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.