I recently read the excellent book Shorting The Grid: The Hidden Fragility of Our Grid by Meredith Angwin. Angwin's book strives to answer the question: why can't some American cities keep the lights on? In the general sense, the answer involves complicated interactions between energy policy, markets, and regulations that have made our grid more fragile to supply shocks. The book is well worth reading in full to deepen your understanding of energy policy, but this post explores just one aspect of energy policy Angwin discusses: the experience of Regional Transmission Organizations (RTOs) and Independent System Operators (ISOs) during a supply shock.

How RTOs and ISOs differ from traditional power utilities

In April 1996, the Federal Energy Regulatory Commission (FERC) issued Order No. 888, which deregulated the wholesale bulk-power marketplace by allowing for the creation of Independent System Operators and non-discriminatory access to transmission. In December 1999, FERC issued Order No. 2000 with the goal of improving grid reliability and reducing price volatility in regions that had adopted the more market-based ISO structure. This order allowed for the creation of RTOs, which tend to be larger than ISOs. The commission believed that these regulatory reforms would lead to greater innovation and lower energy prices for ratepayers, similar to the successful deregulation of the airline and telecommunications industries in the preceding decades.

Most states still operate in markets with vertically integrated energy utilities which directly control or own the transmission and generation of power. That is, many Americans pay an electric company that both generates, dispatches, and transmits electricity. RTOs are sometimes called “deregulated utilities.” They coordinate the demand, supply, and transmission of energy on the grid in their respective territories. (Angwin refers to them as “RTO areas” rather than “deregulated utilities” because they often are subject to more regulation than integrated utilities in practice. I follow her convention.) California, Texas, and New England’s grids are all managed using the ISO/RTO model.

RTOs are prohibited from owning the power plants or transmission lines. They are only responsible for scheduling and managing how electricity will flow to ensure the grid remains balanced, managing the wholesale electricity auctions and providing settlements for buyers and sellers, and helping plan for grid reliability. In RTO areas, the distribution utilities purchase the power from the generators via auctions, and ratepayers are billed by the distribution utility or reseller they have contracted with.

In an integrated utility, there are independent merchant energy generators that build and operate the power plants. However, the utility is a monopoly and there is no competition. An integrated utility compensates the merchant generators as a function of their ‘annual revenue requirement.’ They receive a guaranteed rate of return on their rate base (non-depreciated capital investment) and receive payments to cover depreciation, operating expenses, and taxes. These merchant generators must receive approval from a state regulatory agency–usually a public utilities commission–for any new projects which would be added to their rate base.

An RTO, on the other hand, will host recurring, short-term auctions between merchant generators as its mechanism to ensure there’s sufficient energy to meet the grid’s demand at that moment. Any merchant generator can bid into the auction, they do not need to receive approval from the RTO to build their plant and they are not guaranteed a return on investment. Since there is no competition for transmission, the firms which own that infrastructure are compensated through a guaranteed rate of return, similar to merchant generators in an integrated utility.

Wholesale energy markets during supply shocks: Texas 2021

Each RTO area and ISO operates under its own rules and relevant state regulations as well as common FERC requirements, so the experience for merchant generators may be significantly different when selling power in the area operated by the California ISO (CAISO) versus the Electric Reliability Council of Texas (ERCOT). For example, in order to help ensure grid reliability while navigating various regulations, certain RTO areas have needed to institute additional auctions that have significantly affected market dynamics.

In an RTO’s auction, each of the winning producers is paid at the market-clearing price, regardless of their bid. In many cases, their bids are essentially regulated and are meant to reflect the marginal cost of producing the electricity. In highly competitive RTOs, there are only significant profits to be made from selling electricity when demand outstrips supply during a supply shock.

For example, total electricity costs in Texas on February 16th, 2021–during the ice storm that rocked the state–were $10.3 billion. To put that number in perspective, Texas spent $9.8 billion on electricity in all of 2020, according to Texas Monthly. During these shocks, the RTO permits much higher bids to prevent rolling blackouts or catastrophic damage to the grid. The supply of energy on the grid must always meet the demand in perfect balance, otherwise, the frequency of the grid, 60 Hertz, will increase or decrease and trigger emergency breakers—with subsequent rolling blackouts—or potentially cause damage to critical infrastructure. Unfortunately, this surge pricing was insufficient to prevent rolling blackouts in Texas but it did enable the state to avoid a total collapse of its grid.

We need a reliable and affordable electric grid

Needless to say, policymakers must ensure the 2021 Texas catastrophe does not happen again. The problem is not with RTOs per se, but we need to make significant changes to the current market structures and regulations to ensure we have a grid that is reliable and affordable. In future posts, I will dive deeper into these dynamics and the resulting issues and fragilities in RTO areas.