DO ELECTRICITY MARKETS INTERNALISE SUPPLY RISK?

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DO ELECTRICITY MARKETS INTERNALISE SUPPLY RISK?

• DAVID PEARCE

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THE THEORY

• IF MARKETS TAKE ACCOUNT OF (INTERNALISE) SUPPLY
  RISKS THEN PRICES WOULD EQUAL SUPPLY COSTS
  PROFITS VALUE OF ENVIRONMENTAL IMPACTS
  SCARCITY PREMIUM SECURITY PREMIUM

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COMPLICATING ISSUES

• SUPPLY MONOPOLIES E.G. OPEC MAY KEEP WORLD
  PRICES ABOVE COMPETITIVE MARKET PRICES BY
  RESTRICTING SUPPLY
• DEMAND MONOPOLIES (MONOPSONIES) MAY FORCE PRICE
  UP THROUGH BUYING POWER, RAISING PRICES FOR
  EVERYONE ELSE. MAYBE 5-20 OF OIL PRICE?

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SUPPLY INTERRUPTIONS

• FOCUS ON THESE. TWO EFFECTS
• HIGHER PRICES
• HIGHER PRICE VOLATILITY
• THE FORMER TRANSFERS WEALTH FROM THE IMPORTING
  COUNTRY TO THE EXPORTING COUNTRY.
• THE LATTER MAY MAKE ECONOMIC DECISIONS MORE
  COMPLEX, E.G. WHAT PRICE TO ASSUME WHEN PLANNING
  ENERGY INVESTMENTS? MANY ADJUSTMENT COSTS.

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MARKET ANTICIPATION-1

• BUT WONT MARKETS ANTICIPATE THESE EFFECTS?
• LONG HISTORY SINCE 1970S OF PRICE SHOCKS, SO
  WONT IMPORTERS HAVE LEARNED?
• OTHER EVIDENCE OF LEARNING AND ANTICIPATION IS
  ANY CHANGE IN SIZE OF THE NON-OIL MARKET, I.E.
  SUBSTITUTION FOR OIL.
• BUT EVIDENCE NOT COMPELLING

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MARKET ANTICIPATION - 2

• FRACTION OF OECD ENERGY DEMAND MET BY OIL HAS
  FALLEN 50 TO 40, BUT TOTAL DEMAND FOR OIL HAS
  RISEN. (See Table 1)
• USA HAS RISING OIL IMPORT DEPENDENCE, (See Table
  2)
• SWITCH TO GAS REFLECTS MANY FACTORS SCARCITY,
  PRICE, ENVIRONMENTAL PRESSURES
• IS OECD NOW DOING THE SAME WITH GAS IMPORTING
  FROM POTENTIALLY UNSTABLE AREAS?

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MARKET ANTICIPATION - 3

• ANTICIPATION OF PRICE CHANGES REQUIRES FORWARD
  MARKETS.
• LONG-TERM CONTRACTS EXPECTED TO INTERNALISE
  SECURITY RISKS
• HARD TO TELL IF MARKETS DO INTERNALISE RISKS
• ANOTHER VIEW MARKETS OPTIMISE - ABSENCE OF
  RADICAL ACTION TO REDUCE IMPORT DEPENDENCY MAY
  REFLECT BALANCE OF COSTS AND BENEFITS, I.E. COST
  OF DEPENDENCY RISK lt COST OF AVOIDING THAT RISK.

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SECURITY ADDERS-1

• ADDER THE COST OF INSECURITY AS A FRACTION OF
  ENERGY PRICE
• MEASURING ADDERS
• MILITARY EXPENDITURES? QUESTIONABLE FIXED COST
  THAT DOES NOT VARY WITH OIL FLOW, NOT ALL
  EXPENDITURES ARISE FROM PROTECTING OIL SOURCES.
• NOT ALL ADDERS ARE VE. THERE ARE BENEFITS TO
  HIGH ENERGY PRICES ENVIRONMENT.

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SECURITY ADDERS - 2

• PARRY AND DARMSTADTER (2003)
• MACROECONOMIC ADJUSTMENT COSTS TO USA gtc3 BBL
  FOR USA
• c2 BBL FOR MONOPONY EFFECT
• 5 BBL IN ALL, WITH RANGE 0-14
• OXERA (2003) FOR THE UK. GAS SUPPLY INSECURITY
  MIGHT COST GBP 300 MILLION IN 2030.
• REDUCED TO GBP 180 MILLION IF MORE WINDPOWER AND
  GBP120 MILLION IF MORE NUCLEAR.

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SECURITY ADDERS - 3

• HENCE, UK STUDY SUGGESTS BENEFITS OF MORE
  WINDPOWER GBP 120 MILLION IN 2030, AND BENEFITS
  OF NUCLEAR GBP 180 MILLION.
• COULD BE EXPRESSED AS AN ADDER (OXERA DID NOT DO
  THIS).
• BUT THESE SECURITY VALUES EXCEED THE
  ENVIRONMENTAL BENEFITS OF WIND AND NUCLEAR,
  SUGGESTING SECURITY ADDERS COULD BE VERY
  IMPORTANT

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CONCLUSIONS

• HARD TO TELL IF MARKETS INTERNALISE RISK
• WOULD BE SURPRISING IF THEY DID NOT
• BUT LACK OF MAJOR TRANSITION AWAY FROM IMPORTED
  FUELS SUGGESTS EITHER
• (A) MARKETS NOT GOOD AT INTERNALISING RISK, OR
• (B) COSTS OF RISK REDUCTION EXCEED BENEFIT