Energy: Market or Design?

Bernd Sieker, 2007 || Creative Commons

Many policy dilemmas in energy are driven by fundamental disagreements between several groups of people. There are those who view markets as functional (albeit imperfect) tools for economic decisions. And then there are those who think markets always fail at this task. Add to that the intricacies of the energy sector, and the discussion about markets in the energy sector becomes an argument between economists and engineers written down by lawyers.

This is reflected in the questions tackled by the European Commission in its consultation on the Energy Market Design. The dilemmas are difficult, and the answers are far from simplistic. But at the end of the day you cannot have a market for energy without allowing full market relations between producers and consumers.

Ironically enough, the actual price of energy in the EU constitutes between half and a third of the final price for electricity that consumers pay. The remaining portion is spent on networks, taxes and taxes which are not called taxes but rather “public sector obligations” (PSOs). PSOs are set by member states and their regulators. Tariffs for transportation and distribution networks are usually regulated too. So no markets allowed there.

This has profound consequences. It means that the major portion of the electricity price is determined by non-market actors. So whenever there is a talk of energy security, external shocks or price volatility, we should remember that the largest proportion of determinants of price are created within our borders, by our own bureaucrats or politicians. One of the questions touched upon in the consultation is this: should prices better reflect scarcity? Or to put it in simple terms, would it be beneficial if pricing regimes for energy moved closer to market conditions?

A simple and short answer is yes. Prices based on the market and actual scarcity of goods provide information to market participants and allow for optimal decisions. Actual scarcity should not just become another component of the price regulation calculation. In order to properly reflect scarcity, energy companies must be allowed to offer diversified products and services based on customers choice. From payment plans for electricity which resemble cell phone payment plans to price differentiation for network services.

In simple terms that would mean more options for price formation. We can accept different prices per kilowatt-hour when those differences result from negations between buyers and sellers. Why oppose different prices for transmission or distribution of electricity then?

After all “congestion charges” which are becoming increasingly common are in principle very similar to charging different customers for the same product (e.g. transportation of electricity). They too reflect physical scarcity of the network. So why is it acceptable to have “congestion charges” but not price discrimination for network tariffs?

My guess is that many people simply distrust markets. “Price discrimination” seems whimsical, unfair and inefficient per se. While “congestion charges” seem logical and transparent. This different treatment of essentially the same phenomenon simply illustrates what people think about markets. It is a question of ideology rather than economics.

By the way, there is nothing fundamentally wrong with charging different consumers different prices for the same product. Sellers do that all the time. The technical term is “price discrimination” and yet there is nothing discriminatory about it. As long as the consumer has a choice, this is just a price setting mechanism, not discrimination sensu stricte. One could argue that differentiated Public Sector Obligations for different buyers resemble price discrimination. But I digress.

We do not need perfect markets, markets that mimic the textbook model of perfect competition because in reality such markets do not exist. We will be fine with imperfect but functional prices for energy. Less regulated tariffs and taxes, more market prices. This should be the general direction for the evolution of the European energy market.

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