Tuesday, April 11, 2017


The EU has launched an investigation into German plans to create a strategic electricity reserve, exploring if the measures amount to illegal state-aid that will distort competition in the electricity market. (FT, 7 April 2017)

Prima facie this episode represents a failure to understand, let alone resolve, a fundamental dilemma of electricity wholesale markets.  This is a failure that potentially has quite profound implications for the ways in which European reliability standards and security of supply are defined, and for effective governance of the sector. The UK, originally a prime mover in liberalised markets and operating regimes that replaced the old style world of command and control, may think it is immune from these problems in the post-Brexit world. If so it is mistaken[1]. Pressures to remain part of some form of the single market will be intense.  

EU competition economists continue to misunderstand some of the fundamentals of efficient electricity markets. Most European markets are already, from the perspective of a free market purist, compromised by numerous policy interventions. From the perspective of theorists of the second best, they are also compromised by the inadequacies of EU efforts to introduce carbon trading regimes that produce a carbon price reflective of the true externalities associated with climate change. While low carbon policy is stuck firmly in the world of the second best, you no longer need to be a Nobel prize-winning economist[2] to appreciate that, in this sector at least, competition policy should be fighting an uphill battle to be taken seriously. This is certainly true from a perspective of maximising public and private good. (Politically the priorities are sometimes different of course.)

But the issue of energy-only markets is, in the context of electricity, even more fundamental. It is a simple to state but quite subtle problem. The efficient operation of energy markets has always been posited on the concept of a merit order of generating plant ranked in order of fuel costs (and in principle other short term variable costs of operation). The most expensive plant required to operate sets a “system marginal cost” and this is the basis for a wholesale market price.

Unfortunately this is a wholesale price that is intrinsically incapable of supporting investment in, or continued maintenance of, sufficient generating capacity to meet peak demands. To demonstrate this one has only to ask what reward be earned by a plant that operates only at peak, and, when it operates, is rewarded only by its own short run marginal cost. There is no reward for this plant, and indeed reliance only on system marginal cost pricing would ensure that all capacity was likely to be under-rewarded to some degree. A preponderance of low carbon plant (eg wind or nuclear), with low, zero or negative marginal cost in operation, will ensure that this issue – “paying for capacity” - is accentuated.

Two types of resolution can be proposed for this problem. The first is a “market” solution that relies on scarcity or supply shortages to raise prices to a sufficient degree to ration demand, and for sufficiently long to induce new investment. This is a “purist” solution that has, unsurprisingly, generally proved unacceptable to regulators and governments. It assumes generators will be “allowed” to make substantial excess profits over long periods (to compensate for the long spells of surplus capacity and ultra-low prices).

The alternative is to instigate some form of capacity market. However this necessarily represents some form of central intervention. Inter alia, within a system of capacity auctions, someone has to decide how much capacity is required, and this in turn requires a view on what is an acceptable standard of generation security and reliability of supply. While we might imagine [3], and possibly even create, a world where the reliability of the power supply is left entirely to the market, that is not the world we currently inhabit. The German government is quite sensibly taking steps to remedy some very clear deficiencies in the electricity market and to protect its own consumers and industries (and voters).

At the same time it is impossible to imagine, given the interconnections of the German power networks, that an intervention of this kind can take place without having significant effects on wider EU markets. The idea that a strategic reserve can be insulated from the market, or “held outside the market” is intrinsically unconvincing. If used it necessarily impacts prices during the periods of shortage on which investors are relying to recover their capital costs.

We can see instantly why devotees of the single market in energy have objected to the idea of capacity markets. Capacity markets raise immediately the question of who should be responsible for setting the security standard. The standard must surely be common across the whole market to avoid distortions, but who is to set the standard – Brussels or Berlin? Brussels, one suspects, is not yet ready to answer this question. It prefers instead to cling to the illusion that an energy only market can actually deliver reliable secure supplies across Europe without introducing market volatility and price instabilities.

The UK has its own conflicts to resolve in terms of getting markets to work efficiently in support of energy and policy objectives. But interconnection and other trade issues will ensure it is, even post Brexit, unlikely to be immune from the effects of security and market issues within the EU.

[1] A recent BIEE seminar addressed this subject, identifying the numerous questions that arise for the UK over continued participation in the emissions trading scheme and a range of interconnection agreements.

[2] We are however indebted to Nobel prize winners for pointing out what may now seem, to some of us at least, simple truths. The subject deserves a much longer posting, but a very quick summary of its flavour can be gained from reading a recent issue of Prospect magazine, and an interview with Nobel laureate Joseph Stiglitz.

Another recognised glitch in the elegant mathematical proofs of the wisdom of the invisible hand was known as “the theory of the second best.” This qualifies the presumption for unfettered markets with the caveat that as soon as you’re dealing with an imperfect world, then there is no guarantee that taking away any single distortion will make things better, rather than worse. [Prospect Magazine. October 2016]

In other words enforcing a rigid competition policy doctrine in a market already massively compromised by the carbon externality, may make things worse. It can and does, as we have pointed out in earlier postings. See for example: EU EMISSIONS TRADING SCHEME AND EUROPE’S CLIMATE POLICY. A FLAGSHIP FLOUNDERING.

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