The right goal, the wrong measures – Discussing the proposed interventions on the EU electricity market

As you will have seen from the news, the ongoing energy crisis in Europe is pushing energy prices to record highs and millions of households and businesses are struggling to pay their bill. At the same time, some players in the energy sector are generating large profits due to the same increased energy prices. In response to this, the European Commission (EC) published a proposal with interventions to relieve some pressure in the energy market. Although the current situation does sound like a legitimate reason for the EC to intervene, the interventions have been criticised a lot. Especially a revenue cap for low cost power generation, which has been called impracticable and even counterproductive. What are the exact proposed interventions by the EC? Are the critics justified? And what can we expect next? In this blog I will try to create some structure in the blur of messages around the proposal.

Proposed interventions by the EC

On 30 September the EC member states officially approved three temporarily emergency interventions to address high energy prices in the EU. Now, each member state should come up with an individual implementation plan that must be applicable as of 1 December 2023

1. Reduce electricity demand: a target to reduce overall electricity demand by 10% and an obligation to reduce electricity demand during peak price hours by at least 5%, applicable until 31 March 2023
2. Revenue cap for low-cost power generation: a cap of 180 EUR/MWh on the revenues of generators that produce electricity without natural gas or coal, applicable until 30 June 2023
3. Windfall profit tax for fossil fuel companies: an additional profit tax of 33% on all profits in 2022 and/or 2023 above 20% increase on the average profits of the previous four years

Next to these three interventions, the EC is also investigating the possibility to support energy utilities for increased collateral requirements, to put a price cap on natural gas imports and to improve circuit breakers on trading venues. They are even exploring the possibility to do a full reformation of the electricity market in which the electricity price is decoupled from the gas price.

All interventions can have a significant impact on the energy market, but in this blog I will focus on the revenue cap for low cost power generation as most questions in the short term arise around that intervention.

The struggle of implementing a revenue cap

Since the liberalisation of the electricity market in the 1990’s, a sophisticated system has been created to balance supply and demand and to price electricity at a fair value. There are many markets at which electricity can be traded, from long term futures and bilateral agreements to short term day-ahead and intraday trading. The short term markets are called spot markets and they are a strong indicator of the electricity price on all markets.

Just like many other commodities, price settlement at the electricity spot markets is based on a merit order principle. This means the price is cleared on the last most expensive supplier that is required to meet demand. The price is hence set by the last generator with the highest marginal cost and all previous generators receive that price. As gas fired generators are still needed in our electricity system to create sufficient supply, the price is currently set at a very high level. The proposal of the EC is to skim off part of the excess revenues that this creates for generators with lower marginal costs by capping their revenue at 180 EUR/MWh. The contracted or clearing price on all markets can still exceed the cap, but the seller needs to hand over excess revenues above 180 EUR/MWh to the EC for distribution over the member states that can use it to compensate households or companies for the increased energy bill.

So far, so good, you would say. However, although the theory sounds easy, implementing a revenue cap will be a nightmare. Many sellers of electricity are not the parties actually profiting from the high prices. For example, generators can be in a contract for difference (CfD) in which excess profits are paid to the government, or they can have agreed a PPA in which price risk is hedged with a counterparty. The EC acknowledges this risk by capping only the realised market revenues, but there are an infinite number of hedging strategies and electricity can be sold and resold many times via traders or storage facilities before reaching the spot markets. This makes it highly obscure as to who is actually profiting from the high prices. Assessing the realised revenues of all sellers within a few months, will just be impossible.

Next to that, a price cap will lower the appetite for developers and investors in low cost generators. If we like it or not, the current high prices do represent our dependency on gas and its scarcity in the market. The merit order principle is a very strong mechanism to stimulate investments in generators with lowest marginal cost, which are in this case also the most sustainable ones. Leaving the electricity market as is creates a strong stimulant to reduce gas usage and increase investments in renewables, capping the price will do the opposite. Already now we see renewable energy projects being put on hold to await the interventions and its effects. Investments in renewables are based on long term price projections which are an average of peaks and lows. Capping the peaks feels fair, but for many projects there is also the risk of very low or even negative energy prices in the long term. If some form of price cap remains a topic for discussion for the long term, developers might also require a price floor.

So, what’s next?

Many countries have already started with compensation measures for offtakers. Energy prices have increased in such a steep and unnatural way that the free energy market is not able to respond quick enough and bring prices down again in the short term. A compensation for the most vulnerable is needed to save the economy and prevent many from ending up in poverty. Ideally, those compensations are only targeted to the vulnerable and include proper incentives to reduce energy consumption.

On the generation side, however, it is unclear what is going to happen. The proposed revenue cap seems next to impossible to implement, but the EC and its member states do want to collect money in some way to fund the compensation programs. In theory the revenue cap should only limit unexpected upside of generators and the downside risk is limited. However, there is an implementation risk here as the contracts and hedging strategy of each generator needs to be assessed individually. As a result, the procedure can be so time consuming and so many exceptions need to be made that there is a real risk almost no excess revenue can be collected by the EC.

A much easier, and often suggested alternative is a windfall profit tax for all actors in the energy sector. So not only for fossil fuel companies, but also for developers of renewables, traders, utilities, etc. No highly complex assessment of hedging strategies is needed, but only those that actually profit from the high energy prices are targeted. Implementation is a lot easier, and income for the EC can be significantly higher. Still, the tax should only apply for a limited amount of time as it creates a risk of reduced investment appetite for those assets that are necessary to fight the actual cause of the high energy prices in the long run. However, despite the criticism from the market on the draft proposal, all interventions have been officially approved by the member states in the latest counsil meeting. This makes it highly unlikely that fundamental adjustments can still be made.

In conclusion, the huge disparity between consumers struggling to pay their bills whilst some actors in the energy market make huge profits, means the EU feels it has to intervene to fix what is obviously a broken market. The choice has been between pricing caps on renewable generators or windfall taxes on all generators and the EC has chosen the former. However, as is often the case, a deceptively simple policy may be harder to implement in practice. What seems to be a crystal-clear solution is muddied by a plethora of CFDs, corporate PPAs and resellers. Trying to work out who to cap will be harder than it seems so the much-vaunted realisable revenue for redistribution to consumers may not be as much as the EU hopes. As with many EU policies what works in theory for a civil servant in Brussels may not translate into reality for a home owner in Bremen.