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A Proposal for Reforming an Electricity Market for a Low-Carbon Economy

November 8th, 2013 by Raphael Heffron, University of Stirling

The UK is currently reforming its electricity sector. This gives rise to some pertinent questions: Do the reforms go far enough and can more reforms be expected in the near future?

The UK is not alone in its attempt to transform its electricity sector. The European Union has made three successive bids to reform the electricity market within the last two decades. The latest, namely the Third Energy Package, follows the previous two packages. The electricity sector has proved difficult to reform due principally to the competing demands of competition, energy security and climate change mitigation. Achieving all three in unison remains beyond the capabilities of most government administrations.

After some two decades of pushing the competition agenda it appears near certain that competition has reached the end of its current journey. It has delivered high prices for consumers, little investment in new energy infrastructure, reduced spending in research and development and an oligopolistic market structure. Meanwhile, the rate of carbon dioxide emissions continues to increase exponentially across the world.

Nevertheless, one must ask the question, was real competition ever present? It is claimed that the traditional fossil fuel market incumbents had and still have too much influence. For example in the US, during the presidential election year of 2012 a New York Times analysis revealed that $153 million was spent on television advertisements by the lobby promoting coal, oil and gas and/or criticizing clean energy; this is in stark contrast to a mere $41 million by the clean energy source lobbyists. The EU policy of 20:20:20 by 2020 also distorted competition. Too much faith has been placed in the policies of privatisation and competition. The expectation that the private sector would have motives other than profit was misguided. To achieve aims beyond the profit motive, government intervention is needed. Was the banking industry in the UK not saved by direct government intervention and subsidized support?

Reform should not be limited to just the restructuring of the electricity market, but should also extend to transforming the philosophical underpinnings of the market. For too long the Chicago School approach has dominated thinking in law and economics. It is now time to consider its limitations and move to reform the approach to law and economics and the development of markets. There are other worthwhile goals than just profit. This is the case in the electricity market now more than ever especially in relation to climate change mitigation. With the effects of climate change being accepted it is the considered view of leading scholars across the world that it is happening at an increased pace. For example, a third of the summer sea ice in the Artic has disappeared while the effort to keep below a 2°C temperature increase globally is likely to be exceeded despite the latter being agreed at the Copenhagen Accord.

An electricity market needs to encourage the development of new energy infrastructure. The latter can provide competition to existing energy infrastructure, help lower prices, develop technology, provide employment and contribute to the lowering of CO2 emissions. In addition, research and development needs to be supported by market participants and should not be overly reliant on public sector funding. Consumers should to be able to afford electricity, unlike the current situation where the number of people classified as suffering from fuel poverty is increasing while others choose between fuel and food or, in the most severe cases, some face death.

In examining the EU approach it is increasingly evident that the Third Energy package, since the onset of the financial crisis, is being applied in a rather lax manner. There is perhaps the realization that the pursuit of competition is not a goal to which every economic market needs to adhere to. The legislative changes proposed by the UK for its electricity market reforms are likely to be approved by the European Commission. This is despite the clear incentives and intervention in the electricity market which will favour nuclear energy and renewable energy sources.

It is questionable whether the UK reforms go far enough. Based on the EU experience, it is likely that new reforms will be introduced sooner rather than later. The composition of these reforms deserves rigorous examination and debate. The solution lies in economics and the creation of new economic markets. Different energy sources use different technologies. Also, there are different environmental goals and different safety legislation for different energy sources. The nuclear sector, for instance, has its own safety regulator. The electricity market should be divided up. In this way the competing demands of competition, energy security, and climate change mitigation can be achieved with a higher degree of certainty.

A new outline electricity market would see it notionally divided into five principal parts: (1) Gas; (2) Coal; (3) Nuclear Energy; (4) Renewables; and (5) an Open Market. A percentage of the electricity market would be assigned to each part. Until a designated percentage was met, there would be clear government support for that energy source. Any excess would be traded in the Open Market. This would mean competition for firms within a market for a specific energy source, and one with all the energy sources in an open market (which could include the capacity margin).

A government could then set out to achieve a low carbon economy (such is the aim of the UK government) and over the years reduce the percentage share of coal and gas while increasing that of nuclear energy and renewables. The excess provided by gas and coal to the open market could be charged at a premium with this in turn being used to support the low carbon sources.

The new market would have a number of benefits. It would allow for competition among companies providing the same energy source thus potentially improving the efficiency of each energy source. It would promote new low-carbon technology and give it a sustained chance of success. It would enable an improved method of replacing old technology in particular where nuclear energy is concerned. It would also offer security to investors and encourage them to invest and provide investment for long-term energy projects.

Overall, this approach would serve the core elements of EU energy policy. In separating the energy sources into individual economic markets competition would be increased, CO2 emissions would decrease over time while governments could directly support new energy infrastructure development and increase their own energy security.

Raphael J. Heffron, BA, MA, MLitt, MPhil, Barrister-at-Law, PhD.
Lecturer in Law, Stirling Law School, University of Stirling, Scotland,

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One Response to “A Proposal for Reforming an Electricity Market for a Low-Carbon Economy”

  1. Thierry Dumas Says:

    Although I can see the benefits of this proposal for market reform, it puzzles me for several reasons.

    First of all, product differentiation applied to electricity (which bears all the characteristics of a commodity) seems counter intuitive. Creating a market for each energy source boils down to differentiating electricity upon its carbon content and power generation systems. Introducing a carbon tax on electricity generation (on top of the ETS scheme) or slashing the number of quotas would give a clearer signal to investors – based on a measurable index i.e. carbon content – and would result in a more streamline market than the proposed messy entanglement of technology-specific sub-markets.

    From what I gathered, if we isolate renewable energies (RE) from other markets, we can expect a demand curve specific to renewable energies that would not be too hard to put together but what about the offer curve (assuming we relinquish feed-in tariffs which would still be harmful to non-renewable energy sources even if on a different market)? How do we estimate how much energy is going to be available at a given date on this market? It’s not only a question of how steep or how flat the offer curve is; if the wind doesn’t blow, higher prices won’t make it blow. Then how do we make sure that production matches demand at any given time granted the low predictability of renewables?

    By separating electricity markets, one destroys the merit order mechanism. From then on, how does one industrial consumer or energy trader decides whether to purchase electricity on the RE market or on other ones? It will create a big mess for industrial customers who will have to spend more time and money on contract optimisation bidding for electricity slots here and there to end up with something consistent – that is currently done naturally through the existence of a single market. How would prices be determined on the market for renewables? The marginal costs of renewable energy systems are equal to zero and they would be the only suppliers on their market. Therefore we cannot rely on free market mechanisms, we’d then have to carry on using Feed-In Tariffs (FIT) but then it’s not a “market” anymore. Thus, keeping renewables and traditional energy generation technologies together in the same market is a way of guaranteeing RE producers revenues in the absence of FITs even though it might not be as high as they wished.

    For that matter, what will happen on the open market looks very unclear, yet it’s likely to be pretty chaotic and governed by renewable energy production. Although splitting the electricity market into sub-markets is supposed to isolate chaos from non-renewable energy production, the latter will still be affected by renewables given that they share the same pool of customers.

    There seems to be two reasons why such a market design would probably not introduce security and enable long-term investments:

    • We are talking about long-term planning but energy policies are considered a national issue and are extremely sensitive to political changes which could threaten the whole mechanism’s stability (potential changes every 4 or 5 years is not considered long-term stability) unless politicians from all sides reach a consensus on a binding agreement. Once we’ve decided to implement such a binding scheme, there’s no going back as it is meant to secure long-term investments and thus cannot be altered halfway through regardless of any political motivation. However, the author makes the implicit assumption that companies are short sighted whereas the government lays out plans for the coming decades but I honestly doubt it. Energy companies are the actors which will have to put billions of euros on the table to invest in new generation facilities and that will earn their first euros ten to twenty years from now. Therefore they are the ones who care about long-term trends while political leaders are inevitably constrained by the length of their terms, the coming elections being the ultimate deadline.

    • What about technological breakthroughs – does it mean that we would have to revise the plan on a regular basis? Again, that would deter potential investors or it will make unlikely the emergence of new technologies.

    But more importantly, breaking down electricity markets into sub-markets which all have their own cap defined as a percentage of the country’s total electricity consumption does not rid the industry of the big unknown parameter: future consumption levels (which depend on the penetration of electric vehicles, on energy efficiency measures and so on and so forth). Even with such a mechanism, stakeholders will still be hitching their head on how many TWh will be consumed 20 years from now (both peak and base load consumption) – to be consistent such a central planning scheme should be accompanied by an illusory holistic energy master plan that would give detailed and numerical targets to emerging energy-related markets (along with financial support) and would only bet on a reasonable amount of future solutions rather than having a go at everything, hoping for the optimal technology to emerge in a competitive environment (which again would not be consistent with this proposal for reforming the electricity market). However, such an approach is hindered by our lack of knowledge on potential solution technologies and our little insight on where breakthrough might occur. Therefore, such a stand on energy policy would be excessively risky because it would require to go “all-in” in a technology field (that might turn out to be a dead-end) to build a consistent policy structure around it.

    If there’s a clear government action in favour of under-supplied markets, will there be some kind of insurance to reimburse/compensate plant owners who will have to shut down their facilities because of poor central planning or a fledging economy? So will the proposed scheme turn electricity generation into a risk-free industry and will it help secure investments? I don’t think so; at least not for declining energy sources (i.e. fossil energy in the long run as far as Europe is concerned). We will probably face the same issues as today with utilities mothballing power plants and stuck with a pile of stranded assets.

    The choice we have is basically the alternative between “price” and “quantities”: we either are geniuses in prospective sciences then we enforce such a reform proposal with all that it implies (“quantities”) or we rely on free market principles to shape our future energy mix, suppressing feed-in tariffs and bringing the monetized value of carbon closer to the sum of externalities it generates (“price”) but sitting on the fence seems inconsistent in this case.

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