EU energy price caps – Short-term gain, long-term pain

Aura Sabadus

21-Nov-2022

By Dr Aura Sabadus, ICIS

EU leaders are pushing for a cap on ‘excessive and volatile’ gas prices to shield consumers ahead of winter. Although details are starting to emerge, it is still unclear whether a cap will be implemented and, if so, exactly how.

Whilst serving a clear purpose as a palatable solution to extreme price increases for many, price caps can and do have unintended negative consequences. They can increase demand precisely at the time when prices should be signalling that consumers use less. They can turn the distribution of a commodity, from a place of excess supply to one of high demand, from a simple operation to a highly inefficient, expensive and complex one. And they generally have to be paid for in the future, passing on costs that still have to be borne another day and denting long-term economic growth.

This paper reviews the risks and shows how market interventions lifted gas demand at a time when it should have been reduced in Spain, affected domestic gas production in Romania and led to significant economic imbalances in Turkey.

Proposal

One potential mechanism would see the European Commission propose a ‘dynamic corridor’ which would apply to the benchmark TTF month-ahead price, which would prevent transactions from rising above a set limit.

To counter potential negative effects, the proposals suggest the price corridor could be adjusted at a level where ‘it would not affect the EU’s security of gas supply and intra-EU flows, nor lead to an increase in gas consumption and would not affect the stability and orderly functioning of energy derivative markets’.

The price correction mechanism, as it is called, would be triggered ‘when needed’ and would be reviewed monthly. There would also be allowance for the Commission to order the immediate suspension of the cap at any time if ‘unintended disturbances affecting security of supply’ were to emerge.

Apart from the difficulty of finely calibrating the price to a level that would be sufficiently low to shield consumers but high enough to attract supplies while not lifting demand, there are also multiple risks associated with price intervention.

The default option

Price caps tend to be the default response of governments to unsustainably high energy costs as they seek to shield consumers, rein in inflation and avert social unrest triggered by deteriorating living standards.

Important as they may be in protecting consumers from market turbulence, artificially suppressed prices often lead to unintended consequences with long-term implications for the economy, the security of countries and the environment.

Firstly, capping wholesale or retail prices below the market value of any given commodity comes at an onerous fiscal cost to economies.

Invariably, the difference between the market price and the subsidised tariff leads to higher borrowing to plug the deficit, ultimately resulting in lower spending power long-term.

By capping energy prices, governments merely delay the full payment of a rising energy cost which will ultimately have to be reflected in higher taxation.

Macroeconomic data published by the International Monetary Fund shows that fossil fuel subsidies cost global economies $5.9 trillion, or 6.8% of their GDP in 2020, but that figure is set to rise to 7.4% of global GDP by 2025.

Secondly, in free markets, resources are allocated in line with price signals determined by supply and demand. In regulated markets however, the allocation of resources is either very inefficient or has to be determined in line with complex, pre-defined criteria.

For example, the UK has capped retail electricity and gas bills at £2,500 for a period of six months starting from 1 October 2022 but the cap does not distinguish between poor and wealthy households, applying to both.

A more targeted resource allocation to vulnerable consumers would have entailed the costly task of defining the eligibility criteria and implementing a vast digital infrastructure to identify recipients as well as crack down on anyone caught abusing the system.

Thirdly, suppressed fossil fuel prices encourage higher demand.

Right now, following an unprecedented supply crunch since mid-2021, Europe’s priority should be to reduce demand for natural gas to a level where it can be met by available supplies.

As Russia has curtailed gas supplies to Europe to a fourth of usual contractual levels, gas prices have soared six-fold over the five-year average, reflecting underlying scarcity and prompting an immediate adjustment in consumption.

Contrary to growing criticism that the Dutch TTF price was no longer reflective of underlying fundamental drivers and that it should be reformed, the benchmark correctly reflected the shortfall.

This helped to attract alternative LNG supplies and prompted a 24% year-on-year drop in overall gas consumption in the first 10 months of 2022.

The latest wholesale gas monitoring report published by the EU’s Agency for the Cooperation of Energy Regulators (ACER) confirms that view, noting that despite high volatility and soaring prices, European markets remain functional, providing correct price signals.

In the longer-term a price cap on fossil fuels would have the negative effect of driving up demand for cheap natural gas and implicitly lead to higher emissions at a time when the EU is making real efforts to switch to greener forms of generation, having recently raised its target for renewable energy from 40% to 45% of total production by 2030 over the 2020 baseline scenario.

Fourthly, in free markets, prices fluctuate flexibly in line with fast-changing movements in the supply-demand balance.

That is not the case in regulated markets where once the price is set at a certain level it cannot adjust according to underlying drivers and therefore requires subsequent interventions, leading to ever-more complex regulations and potentially discouraging existing or new investment.

The best illustration comes from the fact that, as European gas markets have not been subjected to politically induced shocks in recent weeks, and demand remains subdued, gas prices have started to fall naturally.

Finally, price caps could lead to extreme situations where traders would no longer be able to honour contractual obligations, potentially bringing down the entire market structure and creating unprecedented costs, as discussed in a recent paper by the Oxford Institute for Energy Studies.

Anecdotal evidence – Spain 

To cope with the impact of rising gas prices in 2022, which in turn lifted electricity costs, the Spanish government decided to cap the price of natural gas paid by gas-fired power plants at €40.00/MWh in mid-June. The cap will be in place until the end of May 2023 but from 1 January will rise incrementally by €5.00/MWh to reach €70.00/MWh in the final month of the regulation.

In parallel, the government introduced a compensation scheme for affected power generators, which will be paid from money raised via the tariffs charged to retail consumers, also known as the PVPC tariff.

A calculation by Spain’s CaixaBank found that by July and August the marginal price of electricity, set by gas-fired plants, was around €140.00/MWh, or 22% below the May price.

It also found that in the pre-cap arrangements, the PVPC tariff could typically capture 60% of the natural gas price swing. For example, a 10% monthly increase in the gas price triggered a 6.3% increase in the PVPC tariff. However, after the introduction of the cap, the ratio dropped to 2.9%.

Nevertheless, the introduction of the cap coincided with a period of drought, which meant that Spanish hydropower production was reduced.

The low gas price combined with falling hydro generation lifted gas demand, which doubled year on year over the summer months at a time when Europe was scrambling to reduce gas demand in response to the Russian supply crunch.

Furthermore, cogeneration gas fired-power plants which were more efficient and environmentally friendly but had been left out of the compensation scheme, had to ramp down. Cogeneration production fell from 15% in the immediate pre-cap period to 9% after the introduction of the cap.

Another unintended consequence of the price cap was that, facing lower revenue on the domestic market, companies started to export electricity to the comparatively more expensive French market. Electricity exports from Spain to France exploded from 0.3% of total Spanish generation in the months preceding the cap to 4% of the total afterwards.

Romania

Romania, like Turkey, has a history of heavy regulation, although its electricity and gas markets have alternated between full regulation and complete deregulation in recent years.

In 2018, the Social Democrat-led government introduced a price cap on natural gas sold by local producers to suppliers at New Lei 68.00/MWh (€17.00/MWh at the exchange rate of December 2018), 76% cheaper than short-term domestic prices at the time.

The introduction of an emergency ordinance not only sparked alarm in the energy sector but also caused reference indices on the Romanian stock exchange BVB to plummet to their lowest levels since 2011, with banks leading losses by nearly 19% and energy companies by 11%.

The price cap had multiple negative effects on the market.

Firstly, under the ordinance, all domestic gas production was expected to be sold at New Lei 68.00/MWh to companies supplying the gas to households. This meant the local output was not sufficient to cover overall demand, forcing suppliers to import gas at higher prices.

Within a few months, prices on European hubs were already plummeting and by August 2019, they were around €3.00/MWh lower than the regulated Romanian gas price.

Throughout this period, Romanian companies were at first forced to import gas to supply industrial consumers and then incentivised to buy abroad by falling hub prices.

By August 2019, Romanian gas imports were 3.5 times higher than the previous year while domestic production, which had been severely discouraged by the price cap, fell by 2.4%, deepening Romania’s dependence on Russian gas.

Apart from the direct impact on production and the revenue of energy companies and banks, the price cap also created layers of regulatory complexity because the government was forced to intervene subsequently to correct the effects of the cap.

The heavy regulatory environment caused largely by Romania’s interventionist policies prompted investors to downsize or even exit the market, including the US’ ExxonMobil which sold its 50% stake worth $1bn in the Neptun Deep block in the Black Sea, throwing into doubt Romania’s prospects of offshore production.

Turkey

Turkey’s electricity and natural gas markets are heavily regulated, with price controls set for all types of consumers: gas-fired power plants, industrial and commercial consumers, and households.

The country introduced a cost-based pricing mechanism in 2008 whereby end consumer tariffs were adjusted in line with exchange rate and oil price fluctuations. The two elements were critical because Turkey’s gas import prices were historically indexed to an oil-based formula and denominated in US dollars.

Although the government was expected to adjust the tariff in line with these fluctuations on a regular basis, over the years it failed to do so.

However, as the Turkish lira depreciated 81% against the US dollar within eight months since the start of 2018, the government had no choice other than to double the tariff to gas-fired power plants by August of that year, triggering shockwaves across the market.

As a result of the increase, gas-fired power generators started to cancel contracts with suppliers who, in turn, were forced to cancel contracts with end consumers, bringing the entire market, which was fast developing, to a standstill.

The shock was amplified by the fact that many companies did not hedge their positions and preferred to cancel contracts in exchange for paying a fee, as opposed to taking on the significant tariff hike.

As electricity generation is over 30% gas-fired, electricity trading was so severely hit that it has not been able to recover to levels seen before the tariff rise.

Despite the major negative impact and high costs to the sector, the regulated tariffs remain in place. Since the end of 2020, the government has had to raise the tariff twelve-fold to capture the sharp depreciation of the Turkish lira as well as fluctuations in TTF hub prices, to which Turkey’s newly-renewed gas import contracts are now linked.

The true extent of the costs of the gas price cap to the Turkish economy is unknown but earlier in February officials said that, even with continued treasury support worth 14.8bn (€795m) Turkish lira, it had become difficult to borrow from banks as the debt to underpin the subsidies was becoming unsustainable.

Conclusion

Capping electricity and natural gas prices is a useful tool to protect consumers from short-term volatility in markets and rein in possible inflation. For that reason, price caps provide a valuable social and political dividend and tend to be a government’s default response to soaring costs.

However, the evidence of recent history shows that price caps invariably come with unintended consequences, which in the long-term can have a negative impact on the economy, the security of supplies of countries and even the environment.

The fact that EU proposals to implement a price cap have led to extensive wrangling over its implementation indicates the difficulties and complexity of such a task, as well as policymaker’s concerns over its long-term impact.

As the example of Spain has shown, a gas price cap introduced in June has in fact led to the doubling of demand precisely at the time when Europe has been aiming to rein in gas consumption, jeopardising Spain’s security of gas supply.

Very often, the distortions that price caps lead to are so severe that the measures required to correct them add more layers of complexity, creating a risky business environment and deterring investment.

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