February's "Big Freeze" winter storm exposed Texas energy market failures, racking up an unimaginable $52.6 billion in incremental electric system costs despite leaving residents short 1.6 million megawatt-hours of electricity – a deficit 1,000 times worse than California's August 2020 outages.

Research from Energy Innovation details the supply- and demand-side market failures responsible for this crisis, concluding that rather than abandoning markets, regulators and lawmakers should correct them through smart policy that bolsters readiness for future climate-driven disasters while facilitating grid decarbonization.

In theory, the Big Freeze price tag amounts to doubling electricity bills if spread over all customers in 2021. In practice, it will manifest through new bill provisions as utilities recover costs over time (which could mean an additional $2-15/month for the next 15-20 years), fewer choices in retail electricity providers (REPs) as several declare bankruptcy or are acquired, and higher insurance costs embedded in REP contracts. Without careful regulatory oversight, these elements could collectively raise the base cost of electricity, disproportionately increasing the energy burden on low-income households.

This price tag was not inevitable. Winterizing power plants or adding dual fuel capability, such as storing and burning oil when natural gas is unavailable, would have more than paid for themselves through revenues captured during the Big Freeze.

Weatherizing all Texas homes would also have been cheaper than the event's incremental electric system costs – even before accounting for physical damage like broken pipes and foregone economic activity, which together may reach $130 billion.

Either of these supply- and demand-side measures might have avoided outages altogether and saved lives. Yet, the prospect of capitalizing on revenue from, or avoiding the costs of, extraordinarily high power prices from the Big Freeze did not elicit the actions needed to prevent the ensuing crisis. The conclusion is clear: Texas energy markets failed in almost every way.

Supply-side market failures

Power plants in most regions can enter contracts or participate in markets that compensate them for committing to generate electricity when needed – an income stream that can represent upwards of 90% of some power plants' revenue. These so-called "capacity" arrangements help power system operators plan for long-term reliability and raise investor confidence in their power plants' viability.

The Electric Reliability Council of Texas (ERCOT), which manages the power markets serving most Texas customers, is unique in the United States, relying largely on its real-time energy market to incentivize long-term investment. When power plant availability is low, ERCOT boosts prices to reward those generators that are operating and incentivize others to come online. When conditions are particularly tight, the price adder skyrockets.

This design yields low profits in an oversupplied market, thereby avoiding the bloat of other regions that frequently overpay for power plants they don't need and keeping electric rates low for Texans. It also has historically kept enough generators in the market to maintain reliability, as those participants wager that periodic windfalls from supply scarcity events – typically hot summer days when demand is high – will be more than enough to cover capital and fixed operational costs.

However, the Big Freeze revealed a disconnect between theory and practice. Energy Innovation estimates that frozen wind turbines could have recovered the costs of winterization packages ten times over during this one event. The profit potential for natural gas-fired power plants was similarly enormous – even after netting out costs from winterization, dual fuel capability installation and unprecedented fuel prices.

Ultimately, the prospect of high prices wasn't enough to meaningfully affect the decisions that could have prevented outages. This may be due to an ignorance of these events' likelihood, uncertainty around the size of such a windfall, or a failure of imagination. Regardless, power plant investors' preference for near-term savings prevented them from capturing historic profits – and led to widespread suffering throughout Texas.

ERCOT and the Public Utility Commission of Texas are also collectively to blame for high power prices, setting them at their upper limit and then keeping them there well after they outlived their incentive function. Maximizing power prices could not bring more generators online due to fuel shortages and frozen equipment, and those power plants that were operating already received astronomical profits, forcing Texans to foot the bill for unnecessary generator payouts. Fortunately, Texas legislators recently passed a bill requiring ERCOT to develop a "circuit-breaker" to reduce prices after a sustained period at their upper limit, while ensuring power plants can later recover any particularly high fuel prices.

Demand-side market failures

Two residential sector decisions also might have avoided the need for outages during the Big Freeze. First, weatherizing homes and adopting energy efficient appliances would have allowed for the use of more services – like heating – for less energy input. Second, conserving energy when the grid is stressed would have reduced the need for power plants to generate electricity.

Energy Innovation estimates the entire housing stock of Texas could be weatherized for less than ERCOT's power price premiums paid out during the Big Freeze. This doesn't account for the additional benefits of weatherization – such as lower utility bills, greater comfort and better protection during outages by maintaining internal temperatures – or other costs from the Big Freeze like broken pipes.

Split incentives are often to blame for this market failure. For example, about 38% of Texans are renters. Renters might not stay in place long enough to capture the financial benefits of weatherizing their units or upgrading their appliances, which accrue over time. Landlords typically pass utility costs onto their renters and therefore similarly lack incentive to make energy-saving investments. Lower-income homeowners also may not be able to afford the upfront investment required for weatherization.

Separately, Texans may have been willing to lower their thermostats a few degrees during these few days to avoid paying the true cost of electricity, which rose several orders of magnitude. However, most homeowners and renters alike choose fixed rate electricity contracts, which protect against unpredictable monthly bills but give no financial incentive to conserve energy.

REPs typically profit from such contracts, buying cheaper energy from wholesale markets and reselling it at higher fixed rates. However, these contracts leave REPs exposed to exorbitant prices that bankrupted several during the Big Freeze.

Electricity contracts indexed to wholesale energy prices, paired with timely notice of when the grid is stressed, offer a solution that motivates highly cost-effective energy conservation and reduces REPs' risk exposure. However, such contracts must include price cap or bill insurance provisions that shield customers from unreasonable costs.

We should correct – not abandon – markets

While these cost-benefit estimations demonstrate that Texas energy markets failed, they are not meant to indict markets themselves. High power prices from ERCOT's markets prevented resources from voluntarily going dark, as natural gas power plants faced with extremely high fuel prices might have done. Markets thus helped narrowly avoid a full grid blackout that could have wreaked havoc and taken months to resolve.

More broadly, markets provide intelligence about complicated systems through price signals and developer choices. They also facilitate the entry of new, cheaper resources and the exit of inefficient ones.

Utilities that own and operate their own power plants – unchallenged in their territories as monopolies – can exist in bubbles, holding onto more expensive resources with which they are familiar, like coal. On the other hand, Texas energy markets quickly revealed the favorable economics of wind farms, with developers building more capacity than any other state.

With the U.S. needing to move rapidly toward clean energy to meet its emissions targets, markets' pace of change and the information they generate provide lessons for more regulated parts of the country. Thus, policymakers can and should enact guardrails that preserve markets while making them more effective.

Demand-side market corrections bring greater resiliency

Legislative debates have paid much attention to supply-side market corrections like mandating power plant winterization. While important, such actions have limited scope and won't protect against downed power lines, cybersecurity attacks and heat waves. Further, investments to bolster the resilience of natural gas infrastructure might not be needed in these assets' lifetimes and will have diminishing returns as the nation weans itself off the fuel.

In an increasingly unpredictable world, resilience measures applied closer to the end user become more valuable. Weatherized homes with efficient appliances and readily-communicated signals for conserving energy can provide cost-effective protection against any disaster affecting the grid. They also pay off absent any disaster through lower bills, greater comfort and reduced emissions.

Lawmakers must consider policies that address demand-side market failures to provide these benefits to all residents, prioritizing access for low-income communities and renters.

The final article in this series will continue with other lessons and solutions to achieve a resilient, low-carbon power system – such as expanding transmission links with neighboring regions, updating building codes and planning for managed grid failure.