Spain and Portugal want to go ahead with a reference price for energy, but this could lead to higher fossil gas consumption, inflated gas prices and less incentive to invest in renewables, warn Lion Hirth and Christoph Maurer.
Lion Hirth is Associate Professor for Energy Policy at the Hertie School in Berlin and Director of the consultancy Neon Neue Energieökonomik. Christoph Maurer is the director of the consulting firm Consentec.
The governments of Spain and Portugal have proposed a “cost of production mechanism” to reduce wholesale electricity prices.
After a consensus could not be reached at the European Council on March 24-25 to implement the intervention across the EU, the two governments opted to proceed with the instrument unilaterally. It has already been notified to the European Commission.
However, the proposal is quite problematic, causing several adverse effects.
Based on public statements and leaks, we understand that the intervention would essentially be a subsidy of natural gas and coal burned in power plants.
The subsidy will be implemented as a rebate based on the electricity produced, assuming a conversion efficiency of 55% to cover the gap between daily gas prices and €30/MWh.
Coal plants receive the same subsidy. For example, at a gas price of €100/MWh, all coal and gas plants would receive around €127 for each MWh of electricity they produce (70/0.55). The costs will be recovered through an electricity tax.
Given the lack of clarity on this aspect, we focus on the subsidy in our next evaluation.
Problem 1: Gas consumption increases
Like all energy subsidies, this intervention will increase energy consumption, here natural gas (and coal). In other words, it will make the fundamental problem we are currently facing, the fact that energy is scarce, worse, not better.
There are at least four main mechanisms through which gas consumption increases.
- Wholesale and therefore retail electricity prices are depressed, making energy savings less attractive. Steel mills and other companies that have reduced consumption will reverse the action, increasing energy and therefore gas consumption.
- With the expectation that the intervention will eventually end, energy-constrained power generators such as biomass and hydroelectric reservoirs will bid at high prices as they anticipate higher revenues in a post-intervention period than during the price ceiling. This will boost utilization of gas plants (and will also lead to higher energy prices as long as gas plants set the price).
- The level and variability of energy prices will be artificially reduced. Therefore, there will be less storage and other flexibility options available to take advantage of surplus renewable energy.
- In industry, cogeneration plants will replace heat-only boilers as only the latter receive the subsidy.
When gas consumption for power generation is inflated, more gas must be saved elsewhere. That means less gas and higher costs for Spanish and European manufacturing that depends on gas.
Problem 2: Inflated Gas Prices and Higher Payments to Russia
The intervention will push up gas prices. In fact, the price of gas must increase enough to induce a reduction in demand in industry and power generation in the rest of the EU that compensates for the inflated use of gas in Iberian power generation, given that the Gas supply is quite price inelastic.
This means higher costs for industrial and residential consumers and higher payments to Russia, since most long-term contracts are indexed to spot.
Problem 3: Reduced investment incentives and investor confidence
Incentives for much-needed investments in flexibility, energy efficiency, storage and renewable electricity generation would be reduced because energy price levels and variability are artificially reduced.
The intervention has the explicit aim of diverting rents away from producers, thus lowering investor confidence, increasing the future cost of capital and possibly being challenged in court, as are retroactive changes to Spanish support systems. to renewable energies in 2011.
Problem 4: Export of subsidized energy and market manipulation
Low energy prices will lead to higher electricity exports in the integrated European electricity market. To address this problem, the proposal includes a provision for two consecutive daily auctions, where the first auction has the sole purpose of determining cross-border trades.
Such a configuration carries a high risk of market manipulation because the offers in the first auction do not have direct economic consequences for the bidders. Coal and gas plants could receive lower bids strategically to boost exports and inflate prices.
Problem 5: coverage and blocking
Mitigating price risks through financial hedging is a core activity of companies in the energy sector and has never been more important than today. With prices effectively set by governments, companies may lose the motivation to hedge. Futures markets can become illiquid.
Having reached this point, returning to the status quo ante could be deemed impossible, effectively extending the need for intervention. to infinity. In addition, industrial consumers who have paid high energy prices in the past and now face competition from companies currently relying on artificially low spot prices could apply for government support.
Behind the Spanish proposals, there appear to be three distinct political goals: protecting vulnerable consumers (households and businesses), taxing windfall profits from power generators, and reducing payments to Russia.
We believe that these goals can best be achieved with separate instruments. Any policy that helps conserve energy will lower prices.
Consumers are better protected through lump-sum payments, which should be targeted at vulnerable households and businesses, as researchers at the Mercator Institute for Climate Change and the Florence School of Regulation, among others, propose.
Windfall profits could be captured using corporate income taxes. Payments to Gazprom must be reduced by trade or competition policy. With energy scarcer than ever, we must let markets do what they are good at: provide incentives to conserve energy and allocate available energy where it is most useful.
More analysis of proposals is available in a recent working paper by Carlos Batlle, Tim Schittekatte, and Christopher Knittel.