Weather and climate change highlight challenges of deregulated retail energy markets

REUTERS/Adrees Latif

September 3, 2021 - Historically, heavily regulated public utilities have had a monopoly on providing retail electric service. But over the past 20 years or so, many states have (to varying extent) deregulated their retail electric service, allowing electric customers to choose their electricity provider.

Retail customers in deregulated markets usually have the ability to choose between the rate-regulated public utility and various alternative (un-regulated) providers. A public utility can also serve as a provider of last resort, if a customer's chosen option ceases to provide service. States with deregulated retail electric service include California, Connecticut, the District of Columbia, Delaware, Illinois, Massachusetts, Maryland, Maine, Michigan, Montana, New Hampshire, New Jersey, New York, Ohio, Pennsylvania, Rhode Island, and Texas.

Deregulation is often presented to ratepayers and voters as a way of lowering electric rates, on the expectation that more competition will lead to lower rates. When California deregulated its energy sector in 1998, lower rates were touted as a key feature of deregulation, and California actually imposed rate caps on its investor-owned utilities as part of its deregulation effort. Similarly, in 1999, when Texas was considering legislation to deregulate its retail electricity sector, proponents of the legislation argued that with Texas's abundant energy supply, lower rates would inevitably result from deregulation.

There is a certain feeling of inevitability of lower electric rates based simply on supply and demand, and to a large extent this has proven correct — there are many alternative providers with electricity rates lower than the rates offered by the regulated utilities.

The problem arises when we consider what it means for rates to be "lower." Retail electricity rates are not static. They can vary based on a number of factors, including — most relevantly — wholesale electricity prices and fuel prices. And while utility retail electricity rates generally do not immediately reflect the cost of wholesale electricity or fuel, retail electricity rates from alternative providers often do.

As a result, retail rates from alternative providers are often far more volatile than those from regulated utilities. This is not a surprise or a flaw — rather it is a feature inherent to the entire structure. The very nature and purpose of deregulation is to free alternative providers from the pricing restrictions imposed on regulated utilities.

What that means in practical terms is that rates from alternative providers are lower than utility rates under normal circumstances, at least some of the time. But while lower rates may be achievable when there is an abundant supply of electric generation capacity, what happens when there are shortfalls of generation capacity?

These shortfalls can result from a variety of challenges, including the development of generation capacity being unable to keep up with load growth (permitting and development of a new combined-cycle gas plant can take years), or more temporary shortfalls due to weather (as we saw in Texas this winter, and in California during recent summer extreme heat events), or major disasters such as wildfires or hurricanes.

The impacts of climate change on weather will also continue to have significant impacts — climate change has put California at increasing risk of extreme heat events (increasing load to cooling requirements), drought (which has reduced available hydroelectric generation in California by about 1,000 MW), and wildfires (which has inhibited electricity imports into California due to fire threats to transmission lines and caused impacts to solar generation due to smoke).

Rate impacts due to electric capacity shortfalls have recently created challenges for both state public utility regulators and legislatures. Generation capacity shortfalls push wholesale prices higher, which in turn impact retail rates in a deregulated market. Though this is how markets are supposed to function, ratepayers have typically been told that deregulation will lead to lower rates, leading to significant pressure being put on state legislatures and public utility regulators to address high rates (one California governor was recalled during the 2000-2001 energy crisis, and a recall election threatens California's current governor).

The effects of these challenges have recently played out in public in both California and Texas.

When California deregulated in 1998, it created "direct access," where retail customers could choose to purchase their electricity from competitive non-utility suppliers called "energy service providers" or ESPs, or the utility (the utility continued to supply the "wires" — transmission and distribution service).

When the California energy crisis hit in 2000-2001, the California Public Utilities Commission capped direct access, due to concerns that customers would flee to ESPs to avoid paying cost the utilities were incurring to procure additional capacity to address the energy crisis.

In 2018, the California Legislature passed Senate Bill 237, which directed the California Public Utilities Commission to immediately expand the cap on direct access, and to provide recommendations on a schedule for removing the cap for nonresidential direct access customers.

On June 29, 2021, the Commission issued its recommendations in Decision (D.) 21-06-033. Expressing concerns about reliability in a fragmented retail market, and about "individual load serving entities los[ing] load due to load migration and [being] unable to enter into long-term commitments for new generation", the Commission recommended that direct access not be expanded at this time. The Commission also cited the price spikes and outages in Texas as an example of what could happen in a fully deregulated market. An application of that decision by a number of ESPs is currently pending at the Commission in Rulemaking (R.) 19-03-009.

Texas itself is also dealing with the impact of the February 2021 winter storms which resulted in outages across Texas, and severe price spikes. Texas retail customers may choose to obtain electric service from Texas's five electric public utilities, at fixed and regulated prices. Or customers may choose to obtain service from an unregulated retail provider. When wholesale prices skyrocketed to $9,000 a megawatt-hour for five days in February, many customers who had market-based contracts with unregulated retail providers saw their bills increase dramatically.

One of Texas's large retail providers, Griddy Energy, actually encouraged customers to switch to other providers to avoid price spikes caused by the cold weather, consistent with the fears of California regulators about customers switching to avoid high unregulated prices. Griddy's customers were then all transitioned to other providers when ERCOT (Electric Reliability Council of Texas) revoked Griddy's right to operate when it failed to make timely payments in the wake of the price spikes.

In June, the Texas Legislature adopted several measures in an attempt to ensure that Texas's electric system is better prepared for extreme weather, and those measures were signed by Governor Abbott on June 8, 2021. However, Texas did not radically change the structure of its retail electricity markets.

As climate change exacerbates electric load volatility, and also impacts access to generation resources, including gas (Texas cold snap), hydro (California drought), solar and imports (California wildfires), states with partially or fully deregulated energy structures will be increasingly challenged to balance the advantages of a deregulated retail energy market with the risks of increasing price volatility, and the inclination to assert command and control type regulation over the development of additional capacity resources.

What is clear from these events is that while deregulation can result in savings for ratepayers, deregulation also exposes ratepayers to volatility risk. In some cases, this volatility risk can be extreme. We question whether it is in the best interest of the grid (and society at large) for ratepayers (at least some ratepayers) to be exposed to the risk of financial ruin due to fuel price volatility. We are not opposed to deregulation, but we do not believe that it is in anybody's best interests for residential customers to be forced into bankruptcy immediately following a natural disaster due to a spike in electricity prices. Compromises are possible between locked-in utility rates and a complete pass-through of wholesale price risk.

We also note that when discussing deregulation, the emphasis is always on price reduction. The average retail energy consumer is not knowledgeable in the workings of the energy markets — nor would we expect them to be — and has no way of understanding the nature of the volatility risk they are accepting by switching to an unregulated rate structure. It would benefit everyone to make sure that consumers are properly and fully informed.

We like deregulated energy markets. But we also believe that legislatures and regulators could do more to protect the ratepayers in a deregulated market, even while allowing the benefits of competition to reduce costs for everyone.

Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias. Westlaw Today is owned by Thomson Reuters and operates independently of Reuters News.

Seth Hilton is a partner at Stoel Rives LLP where his practice focuses on the California energy sector, representing clients before California's energy regulatory agencies including the California Public Utilities Commission and California Energy Commission, as well as in stakeholder proceedings at the California Independent System Operator. He is based in the San Francisco office and can be reached at seth.hilton@stoel.com.

Morten Lund is a partner in Stoel Rives' San Diego office. He is the current chair of the Energy Storage Initiative and former chair of the Solar Energy Initiative and can be reached at morten.lund@stoel.com.