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    The Iberian exception and the gas price cap

    May 13, 2022 - CE Noticias Financieras


      Prologue. The national electricity system operator - Red Eléctrica de España - forecasts a given demand for each day. For example, tomorrow we will need 100 megawatt hours every hour of the day (this is just an example). An auction is then held in which all the technologies (nuclear, wind, photovoltaic, solar thermal, gas) bid in order to offer their electricity and sell it. Let us imagine - working hypothesis - that the estimated demand (the electricity that the country will need) is 100, for example. Well, nuclear and renewables bid in the auction held in that market (colloquially known as pool) at zero. Why zero? Well, because renewables have to sell what they produce when they produce it (wind cannot be stored) and because nuclear, given its technical characteristics, finds it cheaper to operate in fixed mode, and not to stop and start, stop and start, stop and start, stop and start depending on demand. Thus, nuclear and renewables (understood as photovoltaic and wind) always bid at zero euros (0e) to ensure that the electricity they produce always enters the market, that is, to sell all the electricity they generate.

      If all of them (nuclear and renewables) do not add up to 100 (they add up to 90, for example), then other technologies come in, technologies that use an energy source that can be stored (waste that can be stored in landfills, water that can be stored in reservoirs, gas that can be stored in tanks). All these energy sources can wait for the auction to heat up, to get more expensive, to come in at the last minute (unlike wind and photovoltaic - not storable - or nuclear - technically/economically conditioned, as mentioned).

      And what is happening?

      Well, gas and CO2 have become more expensive on international markets. And the combined cycle thermal power plants that burn natural gas to produce electricity have to sell their electricity more expensively to cover costs and obtain their profit margin. That, on the one hand, and on the other? Water. The liquid element is also storable. And it is taking advantage of the situation. The approach is as follows: hydropower estimates "how much gas can be offered to cover costs and obtain a profit margin" and, once this estimate has been made, the operators of the hydroelectric plants (Iberdrola, Endesa and Naturgy) bid in the auction a fraction below what the gas can offer and are awarded the megawatt. For example, hydropower estimates that gas (taking into account how much its price has risen in international markets) could bid at 200 euros per megawatt hour.

      Well, the operators of the hydroelectric power plants go and say: I can generate that megawatt hour at 190 euros... and they are awarded it. And they do it because they can. Because hydropower can keep the tap closed and not release the water that moves the turbine until the auction price is sufficiently attractive, or high enough. This is what some call opportunity cost and others call speculation. Speculation with a public good, water. Water whose use also obeys a State concession.

      And now the market

      Why did Brussels propose the marginalist market? The theory: an inefficient electricity production plant will bid at above-average prices and will never enter the market, because others will have bid their kilowatt hours at a lower price (because they are more efficient). This will force the less efficient one to improve its processes. And the other way around: the producers that sell their electricity cheaper in the wholesale market will prosper (because the wholesalers will buy their kilowatt hours cheaper from them) and will have more benefits than their competitors, who could not enter because they bid more expensive and in the auction the wholesalers logically buy at a lower price for the same quality.

      In other words, the market produces the signals that will force producers to adapt or perish; to become increasingly efficient or disappear. And, in addition, the wholesaler will buy the electricity at the cheapest price, so that when he sells it at retail, he will also be able to do so at a lower price.

      That is the theory

      And when all plants produce kilowatts with gas (and the gas is purchased in international markets at similar prices for all)... that theory can be valid. And the most efficient gas plant, the one that is able to generate more kilowatt hours burning less gas (it is more efficient and therefore offers its kilowatt hours at a lower price in the wholesale market) will be the plant that wins. And if a competitor (another gas plant) wants to take the market from it, it will have to be more efficient (improve its machines and processes) and produce at an even lower price. This will allow it to gain market share and, in addition, the consumer will benefit. That is the theory.

      This way of setting the price was devised when most of the power (most of the plants) had as its main cost the variable cost: fuel, whose price varies. In 1997, when the Government introduced the marginal market, there were more than 11,000 megawatts of power in coal, fuel oil and gas (fuels whose price varies), 7,500 in nuclear and 16,000 in hydro. In addition, 26,000 of gas (combined cycle) were on the way, so that the horizon was sources of electricity with different fossil fuels (with variable prices). And the idea was "we set up a marginalist market and thus encourage competition between players - reasonably homogeneous - and lower the price".

      In addition, the government established aid for nuclear and hydro (more than 8,000 million euros) called Transition to Competition Costs. In these two cases, there was no significant variable cost, since water is free and uranium is not subject to the enormous price fluctuations to which fossil fuels are subject.

      And what is happening now?

      Well, nuclear and hydro have already received these subsidies (to address their transition) and are already amortized, according to most authors. And what else is happening? Well, there are more than 50,000 megawatts of renewable power (thermosolar, wind, photovoltaic), power that did not exist in 1997, and that does not use any fuel because it generates with the wind or the sun.

      Who wins? Nuclear and hydro. Because, being already amortized (thanks among other things to the aid they received) and having as they have very low variable costs (free water and uranium much cheaper than gas), they will charge as the most (thanks to the marginalist market, in which all charge the price that marks the most expensive kilowatt hour).

      And here the two sticks in the shade of the marginalist market fall down. Neither hydro nor nuclear will be encouraged by competition to improve their processes to be more efficient (because they have no competition, because no new nuclear plants or new large dams are going to be built). Nor will the end consumer receive a lower price, quite the contrary. The Government knows this and that is why it has set up renewable auctions to inject more power into the system but without that new power participating in the market (the new auctions have yielded a price for the producer -between 19 and 28 euros-, but they do not participate in that marginalism that perhaps made sense one day but that today does nothing but unnecessarily inflate the price).

      And now comes a pandemic, and then a post-Covid rebound effect (a rebound effect that triggers gas demand on a global scale) and then comes a war in Ukraine and it turns out that Russia is the first gas producer... and gas soars. And as gas fixes the price of electricity (or hydropower fixes it by looking sideways at gas)... the price of electricity also shoots up.

      All kilowatt hours shoot up (because of the marginalist market). All the users of the system pay the price. And the owners of 96.2% of the hydraulic power in Spain (Iberdrola, Endesa, Naturgy), who are the owners of 15,000 of the 26,000 megawatts of natural gas installed in this country, and who therefore know very well, very well how much their combined cycle will bid in each daily auction in the wholesale market (at 200, for example), then I bid at 190 with my hydroelectric ygriega and I get an exorbitant profit margin. A depreciated hydroelectric plant can generate a megawatt hour at 3, 10 or 15 euros.


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