Commissioners on the Public Utility Commission of Texas (PUC) have made clear that the current wholesale electric price cap of $3,000 per megawatt-hour (MWh) will be increased, with the only remaining questions being how high, and how soon.

Last week at a PUC open meeting, all three commissioners expressed support for raising the price cap, with two of the commissioners suggesting that the cap should be raised to as high as $7,500/MWh. One proposal would raise the price cap in time for this summer, effective July 1, 2012.

As has previously noted, raising the price cap is being pursued as a solution to the generating capacity shortage facing the Texas electric grid, where supply is expected to barely meet demand this summer.

Why is raising the price cap seen as necessary?

Investors capable of developing new power plants in Texas are hesitant to build because any new capacity would have higher sunk, or fixed, costs than the largely depreciated assets that are currently on the grid. New power plants cannot typically include these sunk costs in their bids into the Texas wholesale electric market, because doing so would make their offers uncompetitive and price their power out of the market, since the cheapest bids (bids which only reflect lower, short-run marginal costs from fully depreciated assets) are dispatched first. In other words, the "merit order dispatch" of the Texas electric market -- which keeps electric rates low -- also reduces assurances that investors will be able to recoup the sunk costs of new power plants.

To recover sunk costs of new power plants, investors rely on scarcity pricing -- high wholesale prices produced when electric demand outstrips supply. These prices, which hit the market's price cap, exceed the marginal costs of most generation, and allow new power plants to earn a margin to recover their fixed or sunk costs. Currently, the wholesale price cap is $3,000/MWh.

However, there is no guarantee that the price cap will ever be hit in a particular year. Because it takes several years to build a power plant, by the time new plants are built, the capacity shortage which previously produced high prices may disappear, if competing generation developers build more power plants than needed, eliminating the prior capacity shortage. Investors fear an over-supply of new capacity which would prevent scarcity pricing from being triggered, and which would prevent them from recovering the sunk cots of new power plants.

While regulators cannot guarantee to investors that the wholesale energy price cap will be hit in the future, by raising the wholesale price cap the PUC is providing investors with a better chance of recovering their costs. With a higher price cap, if the price cap is only hit infrequently, the higher price level will allow generators to recover a greater amount of sunk costs during those infrequent times.

For example, if the price cap remained at $3,000, and investors only expected it to be triggered on five days in 2014 when their new plants come online, investors might calculate that revenues under the $3,000 price cap would be insufficient to recover fixed costs and insufficient to support the needed new power plants. However, if in 2014, the price cap were raised to $7,500, while still only expected to be triggered on five days, the higher revenues available under the $7,500 price cap on those five days might provide enough of an opportunity for investors to recover their sunk costs, and prompt investors take the risk in building new capacity in Texas.

Of course, raising the price cap will impact Texas electric customers. While few customers directly pay wholesale prices, the level of the price cap is reflected in retail electric rates, because it represents a risk to retail electric providers. Retail electric providers must either bear the costs under the price cap, or must buy insurance and other hedging instruments against the cap -- in either case, they incur costs which they will pass on to retail customers.

While we do not yet know at what level the new Texas electric price cap will be set, it is clear that Texas retail electric rates will be under pressure to increase. That's why it remains essential for customers to shop for a low electric rate, to shield themselves from any price hikes, especially if the PUC raises the price cap for this summer.