Cognitive Limits on the Value of Consumer Autonomy

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Cold weather spikes in Texas electricity prices reveal the risks of uninformed consumer choice in complex markets.

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The extreme winter weather that struck Texas in February had disastrous effects on the performance of the Texas electricity grid—and on the citizens who depend on that grid. The rolling blackouts that were implemented to avoid the complete collapse of the grid caused the loss of at least 49 lives and hundreds of billions of dollars in property damage. The disaster will provide the raw materials for studies that will help regulators learn many lessons about the right and wrong ways to regulate a market.

As teams of researchers gather and analyze the voluminous data that are relevant to understanding the crisis, they will learn much more about the mistakes in market design and the regulatory approach that contributed to the disaster, and the steps required to reduce the risk of a repeat disaster.

The best explanation of the disaster so far has been provided by Alexandra Klass, a professor at the University of Minnesota Law School who has studied the characteristics and performance of electricity markets for decades. Klass points to the need for additional, improved regulation to ensure utilities in Texas invest in measures to insulate infrastructure and prepare better for cold weather.

Another lesson is already apparent. Regulators placed too much faith in the ability of consumers to make intelligent choices among electricity options in a complicated market.

Every residential and commercial consumer of electricity was given a choice to purchase electricity either at a fixed price or at a variable price that was tied to the ever-changing price of electricity in the wholesale market that is operated by the Electric Reliability Council of Texas (ERCOT) and regulated by the Public Utility Commission of Texas (PUC).

Some consumers opted to purchase electricity under a variable price contract, undoubtedly because the price of electricity purchased under a variable price contract was often lower than the price charged under a fixed price contract. Other consumers, rather unconscionably, were actually switched into these rate plans automatically if they failed to renew their fixed price contracts.

A few days after the crisis began, consumers who received their electricity under a variable price contract discovered that they were harmed by the crisis in yet another way. They received bills of many thousands of dollars for just two or three days of intermittent electricity service. The retail price of electricity under variable price contracts increased by 7,400 percent during the crisis, from 12 cents per kilowatt-hour to nine dollars per kilowatt-hour.

In response, Texas Governor Greg Abbott directed the PUC to issue an order prohibiting enforcement of the variable price contracts for electricity provided during the crisis. If the courts uphold that order, the electricity firms that provide retail service under the variable price contracts may confront an immediate financial crisis.

The price of electricity in the Texas wholesale electricity market increased by 10,000 percent during the crisis, from $50 per megawatt-hour to the regulatory ceiling on the wholesale price of $9,000 per megawatt-hour. It is hard to imagine how those firms can survive if they must pay the wholesale market price but cannot recover that cost in the prices they charge at retail.

As Professor Klass has explained, the wholesale market in Texas differs from the wholesale markets in other parts of the country in an important way.

Other regional markets have separate markets for energy and for capacity. Firms that agree to provide capacity are paid to make generating capacity available at all times. As a result, they have a powerful incentive to make the significant investments needed to assure that they can meet their capacity commitments during periods in which weather increases demand for electricity—or creates conditions in which firms are unable to generate electricity unless they have winterized their equipment.

Without a capacity market, the only incentive to make those investments is attributable to the expectation that a supplier of electricity will be able to recover its investment by charging sky-high prices during times of shortage.

As the public uproar about the soaring cost of electricity and the governor’s response to that uproar demonstrate, firms that provide electricity in Texas cannot count on their ability to recover the cost of winterizing their generating equipment by charging high prices during times of shortage. Their decisions not to make the substantial investments required to winterize their generating equipment were understandable responses to the lack of reliable incentives to invest created by ERCOT and the PUC’s decisions not to create a separate market for capacity.

This market design decision created a wholesale market for electricity that is volatile in extreme circumstances. Electricity consumers in Texas could have avoided the unpleasant surprises they found in their electricity bills if they had chosen to receive service under a fixed price contract rather than a variable price contract.

But some decided to purchase electricity under variable price contracts. Although that decision was unwise in retrospect, it is easy to understand why they made that original choice. The price of electricity purchased under a variable rate contract is often lower than the price under a fixed rate contract.

It is unlikely that most residential and commercial consumers knew that ERCOT and the PUC had decided not to create a separate market for capacity. Even the few consumers who may have known about that unusual characteristic of the Texas market are unlikely to have understood the complicated relationship between the decision not to create a separate capacity market and the degree of price volatility that characterizes a wholesale electricity market.

Given consumers’ lack of prior knowledge, it is unfair and unrealistic to blame consumers for making poor decisions in this market environment.

The fault lies with the regulators who created a volatile wholesale electricity market with inadequate incentives for firms to invest in winterization, and then gave unwitting and unsophisticated consumers the option of purchasing electricity under variable price contracts in a market designed in ways that make extreme price volatility inevitable.

A simple lesson is apparent already as a result of the disastrous performance of the Texas electricity market. Regulators do not serve consumers well when they give them the freedom to choose among options in a complicated market that they are unlikely to understand. That lesson is generalizable to any complicated market.

I shudder in horror every time I watch Joe Namath’s commercial urging Medicare beneficiaries to shop for a Medicare Advantage plan in a market that is so complicated that only a handful of experts who study health care markets have any chance of understanding it.

Richard J. Pierce

Richard J. Pierce, Jr. is the Lyle T. Alverson Professor of Law at the George Washington University Law School.