A homogeneous good

Posted in: Comment, News and Updates

A month ago, I wrote about the bizarre market for widgets; that is, for electricity.  It began:

"Suppose you were in the market for 20 widgets.  You might put out a call for makers to submit prices.  So far so good.  Now suppose one maker offered you 19 at 2p per widget, but that was all they had, and you had to buy the 20th widget at 20p from somebody else.  You might think that this would cost you 58p for the lot, and you'd be right.  That might work for widgets but not for electricity in the UK.  If you were buying 19 MWh (at 2p per unit from a windfarm) and 1MWh (at 20p per unit from a gas generator), you'd have to ... buy all 20 at the higher price.  This is the madness of the electricity market whose chief aim is to keep the lights on; it second aim seems to be to ensure prices are kept as high as possible.  Only expensively-educated other-worldly types could have devised a scheme like this."

Exploring all this seeming nonsense, I came across the idea that the problem is that electricity (and natural gas) is a "homogeneous good".  That's to say that current electricity is electricity is electricity ... no matter who produces it or how.  There aren't de luxe brands, or ones that squirt faster through the ether to you, or ones with a better perfume.*  No.  What you buy is what I buy and this means that peculiarities arise in the markets that mediate between buyers and sellers.

I was puzzled by all this economist jargon, and it looked like a neat way of keeping prices high, not to say a cartel of sorts.  Happily, The Economist's Free Exchange column, sensing my confusion, came up trumps.  In an article: Power Corrupts, it set out how the market works.   It began: "Europe’s energy market was not built for this crisis.  It must be reformed without jettisoning what makes it work in normal times".

It notes:

"Just like in any other market for a homogenous good, the price of power is set by the most expensive supplier. This means that even power plants with low operating costs, such as nuclear ones or wind farms, receive the high prices that gas plants are charging.  The result is vast profits—and public outrage. Based on forward curves, Morgan Stanley, a bank, reckons that electricity spending in the EU could rise by more than €800bn, an increase worth an astonishing six percentage points of GDP.   Thus politicians have started to ask whether a different pricing mechanism is needed."

Well, it's nice to know that "Just like in any other market for a homogenous good, the price of power is set by the most expensive supplier" but why is this the case?  Not even The Economist explained this, although it does explain some of the workings of the Grid and the sheer complexity of its operation day-in, day-out.  My guess is that this market is going to have to get even more complex as supply diversifies even more.

Meanwhile, renewables producers are getting eye-watering incomes c/o consumers because their prices are linked to the world price of gas.  However, and this is less well known, in modern contracts for wind farms etc, there are clauses that require excess profits to flow back to the Treasury, and this is now happening unseen by consumers.

Thus, the excessive prices we are all paying for renewables-produced electricity is paid back to the Treasury which simply keeps it.  It follows that the subsidies we are all now about to receive on our electricity costs are (in part at least) flowing from the excess profits of renewables generators.  You could see this as a windfall tax if you like, though the present government would not say so.  We are, however, getting (some of) our own money back in a complicated way.  Actually lowering prices, it seems, is not on.

There is a problem with older wind / solar farms where no such contractual clauses exist.  Here the government is trying to get some voluntary payments out of them (as opposed to a windfall tax!).  We shall likely never hear about how successful or not they have been as the Treasury will want to snaffle this as well.



[1] *There are electricities with a lower or higher carbon footprint depending on source, and this fact is used in company marketing.

[2] I wrote the other day about the risible communications about the changes to electricity (and gas) costs.  Here's an example from the government:

"From 1st October, a new ‘Energy Price Guarantee’ will mean a typical UK household will now pay up to an average £2,500 a year on their energy bill for the next two years. This is automatic and applies to all households.  This will save the average household at least £1,000 a year based on current energy prices from October and is in addition to the £400 energy bills discount for all households."

"typical household", "average cost", "average savings".  There is no mention that it is the unit price which is being fixed and that, therefore, the more you use the more expensive it will be.  No wonder the prime minister was confused yesterday.

Posted in: Comment, News and Updates


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