Iain Wright – 10th March 2022
Everyone knows that Scotland is one of the most energy-rich countries in Europe and everyone also knows that Scotland produces a very high proportion of its electricity from non-fossil sources. Yet people have experienced unprecedented increases in the cost of their energy, with even higher prices expected over the coming months. Social media is awash with anguished posts from people whose energy suppliers have told them that their monthly payments are about to be doubled, or worse. Is it just that we are being ripped off by the energy suppliers, with the solution being to bring the energy industry back into public ownership so that power can be sold at cost?
The answer isn’t entirely clear cut, but public ownership could certainly contribute to fairer pricing and avoid further turning the screws on people in fuel poverty. Of course the counter argument is that it’s all down to market forces and everyone knows you can’t buck the market. But what is “the market” and why does it produce such stratospheric prices when the cost of wind and sunshine remains at zero? Of course we also have nuclear, gas and coal generation on the system, but generation costs for these technologies are all impacted by observable changes in their fuel cost, whereas renewable generation is not. For as long as renewable generation represented a small proportion of total production, electricity market pricing based on marginal pricing (the “least worst” generator offer price that matches total availability to customer demand) could strike a reasonable balance between producer and customer interests. However this balance of interest breaks down as the share of renewables becomes more significant.
But before suggesting any alternative approach, we have to look at current market trading arrangements in order to understand which areas might usefully be targeted for reform. In the context of this short article, I want to focus on the electricity market that, even though it is extremely complex, is nevertheless more comprehensible in its aspects that matter to us.
At the outset we must recognise two key conditions that any reforms must respect. Whether Scotland is in the EEA, the EU, or even still in GB the wholesale market must conform to the current, legally-mandated requirement (even the EU market is largely based on the GB market), that no undue discrimination is allowed between customers or between participants operating in the market; separate business activities (generation, supply, distribution, etc) must not cross-subsidise each other. The market design is “bilateral”, which means that trading takes place between pairs of participants; ie supplier/generator, supplier/supplier, etc. Often trades are conducted on power exchanges, where power is turned into products based on combinations of; baseload, weekdays, weekends, seasons, peak times, etc. Closer to real time, e.g. day-ahead or within day, power is traded on the basis of bids and offers for each half hour, with the price being that at which buy and sell volumes are balanced.
Suppliers use the market to stabilise the cost of the power they sell to customers, by buying the bulk of their power in advance (i.e. hedging their input cost) and refining the balance between their contracted energy and expected sales closer to real time. For example, the winter may turn out warmer than expected, so suppliers will want to sell their contracted power that they no longer expect to be required to meet their sales liabilities. Given the available range of hedging products, timescales and short term trading, what is the market price? Is it the price I paid last year; the price I paid last month; or the price at which I traded this afternoon to match my latest demand forecast? Suppliers must synthesise all these traded volumes and prices into a matrix of half hours and prices, that they use to formulate the tariffs at which they sell to customers. It is probably unnecessary to point out that anyone who thinks this process is straightforward is seriously fooling themselves.
Must these hugely complex trading arrangements have to be binned in order to facilitate more equitable pricing for customers? Arguably not, since the market structure is bilateral as previously described. This means that not all energy is traded on exchanges and suppliers can enter directly into agreements with generators for some or all of their output, at a price agreed between the parties. There is no doubt that a vertically-integrated energy company (i.e. one that both owns generation assets and runs a supply business) could produce power and sell it to customers at cost (NB this doesn’t mean that wind power would be free) and this would not require any expensive reconstruction of existing trading arrangements and systems. However, navigation around the legal/regulatory issues of discrimination and competition law would need a careful approach.
For example, a supplier can lose money on its operations, but if it does so as a matter of policy and the shortfall is made up through subventions from taxation revenue, that would represent discriminatory state aid. But the situation of a supplier passing on the benefit of its own low cost generation to customers is less clear cut. If the transfer price of the power from the generation assets was less than the cost of financing and maintaining the assets, then that would also be clearly anti-competitive, but a transfer price for long term supply of power at some “smoothed” market price would be less overtly favourable to the state supplier and at least arguable. One final thought on a publicly owned energy business is that the government could take a dividend from it, in the event of a windfall profit, and use the money to make payments to fuel-poor customers, no matter which supplier they are with. State aid, discrimination and cross-subsidy are perceived as wrong because they are seen as promoting inefficiency and unfairness. Government intervention to extract unfair gain actually corrects another form of market failure, even if initially confined to publicly‑owned businesses.
Of course, the market is complexity and addressing competition and state aid obligations is always a headache, but in circumstances such as those in which we currently live, it is essential to apply creative thinking to address issues with an energy market that is crushing those with the least resources to cope. It should also be clear from the foregoing, why the idea of a supply only public electricity company is daft.
Although I have previous experience in the community owned renewables space I am not an expert on the way energy markets function I have to say that I do not follow your conclusion that “from the foregoing the idea of a supply only public electricity company is daft.” Elsewhere in the article you say: “….the market structure is bilateral as previously described. This means that not all energy is traded on exchanges and suppliers can enter directly into agreements with generators for some or all of their output, at a price agreed between the parties.”
If there is scope in energy markets for bilateral agreements between generators and suppliers surely it follows that a national energy company established as a “supplier”, thus bringing the state into the market as an active participant, provides scope for a NEC to negotiate bilateral agreements with the full panoply of private sector generators. Every facility producing electricity has its own specific capex, opex and outputs, all of which are factors underpinning the basis of a contract for supply. The NEC can then act as sole supplier based on a “basket average” price. There are no state aid issues whatosever if the commercial sale price is set at the basket average whilst permitting the state to underwrite any subsidy it may wish to provide to domestic consumers. The contract price for supply would also permit a margin for a reasonable level of profit for each generator. If there are fluctuations in the output from individual facilities which give rise to windfall profits these could be offset by after-the-event windfall taxes. Under standard conditions the standard level of profit would be generated and in those circumstances there would be no necessity for a profits tax.
Of course the process for negotiating contracts for supply will depend on full transparency regarding capex, opex, depreciation etc. The NEC may also have the market power to insist on compliance with minimum standards of employment, health & safety, environmental impact management, etc.
To my mind a “national energy supplier” model for a NEC seems perfectly logical so I can’t fathom why you describe it as a daft idea. Am I missing something?
First of all, thank you for taking the time to respond to this article in such a detailed manner. If I may summarise your points as follows, I’ll respond to each of them in turn.
• The need for vertical integration for a NEC isn’t clear
• The NEC could contract with private sector generators on an open book basis and set tariffs based on a measure of average cost plus allowed margin
• An NEC could use its market power to raise environmental and employment standards
• The state aid issue does not engage if tariff prices are above average cost
• Windfall profits would only arise due to output variability
My argument for vertical a vertically integrated NEC is based on the need to own all parts of the value chain, because current market arrangements mean that unexpectedly high wholesale market prices can lead to super normal profits for generators or suppliers, based on their contractual relationship, or just result in the profit being paid to the central fund where support is via the CfD mechanism. The business of “Supply” is normally a low margin activity, as can be deduced from the scale of business failure in this area of the market and perhaps also from SSE’s willingness to sell its supply business so it could focus on its renewable generation activities. So, if you’re operating in an area that is low margin, is more risky compared with other sectors within the same overall market and can only capture a proportion of any windfall gains, why would you want to ignore potential gains that might arise elsewhere and provide further support for your social objectives?
In relation to offering commercial contracts on an open book basis and that are designed to limit generators’ financial returns to below market rates, I can only say, “Good luck with that and tell me how you get on”.
In regard to using market power to achieve anything, I suspect that this would be more likely just to increase costs for the NEC, rather than induce competitors to up their game. After all, there are only so many people that can be employed by the company and the risk of any resultant loss of staff would not be perceived with any level of concern by the rest of the industry. Currently the kind of standards you describe are defined by legislation, which seems to me to be the most effective means of delivering a coherent package of universal societal objectives.
Your fourth point highlights the aspects of operating an NEC that are most complex to address, I think because the solution seems to be so self-evidently sensible. But the legal and regulatory issues I mentioned cannot be ignored.
Even an independent Scotland would face constraints in this area; particularly if it retained any aspiration to join the EEA or EU. Without independence, we remain bound by GB arrangements (energy in Northern Ireland is devolved and operates within the all-island market). The GB regulator has been very strict in its interpretation of cross-subsidy, taking the view that a generator is cross-subsidising a supplier if the transfer price is less than the market price. The sale arrangement would also be discriminatory if the generator would not also sell its power to another supplier on the same terms. These constraints apply even if the two businesses are owned by the same legal entity, because they are still related businesses. Historically, of course, things were different because the electricity industry was run as a collection of state-owned entities with local monopolies in their respective areas of responsibility. But even then it took a Monopolies and Mergers investigation to move the north of Scotland Board away from the kind of weighted average tariff pricing you describe and replace it with the more economically-efficient marginal cost based pricing.
One final consideration is that the wholesale market is based on conventional, ie thermal, generation technologies where the marginal cost of overall system production increases with demand (one of the reasons for half-hourly wholesale pricing). As the proportion of zero marginal cost generation on the system increases, the residual demand to be met from conventional generators reduces and the market price is therefore lower than it would otherwise be for the same level of demand. Introduction of the capacity auction process to the GB market arrangements has been one response to this issue. So we know that market arrangements, in or out of the EU and independent or part of the British Union, have been designed to ensure that all participants operate on a level playing field and that economic value does not leak out from one party to another. Indeed the declared aim of the European target model for wholesale market design is to ensure a uniform price of power across the EU in the day-ahead market. So what is to be done if value is prevented by law and regulation from flowing around the market in a manner that allows targeted support for particular customers?
My answer is for the Scottish Government to create a vertically-integrated, publicly owned power business and extract dividends from each of the legally ring-fenced businesses, in the same way as commercial owners do. Actual revenues would initially be small until the business gained scale but, in the absence of realistic borrowing powers to start off at scale, there seems little alternative. Why has the Scottish Government rowed back from its commitment to a full scale energy/development business, as described above? Who knows, but I can only speculate that there is a lack of expertise about the industry in the inner circles of government and any external advice may have reflected either the vested interests of the industry or unhelpful GB government guidance. Finally on this point, I would emphasise is that a publicly owned NEC should be run at arms length and definitely not as a quango, as an organisation of this sort would require considerable technical and commercial expertise, rather than being overseen by establishment figures.
Finally, I note your point about windfall gains in relation to variability of output, but I would point out that gains are a product of price as well as volume. In the current market environment, it is price that is the issue and the source of windfall gains for renewables (and others). The market price for marginal transactions defines the revenues of renewable producers who trade unhedged power, so these generators see a wall of cash heading their way while their input cost remains zero, so their inframarginal rent is the full market price (minus a relatively small amount for operation and maintenance). Is this realistic? Well the industry has now matured to the extent that a growing amount of capacity has paid off its development loans and no longer benefits from support mechanisms that have run their course, allowing owners the option of accepting full exposure to market prices.
You may argue that what I’ve suggested isn’t really the best solution, but my response is that we have to recognise the realities of our current situation and it’s better to get started on something that can be done now, rather than shout from outside the industry about changes you want made before you’d be willing to participate.
Iain, I think you have missed my basic point – the NEC as sole supplier would control the market and set the prices – both for the purchase from generators and the sale to commercial and domestic consumers. Subsiding domestic energy prices (but not commercial ones) would not breach any state aid rules whatsoever.
You say “good luck with that” in response to my suggestion that the NEC would be able to negotiate bilateral agreements with individual generators, but if the distribution network is in public ownership the generators have no other means of selling their output – the NEC would be a monopsony. Obviously bilateral agreements are for negotiation but if a power generator wants a contract to supply in Scotland they would have no choice but to deal with the NEC. They can walk away if they wish but then what do they do with the infrastructure they abandon by doing that? It would be in circumstances where no private sector generator wants to contract with the NEC that state ownership of the generating capacity would have to be considered but I think such a scenario is unlikely.