Electricity microeconomics does not change: only the use we make of it

Energy is back on the top of the policy agenda in Europe due to the skyrocketing prices recorded since Summer 2021 and the concerns for the security of supply generated by the war between the Russian Federation and Ukraine.

FSR invited Thomas-Olivier Léautier, chief economist at TotalEnergies and part-time professor at FSR, in an FSR Talk on 23 March 2022 to discuss whether the decarbonisation goals adopted by the EU and the energy crisis are challenging or not the design of electricity markets in Europe.

Dr Léautier opens his talk by observing that the choice to reduce the greenhouse gas (GHG) emissions of the energy sector in Europe and the turmoil in commodity markets generated by the conflict in Ukraine have exacerbated the tensions that often exist between the view of the economists and the view of the politicians (and the broader public in general). The former often think that letting market forces act and prices freely move over time and space is necessary to use resources efficiently. Given the characteristics of electricity demand and supply, it should not surprise that the price of electricity is sometimes very much different in the same place between noon and 6 pm or between Norway and Spain at the same time. Indeed, it is efficient that those spreads occur.

However, politicians and the broader public, in general, have frequently some difficulties in accepting this fact. Significant differences in prices over time and space are typically perceived as unjustified and unacceptable. As a result of that, in situations like the one that Europe is now experiencing, there is often a loud call for public intervention and for the reform of the rules that govern the sector. This is understandable and can be legitimate but won’t change the hard reality of electricity costs and their structure. Someone, somewhere, will have to pay at some time those costs. There is no doubt about that.

Of course, new technologies are emerging, consumers are getting more different one from the other, and governments are prioritising the deep decarbonisation of their systems and a higher level of security of supply, but these trends do not significantly alter the landscape and the constraints to take into account when designing public policies and sector regulation.

Economists are aware that electricity markets are, in practice, far from perfect, especially in sending long-term signals. As for many other commodities, producers and buyers of electricity rarely sign forward contracts with a duration beyond a few years. These “missing markets” prevent the adoption of efficient risk-sharing arrangements and tend to discourage adequate investment in new generation capacity at the lowest cost. This is a valid concern that may justify government intervention in the form, for example, of capacity mechanisms or administratively-set reliability standards. However, it is important to remember that it is precisely the uncertainty about the timing and form of government intervention that explains, at least to a certain degree, the aversion of market players to commit on a very long timeframe.

This vicious feedback loop is not easy to deal with and seems to create a typical 0-1 problem: either governments do nothing and accept the results of the energy-only market, or they take full responsibility for adequacy and procure energy long term for the entire system. Unfortunately, both options present drawbacks. In particular, having the government procure energy long term could be acceptable, especially in historical moments like the current one where security ranks higher on the political agenda, but it is likely to represent a slippery slope that generates increasing inefficiencies.

A partial and delimited solution to the problem of system adequacy would be to mandate a minimum hedging ratio by all energy retailers for the following two or three years. This solution, recently proposed in the debate on the reform of the European electricity market design, has been adopted in New Zealand, where retailers are obliged to cover a significant share of their supply obligations a couple of years ahead of delivery. Obviously, this is not sufficient to promote an adequate level of long-term arrangements and generation investment de-risking. Still, it can at least mitigate the worst consequences of large fluctuations in the spot market.

According to Dr Léautier, rather than trying to reform the electricity market design or to reduce the price of carbon emissions, European policymakers should understand that the recent massive increase in the level and volatility of electricity prices is mainly related to problems in the supply of natural gas to Europe. In this context, one of the most sensible measures to take is to focus public intervention on the less affluent consumers and shield them from the economic consequences of higher prices by redistributing, for example, the revenues of ETS auctions to their favour. On the contrary, more affluent energy consumers should be exposed to prices that highlight the current higher cost of producing electricity and induce a more efficient use of electricity and/or investment in new generation or storage capacity. Alternative solutions currently debated, such as introducing price caps on the bids by gas-fired power plants and providing out-of-market payments to de-couple gas and electricity prices, are not easy to implement in practice and may create additional distortions and inefficiencies. Better to stay away from playing with them.

Do you want to know more?

• FSR Talks on 19 September 2019:“Imperfect markets and imperfect competition”
• Executive course to master electricity markets