Texas is freezing. An Arctic cold front has invaded the American Midwest, culminating in the very rare snow in the normally warm, dry state of Texas. Millions of homes are experiencing power shortages and rolling blackouts. Many of my friends in Texas have been telling me their horror stories under thick wool blankets.

Political pundits have taken to social media and the news, quick to point fingers. This is not what this interlude is about. I will leave the political analysis to the people who do that for a living. Instead, I will bring up some of their arguments and seek to examine why Texas is freezing from an economic perspective.

Texas is freezing because of deregulation.

This is probably right, but it's not helpful to our analysis. Why did deregulation cause Texan grids to fail? Other states have deregulated their power grids, and they're not all freezing. Utilities companies are comparatively more regulated compared to other types of companies.

This analysis is not wrong, but it is insufficient. There is more to a disaster caused by economic conditions than "well, they shouldn't have deregulated," just as there was more to the Great Depression than "well, the stock market crashed."

Texas is freezing because the wind turbines have frozen over.

Not exactly. The second half of this statement is factually correct. Many wind turbines in Texas were not designed to handle these low temperatures, and about half of them have indeed ceased operations. They need a thorough de-icing to resolve the issues they're experiencing.

However, this isn't some shocking betrayal from the wind-turbine industry. This has been expected for weeks. Wind power generation in Texas is actually above projections at this moment. The power suppliers in Texas have been correctly predicting low wind output, and wind power is less than a tenth of power expected to be generated in winter. Shutting down all the wind power in Texas should not cause blackouts and brownouts for multiple days because utilities should have been prepared for such an event.

But why were they not prepared?

Texas is freezing because of climate change, and if only people would stop denying the issue…

Very true. This explains why this probably won't be the last time Texas faces this issue.

It is a larger problem though, one that explains a lot of extreme weather patterns that are about to incur a higher cost on doing business all over the world. If someone is looking for a "how do we really root out this problem", this is your answer.

However, it does not explain the immediate reason for why the short run supply of electricity in Texas is facing widespread shortage.

Snowing in Texas is rare. This won't happen again.

Oh no.

Are you in charge of ERCOT?

I hope not.

So what's the actual economic reason why Texas is freezing?

This is a problem with market incentives.

Let's start from the top. Deregulation. In the 1990s, American power grids deregulated on a state-by-state level. The Northeast is deregulated too, but they haven't faced these kinds of shortages except in very rare and localized events. Ohio, Illinois, Oregon… etc are all deregulated. Many states have deregulated electricity.

What does this mean?

Normally, market deregulation refers to corporations having less rules and being allowed to operate with less government oversight. Like a construction site no longer requiring workers to wear hardhats. Or a meat packing plant having less food safety inspections.

Electric grid deregulation doesn't mean quite the same thing.

Electric deregulation means that your highly regulated utility company is still in charge of providing you power through the power lines, but the entities that actually make the power can be less regulated private companies that ideally compete for lower prices. This saved states and customers a lot of money in the 90s, and the trend continued until Enron, a Texas power company, failed.

The wires and poles that go to your house are still highly regulated. The utility company is still restricted on how much money they can make from their customers; they're a non-profit. The big difference is who is in charge of generating electricity: in a regulated energy market, this would be the utility company, and in a deregulated energy market, this would be private power plants.

In Texas, like many other states, they've opted to deregulate their energy market.

Regulation of the energy market is not dark magic. Louisiana and Mississippi are two states right next to Texas with regulated energy markets. They, too, are experiencing outages. Nowhere near as bad as Texas, but market failures occur due to bad incentives regardless of who owns the power structure.

Let's go even deeper into why Texas is facing the worst problem right now: bad market incentives.

What are the bad incentives?

The cost of electricity is actually many things: the actual electricity being provided to you, the delivery to your home, the maintenance of the infrastructure, energy credits and benefits by the government… etc.

What is really relevant here are two big items: the price of energy commodity, and capacity. Energy commodity is the cost of generating the electricity, aka the power plants' costs. The capacity is the overhead that the utility company incurs because power companies can't just generate exactly the right amount of electricity for everyone; they must make more than what everyone is using.

Many states pay power plants to provide additional capacity that they can use in an emergency.

In Texas, unlike many other states, they did not do this. Instead, they pay an increased rate to operators as the demand increases in real time. Overall, this does come out to a little cheaper, and it is one possible solution to the problem. It should theoretically make power plants create additional energy to pad Texas's needs.

So why is it failing?

Energy supply is inelastic. This means that it takes a while to build power plants to actually give you power. ERCOT's (Texas's utility manager) increased rate is supposed to make private companies want to build capacity, but this has turned out to be a lie.

Wind farms have become very profitable. Solar farms have become very profitable. After all, green energy costs have come down now, and they make back their initial investment costs very quickly and reliably. Adding a new wind turbine to the grid is a no-brainer if you're an alternative energy investor.

On the other hand, not so much for gas generators. Without dipping into creative accounting and providing the additional services they do, during non-summer months and off-peak hours, gas power operators are hemorrhaging money despite the current low global cost of actual petroleum.

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The market responded to these incentives. Since 2019, more than 95% of new power generation in ERCOT is renewables. ERCOT's job is to make sure that power costs remain low, and these new green energy generators do increase overall grid power, so it would appear that they are technically doing their jobs.

However, the lack of a real long-term incentive for reliable electricity sources means that the actual baseline power generation in the state has been chipped away in favor of intermittent sources.

Many praised them for this extraordinary move to alternative energy, but ignored the fact that their gas and natural gas generation infrastructure were falling stagnant. What they should have done was upgrade their baseline capacity along with investments into green energy.

Winterization?

This buzzword is being thrown around.

During the 2011 Groundhog Day Blizzard, the regulated New Mexican energy markets found itself unprepared for the cold weather. Power outages became rampant and a state of emergency had to be declared. They've since invested millions into winterizing their power generation equipment, which is why the border city of El Paso is doing relatively well.

Given that Texas has never had this issue bite them hard before, it seems unreasonable to assume they would have winterized their old power plants had ERCOT been in charge of their own power plants instead of individual operators.

Aren't power plants paid more during peak hours when demand is high and intermittent solar/wind power are offline?

Yes, they are. However, since these demand periods aren't actually predictable, expensive baseline operators like gas generators have opted to only work during the summer, or to keep only to the bare minimum level of operations to reduce cost and stay in business.

One of the measures they've taken to do this is to keep the least amount of fuel on site possible in non-summer seasons.

What actually happened:?

When the cold front came, wind turbines froze. This was expected.

Then, wellheads for natural gas froze. Natural gas extraction has plummeted over the last couple of weeks.

This should be fine, right? Texas is an oil and gas state. It has a lot of oil and gas.

Oil and natural gas generators tried to make up for the demand as prices skyrocketed. It unexpectedly became very profitable to generate electricity using fossil fuels, but these power plants quickly ran out of fuel on-site. They couldn't find enough fuel to keep their gas generators going, and as I write this, Texas's oil refineries and wells are shut down… because they're freezing too.

Gas prices have risen for six weeks, and they are looking at a possible 20 cent jump in Texas. Across the US, gas prices are expected to rise as well. Those operators expect to need a couple of weeks to get back to normal.

ERCOT has just been authorized to up the limit on how much they are willing to pay to $9,000 for each megawatt of energy right now. This is up to 50 times the normal price for natural gas. Every power plant that is currently offline is losing out on millions of dollars every hour they are not in operation. This shows how dire the situation is on the supply end; there is simply no more oil or gas available to burn.

Texas is freezing because they ran out of oil and gas.

What about nuclear power?

Nuclear power is the ultimate in baseline generation. They'll give you power even if you don't want more.

However, as stated above, Texas's electricity pricing structure absolutely hates this. It rewards generating energy, but not a steady supply of it. That's why very little of Texas's power comes from nuclear energy. This will probably not change in the short term given how long it takes to build nuclear plants.

What about the Texas Interconnection? Isn't this only happening because they aren't connected to other states?

Texas maintains its own power grid, called the Texas Interconnection. This is a political, rather than technical, separation. Texas is still tied to the Eastern, Western, and Mexican power grids. This separation is less relevant in an emergency.

In fact, in California, the utility manager CAISO has asked its customers to voluntarily conserve power during peak hours because that excess power is being sent to help offload stress on Midwest and Texan grids. Unfortunately, power over long distances is inefficient, which is why we can't just have a massive solar farm in Arizona power the entire USA. These power plants have to be built locally.

Texas has over 30 GW of unfilled demand. This isn't a problem that can be solved from its neighbors or California.

So what now?

Well, there are likely going to be a few rule changes going forward.

First, the short-term fix is that oil and gas power generation operators are probably going to be asked very politely by the residents of Texas to keep additional fuel supplies on hand for this kind of emergency in the future. That won't solve the underlying problem, but it might give them a bit more of a warning next time.

Electricity prices will rise for Texans.

There will probably be some kind of change to the electricity demand pricing to pay out higher for peak hours, but also probably not enough to really improve grid capacity. Combined-cycle gas generators are not cheap. And ERCOT's pricing structure is not set up to incentivize a higher baseline generation at all.

Logically, unless they make drastic, politically unlikely changes, what happened this weekend will probably happen again, either this summer or the next time they see another one of these winter storms. If my impression of what the climate scientists are saying is correct, that is supposed to be a more common occurrence from now on, which doesn't bode well for the stability of the Texans' power supply.

So, this means that replacing fossil fuel energy with alternatives is bad?

No.

Not at all. Other states have managed this replacement without leaving their baseline capacity hollowed out. States like California.

Hold on a second, isn't this the same thing that happened to California last summer?

No.

Why not? CA had rolling blackouts too.

Totally different situation. California's energy issues had two causes.

One, in the fall of 2019 and 2020, Northern Californians' favorite (and only) energy provider PG&E deliberately shut down the state's power in batches because of fire risk. Back in 2018, one of their old exposed power lines started a forest fire that burnt down half the state. That's one of the things that happen if you don't constantly maintain infrastructure. The dry forest is the result of climate change and outdated forest mismanagement techniques, but that's another topic.

PG&E was successfully sued for a lot of money from all the people who lost their houses and businesses. They went bankrupt, again. They pleaded their case to a federal judge, who basically told them, "hey, if you can't make sure to not burn down the state while you're doing the job, then maybe you're in the wrong business."

They took that literally and just decided to shut down power for everyone. It would cost them about $15,000 per customer to begin to address the issue so clearly not something they are planning to do in the short term. A disaster, but not a short-term economic incentives issue.

Two, in August 2020, CAISO did a very similar thing to Texas in that they did not have enough power to supply the energy grid, but the similarities ended there. California has more than enough power generation and capacity available, but the operators made mistakes and overestimated how much power they would be able to have on that particular week.

They thought they could leverage Demand Response resources to lower their load. These are factories, ports, malls… etc that they can basically pay to use less power on demand in return for some free power. Unfortunately, due to the pandemic quarantines, very few of them were operating at full capacity at the time, so there wasn't much power usage to lower.

CAISO looked towards the hydro generators. Which were not generating as much power as they normally should be because the state was in a drought.

CAISO then thought maybe they could ask the other West Coast states to sell them power. In the middle of summer. When the other states were also running into record temperatures and power usage. As explained earlier, this wasn't a problem that could be solved from Texas either.

When they saw this, they overreacted. They ordered utilities to cut power to customers, despite having significant power reserves remaining.

Texas's issue is due to bad economic incentives regarding baseline demand. California had no such problems. It incentivizes a diverse range of power generation and has more than enough capacity to generate all the power it needs, as long as it correctly predicts how much power it needs.

CAISO merely failed to correctly model the power they needed during one bad week. They've since fixed the problem by raising caps on energy import prices from other states, and this probably won't happen again. The PG&E issue probably will though, which is why I now have a portable generator lying around in my basement…

Anyway, this was hopefully a short and easily understandable introduction to why there is insufficient power in Texas right now. It explains how you can run out of oil for energy generation in a state that is known for making and exporting oil.

It also further reinforces one of the themes in the story, which is how bad incentives can really screw things up in the market, regardless of good intentions. It explains how an oil state can run out of oil and why countries that export food can run out of food.

For all my friends and readers in Texas, I hope you can stay safe and stay warm over the next couple of days/weeks as power comes back online!