The Generation Gap

March 1, 2014
Texas Monthly
Loren Steffy


Just after seven a.m. on January 6, as Texans awakened to one of the coldest mornings in years, an email and social media alert went out from the Electric Reliability Council of Texas: "Reduce electric use now. Risk of power outages exist throughout Texas. Power warning in effect." The last time a hard freeze gripped Texas so tightly, in February 2011, power blackouts rolled across much of the state as ERCOT, which operates the state's power grid, struggled to meet the demand. Then, just as in January, power plants unexpectedly went offline when the state needed them most. This time blackouts were averted, but barely.

This isn't the free-market wonderland that lawmakers envisioned back in 1999 when they voted to deregulate electricity, turning most of the state's power system over to private companies. That decision, which was helped along by some arm-twisting from Houston's Enron Corporation, was supposed to result in a robust market, thriving with competition, which would drive down prices for consumers, unleash a host of twenty-first-century innovations, and boost reliability by encouraging newer—and greener—generating plants. Texas, it was claimed, would become the envy of the nation for its cheap and abundant power, and the companies involved would make fat profits in the process. "Competition in the electric industry will benefit Texans by reducing monthly rates and offering consumers more choices about the power they use," said a euphoric Governor George W. Bush.

Yet a dozen years after the launch of deregulation, which affects about 85 percent of the state, the system remains arcane and confusing to many consumers. The law eliminated the old monopolies and created three distinct divisions: generators, who produce the energy; transmission companies, which transport the electricity to people's homes; and retailers, who buy electricity on the wholesale market and resell it to residents and small businesses. (Larger businesses, which often generate their own power, usually bypass the retailers.)

Houston Lighting & Power (HL&P), for example, split into three entities: NRG Energy ended up in the generator role, CenterPoint took over the transmission system, and Reliant inherited the customer base. In Dallas, TXU made a similar split, although all three companies—the generator, Luminant; the transmission company, Oncor; and the retailer, TXU—operate under the umbrella of Energy Future Holdings. How's that working out? Well, EFH, the state's biggest utility, now faces potential bankruptcy, and thanks to reliability issues, consumers throughout Texas brace for the possibility of those rolling blackouts every winter and summer.

Part of the problem is that breaking up the old monopolies created a far more complicated system for the state to oversee. The wholesale market that the generators participate in is managed by the nonprofit ERCOT, which is itself overseen by the Public Utility Commission and the Legislature. The transmission companies are still directly regulated by the PUC, which must approve the rates they charge retailers. The PUC also oversees more than one hundred retailers, who compete against one another by offering customers a dizzying array of contract terms and rates. In other words, "deregulation" is a misnomer. Texas has a hybrid of regulated and deregulated markets, a mishmash that requires more government involvement and bureaucracy than the old monopoly system. It's still heavily regulated, yet it's prone to unintended consequences that blindside everyone involved, especially consumers.

"When you rope a calf and you've got all four legs tied, that calf is well regulated," said Ed Hirs, a professor of energy economics at the University of Houston. "If one of those legs gets loose, the calf is still regulated, but it will kick the hell out of you. That's the Texas market."

The first kick came when natural gas prices began to soar soon after the law took effect. Lawmakers had tied the wholesale price of electricity to natural gas (which they thought would remain cheap) because many of the power plants in the state used it for fuel. Then the average price that utilities paid for gas surged from about $3.10 per thousand cubic feet to almost $12, pushing electric bills well above the national average. Only last year did electricity prices drop significantly, as hydraulic fracturing unleashed a glut of natural gas.

It is nearly impossible to argue that deregulation has been beneficial to Texas consumers. According to a recent analysis by the Texas Coalition for Affordable Power, deregulation cost Texans about $22 billion from 2002 to 2012. And residents in the deregulated market pay prices that are considerably higher than those who live in parts of the state that are still regulated. For example, TCAP found that the average consumer living in one of the areas that opted out of deregulation, such as Austin and San Antonio, paid $288 less in 2012 than consumers in the deregulated areas. Over the course of a decade, those savings have topped $4,500 per household.

Nonetheless, among the army of consultants, lobbyists, and generators who have profited from deregulation, denial of failure runs deep, as does an unshakable faith in the mirage of competition. In theory, generators compete, but in practice the competition doesn't mean much: with the state too often on the verge of rolling blackouts, there's no market efficiency. Every plant, no matter how old, dirty, or expensive, is needed. So none of them are actually competing for anything.

Consumers face a litany of choices among retailers, but this competition, too, is largely hollow. Retailers all sell basically the same thing, which they buy at the same wholesale price, and the market has spurred virtually no innovation of note. One worthy innovation, the rollout of smart meters, is hardly an advertisement for deregulation: it was overseen by the transmission companies (which are still regulated) and paid for in advance by customers just as it would have been in the old days. So consumers are paying higher rates and paying for capital improvements before they happen. It's the worst of both worlds. And it's not as if the retailers themselves are making out all that well; a few have told me that their profit margins are as narrow as one percent.

If the consumers aren't winning and the retailers aren't winning, who is? For a while, generating electricity was where the money was, and no one smelled the potential to make money more than Fort Worth billionaire David Bonderman. After HL&P split, the law required the sale of HL&P's power plants, which was done at fire-sale prices. Enter Bonderman, who snapped up the plants for about $3.7 billion in 2004. A year later, he sold them for $5.8 billion. Not bad for a year's work.

By 2007, Bonderman was angling for an encore. Teaming up with the New York equity firm Kohlberg Kravis Roberts & Company and the investment banking giant Goldman Sachs, he put together $45 billion to buy TXU in one of the largest leveraged buyouts in history. It turned out to be one of the biggest leveraged flops in history. Today the company lingers on the brink of bankruptcy, and its investors stand to lose billions. The story of how the state's biggest utility became its biggest economic basket case is the stuff of Texas legend, reminiscent of Boone Pickens's wrong-way bet on natural gas and the Hunt brothers' attempt to corner the silver market. Most of TXU's power came from coal-fired plants, and coal at the time was much cheaper than natural gas, which set the price in the wholesale market. That meant TXU could generate power on the cheap, then sell it onto the grid for much more. It was essentially a guaranteed profit that could easily be used to pay off the $44 billion in debt that Bonderman and his billionaire buddies piled on top of the company, which they renamed Energy Future Holdings.

Then fracking caused the price of natural gas to plunge, wiping out the profit guarantee. With thinner profit margins, the debt from the buyout became a crushing burden, and by last year the future for EFH looked bleak. In October it came within a financial whisker of filing for bankruptcy before dodging a Halloween deadline by making a $270 million debt payment. That kept creditors at bay, but they are still haggling over plans to carve up the company through a "prepackaged" bankruptcy, the corporate equivalent of a quickie divorce.

Ironically, the bankruptcy could bring into focus one of the few bright spots of deregulation: consumers are no longer getting stuck with the bills for utilities' financial follies. Many residents of El Paso remember how, in 1992—well before the onset of the deregulation era—they were forced to fund about $1.2 billion of El Paso Electric's bankruptcy reorganization. Today, by contrast, it is EFH's bondholders who will bear the brunt of the company's failure. What's more, if Luminant's power plants are sold off piecemeal in bankruptcy, it may improve competition on the generating side of the market by creating more generator companies. The billionaires' bad bet may turn into consumers' best hope for reversing a decade of deregulation’s failures.

Unfortunately, more generators won't necessarily lead to additional power plants. With gas prices so low and retail contracts sold mostly on an annual basis, generators can't get financing to pay for new construction because they can't predict their revenue stream more than a year or two out. "There's no method for compensating anyone in the market for building new generation," Hirs says. Without more plants, the chance of blackouts keeps rising.

On a typical day, power on the wholesale market sells for between $30 and $100 per megawatt hour. *But during January's cold snap, prices spiked to $5,000. At times like that, generators make big money, which creates an incentive to withhold power from the market. "They know if they hold back and get into real shortages, they will reap tremendous rewards," Hirs says. Electricity traders have raised questions about suspicious activity that suggests withholding has been going on, but no one has proved anything. What we do know is that the free market isn't responding the way the architects of deregulation expected. The market doesn't care if your AC isn't running in August.

The PUC's solution has been to move even farther away from a free market, by doubling the state's wholesale price caps in hopes of encouraging the generators to build more plants. The problem is that the caps, which were doubled once before, are already quite generous; that $5,000 price tag in January was much higher than was seen in the East Coast markets, which were blanketed by snow and subfreezing temperatures. And still we've seen no new construction. The PUC is also pondering a separate capacity market to pay generators for building backup plants to be used during times of peak usage. Needless to say, this has the support of generators, who recently formed a group called Texans for Reliable Power to push for the plan, which might bring greater stability. But consumers will pay for it. "The story from 2001 to present is that Texas used to be the low-cost producer, and now it's the high-cost producer," says energy analyst Robert McCullough. And once natural gas prices begin rising again, our utility bills will go up again too.

For all its failings, deregulation can't easily be undone. Re-regulating the grid would probably require state seizures of electric assets—an extremely unlikely occurrence. Fortunately, there are other ways to mitigate deregulation's failure. McCullough suggests adding a "capacity mandate" for generators. Rather than making consumers pay for reliability, the PUC could require generators to meet reliability standards. In other words, if you want to operate a generating plant, you have to commit to having a certain amount of capacity in reserve. The PUC could also improve its program under which large commercial customers get breaks on their bills by agreeing to reduce electricity use in times of peak demand. Currently, the incentives aren't strong enough and they aren't offered to residential customers. Regulators could also beef up oversight of the wholesale market to make it more difficult for generators to withhold power and drive up prices.

There are more radical ideas, such as cities' investing in generating plants on their own, using their tax-free bond status to finance construction and then hiring power companies to run them. That would resolve the capacity backlog, reduce construction costs, and increase competition on the generating side of the business. At the same time, the Legislature could consider allowing cities to buy power on behalf of their citizens, which would strengthen their negotiating position. Renewable fuels also might play a role, with individual subdivisions eventually using small-scale solar installations, for example, to balance the grid.

All of these, of course, inevitably increase government participation in a market that purports to be free, which may be the true lesson of deregulation. Electricity is as essential to modern life as health care, water, and transportation, each of which benefits from a mix of free-market principals and heavy governmental involvement. Advocating for more government action isn't a popular move, but if nothing is done, higher rates and a lack of reliability will soon start to scare off business—which is the sort of thing that gets Texas lawmakers to shrug off their free-market ideology, if only momentarily. "Industry tends to look for stable environments," McCullough says. "And right now the Texas electric market is an amazing failure."

Correction: A previous version of this article mistakenly referred to the megawatt hours as kilowatt hours. We regret the error.

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