Designing a European energy price regulation system: some basic principles

Abstract

ABSTRACTThe recent surge in energy prices in Europe and their high volatility, have a very large impact on its economy. Policymakers have sought to counteract the impacts of the unprecedented energy price shock with a plethora of measures albeit with limited success. This paper proposes a dynamic, flexible system of energy price regulation at the retail level. The mechanism is simple, automatic and has a number of parameters that can be adjusted to fine tune its execution. It is shown how the mechanism leads to toppling of energy prices and reduces their volatility. At the same time, it does not prevent energy prices to absorb long-run fundamental/ market-conform price trends.KEYWORDS: Energy price shocksenergy price controlJEL CLASSIFICATION: E31E61E64 AcknowledgmentsWe thank both referees for useful comments on our paper. Konings acknowledges financial support of the Methusalem grant numer METH/15/004.Disclosure statementNo potential conflict of interest was reported by the author(s).Notes1. The EU (European Commission (Citation2022c,b)) also realises its much stronger bargaining power than individual countries when it comes to external negotiations on energy and energy security measures: “The EU is stronger when acting together. The EU should act jointly to harness its market power through negotiated partnerships with suppliers.” And “Solidarity is fundamental. Joint gas storage is an insurance benefitting everyone, and to which everyone should contribute in a fair way. This is why Member States without storage should contribute to the storage filling levels in other Member States and in exchange benefit from enhanced security of supply. The burden sharing mechanism embedded in the proposal ensures a fair allocation of security of supply costs among all Member States as they all benefit, thanks to the EU energy market, from lowering the risks of supply disruption regardless of where storage is located in the EU.”2. https://www.consilium.europa.eu/en/press/press-releases/2022/12/19/council-agrees-on-temporary-mechanism-to-limit-excessive-gas-prices/3. Energy prices set in contracts would also need to respect the maximum prices that will prevail (otherwise speculative gains could be made): in case the contracted prices would exceed the maximum price level, the latter becomes binding rather than the energy price according to the contract. By a proper formulation of price setting in the contracts this will be unproblematic.4. A good example is Belgium’s Social Tariff that charges electricity for the lowest incomes at a lower rate than other consumers. The difference between the Social Tariff and the electricity price is paid by the government. This measure in other words subsidizes energy bills of the lowest incomes.5. Campbel (Citation2018) finds that in most parameters of his energy supply model, a price cap policy is preferable over a revenue cap (which would have some similarity to an excess profits tax).6. The UK system dates back already from before the current energy price crisis. In September 2018, its energy regulator Ofgem proposed that the initial level of the “default tariff price cap” would mean that energy suppliers would not be allowed to charge more than £1,136 a year for a typical dual fuel customer paying by direct debit, and that this would save the 11 million British households on default or standard variable tariffs an average of £75 a year on their gas and electricity bills. The price of the cap is set for each unit (KWh) of gas and electricity used, plus a daily standing charge, so that it varies with consumption. Ofgem designed the cap level to take into account several factors: wholesale energy costs (how much a supplier has to pay to get the gas and electricity to supply households with energy), energy network costs (the regional costs of building, maintaining and operating the pipes and wires that carry energy across the country), policy costs (the costs related to government social and environmental schemes to save energy, reduce emissions and encourage take-up of renewable energy), operating costs (the costs incurred by suppliers to deliver billing and metering services, including smart metering), payment method uplift allowance (the additional costs incurred through billing customers with different payment methods), headroom allowance (allowing suppliers to manage uncertainty in their costs), the return on suppliers’ investments, and VAT (5% tax added to the level of the tariff).7. This argument is eloquently made by Cowan (Citation2002):”An unregulated firm can be expected to set its prices to maximize profits, leading to both deadweight losses and transfers of purchasing power from consumers to the firm, both of which are costly to the regulator. At the same time, the regulator wants to encourage the firm to be efficient. A price cap tackles these problems by the very straightforward solution of fixing the firm’s price (or the price path over time). The firm thus bears the risks associated with varying exogenous input prices and shifting demand. At the same time, the firm has full incentives to reduce its costs, as the price is not adjusted downwards when it succeeds in cutting its own costs” (p.169).8. In April 2022, the EU’s Agency for the Cooperation of Energy Regulators, ACER (Citation2022) purports that EU energy markets are not to be blamed for high energy prices: “ACER finds that the current wholesale electricity market design ensures efficient and secure electricity supply under relatively ‘normal’ market conditions. As such, ACER’s assessment is that the current market design is worth keeping. In addition, some longer-term improvements are likely to prove key in order for the framework to deliver on the EU’s ambitious decarbonisation trajectory over the next 10–15 years, and to do so at lower cost whilst ensuring security of supply. Whilst the current circumstances impacting the EU’s energy system are far from ‘normal’, ACER finds that the current electricity market design is not to blame for the current crisis. On the contrary, the market rules in place have to some extent helped mitigate the current crisis, thus avoiding electricity curtailment or even blackouts in certain quarters” (p.2).9. The European Commission (Citation2022a) recognizes in its Energy Emergency Note, the importance of the size of the EU energy market EUs: “Europe can build on its strengths by leveraging the single market to make joint purchasing a reality and keeping market prices in check, including by putting a limit to excessive price spikes as well as by making the best use of existing infrastructure to ensure that gas flows where it is most needed” (p.2).10. They conclude: “The EU’s era of low gas prices is over. A model that has served the EUs economy for some 20 years has most likely come to an end. And so has the liberal paradigm that served as its blueprint”11. The origin of modern price and wage control date back to the 1970s when a period of chronic inflation and price instability emerged. In the summer of 1971, President Nixon installed a complete 90-day freeze of wages and prices on advice of the Cost of Living Council after inflation reached six percent. The measure had broad support and inflation seized directly. However, later on in 1974 inflation returned as a result of the First Oil Crisis. In his study on the price and wage controls in the US since WOII, Rockoff (Citation1984) provides a nuanced view: the price control measures to contain inflation were important and effective.12. Modern financial markets and energy markets have become completely intertwined, and energy trade is as a result also covered by financial legislation. Lacking or poor financial regulation can cause catastrophes in energy markets consequently. While work in progress, the European Commission’s efforts to strengthen the financial regulation of energy trade has led to a set of regulatory proposals aimed at stabilizing financial markets and limiting volatility of energy prices. This subject is clearly of importance to our analysis but is left for additional research.13. According to G7 (Citation2022): “As for oil, we will consider a range of approaches, including options for a possible comprehensive prohibition of all services, which enable transportation of Russian seaborne crude oil and petroleum products globally, unless the oil is purchased at or below a price to be agreed in consultation with international partners” (p.5).14. See e.g. Froot and Obstfeld (Citation1989), Krugman (Citation1991) and Bertola and Caballero (Citation1992) concerning the workings of exchange rate target zones.15. Luxembourg applies a comparable price-smoothing mechanism for oil products based on an agreement with its national oil-industry federation. This mechanism sets a maximum price for oil products (including gasoline, automotive diesel, heating oil, and liquified petroleum gas (LPG)) sold to the end-consumer. The pricing formula is based on the published price of oil products, to which the government adds a standard cost of transport, a standard distribution margin covering the profits of the importers and the filling stations, and the cost of compulsory storage.16. For details on the maximum fuel prices in Belgium, see https://www.energiafed.be/nl/maximumprijzen/evolutie (in Dutch).17. International Monetary Fund (Citation2012) analyses the pricing, fiscal and distributional effects of a number of alternative fuel-price smoothers that have been used in practice. The case of Belgium and Luxembourg is however not taken into account.18. The Ornstein – Uhlenbeck process is a stationary Gauss – Markov process which over time will be reverting to drift to its mean. The process can be seen as a modification of the random walk in continuous time, or Wiener process, that incorporates a tendency of the random walk to move back towards a central location, with a greater attraction when the process is further away from the center.