, the state started inching its way into the game.

First, it gave authority for district courts to settle disputes between cities and private utilities (companies that controlled the generation, transmission, and sold directly to the consumer).

Then, Texas gradually increased the power that municipalities had over electric utilities, shifting the balance of power from the companies to the government. Cities now had the power to set prices that were a maximum of 10% over costs.

The artificially low prices and increased regulation pushed companies to grow larger and larger to try to be profitable. Then, in 1924, they started to interconnect their grids to improve the reliability of their systems.

At this point, many of the grids in Texas connected themselves to out-of-state grids at many locations.

That's when FDR changed the game and incentivized the creation of the separate Texas grid.

He signed two bills into law.

The first was the Public Utility Holding Company Act, which gave companies an ultimatum. They could divest from grid companies in multiple states, physically connect those grids, or submit to regulation by the SEC.

The second was the Federal Power Act, which gave companies another ultimatum. They could disconnect their grids across state lines or be subject to regulation by the new Federal Power Commission.

So, over the next ten years, most parent companies that owned the major Texas grids sold them off to escape regulation by the SEC. Then, those companies agreed not to run connections over state lines to escape regulation by the Federal Power Commission.

The isolation of the grid could happen in Texas and not other states because the utilities composing the grid were mostly private companies (although heavily regulated ones), and Texas was large enough to benefit from economies of scale.

Around the state's edges, utilities chose interconnection over deregulation, which is why the Texas grid doesn't cover all of Texas.

Importantly, these interconnections were temporarily resumed for the war effort in 1943 when FDR suspended FPC rules.

By the end of WWII, the Texas power companies consolidated into two grids, north and south.

Those two systems joined in 1967, creating the Texas Interconnected System, agreeing not to connect their systems out of state.

Then, a few years later, in 1970, they created a nonprofit organization called the Electric Reliability Council of Texas, or ERCOT. At first, this organization was to assist in the planning, operation, and restoration of members' transmission infrastructure. They were essentially there to monitor the system and give advice.

Five years later, in 1975, the state got involved and passed the Public Utility Regulation Act, creating the Public Utility Commission of Texas, or PUC.

This organization's main power was setting rates for all state private utilities and is the primary regulator for the rest of the story.

We must pause for a second for everybody's favorite Texas Electrical Grid story, the midnight connection.

Essentially, an Oklahoma utility company was envious of the low Texas electricity rates, so they secretly connected with a Texas utility across the border against every agreement the Texas company had signed. Several Texas Utility Companies disconnected from the TIS for fear of federal regulation, and lawsuits sparked from every side.

You should read this story because it's fascinating, but it has no long-term effects, so we aren't going to dive deep here.

Back to our main story, in 1981, the members of ERCOT (still a completely private company) voted to give the operation of their whole transmission infrastructure system over to the company.

In 1995, the Public Utility Regulation Act was expiring, and Governor George W. Bush had his sights set on massive reform.

This reform changed how the energy markets worked in many ways, but we will focus on the big two.

The first was the unbundling of the electricity market. There were going to be three distinct groups that participated in a competitive market: generators, transmission, and providers.

Remember that, at this point, the only providers were utilities, who still had regional monopolies.

Second, they restructured ERCOT again to become an independent system operator or ISO. ERCOT would now ensure that all qualified generators can connect to the grid, operate all transmission lines under a uniform policy, and ensure that all wholesale purchasers, or providers, get access to the same rates.

Four years later, the legislature allowed new entities called Retail Electric Providers to purchase electricity and sell it to end users.

So, let's dive into the structure of the Texas Electrical Market. Over the first decade, there were many debates and transitions the Texas Electric System went through.

The first problem to solve is how to let new companies enter the electricity provider and generation markets without the established utilities crowding them out.

The legislature created a "price to beat" that the established utilities could not sell beneath.

The utilities could also not hold more than 20% of generation capacity in this period, forcing some companies to auction off power plants.

This new system started in 2002 and ended in 2007. Just long enough to allow new companies to establish themselves.

These reforms worked. By 2008, 85% of users had tried at least two service providers, and 40% of the users were with new providers.

The next problem was dealing with the congestion of transmission lines when deciding where power would originate.

The two options were zonal and nodal systems. A zonal market would split ERCOT into regions to keep generation close to consumption and only charge congestion pricing when moving across those regions.

A nodal market would charge congestion pricing by the wire with no regions.

Long story short, ERCOT went with the zonal model, which collapsed in three weeks and transitioned to the nodal model, which we use today.

Another problem is resource adequacy, which is just a fancy phrase for generation investment. How do you ensure that companies will invest enough in energy production?

The first option is to allow prices to direct investment. When prices rise, they encourage companies to invest.

The second option, the rest of the options thrown together, is to incentivize excess capacity in one way or another.

Because option two would require massive investment in inspections and checks, ERCOT went with the first option and saw world-leading investments in generation capacity.

In a pure market system, they would do away with the energy price cap altogether, but they decided to just increase it. They also added market transparency to increase trust but delayed it to a sixty-day lag to prevent collusion.

Then, we have the transmission market. Texas, unfortunately, did not create a market in this instance. Transmission infrastructure is mandated and approved by the Public Utility Commission of Texas.

It is a top-down design that guarantees a specific rate of return to transmission companies.

Unfortunately, you have two programs far from the market standard: Renewable Energy Credits and the Energy Efficiency Resource Standard.

The first is an incentive to build more renewable energy power generation, even if that's not what the grid needs.

The second incentivizes power retailers to shave demand at peak times, taking away incentives to provide excess capacity.

So, Texas created a "competitive market" for electricity, which provided one of the highest amounts of electricity per capita at one of the lowest costs in the US.

So now we can complete the history with the crashes of 2011 and 2021. These crises were a lot simpler than they seemed. Demand spiked during record-cold winters because Texas heating systems are very energy-inefficient. High demand paired with low supply as power generation systems froze.

No. It wasn't just wind farms or natural gas that froze. All types of power generation, including coal and even nuclear, froze.

So, in 2023, the Texas Legislature created a fund to offer low-interest loans to power generators to construct "dispatchable power." This reform was utterly antithetical to the Texas system.

So, what are the problems with the Texas Electric System?

The first problem is incentives. Between ERCOT and the PUC, no one has complete responsibility, and because both are now government entities, they have sovereign immunity and can't be sued. Nothing bad happens to these people if they mess up.

The second problem is the transmission market. It is underdeveloped because it is run by bureaucrats and not as a market. That is one of the reasons we have solar farms in Bell County. If we had a more robust transmission infrastructure, they would be in West Texas, sending power over long-distance lines.

The third problem is poor incentives. The government is spending money incentivizing renewable energy, natural gas, and energy efficiency. All of these distort a market that is better equipped to operate on its own.

The solutions to the Texas Electric System follow, but I'll present them in reverse order.

The first is to eliminate any incentive programs that the state has to conserve energy or favor one type of power generation over another. Then, we can add a tax on everything the federal government subsidizes to return to the market prices.

You could put the money from that tax in a sovereign wealth fund. Just don't give it directly to the general fund.

This fix would ensure that Texas arrives at the right blend of power resources, not just the blend of the people who spend more on lobbying.

The second is to turn the transmission system into a decentralized market, as we did for generation and retail consumption.

This solution would incentivize more investment in transmission infrastructure and remove market power from the few established players.

The third and final step is to eliminate the PUC and restructure ERCOT into an organization liable for its wrongdoing and financially incentivized to do better.

Private markets work better because they are liable for their failures and rewarded for their successes.

We've proven that markets work better than state direction. Let's go all in.

What do you think? Do we need the state to incentivize the market?

Let me know in the comments.


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