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Does electricity market integration benefit to consumers?

February 5th, 2008 by Dominique Finon, CNRS Paris

Market integration results in increasing electricity bill for consumers in countries enjoying large power generation capacities at low cost. Generally, the rationale for opening-up the market makes sense if enough freedom of choice exists so that considerable effects of production reallocation can be expected. When there are too many restrictions in the system, market opening leads to redistribution without any reallocation.

Electricity market integration is supposed to be beneficial to all the economies as it will be for any other good market. Electricity with lower marginal cost of production in some countries will be sold internally as well as in the neighbour countries on the same playing field. The price on the integrated market will be established between the lowest price and the highest prices on the respective markets when they were not integrated. It will benefit to the consumers in the high cost production countries and it will increase the profitability of the lower cost producers in the other countries.

In the longer run the comparative advantage of the low-cost producers should lead to an increase in low-cost capacities. The scarcity rent on the low cost equipments, which acts as a windfall profit resulting from the change of the demand function, are generated by the way price is set on the integrated hourly markets: marginal capacities in the high cost countries set the price in all the integrated markets when interconnection capacities are sufficient. This scarcity rent incites the efficient producers to invest in these technologies. Consequently, capacities would migrate from high-cost producers to low-cost producers and, after several years hourly prices would adjust to the marginal costs of low-cost producers. Eventually if the high cost producers are able to master the technologies of the low cost producers and are not restricted from developing them, they can react by developing also these technologies and contribute to the lowering of hourly electricity prices in the long term.

The problem with newly integrated electricity markets is that this economic scheme is purely theoretical. It ignores the reasons for which producers have low marginal costs of production in some countries and high in other countries at the moment of the regulatory shock of markets liberalisation and integration. It does not distinguish production by existing and out-written equipments and production with new equipments, to qualify the efficient technologies. Finally, it supposes that development of all technologies is free and unconstrained.

In a context of high fuel price, technologies with low variable costs and high investment costs are both the most efficient in the short term to operate in hourly markets and on the long term in terms of total costs, provided that they are built within an industrial organisation allowing to allocate investment risks not only to the producers. However, their development is not free. Nuclear and hydraulic plants are subject to permanent political and social restrictions. Moreover, hydraulic plants are constrained by definitive limitations of resources.

The scarcity rent drawn by low cost generation units installed well before cannot be used to invest in new units, contrarily to the hypothesis of the theory. Consequently the price increase in the country with low costs producers resulting from the market integration, will not help the purpose of the market integration for all the consumers, i.e. a price decrease in every sub-market of the single market which would be reached with investment. In particular, consumers from the countries with low cost production will never take advantage from the low level of market price that they would have been benefited if their national markets were not integrated into the single market. In any case they loose money from the liberalisation in comparison with the low level of regulated tariffs that they were paying in the former system of regulated monopolies.

Occasional congestion at interconnections add a dimension to the problem. The interconnections can constrain physical commercial flows during a part of the year in particular when two countries have a very different structure regarding their fleets of equipments at the moment of the market integration. Consumers of the low cost country would pay less during period of congestions than if there would be no physical restriction to trade. Transmission system owners extract some rent coming from the difference of market prices between the two markets during periods of congestions, via the revenues of auctions. But they will be incited by the regulators to develop interconnection capacity by using this rent to allow a wider inter-market trade. At the end of the day, consumers of the low cost country will pay yearly as much as consumers in the high cost countries.

Whatever it could be about congestion, this redistribution effect which results from market integration instead of a reallocation effect will concern the Nordic consumers which could be one day affected by the development of large interconnections with the German and Dutch markets. But the issue is in fact the most problematic for all the French retail consumers when the regulated prices will be suppressed in a next future, given the predominance of nuclear generation (around 85%) in France. They will be in a situation in which they will pay a much higher price during 60% of the year, period during which nuclear production would be marginal on the hourly market if the French market would be insulated from the foreign markets instead. Nuclear would be marginal during 5000-6000h instead of 1000h on the integrated markets. So they would pay on average around 35 €/MWh in the situation of French market isolation, instead of 55-60 €/MWh, (the variable cost of a marginal CCGT on the German market, to simplify) when the French market is integrated to the continental one. The more striking problem is that on the integrated market the loss of French consumers’ will not help at all the German, Belgian or Dutch consumers to benefit from lower prices. Indeed, even with the exchanges between national sub-markets, the hourly prices do not change really in their respective sub-markets. On the continental hourly market, French nuclear production is marginal during a too short period (1000 h as said before) to significantly affect the market prices. It could do it if the French nuclear fleet would be double that it really is.

This situation would be acceptable politically if every electricity company on the continental market, and EDF greatly, could use the scarcity rent of their low marginal cost equipment to invest rapidly in equipments of efficient technologies to supply all the markets. It is the economic function of a scarcity rent in a reproducible production factor. But political restrictions on any new nuclear plant development are effective everywhere. Even in France if EDF or any entrant as Suez-Electrabel may invest in nuclear plants, it will be politically acceptable only at the margin if new plants are aimed to supply the other markets. In other words, French producers could not double their nuclear fleet for supplying other markets. Consequently, there will be no reallocation of production towards the more efficient producers on the long run. The scarcity rent of existing nuclear equipments could not play its usual economic function. It is a windfall profit that should be reallocated to French citizens in a way or another (see my recent working paper with J.M. Glachant “la hausse inévitable des prix de l’électricité en France”). It is important to notice that presently the sales under regulated tariffs suppress scarcity rent of the EDF’s nuclear production that it could be drawn from the local retail market with market prices (90% of the sales are under regulated price, even on the industrial segment), while EDF draws it normally on foreign markets.

To a lower extent it is also the situation of Swiss and Austrian consumers during part of the year when the electricity companies prefer to store inflow in reservoirs in order to sell electricity at high prices during winter or for reserve needs of neighbour markets, rather than to produce and supply them. Hydro power producers in Austria are happy to supply German networks with reserve power to compensate for fluctuations of wind energy at an increasing rate. This leads to windfall profits in Austria because the marginal capacity in Germany is gas-fired and has a much higher variable cost.

To conclude, market integration raises a key issue concerning consumers’ interests in countries enjoying large low cost production capacities at the moment of the market liberalisation and integration. Generally, the rationale for the open market approach makes sense if enough freedom of choice exists so that considerable production reallocation effects can be expected. If there are too many restrictions in the system, market opening will lead to redistribution without any reallocation.

This makes legitimate to contemplate redistributive compensations towards local consumers in countries which benefited from low cost producers. In the European and national conflicts on regulated tariffs which remain in some countries among which France, it could not be heretic to take into account that market integration of electricity industries cannot intrinsically have positive effects on prices to final consumers in short term as well as in long term because efficient technology development is constrained everywhere. It has only significant positive effects on revenues of companies and their shareholders profit. It is not exactly a convincing result for the consumers of countries with low cost productions, particularly when they understand that their sacrifice is useless.

In the long-lasting conflicts on the regulated tariffs, it should be desirable to forget general textbooks on market economics in order to understand the functioning of the own mechanisms of competition on integrated hourly markets. Perhaps the illegality of regulated tariffs to domestic consumers which are also the citizens will appear a not so crucial problem to urgently solve. Indeed what is at stake is the political econonomy of the market reform. To win the acceptation of the reform would need to reallocate scarcity rent in a visible way to citizens. Tax on the historic operator’s revenues and dividends associated to the State’s shareholder position which will be paid to the public budget are a channel of reallocation but it could not be perceived as such by citizens in a country like France. Direct payments from these dividends” to the consumers-citizen, or regulated tariffs which would be designed as payment of drawing rights on existing nuclear assets are two solutions which would perform this catalyst function of reform acceptability.

Dominique Finon
CIRED (CNRS-Paris) and Gis LARSEN (CIRED-EDF R&D-GRJM)

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4 Responses to “Does electricity market integration benefit to consumers?”

  1. Goudriaan Jan Willem Says:

    Interesting contribution and good observation. I have spoken with large energy users (steel industry) who fear interconnection as it will pump electricity to higher priced countries driving up cost, and threatening these industries and the jobs concerned (long established and based on historic calculations of cost) Prices in europe’s socalled most liberalised market the UK are going up and more people are pushed into fuel poverty.

    Theoretically the contribution is of interest, pratically and politically Europe has problems with coordinated taxation policy on the scale referred here.

    There are so many side and secondary bite back effects of energy liberalisation (fragmentation of health and safety policies in the UK are a recent example), so much ignorance of Keynes on utility economic policy and so much zealous effort to create liberalised markets that it is forgooten that when citizens have been asked to judge: Latvia, Switserland and some municipal referenda in Germany and Netherlands, on the merits of liberalised electricity or public services they prefer a regulated and public service system over the market in tehse areas. The European Union needs to rethink its market based policy in these network services like electricity as indeed as this contribution suggests textbook economic theory might not apply.

    Jan Willem Goudriaan
    EPSU
    http://www.epsu.org

  2. Eileen Fumagalli and Clara Poletti - IEFE Says:

    Professor’s Finon post raises a number of interesting points on the opportunity to foster power market integration. We would like to contribute to the discussion by highlighting some issues on which we do not fully agree with him.

    Professor’s Finon piece neglects potentially important efficiency gains that could arise from tighther market integration. Even assuming modest long term effects,integration is crucial to increase efficiency in the use of existing capacity. Thanks to integration, high cost generation capacity is displaced in many hours by lower cost capacity. This implies a reduction in total costs of production; which causes a net increase in total welfare. Further, grater integration may make it unnecessary to build generating units that, in separate markets, might be necessary to build, if anything to match the reserve margin targets. In the end customers would pay for those extra costs that could be avoided with greater integration. We thus see strong efficiency reasons to increase power markets integration.

    The impact of market integration on consumers’ welfare identified by Professor’s Finon is by no means different from what we observe in all markets. Mozzarella-cheese eaters would most probably benefit from a ban on using Mozzarella in pizzas, since the ban would reduce demand for Mozzarella and hence prices. A ban on exporting Mozzarella would likely have the same effect, on Italian eaters. These (inframarginal) effects have not prevented EU citizens from pursueing a single market for all good and services. We don’t see why – in this respect – electricity deserves a different attitude.

    The relationship implied by Professor Finon between investment (in generating units or transmission networks) and rents (from wholesale electricity sales or from the allocation of transmission capacity)is not obvious. Investments in generation are decided and implemented when the expected profits are greater than cost; investements in network expansions should be carried out – in a regulated environment – when they increase welfare, according to the assessment of the institutions responsible for network development. The cost of network development may be greater or lower than the rents accruing to TSO’s from the allocation of existing capacity. The availability of rents is neither a necessary not a sufficient condition for those investments. rents remunerate past investments in scarce resources. We see no immediate reasons – aside from major imperfections in capital markets – to condition investments on self-financing.

  3. Didier Holleaux Says:

    I agree to a great extent with professor Finon.
    I would add two comments;
    The first one is that there is a sort of coumpounded effect in the fact to deprive the citizens of the countries who accept nuclear power plant of the benefits of such plants (i.e. lower electricity prices): once the link is destroyed between having a power plant and benefitting from it, it is most probable that the very broad public acceptance of power plants in a country like France will vanish, therfore limiting further the possibility to build new such plants and therefore increasing the average cost of future power production.
    The question could even be reversed: if we suppose that the average price of electricity in Europe will decrease because of market integration (what I don’t believe will happen), what is the political legitimity of a reduction resulting from the inclusion of nuclear power plant in such integrated market benefiting to citizens of countries who refuses to have nuclear power plants?

    The second comment is that Canada has found an original solution to the question of allocating the benefits of large infrastructures to the citizens who are accepting the (negative) externalities of such infrastructures: a part of the power produced from the large hydrolelectric plant of Bay James is not put on the competitive markets but is called “électricité patrimoniale” and sold at cost to different types of consumers (the repartition between these different types being decided by parliament). Consumers can then buy a limited share of this “électricité patrimoniale” and buy the complement of their needs on the open market. This allow conciliation of a direct return to the citizens, for the investment and externalities they have accepted, and of an open market for the remaining part of the electicity. In the case of nuclear in France, but also in the case of hydroelectricity in Scandinavia, allocating 50 to 60 % of the power produced through such mechanism will encourage both the industry to build such plants (since they will pocket 40 to 50 % of the rent) and citizens to accept them (since they will pocket the lion’s share of the rent).

    One final comment, regarding the above contribution by people of IEFE: the purpose of professor Finon’s paper was to highlight that electricity markets aren’t behaving as market theory says they should because building low cost power plant and electricity grid interconnections isn’t just a decision which is in the hands of the industry, but the ressource is scarce and accessing it requires a lot of time and public acceptance. Therefore pretending to compare it with mozzarella’s market just shows that the authors of the comment have failed to capture what the paper was all about.

  4. Guido Cervigni Says:

    I have a problem with Didier’s proposition that electricity markets don’t behave like “economic theory says … because the resource is scarce and accessing it requires a lot of time and public acceptance”. Scarcity features in all areas of the economy. In this respect, the product “acceptance of a nuclear plant” is a scarce resource as many others.
    Professor Finon’s approach implies a specific device for “owners” of that scarce resource to appropriate its value. This device is: limit export so that an excess supply situation in France will translate into lower electricity prices for France customers. Drawbacks: inefficiency, no single market, untargeted distribution on the rent among France citizens …(those living far away from the nuclear plants will get the same low prices as those living near the plants ….)
    In the public finance toolbox there are policy instruments that can be deployed to protect the “owners” of the right to accept (or veto) the construction of a nuclear plant. Properly designed mechanisms would allow achieving this protection at a lower efficiency cost. Simplifying a lot, you can just tax nuclear plant owners and redistribute what you collect to the threatened local communities.
    The speciality highlighted in Professor Finon’s piece has not to do with scarcity but, in my understanding, with something different: the (implied) impossibility to extract economic rents from French generators through instruments with a low impact on the electricity market.

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