How much does it cost to release electricity and gas prices?
Here are the advantages, disadvantages and costs of the proposals to "decouple" the prices of electricity and gas. The article by Carlo Stagnaro and Simona Benedettini for Lavoce
In the election campaign, practically all parties seem to agree that the rules for the functioning of the electricity market need to be profoundly reformed. The way out shared by the leaders seems to be the “decoupling” from the price of natural gas from the prices of electricity produced from renewable sources. The debate is not only Italian: the conclusions of the EU Council of Energy Ministers of 9 September refer to the issue and make proposals to that effect. The Czech presidency itself had pushed in this direction, while Greece had long proposed a mechanism to achieve the same result. Spain and Portugal, on the other hand, have already adopted a mechanism with a similar purpose which has been provisionally approved by the European Commission. Finally, President Ursula von der Leyen put forward a proposal for a regulation which, among other things, aims to cap the revenues of plants for the production of electricity powered by sources other than gas. What do these proposals consist of? And what strengths and weaknesses do they have?
The "system marginal price" mechanism
The price of electricity is formed through a series of sequential sessions, which guarantee the balance in real time between supply and demand. The main one – the day-ahead market – defines the energy production and withdrawal schedule for each hour of the day following the close of trading.
To this end, a central counterparty (in Italy, the Electricity Market Operator, a company of the Gse group) collects and aggregates the offers presented by energy producers and consumers. The former are ordered in ascending order of the relative marginal production costs (ie the costs for fuel and CO2 emission certificates): the resulting curve is known as the order of merit curve. Symmetrically, the bids are ordered in decreasing order of the relative marginal utility: a demand curve derives from this. It is easy to understand that the demand curve is much more rigid than the supply curve: while the latter reflects the variable costs of the plants, the demand curve is made up for the most part by loads that cannot be disconnected (for example, hospitals) or scarcely reactive to short-term price changes (for example, household consumption).
The point where the two curves cross defines the equilibrium price at which the quantity of electricity for which a matching between supply and demand has been reached will be exchanged. This price – corresponding to the marginal cost of the system, that is, the marginal cost of the most expensive electricity generation technology necessary to satisfy demand at that time – is applied to all the plants that contribute to covering the demand. Consequently, while the marginal plant receives a price with which it is able to cover only the variable costs, the infra-marginal plants (i.e. those located to its left in the supply curve) receive a price higher than the respective marginal costs. . The difference, called infra-marginal income, allows these plants to recover fixed costs and remunerate the invested capital. In fact, normally plants with low or even zero marginal costs (for example renewable and coal plants) are characterized by high fixed costs, while those that have high operating costs (for example turbogas) have low fixed costs.
The price increases and the proposed solutions
The debate on the reform of the price formation system and its adequacy to reflect the characteristics of energy systems dominated by renewable sources has been open for some time. The European Commission has instructed Acer, the agency that coordinates European energy regulators, to analyze the problem. Acer has concluded that the system marginal price remains the most effective mechanism, since: 1) it allows to minimize the purchase costs of electricity; 2) provides adequate coverage of the investment costs of renewable electricity generation sources and nuclear power plants. Some – indeed, a minority to which one of the authors of this piece belongs – believe that there are reasons to gradually change the system.
However, the debate that has been unleashed in recent months in Europe has different motivations. It starts from the rise in gas prices, which has dragged electricity prices to record levels across Europe as early as the second half of 2021. The situation was then exacerbated by the war between Russia and Ukraine. Hence a proliferation of more or less articulated proposals, with a common characteristic that clearly distinguishes them from others advanced in the past: while the latter intervened on the methods of submitting offers within a single market (since energy electricity is a perfectly homogeneous product), the new ideas start from the assumption that the market is directly or indirectly "broken", separating (physically, financially or administratively) plants with high marginal costs from those with low or zero marginal costs.
The proposals put forward are essentially three: 1) imposition of a ceiling on the revenues from infra-marginal electricity generation technologies; 2) the creation of two separate power exchanges, one for infra-marginal electricity generation technologies and one for gas plants; 3) the payment of a subsidy to gas plants for the purchase of the fuel necessary for electricity generation.
Imposition of a ceiling on the revenues from infra-marginal electricity generation technologies
The imposition of a ceiling on the revenues of infra-marginal electricity generation technologies is the proposal put forward by the European Commission in the context of the State of the Union address of 14 September 2022. The measure consists in setting a ceiling on the price that the infra-marginal electricity generation can be achieved for each MWh sold. Traders will continue to sell their production on the power exchange at the market price and the equilibrium price will continue to be determined using the marginal price system. However, if market prices are above the cap, the infra-marginal producers will have to settle for the cap and return the difference to the system. This amount of resources must be used to finance interventions in support of household and business bills. A variant of this mechanism has been in force in Italy for some months, introduced by article 15-bis of law decree no. 4/2022. It is applied not for all infra-marginal technologies but only for photovoltaic plants with a power greater than 20 kW, which benefit from incentives in the form of fixed bonuses, and renewable plants with a power greater than 20 kW, which, while not enjoying incentives, entered into operation before 2010. While the Italian mechanism has set a ceiling roughly equal to the average price of electricity in recent years (60-70 euros / MWh), the Commission has proposed a cap slightly higher than the average of the peaks observed in the past (180 euro / MWh).
The objective of this mechanism is to reduce retail prices by redistributing, at the bottom of the list, that part of the infra-marginal rent that is judged to be excessive. In some respects, it is therefore equivalent to a tax on infra-marginal installations aimed at providing a subsidy for consumption.
Creation of separate power exchanges for infra-marginal and marginal technologies
During the EU Council of Energy Ministers on 26 July, Greece put forward a proposal for the reform of the power exchanges which provides for the establishment of two distinct and consecutive sessions of exchanges. A first session would be dedicated to production plants with high fixed costs and low variable costs, ie infra-marginal technologies. A second session, on the other hand, would be dedicated to programmable technologies characterized by positive marginal costs, such as coal and gas plants. In this second session, the operators would offer the electricity necessary to satisfy the residual demand, that is the share of consumption not covered by the production of the infra-marginal (renewable) plants in the first session. The remuneration of the plants participating in the first session should come from the stipulation of difference contracts with public and private buyers. For plants that do not do so, (voluntary) participation in a market is envisaged, the so-called green power pool, managed by a public entity that operates as a single buyer. Plants offering their own production would continue to be remunerated according to the system marginal price mechanism. The purchase price of the kWh would be determined, in this mechanism, by the weighted average of three values: (1) the average price paid for the difference contracts; (2) the clearing price of the second trading session; (3) the weighted average price, for the quantities traded, on the green power pool. The mechanism appears complex and, in some respects, obscure. The objective, however, seems to be that of intervening on the wholesale prices of electricity, releasing them from the marginal cost of the system and hooking them, instead, to a system of communicating vessels segmented by technology. In practice, it is a profound revision of the design of the market: the sense is to structurally abandon a system in which equilibrium prices reflect marginal costs (which is, in truth, the norm in commodity markets) to adopt one where the equilibrium price approximates the average costs of the system (obviously including fixed costs).
"El tope al gas"
“El tope al gas” is the measure adopted in Spain and Portugal and provides for the adoption of a cap (“tope”) on the cost that gas plants have to bear for the purchase of the fuel necessary for electricity generation. The ceiling is set at 40 euros / MWh for the first six months of application of the measure. From the seventh month, the ceiling will be increased by 5 euros / MWh each month, up to the maximum value of 70 euros / MWh. The purchase price of electricity will continue to be determined according to the marginal price system. However, consumers will achieve savings, compared to the homeless situation, thanks to the lowering of the sales prices of gas plants due to the lower costs of purchasing the fuel made possible by the adoption of the tope. To allow thermoelectric producers to purchase gas, a subsidy is envisaged equal to the difference between the tope and the market cost of gas. For example, if gas costs 100 euros / MWh, thermoelectric producers will offer on the power exchange at a price compatible with the tope (i.e., as if gas costs only 40 euros / MWh) and will receive the difference (60 euros) at the foot of list. The subsidy is divided between different subjects: (i) buyers on wholesale markets in proportion to the volumes purchased; (ii) an additional component in the bills of end customers who, having not chosen a supply on the free market, continue to buy electricity at regulated prices; (iii) higher revenues due to additional exports to France due to the lowering of Spanish electricity prices following the introduction of the tope.
In some ways, the tope is a symmetrical measure with respect to the mechanism for capturing infra-marginal rents: it intervenes in the wholesale markets, artificially lowering the marginal cost, only to recover the sums necessary for the subsidy downstream. In both cases, the objective is to guarantee the recovery of costs by gas producers and to cut the infra-marginal rent within a threshold considered tolerable.
The pros and cons of the proposals
The proposals analyzed all aim to lower the price of electricity. And, in a different way, they succeed. However, none are cost-free. Not only because in some cases, such as for the Iberian tope, it is a question of finding resources to finance an explicit subsidy or, as for the Greek proposal, it is necessary to resort to a public entity that buys electricity from those operators who have not succeeded. to enter into contracts for differences on the market. The most significant costs that risk deriving from interventions on the design of power exchanges are in fact those produced by different types of side effects on the functioning of the market.
Each proposal has pros and cons. The mechanism for capturing the infra-marginal rent has the advantage of not formally changing the wholesale equilibrium prices, and therefore does not risk distorting the exchanges of electricity between states. The Greek system has on its side the ambition to rethink the functioning of the market as a whole, without attempting to patch up a mechanism deemed obsolete. The tope fully safeguards the market design and intervenes upstream to cure what is considered an exceptional and pathological phenomenon, that is, the rise in gas prices. The last two mechanisms – the Greek and the Iberian ones – produce effects on wholesale prices and, therefore, presuppose a common adoption at European level. Otherwise, there is a risk of increasing the demand for exports of electricity to interconnected markets which have not adopted similar measures (and which therefore systematically express higher prices). In the case of the Iberian model and the adoption of the ceiling on revenues from infra-marginal technologies, there is a further criticality connected to the correct identification of the value of the ceiling. If it were “too low”, in the case of the tope the risk is to accentuate the effects on exports and on the safety of the electricity system described above. In the case of the ceiling on revenues from infra-marginal technologies, there is also the risk of not allowing adequate coverage of investment costs.
The Greek proposal also has further and specific limits with respect to those common to the three proposals. In the first place, since there is no obligation to participate in the so-called green power pool, it is not clear how plants that fail or do not find it convenient to enter into contracts for differences on the market can be remunerated. Secondly, in the session dedicated to marginal plants there is a high risk of the exercise of market power if some participating gas plants prove essential to meet the electricity needs in certain hours of the day and market areas. The latter aspect could undermine the objective of lowering the purchase price of electricity. The complexity of implementing the mechanism should not be underestimated, which takes a long time not only to adapt the rules for the functioning of markets and cross-border electricity exchanges, but also because the new model would require the stipulation of agreements between the operators of the exchanges and between these and the electricity transmission network operators who often require unanimous consent.
If the proposals are implemented, these limits will translate into costs that are difficult to perceive, but which will not fail to present the bill to end customers.
All the measures – even if adopted at EU level – can then have different effects on member states, as the extent of their impact will depend on the composition of the sources used for electricity generation. For example, in countries where the incidence of renewable sources or nuclear power is higher, the effect on bills of the ceiling on revenues from infra-marginal technologies will be greater than in countries where renewables and nuclear power cover a smaller share of the needs. In a different way, and through different channels, the three proposals bring energy prices closer to average generation costs: the system for capturing the infra-marginal rent does this by making available to final consumers a sum that is greater the larger is the quantity of energy produced from sources other than gas; the Greek mechanism does this through the weighting of prices in the two exchanges, one destined for sources with low marginal costs and the other for those with high marginal costs; and the tope through the disbursement of a subsidy to gas producers which must be higher the greater the incidence of gas in the electricity mix.
Italy is the country with the greatest incidence of gas on the electricity generation mix. Therefore, the risk is that the outcome is to generate Italian prices that are lower than the current ones, but substantially higher than those of other countries such as France and Germany. This could give significant problems especially to that part of Italian manufacturing that is export-oriented and that is confronted with other European companies. The idea of decoupling markets – through administrative interventions that separate renewable sources from others – is a great political success, but it can take on many different meanings. Almost all of them, however, have to do with the desire to contain prices, reducing the amount of infra-marginal rents. In the design of post-liberalization markets, the marginal price system finds its justification in the need to encourage investment in new generation capacity, especially in plants – such as renewables – with high fixed costs, but low or zero marginal costs. . The direct or indirect imposition of a cap on revenues can, in perspective, discourage new investments, to the detriment of both the efforts to overcome the current crisis by reducing dependence on gas and the European decarbonisation programs. In any case, from this point of view the question is eminently empirical: a sufficiently high cap (for example the 180 euro / MWh suggested by the EU Commission) is not necessarily an obstacle in this respect, while a too low threshold (such as 60-70 euro / MWh set by the Sostegni-ter decree) can prove to be counterproductive. On the other hand, it is an attempt to answer a problem that does not depend on the (mal) functioning of the electricity markets: it derives from the exceptional trend in gas prices. One wonders if this is not the case to follow the ancient Anglo-Saxon wisdom: if it ain't broke don't fix it .
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/energia/disaccoppiamento-prezzo-gas-elettricita-costi/ on Sun, 25 Sep 2022 06:26:46 +0000.