Yanis Varoufakis: Time to Blow Up the Electricity Markets

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Yves here. This post provides a useful, high level description of how the EU electricity markets work, according to some definition of “work”. As Varoufakis makes clear, this scheme is so complex and riddled with internal inconsistencies that only an economist could love it.

The post is mainly about the malfunctioning electricity market. But it also mentions in passing, and unfavorably, the market for greenhouse gas permits. This pretends to be a prohibition scheme (companies are not supposed to emit more than the totally allowed via permits) but yours truly has been reading intermittently since this market started of massive gaming by traders. And programs like this don’t add up to much unless there is serious monitoring, fines, and the ability to force plant closure of recidivist violators. Again, readers please correct me, but I certainly haven’t encountered stories of EU companies being hit with even nuisance-level fines.

However, in the end, Varoufakis falls for this idea at the end by advocating a sounder market approach, a carbon tax. But this is still the wrong approach for combatting an existential threat (at least from the perspective of human civilization and a lot of flora and fauna). As we wrote in 2019:

There is yet another reason why carbon taxes and pricing are not good ways to combat climate change. Economist Martin Weitzman developed a framework for how to deal with externalities like pollution. Andrew Haldane’s summary:

In making these choices [between taxation and prohibition], economists have often drawn on Martin Weitzman’s classic public goods framework from the early 1970s.13 Under this framework, the optimal amount of pollution control is found by equating the marginal social benefits of pollution-control and the marginal private costs of this control. With no uncertainty about either costs or benefits, a policymaker would be indifferent between taxation and restrictions when striking this cost/benefit balance.

In the real world, there is considerable uncertainty about both costs and benefits. Weitzman’s framework tells us how to choose between pollution-control instruments in this setting. If the marginal social benefits foregone of the wrong choice are large, relative to the private costs incurred, then quantitative restrictions are optimal. Why? Because fixing quantities to achieve pollution control, while letting prices vary, does not have large private costs. When the
marginal social benefit curve is steeper than the marginal private cost curve, restrictions dominate.

The results flip when the marginal cost/benefit trade-offs are reversed. If the private costs of the wrong choice are high, relative to the social benefits foregone, fixing these costs through taxation is likely to deliver the better welfare outcome. When the marginal social benefit curve is flatter than the marginal private cost curve, taxation dominates. So the choice of taxation versus prohibition in controlling pollution is ultimately an empirical issue.

Needless to say, with more and more scientists calling climate change an emergency, limits and prohibitions are the proper tools.

By Yanis Varoufakis, an economist, member of the Greek Parliament, and former Finance Minister of Greece. Originally published at Project Syndicate; cross posted from his website

The European Union’s power sector is a good example of what market fundamentalism has done to electricity networks the world over. With the end of cheap natural gas, retail consumers and businesses are paying the price for their governments’ embrace of a shoddy theory.

ATHENS – The blades of the wind turbines on the mountain range opposite my window are turning especially energetically today. Last night’s storm has abated but high winds continue, contributing extra kilowatts to the electricity grid at precisely zero additional cost (or marginal cost, in the language of the economists). But the people struggling to make ends meet during a dreadful cost-of-living crisis must pay for these kilowatts as if they were produced by the most expensive liquefied natural gas transported to Greece’s shores from Texas. This absurdity, which prevails well beyond Greece and Europe, must end.

The absurdity stems from the delusion that states can simulate a competitive, and thus efficient, electricity market. Because only one electricity cable enters our homes or businesses, leaving matters to the market would lead to a perfect monopoly – an outcome that nobody wants. But governments decided that they could simulate a competitive market to replace the public utilities that used to generate and distribute power. They can’t.

The European Union’s power sector is a good example of what market fundamentalism has done to electricity networks the world over. The EU obliged its member states to split the electricity grid from the power-generating stations and privatize the power stations to create new firms, which would compete with one another to provide electricity to a new company owning the grid. This company, in turn, would lease its cables to another host of companies that would buy the electricity wholesale and compete among themselves for the retail business of homes and firms. Competition among producers would minimize the wholesale price, while competition among retailers would ensure that final consumers benefit from low prices and high-quality service.

Alas, none of this could be made to work in theory, let alone in practice.

The simulated market faced contradictory imperatives: to ensure a minimum amount of electricity within the grid at every point in time, and to channel investment into green energy. The solution proposed by market fundamentalists was twofold: create another market for permissions to emit greenhouse gases, and introduce marginal-cost pricing, which meant that the wholesale price of every kilowatt should equal that of the costliest kilowatt.

The emission-permit market was meant to motivate electricity producers to shift to less polluting fuels. Unlike a fixed tax, the cost of emitting a ton of carbon dioxide would be determined by the market. In theory, the more industry relied on terrible fuels like lignite, the larger the demand for the EU-issued emission permits. This would drive up their price, strengthening the incentive to switch to natural gas and, ultimately, to renewables.

Marginal-cost pricing was intended to ensure the minimum level of electricity supply, by preventing low-cost producers from undercutting higher-cost power companies. The prices would give low-cost producers enough profits and reasons to invest in cheaper, less polluting energy sources.

To see what the regulators had in mind, consider a hydroelectric power station and a lignite-fired one. The fixed cost of building the hydroelectric station is large but the marginal cost is zero: once water turns its turbine, the next kilowatt the station produces costs nothing. In contrast, the lignite-fired power station is much cheaper to build, but the marginal cost is positive, reflecting the fixed amount of costly lignite per kilowatt produced.

By fixing the price of every kilowatt produced hydroelectrically to be no less than the marginal cost of producing a kilowatt using lignite, the EU wanted to reward the hydroelectric company with a fat profit, which, regulators hoped, would be invested in additional renewable-energy capacity. Meanwhile, the lignite-fueled power station would have next to no profits (as the price would just about cover its marginal costs) and a growing bill for the permits it needed to buy in order to pollute.

But reality was less forgiving than the theory. As the pandemic wreaked havoc on global supply chains, the price of natural gas rose, before trebling after Russia invaded Ukraine. Suddenly, the most polluting fuel (lignite) was not the most expensive, motivating more long-term investment in fossil fuels and infrastructure for LNG. Marginal-cost pricing helped power companies extract huge rents from outraged retail consumers, who realized they were paying much more than the average cost of electricity. Not surprisingly, publics, seeing no benefits – to them or to the environment – from the blades rotating above their heads and spoiling their scenery, turned against wind turbines.

The rise in natural gas prices has exposed the endemic failures that occur when a simulated market is grafted onto a natural monopoly. We have seen it all: How easily producers could collude in fixing the wholesale price. How their obscene profits, especially from renewables, turned citizens against the green transition. How the simulated market regime impeded common procurement that would have alleviated poorer countries’ energy costs. How the retail electricity market became a casino with companies speculating on future electricity prices, profiting during the good times, and demanding state bailouts when their bets turn bad.

It’s time to wind down simulated electricity markets. What we need, instead, are public energy networks in which electricity prices represent average costs plus a small mark-up. We need a carbon tax, whose proceeds must compensate poorer citizens. We need a large-scale Manhattan Project-like investment in the green technologies of the future (such as green hydrogen and large-scale offshore floating windfarms). And, lastly, we need municipally-owned local networks of existing renewables (solar, wind, and batteries) that turn communities into owners, managers, and beneficiaries of the power they need.

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30 comments

  1. PlutoniumKun

    It seems almost an iron rule of synthetic markets in natural monopoly situations that they end up being manipulated to produce a result the opposite of that intended. The EU market (which in reality operates very differently across the EU as countries were permitted a lot of leeway in implementation) has had some good outcomes, but it was almost inevitable that it would result in either chronic shortages or crazy price increases at some time. Its not even clear that the current very profitable circumstances for wind and solar will result in major investments as companies may prefer to reap the benefits rather than roll out quick investments when construction prices are rising rapidly.

    btw, one thing not mentioned is that one of the key motivations for creating complex energy markets was simply to break the power of major unions – being able to switch off the lights made workers in the former national power companies very well protected. This is obviously not the situation now.

    Reply
    1. Ignacio

      Yes, each country or region has their own operative and different ways of translating costs into the retail markets. The liberalization in Spain can be seen as total disaster and in this market the retail newcomers are now facing bankruptcy with NG escalation (link in Spanish).

      Reply
    2. vao

      The situation described by Varoufakis and your comments refer to the overall EU framework — but it becomes even more complicated and illogical when the characteristics of individual country markets come into play.

      Example: France. The major electricity producer is EDF (the former state operator, still 86% owned by the French government), which can rely upon its pool of atomic power plants to deliver relatively cheap energy — two thirds of all electricity produced in France. But that means it would have a near monopoly on the market, and the EU commission would not accept that; there just has to be a multiplicity of competitors selling electricity and vying for customers.

      Since it is technically and economically unfeasible to split EDF in various companies, about a decade ago the French government set up a scheme called ARENH which works as follows:

      1) EDF is obliged to sell up to 25% of its production (i.e. 100 TWh) to its competitors.

      2) The price is fixed at 42€ / MWh — lower than the market prices, and also lower than the 48-52€ EDF deems necessary to cover its costs.

      3) Those resellers must apply for a portion of those 100 TWh. If there are too many bids, the “lots” are reduced proportionally.

      The result is that EDF is forced to sell electricity below market prices to middlemen that just pocket the profits by reselling it at a higher prices.

      Worse: in 2016, the market prices plunged to about 20€/MWh — and the buyers of ARENH invoked a “force majeure” clause to get free from their commitment of buying energy from EDF at the ARENH tariff. Retailers played a similar game in 2020 after the disturbances on the market because of the coronavirus pandemic.

      Even worse: the recent massive increase in prices for gas has led retailers to clamour for an increase of the ARENH cap; the government complied and raised it to 120TWh. The ARENH tariff was also raised to 46.20€, and from 2022 onwards to 49.5€ (but the EU commission must validate this last increase). However, because of the issues with its power plants (many of which have stopped producing because of technical defects due to aging, or too little/too hot water in the French rivers), EDF cannot at the same time supply 120TWh to retailers and fulfil delivery contracts to its own customers — and must therefore buy electricity on the spot market (at very high prices) to resell it at ARENH tariff to retailers… Oh, and in addition the French government froze the price increases that EDF could bill to its customers.

      No matter the price level, ARENH is a losing proposition for the largest electricity producer. EDF has been bleeding money with all those supposedly market-oriented measures, and has even been suing the French government for compensation. The renationalization of EDF becomes also quite understandable; for its part, the German government prefers to shower subsidies onto German energy producers (Gazprom Germania, Uniper, VNG) rather than nationalizing them outright.

      Reply
  2. Cristobal

    The first thing that struck me about the market pricing scheme as described by Mr. Varoufakis is that a number of new companies will be created. We will have producer companies, owner(s) of the transmission facilities, retail companies. I recall when NYS entered into this type of scheme there was a virtual explosion of these new companies. Now, I suppose tthat all these companies are in this business out of th goodness of their hearts. The employees, the office facilities and all are regarded as some kind of publicservice. Basically, it seems as if at least three profit centers have been inserted between the generation of electricity and the consumer. Back then, and now, I fail to see how this scheme saves the consumer money. It seems more like a scam for the well connected (who, exactly, will be setting up these new companies) to fleece us all. I vote for public utilities.

    Reply
  3. jackiebass63

    In NYS where I live periodically you get to choose your electric and natural gas supplier. You can chose a fixed or variable rate, a period of time, and the company suppling the gas or electric.I have always chosen a fixed rate for the longest time. I have never been burned by the price drastically dropping. Usually just the opposite happens. The price increases for the variable rate. This choice also keeps my bill stable. In my area NYSEG delivers the gas and electric. About half of my bill is fuel cost and the other half delivery.

    Reply
  4. Cristobal

    (More)
    This is not efficiient. In economic jargon I think we could say that the transaction costs of this scheme are out of sight.

    Reply
  5. Dave in Austin

    If you want private entities to make very large, long-term investments in generating capacity, you must either provide subsidies that limit the downside risk or allow the people taking the big risk to potentially make big rewards.

    The flaw in the “marginal cost” argument is that a very large investment must be made to make the first unit and the price goes down as you are able to allocate the fixed costs among a large number of units. So the producer sustains a large loss if there are not a lot of units produced and is rewarded by making a big profit if many units are produced. Under the marginal cost theory the first million Toyota Corolla’s should cost $50,000 each and the last million should cost $10,000.

    In the case of energy, the goal right now is to limit consumption by increasing prices. If you vary prices by marginal cost, what do you do if the production of hydro and wind has been locked-in at a reasonable price by users who wanted to reduce risk while consumers benefited from the lower price of “cheap Russian natural gas”? We are seeing the same problem in Pakistan which lived off last-minute prices of LNG which have been low rather than long-term more expensive contracts like the Japanese did. Pakistan looked smart and the Japanese looked foolish when the spot market for LNG was cheap. Now that the spot market has gone up, the gas Japan gets looks like a bargain.

    European consumers- and governments- benefited from cheap Russian gas. And even with big subsidies solar in Germany was more expensive. Wind was more competative but the incentives to mass produce windmills was not there when Europe had cheap natural gas. Now suddenly the flaw in that decision- and the decision to shut down Russian gas imports- is apparent and the only short-term choice is to limit use. So the whole “marginal cost” argument is a covert way of trying to decide “Who gets the cheap renewables and at what price?” The windfall tax is appropriate but selling the cheap electricity at a low price just encourages use.

    Reply
  6. JW

    If in an alternative universe, the aircon in a stuffy office in NY had been turned on in 1988, and the IPCC had not been born;
    CO2 emission targets per set of coal fired generation had not been imposed
    Unreliables had not been granted ‘must run’ status and obscene subsidies, and had not replaced reliable nuclear baseload generation
    NS2 was operating
    Coal would still be setting marginal prices, gas would not be required to back up unreliables GW for GW, nuclear would be the only ‘must run’ baseload generation.
    In this universe , prices would be nice and low with loads of supply.
    Ask yourself, was any of this beneficial or necessary? Answer…nope, not a bit of it.
    Its not ‘economics’ that are wrong, its the useless meddling in it, and associated ideology that has got us to this position.
    And the US is heading ever so quickly in the same direction.

    Reply
    1. NoFreeWill

      the market hates nuclear because of high startup costs and unreliable profits…. so i’m not sure the economics are right in your scenario either. and fossil fuels and nuclear both have massive state investment and subsidies to get them built. the so-called free market has always been a product of meddling and letting it do what it wants is how we got here, not the other way around. incentives/subsidies for renewables have long been paltry compared to what we need… and the storage that would make them reliable isn’t being invested in either.

      Reply
      1. digi_owl

        Yeah, there has never really been a free market in any proper sense. Usually it is just a shorthand for getting people to curtail government regulations.

        Most of technological development has happened on the back of wars driving governments to write blank checks in order to expand production of the latest wonder weapons.

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  7. Jack

    The more I read NC the more I have come to feel that the word “market” in its various forms is just a code word for screwing the average consumer and enrichment of the well connected. As was previously recently discussed here in a post on the US electricity “market”, not having a plan and letting the “market” determine what electricity is available and at what cost is a recipe for failure. Planning and over all control by an entity who has the common good as its goal does result in success. Just look at the TVA here in the US as an example. Sure, there were some problems, but the TVA did and still does a lot of good. Roosevelt argued in 1932 that government owned power plants would serve as a “yardstick to prevent extortion by private power companies”. Government, good government, has a place in society. IMO anything that affects everyone, be it a utility, banking, transportation, medical care, etc., needs to be highly regulated and not left to the “market”.

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  8. Ignacio

    In defence of Varoufakis, the scheme of carbon tax he seems to be proposing is used as a redistribution tool mainly (rather than a cap on emissions) from largest consumers to the poorest, when actually it is the contrary right now and the public at large tends to pay large part of the energy-intensive company bills. The excuse is that these companies create employment so everybody has to pay them for being so magnificent to create so much needed industrial jobs. Another perverse incentive is created by extorting government to come up with incentives not to delocalize those jobs elsewhere.

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  9. The Rev Kev

    I actually take umbrage when twice Yannis says things like ‘The blades of the wind turbines…contributing extra kilowatts to the electricity grid at precisely zero additional cost’ and ‘The fixed cost of building the hydroelectric station is large but the marginal cost is zero: once water turns its turbine, the next kilowatt the station produces costs nothing.’ He is an economist and should know better. That is like you driving down the road saying that you are paying nothing while driving those miles – but ignoring the regular costs of fuel, maintenance, repair, registration, insurance, etc. Anywayyyy.

    I can see the problem here. The EU, in its infinite wisdom, decided to let the magic of the markets have their way with the electricity supply in all aspects. The same way that they were trying to force EU countries depend on the spot market rather than long-term fixed price contracts. Who benefited from this philosophy? Why people like traders of course who are making out like bandits. Think of the commissions that they have earned this year alone. Of course all those countries that went with spot prices are totally screwed but you gotta break a few eggs to make an omelet, amiright?

    So I have an idea. Nationalize the whole lot. The grid and the power generators. Then let those countries that that have excess sell to those that don’t have enough. It may not be a complete solution but any solution that gets private financial firms out of vital infrastructure you gotta count as a win. So in short, it was markets that helped get us into this mess and as long as it is profitable for them, they are not likely to be the people to help us get out of this mess. Will they do it? In a word, no.

    Reply
    1. Lex

      A hydro plant was probably the best/worst example he could have chosen. I don’t know of any other generation source that’s as close to cost free for long term operations. I’ve worked on plants that had the original turbines from the early 1920’s. Compare to wind turbines that have constant PM work and blade replacements regularly. I get your point though, and it’s a good one.

      Reply
  10. IEL

    Another wrinkle of privatization is that coordinated planning becomes much more complex, as the set of stakeholders increases dramatically and no one actor controls both generation and transmission. In the US, even if the Federal and state governments in a region agree on what to do (a fairly rare occurrence), the many owners of generators and transmission lines may not be wiling to cooperate.

    Reply
  11. Lex

    Markets aren’t the solution. Markets are a possible solution to some issues, but we’ve equated markets and capitalism for so long that they’re considered the same thing. That’s deeply problematic and markets aren’t always the correct solution to a problem.

    Electricity generation is one of those problems that markets are a terrible solution to apply. The costs and timeframes are too big for capitalism to respond to well and the same goes for markets. Power generation takes very long term planning, huge infrastructure investments and interaction at too many levels from major capital to residential consumers. The lifespan of a coal plant is measured in decades and they can run for decades after their designed lifespan. But you can’t easily build a new one. If we want renewables, the only way is direct and massive government investment. Above someone mentioned TVA and someone else the French national generator. These are the right way to do electricity and the same goes for grids. Forcing markets onto everything just means more rent seeking along the line. I don’t know if it must be this way, but I haven’t seen anything but in my almost 50 years on the planet.

    Reply
    1. digi_owl

      Frankly markets as economists envision them seem to only really work when dealing with perfectly interchangeable products where the customer has nothing to lose from shopping around for the best price.

      Closest one has come to that would perhaps be USSR.

      There is a reason why everything from marketing on up is all about making the choice space as agonizing as possible.

      Reply
  12. Adam

    I always wonder if military administration is the way to do nationalization that the right will begrudgingly accept. I was disappointed when Trump wouldn’t invoke the Defense Production Act, but it seems like the military administration is trying to hide itself as long as possible. If the energy crisis could bring it into full view then we might have an honest conversation about what kind of society we can and want to live in.

    Reply
  13. deplorado

    In a related video, here is Varoufakis explaining in the first 25 minutes in a bit more color how the EU electricity market works:

    https://youtu.be/NicE0-N9ux0
    E63: Europe’s electricity market: the scam of the century?
    Streamed live on Sep 8, 2022
    DiEM25

    I find faults with a lot of what Varoufakis tends to offer as solutions, but at least he is good at voicing critical policy and practices contradictions which is vital to the public interest, and I wish there was even more detail and it is taken up by parliaments and media, or at least opposition parties across the EU.

    Reply
  14. Tim

    That’s a lot of fancy words and stuff in the article. He could have just said Neoliberalism took over the European energy markets, and we’d all nod our heads understanding what it all means.

    Reply
    1. digi_owl

      Sadly he is convinced, even after his stint as Greece’s finance minister, that EU can be reformed to the benefit for the European population.

      Reply
  15. dean 1000

    Centralized production of electricity, by the state or a corporate creature of the state, is the most inefficient, interruptible, interdictible means of producing electricity. We know this because we know there is no rational basis for the high electric rates in European countries.
    We also know that centralized production is the only means currently available for most of us.
    Why? A failure of capitalist markets and the politicians that create those markets.

    The DOE proved the feasibility of solar power in 1998. More than enough time for tax free corporate retained earnings to build thermal solar power plants everywhere, like that huge solar plant in Spain that produces electricity at night, no batteries thank you very much.
    The fact that it takes more oil/gas to heat homes in northern climes didn’t prevent the use of oil & gas. So it shouldn’t prevent using solar.

    What happened to all that talk a few years ago about producing electricity at the point of use – Your house using rooftop hybrid solar/mini wind turbines. Homes independent of markets and politicians would be a big step on the road to freedom. In the meantime nationalize electricity production and the grid.

    Thanks for the reminder Lex. markets existed before capitalism, the state and probably the tribe.

    Reply
    1. Tim H.

      Like so many other things, markets are wonderful in moderation, contemporary practitioners, having somewhat isolated theirselves from feedback, are on a bender. Such immoderate markets in neolithic times would’ve met …energetic feedback and the survivors would practice moderation.
      Bear in mind that the longer markets operate without regard to collateral damage, the more attractive nationalization looks.

      Reply
  16. Power sources

    Since this is one of better analyses of the complexity in power delivery, would like to add a bit more via sources for interested/to stimulate more discussion and enable debate without being dismissable as misinformed. Varoufakis refers to UK markets so following are from:

    https://www.drax.com/power-generation/silent-force-moves-electricity/
    A v. useful overview of grid issues (follow all links for details)

    https://www.gridwatch.templar.co.uk/

    https://www.gihub.org/emerging-funding-and-finance/case-studies/contracts-for-difference-cfd-to-accelerate-electricity-market-reform-and-launch-auctions-for-renewable-energy/

    https://www.emrsettlement.co.uk/settlement-data/settlement-data-roles/

    Reply

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