August 2022: Unpacking the Rhetoric on European Energy Price Caps
Smoke and Mirrors
Removing the Link Between the Price of Gas and the Price of Electricity
On Monday, European Commission president Ursula von der Leyen said: “Currently, gas dominates the price of the electricity market . . . with these exorbitant prices, we’ll have to decouple”.
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This leads to some obvious questions:
Why does gas dominate the price of the electricity market?
Is it possible to decouple the price of electricity from the price of gas? In the short term OR in the long term?
Why does gas dominate European electricity prices?
Gas sets electricity prices because it is the marginal source of power when more electricity is needed.
When the grid demands more power than what is available from nuclear power (mostly French), hydro, wind, solar and base coal power, then the grid has to turn to gas. The reason there can be idle gas capacity is because gas power plants are cheap to build and provide a flexible source of power that can be turned on or off at any time.
Of course, in the long term, if we had a lot more nuclear power, then the price of electricity would be set by the cost of nuclear.
If we had a lot more renewables, the price would be set by renewables… but, only when it is windy/sunny. When it is not windy/sunny, the price of electricity would be set by gas during a significant portion of time.
Lastly, if we had a lot more renewables and a lot more energy storage (short and long term), then the price of electricity would be set by the combined cost of renewables and storage. For this to hold true, it’s further required that the cost of renewables + storage be cheaper than:
Gas (with carbon credit or carbon capture costs included in gas prices, if in effect).
Anything else (coal, geothermal).
To repeat, the only time renewables can set the price of electricity is during periods of high wind/sun and/or low demand. At other times (which includes crucial times of high grid demand), the price (in a free market system) will be determined by the lower of a) fossil fuels (including taxes + carbon credits, if in operation), b) nuclear, c) renewables + storage. Btw, when I say “renewables + storage”, this really means the cost of storage because the cost of renewables is already very cheap (although I find it hard to unpack what role subsidies play in this).
Who is making money with these high gas prices?
Gas drilling companies
Yes, the gas producers like Gazprom, Shell, BP, Occidental etc. are all making lots of money. Some of them may have pre-sold their gas one year ago or more - for lower prices - so this is somewhat reducing their profits. However, fossil fuel companies often do not fully pre-sell their fossil fuels. So, generally, when prices of gas/oil go up, they make a lot of money.
Gas power plants
These companies buy gas, burn it, and sell the electricity. To first order, high gas prices aren’t necessarily good for them because, even though they get paid more when electricity prices are higher, they are paying more to buy the gas.
Side-note: There are other effects at the moment that favour gas power plants. For example, if French nuclear power is partially down (which has been the case due to maintenance/corrosion), then the rest of the grid needs to make up for that lost power. This results in a premium for anyone who helps make up that power. This isn’t specific to gas power plants, but gas is usually the most flexible and reliable source of power and the one that can be turned on as required, so it’s a power source that benefits.
In a simple market with no pre-selling of electricity, all electricity suppliers get paid the market price. So, if gas (which is most flexible and available) sets the market price, then every other supply of power (including wind) starts to make lots of money because the marginal cost of wind is very low (most of the cost of wind is in the capital investment, not the operation).
On the one hand, this is good for renewables because investors - seeing that renewables can print money during a gas crisis - should somewhat spur investment in more renewables.
On the other hand, going back to Ursula von der Leyen’s quote above, there is a dislike for gas setting the marginal price of electricity because:
a) It makes windfall profits for oil and gas companies
b) It gives windfall profits to renewables. (My guess is that she and the broader public dislike this point less)
c) Utilities make windfall profits
Actually, point b) is not exactly correct because much wind power is sold well in advance. Specifically, if you are building a new wind farm, it is common to pre-sell the first 3, 5 or 10 years of electricity at a pre-agreed rate in order to provide cash-flow certainty. This cash-flow certainty makes it cheaper to get bank loans to finance the project.
Utility companies buy all sorts of power and then sell it to homes and businesses.
Utility companies often buy power in advance* (many years) from renewable energy companies. This is valuable for renewables because - as mentioned above - it gives them cashflow certainty from their large upfront investment. For example, a utility might have bought wind in advance at $0.03 per kWh, whereas right now the marginal price of electricity is $0.20 per kWh. So, if gas prices (and hence electricity) prices skyrocket, the utility that benefits from having bought all of that wind cheaply in advance.
There is outrage that utilities are making windfall profits because of gas price spikes. However, when you think this through fully you realise utilities (directly or indirectly) - in the past - often made deals to give renewable companies cashflow certainty and take on the risk of volatile energy prices. If energy got cheaper, then the utility company would out because they have pre-agreed to pay renewables a fixed rate. Now that energy is getting really expensive, it makes sense that utilities are earning profits.
So, what are taxes, levies and outrage at windfall profits going to do? They make it less attractive in the future for utilities (or banks or hedge funds) to give long-term fixed price contracts to renewable energy, which makes it harder to finance renewables.
Now, one might argue that the Ukrainian war was not foreseen by most people, so the excess profits are anomalous and won’t affect how people and companies think about the future. (A market purist would counter argue that markets do factor in the costs of unexpected events.) Broadly, I think there are reasonable arguments as to whether unexpected energy costs should be borne by companies versus governments. So, I’m less interested in arguing whether the profits are “windfall” or not and more interested in highlighting that:
The distribution of profits in a gas spike are more complicated than it might seem and we should be thinking about the full system and multi-timescale effects.
“Windfall profit” language is politically popular because it assigns scapegoats (utilities, gas companies, renewables companies) for the problem of energy shortage and high energy prices.
The actual causes for high energy prices are a) A pre-Ukrainian war naivity around the importance of energy independence from one’s adversaries, b) an absence of fundamental understanding of power grids - especially the concept of the marginal supplier of power - in political discourse, c) loosely related to point a., strong corporate interests in maintaining reliance on fossil fuels. [And I realise gas companies are falling both into the scapegoat and actual cause category and I think this is true because both things can be true at once, plus not all gas companies are the same.]
*Actually, utilities may or may not do this directly. Often there is a layer in between involving banks and hedge funds that buy contracts different amounts in advance.
How can you decouple electricity from gas price?
If you take the question of decoupling electricity prices from gas, the only answers I see are those I have given above: a) renewables + storage, b) fossil fuel continuation (with or without carbon markets or carbon capture), c) nuclear. None of these are short-term fixes.
Ursula von der Leyen is talking about something different when she talks about decoupling - emergency intervention: capping the price of gas. How? Simply by requiring that gas not be sold for more than a certain price.
Won’t gas plants then just turn off and we’ll have power shortages? No, because while government will cap the price of gas, they will subsidise gas plants for any costs above that cap.
Aren’t we just back to the start then? Not exactly.
Gas power plants are roughly in the same place with a price cap. The gas price might nominally be $50, but power plants are still paid for costs above that by the government.
Utilities buying power from the gas plants get cheaper electricity because (at least on paper) the gas plants pay a lower price for gas. So, the gas price cap benefits utilities.
How does the government pay for subsidies to the gas power plants? One option is to charge an excess fee to the utility companies.
Doesn’t this just cancel out the reduction that the utility companies got from the gas power producers? Yes! And this is largely what Spain and Portugal have done over the last year or so.
Based on what I’ve described above, the price cap doesn’t change much. However, there is one thing that a gas price cap does do - it reduces (albeit in a very artificial way) the price that all other electricity suppliers get paid to a price that is lower than what the market price would have been - i.e. wind, solar, nuclear, coal (or the profits now earned by those who pre-bought energy from those suppliers).
Hmm, so you funnel money from the technologies that are not gas, and use that to subsidise gas…
My preferred approach
My preferred approach to tackling rising energy prices would be:
In the short term, support low income people with a combination of i) one-off cash payouts to social welfare recipients and pensioners (obviously there will need to be a few of these because the problem isn’t going away soon), ii) raising the income threshold at which income tax starts being payable (this should anyway be raised because of inflation). [Finance ministers probably hate option ii. because it erodes the tax base, but it does have the benefit that it doesn’t discourage employment as much as social welfare increases.]
For the medium to long term supporting a) renewables + storage, b) nuclear (split funds between conventional, modular and fusion), c) carbon capture. For each of the three, I would set up a red-tape cutting panel - at the national and not the EU level - that is measured on safety, allowing technological progress and simplifying regulations.
Meanwhile, I would not waste time and add complexity by trying to apply windfall taxes or price controls to energy markets.
Yanis the former Greek Finance Minister.
I enjoy listening to this guy because he’s not mainstream and tends to question what we take for granted. There’s a good, short and recent podcast with him here, and a Twitter summary of the podcast here,
That’s it for this month, cheers, Ronan
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