Tuesday, May 24, 2016


Europe is in an intellectual mess over several features of its energy and climate policies. This extends to a serious lack of comprehension of some of the most fundamental aspects of electricity economics.  Enthusiasts for competition and free market approaches to the power sector have a preference for what are called “energy only markets”. Unfortunately, and increasingly, these do not work. They do not act as a signal for sufficient investment, or, with non-fossil technologies, even as a useful signal to promote efficient operations. So nation states are increasingly turning to measures such as capacity markets to ensure secure supplies for their citizens. But the realities of national decision making on what is acceptable security further undermine the basis for an overly restrictive competition theorists’ concept of a single European market in electricity.

The European Commission on 13 April 2016 adopted an interim report of a sector inquiry into capacity mechanisms. Commissioner Margrethe Vestager, in charge of competition policy, said that:  "European consumers and companies should not have to face black-outs, and capacity mechanisms can help to reduce this risk. At the same time, consumers should not overpay for electricity and competition should not be undermined. The report published today shows that there is a lot of room for Member States to improve how they assess whether capacity mechanisms are needed, and how they design them. Mechanisms that are open to electricity providers across EU borders are key to building a true Energy Union in Europe."

In other words, energy-only markets are not working.  If they were, why would the market not ensure, as it does in most sectors of the economy, adequate supplies of what people need, when they need it?

Why energy only markets do not work.

A peculiarity of conventional wholesale electricity markets is that they are driven by the short run marginal (fuel and operating) costs of the marginal plant needed at any point in time, normally referred to as SRMC. But if prices are based on SRMC they cannot in normal circumstances provide an adequate reward that covers the full costs, including capital costs, of the capacity required for a secure system. This phenomenon has long been recognised as a fundamental feature of electricity economics.

This anomalous feature of the market can sometimes be masked during periods of technical change and strong fuel price differentials, of which one example was the period of very cheap gas combined with the growth of new combined cycle gas plant (CCGT). In these periods prices continue to be set by increasingly marginal high fuel cost generators, and new low fuel cost plant can earn large profits.  But such periods are exceptional.

What we are now seeing with the growth of renewables is an accentuation of this fundamental weakness in energy-only wholesale market mechanisms. With renewables, fuel costs are zero and as the share of renewables increases, joining other low carbon plant such as nuclear that also has a very low SRMC, the power system as a whole becomes increasingly subject to a zero wholesale price. Unsurprisingly this has led to fears of a capacity shortage and real threats to supply security.

Energy-only markets of this kind do of course have some advantages.  They are easy to grasp intellectually and they lend themselves naturally to a comparatively easy translation across borders. It is therefore not surprising that they should have been grasped with such enthusiasm by proponents of competition and the internal market, an enthusiasm captured tellingly in the above quote from the Commissioner. The increasingly evident distance from economic and financial realities is unfortunate.

Capacity markets are yet another remedy that constitutes a central intervention.

One market solution is to allow higher prices that reflect scarcity, and to choke off consumer demand rather than just depending on a SRMC mechanism.  This reliance on price spikes immediately hits political and regulatory problems, those implicit in the Commissioner’s statement that consumers “should not overpay”. An alternative was the UK approach adopted in 1990. The UK electricity market reforms, the model on which much of subsequent EU endeavour has been based, recognised the problem in the design of the new market structure. The new market rules set a penalty charge for failure to supply, constructed around a notional value of lost load (VOLL).

This was intended as a minimal intervention, and to mimic how a market might operate under conditions of capacity shortage, with the level of VOLL as the critical parameter in setting the security standard expected by consumers. It was a clever administrative device but suffered some of the same drawbacks as reliance on scarcity pricing. It was not well understood and provoked regulatory and political concerns, as well as accusations of market manipulation. At its best it remained an administrative intervention, supplementing a “pure” energy only market. However it demonstrated another important point very clearly, the fact that the issue of determining how much capacity the system should have is inextricably linked with the standard of generation security that is required. In other words it is a regulatory or political decision.

The market issue for capacity mechanisms is that they require some central authority, regulator or government, to conduct the auction, to decide how much capacity is needed, when and where it should be, how bids are to be compared and evaluated, how delivery is to be monitored, and also of course how the new capacity is going to be remunerated. In other words it draws the government into the role of a central purchaser and coordinator, acting over and above whatever else may be going on in the energy-only market.

Now is not the point to comment on the pros and cons of such a development. Clearly such interventions can be done competently or incompetently. The point at issue for the competition authority is that it is national governments that set the national standards of security with which they are comfortable.  But, in the context of an EU internal energy market based on energy-only principles, any decision on security and capacity by any one member state necessarily impacts on every other national market in the EU. Some of these impacts may be trivial, but if a country like Germany (say), close to the centre of gravity of Europe, opts to increase its security standard, it induces additional capacity. This will automatically tend to undermine the energy-only prices on which generators in other countries across the EU are relying.

To take this point to its logical conclusion, the competition and state intervention issues with which the Commission is wrestling cannot be resolved without a single central EU authority determining a common security standard across the EU. This is not going to happen any time soon. Moreover the capacity issue is far from being the only aspect of low carbon imperatives that will challenge the competition authorities.

1 comment:

Anonymous said...

I think you could emphasise one of the reasons scarcity pricing runs into trouble with regulation. De facto, and especially in relatively concentrated markets, it is impossible to say where normal market operation stops and abuse of a dominant position begins.