Monday, October 18

Much more than the price of energy

The shortage of gas in international markets is causing sharp rises in its price, which in turn has pushed up electricity prices. But the price of gas is not entirely to blame.

The problem has been exacerbated by the design of electricity markets, in which all electricity is paid for at the price of the most expensive technology, which is currently gas. This is causing strong transfers of income from consumers to electricity companies, which are seeing their prices multiply without their costs having barely increased. Only a small part of electricity generation consumes gas, and a good part of it does so through long-term contracts, the prices of which are much lower than current gas prices on the spot markets.

The economic and social consequences of rising energy prices are difficult to overstate. In the collective memory is the oil crisis of the 1970s, which led to double-digit inflation and a deep economic recession. Today, the fear is that there is not enough gas in Europe to weather the winter and that, in the face of a rigid gas supply in the short term, market adjustments will be made via demand reductions.

Thus, the rise in energy prices would find a new equilibrium in which a part of the industry – intensive in the consumption of gas and electricity – could be left off the hook. This would lead to the closure of some industrial production plants, as has already been seen in the United Kingdom, and to the reduction of the production of others, as is already happening in the steel industry, metallurgy, or chemistry in Spain.

Some companies will be able to avoid closure by transferring their higher energy costs to the prices of final goods and services, but this will only fuel an inflationary process that will also end up affecting core inflation. The purchasing power of families will be reduced, and with it their ability to demand other goods and services in sectors that still rely on the impulse of aggregate demand to overcome the crisis after the pandemic.

The increase in electricity prices could even affect the fulfillment of the milestones and objectives of the Recovery and Resilience Plan through the inflation channel, by reducing the purchasing power of the funds allocated to each investment project, and by making the cost more expensive. electrification process, which is one of the vectors of the Plan for green and digital transformation.

But, in this inflationary context, the greatest risk is that the monetary authorities err in the diagnosis and react with rises in interest rates, which would only make recovery more difficult. We are not facing an inflation caused by an overheating of the economy, but by an exogenous supply shock –such as the rise in gas prices– whose effects have been multiplied by inadequate regulation of the electricity markets. For this reason, the true anti-inflationary policy is not a monetary contraction, but rather the adoption of measures to tackle the causes of higher energy prices.

This has been demanded by the ministers of economy and finance of Spain, France, the Czech Republic, Greece, and Romania in a recent joint statement. They ask Europe to adopt a common approach to review the functioning of the gas markets and emission rights, to establish common guidelines for the joint storage and purchase of gas, to reform electricity regulation, and to continue to support the investment in renewable energies and other low-carbon assets as a way to enhance the Energy Transition and thereby reduce our dependence on gas.

Specifically, the signatory ministers claim to improve electricity regulation to “better establish the relationship between the prices paid by consumers and the average costs of electricity production.” It is an explicit recognition that, indeed, companies are billing more for electricity than it costs to produce it, at the expense of consumers.

The question is, how to achieve this goal? The solution is to design electricity markets capable of revealing the true average costs of each technology, unlike current markets that only manage to reveal the cost of gas generation.

This objective is already being achieved for the new renewables that enter the market through auctions of long-term contracts, held by the regulator on behalf of all consumers. By making companies compete, before undertaking investments, to determine the price of their production in the long term, their prices are stabilized around their average costs, transferring to consumers the lower costs that come from the hand of renewables.

Price regulation

The Gordian knot of the reform lies in the remuneration of the existing generation park –mainly nuclear and hydroelectric– because the impossibility of continuing to invest in these technologies makes it difficult for competition to contribute to solving the problem. Therefore, to avoid further distortions, it seems inevitable to resort to price regulation that prevents the over-remuneration that nuclear and hydroelectric plants now enjoy, protected by the lack of competition, from continuing to put the economy in check.

Therefore, the question that arises is: at what price to pay back the production of nuclear and hydroelectric plants? Can the regulator of the price proposed by the electricity companies themselves be trusted? Obviously not: it is in their own interest to make the regulator believe that their costs are high in order to obtain a more favorable remuneration.

The only reliable way to overcome the asymmetric information that haunts the regulator is to carry out a regulatory audit that reveals what your variable costs are, and what part of your fixed costs have not yet been recovered through the various regulated payments and benefits of market they have received for decades.

Only with this verified information will it be possible to establish a price for nuclear and hydroelectric generation that provides them with a reasonable profitability, as well as stable, the latter question for them is not trivial if it is taken into account that the expansion of renewables will depress the wholesale market prices in a few years.

Maintaining institutions that generate imbalances as strong as the one currently being generated by the electricity market is simply not sustainable. From a reform capable of “better establishing the relationship between the prices paid by consumers and the average costs of electricity production”, we will all come out ahead.

Europe – with the push of Spain – should lead this reflection from the regulatory perspective, aligning the review of the Single Energy Market with the objectives of the European Green Deal and the urgency of consolidating a sustained, balanced and environmentally sustainable recovery, which distributes its benefits equitably in society.

This review of the regulatory mechanisms would also make it possible to undertake the Energy Transition at the lowest cost to society, making it easier for citizens to perceive its benefits as a necessary condition for the social support that this profound change needs. And if Europe does not do it, it will be the Member States who do it, on their own. But then the essence of the European project will have been lost, jeopardizing its own continuity. At stake is much more than the price of energy.

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