What lessons can be learned from the Iberian price cap?

LONDON (ICIS)–The implementation of yet-further price caps in Europe is being touted as one possible solution that policy makers could use to tackle the rise in electricity prices.

While price caps may be effective in reducing the electricity price for consumers, as seen in the case of Spain and Portugal, they also come with several unintended consequences.

In this analysis we examine the effectiveness of price caps with reference to the Iberian exception, as the market awaits further details on the exact market-intervention measures the European Commission looks to implement.

Overall, we find that while there is a material reduction in prices, the artificial lowering of the electricity price through a cap on gas leads to an increase in gas demand and generation. This has the potential to put further strain on already tight margins heading into winter which, on a European level, would worsen the current crisis.

The Iberian price cap – background

The European Commission gave the green light to the ‘Iberian exception’ on 8 June, permitting Spain and Portugal to artificially reduce wholesale electricity prices by capping the price of gas used for electricity generation.

The cap consists of a direct payment to gas-fired generators of electricity that covers the difference between the wholesale price of gas and the cap limit.

The cap is in place at €40/MWh for the first six months of the cap period, increasing by €5/MWh every month until 31 May 2023. The overall average cap will be €48.8/MWh.

As we previously analysed, Spain and Portugal have the lowest level of interconnection across European countries by the European Commission’s definition. On this basis alone, it is unlikely we see a similar price cap as the one in Spain applied across countries, which in some cases have several interconnections.

Analysis of Key Impacts

Price

The main goal of any intervention in the market via a price cap would be to bring down electricity prices from their current astronomically high levels for end-consumer benefit. In this sense the Iberian price cap has worked as intended.

Spot electricity prices in the Iberian pool have averaged €149/MWh since the beginning of the price cap. This compares to an average price of €332/MWh without a cap. Accounting for the levy paid to gas plants, this equals to a net benefit of €54.25/MWh lower prices overall.

The lower price may also lead to a softer demand response by limiting demand destruction. In fact, as will be explained below, the lower price and subsidised gas leads to higher demand.

Source: OMIE, ICIS

Net Trade

One of the main impacts from the lowering of the spot price is the change in the delta between Spain and France, leading to a rise in exports.

Since the implementation of the price cap, exports from Spain to France have averaged over 1.6GW more compared to the same period last year. Part of this can be attributed to the low nuclear availability; however, the extreme discount between the Spanish and French spot market is mostly a result of the price cap.

This highlights a big risk of a price cap, if not implemented homogenously across borders. Spanish consumers are effectively subsidising cheaper electricity for French consumers, which will eventually be recouped from the consumers through levies and taxation.

At the same time, the increase in export demand increases the demand for additional gas generation. Spain was, for the first time, importing French gas in August which on an energy basis was effectively being exported back to France via electricity interconnectors.

Generation

Gas-fired generation in Spain has surged so far this year both a result of low hydro availability and the price cap.

Gas generation in August was 8.2TWh compared to 5.3TWh in the same month last year, while averaging 6.45TWh in 2022 so far compared to 4.4TWh in 2021.

Higher gas burn has been exacerbated by extremely low hydropower availability across the Iberian Peninsula. Generation from hydro power has averaged 1.8TWh monthly so far this year compared to 3.2TWh in 2021, dropping to as low as 1.3TWh in July.

While it is difficult to separate the increase in gas generation between price cap, higher export demand and low hydro, the price cap has pushed gas ahead of coal in the merit order at a time when the market is facing a supply shortfall amid low French nuclear availability.

Calculating the marginal cost of gas with a fuel price of €40/MWh (the current level of the cap) shows that the least efficient gas plant (with a marginal cost of €195.23/MWh) is ahead of the most efficient coal plant (with a marginal cost of €212.01/MWh) in the merit order.

While the market is primarily facing a gas supply crunch amid a risk of Russian supply being cut off, artificially increasing the demand for gas would worsen the current tightness.

Conclusion and Possible Outcomes

In summary, the implementation of a price cap, while succeeding in reducing the electricity price, can lead to distorted price signals that:

• Increase exports to neighbouring countries due to a change in cross-border spreads
• Limits needed power demand destruction through lowering of price while increasing demand for gas at a time of scarcity in supply
• Brings gas ahead of coal in the merit order

By capping prices from rising, you limit demand reduction, meaning that while the measure fails to fix the demand issue it also worsens the overall balance by increasing demand. Thus, like most of the myriad of proposals suggested, a price cap only tackles the symptoms (high prices) and not the cause (tight supply), and in fact worsens it.

In Spain, this was exacerbated by low hydro and high cooling demand through summer. In the context of Europe, hydro levels are similarly poor across markets. Coupled with low French nuclear availability and the ongoing gas supply risk, a cap on gas could worsen the overall dynamic.

Additionally, Spain is unique in its low level of interconnection with the rest of Europe. A price cap would only be effective if it does not distort much of the market. For other countries, a price cap would see much severe distortion of cross-border flows and could lead to higher volatility in prices.

While an Iberian-style price cap for the rest of the EU would not make much sense from a power (or gas) market perspective, it is still a potential option that is likely to be seriously considered due to its political advantages. It would help to protect consumers from skyrocketing prices and would also help to contain inflation across the EU, which is becoming increasingly problematic for Europe.