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Consumers and Price Volatility: Texas Electricity Prices

posted by Adam Levitin

Some Texas consumers who didn't lose power are now finding themselves socked with massive electric bills, as high as $17,000. The reason? They were paying variable kW/h pricing for their electricity at wholesale rates, without any sort of price collar. The Washington Post explains

The state’s unregulated market allows customers to pick their utility providers, with some offering plans that let users pay wholesale prices for power. Variable plans can be attractive to customers in better weather, when the bill may be lower than fixed-rate ones. Customers can shift their usage to the cheapest periods, such as nights. But when the wholesale price increases, the variable plan becomes the worst option.

This story jumped out at me for two reasons.

First, it seemed like a replay (on steroids) of the risks of adjustable-rate mortgages with prepayment penalties, and second, it seems like another chapter out of Jacob Hacker's fantastic (and still totally relevant) 2006 book The Great Risk Shift

Allowing individuals to purchase electricity at variable wholesale pricing was an obvious recipe for disaster from the get-go. Sure, it's cheaper for individuals when there's mild weather. But it shifts all of the risk of weather volatility to individuals. Individuals are incredibly poorly equipped to manage market price volatility. Indeed, few individuals are likely to understand electricity market pricing dynamics, particularly how Texas's Lone Star stand-alone grid works (or doesn't). Individuals aren't well equipped to manage electricity price volatility because most individuals are either on a fixed salary or have variable earnings that change with a fairly limited band. Moreover, those who have more variable income (other than, say an annual bonus or a farmer or artist with seasonal income) often cannot predict when those variations will occur. It doesn't take a Nobel Prize in economics to realize that variable pricing is just not good for consumers because they cannot readily diversify their income or exposures, or insure against most risks (excluding high net worth individuals who can self-insure). 

I'm not sure whether to feel sorry for the consumers who got stuck with huge bills or not. On the one hand, they clearly weren't expecting this risk when they got into their deal, and the State of Texas let them be served a potentially toxic electricity pricing deal. A reasonable consumer might think that if it's on the menu, it can't be that dangerous. On the other hand, the consumers with these huge bills did get the upside of lower bills in mild weather, and their variable rate plans effectively shifted cost to safer, stodgier consumers with fixed rate plans. Now it looks as if the state might bail out some of the consumers who got clobbered with huge bills, which means that there's a redistribution from the consumers who played it safe to those who took the risky deal.

If I recall, it was precisely that dynamic—bailouts of folks who took on too much market risk—that trigger the Rick Santelli rant that kicked off the Tea Party in 2010. Hopefully, this time the anger will be directed not at the unfortunate consumers, but at the anti-regulatory ideologues who in the name of free markets and consumer choice allowed consumers to be given an option that is affirmatively inappropriate for anyone except high net worth individuals who can self-insure against price fluctuations. 

So bringing this back squarely to consumer finance and credit, let me throw out an idea: maybe suitability standards have a role in consumer credit. We have suitability standards for investment products and separate rules for high net-worth individuals ("accredited investors"). Why not for credit products? Ability to repay requirements, which are increasingly common, shade that way. Perhaps it's worth thinking about whether suitability makes sense in the consumer finance context (or alternatively, why we aren't using it as the standard). 


Same logic should also be applied to student loans.

TC--I disagree. While the situations look similar on the surface, the is an important difference between the electricity issue and student loans (and mortgages), namely there are not any negative externalities (that I can see) from not bailing out folks stuck with big electric bills. But there are negative externalities from student loans and mortgages.

With student loans, overleveraged borrowers are overleveraged to a totally different degree than someone with a $4k electric bill. The $4k electric bill won't keep the consumer out of the homeownership market, for example. The $100k in student loan debt might, and that affects not just the consumer, but homeowners who will have to sell their homes for a lower price because of lower demand.

With mortgages, the problem is that home prices are correlated geographically, so a foreclosure on my block affects my house price (and might itself change my calculus on strategic default).

Maybe a $4k electric bill wouldn't keep most consumers out of the homeownership market. But a $17k electric bill might - if they can't pay (or make arrangements) and their credit is ruined. Such an effect not only jeopardizes homeownership, but also homerentership and employment possibilities. Surely there must be some externalities downstream from all of that.

Whatever the externalities of each debt/default type, the major difference is that only one can't be discharged in bankruptcy.

Any bailout will be framed as bailing out consumers, which in actuality is a bailout of the utilities that delivered power at rates that their counter parties couldn’t afford. The end impacts on all parties remain unchanged, but the framing allows blame or focus to the desired group.

I wonder whether suitability standards would be worth the implementation effort. Just putting bounds on the variability might be a better solution--unless there's a reason to think there are a significant number of sophisticated residential consumers who really want to assume the risk of major system failures. Allowing regular consumers to respond to wholesale price fluctuations within a limited range, on the other hand, should retain some of the potential efficiency benefits (like the incentive to reduce usage at peak times).

I think TC's point on student loans may have been that some kind of suitability standards should be applied before allowing someone to take out a student loan. The equity issues around that would be difficult, but I think I do agree with the implicit argument that part of the student loan problem is an origination problem. To me, it seems too easy to take out a life-changing amount of money as a teenager. I also suspect--without hard data--that the availability of student loan money feeds the high inflation in tuition rates.

The Texas Public Utilities Commission on February 16 *ordered* ERCOT to *increase* wholesale electricity prices to the maximum allowed of $9,000/MWh even though ERCOT's near-real-time auction was yielding much lower prices (as low as $1,200/MWh). So some of those giant consumer bills were imposed by fiat of the State of Texas overriding its own so-called "electricity market". I link to a news story, but the PDF of the order is readily available.


Of course "normal" prices are down around $50/MWh, so $1,200/MWh during the deep freeze was already very high. The Texas PUC ought to pay part of all the consumer bills that reflect a wholesale price of $9,000/MWh after it intervened to force the price up to that level.

The whole Texas "market" is almost as badly contrived as the similar California "market" which collapsed in a maelstrom of blackouts and insanely high bills 20 years ago, revealing the idiocy of the market design as well as the perfidy of Enron (a Texas firm, you may recall). Requiring all electricity to be sourced from a spot market is a recipe for occasional extreme price spikes, especially when generators game that market.

Although a quick web search will turn up oodles of economics papers on electricity market design, when you actually read those, you discover that there is no persuasive rationale for the way American electricity markets are currently structured. It's all crony capitalism and rent-seeking. For a quarter century the electricity "deregulation" (really *different regulation*) crowd has been promising lower prices and delivering higher prices. Seriously, look at the empirical data. In Texas particularly as in other States, customers of not-yet-restructured "old-fashioned" utilities have paid much less for power than customers of "deregulated" supposedly-more-efficient utilities. All the fancy "market design" is mostly a cover for charging electricity users prices which are both more volatile and higher on average for less reliable service.

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