Fixing energy markets

Politicians have finally threatened action to “fix” a broken energy market that could impoverish households and drive industry out of Europe. Listen to a discussion on what needs fixing and a passionate defence of the marginal pricing model, where the most expensive power plant sets the wholesale price. What short-fixes are urgently required, and how could policymakers reduce the risk of future energy price shocks?

Host: Richard Sverrisson, Editor-in-Chief, Montel
Guest: Stephen Woodhouse, Director at Afry Management Consulting.

Transcript

Richard Sverrisson, Editor-in-Chief, Montel: 0:06

Hello listeners and welcome to the Montel Weekly podcast, bring You Energy matters in an informal setting amid soaring energy prices. Politicians across Europe face mounting pressure to intervene in the markets as industry and households struggle to pay bills. But is the energy market broken? Are we in the midst of an energy crisis or an energy price crisis? And how can policy makers fix the core issues? A lack of gas drought. Low hydro levels. We've seen Spanish proposals to cap prices caused to decouple gas from electricity prices with criticism of the marginal pricing model where the most expensive power plant sets the wholesale price in a wish to intervene and to be seen doing something. How can politicians avoid knee jerk interventions and unintended? Consequences. Helping me, Richard Sverrisson to discuss these complex issues is an expert on market design and energy markets. Stephen Woodhouse of Afry A warm welcome to you, Stephen.

Stephen Woodhouse, Director at Afry Management Consulting: 1:02

Richard, thank you very much for the introduction.

Richard Sverrisson, Editor-in-Chief, Montel: 1:04

I just wanna talk about, start off by market intervention. Why what is it that needs fixing here, Stephen?

Stephen Woodhouse, Director at Afry Management Consulting: 1:09

I would say we neither in an energy crisis nor an energy price crisis, we're under siege, and that's in relation to our fuel supplies. The best time to deal with the siege is before it happens, by laying in stores, putting in place alternative supply, routes, self-provision, minimizing waste, and extremists, ensuring that you have a fair allocation. Now, we didn't do those things beforehand. We're trying to do them now, and I do think it's important to distinguish between the things that we need to do in the short run. And the things that we need to do to make sure that our market continues to operate in the long run.

Richard Sverrisson, Editor-in-Chief, Montel: 1:44

Are we in an energy crisis or an energy price crisis?

Stephen Woodhouse, Director at Afry Management Consulting: 1:47

If you follow the logic that it's a siege, I guess it's an energy crisis, but it's being, the siege is conducted through a market which underpins both our society and our economy. So anything which goes through a market becomes a price crisis. And it's. In the immediate term, we are not at the point of having a shortage of gas. We're at the point of having very high price gas. I think if we look forward to the winter, it's quite possible that it beco that it could become shortages.

Richard Sverrisson, Editor-in-Chief, Montel: 2:16

The current market design. Would you say then that it's fit for purpose and the current market environment? What, if you, if can you go into some detail maybe about the short term fixes versus the longer term fixes that you are mentioning there? Stephen?

Stephen Woodhouse, Director at Afry Management Consulting: 2:28

Market designs are created by economists, and the primary objective is efficiency, both for investment and operation. We don't design markets for political acceptability, and that I think is where things start to break down. If the markets are delivering results, which are not politically acceptable, we should then expect some kind of intervention. I'm a, I'm an economist. I've been a, an economist nearly all of my life. I still find it incredibly hard to understand the logic of a model where when we are facing a shortage, we don't make the marginal price reflect that shortage. If we subsidize the price of electricity or gas, we are not doing the thing that we need to do most, which is incentivize people to reduce their consumption and with electricity, which is time dependent, reduce their consumption at certain times, perhaps. We're doing the opposite. So anything which takes away the marginal price signal doesn't seem to be helping. But we must recognize that not everybody can afford to pay those prices, and there will have to be some kind of redistribution around that. And normally economists absolve themselves for redistribution, saying that's a matter for politicians. It is critical that the unaffordability of energy to chunks of our society and perhaps chunks of our economy is going to need to be dealt with. I still don't think that the fundamentals of the market design are what is wrong. What is wrong is that there's not been enough forward hedging, and we've seen over many years that consumers and agents on behalf of consumers. Don't hedge forward very far. So if we are genuinely concerned about the types of shock that we're seeing today happening in the future, perhaps we need some more institutionalized hedging, which of course exists today already in the form of, for example, CFDs and feeding tariffs for renewables. And maybe the answer is to extend that type of contract structure further, even perhaps to existing renewables. And we'll come back later about whether that's on a voluntary basis or otherwise.

Richard Sverrisson, Editor-in-Chief, Montel: 4:47

Some companies have forward hedged and are in deep trouble. I'm, looking at a large German utility Finn utility. These guys have forward hedged themselves and yet because of the scarcity of gas they're in a serious financial, trouble.

Stephen Woodhouse, Director at Afry Management Consulting: 5:00

I wasn't particularly talking about the forward hedging of gas. I was talking about the knock on consequences on electricity prices. So the critical issue today is that we are facing marginal energy prices. So we have a diminishing share of gas in the mix as renewables march further on. But that share of gas generation, which is fueled by gas prices and carbon prices, which have both gone up, let's say tenfold, that affects the entirety of the electricity market and not much of the volume of the electricity is forward hedged in a way that can withstand that kind of shift in the marginal price. Nobody was anticipating tenfold multipliers in the price. For sustained periods of time.

Richard Sverrisson, Editor-in-Chief, Montel: 5:43

Absolutely. We're in an extraordinary situation at the moment Stephen, but so if I'd say that you would be a storch defender of the marginal pricing model, then,

Stephen Woodhouse, Director at Afry Management Consulting: 5:51

Yes. But it does need to be complimented with measures that deal firstly with the immediate crisis and help prevent future crises. As I say, you need. You need to diversify your supply routes. So it's been a particularly bad time to be closing a lot of nuclear capacity in Europe, although maybe the timing isn't completely coincidental. What we are finding though is that the policy risk is becoming unmanageable. So at the moment we've got consumers who can't afford to pay their bills. We've got a portion of the market whose underlying costs have gone up very substantially. We've got another portion of the market on the production side whose costs have not gone up very substantially and the market price has. In economics terms, they're getting a lot more producer surplus than previously. Now, if we need to find money from somewhere to support consumers ultimately one way of doing that is to take money from the future by borrowing. We can redistribute between consumers today using taxation and spend. But the obvious place at the moment is to take some of the producer surplus from the generators who are earning these high prices, but are not facing the high gas and carbon costs. So from a political perspective, it is very obvious why it is the producers that we're targeting for a lot of the immediate remedial measures Now. The politics of that aside, what we must remember is we will need investors in the future. So whatever the measures are to take away some of those producer gains that produce a surplus in the short run, it has to be done within the reasonable expectations of the investors rather than against them. I'm not involved in the politics of this. Windfall taxes are usually something that economists prefer to avoid discussion of. But where they do, you have to say that this must be done in a way that's literally a windfall, a lightning strike tax. So as not to raise expectations of repeat behavior, because if you do, you will deter investors. Now if we're looking at the longer term solutions. Energy does underpin our entire world. We are becoming more and more dependent on electricity to run our society. Maybe electricity is different and maybe the regime we have for liberalized energy markets perhaps needs a coder that, super normal profits won't be permitted in the industry, and that becomes part of the licensing regime. The damage of windfall taxes is, they happen against the expectations of investors, and therefore they deter future investment if you can make them part of the backdrop. As a planned contingency under certain circumstances. Maybe that's the way to improve the stability of the markets in future.

Richard Sverrisson, Editor-in-Chief, Montel: 8:56

But determining a windfall tax actually is a fine line, isn't it? What's a what's a reasonable rate of return and what's a massive or. I've seen the Germany German ministry called them insane prophets from some producers, so over the weekend. But how do you determine what's a windfall and what isn't?

Stephen Woodhouse, Director at Afry Management Consulting: 9:14

No. I would rather be having that discussion when there isn't a crisis on them when there is, that's, that I think is the point. Most markets fail because of policy interventions. So making sure that you've built in some robustness. Against the things which are going to cause policy, event interventions is good market design. And we often overlook that. So I give an example. It's a very common story that a feed in tariff is announced for renewables in a country and the price looks generous and the cost of the underlying technology falls quickly, and the take up of the feeding tariff becomes runaway. The total cost looks incredible, and they make a radical change to the policy. I think in Britain that happened. There was a judicial review and the government got forced to change. There've been retrospective changes. Now all of these things are actually relatively predictable. So if you had built in the off tap when you designed the policy, we wouldn't have had these policy induced shocks. So what I'm advocating is. More forward thinking when energy market designs are put in place to what are the stresses and what are the circumstances where this will cease to work? And it is always that they cease to work on a political level before they cease to work on an economic level.

Richard Sverrisson, Editor-in-Chief, Montel: 10:36

We've seen several proposals we've seen already a Spanish intervention into the markets that was approved by the European Commission. And, several countries have urged a decoupling of gas from power prices. Now how can you do that? Will that work in practice? In, in practice, Stephen?

Stephen Woodhouse, Director at Afry Management Consulting: 10:54

You can make anything work in practice in the short run. The impact on the future market in the long run is the question. So of course, if you have one. Marginal technology that's a lot more expensive than everything else. If you simply care about consumer prices, consumer surplus, and you have no interest in producer welfare, if you can subsidize that marginal technology, you get that money back several times over because you reduce the prices for all consumers. They're using a very effective. Lever there it requires a windfall tax to actually fund the subsidy to the gas as I understand it. And another type of measure is what's proposed in Greece where we simply don't pay the marginal price. To certain technologies, based on fuel price discrimination, there are some oddities in the Greek proposal that they distinguish between, as produced intermittent variable generation and dispatchable generation with a fuel price. But they have allocated renewable plus storage into the as produced. And that's because I think they can't figure out what the fuel price should be for it. And that is exactly why we need marginal price economics. You, your price reflects the marginal actual cost and the marginal opportunity cost. And in a Norwegian system of old, the marginal fuel was water, and you had the choice whether to let it out in the run of river schemes or hold it back in the reservoirs and let it out later. But that doesn't mean you have a zero price system. It means the opportunity value of that water is what determines your price. And any market system which doesn't have marginal pricing at its heart is likely to have inefficient dispatch. Most critically of all, it's likely to have inefficient use of electricity, both in terms of the quantity but also in the timing. And the one message we have to have for the future is that we have to be much more careful in the amount of energy we consume, in the amount of energy we waste. And as I say, with electricity, it's also critical to know are you consuming energy at the right times? Marginal price signals are really the only tool we have to be able to ensure efficiency in, in, in those dimensions.

Richard Sverrisson, Editor-in-Chief, Montel: 13:23

Several politicians, sadly don't agree with that view. Who do they, Stephen? You've seen Boris Johnson, Macron, even Ula La Wanderly saying that the system needs fixing. But I dunno what are we're having a meeting of the energy ministers on on, on Friday, the same day as we go out. What are your hopes here, and even maybe some of your fears that concerns that that the politicians will come up with some proposals here that may not fit the purpose that they're designed for?

Stephen Woodhouse, Director at Afry Management Consulting: 13:48

Let me be clear. We have to distinguish between the marginal prices that people pay at the edges, which influence behavior, and then the average prices that they have to pay. So finding a way that some consumers are protected from the full force of the price is one thing charging them the average? I would prefer that they were given money and still charge the marginal price. So they still saw that a kilowatt hour costs a lot of money and they should do what they can to reduce it. If you subsidize the price per kilowatt hour, you are giving completely the wrong messages. So it would be better if you are redistributing money to do it in the form of money. Or at least to do it so that the marginal price signal is not reduced. Because ultimately we're gonna have to reduce our energy consumption. And anything which damages that incentive is gonna make things worse in the long run. So I'm not against the idea of taking money from one group of producers or even from future consumers, we're talking about setting up funds and borrowing money. If you can lock in producers. To some kind of long-term CFD through a long-term hedge backed by the government and backed by future consumers and taxpayers. Ultimately, that seems to be a reasonable model. You are effectively then pushing today's cost onto future consumers, but don't destroy the marginal price. Mechanism, which is the basis of markets absolutely everywhere.

Richard Sverrisson, Editor-in-Chief, Montel: 15:18

It's very clear, Stephen, and here that, I can hear, we need to be incentivizing energy efficiency, lowering consumption. But for example, the talk of a cap on prices. Has that lowered gas demand in any sense?

Stephen Woodhouse, Director at Afry Management Consulting: 15:31

I would imagine quite the opposite. We had a similar situation in Australia, so we've had, we've been having, gas induced gas price induced crises in energy markets globally. We're currently working in Singapore on a similar matter. It went like this in single in, in Australia. There was a price cap. I think they reduced the price cap, the cost of. Energy production went above the price cap and so the producers stopped producing because they were going to earn less revenue than the price cap and the market was then suspended. A lot of these things are actually badly designed and badly implemented I'm sure it would be possible to engineer some structured price cap that applied to certain types of generator or not to other. Not to others or that, targeted the fuel cost of the most expend of generators, as in Spain. You can make these things function politically in the short term, but they're not the basis for a long-term design of an energy market that supports investment. Which is why we need to separate ad hoc short-term emergency measures while the siege is un underway from what our long-term design is to protect us against whatever the next type of siege is going to be. And I can imagine we won't be able to predict exactly what form it takes.

Richard Sverrisson, Editor-in-Chief, Montel: 16:55

We've seen in recent days a lot of emergency funding made available for utilities. What's your view here, Stephen? Is this, as you say, a reaction to the short term siege and that's necessary in a way to redistribute or is, what's your view?

Stephen Woodhouse, Director at Afry Management Consulting: 17:09

So by that do you mean supply companies to, to fund price cuts to consumers?

Richard Sverrisson, Editor-in-Chief, Montel: 17:13

More like providing credits to to big utilities who are facing in, very high margin calls in wholesale markets.

Stephen Woodhouse, Director at Afry Management Consulting: 17:20

Sorry I'm with you. We need our energy utilities. We need them to be functioning in the midterm. We can't afford to go under in today's, which is an ultimately a geopolitically induced crisis. So if that is the short term price, it may be a necessary one. The alternative is to take the French model and Renationalize. Our energy system is part of our society and our economy, and it needs to be protected. Ultimately, that's the ultimate role of government is to keep its citizens secure and our energy system is a critical part of our security.

Richard Sverrisson, Editor-in-Chief, Montel: 18:01

Absolutely. Some of the proposals we've seen from Spain, from Greece and else. Could any of these work on a pan-European level? The Spanish system works well within the Spanish context, the Greek maybe with their own system. Is there anything here that you see, ah, yeah, that could actually work on a European level?

Stephen Woodhouse, Director at Afry Management Consulting: 18:19

The Spanish one will work very badly if it's not done on a European level because it will make Spanish electricity quite cheap relative to its neighbors. Thankfully, it doesn't have very much interconnection with its neighbors. I think it applies in Spain and Portugal, so I think. You know quite what's happening on the interconnected to France. I don't know. But if nothing was done, one might imagine that they're just exporting cheap energy to France, which has been artificially subsidized and paid for by by the Spanish well windfall tax. So it would only work to do that on a pan-European le basis. I personally have much more time for the idea of the Greek style model. I find it difficult to distinguish the Greek model really from a world of CFDs. So the concept of the Greek model is that you make a technology split and some producers are paid the marginal cost, but you first run the whole, the day ahead market with the must run generation. Then they declare their volumes. Now that isn't so different to them pricing at zero in the market, which is pretty much what happens today. The difference is you don't pay them the renewable generators, the market price, they're settled under some long-term contracts. But if those long-term contracts took the form of a CFD on the wholesale price. It would have pretty much the same effect. And indeed, that's the way the later sets of renewable generation are funded in Britain. So we got CFDs around the day ahead market price for the variable renewables. So it has pretty much the same effect of the Greek model. Without having to completely disrupt the way that, the day ahead trading functions. The whole concept of day ahead trading is that they're all just megawatt hours. They're not fuel type specific, they're not unit specific. They're just megawatt hours. Anybody can trade them. So we don't have a distinction between the renewable and the and the conventional. Liquidity in our intraday timeframe is already poor. So if we start breaking up the two types of energy in any way at all, I really fear for the liquidity of the markets. So I don't believe market separation is gonna solve any problems in the long term, and if you want to achieve that separation of revenue. Do it through CFDs or some other kind of mechanism to redistribute money. You can do it in quite a few ways and encourage those generators who perhaps don't currently have a CFD to take one. So we saw, a long time ago there was the opportunity for German renewable generators with a feed in tariff. I think it was on a monthly basis to opt to take the market model. So the idea that generators with some kind of market based remuneration, a green certificate or a merchant plant, the idea that they might voluntarily take a contract, I don't think is a problem. And of course we are in a world where we're moving towards coercion. At, but at least have a structure of a CFD or that type of contract that allows the money to be re redistributed, to sit around the existing market mechanisms rather than impose something which breaks up the market.

Richard Sverrisson, Editor-in-Chief, Montel: 21:42

Absolutely. For those listeners who are unaware of CFDs, they're contracts for difference. But Stephen, if I, we can just round off here by, by asking you to get your crystal ball out and look a little bit into the future saying, once, hopefully we're on the other side of this crisis, things are starting to normalize again. What will the wholesale energy market look like in say, 2024? 2025?

Stephen Woodhouse, Director at Afry Management Consulting: 22:04

I fear it will look much less like a market than it does today. So if this crisis persists, we're genuinely I sit in Britain, we're genuinely talking about millions of people going into energy poverty. Tens of millions of houses of households, sorry, 10 million households, I think was the figure I heard the other day. This is a serious crisis. I will expect there to be some quite significant market interventions. We don't have time to do anything properly, how long would it take to change EU femia? Along the lines of the Greek model. We all know how long it took to put in place in the first place. So I don't think any of those types of changes are likely to be in place, in a couple of years time. I think more likely is that we put in place some real financial redistribution measures. But the outcomes of the market, I suspect, won't look like market outcomes at that time. Hopefully, it will resolve itself not long after.

Richard Sverrisson, Editor-in-Chief, Montel: 23:02

Fingers crossed. Stephen. Stephen, thank you very much for joining the Montel Weekly Podcast.

Stephen Woodhouse, Director at Afry Management Consulting: 23:07

Richard, thank you for the opportunity to share my thoughts.

Richard Sverrisson, Editor-in-Chief, Montel: 23:10

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