The effect on prices of liberalizing electricity markets

ResearchBlogging.org An article in the latest Energy Policy titled “Electricity market integration: Redistribution effect versus resource reallocation” discusses the effect on electricity prices when a country liberalizes the electricity sector, and integrates it into an international market. The main argument is that the effect differs according to the source of electricity dominating a country’s production. Some electricity production, like hydro or nuclear, requires a large initial investment, but is relatively cheap to produce per unit after that. Others, like coal, is cheap to set up, but have a more expensive raw material and thus a higher per unit (marginal) cost.

The article looks at the effect of integrating a market that is dominated by nuclear power, France, into the large European market for electricity, which is coal dominated. Since the investments for the nuclear power plants have already been made, the price of electricity in France is much lower than in f.ex. Germany. When the market becomes shared, the prices immediately rise sharply in France. However, since the energy mix is altered, this does not result in more nuclear power coming online to benefit from the much higher marginal profit to be gained now [1]. The reason for this is that electricity companies have few incentives to make large investments that pay off in the long term when they could instead just get large windfall profits immediately. So the energy mix is distorted in favor of short-term investments with a higher-marginal cost, as these are still profitable under the regime. This could have been fixed by government interventions, but large hydro dams or nuclear plants are politically sensitive, so governments are wary of going into this.

Here I quote from the article’s concluding paragraphs:

Electricity market integration results in an increased electricity bill for consumers in countries enjoying a large share of power generation capacities at low variable costs when market liberalisation occurs, while it does not result in decreased prices in neighbour countries. It is the case for hydraulic and/or nuclear systems as Nordic countries, Switzerland, Austria and France in Europe, and some Provinces in Canada when they are or will be integrated with neighbour liberalised markets with competitive trade. At the same time, the scarcity rent on the low-cost equipments resulting from the market integration cannot be an incentive for producers to invest in technologies with low variable costs like nuclear and hydro, because the development of these technologies face non-economic constraints in Europe. It acts as a windfall profit resulting from the change of the demand function on their sub-markets.

As we can see (if we understand the technical language here correctly), this situation pertains to the Nordic countries too, and especially a country like Norway, with nearly 100 % hydro electricity. After describing a situation where domestic producers can suddenly charge a lot more for the same electricity without making any concessions to consumer, the article goes on to discuss how this can be remedied. They propose taxing electricity producers according to the size of their new profits and redistributing this by subsidizing energy conservation efforts with consumers.

This sounds like it might be a good idea, and windfall taxes are nothing new. They have been used to reimburse consumers during sudden peaks in oil prices, for example. However, the question remains whether simply setting up subsidies for energy conservation have the desired effect. It also poses some challenges to a system like Norway’s, where the electricity utilities are mostly publicly owned. Who is being slighted by the windfall then, and what will the redistributive effect of the introduction of a windfall tax be?

[1] Marginal cost is the price of producing one more unit when investments in production facilities have already been made. If it is profitable to produce one more MW of nuclear power at a low price, for example because the government subsidized the building of the plant, the marginal profit will go up when the prices go up.

Finon, D., & Romano, E. (2009). Electricity market integration: Redistribution effect versus resource reallocation Energy Policy DOI: 10.1016/j.enpol.2009.03.045

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One Response

  1. interesting material, where such topics do you find? I will often go

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