European energy prices reach levels never seen before. Wholesale prices for power and gas are up 1500% from the 2010s average in many places. Electricity with delivery in Germany in 2023 now trades at €560/MWh, compared to a long-time average of around €40/MWh and five times higher than the previous record during the commodity frenzy of 2008 (Figure 1).
Figure 1 German electricity prices since the onset of the liberalised market
Note: Front year base future, inflation-adjusted).
Data source: EEX.
The impact on firms and citizens has been delayed in many countries because consumers are often hedged. However, the medium-term consequences on many energy-intensive industries will be devastating and the social impact severe, particularly for low-income households who use gas or power to heat their homes. Spanish retail consumers felt wholesale prices more immediately since real-time pricing is widespread in the country.
It is with increasing desperation that governments are looking for ways to alleviate the pain. Some of the proposed governmental interventions address the gas sector directly, such as a price cap for Russian gas (Martin and Weder di Mauro 2022) or an EU gas-purchasing cartel (Crampton et al. 2022). Others consider changes to the way electricity markets work.
Commodity markets price at the margin, and so does electricity. Hence natural gas-fired power plants frequently set the price, given the poor availability of European nuclear and hydropower. Generators with lower production costs, such as wind and solar energy but also coal, benefit from inflated margins. Several senior officials have put into question the economic principle of marginal pricing, calling it “frankly ludicrous” (Boris Johnson),
“absurd” (Emmanuel Macron),
and concluding that “this market system does not work anymore” (Ursula von der Leyen).
In an attempt to redistribute the producer rents of inframarginal electricity generators to consumers, Spain and Portugal introduced an electricity wholesale market intervention known as the ‘tope al gas’ in mid-June. It combines a subsidy for fossil generators with a tax on electricity in an attempt to yield a net electricity price reduction for consumers by taking away producer rents from renewable generators and nuclear power plants.
In an ex-ante assessment of the policy, we have been quite critical of the instrument (Hirth and Maurer 2022). Two months have passed since the introduction – what have we learned?
How effective has the instrument been in Spain? Since the intervention up until 13 August, the spot price on Spain’s power exchange averaged €144/MWh, compared to an estimated €299/MWh without the instrument (Figure 2). However, consumers paid a tax of €109/MWh, so the net benefit was €46/MWh. While that seems quite a modest effect for an intervention of this size, there has been a net benefit to consumers.
Figure 2 Average daily Spanish spot prices with and without the levy
Sources: epdata.es (2022a), epdata.es (2022b)
How promising is it then to apply the same instrument in other countries? We see three major problems: leakage, gas consumption, and forward markets. Other issues include the calibration of the subsidy across diverse power markets, the distribution of costs and benefits across countries, and the impact on large hydro reservoirs, but those are beyond the scope of this column.
The instrument aims at depressing wholesale power prices. Naturally, this increases net exports of electricity to interconnected neighbours that do not intervene in the same way. Effectively, part of the subsidy leaks. Bilateral trade between Spain and France used to be more or less in balance, with net flows in one or the other direction depending on the day, but since mid-June, electricity flows from Spain to France have surged (Figure 3). The interconnectors are almost entirely used to export power to France. If the capacity of the interconnectors that is available for commercial trade had not been reduced by 32% since the intervention (Figure 4), leakage would have been even larger. Most countries in the rest of Europe are much better interconnected than the Iberian peninsula, so member states would be faced with very serious leakage if they introduced a similar instrument unilaterally. Even if there was a union-wide application of the instrument, leakage to neighbouring non-member states would remain a serious concern.
Figure 3 Average daily flows and capacities at the Spanish-French interconnectors
Source: OMIE (2022).
Figure 4 Average interconnector capacity for exports from Spain to France before and after the introduction of the price cap
Sources: OMIE (2021), OMIE (2022).
Increased exports and increased electricity consumption as a response to the depressed prices lead to more gas being burned in power stations. In Spain, gas-fired power generation increased by 42%. In the Iberian case, that may not be a huge problem because of the abundant LNG import capacity. It is dramatically different between North-Western and Eastern Europe, where gas prices are much higher, and import terminals cannot channel additional shipments (Heller 2022).
The third issue concerns forward markets. The ‘tope al gas’ is an intervention that focuses on the spot market. Consider the case of an improved intervention, where gas gets a high subsidy, but coal gets a reduced subsidy. Whenever gas is on the margin, spot prices are greatly reduced, such that profits of coal plants are depressed despite the subsidy they receive. These are the producer rents that the instrument redistributes to consumers.
However, in many European power markets, conventional generators are hedged, meaning they sell most of their expected output months or years ahead on financial markets through forward contracts. If they are hedged, generators keep selling their actual production physically on spot markets but get compensated for the price difference between spot prices and forward contracts. A depressed spot price reduces their income on spot markets but equally reduces their payment obligations in the forward clearing. In other words, they are indifferent toward spot price levels. But they still receive the subsidy! (And must receive it to achieve the intended effect on spot price levels.) So, if fossil generators are hedged, the intervention does not take away windfall profits but actually creates a windfall for them.
On the other side, consumers that have fixed-price contracts or have hedged themselves on forward markets still have to pay for the subsidy through the new tax. Chances are high that consumers would initially pay more, not less, for electricity in countries where hedging is common. Forward hedging is a key element of most European energy markets for good reasons. Any policy intervention that does not factor this in is prone to fail.
The Spanish-Portuguese wholesale market intervention is a thought-through instrument that has, despite significant drawbacks, merits for the specific context. However, three conditions need to hold to make the intervention work as intended: little interconnection to neighbouring countries, an unconstrained gas market, and only limited forward hedging. In many European countries outside the Iberian Peninsula, none of these prerequisites holds.
To mitigate the impact of high energy prices, targeted measures such as income support (e.g. Bethuyne et al. 2022) are better policies than an intervention in the wholesale market.
Bethuyne, G, A Cima, B Döhring, A Johannesson, R Kasdorop and J Varga (2022), “Targeted income support is the most social and climate-friendly measure for mitigating the impact of high energy prices”, VoxEU.org, 6 Jun.
Cramton, P, A Ockenfels and S Stoft (2022), “An EU gas-purchasing cartel framework”, VoxEU.org, 26 May.
epdata.es (2022°), “Precio medio del mercado mayorista de electricidad”.
Epdata.es (2022b), “Evolución diaria del precio de la luz en el mercado mayorista espanol”.
Heller, F (2022), “Spain could replace Russia in becoming EU’s main natural gas hub”. euractiv.com.
Hirth, L and C Maurer (2022), “Why Spanish-Portuguese proposal to intervene in wholesale energy markets is problematic”, euractiv.com.
Martin P and B Weder di Mauro (2022), “Winter is coming: Energy policy towards Russia”, VoxEU.org, 23 Jul.
OMIE (2021), “Capacity and occupation of the interconnectors after Day-ahead market technical constraints”
OMIE (2022), “Spot today”.