Streetwise Professor

August 29, 2022

New European Energy Policy Follies: The Inevitable Consequence of Past European Policy Follies

European power prices are going hyperbolic, with day ahead prices in swathes of the continent varying between €660 and €750/MWh.

For those who want to play at home–spot the congestion!

Even more remarkably, Cal 2023 power prices are around €1000/MWh in German and France:

That’s for baseload, folks. 24/7/365. Peak Cal 2023 French power is currently at €1425. Ooh la la!

This has of course set of a flurry of policy proposals.

None of these proposals will mitigate the fundamental problem–energy supply is extremely scarce. Most of these proposals will actually exacerbate the underlying scarcity.

Instead, these proposals are all about how to distribute the cost of scarcity. They are fundamentally redistributive in nature.

The proposals include price controls (natch), windfall profits taxes, and nationalization.

Price controls always exacerbate the scarcity and create actual shortages by encouraging consumption and discouraging production. They will necessitate rationing schemes. In electricity, rationing often involves brownouts and blackouts. Planned blackouts, such as no power availability at all for some hours of the day.

WIndfall profits taxes attempt to capture the surplus of inframarginal (i.e., low cost) suppliers, and redistribute that surplus (somehow) to consumers. Redistributing through subsidized prices exacerbates scarcity because it increases demand.

Windfall profits taxes may otherwise have few distorting effects in the short run, given that supply from the inframarginal firms is likely to be highly inelastic (they basically operate at capacity). (Ironically, the scheme to hit Russia by capping the prices it receives on oil is predicated on a belief that supply is highly inelastic.). However, windfall profits taxes have very deleterious long run incentives. They deprive those who invest in production capacity of the value of those investments precisely when they are greatest (which really distorts investment incentives). Even the risk that windfall taxes will be imposed in the future depresses investment today. Meaning that although such taxes may not do too much damage in the present, they increase the likelihood of future scarcity.

The reach of windfall profits taxes is also limited. Many of the rents resulting from the current world energy situation accrue to input suppliers (e.g., owners of LNG liquefaction capacity, coal miners that export to Europe) who are beyond the reach of grasping European hands via windfall profits taxes. (And are the Norwegians going to transfer wealth to Europe by imposing windfall taxes on their gas production and writing a check to Brussels? As if: the Norwegians are already talking about limiting energy exports to Europe.)

Nationalization can be a crude form of windfall profits tax: nationalizing low cost producers basically seizes their surplus. Nationalization can also be a form of subsidization: seize unprofitable firms, or firms that can only survive by charging very high prices, and sell the output below cost. Losses from below cost sales are socialized via taxpayer support of loss-making nationalized enterprises (which creates deadweight costs through taxation present and future).

Nationalization of course generates future operational and investment inefficiencies due to low power incentives, corruption, etc. Moreover, to the extent that nationalized entities subsidize prices, they will encourage overconsumption, and thereby create true shortages and necessitate rationing.

All of these policies aim to mitigate the pain that power consumers incur by shifting the costs to others–and in the forms of subsidies funded by general taxation, the overlap between those who receive the subsidies and those who pay them is pretty large. But even this transforms a very visible cost into a much less visible one, and thus has its own political benefit.

The Germans–at least the Green Party ministers in the government–are advocating a fundamental change in the market mechanism, specifically, eliminating marginal cost pricing:

“The fact that the highest price is always setting the prices for all other energy forms could be changed,” Economy Minister Robert Habeck, who is also the vice chancellor in the ruling coalition in Berlin, said in an interview with Bloomberg.

“We are working hard to find a new market model,” he said, adding that the government must be mindful not to intervene too much. “We need functioning markets and, at the same time, we need to set the right rules so that positions in the market are not abused.”

Marginal cost pricing is a fundamental economic tenet: price equal to marginal cost gives the right incentives to produce and consume. Below marginal cost pricing (the cost of the most expensive resource sets the price) encourages overconsumption. Further, unless marginal units are compensated there will be underproduction. Both of these create inefficiencies, exacerbate scarcity, and can lead to actual shortages and the necessity of rationing.

On a whiteboard you could draw up a pricing mechanism that perfectly price discriminates by paying each resource its marginal cost. This effectively appropriates all of the producer surplus which can be redistributed to favored political constituencies. But this doesn’t cover fixed costs and a return on capital, which discourages future investment.

Further, classroom whiteboard exercises are usually impossible even to approximate in reality. Knowing what marginal cost is for each resource in a complicated system is a major problem, especially when you take transmission into consideration. The likely outcome would be some sort of kludge with roughly average cost pricing combined with some Rube Goldberg scheme to compensate producers. This whole system would involve massive redistribution and all of the politicking and corruption attendant to it.

The real problem the Europeans have is that they want to kill the market messenger. The market is signaling scarcity. The scarcity is real, and acute, but they no likey! And by the nature of energy production–capital intensive, with moderate to long lead times to enhance capacity–the scarcity will continue for some time, with little the Europeans can do about it.

In other words, they can’t fix their real problem (scarcity), which is the harvest of their previous policy follies. So they are left to find redistributive schemes to allocate the costs in a politically satisfactory way. These redistributive schemes–price ceilings, windfall profits taxes, nationalization, fundamental restructuring of the market mechanism–all tend to exacerbate scarcity in both the short and longer runs.

The fact is, when you’re screwed, you’re screwed. And Europe is well and truly screwed. What is going on in policy circles in Europe right now is figuring out who is going to get screwed hardest, and who is going to get screwed not so much. And there will be substantial costs, both in the short but especially the longer term, as whatever Frankenstein “market” emerges from these frantic policy stopgaps will wreak havoc in the future, and will be very hard to put down.

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  1. What have Ireland Spain & Portugal done right?

    Comment by Ty Kelly — August 29, 2022 @ 3:34 pm

  2. Professor, I wanted to ask your opinion about effects of sanctions against Russia, implemented by EU and USA. Do you think it would be correct to say that these sanctions failed? The main goals of western sanctions policy were to undermine Russia’s ability to finance its army and to strongly degrade living conditions in Russia and thus cause mass protests against Putin. It currently looks like that these aims won’t be reached in the coming several years.

    Comment by mmt — August 30, 2022 @ 4:14 am

  3. @Ty Kelly: I couldn’t say for sure, but I think Ireland is mostly powered by oil (transport, heating) and coal+wind (electricity), so maybe they’re somewhat insulated from problems in the gas supply. And in relative terms, the comparison to France and Germany isn’t really representative: France is suffering a lot of downtime in her (relatively old) nuclear reactors and Germany is suffering a lot of downtime in the brains of the people who set energy policy.

    And as every year, there will be people saying “See, France has nuclear power and they don’t have enough electricity, and since correlation equals causation, nuclear power is bad for the energy supply”. Rather than, say, the French just don’t have quite enough nuclear power.

    Comment by HibernoFrog — August 30, 2022 @ 4:20 am

  4. @Ty Kelly: reg. IE, ES, PT – they may count as ‘3rd world’ in the meantime already…like Italy…

    I’m not sure whether the picture is complete. What you have in the news here in Europe is Energy providers with billions of losses and the people having to pay 3 times through their tax money that the state uses for bail outs (without taking equity stakes), additional levy on the energy bill and higher energy prices.

    And of course, not easy to get the info what happened, like the local energy provider in Austrian city Vienna is said to need up to 8 billion EUR from the state. They say, everything would be fine, they did not speculate, they were hedging. They seem to produce some energy themselves and sell it. But also buy gas and energy and sell and provide these to their local end-customers. They would have sold their own produced energy up to two years in advance. The prices for the purchases for their customers on the market would have increased and they’d require margin payments. Others say, the would have sold (short) 3 times more energy then they produce and the re-purchase of the 2/3 now is costly.

    I’m not convinced myself, the price mechanism and the logic with an exchange works as in theory. Because there is no market for e.g. gas as there is for used cars. The supply of gas has more constraints per se, so if you rice by constraints, prices will react more. But it cannot solve the physical market. The few pipelines from the east depend mostly on Poland and Ukraine and they seem to have decided to restrict it, maybe by proxy and it were the US or UK who took the decision. North stream I suffers from the West’s measures and North stream II is simply blocked by political pressure from the US. The situation could easily be solved by taking North Stream II in use. There is no free market and the messenger’s signal does not help, as political decision centers seem to want the situation as it is. And as there is no free market, free market rhetoric won’t help.

    What did ‘Killing Joke’ sing in ‘Age of Greed’:

    Privatise the people’s lives
    Be part of the company (or fade!)
    The appliance of science to privatise their lives
    Water is our business
    Electricity is our business
    Gas is our business
    Lives are our business
    Business is our business
    Your money – my time
    Your stinking industrial bathwater – my wine
    Imbalance induces hate
    How will you fill the gap
    Between the endless buffet
    And the scraps of food I have
    I feel hate I feel hate
    I feel hate I feel hate
    (Don’t be afraid to show your hate, hate!)
    You just treat me like a commodity
    You didn’t know I couldn’t even afford to feed my family…

    Comment by Mike — August 30, 2022 @ 4:51 am

  5. “What have Ireland Spain & Portugal done right?”

    As a resident of Portugal. Iberia is not connected into the European energy distribution system in any major manner.

    Comment by Tim Worstall — August 30, 2022 @ 5:18 am

  6. “Do you think it would be correct to say that these sanctions failed?” Let me weigh in. It depends on what you think their purpose was. If you take the purported purpose as being the truth – viz to hurt Russia but with negligible pain for the West – no; they’ve failed as far as I can see. We’ve damaged ourselves to no good end.

    But if you think the true purpose was to bugger up the European NATO countries then they appear to be a triumph of underhand dealing.

    But who in the West would want such a thing? Well, you could start with the eco-fascists who were in action before the sanctions were introduced. Was Merkel on Moscow’s payroll? In Britain the whole energy calamity was launched by Ed Miliband when he was Energy minister in the last Labour government. His father was a notorious communist sympathiser. Was Ed? Dunno. How about his Liberal Democrat successor, Ed Davey? How about the Conservative Prime Ministers Cameron, May, Johnson?

    The other place to look is the USA. Did the Washington Deep Swamp plot to have their European competitors shoot themselves in the foot? Could be, but are they competent enough to think of such a thing and then to execute it?

    It’s tempting to rant about the shortage of people in government with any understand of the sciences. But having seen the near-genocidal balls up The Science has made of the Covid response I certainly would rather not give any more power or influence to the sort of scientists who would be attracted to the government honey pot.

    Comment by dearieme — August 30, 2022 @ 6:15 am

  7. @Mike: It’s a stretch to call Ireland, 13th richest country in the OECD by average salary, 7th globally by per-capita GNI (let’s forget about GDP in Ireland’s case, due to multinational shenanigans) and 2nd on the UN Human Development Index, as “Third World”.

    Comment by HibernoFrog — August 30, 2022 @ 7:10 am

  8. @HF: yet The Republic was pretty Third World in the 60s and (at least) early 70s. Who rescued it? I’ve seen the success attributed to civil servants. It seems unlikely but it’s logically possible. Is there anything I should read on the subject?

    Comment by dearieme — August 30, 2022 @ 8:40 am

  9. @dearieme: I’m afraid I’m no scholar, but I think it’s fair to say that Ireland’s transformation from desperately poor basket case (imagine trying to implement economic self-sufficiency in a country of less than 3 million. Madness!) to a modern economy was very much the result of politicians being willing to listen to civil servants, and civil servants in turn being willing to listen to experts. The practical upshot being huge investment in education, business-friendly regulations, stable politics, plus there were inherited traits: a reasonably impartial legal system based on the the British system, speaking English, a powerful agricultural sector so we weren’t starting from absolute zero and a HUGE diaspora as a source of investment and know-how. If I had to pick any single thing though, it would be special economic zones – so I can give you at least one very good recommendation: The podcast “99% Invisible” did an excellent episode a few months ago about the invention of the special economic zone around Shannon Airport. Well worth a listen.

    Comment by HibernoFrog — August 30, 2022 @ 9:48 am

  10. @HibernoFrog: IE…take alone the weather…well, how seriously can a third world classification been taken anyway and what does it mean? If you google it, originally it means not belonging to the US/NATO block, nor to Russia, China etc., so Ireland was officially like the neutral countries, e.g. also Switzerland, a third world country. And it’s still not a NATO member, as far as I know. What is the first world now and what the second? Does 3rd world now mean a ‘developing country’? And would this imply, e.g. the EU states would not develop anymore as countries and would this be a good thing? I don’t trust the statistics, rankings and ratings…

    Comment by Mike — August 30, 2022 @ 9:51 am

  11. No mention of the impact of rampant speculation on prices? Sure, there’s scarcity, but is it really that scarce? Compared to recent winters?? Dudo.

    Methinks some norty hedge funds have taken positions – these alleged shortages were signposted way back in the Spring, plenty of time to adjust their trading positions to maximise their returns.

    Here’s a policy proposal for the UK: get the f*ck on with building our new nukes, and install PV on every goddamn south-facing roof. Oh, and only export when we have a surplus, and charge top whack for it.

    Comment by David Mercer — August 30, 2022 @ 10:04 am

  12. @dearieme – Ireland “Who rescued it?”

    Two factors: the EU and low corporate taxes. Since Ireland was very poor, it got lots of money from the EU which was wisely invested in infrastructure. It also decided that high-tech multinationals were a good thing, so had very low corporate tax to attract them, leading to Intel, Apple, Google, Facebook etc all investing a lot. This was so successful that Ireland refused to accept €13bn from Apple that the EU said shouild be charged in tax – that’s more than a quarter of the total annual tax raised in Ireland. And Ireland won, showing just how successful its strategy is – worth turning down such a huge amount of money for.

    Comment by Charles — August 30, 2022 @ 2:08 pm

  13. @Mike: Fair enough – by that definition, Ireland would indeed still be “3rd world” in the sense of being non-aligned. I consider that a poor effort by us though: For a country with so much wealth to still rely on the UK to patrol her airspace is, in my opinion, just shameful freeloading. Same for the loose tax laws: It’s not as bad as some people imply (notably, companies like Google, Facebook, etc have thousands of high-level employees in Ireland, so the tax domiciliation of their European divisions there is legitimate) but there are an awful lot of abuses where Ireland is just facilitating the ripping-off of our neighbours to little benefit to ourselves – again, shameful freeloading.

    @David: I would add one more to your list, we need more pumped storage to go with all those PV panels…

    Comment by HibernoFrog — August 31, 2022 @ 2:24 am

  14. @HF,

    Here’s an idea, instead of scapegoating Ireland, maybe the EU nations could reduce their ruinously high tax rates and compete.

    Comment by The Pilot — August 31, 2022 @ 8:43 am

  15. And, where are the green warriors now quoting how renewables are the cheapest source of electricity?

    Comment by The Pilot — August 31, 2022 @ 8:44 am

  16. @The Pilot: I’ve read there is energy mix in the EU, but a price mechanism, where the scarcest=most expensive energy source determines the energy price. This would be from gas at the moment. It would mean that there would be profits when energy is from other sources. And the gas shortage is politically driven. There are companies with profits and those with losses. Those with losses could ‘take’ earlier profits and get now bailed out for the losses wuth tax payer’s money and levy charges, plus generally higher energy prices. This is what it looks like, or is it different?

    Comment by Mike — August 31, 2022 @ 1:57 pm

  17. It’s worth pointing out that UK didn’t have an energy policy before the miners’ strike. The department was only created in 1974 and has royally phcked up the market ever since.
    Out of several ways of weaning Europe off Russian gas, the lead times are:
    Fracking: one year
    North Sea gas: 4 years
    Nuclear: 15 years
    Guess which one the Department of Energy is prioritising.

    Comment by philip — August 31, 2022 @ 7:41 pm

  18. There are two and only two ways out of the energy crisis.

    1. Go to war with Russia. This is not as insane an option as you might think. David Attenborough has been advocating a ninety percent human population cull for decades.
    2. Surrender to Russia by withdrawing sanctions and telling Joe that his Ukrainian Adventure is over. Much Western face will be lost but the problem will go away immediately.

    The alternative is excess cold deaths in Europe this winter in the order of a million or more. (It’s usually about half a million.)

    Comment by Michael van der Riet — August 31, 2022 @ 11:10 pm

  19. Agreed that Europe’s approach to crisis management can ‘add layers’ but Europe has more supply-side options than market prices or media reflect EG the Dutch Groningen gas field, Europe’s breakglass option with enough capacity to fill the Russia-sized hole in Europe’s gas supply for 3, maybe 4 years. The Dutch don’t want to recomission the field but a potential EUR400bn payday + intense pressure from Germany might help the thought process. There’s more on the list eg US, Norway, Israel, Egypt, Qatar although some of those come with not-so-friendly deal terms.

    Plus crises always seem to happen in August (worst possible time). Price deltas of ~600% in response to a potential (emphasis) <2% supply shift speak as much to market dislocation in an information vacuum/thin liquidity as anything else. No doubt some opportunism in there too. EU expected to weigh in on Sep14. They have a couple big(ish) bazookas at their disposal and making noises they will use them.

    Does anyone know how Germany filled their gas reserves from practically nothing to 80% in <8 weeks? Serious question.

    Comment by John — September 1, 2022 @ 5:04 am

  20. @van der Riet,

    Care to speculate on the total excess deaths Ukraine has suffered to date and, more to the point, the number of excess Eastern European deaths will result from Russia invading in the future? It’s pretty clear Russia won’t stop, if Putin wins in your option Two.

    Comment by The Pilot — September 1, 2022 @ 6:39 am

  21. >>Yes, high gas prices/gas scarcity courtesy of Vova is contributing to high power prices<>Yes, high gas prices/gas scarcity courtesy of the warmonger neocons in Washington, NATO, and their vassals<<is contributing to high power prices

    Comment by Richard Whitney — September 4, 2022 @ 10:30 am

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