Germany proposes to cap electricity revenues for inframarginal technologies

By Stefan Konstantinov

LONDON (ICIS)–The German government announced on Sunday 4 September that it would impose a windfall tax on some electricity producers. It would use the resulting proceeds to finance a new €65bn energy relief package designed to support consumers and mitigate the impact of high inflation and energy bills. This new package brings the total cost of the aid measures Germany has enacted this year to €95bn.

Overview

According to the official document, the government would impose a cap on the profits of energy producers who generate electricity from wind, solar, biomass, coal, and nuclear energy rather than gas as the marginal and price-setting technology. Such companies were making “excessive” or “accidental” profits because the market price of electricity was determined by the – currently extremely high – price of gas.

A maximum value will be set for the proceeds on the spot market for each technology. The difference between the wholesale price and the revenue cap will be paid to the distribution network operator through the existing infrastructure of the German EEG levy.

Proceeds from the tax on the profits of inframarginal power generation technologies would go towards an “electricity price brake,” which will provide private households and small enterprises with an allowance of electricity at reduced prices.

The government stated that the proposed measures were closely aligned with recommendations by the European Commission which ICIS analysed recently: to impose a cap or a tax on inflated profits generated by some electricity producers to fund support measures for households and companies. The government also specified that if the EU did not implement these policies as a result of the scheduled European Commission meeting of energy ministers on Friday 9th September 2022, Germany would go ahead and reform its national electricity market itself.

Merits of the proposal

The concept of calculating an ex-post technology revenue limit and asking inframarginal generators to surrender their profits above that level has some important advantages over the cap on natural gas prices (the marginal fuel) implemented in Spain and Portugal which ICIS analysed recently. The fundamental functioning of the power market and its parameters (spot prices, power despatch, cross-border trading, and gas burn in the power sector) are unaffected by the suggested approach.

Also, the proposal specifically states that the revenue cap only applies to the spot market, where inframarginal generators might get excessive profits. Our ICIS understanding is that if generators sold their output on the forward market, then they should be unaffected by the revenue cap, which makes full economic sense.

Critique of the proposal

A complication, which we discuss in our recent analysis of the European Commission proposal is how to deal with contract-for-difference (CfD) hedging as producers who have hedged against low prices with a CfD contract stand to lose out.

If a theoretical coal plant had signed a CfD with an offtaker at, say, €100/MWh and the spot price is €500/MWh when they come to sell, they would have to pay the buyer €400/MWh meaning they effectively sell the power at €100/MWh. However, if the spot price they can receive is capped at, say, €300/MWh then the plant operator faces a loss of €100/MWh.

The government document is also relatively light on details about how the process of setting a cap on inframarginal technologies would work in practice. The following questions remain to be answered by a more technical policy implementation document, if the government does go ahead with implementing the measure:

• How, and on the basis of what logic, will the revenue caps be set for the different technologies?
• How will the widely differing fixed and capital costs of different generators be considered? The government document speaks about variable marginal costs only (fuel, carbon, and variable operations and maintenance costs). Would any importance be attached to the full set of generator costs, including the proportional share of fixed and investment costs that a generator needs to recoup in any given hour of operation, if it is to recoup its initial investment cost, and cover its fixed operational and maintenance costs?
• Related to the above, would the differing age, and with that, degree of capital depreciation of assets, be accounted for? As an example, an old inframarginal thermal plant such as coal / lignite which over its lifetime has recouped its initial investment and capital cost, would have a very different revenue profile compared with more recent renewable assets which are highly capital intensive and which require a significant amount of revenue above their low marginal running costs to cover fixed investment costs.

ICIS opinion

The ICIS view on the German proposal for an inframarginal power technologies revenue cap is that it is a policy measure that is borne out of necessity and out of the need for politicians to address the looming social and political issues which extremely high energy prices for end-users are likely to cause over the coming winter. The need to protect vulnerable households is a very valid reason, and the proposal aims to get budget revenues in a way which causes less market distortion compared with other similar approaches. Also, the proposed measures are not permanent, but would only be valid during the period of very high energy prices.

Despite all of the above points, this measure still has the potential to cause damage to the optimal functioning of the electricity market.

If the revenue caps are set too low, they will disincentivise the investment in non-gas and low-carbon generation technologies, such as renewables. This is the opposite of what the electricity market needs right now and is providing the corresponding signals through high prices.

Also, if the subsidised amounts of energy for households are set at too high levels, this would disincentivise end users to conserve energy.

This would again lead to the opposite effect of what the market is signalling now – in terms of the need to reduce demand so as not to rely on expensive gas-fired generation.

In summary, if implemented too heavy-handedly, the mechanism runs the risk of reducing the supply of non-gas generation, while keeping demand flat instead of decreasing it, which would be highly counterproductive. The government would hence need to closely scrutinise the functioning of the system after implementing it, to ensure that the distortions to the market are kept to the minimum while protecting vulnerable energy end users, and minimising the risk of wasting taxpayer resources and extending the crisis.