Gas costs in increasing electricity prices in Europe is only half the story. Taxing windfall profits better than regulatory changes in a rush 

Enric R. Bartlett & Tulio Rosembuj

Abstract

Some corporations would profit from the current crisis while everyone else suffers. Moreover, the government will be spending trillions on saving the economy. Naturally, this spending would benefit the winners since they spent on their services. One reason for these extraordinary profits is not enough competition. Another could be an outdated market design. However, the deep shock produced by the weaponization of gas by the Russian government in the preparation and development of the Ukraine invasion has the most significant part of it.

While public powers think about which steps to take to improve the market design and the competition within it, a tax on the extraordinary profits that some companies are earning is a way to fairly distribute the effects of the crisis and buy time for a wiser and proper updating of the regulatory framework.

 

Keywords: competition; energy prices; extraordinary profits; marginal price; market intervention; pay-as-bid; pay-as-clear; price caps; weaponization of gas; windfall taxes.

1.Introduction

Electricity prices have increased dramatically in Europe since the beginning of 2021. The growing demand for power in the first semester of 2021, in the aftermath of the pandemic crisis, and the skyrocketing costs of CO2 emission allowances, have their part in it. However, President Putin’s energy weaponization in preparing and developing the Ukraine invasion is the more relevant factor to this outcome. We are in a kind of hybrid war, and the war has costs.

The context commented is producing two tremendous wealth transfers, one from EU Member states and other countries to those gas and oil producers, and another within the borders of every Member State, between consumers and energy producers. This situation has determined the highest inflation rate in the EU in forty years.[i] Consequently, the EU Member States have rehearsed policies to contain the energy price increases and their harmful effects on households and businesses. To facilitate a rapid and coordinated response, the EU Commission published a Communication including a toolbox of measures to help meet the challenge in October 2021.[ii]

Actions ranged from emergency income support and avoiding disconnections from the grid, reducing taxation rates for vulnerable populations, and shifting the financing of renewable support schemes away from levies to sources outside the electricity bill. Also, market interventions compatible with state aid rules while technology neutral and not discriminatory include reductions in harmonized environmental taxes and stepping up market surveillance. Furthermore, the continuity after these measures of sharp energy price spikes led to discussions over whether the wholesale electricity market’s framework was responsible for massive electricity price rises and proposals to overhaul its design.

In this article, we comment on this subject, considering the European Union Agency for the Cooperation of Energy Regulators (ACER) reports and different proposals from member states. To do that, we start looking at the internal energy market evolution (Chapter 2). The returning discussion on the merits of the marginal price method, “pay as clear” versus the “pay as bid”, is the second issue we deal (Chapter 3). The relevance of design methodology does not hide that its delivery depends on the degree of competition among market players. To this end, we consider the competition status quo in one of the Member states, Spain, and assess if we can conclude something at the EU level (Chapter 4). In addition, the war situation drives us to consider a measure adopted in previous wars, windfall taxes (Chapter 5). We do this at a summarized conceptual level and looking past experiences. After that, we assess the willingness of governments to use their tax powers and the factors conditioning it. At this point, we pay particular attention to the regulators’ point of view on windfall taxation versus regulatory changes. Approaching the end of our arguments, cope with more reasons to use taxation instead of new regulations (Chapter 6) and the convenience of not mixing emergency measures and structural changes (Chapter 7).

Finally, we filter proposals of capping revenues or taxing them through energy law principles lenses (Chapter 8) and summarize some conclusions (Chapter 9).

2.The internal energy market is a work in progress, not a goal fully achieved

The preliminary assessment from the European Union Agency for the Cooperation of Energy Regulators (ACER) on high energy prices and the current wholesale electricity market design, dated November 2021, shows that the exposure to high electricity prices in different Member States is not uniform.

Member States are presented in three groups, with prices ranging between more than 150 €MW/h, group 1; between 120 and 150 €MW/h, group 2; and less than 120 € MW/h, group 3[iii]. These differences allow us to conclude that the internal energy

market is a pending objective. We are in the process of integrating the national markets of different Member States. Different prices match different countries’ energy mixes and a different degree of transborder interconnections. The highest prices appear where the interconnection levels are more limited, which underwrite that an internal electricity market requires a regulatory framework and physical infrastructure.

ACER, in the same report cited before, highlights that:

“A key feature of the EU electricity market is that prices and trades of electricity are determined through a coordinated process to set prices known as “market coupling” (…). The integration of Europe’s national markets via market coupling decreases price volatility and optimizes the use of resources across Europe.(…)”.[iv] Market coupling requires enough physical interconnections between national markets. The transborder interconnections weakness between Spain and Portugal, in the Iberian Peninsula, with the rest of Europe, precisely was used as justification for the “Iberian Exception” when the European Commission in April allowed them to cap the price of natural gas used in power plants.[v] The measure came into effect in May and will last for a year, with the cap averaging €48.80 per megawatt hour. Companies using gas are compensated by the difference between their bids and the cap.

3.The long-lasting discussion on “pay as clear” versus “pay as bid” method

The EU electricity market builds on a marginal price method, called “pay-as-clear’ market”. ”The key feature of the market is that the price is set by the marginal cost (i. e. the cost of producing one more MW/h of electricity). As the art.6.4 of Regulation on the internal market for electricity[vi] sets:

“The settlement of balancing energy for standard balancing products and specific balancing products shall be based on marginal pricing (pay-as-cleared) unless all regulatory authorities approve an alternative pricing method on the basis of a joint proposal by all transmission system operators following an analysis demonstrating that that alternative pricing method is more efficient. (…)”.

ACER Decision 04/2020[vii] adopted an Algorithm methodology named Euphemia, to deal with the price coupling.[viii]

Producers are put on the market in merit order starting with the least costly up to the most expensive power plant. The last plant needed to meet the demand within the time frame in question sets the price, and all producers are paid the same price (provided their bid comes under the final clearing rice)”.[ix]

The “pay-as-clear” methodology’s superiority over the “pay-as- bid”, where every producer receives the price offered, rests, for ACER and different authors, in that every producer has incentives to make bids according to its real costs, whatever the technology used. The method allows them to sell energy for the longest time and receive the same amount as each other, provided they are within the auction price.

The marginal price method worked smoothly when carbon and gas were the primary fuels to generate electricity. In both, operational expenditures were the main cost drivers instead of the central role that has capital expenditures in the wind and solar power plants. Moreover, the cost differences from different technologies kept within a relatively narrow scope compared with today, after the Ukrainian war and pandemic shocks in gas prices. It also helped smooth functioning the difficulties of energy storage that hampered the possibility of speculative bids.

On the other hand, different studies uphold that the proposals to use “pay-as-bid”, commit the error of considering that the bidders’ behaviour will be the same in both methods.[x] As the authors say, this is not the case.

Adaptation to the game rules is essential. However, it is not the only decisive factor. The degree of competition among the different bidders is another. It is a context circumstance also.

Since long ago, studies have shown that the marginal price method provides the lowest prices when the market tends to perfect competition. Still, the “price-as-bid” has the same decreasing effect in oligopoly situations.[xi]

A FSR’s policy brief, which highlights the “pay-as-clear” method superiority, presupposes “a competitive market setting”.[xii] This enough competition propels all producers to make their bids at the minimum price equivalent to their operational costs, short- term costs and adding opportunity costs. If all the producers adopt this strategy, the most efficient market will result: the entire demand will be met at the lowest possible price.

4.Getting national champions has dented competition

The power market of some utilities in their national markets is a significant issue to consider. Looking at the Spanish case, as evidence of a widespread European situation, in 2019, before the Covid-19 pandemic, three energy groups provided 53% of peninsular electricity production (24% Iberdrola, 19% Endesa, 10% Naturgy), and two others added 10% (EDP 6%, Repsol 4%).[xiii] The latter figures show a moderated market concentration. However, considering only the capacity not reliant on weather conditions such as wind or sun, things change a lot. The three first mentioned firms provide:

Nearly 90% of hydraulic power More than 90% of nuclear power Almost 75% of gas-powered cycles

The later not optimal competition context is not casual. The European member states, with the UK exception, have promoted national champions. Most of them, France aside, are private enterprises. Therefore, it is no surprise that their boards react against public policies to contain their profits.

Even though gas costs are relevant, they are not the entire story about the last year increasing electricity prices. Again, we can look at the Iberian Market to support this statement with facts.

In the last three years, hydraulic technology has determined the clearing price in Spain more times than any other.

At 21:00 on March 8, 2022, in the Iberian Market, hydraulic technology, using infrastructures that are mostly paid off, reached almost €655 per MWh[xiv] despite average costs of €3 to €10 per MWh.

It seems crystal clear this outcome falls far from the aim of providing final customers, household and business, with competitive and affordable energy, paramount in the EU Regulation on the internal electricity market.[xv]

Even if someone would say that is a case of opportunity cost[xvi] concept application, it deserves some comments. The hydraulic producers assess the price at which gas producers can offer to cover costs and get a benefit. Once they made that, they offered in the auction slightly below it, awarded the MW/h production. As the operators are mostly the same in both technologies, it is not a very difficult calculation. The primary factor here is not enough competition. Nevertheless, two more factors justify further consideration. Firstly, this speculative operation is done using a public good, water, privately operated after awarded in a concession, and, secondly, that is the only technology that nowadays can be stored as future power on a large scale.[xvii]

5.Taxing windfall profits justification

Traditional public finance has had a specific answer to market abuse of speculation and competitive market manipulation, which meant direct taxation on windfalls or excess profits on the beneficiaries.[xviii] The excess profits are those unexpected, coming from facts out of the ordinary or everyday situations, creating an exceptional advantage for someone without particular efforts, intelligence, risks or capital—a windfall from heaven. For the traditional doctrine, such as enough argument to subtract public revenues from the private sector in favour of the public sector because they did not have any significant foundation cause except the enrichment.

The excess profits tax justification relies on two arguments. On the one hand, it is a consequence of a rupture of free competition in the market that favours privilege to those who perceive it. Nevertheless, on the other hand, this obliges the public power to tax the higher ability to pay demonstrated.

For reasons of distributive justice, the tax must charge the excess remuneration to certain factors of production, understood as compensation higher than what is necessary to provoke the offer. The surplus arises in exceptional situations, i.e., war and postwar or monopolistic or oligopolistic markets.

Right now, the European member states, and the UK, are in a kind of war without a formal declaration. Moreover, different EU national markets are far from a vibrant competition scenario.

The tax on excess profit is a burden on the part of the income considered to exceed the average remuneration. The extra profit does not derive from free competition. The tax impact does not go to consumers since the beneficiary’s power market prevents competition or the offer of substitute goods. In words written by John Atkinson Hobson more than a century ago: “There is no tendency for a tax on surplus-profits to be shifted on to the consumer, it will lie where it is put”.[xix] The same J.A. Hobson systematically differentiates between costs and benefits and between excessive costs and benefits, considered unnecessary and, ultimately, qualifying as income not earned or created by the subjects who receive it as benefits. The reasonable profit excludes the excess gain whose source is chance, manipulation or opportunism of the company. There is a part of the economic value created that belongs to the State.

The tax levies the surplus of the average benefit concerning each company’s net worth, according to the circumstances of each sector of economic activity, during a determined period.

The surplus is above and beyond average income, i.e. the innovation premium in relation to the regular business activity, the income from innovation, and the excess levied is the surplus for taking advantage of the oligopolistic position or by chance.[xx] It is difficult to establish where the standard benefit ends, as ordinary cost and the surplus begins, but it is not an impossible mission. The legislator is more or less aware of the potential tax to establish without disturbing the industry or sector’s continuity. The excess profit is a specific manifestation of a higher ability to pay.

5.1.Let us look by the rear mirror

Windfall tax has been used when extraordinary circumstances determine unjustified wealth transfers. During World Wars, the British excess profits duty aimed to isolate the windfall element in war profits and tax this element at as high a rate as possible, until 80 per cent in 1917, or the 100% imposed after 1940.

The logic of such a tax develops in three stages. The first step tries to isolate the windfall element from the ordinary profit of the business; the second step tries to determine an allowance for extra profit due to capital investments and additional work because machinery set up for war purposes would be of little use. Finally, in the proper estimation of ordinary profit, the third step should consider the profits preceding the war and the prospects of their increase.

The US had implemented a windfall profits tax during the first World War. Senator La Follette Jr. introduced in the US Senate an amendment on the Excess-Profits Tax of 1940 on corporations on June 19, 1940.[xxi] Still, the proposal was defeated on the merits of do not smash business by imposing too much of a strain. One week after, President Roosevelt sent a message to Congress advocating for a “steeply graduated excess profits tax on corporations and individuals to ensure that “a few do not gain from the sacrifices of the many”.[xxii]

Ultimately, the result was a broad-based windfall profits tax. In 1940, its rates ranged from 25 to 50 per cent. In 1941, from 35 to 60 per cent. However, it reached a flat rate of 90 per cent in 1942 with a postwar refund of 10 per cent. Finally, in 1943 the rate was increased to 95 per cent, with a 10 per cent refund.

Excess profit tax foundation was to curtail war profits above- normal profits, preventing the opportunistic or hazardous profiteering by some. There is an extraordinary ability to pay, which claims to reduce the tax burden between the taxpayers: poor and wealthy. That way, the excess profits tax supplemented the corporation income tax in the USA during World War I, World War II and the Korean war.

Excess profits are the excess of the average annual earnings of a business corporation. The amount of excess profits depends on the taxpayer’s election either a) by a comparison of earnings in the taxable year with earnings during the base period of 1936-39 inclusive or b) by a computation of the rate of return on invested capital put into the business (at least 5% to 8%, including half the borrowed capital). The method was to adopt a high tax rate (95%)

The final tax liability will be determined by the method resulting in the lower liability.

5.2.Governments are shy to use their tax powers

The essentiality of the service provided and the need for hefty investments to transform the energy mix to fight global warming are levers big energy companies use without complexes.

So, the UK government has backtracked its announcement of taxing the windfall profits these companies are said to be getting. So also, the Spanish government, at least until 12 July 2022, when its Prime Minister announced a tax on extraordinary benefits for the more significant energy groups.

Last May, the UK Treasury examined “appropriate steps” to ensure that the electricity generation sector contributed to a £15bn support package for rising household bills. The floated idea was to impose an additional tax of 25% on profits from the extraction of oil and gas from the North Sea. This tax will be applied on top of the standard 30% corporation tax rate and 10% supplementary charge on these companies’ profits, giving a total tax rate of 65%. However, 31 companies told the Treasury they would cut investment if it went ahead with the tax.[xxiii] Another reason frequently cited against taxing proposed measures is that billions of pounds, dollars, or euros are wiped off the value of listed companies. So, it also deserves further consideration for the sudden drop. Is it a free reaction of a free market that discounts the guessed effects on the company’s balance sheets of the announced measure? Or is it a consequence of some investors’ market power in the stock exchange that they can reverse quickly at will? In any case, it is worth mentioning that the changes in the value of stocks traded caused by proposed regulations are mentioned by boards when it goes down, but, logically, not when it goes up.

Still, after those circumstances, the Treasury redirected its efforts to carry out “comprehensive” reforms of the electricity market, which would decouple electricity prices from those of gas. Instead of taxing extraordinary profits, the governments have refocused their actions on new legislation and regulations trying to reduce them.

As we have seen, it is the same strategy followed by the Spanish and Portuguese Governments, which capped, for twelve months, the gas price used to generate electricity once they got the European Commission’s authorization. Both governments, with countries sharing the same bidding electricity market, guaranteed that the cap would not distort the domestic EU market and did intense lobbying to get their way.

The narrative build-up against windfall taxes presents them as a kind of troy leftist horse in the soul of capitalist societies. Each one talks about the fair as it goes in it. However, it is worth remembering that besides the use of these extraordinary taxes in war times, governments so far of a leftist approach, such as the British government in 1981, led by Mrs. Thatcher [xxiv] , introduced a special budget levy on banks. The following year, when oil prices soared, imposed a special tax on North Sea producers. At the time, those oil firms argued that extra taxes would limit investment, but the industry flourished.

5.3.What does the regulators say?

In this regard, it is worth consulting the handbook of the Agency for the Cooperation of Energy Regulators, ACER, about the design of wholesale electricity market, published in April 2022[xxv] which was commissioned in October 2021 by the European Commission[xxvi]. Its most anticipated section was the analysis of possible structural intervention measures, which ACER divides into five categories, ranging from the least to most interventionist:

1) Support for vulnerable consumers: cash transfers and lowering taxes. 2) Tax on windfall profits to redistribute the impact of high prices from those deemed to earn the most to those suffering the most. 3) Lowering the bid price of gas- fueled power plants affects other technologies (wind, water, etc.). Because using marginal price auctions to cover all demand, i.e., the latest technology to enter the market determines the price of the others.  4) Maximum tariffs for each time slot, regardless of the marginal or closing technology. 5) Division of the electricity market into different technologies, establishing, when possible, production quotas and prices for each one.

As we see, capping the bid price of gas ranges in the third category; windfall taxes tallies with category 2 of ACER proposals. The “excessive” profit is the difference between the extraordinary high electricity prices revenue and the “standard” profit a market participant could reasonably expect, considering generating costs and initial investment.

The last one it is not only ACER’s point of view. For example, the International Energy Agency (IEA) 10-Point Plan to Reduce the European Union’s Reliance on Russian Natural Gas, presented on 3 March 2022,[xxvii] sets as Action 6 to enact short- term measures to shelter vulnerable electricity consumers from high prices financed through taxing windfall profits. In its own words:

“With today’s market design, high gas prices in the EU feed through into high wholesale electricity prices in ways that can lead to windfall profits for companies. This has significant implications for the affordability of electricity, as well as for the economic incentives for the broader electrification of end-uses, which is a key element of clean energy transitions.

-We estimate that spending by EU member states to cushion the impact of the energy price crisis on vulnerable consumers already amounts to a commitment of around EUR 55 billion.

-Increases in electricity costs are unavoidable to a certain extent when gas (and CO2) prices are high. But current wholesale markets create the potential for profits for many electricity generators and their parent companies that are well in excess of the costs related to operations or capital recovery. Current market conditions could lead to excess profits of up to EUR 200 billion in the EU for gas, coal, nuclear, hydropower and other renewables in 2022.

-Temporary tax measures to raise rates on electricity companies’ windfall profits could be considered. These tax receipts should then be redistributed to electricity consumers to partially offset higher energy Measures to tax windfall profits have already been adopted in Italy and Romania in 2022”.

A few days after, the European Commission published its Communication REPowerEU: Joint European Action for more affordable, secure and sustainable energy[xxviii], which sets guidance on the application of infra-marginal profit fiscal measures, affirming in its annex 2:

“In the current crisis situation, Member States may exceptionally decide to take tax measures that seek to capture some of the returns that certain electricity generators gain.

Redistributing revenues from fiscal measures on infra-marginal rents to final electricity consumers would partly prevent that current high gas prices increase the costs incurred by final customers. It would also while preserve efficient marginal wholesale electricity prices needed for efficient dispatching and market coupling in the European single electricity market.

However, such a measure would nonetheless need to be carefully designed to avoid unnecessary market distortions, while incentivizing additional investment in renewable energy”.

The Italian government, led by Mario Draghi, have proposed a measure like this, that translated into an extraordinary levy as a solidarity contribution.[xxix]

The tax base (art. 37) of the extraordinary solidarity is: the “increase in the balance between active and passive transactions, referring to the period from 1 October 2021 to 31 March 2022, compared to the balance of the period from 1 October 2020 to 31 March 2021. The contribution is applied in the amount of 10 percent in cases where the aforementioned increase is more than € 5,000,000. The contribution is not due if the increase is less than 10 percent.”

We can debate if “the increase in the balance between active and passive transactions” is the best means to identify the extraordinary benefits. But it seems heads to dismiss the companies’ claim that part or most of the energy they have sold during the period was contracted previously, at lower prices, through power purchase agreements (PPA) and so that they have not benefited from the increases in the market prices.

Indeed, when the energy has been sold in advance at a lower price, there is no extraordinary benefit. Still, the state’s tax agencies know to identify these situations when calculating the tax base to avoid unjustified charges.

Likewise, not all producers are harvesting extraordinary benefits. When this is the case, the windfall tax does not apply. If a producer has a contract at a determined price with, for instance, Gazprom, which cuts the gas flow, the producer company has to buy it in the market at much higher prices.[xxx] So that company has a liquidity problem even if it sells power at a high price later. If the company cannot pass the total surcharge on to customers could shift into a solvency problem. If that company has to go to the futures market, the guarantees to assure future transactions are costlier. The situation described before has triggered emergency rescue measures of different market operators from, for instance, the German government.[xxxi] The extraordinary EU Energy Council 9th September invited the Commission to design emergency liquidity instruments to address this situation.[xxxii]

6. Other reasons to use the taxation tool instead of new regulations

Furthermore, there are other reasons to choose taxation instead of regulation to confront an exceptional situation we live in, with many unknowns. Regulatory stability is an objective linked to the principle of legal certainty. Encourage and create stable conditions for investors is one of the commitments set up in the Energy Charter Treaty, considering a precondition to promote investments[xxxiii]. So, speeding-up regulatory changes spreads anxiety and restlessness among investors.

Furthermore, it risks poorly thought out structural changes to cope with temporal drawbacks. The side-effects, the un- expected effects, even the un-desirable-effects, are a reason to refrain from doing changes in a rush.

We have some recent examples.

The Iberian exception, which entered into force (15 June), has been a brake on wholesale prices and saved customers a lot of money. However, between the day took effect and 18 August, the electricity production with gas increased in Spain an 120%

[xxxiv]. Heatwaves that increased demand, and lower production trough solar, as a consequence of haze, wind, and hydro (-64%) are the official explanation. Nevertheless, in a scenario of severe drought, many hydropower plants have run at a very high production threshold in the previous months. So, the companies’ decisions about the production mix influence the final price of the day ahead market and others linked and can determine undesired effects from the changing regulation.

Producers by gas could have bought part of the gas used to produce power time in advance and at prices much lower than the spot price when it is burnt. Getting the premium from these differences is reasonable. They have risked that instead of the spot price being lower or not being able to use it if their bid falls out of the clearing price. However, one potential undesired effect could be that electricity producers by gas, once guaranteed that they will be compensated by the extra charge over the gas price ceiling, make bids higher than their costs require and stretching up the bids from different technologies. It seems a disincentive to competitive offers and can potentially promote rent-seeking. This undesired effect could arise whatever the technology (renewables, for instance) with the price capped. Furthermore, to ease tensions with producers, the governments tend to put up the cap threshold, which could have an additional inflationary effect on bids.

Last but not least, a cap like the Spanish one on electricity gas generated is true that slows the price increase in the other technologies but does not allow capturing the extraordinary benefits of gas generation. Even if the gas burnt is costlier, the MW/h electricity selling price could provide an exaggerated margin in strained supply, which translates into opportunity cost.

The EU electricity market regulation results from years of legal norms (regulations, directives) and governance, tested by time. Eu energy law is not engraved on stone, but speeding up changes, in a moment of extreme events: Covid-19 pandemic, need to decarbonize economy and war, that determines its output, maybe it is not the most intelligent answer. As hard cases make bad law, to regulate in a rush makes bad regulation. It is a sub-optimal way of tackling fast-changing circumstances, considering the unforeseen consequences that can provoke. It is worth mentioning the recital 6 of the regulation on the internal market for electricity[xxxv]:

“State interventions, often designed in an uncoordinated manner, have led to increasing distortions of the wholesale electricity market, with negative consequences for investments and cross-border trade”.

The empirical backing of this settlement explains many authors’ comments are aligned[xxxvi].

Still, the warning in the ACER’s Final Assessment of the EU Wholesale Electricity Market Design is even more alarming: “In current EU electricity market design, market prices are freely formed by demand and supply. This ensures not only an optimal market outcome but also a level-playing field across the EU. By contrast, when electricity wholesale prices are regulated, e.g. by introducing price caps, undesired effects including security of supply concerns or market exit issues may arise”[xxxvii].

7.Not to mix emergency measures with structural changes.

The ACERs’ defence of the EU electricity wholesale market design accepts that it is not future-proof. Its April 2022 assessment identifies several areas where policymakers could further emphasize future-proof the current electricity market design[xxxviii]. Other studies are more demanding in the urgency of rethinking the existing market framework.

In ” Key Themes for the Global Energy Economy in 2022 ” David Robinson asks: Will 2022 be the year for rethinking wholesale electricity market design in Europe? We recommend reading the chapter in full[xxxix] but let us quote a paragraph:

“(…) In a zero-carbon world, the whole bases of the present market design -to secure enough generation supply to meet uncertain demand -may fall away. Currently, the policy focus is just to get enough zero-emission supply on the system, while continuing to balance the system in the usual way, via incentives on the supply side, such as capacity payments and spikes in short-term spot market prices. But as generation becomes less dispatchable and demand-side resources become more dispatchable, the current approach ceases to make sense. We do not know what exactly will replace it, but the priority must be to create a balanced system with the right incentive structure (for demand-side response, storage, power to gas, dispatchable renewables or other solutions), rather than a series of random interventions directed by governments that produce a lopsided supply-driven system”.

We are watching technological changes in power production, storage and transport. Many factors shape a market design’s outcomes (such as the competition among participants, infrastructure bottlenecks, etc.)[xl]. Moreover, moving a regulatory item can trigger unfavourable side-effects in different market layers. All these bonded complexities suggest being cautious in reforming the structural regulatory framework.

On the other hand, in crisis times, one usual assessed answer is to suspend the market’s standard functioning rules, which are not delivering as forecasted. Set cap prices are one way of stopping the standard market rules.

A gas price cap is one of the emergency and temporary interventions that the Energy Council, which met on 9 September 2022, had invited the Commission to present[xli]. Others were capping the revenues of inframarginal electricity producers with low production costs and introducing a solidarity contribution from fossil fuel companies. The last one is a tax, although the wording avoids the technical name and chooses a more fraternal denomination. The other two are caps. The Commission proposal[xlii] falls short of capping gas prices and features doing it over inframarginal electricity producers.

The regulation on the internal electricity market prevents limits, both ways, maximum and minimum, on the wholesale electricity price (art. 10.1) However, Nominated Electricity Market Operators (NEMOs) may apply harmonized limits on clearing prices for day-ahead and intraday timeframes. “Those limits shall be sufficiently high so as not to unnecessarily restrict trade, shall be harmonized for the internal market and shall take into account the maximum value of lost load” [xliii]. (N art. 10.2)[xliv]

Regarding recovering excess revenues from generators with lower marginal costs, such as renewables, nuclear, and lignite (“inframarginal technologies”), the Commission proposes setting an ex-post cap on revenues per MWh of electricity produced.

“To avoid undermining the assessment of profitability when investment decisions were made, the cap should therefore not be set below the expectations of market participants as to the average level of electricity prices in the hours during which the demand for electricity was at its highest, before the Ukraine by Russia”[xlv]. The Commission argues that despite price differences across regions in the Union, the average market price expectations for peak hours during the last decades were consistently and significantly below 180€/MWh. Furthermore, it asserts that “simulations based on observed prices over January through August 2022 show that a cap set at 180€/MWh would have resulted in stabilizing the average revenue around 150 €/MWh”[xlvi] . From these claims, the Commission deduce three consequences:

-The capped price cover producers’ investments and operating costs.

-It should be uniform across the Union to preserve the functioning of the internal electricity This way, it would maintain price-based competition between electricity producers based on different technologies, particularly for renewables.

-Given that the revenue cap does not interfere with the formation of prices”, consumers would be interested in concluding long-term power purchase agreements which allow them to benefit directly from prices lower than those observed in the market.

The Energy Council asked the Commission to square the circle: to suspend the market rules to set prices and, at the same time, no to interfere in the formation of prices. As this is impossible, the Commission shifted from wishes to a given. The fault lines of the Commission’s argumentation are similar to those proposals to use “pay as bid”, considering that the bidders will not adapt their behaviour to the new playing fields. Setting a maximum cap has an inflationary effect; bidders tend to approach the regulated threshold. Moreover, the undesired effects derived from a lack of enough competition in some markets will increase as market participants know the maximum productive bid for everybody (180€/MWh).

 

8.What results from filtering capping revenues or taxing them through energy law principles lenses?

The most affected of the three structural principles of energy law[xlvii]: affordability (economic efficiency), security of supply, and sustainability, will be the first. The interference in price formation through a cap will push them up and erode consumers’ budgets.

It would be naive to assume that boosting taxes will not affect producers’ bids. They will try to pass the tax on consumers and keep benefits as high as possible. However, it is riskier without concerted, and illegal, behaviour with competitors, as their bids could fall out of the clearing price.

Security of supply depends on enough power provided even in scarcity circumstances. We agree with the Commission’s assertion that 180 € MW/h lets to cope with producers’ investment and operational costs. Still, member states, such as Spain, were strongly invited to abolish them, considering that a threshold like that could drive undersupply in extreme conditions[xlviii] . This undesired outcome has no place if there is no previous limit and if the extremely high prices in the market determine extraordinary benefits, which will be taxed afterwards, and its proceeds redistributed.Considering the bids made in auctions to award capacity in renewables[xlix], lower than the Commission’s proposed cap, it seems that it has no adverse effect on investments heading to decarbonize the power mix.

In the light of the preceding considerations, particularly the filter through energy law principles, maybe the best way to cope with this man-made energy crisis is not to delete or suspend the most relevant principles of the EU internal electricity market regulation as (art. 3):

“a) prices shall be formed on the basis of demand and supply; (b) market rules shall encourage free price formation and shall avoid actions which prevent price formation on the basis of demand and supply”.

We think it would be wiser to buy time for further reflection. And the good news is that tax law allows urgent measures to avoid an unbearable situation of enormous wealth transfer from consumers, individuals and enterprises to energy producers that benefit from prices not correlated with their costs. So maybe it is unnecessary to innovate against the clock. It is enough to apply the accepted wisdom on windfall taxes. If the diagnosis is wrong, the proposed solution will also be. The Council, when tasking the Commission, and logically this one when framing a proposal, focus on producers but forgets the role that traders (financial markets and assurers) play. As they hedge producers’ positions or buy their “product”, they can collect extraordinary benefits instead of producers and, in some way, do a legal “laundering” of benefits that nobody will cap nor tax. The abovementioned situation demands a more integrated strategic regulators approach (over energy and financial markets, emissions rights), at least at the same level as market operators. The fragmented regulation competencies between financial and energy regulators favour loopholes that do not benefit consumers’ interests. The traders’ role and their claw on the percentage of profits demand a tax design that detects where the windfall income goes to recover it for society’s interest.

9.Conclusions

A combination of factors such as growing demand or soaring costs of CO2 emissions allowances has resulted in a dramatic increase in European electricity prices since the beginning of 2021. Still, the energy weaponization by the Russian government in preparing and developing the Ukraine invasion is the more critical aspect of this outcome.

Tax reductions and different kinds of state aid to vulnerable consumers and enterprises have been tested until near the limits of fiscal discipline. However, it neither stopped the energy price spikes nor avoided the most rampant inflation rate in forty years. So then, the debate shifted to market design and ways to avoid unfair gains from energy producers.

Any analysis to provide practical recommendations has to consider reality as it is. So, our approach requires admitting that the European internal energy market is a work in progress but not yet fulfilled. Some of the gaps to reaching this goal are physical bottlenecks, such as insufficient transborder interconnections, that a mere regulation change, published in official journals, cannot deliver without parallel investments.

The discussion on the merits of the marginal price method, “pay-as-clear” versus the “pay-as-bid”, is a returning issue every time prices rise. This time has not been different. We agree that those are upholding “pay-as-bid” to lower prices sometimes wrongly assume that the bidders’ behaviour will be the same in both methods. However, indeed, it is not the case.

Furthermore, the “pay-as-clear” method requires enough competition to push all producers to make their bids to meet the entire demand at the lowest possible price. Therefore, it is not surprising that the last one a priori is more challenging to find after the successes of policies to build national champions that hold significant power in their national markets.

The scarcity of gas supply to the EU instrumented by companies that operate as an extended arm of the Russian government, combined with insufficient competition in national markets and an EU internal market not fulfilled, is the source of windfalls or excess profits for some enterprises. Taxing windfall profits is the answer to that given by traditional public finance, tested since the first world war. The critical factor in its application is differentiating costs and benefits to identify taxable income not earned or created by subjects who receive it as benefits. Still, frequently, governments have backtracked their announces from levying taxes on this kind of profit after lobbying by enterprise boards. The two main reasons against using taxing powers have been that: 1- these windfall profits do not exist, and 2- they will jeopardize the multi-billion investments needed to advance the energy transition.

The first objection deserves consideration but can be upheld or rejected through regulatory accounting. The second is tricky if unearned profits exist. It is equivalent to a capital injection without delivering shares to investors. However, after these lobby activities, governments have redirected their efforts to reform the electricity market. Instead of taxing extraordinary profits, governments try to reduce them. Capping prices seems to be the preferred option.

There are different reasons to opt for taxation instead of new laws and regulations to confront our current situation, with many unknowns. To summarize some of them: 1- Speeding-up regulatory changes spread anxiety among investors as they like stable conditions to build their business plans; 2- It risks introducing structural changes to manage temporal drawbacks; 3- Even well though changes can produce unexpected and un- desirable-side effects, much more those adopted in a rush under pressure.

The technological changes in power production, storage and transport indeed demand a market designs’ rethinking. Still, as far as it is possible to cope with the extraordinary situation of skyrocketing electricity prices without suspending or throwing away market functioning rules, painstakingly constructed and tested, in a rush, it is wiser to buy time to think about it.

To tax the extraordinary profits that some companies are earning is a way to fairly distribute the effects of the crisis without interfering in price formation. It avoids the inflationary effects of capping prices and so matches better the principle of the energy law of affordability (economic efficiency). Moreover, it does not risk driving to undersupply in extreme conditions, which another principle, the security of supply, tries to prevent.

 

BIOGRAPHY:

Tulio Rosembuj is a former Professor of Financial and Tax Law at the University of Barcelona. He has been guest professor at the Universitá LUISS, Rome, where he leaded the course “Diritto Fiscale Europeo”. His most recent published book is “Complejidad y resiliencia fiscal. Riesgos sistémicos, impuestos sistémicos”. Ed. El Fisco (2021). trosembuj@telefonica.net

Enric. R. Bartlett Castellá is associate Professor of public law at Esade Business and Law Schools (Universitat Ramon Llull) in Barcelona, Spain, where he has served as Law School‘s Dean. He is PhD in law and secretary-controller of local administration. He has been Deputy ombudsman of Catalonia (1993-2004). His most recent studies deal with the regulation of the economy to achieve a just energy transition, in issues such as energy communities, fighting energy poverty, investment protection, or to promote innovation. Member of the Section on Energy, Natural Resources, Environment & Infrastructure (SEERIL) of the International Bar Association (IBA). Member of the Asociación Española de Derecho de la Energía (AEDEN) enric.bartlett@esade.edu

 

NOTAS AL FINAL:

[i]9,82% in 1982 https://www.macrotrends.net/countries/EUU/european-union/inflation-rate-cpi Accessed 27th

September 2022.

[ii]Communication from the Commission to the European Parliament, the European Council, the Council, the European Economic and Social Committee and the Committee of the Regions Tackling rising energy prices: a toolbox for action and support COM/2021/660 final https://eur-lex.europa.eu/legalcontent/EN/TXT/?uri=COM%3A2021%3A660%3AFIN&qid=1634215984101 Accessed 14th September 2022.

[iii]ACER’s Preliminary Assessment of Europe’s high energy prices and the current wholesale electricity market design. Main energy price drivers, outlook and key market characteristics (fig. 2 and table 1, p.6) https://acer.europa.eu/sites/default/files/2022- 05/ACER%27s%20Preliminary%20Assessment%20of%20Europe%27s%20high%20energy%20prices%20and%20the

%20current%20wholesale%20electricity%20market%20design.pdf accessed 8 September 2022.

[iv]Ibid, 4.2, p. 11.

[v]Approved by EU Commission under EU State aid rules, in line with the Commission’s Communication on security of supply and affordable energy prices and the European Council conclusions, both from March 2022. https://ec.europa.eu/commission/presscorner/detail/en/ip_22_3550 Accessed 8 September 2022.

[vi] Regulation (EU) 2019/943 of the European Parliament and of the Council of 5 June 2019 on the internal market for electricity (recast) https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A32019R0943 Accessed 8 September 2022.

[vii] On the nominated electricity market operators’ proposal for the price coupling algorithm and for the continuous trading matching algorithm, also incorporating TSOs’ and NEMOs’ proposals for a common set of requirements of 30 January 2020 https://www.acer.europa.eu/Official_documents/Acts_of_the_Agency/Individual%20decisions/ACER%20Decision

%2004-2020%20on%20Algorithm%20methodology.pdf Accessed 8 September 2022.

[viii] For its characteristics see the description prepared by the National Energy Regulators (NEMO) Committee https://www.nordpoolgroup.com/globalassets/download-center/single-day-ahead-coupling/euphemia-public- description.pdf Accessed 8 September 2022.

[ix]ACER’s Preliminary Assessment of Europe’s high energy prices and the current wholesale electricity market design. (2021) p.11.

[x]Alberto Pototschnig; Jean-Michel Glachant; Leonardo Meeus; Pippo Ranci Ortigosa. Florence School of Regulation (FSR) Policy Brief. Recent energy price dynamics and market enhancements for the future energy transition January 2022. P. 5 https://cadmus.eui.eu/bitstream/handle/1814/73597/PB_2022_05_FSR.pdf?sequence=1&isAllowed=y Accessed 9^th September 2022.

[xi]See for example, Christos Skoulidas, Costas Vournas, G.P.Papavassipoulos. An adaptative Game for Pay-as-Bid and Uniform Pricing Power Pools Comparison. January 2022. https://www.researchgate.net/publication/242102105_An_Adaptive_Game_for_Pay-as- Bid_and_Uniform_Pricing_Power_Pools_Comparison Accessed 9th September 2022.

[xii]Alberto Pototschnig and other authors (January 2022) Op. cit. p. 5.

[xiii]The Spanish power sector in numbers. 2019 Report. Naturgy. https://www.fundacionnaturgy.org/en/producto/2019-report-the-spanish-power-sector-in-numbers/ P.14 Accessed 9th September 2022.

  [xiv]https://www.omie.es/en/market-results/daily/daily-market/daily-hourly-Price?scope=daily&date=2022-03-08 Accessed 9^th September 2022.

[xv]Recital 3r. Regulation (EU) 2019/943 of the European Parliament and of the Council of 5 June 2019. https://eur- lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A32019R0943 Accessed 9th September 2022.

[xvi]As is known, opportunity costs represent the potential benefits a business misses out on when choosing one alternative over another. In this case, to use water to power that day and hour instead of another.

[xvii]A parliamentarian group in the Spanish Parliament, Podemos, which backs the central coalition government, proposed (September 2021) that when the hydraulic concession term ended, it returned to the public administration that granted the concession and was managed by a public entity. A timely proposition: a good number of hydro permits have arrived within their limit time (75 years), or they will do so soon. However, most of the Parliament, even the Socialist party, a senior partner in the coalition government, rejected the proposition. https://www.congreso.es/public_oficiales/L14/CONG/BOCG/B/BOCG-14-B-182-1.PDF Accessed 9^th September 2022.

[xviii]Benvenuto Griziotti. Principios de Política, Derecho y Ciencia de la Hacienda, Madrid, 1935, p.11; Studi di Scienza delle Finance e Diritto Finanziario, II, Milano, 1956, p.141; Primi Elementi di Scienza delle Finanze, Milano, 1962, p.104.

[xix]Taxation in the new State, published in Methuen, Massachusetts in 1919. The edition consulted has been published in New York, 2013, p.34.

 [xx]In this way, Dino Jarach, Finanzas Públicas y Derecho Tributario. Buenos Aires, 1983, p.677 “Imposition to the excess profits directly affects the companies that produce them without the possibility of shifting and… allows the State to collect the tax from the taxpayer indicated by the law, which is affected… Also, the tax is equitable, since it undoubtedly taxes surplus income, but they leave the taxpayer the average income and a part of the said surplus. Hence, adherence to both the rational and the equitable is recognized.”

[xxi]https://www.govinfo.gov/content/pkg/GPO-CRECB-1940-pt8-v86/pdf/GPO-CRECB-1940-pt8-  v86-6.pdf pictures 29 to 32.

[xxii]Message to Congress on 1st July 1940 https://www.presidency.ucsb.edu/documents/message-congress-steeplygraduated-excess-profits-tax Accessed 9th S

[xxiii]https://oeuk.org.uk/31-energy-companies-sign-letter-to-government-warning-windfall-tax-could-jeopardise-uk- investment-jobs-and-net-zero-target/ Accessed 9^th September 2022.

[xxiv]Mr. Geoffrey Howe was the chancellor.

[xxv]ACER’s Final Assessment of the EU Wholesale Electricity Market Design https://www.acer.europa.eu/sites/default/files/documents/Publications/ACER%26%23039%3Bs%20Final%20Asse ssment%20of%20the%20EU%20Wholesale%20Electricity%20Market%20Design.pdf Accessed 9th September 2022.

[xxvi]Communication from the Commission to the European Parliament, the European Council, the Council, the European Economic and Social Committee and the Committee of the Regions Tackling rising energy prices: a toolbox for action and support COM/2021/660 final https://eur-lex.europa.eu/legal- content/EN/TXT/?uri=COM%3A2021%3A660%3AFIN&qid=1634215984101 Accessed 14^th September 2022.

[xxvii]https://www.iea.org/reports/a-10-point-plan-to-reduce-the-european-unions-reliance-on-russian-natural-gas

[xxviii] COM(2022) 108 final Strasbourg, 8.3.2022 https://energy.ec.europa.eu/system/files/2022- 03/REPowerEU_Communication_with_Annexes_EN.pdf Accessed 9^th September 2022.

[xxix]DECRETO-LEGGE 21 marzo 2022, n. 21 Misure urgenti per contrastare gli effetti economici e umanitari della crisi ucraina. https://www.gazzettaufficiale.it/eli/id/2022/03/21/22G00032/sg Accessed 8th September 2022.

[xxx]In August 2022, natural gas prices reached a new 340 EUR/MWh record. As a reference, one year ago, in August 2021, the same price was around 40 EUR/MWh. Data from the “background brief” previous to the Extraordinary TTE Energy Council of 9 September 2022. https://www.consilium.europa.eu/media/58893/background-brief- energy-220909.pdf Accessed 12th September 2022.

[xxxi]At the end of July 2022, Germany rescued gas importer Uniper with $15.3bn bailout. As part of the bailout deal, the federal government will purchase a 30% interest in Uniper.View https://www.offshore- technology.com/news/germany-rescue-uniper-bailout/ Accessed 12th September 2022.

[xxxii]See Point 8. d) Presidency Summary https://www.consilium.europa.eu/media/58929/presidency-summary- 220909.pdf Accessed 12th September 2022.

[xxxiii] Art. 10.1. https://energy.ec.europa.eu/topics/international-cooperation/international-organisations-and- initiatives/energy-charter

[xxxiv] Data from the National System Operator, Red Eléctrica de España https://www.ree.es/es/datos/generacion/estructura-generacion Accessed 9th September 2022.

[xxxv]Regulation (EU) 2019/943 of the European Parliament and of the Council of 5 June 2019 on the internal market for electricity.

[xxxvi] As an example, in Alberto Pototschnig et al in FSR Policy Brief (2022) cited, p.3. “Conversely, ill-designed emergency measures or distorting price signals by interfering in market price formation may roll back EU market integration and overall competition, thereby endangering the benefits achieved up until now and possibly increasing the overall cost of the energy transition up ahead, as further expanded below.”

[xxxvii]ACER’s Final Assessment of the EU Wholesale Electricity Market Design https://www.acer.europa.eu/sites/default/files/documents/Publications/ACER%26%23039%3Bs%20Final%20Assessment%20of%20the%20EU%20Wholesale%20Electricity%20Market%20Design.pdf P.18-19.

[xxxviii]Ibid, pp 4-5 highlights: 1. Making short-term electricity markets work better everywhere; 2. Driving the energy transition through efficient long-term markets; 3. Increasing the flexibility of the electricity system; 4. Protecting consumers against excessive volatility whilst addressing inevitable trade-offs; 5. Tackling non-market barriers and political stumbling blocks and – as a way to justify its own approach- 6. Preparing for future high energy prices in ‘peace time’; being very prudent towards wholesale market intervention in ‘war time’ where sets: “The need for interventions in market functioning should be considered prudently and carefully in situations of extreme duress and if pursued should, ideally, seek to tackle ‘the root causes’ of the problem (currently gas prices). Additionally, ACER points to a few structural measures for hedging, which might be considered to alleviate possible concerns about future periods of sustained high energy prices.”

[xxxix]The Oxford Institute for Energy Studies OIES Paper SP: 20, pp 42-43, January 2022, https://www.oxfordenergy.org/wpcms/wp-content/uploads/2022/01/Key-Energy-Themes-for-the-Global-Energy- Economy-in-2022-SP20.pdf Accessed 12th September 2022.

[xl]These facts can determine the uselessness of an assessment following the established knowledge strictly. A comment on that in Enric R.Bartlett Castellà “Uns senyals de preu sense destinatari, ¿Justifiquen mantenir el sistema de preu marginal?”, March 2022 . The author argues, commenting ACER’s Preliminary Assessment of Europe’s high energy prices and the current wholesale electricity market design (November 2021), that the marginal price system in the Spanish electricity market is sending signal prices to nobody. And this is the case, in the authors’ opinion, because: is no physical capacity for more hydro, nuclear is in a decommission process, there are very few transborder interconnections, and there is a lack of regulation on demand-side response, storage, etc. https://www.smartgrid.cat/2022/03/06/uns-senyals-de-preus-sense-destinatari-justifiquen-mantenir-el-sistema- de-preu-marginal/ Accessed 13th September 2022.

[xli] See presidency summary & 8. https://www.consilium.europa.eu/media/58929/presidency-summary-220909.pdf (Accessed 27th September).

[xlii]COM (2022) 473 final 14.9.2022 Proposal for a Council Regulation on an emergency intervention to address high energy prices.

[xliii]Regulation (EU) 2019/943 of the European Parliament and of the Council of 5 June 2019 on the internal market for electricity (Art.10.1).

[xliv] Ibid. (Art.10.2).

[xlv]COM (2022) 473 final 14.9.2022 Proposal for a Council Regulation on an emergency intervention to address high energy prices, p.6.

[xlvi] Ibid.

[xlvii] For an in-depth study about energy law principles, see Iñigo del Guayo (2022) 40 JERL pp 43-60.

[xlviii] ACERs’ Decision 04/2017 of 14th November 2017 On the nominated electricity market operators’ proposal for harmonized maximum and minimum clearing prices for single day-ahead coupling, para 23, sets 3000 €/MWh and

-500€/MWh as those limits, maximum and minimum. https://acer.europa.eu/Official_documents/Acts_of_the_Agency/Individual%20decisions/ACER%20Decision%2004

-2017%20on%20NEMOs%20HMMCP%20for%20single%20day-ahead%20coupling.pdf Accessed 28^th September 2022. It was received in Spain through a Resolution from the Energy Regulator (National Commission of Markets and Competition CNMC) on 20th May 2021. https://www.boe.es/boe/dias/2021/05/20/pdfs/BOE-A-2021- 8362.pdf Accessed 28th September 2022.

[xlix] Between 14,89€/MWh and 29 €/MWh are the prices awarded to solar and wind production in official auctions in January 2021 in Spain. It is worth remembering that 95% of energy price is long-term for power plants to build. So, the latter prices let, in investors’ view, a viable business plan. See Resolution from the General Directorate of Energy and Mines, 26 January 2021, https://www.boe.es/diario_boe/txt.php?id=BOE-A-2021-1251 Accessed 28^th September 2022.