photo Nick Page
In the EU, and the UK in particular, the liberalisation of the electricity market is rapidly being reversed and replaced by old-fashioned command-and-control policies, writes Carlo Stagnaro, Senior Fellow of the Italian free market think tank Istituto Bruno Leoni. One of the main reasons for this reversal are interventionist climate policies. According to Stagnaro, who has a new book out on energy liberalisation, this trend will lead to inefficiencies, higher costs and potentially even blackouts. He calls on policymakers to pick up the liberalisation baton again.
After World War II, the electricity industry in Europe went through a period of nationalisation, partly because of the technical nature of the sector, and partly because of the ideological climate that prevailed in those days. Over time, however, it became clear that the arguments for nationalisation were unconvincing. Firstly, changes in technology led to the ability to produce electricity on a smaller scale. Secondly, it became clear that, even if some parts of the process of electricity production and distribution had ‘natural monopoly’ aspects, other parts did not. Moreover, it became increasingly understood that state electricity suppliers were very inefficient.
The British U-turn was paralleled by a push from the EU as well as other member states towards interventionist climate policies
The UK led the way when it came to reform. The UK market was deregulated, competition was promoted and the industry was privatised. There was then price-cap regulation of the natural monopoly element. But competition worked. From 1990 to 1999, electricity charges for domestic consumers fell by 26 per cent, with a larger fall for industrial users. Electricity companies were able to use cheaper fuels (not necessarily more expensive domestic fuels), free from political constraints. It was not only energy prices that fell in the UK after liberalisation; energy-related greenhouse gas emissions fell by 12 per cent between 1990 and 2010, and emissions per unit of GDP fell by 45 per cent.
EU liberalisation
Subsequently, there have been a number of attempts, through EU directives that followed the British model to some extent, to liberalise electricity markets in the EU more generally. By 2007, all EU member states required third-party access (TPA) to electricity networks, and most had transparent wholesale markets and a degree of consumer choice. As a result, the average market share of incumbent dominant firms in the EU fell from 64.9 per cent in 1999 to 55.9 per cent in 2010. Several private and foreign companies also entered markets that had previously been state monopolies. These steps were also accompanied by harmonisation and centralisation of regulation at the EU level.
When the demand for electricity falls – as it did post-2008 – renewable energy producers are immune to the consequences
Around ten years ago, there began a major policy U-turn in the UK. Steps that reduced competition and the degree of liberalisation include limiting the number of offers and tariffs that suppliers can make to residential consumers, measures that direct electricity generating companies towards particular technologies and long-term agreements to fix prices in markets (such as the agreement with suppliers of new nuclear technology that guarantees them a price about twice the current wholesale price of electricity). These measures will crowd out non-subsidised investments in which the taxpayer does not bear the risk.
The British U-turn was paralleled by a push from the EU as well as other member states towards interventionist climate policies. For example, many member states often capital subsidies or tax breaks to install renewable capacity, direct subsidies for renewable energy and feed-in tariffs, which treat renewable generation very favourably. In addition, member states grant either priority access or guaranteed access to the grid for ‘green’ electricity.
Market distortions
These policies have many detrimental effects. For example, when the demand for electricity falls – as it did post-2008 – renewable energy producers are immune to the consequences. Also, subsidies vary hugely across different technologies and different countries. Photovoltaics received an average subsidy of €496/MWh in the Czech Republic and slightly lower subsidies in Belgium, France, Italy and Luxembourg, whereas biogas and waste received an average subsidy of only €2.76/MWh in Finland. These differences cause enormous market distortions. In addition, for a given cost, the reduction in carbon emissions has been much smaller than if more economically rational mechanisms had been used.
In France, the marginal cost of reducing emissions could be around 50 times higher than in Finland
The cost of reducing CO2 outputs has been huge under EU policies. Even in Finland – the country that has been able to reduce CO2 emissions most cheaply – the cost per tonne of reduced carbon emissions has been around three to five times the value of permits under the EU emissions trading scheme, which provides a proxy for the cost of achieving the decarbonisation goals efficiently.
In France, the marginal cost of reducing emissions could be around 50 times higher than in Finland. This arises because the compulsory use of national renewables targets means that countries such as Sweden and France are replacing generating capacity that emits very little carbon with renewables. This is hugely wasteful. A carbon tax or cap-and-trade system alone would lead to a much more efficient outcome.
Further problems caused by climate change policies include the genuinely competitive part of the market being reduced in size as well as significant supply-and-demand imbalances. The intermittency inherent in many renewable sources of energy also leads to price spikes and the potential for either huge increases in consumer prices or blackouts.
Highly regulated
What is even worse, one intervention begets the other. For example, intermittency has led to pressure for regulated capacity support mechanisms – yet another intervention in the market. These reduce competition further by remunerating electricity producers in a highly regulated environment. Producers are rewarded not for actually producing and distributing power, but for simply having the capacity to do so.
We are a long way from liberalised and efficient energy markets in which CO2 emissions are reduced in the cheapest possible way
Regulatory intervention in this area is not necessary. Where there is the potential for intermittency, market processes are needed to discover whether consumers prefer energy markets to be subject to price spikes and intermittent supply, or whether they prefer a higher average price and more reliable supply and price patterns. Different consumers may have different preferences that can be provided by different companies or tariffs.
Thus, although the latest EU climate change policy may prove to be less expensive than its predecessor, we are a long way from liberalised and efficient energy markets in which CO2 emissions are reduced in the cheapest possible way.
The UK needs to return to, and the EU to develop, a fully liberalised and competitive energy market. Even if policymakers believe they cannot rely on free markets to correctly price negative externalities from carbon emissions, they should devise policies that supplement markets in internalising the environmental costs of energy production and consumption patterns. This should be combined with liberalisation and the promotion of competition and innovation, both at the wholesale and retail level. The UK experience between 1990 and 2005 showed how successful such policies can be.
Editor’s Note
Carlo Stagnaro (@CarloStagnaro), Senior Fellow at the Istituto Bruno Leoni, currently heads the technical secretariat of Italy’s Minister of Economic Development, Federica Guidi. The above article is a summary of his new book, Power Cut – How the EU is pulling the plug on electricity markets, published in December 2015 by The Institute of Economic Affairs. You can download free copies of the book here. The ideas and opinions expressed in this article belong to the author alone, and do not necessarily reflect those of the institutions with which he may work or cooperate.
Many of the assertions contained in the article are unfounded. “State electricity suppliers were very inefficient”. Really? how so? The main input to (fossil) stations is, erm fuel. Most member states in the 1980s tended to source their fuel locally (often for employment reasons). Econometrically you could argue this was inefficient. However, there are social reasons for doing so. This argument is being played out in Poland, now (& I have some sympathy for Polish coal miners & their desire for paying work).
Holding up the UK as leading the way with respect to market reform is a rather old trope which has been comprehensively discredited by events. Let me quote Prof Michael Grubb, Ofegm’s economic advisor “in the 1990s and 2000s the energy companies in the UK sweated their assets and failed to invest”. So the UK led the way did it? IMech-E this week: UK faces blackouts due to a failure to invest, by energy companies in new generation. Take a look at my recent article on the profitability of generation in the UK. Conclusion: total & complete market failure in the UK with energy companies not investing. Or let’s try this: at the time of UK privatisation in 1990, R&D spend by the generation/network sector fell from £400m to exactly… zero in one month. It was not until the 2000s that Ofgem realised… oops we had better do something about this. Efficient markets, in the UK? I don’t think so.
Or this: UK highest wholesale and retail (energy only) prices in Europe. In this context, the writers comment ” But competition worked” suggests a total detachment from reality. Or this “energy-related greenhouse gas emissions fell by 12%” – yes due to de-industrialisation as successive UK governments eviscerated the UK industrial base (& continue to do so) – which in turn led to outsourcing of emissions to China. Currently the UK population regards UK energy companies in the same way as they do estate agents, cold callers and child molesters.
Implying that competition worked & then recently it did not, again defies reality (see the Grubb quote). By contrast competition has worked in Germany because there is vast competition from a wide number of players from local coops through to the usual suspects. This does not exist in the UK where the market is designed for the benefit of large players. A cursory glance at energy-only retail prices (6euorcents/kWh Germany – 14eurocents UK) tells you all you need to know with respect to competition and its lack thereof in the UK compared to other EU MS.
Tariffs: the reduction in offers (mandated by Ofgem) was made because ordinary people (you know the ones who should benefit from “competition”) could not understand the offers – which were “complex”. Complexity was used by the energy companies to rip off consumers (not for nothing is the UK know as “rip-off UK”).
I’m going to finish this somewhat long response by noting that the article paints a Dorian Grey like picture of the “benefits” of competition which is a massive distortion of reality.
Dear Carlo,
Thanks for publishing this, I have been thinking along the same lines for a while now. While the UK was once a proponent of liberalisation in the EU it has returned to an era of centralisation and intervention. While intermittency may partly have driven these reactions, it is hard to blame renewables per se. What we should blame is the terrible market design that most energy markets currently have and the incumbents abusing politicians to receive subsidies. I completely agree that we should move to further enhancing the energy market to deliver based on price signals and competition. Renewables are largely able to compete now in a market context provided that it rewards flexibility and we utilise demand flexibility to balance intermittent renewables to avoid either a large socialised balancing market or a capacity market.
The author seems to have a very narrow focus on electricity prices. The negative effects of using fossil fuels on health, the environment and the future of humanity are however substantial (and that is a giant understatement). Yet, the author mentions these effects, expressed as external cost, only as an afterthought. He only seems to agree with environmental and climate policies as long as they don’t get in the way of his free-market ideology.
Ignoring the external costs optimises the profits of the power producers, but gives society as a whole an sub-optimal result. In the end citizens must pay for higher health care costs, higher dykes, dealing with climate refugees etc. However, it makes not so much sense to have the market determine a price for these external costs. Prices are just not the same things as costs. For the market mechanism to work the real external costs should be included in the price of a product. Creating an artificial scarcity with a cap and trade scheme does not ensure this. Furthermore, the current cap and trade scheme is full of loopholes and susceptible to fraud.
In an ideal world the external costs would be determined on the basis of the best scientific estimate, and added to the price of the fossil fuel. The revenue would be used to mitigate the negative side effects of the fossil fuel power production. However, this would only work if all countries in the world would participate, otherwise energy intensive industry will leak away to non participating countries. So in the real world, where countries do not co-operate very well, this is not a feasible solution. In the real world we have to use a patch of imperfect policy instruments. Of course, these instruments have to be used wisely and effectively. For example the German feed in tariff system has been very effective in bringing down the price of renewables, whereas the clumsy imitation of this policy in Spain over-subsidised photovoltaics causing first a boom and then a burst when the conservative government over-corrected the policy.
Climate change is the big horde of mammoths on the market place, and we need to phase out CO2 emissions fast. If this can be done by a feasible free-market based solution that is fine by me. But the author does not propose such a solution. Until somebody comes up with such a realistic solution and gets it accepted by the politicians we should not sacrifice the real world policies we have now in the name of free-market ideology.
A side note: For the liberalisation to succeed it is essential that transmission grids and distribution grids are not in the same hands as power production and power retail. This splitting of the former utilities has been carried out in Europe only in a half-hearted way: Transmission grids have mostly been split off, but distribution grids are often still in the hands of power producers, giving them power to sabotage these pesky little distributed power producers.