Energy Price Caps: What are we talking about?

Judith Arnal

6 mins - 30 de Enero de 2023, 08:07

One of the main economic consequences of Russia's war against Ukraine is the sharp rise in energy prices. This poses a twofold problem: on the one hand, Russia, one of the world's leading exporters of oil and gas, sees its public revenues rise, thus having more resources to finance the war; on the other hand, EU households and industries are facing unbearably high energy bills.
As a result, there have been a plethora of measures adopted at international, European and national levels, dubbed 'caps' on energy prices. But what are we talking about? Do all these measures serve the same purpose? Are they all effective and advisable? Let's take a look.

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Starting with the international level, on 5 December of last year, the G7 and the EU agreed to introduce a cap on Russian seaborne oil prices at $60/barrel. But by then, the G7 and EU countries had already banned the import of Russian oil into their territories. So, what is the point of this price cap? Most financial and shipping underwriting services are based in the EU or the UK. Without these services, shipping cannot take place. With the price cap, the provision of these services or the transport of oil by a cargo ship from one of these countries is prohibited if the price of Russian oil exceeds $60/barrel. 

Is this measure working? On 5 December, the spot price of oil from the Urals fell below $60/barrel and has remained so ever since. According to the Centre for Research on Energy and Clean Air, the oil price cap and the import ban cost Russia €160 million per day. However, Russia still earns €640 million a day from the export of fossil fuels. Therefore, on 5 February, another limit on the price of refined petroleum products will come into effect. There are also calls to reduce the oil price cap to below $60/barrel. 

Let us turn now towards the EU. One of the main benchmarks in terms of natural gas is the TTF, to which many long-term contracts are referenced. However, as a result of the tensions caused by the war, the price of the TTF soared last year, reaching a record high in August. For this reason, the EU has proposed two measures: on the one hand, the search for an alternative and more representative index; on the other hand, the setting of a limit on the price of the TTF. Precisely, on 19 December of last year, a limit was agreed on the price of the TTF, legally known as the market correction mechanism, which will come into force on 15 February. 

To activate the mechanism, it is necessary that, for at least 3 days, the price of TTF reaches 180 €/MWh and that it is €35 more expensive than liquefied natural gas (LNG). Once activated, no transactions exceeding the sum of the LNG price and €35 will be allowed. When the LNG price is less than €145, the limit will be €180. Once activated, the mechanism will be in place for 20 days. The mechanism will apply to TTF derivatives between 1 month and 1 year. However, at the insistence of countries such as Germany and the Netherlands, unconvinced by the price intervention that this mechanism would entail, important deactivation clauses were introduced.

Is this measure working? If this mechanism had existed in 2022, it would have been activated more than 40 days in August and September. On 23 January of this year, both the European Securities and Markets Authority (ESMA) and the Agency for the Cooperation of Energy Regulators (ACER) published reports assessing the mechanism. These reports note that the mechanism has not had any positive or negative effects so far, but if activated, it could generate disadvantages. ESMA points out that the distortion of the price signal could lead investors to avoid it in various ways, creating problems of liquidity, transparency and financial stability. ACER notes that the likelihood of the mechanism being activated in the next two years is, in principle, low, but if it is activated, there would be risks in the form, for example, of possible price divergences between European gas markets.

And we end with the national level, specifically with the Iberian mechanism. The electricity market is marginalist. This implies that the price of electricity is set by the most expensive technology in each hourly period. With the sharp increases in gas prices, the most expensive technologies are those that use gas, e.g. thermal power plants. This brings great benefits for the rest of the infra-marginal technologies, such as renewables, which, with much lower costs, charge the same price as thermal power plants. Indeed, the Iberian mechanism seeks precisely to partially "demarginalise" the market, limiting the price of gas used by thermal power plants and which is passed on in the bids that end up setting the price of electricity on the wholesale market. During the first 6 months of the mechanism in vigour, the reference price of gas will be €40/MWh, increasing by €5 per month until it reaches €70/MWh. Thermal power plants are compensated by consumers for the difference between the market price of gas and the reference price.

Is this measure working? There is every indication that it is. Just look at the daily prices in the EU wholesale electricity markets. According to the Ministry of Ecological Transition, this measure has already led to savings of more than €4.5 billion. However, one should bear in mind that this measure tends to encourage gas consumption, going in the opposite direction to decarbonisation efforts, and exports of electricity subsidised by Spanish consumers to other countries. 

Price caps are a very serious measure and one that usually backfires by distorting market signals. It is good that limits are established to avoid the enrichment of Russia or that mechanisms, such as the Iberian one, are introduced to limit the impact of anomalous market situations. But this must be temporary. It is necessary to promote structural measures, such as the reform of the electricity market. In this respect, we will have to see what proposal the European Commission makes in this regard in the first quarter of this year. 
Read the original article published in Cinco Días

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