J.P. Marín-Arrese | PM Pedro Sánchez bet hard in the recent EU Summit when he pressed for an overhaul of the current marginal cost pricing in the electricity sector. While missing his goal, and rebuked by Germany and Holland, he was given as a consolation prize the promise that Spain and Portugal could cap electricity gas prices on a temporary basis, subject to final scrutiny by Brussels. Decoupling the most expensive energy source from the basket seems a straightforward and sensible way to cut down the skyrocketing power bill. Yet, it delivers far fewer benefits than damages if implemented for too long.
Out of rough conventional wisdom, most observers in Spain denounce the large windfall benefits electricity firms obtain from marginal pricing. As the costly gas power plants set the benchmark price for the whole supply, they conclude cheaper sources enjoy unwarranted income margins. Yet, they fail to understand that such a marginal set-up covers not only profits but also fixed costs. Decoupling every energy source and pricing it at its marginal barrier would only meet variable costs. Unless public money is used to foot the rest of the bill, such scheme would plunge the electricity sector into terrible bankruptcy.
Under the current single clearing-price system, supply bids aim at covering overall marginal costs thus leaving room to finance fixed costs and margins. The alternative option involves splitting the market, each segment quoting a different price. The UK implemented this model with limited success. Most electricity is traded in the spot day-ahead market on a single tender basis while a balancing mechanism is used to adjust demand and supply hourly under a pay-as-you-bid arrangement. As players enjoy ample mutual information, they maximise their profit by bidding at average instead of marginal costs in each segregated market. Thus, such scheme fails to secure consumers’ interests as prices far from lowering could eventually hike.
In the current exceptional circumstances, capping gas produced electricity might work for a short while. It involves complex arrangements so that full coverage of fixed costs and reasonable profits can be guaranteed.
Otherwise, investment would plummet, as would investors’ confidence in Spain. Not so many years ago, the Government put a cap on consumers’ electricity bills and financed the ensuing tariff deficit through future pay promises discounted by banking institutions. The experience ended up in an utter fiasco as rolled over interests led to unsustainable public liabilities.
Market facts remain impervious to political will. Trying to put a stop to the current price hike could affect overall efficiency negatively and lead to subdued supply. Public meddling in the way demand and supply match can only lead to detrimental distortions and undue production imbalances. Miracle solutions fuelled by sheer populism always prompt a backlash.