PRICE CAPS. HYPOCRISY GOES INTO OVERDRIVE, BUT ARE WE WITNESSING THE DEATH OF NEO-LIBERAL PRINCIPLES FOR THE ENERGY SECTOR?

As we head at increasing speed for the policy train wreck of the forthcoming Brexit negotiations, the British political class (and MPs by an overwhelming majority) has chosen to divert our attention into one of the most pointless general elections of all time. This will inter alia call a temporary halt to the searching examination of false promises and expectations, and simple untruths,  that Hillary Benn’s House of Commons Select Committee on Leaving the European Union has been conducting. Readers not looking for the usual energy policy content of this blog may wish to read no further and refer instead to the Committee’s recent reports. These tend to be understated, but the material is there. In due course we will no doubt learn more about the effectiveness of EU exit in curbing immigration, boosts to our national income, the wonderful new trade deals on offer from Donald Trump, and much, much more.

POLICY TRAIN WRECK

However in the meantime the campaign will provide a useful opportunity for our leaders to hide from reality. Nevertheless connoisseurs of duplicity, smoke and mirrors, and hypocrisy, if not satiated by other aspects of the Brexit debate, can still find some rich material in campaign discussions on the subject of energy prices. The subject of energy price caps has come to the fore, just as it did before the 2015 election, with Ed Miliband’s promotion of the idea.

2015. RED ED'S POLITICS OF THE BANANA REPUBLIC. … like the pledge to cap energy prices, [these policies]  … merely serve to stoke up the politics of division. [Daily Mail].  “And despite the criticism of many experts, he remains committed to the principle of using State power to cap energy prices, with bills frozen by law until 2017, which strikes me as economically illiterate.” crowed another Mail columnist. BACK TO THE BAD OLD DAYS, the Daily Mail front page had screamed earlier in September 2013 on the same price cap issue. For the Spectator it had been MILIBAND'S LA-LA LURCH TO THE LEFT.

2017. But when the Mail reported earlier this month on Tory plans to take action on bills in the face of the latest rise by one of the big six energy companies, such statist intervention had become CRACKDOWN ON ENERGY RIP-OFFS. The Telegraph said prices would go up before Miliband’s freeze, while the Times and the Sun warned the “lurch to the left” risked blackouts. The Times’s editorial described his plan as “flawed in practically every detail”. [But] on Sunday, the Sunday Times welcomed May’s price cap as an “attempt to capture the political centre ground”. [Guardian]

The ironies in the contradictory treatment of the same policy when promoted by different factions are amusing. But actually there is a deeper significance to this volte face from the party of market fundamentalists.

As it happens I regard the use of price caps as misguided under most circumstances, now putting myself at odds with both Labour and Conservative. Obvious reasons are the risk that interventions confined to price will reduce supply and deter investment, and that it is better to address the disease (market failure) rather than the symptom. Nor do I entirely buy the view that the energy companies are making excess profits (see an earlier posting). But the endorsement by the Conservative party[1] of such a quintessentially statist, interventionist approach signals something more than simple electoral opportunism. It arguably represents the end of the road for the pretences of market liberalisation. This is certainly so in the UK, arguably the pioneer of deregulatory principles and their application.

Network costs, which can account for a third or more of a domestic consumer’s bill, have always been heavily regulated, even after privatisation in 1990. Generation investment is now almost entirely dictated by government, either directly through support for nuclear or renewables, or more indirectly through centrally controlled capacity auctions. The remaining element of the electricity supply chain, retail supply, has always been at best pseudo competitive, but that too is now being taken under the umbrella of government. What all this amounts to is the complete capitulation of the neo-liberal approach, at least in the energy sector.

It is surely time to recognise that this is a sector beset by market failure and that we need, not a series of ad hoc sticking plasters but a complete re-think of how we want the sector to operate and how we can better structure it to use the real dynamics that can come from competitive markets in driving efficiency and innovation. There is no point in pretending that we are still operating a laissez-faire competitive system, or that government can remove itself from the multiple policy choices and commitments that the sector, and particularly a low carbon power sector, will require.

There are further ironies and further opportunities for amusing speculation. The UK is not alone in wrestling with the paradoxes of the flawed neo-liberal paradigm. My last posting discussed a significant issue arising in a German and EU context. The EU followed the UK up the hill of unbundling and market solutions, but at least 15-20 years behind. The dawning realisation in the UK of the need to reverse direction and head downhill will shortly see it meeting an EU still struggling towards the summit.

But will this be an element in Brexit or future trade negotiations? And if we struggle to get back into the EU in (say) 2025 will be obliged to make further reverse policy changes to meet the EU energy sector and competition and state aid rules at that time. Or will the EU by then also have learned something from our experience as well as their own?

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[1] This is after all the party of the ayatollahs of free market fundamentalism such as Redwood, Lawson, Lilley et al.

ANOTHER CLASH BETWEEN EU COMPETITION LAW AND SENSIBLE ENERGY POLICY

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.

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[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.

[3] See recent posting. DOUBLE STANDARDS FOR RELIABILITY IN POWER SUPPLIES. NOT SUCH A BAD IDEA.