DO ELECTRICITY MARKETS INTERNALISE SUPPLY RISK? DAVID PEARCE

2 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

3 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?

4 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’.

5 MARKET ANTICIPATION-1 BUT WON’T MARKETS ANTICIPATE THESE EFFECTS? LONG HISTORY SINCE 1970S OF PRICE SHOCKS, SO WON’T 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:

6 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?

7 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 < COST OF AVOIDING THAT RISK.

8 ‘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.

9 SECURITY ADDERS - 2 PARRY AND DARMSTADTER (2003) MACROECONOMIC ADJUSTMENT COSTS TO USA =>c$3 BBL FOR USA + c$2 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 REDUCED TO GBP 180 MILLION IF MORE WINDPOWER AND GBP120 MILLION IF MORE NUCLEAR.

10 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

11 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