A comment by CERRE Academic Co-director Professor Michael Pollitt, January 2022
Energy markets are designed to achieve certain societal goals. When they don’t achieve them, questions are naturally raised as to whether the market design should be changed. Recent high and sustained gas prices and associated very high prices for electricity have focused attention on the nature of gas and electricity markets in Europe and whether they are working in society’s interest.
What do we mean by market design?
When talking about energy markets we need to be careful to clarify what we are talking about. Are we talking about wholesale or retail markets? Gas or electricity? Or something else?
Also how would we judge if a market design is not working and needs to be changed? It would need to both be working in a way that could not have been predicted, and be capable of being changed into something that would work better.
High energy prices are not necessarily a failure of market design if energy is genuinely scarce. So far Europe’s electricity and gas markets have delivered energy security. Gas and electricity supply have not had to be curtailed in Europe.
Nor are high prices necessarily just a function of market design itself, they could be the result of a failure of market participants to correctly predict high prices and adequately invest and/or contract against them. Gas prices were very low in April 2021 and there seems to have been a general failure to foresee significant increases in the demand for gas coming.
What have we (re-)learned about market design?
While markets may work in the long run (via high prices leading to investment and lower prices in the future), consumers live in the short run and may not be able or willing to wait for the long-run effects to come through, demanding regulatory action to bring forward lower prices.
However, we have learned several new things as a result of the prolonged high prices (at time of writing, we are now in our fifth month of very high prices).
First, Europe is very reliant on imported natural gas and exposed to both the behaviour of Russia and prices in the global liquefied natural gas (LNG) market. Natural gas prices continue to drive electricity prices in Europe in spite of the progress made with the roll out of renewables. As we move to net zero, sudden upswings in the demand for natural gas will become more, not less marked, even if average annual demand for gas declines.
Second, aggregate wind output can be low for a prolonged period and this now has a significant effect on the demand for natural gas for power generation. This necessitates a change to the contractual arrangements for natural gas to ones which are much more flexible (for example wind speed indexed gas contracts).
Third, retail business models have to be regulated more closely. We learnt in the financial crisis that anyone with a computer can make money in good times by buying short and selling long and undercutting more responsible players who match their buy contract lengths with their sell contract lengths. When the good times end it is society and/or more responsible buyers and sellers who have to make good on the losses that result from such irresponsible trading. National Regulatory Agencies (NRAs) have to regulate this more closely for households and for small and medium-sized enterprises (SMEs), who cannot be expected to pay attention to the financial soundness of energy retailer business models.
Fourth, we have been reminded once again how unusual electricity market design is. In spite of the fact that the underlying investments in generation and network assets are long term and substantially drive the true economic cost, wholesale electricity prices are determined on the price of the marginal unit, which can be much higher than the average unit for prolonged periods. Even though consumers might be willing (and almost certainly are willing) to commit to paying prices which lock in longer run average costs, they are not able to commit to doing so under the current retail market design. While fossil fuel costs were a substantial part of long run total costs this might have been acceptable, but as fossil fuel costs decline as a share of average total costs, this payment model will seem increasingly bizarre to non-electricity intensive customers.
Fifth, general tightness of supply and demand creates opportunities for strategic residual monopoly behaviour as the market power of individual players behind constraints is increased. This could be occurring in local electricity congestion markets and in the European gas market as a whole. This is something that requires real time market monitoring and rapid intervention by NRAs and competition authorities. Political support for any market in a democracy is premised on appropriate regulatory oversight of anti-competitive behaviour.
Sixth, residential and small business price caps have been very controversial in the current crisis. The inability of prices to naturally adjust to higher wholesale gas and power prices has worsened the position of energy retailers. However, it has, in some cases, postponed large price rises. Clearly the way price caps are calculated has to reflect true underlying costs and should be robust to any change in cost during the price cap period. Regulators need to review the length and flexibility of price caps, and what price caps must imply for the contractual position of retailers. A six-month price cap based on forward wholesale prices could be ok if the retailer has also locked in wholesale costs for six months. The failure to let retail prices naturally rise has led to much higher demand than would have been the case if wholesale costs had been passed through more rapidly to final consumers, though it has no doubt protected poor and vulnerable customers.
Finally, there has been a resounding silence in the current crisis on the issue of demand-side flexibility. This crisis has been about the supply side. But what about the demand side? A big reduction in energy demand would have helped mitigate the price rises and reduced the financial burden of the crisis.
So does market design need to be changed? And if so how and when?
We have the market design in Europe we see today because it does actually minimise the use of expensive fossil fuels. Efficiency in fossil fuel use was the whole idea behind creating wide area electricity and gas markets across Europe. Prolonged periods of high fossil fuel prices will surely prompt reduced fossil fuel use and investment in low-carbon alternatives, just as it did following the first and second oil shocks. Any gaming by fossil fuel producers in the current crisis is surely counterproductive in the long run.
Wide area electricity and gas markets in Europe also reduce the significance of the price impacts for individual jurisdictions that would be the worst affected by the shortage of gas. For instance, if Norway were not interconnected with the rest of Europe via electricity interconnectors, electricity prices would be even higher in the rest of Europe. Sharing the adjustment to underlying scarcity across Europe mitigates the worst local price rises and improves security of supply under stress conditions.
More renewables will not necessarily solve the ongoing issues with the current market design for the electricity market in Europe. The crisis has revealed that low renewables output might incentivise building more renewables but won’t guarantee them being available more often. What will be increasingly difficult to explain to consumers as renewable capacities increase is why the energy prices are still so linked to fossil fuel prices.
Energy market design cannot be changed quickly and should not be changed in response to a short run problem. The single markets in electricity and gas took almost two decades to develop and remain a work in progress. They have kept electricity and gas flowing in Europe and increasingly protect peripheral EU nations from the increased energy insecurity that they might otherwise experience.
However net zero seems set to make Europe increasingly reliant on the availability of European wind. What we need is an energy market design which can handle that wind-induced volatility. While we can hope for a global market permanently awash with cheap green hydrogen, that remains a distant dream. Thus short run price signals remain necessary and the contractual position that energy consumers are exposed to must be carefully considered. As the importance of capital costs rise in the energy system and fossil fuel price exposure reduces, how consumers pay for energy should change to reflect the capacity they create the need for.
There would therefore seem to be an increased role for longer term contracting within the European energy system where consumers are able to lock in a significant part of their energy costs at fixed prices. Contracts for Differences (CFDs) written by the government can help do this for low carbon generation, as can regulatory asset based funded investments in generation and network assets.
Better ways to induce demand-side flexibility, other than by sharp rises in prices, need to be investigated. More controlled shifting of device demand across the day could increase flexibility without the use of indiscriminate price based rationing. Deeper demand response can be complemented by increasing the availability of low carbon base load power (for example from nuclear, biomass, or hydrogen), which could be of increased value if intra-day demand side flexibility could be improved.
As we move to net zero, market design will need to evolve. What most energy customers will care about is not the design of individual wholesale markets but the retail market for energy. However, the nature of the retail market and its regulation will have implications for the design of wholesale markets.
To be continued….
*With thanks to CERRE members for a helpful discussion at the CERRE Market Design Workshop on 7 December 2021. All of the views expressed in this paper are those of the author only and should not be taken to represent the views of any other party with whom he is associated.