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Painkillers for price spikes


by Leonard S. Hyman and William I. Tilles


As Oilprice readers know, the price of energy has spiked (to put it mildly) in Europe. Sample residential bills have more than doubled in some places from last year to this. In response, European governments want to help their hard  pressed citizens, not to mention hard pressed businesses. Russia's war against Ukraine caused the spike in prices and in wartime governments often take what they believe to be essential steps to control their economy. So what to do?


Right now a Europe formerly dependent on Russian gas has two options. First, put a cap on energy prices. That at least prevents further economic pain because it keeps prices from rising more. But this creates another set of problems. What if the price cap is set meaningfully below current market prices? In other words, if for example gas prices are set by the government at $1 but the supplier of gas has to pay $2 to drill for or purchase gas, who makes up the difference? Either the supplier loses $1 on each transaction or does the government compensate suppliers for all or most of the $1 difference? Obviously suppliers can't stay in business losing money on each transaction (they can't make it up on volume) so the government has to step in. But, by government action to cap prices, the customer does not receive an accurate price signal that energy is in scarce supply and perhaps should be consumed more carefully. This well intentioned policy spares the customer pain—until either the energy supplier or the government decides that this financial burden is too much. But this type of government policy does not address the root cause of the problem which is too much demand relative to a supply scarcity.  


The other means by which governments can provide  relief for high energy prices is to simply give energy consumers cash. This subsidy method, sometimes called a rebate, has a distinct advantage in that it aids the consumer but leaves in place the incentive to use less of the scarce resource due to high prices. Good policy, but now the government has to figure out who should get how much money. By usage? By income? Imagine how well connected industrialists and the wealthy could manipulate the payments to their advantage. And, of course, the government pays.


Some politicians have proposed a windfall profits tax on energy company profits and would use these revenues as energy rebates. The rationale for this is that oil and gas companies and electric generators are reaping huge fortunes at the expense of the citizenry for reasons that have nothing to do with their business acumen or smart investments. Mr Putin's recent aggression and stricter Saudis drilling targets are making them rich. So charge a punitive tax on the excess profits being earned now and give the money back to consumers. It's a great idea except for its consequences—it serves to drive away new corporate investment in the long run. Redistributive ideas like this are asymmetrical. No one ever proposes an oil company subsidy or negative windfall tax payment when energy company profitability is weak during an economic recession for example. Who wants to invest in a business in which you can keep large losses but are denied periodic big profits? 


Another possibility is that the sellers of energy could set up a price scale that raises price as usage goes up. In other words, you pay $1 per unit for the first hundred units, then $1.50 for the next hundred, and $2 per unit thereafter. In theory, this rising scale creates an incentive for conserving energy. However, we know that electricity and natural gas usages are relatively inelastic to price or income in the short term. That means raising prices will only have a minimal impact on demand. But that is good news in a perverse way because it means the energy supplier will collect more from high volume users (presumably but not necessarily wealthier) and transfer  that extra payment to the low volume (presumably poorer) users in the form of a price subsidy (for their lower volumes consumed). The only trouble with this scheme is that the suppliers have to keep track of use per customer and make sure that customers are not sneaking in extra usage from another supplier. This pricing is common for regulated monopolies but Europeans (and especially the British) don't like monopolies. 


In the short term people and industries cannot adjust usage much in the face of higher natural gas or electricity prices or changes in income. Such is the nature of inelastic demand. But in the long term they can. In other words a 10% price increase affects  short term demand by 2% at best but affects long term demand by 12%. A decline in income (expected in the coming year) plus higher prices likely will decrease demand. Continued high prices would tank demand. (Customers need time to buy new furnaces or LED bulbs.) But in the end continued high prices will do more than shift demand from Russian to Qatari gas. The prospect of continued high prices will destroy demand for natural gas forever. Short term, Europeans could face a winter of lowered thermostats, cold showers, idled industrial facilities, and dimly lit streets. But longer term, we suspect energy managers might want to consider the impact of stranded fossil fuel assets because longer term Europeans will be using a lot less gas than before the Russia-Ukraine war.


October 2022

Electricity decarbonization is not that expensive, so let’s get on with it

Electricity decarbonization is not that expensive, so let's get on with it



by Leonard S. Hyman and William I. Tilles


Presentation to Society of Utility and Regulatory Financial Analysts

Richmond, VA 

23-24 April 2020




To reduce  greenhouse gas (GHG) emissions that cause  global climate change, we must sharply reduce or eliminate fossil fuels from electric generation. That  would reduce GHG  emissions by a quarter.  Then  we must convince consumers to switch from direct use of fossil fuels to  carbon-free  electricity.  Electrifying  transportation would cut GHG  emissions by another quarter, but only if the electricity consumed were  were carbon free. Decarbonization of electricity has to go first. Otherwise,  consumers would substitute one fossil fuel for another.


Cost of decarbonization cannot be considered separately from  the electric industry's  need to modernize and replace old plant.  In real terms, over 20 years,  price of electricity would  rise by one half to pay to modernize and replace plant alone and  would double, with decarbonization  accounting for the differential. That is, real prices would  rise roughly 2% to 4% annually, with the difference the price of decarbonization.   The electricity bill equals 2% of GDP and the household bill only 2% of household income, so  projected price increases   should have little  impact on the average consumer


The electricity sector would have to make capital expenditures of  $5-$8 trillion over two decades, depending on the degree of decarbonization. The capital markets could easily absorb  the   $100-$200 billion a year of  securities needed to finance the expansion, and would do so at historically low capital costs.  The process should not require government subsidy. 


Does  the industry have  20 years to do the job? Only if it first  closes  coal-fired power stations and does not replace them with gas-fired ones. That would  slash the industry's GHG  emissions by two thirds.  Can we be confident that decarbonization will cost so much more than a business-as-usual approach? Maybe not,  because  there is  more of a likelihood  that  new technology costs will fall and fossil fuel costs rise than the other way around.  


In sum, the electric industry can raise  money at low cost  to decarbonize  and  customers will face only single digit price increases yo pay for it, so let's get on with it before it is too late.




 You can read the complete paper here: 








 Here are the appendices with data sets. 




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Renationalize the  UK's Utilities: Where Will the Money Come From?


Thirty Years after the Electricity Act of 1989, which  launched the great experiment, the privatization of the UK's energy utilities,  Jeremy Corbin's Labor Party wants to bring the companies back into government ownership, And he will if he wins the next election.  And considering the sorry state of the Conservative Party, he might win. The financial press now seems more concentrated on the future Labor Government's payment plans than on  whether nationalization is a good idea. Makes it seem like a foregone conclusion.


The owners, then, may be more focused on getting the right price  than keeping the assets. They  start by playing the international card.  Foreigners own most of the industry.  Not paying a proper price for the assets will upset them, will cause the world to think the UK is a bad place tin which to invest, will raise UK capital costs in the future, might even get tied up in international arbitration and treaty issues.  So they say.  But back in 1997, when Labor levied a windfall profits tax on mostly foreign-owned utilities, forcing  foreign owners to pay a tax brought about by the excesses of the previously British owners, nobody said anything about international treaties or boycott of investment in the UK. The present utility owners will get paid, but maybe not as much as they would like. Hauling the UK into international courts seems unlikely.You pays your money and you takes your chances,


Next issue: can the new (if elected) Labor Government find  money to buy the industry?  Well, Labor intends to print bonds with which it will pay for the utility shares.  It will receive, in return, control of profitable local utility monopolies.  Those monopolies earn returns four to six times as high as the under 2% interest rate on the government bonds. The new government owner could earn a nice profit on the deal, or it could use the lower capital cost to reduce electricity delivery charges by 5-10%.  Either way, there's no problem coming up with the money.


So, the real issue is price.   Owners of the utilities, by and large, bought them at prices well in excess of the regulatory asset value on which their returns are based. Financial theory says that utility stocks sell above regulatory asset value when they earn returns above the cost of capital.  Basically, then, the buyers paid more than regulatory  asset value because they expected the utility more than it needed to service its customer. They had no guarantee that excess return would continue, no guaranteed that regulatory asset value would remain high, no guarantee that regulators would continue to allow high returns, and no guarantee that Parliament would continue the regulatory system.


Well, maybe the government should pay market value (which some of the analysts confuse with fair value).  You know, an asset is worth what the market says it is worth. Problem is that most of these utilities are not traded in the market. And, the market values stocks on the basis of future earning power.  Labor could win office, take over the regulatory system, push down profits, which would push down market values, and thereby cut the price it would have to pay.  Not a good set up for investors. 


Bottom line. Bet on regulatory asset value, which may or may not  leave  investors with book  losses. As for the international consequences, the UK would surely survive. As for the industry, if nationalization occurs, too bad that this experiment will, as T.S. Eliot put it, end with not a bang but a whimper. 

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What do the British know about regulation that we don’t?



Regulation is back in the spotlight. Moody's, the bond rating agency, just issued a review of  regulation worldwide, that started with these words:  "Prudent regulation key to mitigating risk…"  The bond rating agency put its emphasis on mitigating the risk of carbon mitigation but pretty much opened up the relevance to other risks.  What about   regulation itself as a risk  factor, especially when the regulators decided to change  policies?   American regulators, we know,  have begun to re-examine  their policies in light of experiments elsewhere designed  to encourage  utilities to operate  more efficiently and then pass on  savings to consumers—- most notably the British  effort  that  began in 1990 which failed to radically reduce  prices  but did line the pockets of the utilities.  Whether shifting  American regulation to the British model will reduce risk is a big question.  Evidence indicates that it won't,   but who knows?


What's wrong with American-style regulation?  Critics oppose  it  because it focuses on  rate of return.  The regulator sets prices calculated to cover all operating costs plus a fair return on the investment in assets dedicated to serving the public.    Thus, the American utility has no incentive to reduce costs because it can pass on all costs to customers, and it has every incentive to over- invest  because it can earn a guaranteed return on that investment.   


Way back in 1962, two economists, Harvey Averch and Leland Johnson, published an article making that case, and  policy makers — including the British— have latched onto  the Averch-Johnson Effect ever since. But maybe the policy makers  missed the point,  which economists, incidentally did not.   Namely that  no sensible managers will invest capital unless they expect that investment to produce a return in excess of its cost. 


Financial theory tells us that when a company earns more than its cost of capital, its stock  sells  above  its  book value.  Successful companies generally earn more than cost of capital, so no big deal.    Regulated utilities, though,  have given up their right  to earn a high return profit in exchange  for protection from competition.  Regulators, instead,  set a fair return, generally defined as  cost of capital.  Yet,  the price of utility stocks in the post war period  fell below book value in only 14 of the 71 postwar years.   (Twelve of those fourteen years encompassed the nuclear building disaster and the Energy Crisis.)   Furthermore, the stocks generally sold substantially above book value.  Financial experts  agree that  utilities  should earn more than   cost of capital, as a precautionary matter,   but how much more?


Perhaps, then, the real issue is not  whether rate of return regulation itself encourages expensive over -investment but rather whether regulators set the correct return.  As for whether alternative regulatory formulas encourage greater efficiency in operations,  studies show that they do, but they also increase the cost of capital.. So, for  the alternative system to work for consumers  over the long term,   the additional operating efficiencies must  exceed the increase in  cost of capital. 


We can understand the desire of policy makers to do something different, but perhaps  doing the job they presently have better might be a good start. 


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Government Study Trashes British Electricity Structure



Early in the year, British politicians upset by the high electricity prices brought about, in part, by their energy policies, decided to commission a study (Cost of Electricity Review), but instead of empaneling a committee of regulator and civil servants, they handed the task to one of the UK's pre-eminent energy economists, Dieter Helm, and in reporting back, he minced no words. The report's policy analyses and recommendations have implications for both the American and British electricity markets.  Here are some takeaways:


Consumers pay too much— The British are in the process of decarbonizing their economy , but the government has managed to stumble into some of the most expensive ways of doing so. It started by picking the most expensive and needlessly complicated  ways of doing the job. It should have started with a uniform price on carbon throughout the economy. That would have triggered  the most economic energy saving and decarbonization moves first. It didn't and now consumers are stuck with long term obligations for too expensive renewables. And, the government should have realized and acted on the fact that closing down coal-fired power plants is one of the cheapest ways to reduce carbon emissions.


Neither the government nor the regulator are good at making long-term predictions— As a result, consumers are stuck paying for energy plans based on grossly erroneous assumptions and utilities will benefit for years to come from the bad projections made by the regulator for those long duration price plans that the British extol.  With technology changing so fast, making a long term projection and then signing contracts on that basis (as the government did on behalf of its citizenry) makes little sense. 


Resiliency of the system is a "common property" —  Having too much is definitely better than ha ing too little, but no market participant is going to put up extra money to help the network. 

Getting the right amount of resiliency is  not a problem solved by individual profit maximizers. Therefore the government or regulator has to  make the decision. But the decision-maker can use competitive mechanisms to get the job done at the best price.


Fold the functions of generation, supply (retail sale) and distribution into one entity at the local level— The UK pioneered in separating the functions, apparently believing that the market would get it right, but separation seems not to have led to optimal decisions.  Managers might be able to make better decisions if they can choose between different ways of solving a problem.


Fix a margin on supply (retail)— Right now the supply function is supposed to be deregulated, which has meant that various suppliers, all buying from the same wholesale market, offer a confusing array of price schedules that often lead consumers to pay too much and do not reflect changes in wholesale price fast enough. So, set a default tariff with a fixed margin to help consumers. 


The existing market, with prices set my the marginal cost of fossil-fueled generators will not work in the future—  The industry is heading toward a new structure, in which renewables provide a large proportion of energy, consumers  and producers have the ability to store electricity and  control usage via smart devices.  Renewables have high fixed costs and no fuel costs. The market has to pay the fixed costs no matter what, and no variable costs. Electricity could become similar to cell phone service. You pay a monthly bill for a plan that  allows you up to a given capacity level (let's say, so much data).  In other words, you will pay the monthly bill and get the electricity for free.  The reformed industry structure of wholesale market and four  separate industry sectors (generation, transmission, supply and distribution) each marching to a different tune,  may be on the way out the door. 


Does it look as if the past quarter century of electricity restructuring, with all its brave assumptions about market efficacy and dramatic cost savings, has simply diverted the industry and policy makers from the really big issue, meeting the challenge of climate change in an efficient and timely manner? Dieter Helm does not say that, but that may be the most important takeaway of all. 

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