Challenges Facing Power Generators in ERCOT

Although nearly all energy experts agree that demand for electric energy in Texas will outstrip supply in the coming years, developers of new power generation facilities are facing significant headwinds. The cause of the problems is a unique mix of circumstances.

The competitive energy markets managed by the Electric Reliability Council of Texas (ERCOT) have been hailed by some as the best in the country for allowing the “free hand” of the wholesale generation market alone to send the appropriate pricing signals for new power plant construction. The following factors, however, pose challenges to ERCOT’s future energy supply:

An unwillingness on the part of suppliers to enter into long-term power purchase agreements.A related lack of liquidity in the term energy markets.A general reluctance on the part of lenders to provide financing for “merchant” projects.Regulatory changes affecting both existing generators and developers of new power plants.The absence of a capacity market.

Because the time needed to develop and complete an electric generating facility can exceed three years, Texans may face serious power shortages if some of these issues aren’t resolved in the near term.

Demand for electricity in ERCOT is rapidly approaching the level of existing supply. ERCOT has a target reserve margin (the percentage of available resources above peak demand) of 13.75%. Maintaining that reserve margin is critical to ensuring stability of supply and avoiding blackouts and brownouts. However, in each reporting year after 2014, ERCOT currently projects the reserve margin to fall below this target level.

Three main factors make adding new generation in Texas difficult: its deregulated market, regulatory issues specific to ERCOT, and weak market signals.

As of Dec. 31, 2001, investor-owned utilities (IOUs) in ERCOT were required to unbundle their operations. Following deregulation of the ERCOT electricity markets in areas served by IOUs, the provision of service to end-use retail customers became competitive, and electric providers no longer had a captive body of retail customers. Without a captive body of customers, it became extremely difficult for suppliers to predict prospective demands for power. As a result, they are now generally unwilling to commit to long-term wholesale power purchase agreements or to the construction of new projects.

Although the useful life of a thermal generation facility can exceed 40 years, the capital costs to complete those facilities are extremely high. Though a 40-year power purchase agreement is not necessary to induce investors to build a new power plant, some level of predictable cash flows for a significant period of time will likely be necessary.

Those investors having a larger appetite for risk may be willing to invest without a long-term contact, but in order to do so, these higher-risk investors would also expect higher returns on their investment and would need to see forward pricing fundamentals/signals that suggest that those higher returns are forthcoming.

In recent times, however, the low price of natural gas has depressed the forward market for power and, as a result (with limited exceptions), those higher-risk investors have yet to see sufficient potential returns at the level required to start construction.

Moreover, even if such investors are persuaded that their equity investment is warranted, in most instances, project debt will also be needed to finance construction.

As lenders tend to be risk-averse, securing financing for uncontracted projects is likely to be a challenge in the current debt markets.

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