[petejh]

Some changes to the European gas market coming down the line which are interesting*, if you're that way inclined. Likely we'll be seeing in the UK some form of what's being proposed.

The EU, via Germany, announced yesterday an intervention to the standard 'marginal pricing' market for electricity. Marginal pricing is the mechanism by which virtually all commodities are traded. Two excellent explainers below, the first on how marginal pricing works, the second on how the EU's proposed new market mechanism will work.

Basically the new model proposes that spot market price for electricity per MW/hr, as set by supply/demand, will remain unaffected. Electricity generators with the lowest costs of generation - and thus the highest profits (solar and wind, nuclear) - are to have a greater proportion of their profits taken away. Higher-cost generators - thus lower profit margins, e.g. those that use coal or gas to produce electricity - are to have a smaller proportion of their profits taken away. The surrendered profits presumably will be used to fund subsidies to help people afford electricity. Illustration below (y-axis = cost of generation as it's not obvious).




It will be interesting to see what incentives perverse or otherwise this new market system introduces, as it couldn't be more different to the usual way commodities markets set prices, which as a consequence incentivises (via larger profits) those producers with the lowest-costs. Many questions around how it will work with forward pricing, and which generators it will end up incentivising in the short-term versus long-term. Also whether this is a temporary intervention or a long-term change to the market. I'm interested to see what if any impact this will have on renewables investments.

No doubt economists will be carrying out studies for years to come on the European gas and electricity market of 2022..

Explainer on marginal pricing here: https://neon.energy/marginal-pricing
Explainer on the new European market model: https://twitter.com/LionHirth/status/1566652036623515649?s=20&t=6wALlTuHIxJ7dZHk7NUwxA



*I find this stuff pretty fascinating and it couldn't be much more relevant to people's lives than this year. But I'm sure many won't. Also am I the only one amused at the irony of a mainstay of capitalism - the marginal pricing mechanism for commodities in a free-market - being rendered unworkable due to a Russian invasion?

[Johnny Brown]

Classic economist line there - The market is working great, it just produces a terrible outcome.

There was a letter to The Times on this:

https://twitter.com/wilkesb/status/1565258473960624130/photo/1

Basically the new model proposes that spot market price for electricity per MW/hr, as set by supply/demand, will remain unaffected. Electricity generators with the lowest costs of generation - and thus the highest profits (solar and wind, nuclear) - are to have a greater proportion of their profits taken away. Higher-cost generators - thus lower profit margins, e.g. those that use coal or gas to produce electricity - are to have a smaller proportion of their profits taken away.

This Twitter thread suggests this is already the case in the UK. It also implies that marginal costing is not really the free market your link suggests.

[SA Chris]

The flaw there is "show that new leadership was capable of making the tough decisions". I'm not holding my breath.

[petejh]

Classic economist line there - The market is working great, it just produces a terrible outcome.

Also immortalised in sayings such as 'the worst system possible, except for all the others'.

This Twitter thread suggests this is already the case in the UK. It also implies that marginal costing is not really the free market your link suggests.

Had a read, he isn't suggesting this. He's suggesting it should be changed to the system described in my original post, i.e. the German proposal to stop 'marginal pricing' (the cause of current high prices), begin 'revenue cap pricing'.

[abarro81]

I think JB is referring to this tweet:
I should, however, add a twist. Many renewable energy producers are already subject to contracts that essentially fix their prices, with the government already taking the risk on price variation. See https://lowcarboncontracts.uk.

I don't know what proportion of solar in the UK is on a fixed price, but historically these have been pretty common - I was under the impression that "merchant" solar (selling at grid prices) was relatively uncommon in Europe until recently and most projects will have been using a fixed price either via government or a commercial PPA arrangement?

I was also under the impression that some of our nuclear fleet operates on a strike price mechanism that's essentially the same as this, though maybe that's only the stuff that's not been built yet?

[seankenny]

*I find this stuff pretty fascinating and it couldn't be much more relevant to people's lives than this year. But I'm sure many won't. Also am I the only one amused at the irony of a mainstay of capitalism - the marginal pricing mechanism for commodities in a free-market - being rendered unworkable due to a Russian invasion?

I don’t know the first thing about energy pricing but it is interesting, thanks for posting. One possible way to think about what’s happening might be to consider that markets fail all the time due to failures of information, and that now energy prices have gone so high that they no longer contain any useful information. Or any useful information beyond “you can’t afford this” to which the only possible response is to stop consuming the stuff.

Stiglitz’s Nobel lecture is good on this - https://www.nobelprize.org/uploads/2018/06/stiglitz-lecture.pdf.

As you say, a goldmine for future studies.

[Johnny Brown]

Yep, referring to Pete's summary rather than the link.

the current excess electricity profits arising because prices are based on the cost of gas production already flow to the government, a little-known fact.

What isn't clear to me is whether marginal pricing is the true free market your link claims, or subject to a lot of fixing to stop energy firms going bust, as that fella on twitter implies.

Either way, as Sean points out, we're seeing the limitations of the correct functioning of markets aren't we?

[Nigel]

Are the profit magins for each producer type capped at the same amount? Or is it a sliding scale of some kind?

[petejh]

How's your German?

https://twitter.com/jbebermeier/status/1566352756125884417


It doesn't go into that much detail, about relative sizes of margin remaining after cap. Devils will be in the detail no doubt.

[petejh]

Yep, referring to Pete's summary rather than the link.

the current excess electricity profits arising because prices are based on the cost of gas production already flow to the government, a little-known fact.

Got you.

What isn't clear to me is whether marginal pricing is the true free market your link claims, or subject to a lot of fixing to stop energy firms going bust, as that fella on twitter implies.

I doubt if that's clear to anybody! Big subject.. Pick a market without distortions, perverse incentives and downright corruption. 'the best worst system we have etc.'.

[abarro81]

I don't know what proportion of solar in the UK is on a fixed price, but historically these have been pretty common - I was under the impression that "merchant" solar (selling at grid prices) was relatively uncommon in Europe until recently and most projects will have been using a fixed price either via government or a commercial PPA arrangement?

I just did a very quick bit of digging on commercial PPAs - I get the impression that in this will just be shielding a company from paying full price at the moment: Google (or whoever) will be selling into the grid at an exorbitant price and buying back at the same exorbitant price... so no-one is really making any excess money off PV or wind installations with those contracts. You'd just effectively be forcing a company that's locked themselves into fixed prices out of a fixed price contract, for better or worse

[petejh]

Either way, as Sean points out, we're seeing the limitations of the correct functioning of markets aren't we?

Depends what you think is the 'correct' purpose of markets I suppose. If you believe markets exist - at all times and under all circumstances - to make our lives easier by making exchange of goods efficient whilst sheltering us at all times and under all circumstances from economic shocks, then yes it's reaching its limit.
But I'm inclined to agree with the energy economics prof, who's implying that most markets most of the time do make our lives easier by allowing efficient exchange of goods, but sometimes under exceptional circumstances, they don't and may need interventions to cushion the shock. But be very careful you don't fuck about with markets too much once a major crisis has passed or you risk throwing out the baby (efficient markets) with the bathwater (high prices in a major crisis). As per the link above:

The power market, the mechanism that clears demand and supply, works smooth and fine. It’s not
dysfunctional or broken. It works exactly as you would expect it to work, given sky-high gas prices.
What’s wrong is not the market, but the outcome it produces. That’s a hell of a difference. High prices
are an existential threat to many households and firms.

None of the above implies electricity markets produce outcomes that are desirable. Currently, I think
they do not. I’ve been advocating for cushioning policies for those affected since March. But claiming
that “this market system does not work anymore” is, in my view, simply not true.

[Offwidth]

Thanks for this Pete.

On a related subject I watched this debate yesterday which had some interesting stuff on pros and cons of windfall taxes with a look at some alternatives

 https://ifs.org.uk/publications/ciotifs-online-debate-it-time-windfall-tax

[Fultonius]

I had written a reply to this a few weeks ago on my phone, but lost wifi then never got round to posting and at some point lost the draft. I think it was something like this:

As JB alludes to, in the UK our electricity market is far from "free", and it will only become increasingly less so.

All major offshore wind farms basically operate on a 15yr contract with the Low Carbon Contracts Company. This price is set in an auction pre-construction. If the market rate is higher, wind producers pay back the LCCC the difference, when prices are low the LCCC pays producers the shortfall.

In the early days the "strike price" was in the £100/MWh (10p/kWh) region, but the latest rounds of bidding are down in the £45-£50/MWh. Which means, at current wholesale prices, those (older) producers are currently paying back £100-£200/MWh to the LCCC.

Originally the LCCC added a levy to consumers bills, but it can't be long until they    https://utilityweek.co.uk/lccc-expects-to-return-39m-of-cfd-payments-to-suppliers/

The Low Carbon Contracts Company (LCCC) has said it expects to return more than £39 million of Contracts for Difference payments to suppliers as result of exceptionally high power prices over the last three months of 2021. The body said the final quarter of the year was the first in the scheme’s history in which generators returned more money than they received.

I need to read up more on this - I'm not sure what happens if the LCCC is consistently in surplus, do those with the lowest strike price get a proportion back?

[Edit]Aaah, so the £39m rebate is for the LEVY paid by all suppliers to fund the LCCC, rather than a return to the individual wind producers (I guess they will get a proportion). [/edit]

Either way, the more offshore wind that comes on, the more the price is stabilised at a low level. There are higher balancing costs, but last time I checked I think it was around 20% on to of the base cost of electricity. Gone are the days where wind was "expensive and costing consumers millions".

I think new gas (and certainly new nuclear) are also part of the CfD market, but not sure. Would be pretty shit to be an electricity producer with a fixed price for the produced electricity and a highly variable and unpredictable input cost (gas).

[petejh]

Yes that is mostly all explained in the first post (most of it is in the diagram). Your last sentence is what happened to all the small electricity suppliers who went bust this year and last, due to them not making any profit margin on the spot wholesale cost of electricity, after they'd forward sold electricity at lower fixed prices to retail consumers, not banking on the macro risk that the world might change and wipe them out..
And is also why the market system (marginal pricing model) produces high electricity prices - gas fired generators are the most expensive producer at the far righthand side of the cost curve hence they set the price i.e. they don't make a loss because they are in effect producing a fungible commodity with one price - electricity in this case - and that commodity has enough demand to justify them producing it. Note that there are producers beyond the righthand side of the cost curve who aren't producing at x-demand level. If demand went up to x+1, the more expensive producer would start producing and the cost of electrify would increase to the new marginal cost of most expensive producer.

The reason the market system is hurting people is because 40% of supply has been removed in exceptional circumstances, and until alternatives are created there isn't enough supply to supply everyone at a reasonable cost. Hence Aussie coal in barges to German coal-fired plants.

The market is still a free market if it includes contracts for difference. It's just forward hedging to reduce investment risk, like all commodities markets do. It's common for commodity producers sell a proportion of their product at a forward hedged price to reduce margin risk in low price cycles. OK it might have been put on the wind companies by the government, but much more likely is that the wind companies wanted a degree of certainty on their investment provided by a guaranteed price. Same as for the nuclear - ask a company to put up 50% cost of a new nuclear build with no certainty of a minimum price to cover the risk of them losing money during a commodity cycle low; no chance it'll ever get built. Can't have it all - if you want full profit margin on the commodity sold then as an investor you have to be prepared to put up all the money and take the risk that the commodity price (in this case electricity) might be low for years and you make a loss - as the O+G giants do in the inevitable cycle lows.  And then you risk a windfall tax during booms anyway!

[Johnny Brown]

Thanks Pete, that’s a clearer explanation of the market than I’ve seen elsewhere. However it feels to me like we shouldn’t be too far away from a time where renewables are sufficiently big and reliable that a company could provide all green power AND undercut the whole gas-based marginal pricing model. Say Uk wind & solar plus French nuclear & Norwegian hydro bought in to cover gaps? Or are we saddled to gas prices as long as they provide any input at all, anywhere?

[petejh]

UK wind, solar and nuclear (and coal) are undercutting the cost of gas-produced electricity right now. Have been pretty much all year ever since wholesale gas price rose last year. Look again at the diagram in the link on marginal pricing - wind, solar, nuclear, coal, in that order, are the lowest cost of electricity production. Gas is by far the costliest. Again partly why coal is in big demand as it's cheaper than gas (currently) and the west has it.

[petejh]

The 'being saddled to gas prices' is the part that the UK and the EU are unsaddling right now. They're doing it by slightly different mechanisms but which have broadly the same result for retail consumers.

UK is introducing a sliding (rising) cap on price charged per unit of electricity dependant on generation technology - starting low and rising, from wind through solar/nuclear/coal to gas. The cap is lowest on wind, higher on solar, higher again on nuclear, higher again on coal.  On gas there is no cap on profit margin because the profit margin is small already (due to high cost of production remember).

So it's a market intervention, because that isn't how commodities markets should work whe nthe product is fungible - electricity is fungible, same thing everywhere. By having the sliding cap you disincentives the cheaper form of production in the long term.

The EU want to do something similar, except the difference between the cap unit price a wind farm receives versus the excess profit the EU takes, will be paid by the wind farm into a fund which in turn pays for subsidies to retail consumers. The UK seems to be capping the price the wind farm charges the retail market, and government pays the wind farm the difference between the cap and the actual unit price of electricity the company would have charged the retail customer based on marginal pricing, had there been no cap.

Both approaches preserve the model of marginal pricing of electricity because it's this market model that incentivises efficiency, but they're shielding the retail customer from paying the marginal price.

The CfDs the wind/solar/nuclear companies signed up to muddy the waters a bit, as noted above by various people.

[Nigel]

How's your German?

Scheisse I'm afraid.

I think your last post might have answered my question about sliding scales, although I'll admit I'm not sure! Reading you as my only source (no time to delve) I'm still not totally clear on the difference between the UK vs EU proposals. Got any links that might make it clearer? (In English!)

Thought it might be of interest to contextualise UK electricity generation per type, over the last decade, as this plays into the overall picture and people are unlikely to know this off the top of their heads:



Some clear patterns there *.

Also worth knowing that 50%-ish of our gas usage comes from North Sea gas fields classed as "domestic", about 30% comes via pipeline from Norway, and about 20% as LNG on ships from Qatar, the US etc. 2021 figures here, expect similar this year:
 

You can put all that together to see that we are quite exposed to high gas prices as we use a lot of gas, in order to replace coal. But we also in total use a lot of nuclear and renewables so, whatever any pricing changes do, they should have an effect (?). Note that it might look like we are smashing it on renewables, but we are around the EU average (Google it).

*These figure do vary by a couple of percentage points here and there from the UK Gov figures in link below: https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1032260/UK_Energy_in_Brief_2021.pdf but they ballpark agree and its a better visual. The trend is correct.

[andy popp]

it feels to me like we shouldn’t be too far away from a time where renewables are sufficiently big and reliable that a company could provide all green power AND undercut the whole gas-based marginal pricing model. Say Uk wind & solar plus French nuclear & Norwegian hydro bought in to cover gaps?

Apologies if I'm misunderstanding the point/question here, but I understand that Denmark regularly generates more than 100% of its electricity needs from wind - 115% yesterday, 120% last Friday. I can't see that the country enjoys any great natural advantages over the UK when it comes to wind power, so of course it should be possible. No idea about what it means for energy prices though I'm afraid.

[remus]

Apologies if I'm misunderstanding the point/question here, but I understand that Denmark regularly generates more than 100% of its electricity needs from wind - 115% yesterday, 120% last Friday. I can't see that the country enjoys any great natural advantages over the UK when it comes to wind power, so of course it should be possible. No idea about what it means for energy prices though I'm afraid.

The UK also semi-regularly generates more than it requires from renewable sources (which can have the interesting side effect of energy prices going negative i.e. energy companies paying consumers to use power!) The issue is the variability in the amount of power provided by these sources means you either need a hugely over-specced amount of power from these sources to cover lulls (which has loads of it's own problems), or you need significant base load capacity (the nuclear + hydro JB was referring to) and preferably a power source that can respond quickly to fill any gaps between the base load and whatever you're getting from renewables at the time (which is currently done with gas and a little pumped hydro in the UK).

Another option is that the world gets a lot better at adjusting it's power usage to what is available at the time (make toast while the sun shines). I guess this will happen to an extent. Yet another option is distributed battery storage, for example in people's electric cars: say you have 20million EVs, each with a 50kWh battery, that gives you ~1TWh of battery storage which compares well to something like DInorwig pumped hydro (~9.1GWh) (glossing over the huge practical difficulties of what using all those batteries would actually entail).

On a more concrete level, power grids between countries are typically getting better at connecting to each other (using high voltage DC interconnects) which means that when e.g. Denmark produces 120% of it's capacity in wind it can export that power to someone who can use it. This does seem to work well but can cause stability issues if the link goes down (as happened recently with a France/UK interconnect).

[andy popp]

My ignorance showing, I didn't realise the UK also manages this quite regularly. Clearly reliability is the main issue and though I get the impression it happens more than semi-regularly here there must be times when it doesn't - but I don't know how often that is. Yes, the surplus is exported elsewhere in the EU.

[petejh]

I’m still of the opinion that the fire which shut down the IFA UK-France interconnector last year was Russian sabotage and a warning shot by Russia, pre-Ukraine, of the sort of thing it could do to electricity supplies mid-winter to compound the European gas tightness. A disruption to the interconnection system at this time would almost certainly tip the balance into temporary blackouts.

Similar to the suspected Russian sabotage of various undersea internet connections between Svalbard, Greenland, Canada, Iceland in the last few years. If you do some digging around Reuters, Bloomberg etc. it’s considered at least ‘suspicious’.

Interestingly they developed the cable cutting capability as a response to the network of sensors under the Atlantic and pacific which detect Russian subs. I was based for a short time at Brawdy in south wales, where the Atlantic  sensor cables came ashore and the US had a ‘secret’ listening station. Interesting story of them tracking a whale transiting all the way across the Atlantic to provide proof the system works to a disbelieving US Navy.

[teestub]

I’m still of the opinion that the fire which shut down the IFA UK-France interconnector last year was Russian sabotage and a warning shot by Russia, pre-Ukraine

This seems a bit tin foil hat territory, any credible sources?

[chris j]

My ignorance showing, I didn't realise the UK also manages this quite regularly. Clearly reliability is the main issue and though I get the impression it happens more than semi-regularly here there must be times when it doesn't - but I don't know how often that is. Yes, the surplus is exported elsewhere in the EU.

The unreliability of supply is a problem that has to be solved by storage sooner or later.  Take Scotland for an example - they have a rapidly growing renewable capacity, but when it's properly cold in winter there's often a high pressure and no wind for days at a time. Given the SNP & Greens unwillingness to replace any of the nuclear plants I don't know where they expect to turn other than relying on NS and Norwegian gas.