Green subsidies for energy intensive industries

In France, while the Energy Transition for Green Growth legislation remains in draft form due to disagreements between the Senate and the National Assembly, the Senate is debating draft legislation on promoting Growth, Activity and Equal Economic Opportunities (known as the Loi Macron), which the government passed through the Assembly using Constitutional Article 49-3. In the course of this debate seventeen senators have tabled an amendment to regulate the access of big industrial consumers of energy to megawatt hours generated by renewable energy sources[1]. To not use the Energy Transition bill as the vehicle for this initiative is part of a parliamentary strategy, an analysis of which does not fall within the remit of the authors of this blog. However, because yet again the issue of distorting market mechanisms has been raised, economic discussion is warranted.

Setting electricity prices

The wide fluctuations in electricity demand are both regular (day-night, seasonal) and exceptional (heat wave, cold spell), and they are now compounded by intermittent sources of energy production. These factors have motivated electricity companies to develop a peak load pricing model, as theorised by Marcel Boiteux in 1949. [2]  During off-peak periods, when electricity demand is lower than installed production capacity, the price of electricity should be equal to short term marginal cost: the price essentially covers fuel costs and some of the facilities remain idle. During peak periods, electricity demand overloads the installed production capacity and adjustment is made via the price, which is set at the level purchasers are willing to pay for this capacity. Producers make no profit outside peak periods. In peak periods, if the mix of production plants is correctly dimensioned, prices cover both operation costs and the whole fixed cost of power plants, including the return on invested capital.

Marcel Boiteux originally developed peak period pricing for EDF, an integrated public monopoly. It is an optimal pricing system in that it maximises the economic surplus of electricity production and consumption. Since then, economists have demonstrated that if the power industry is competitive, market prices replicate optimal public pricing: the off-peak price is equal to variable cost, and the peak period price is far higher to balance supply and demand and cover all fixed costs. It is in fact the application of a more general finding, known in economic literature as “The first theorem of welfare economics”.[3]

Peak period pricing is used in other industries where demand also fluctuates according to the period and the product cannot be stored. Hotel rooms on the coast are more expensive in August than February, and the opposite is true in ski resorts. What makes the energy industry unique is the large disparity between off-peak and peak prices. Depending on production technologies and fuel prices, the former falls within the range of 20-40 euro per megawatt hour, while the latter can rise to several thousand euro per megawatt hour, one hundred times higher than the off-peak price. 

Subsidised access to renewable megawatt hours

The senators who tabled the amendment to the draft bill on Growth, Activity and Equal Economic Opportunities are proposing a one year trial to cap electricity prices for some energy intensive companies, if they become more flexible in their consumption patterns. Their argument can be summarised as follows: when the wind is blowing and the sun is shining, there is abundant electricity supply compared to demand. However, when there is no sun or wind, the electricity supply dwindles. Consumers, especially big consumers, should therefore be encouraged to shift their power usage from peak to off-peak periods. “An experiment not exceeding a one year period shall be undertaken, involving so-called energy intensive companies, who would adapt their electricity needs to supply capacity during periods of low demand”. What are the incentives? “In exchange for this flexibility and for the period of the experiment, the cost of electricity consumed will not exceed the value of the reference price paid by the company at the date of the experiment, whether these are regulated or other “historical” tariffs”.

The participating companies therefore commit to shifting their consumption to off-peak periods. In exchange there will be a price cap, based on recent invoice history.

Tariffs are back

The idea of making consumers flexible by offering a price that will not vary is puzzling to economists.  It is hard to believe that without the incentive for profit, energy intensive industries will adjust their consumption according to the vagaries of nature.

This amendment is above all indicative of the race for economic rent which disrupts our economy. Commercial and technological upstream and downstream competition, which should be the driver of a modern economy, is being replaced by a competition for subsidies. Yes, the senators are right to note that the wholesale electricity price varies according to supply and demand conditions. In particular, the emergence of subsidised renewable energy has resulted in periods of low prices, sometimes even negative prices. Yes, they are right to suggest that consumers who shift their electricity consumption to low priced periods should reap the benefits, especially as the potential smoother load curve is good for the community as a whole.

But why is a regulatory framework needed to implement this virtuous process. What is today preventing large consumers from directly purchasing on wholesale markets at spot prices and thus taking full advantage of the differential pricing their flexibility entitles them to? If they do not wish to develop the capacity to intervene directly on the wholesale markets, what prevents them from negotiating a contract with their supplier which favourably reflects their flexibility? If they are not satisfied with the offer from their current supplier, why do they not contact another provider in the electricity supply market? [4] Had the senators forgotten that electricity provision to energy intensive industries in France has been open to competition since … 2000?

The proposed amendment is therefore not justified in terms of economic efficiency. It is simply one category of customers (namely the big energy consumers) who are lobbying to receive subsidies from the community. Indeed, it does not take a genius to imagine what will happen. If the wholesale market price of megawatt hours delivered to energy intensive industries is higher than the regulated contract price, the provider who purchases at the spot price and sells at the capped price will incur a deficit. How will this shortfall be covered? Obviously by asking the community for a contribution to encourage this virtuous behaviour. The readymade mechanism called on will be the Contribution to the Public Electricity Service (CSPE)[5], an uncontrolled catchall. Let us now assume that the opposite were to happen: the wholesale market price of megawatt hours delivered to energy intensive industries is lower than the regulated contract price. Can anyone imagine that the community will benefit from a negative CSPE? Probably not. It is far more likely that we can look forward to another amendment, giving the energy intensive industries the right to break the supply agreement set out in the previous decree.

The amendment tabled in the Senate is a response to the end of regulated tariffs. With the entry into force of Law n° 2010-1488 of 7 December 2010 on the new organisation of the electricity market (Loi Nome), yellow and green tariffs (applicable above 36 kVA of electrical power) will be abolished from 1 January 2016. This episode in the Senate clearly illustrates that France continues to be committed to a centrally-steered economy, based on tariffs rather then prices.

Temporary and permanent solutions

The flexibility incentive scheme discussed above is planned to only run for a year, and on a trial basis. When, how and by whom the trial will be assessed are still open questions. In an effective trial, half of the energy intensive industries would be randomly selected and subject to wholesale market fluctuations, while the other half would benefit from the proposed regime.  A good econometrician could then say if he observed significant differences in behaviour.

The European Commission’s opinion on this form of state aid is also awaited with interest.

Finally, it should be noted that to reduce the risks of imbalances in the power system as well as avoiding always unwelcome blackouts, France is currently developing a capacity mechanism. Also originating from the “Loi Nome” (7 December 2010), it is expected to be operational in 2017. The next post will focus on this mechanism.