[BETA] Fortnightly

Developers of new capacity may find that the plant retirements they're counting on are further off than expected.

Strong economic growth , an abundance of older, inefficient power plants, strategic access to gas supplies, and a relatively isolated electricity market have attracted scores of developers to Texas. In 1999, the reserve margin in Texas shrank to 9.5 percent. However, more than 10,000 megawatts of capacity is under construction in the state, totaling a 16 percent increase in supply. Financing has closed or purchase power agreements have been secured for another 2,000 MW.

RDI projects that a 16 percent increase in supply could cause electricity prices to fall to as low as 2.1 cents per kilowatt-hour. If no existing supply is retired, electricity prices could remain below the cost of new entry for more than five years.

One factor that could shorten the period that prices remain low is demand growth. Our analysis assumes annualized growth of 2.2 percent, but recent growth has been closer to 3.3 percent. However, to RDI, the critical factor that remains to be seen is the response of generators to low electricity prices. Specifically, will generators mothball existing higher-cost generation?

RDI's analysis indicates that 30,000 MW of less-efficient generation in Texas likely will suffer cash losses if no capacity is closed. Many of these plants could avoid losses by substantially reducing operating costs. To the extent that costs can be reduced, retirements certainly will be diminished.

A more important factor influencing retirements is market fragmentation. Texas is becoming more fragmented as new generation enters the market. The top two companies control 50 percent of the capacity in the market. By next year, they are expected to control only 40 percent. Also by next year, six new companies each will have developed more than 1,000 MW of new capacity.

Increased fragmentation reduces incentives to retire capacity. In a concentrated market, a company that retires capacity tends to have more capacity in the market that will benefit from resulting price increases. Also, in a fragmented market, companies tend to resist closing capacity because the closure may benefit their competitors. Instead, one company waits for other companies in the market to reduce their capacity, especially if the company believes price recovery is just around the corner.

One final factor influencing retirements is the financial consequence of closure. If a company mothballs or closes a plant, it may be forced to take an impairment on assets. If a company has recently financed or refinanced assets, it may not have the stomach to take such an impairment.

In Texas, increased fragmentation and the potential for cost reductions likely will result in fewer retirements than some developers may anticipate. That could prolong the financial pain of new market entrants, but it may provide lessons that discipline development in other regions.

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