Chances are Texas homes and businesses will increasingly hear the term “scarcity pricing” as concern grows about potential electricity price spikes this summer and into the far future years of 2022-2030.

Company decision-makers should understand how scarcity pricing dynamics influence their energy contracts – especially if they are reviewing their energy position now, as experts advise, in preparation for what could be a wild ride.

Here’s a brief tutorial on scarcity pricing as set by the Electric Reliability Council of Texas (ERCOT), which oversees the Texas wholesale power market.

Scarcity pricing is an economic term that refers to the price escalation that occurs when supply becomes tight in a commodity market. As demand edges close to supply limits, prices rise, reflecting the growing scarcity.

Potential exists for scarcity pricing in the ERCOT market this summer due to a combination of strong growth in electric consumption, the retirement of 8,700 MW of power plants and the lack of new generation entering the market. As a result, ERCOT predicts a historically low reserve margin, which is the cushion of power-generating capacity available when electricity demand is at its highest.

High prices are typically caused in two ways. First, prices can rise when demand increases and less efficient (i.e. more expensive) generation is needed to satisfy demand.  The cost of generation increases dramatically when demand is very high and the least efficient generation in ERCOT is called upon.  The price cap for the cost of generation (the highest price a generator can charge for electricity) has increased over the years from $3,000/MWh in 2011 to $9,000/MWh today. The chart below from ERCOT shows the history of price cap increases.

During periods of very high demand early this summer in June 2021, we saw the cost of generation at or near this price cap. This is the first way we can see scarcity pricing.

The second way we can see high prices this summer is through a pricing mechanism called the Operating Reserve Demand Curve (ORDC), which ERCOT put in place to ensure electricity prices accurately reflect shortage conditions. Instituted in 2014, the ORDC automatically increases the price of power as reserves get tighter. The ORDC adder activates when operating reserves decrease below 6,000 MW and continue to decline, with the maximum price adder applied when reserves drop to 2,000 MW.