March 2, 2004

Increasing the reliability of electricity production: a cost-benefit analysis

Government measures to raise security of energy supply are expensive

Press release
Overheden moeten terughoudend zijn bij het nemen van maatregelen die gericht zijn op het verbeteren van de energievoorzieningszekerheid.

Read also the accompanying document 'Increasing the reliability of electricity production: a cost-benefit analysis'.

Governments should be very cautious in intervening in markets in order to realise a secure supply of energy. The costs of measures in this field, such as subsidising biomass, capping depletion of natural gas fields or imposing capacity requirements on electricity producers, exceed their benefits. Improving the functioning of energy markets, on the contrary, appears to be a fairly efficient approach of realising a secure supply of energy. A market functions well if suppliers as well as consumers are able to respond to changes in prices of energy which reflect changes in scarcity on the market.

This conclusion follows from the report ‘Energy Policies and Risks on Energy Markets: a cost-benefit analysis’, published today by CPB Netherlands Bureau for Economic Policy Analysis. The CPB has conducted this research on request of the Dutch Ministry of Economic Affairs. In its research, the CPB has developed a framework of cost-benefit analysis and has applied this framework to a number of conceivable policy measures.

The main result from the analysis is that costs of disturbances on energy markets generally are smaller than costs of measures directed at preventing or mitigating consequences of those disturbances. Related to this conclusion is the finding that energy markets are able to deliver a secure supply if those markets are well organised. If markets function well, prices give incentives to producers to invest when supply becomes scarce, while consumers are encouraged to reduce demand. If, however, prices do not reflect real scarcity, or if producers or consumers are unable to respond to changes in prices, security of supply problems could appear. Therefore, establishing and maintaining well-functioning markets is an efficient approach in realising a secure supply of energy. That approach includes the removal of entry barriers, securing equal access to essential facilities, such as networks and storage, giving incentives for investments to network owners, and increasing transparency of markets.

A few years ago, the world was shocked by the Californian power crisis. The market for electricity of the largest state of the United States failed, causing rolling black-outs for several days. The crisis fuelled the discussion whether liberalised electricity markets are capable of delivering a sufficient level of security of supply. Recent outages in America and Europe as well as the cooling water crisis in the Netherlands have increased the urge for policy makers to act.

The key question is whether and how governments should be involved in taking measures regarding the security of energy supply. Do markets fail in securing supply of energy? And: do benefits of government action outweigh costs incurred by government measures? In order to answer these questions, the CPB has developed a framework for analysing costs and benefits of government measures in the field of security of energy supply and has applied that framework to a number of conceivable policy options. The measures analysed comprise the following:

  • extending the size of the strategic oil stocks;
  • subsidising the use of biomass in the transport and chemical sectors;
  • conserving the Groningen gas field;
  • encouraging investments in wind turbines, coal-fired plants or nuclear power plants in stead of gas-fired plants;
  • giving incentives to electricity producers to invest in reserve capacity;
  • raising the levy on the use of electricity;
  • Implementing changes in the regulation of electricity networks.

Like insurances require periodic premiums, policy measures in the field of security of supply require periodic activities incurring costs regardless whether a crisis happens. The benefits of these measures, however, are fully dependent on the occurrence of a crisis. Therefore, the frequency at which crises happen determines the efficiency of a policy measure. In CPB’s newly developed framework, the break-even frequency of policy options plays a key role. That frequency tells us how often a specific crisis should occur in order to have the benefits match the costs.

Most of the policy options analysed require a fairly or even extremely high frequency in order to achieve a break-even point between costs and benefits. For instance, oil prices should surge strongly for a period of six months at least every seven years in order to make additional investments in strategic oil stocks efficient, as recently proposed by the European Commission. Such a high frequency of that type is, historically, improbable, making the policy option economically expensive.

Encouraging the use of biomass in the transport and chemical sectors is a measure aimed at decreasing the vulnerability of an economy to oil price movements. This measure would be highly inefficient: even if the crude oil price were permanently on a 20% higher level this option entails high losses of welfare. The analysis of this measure includes the assessment of environmental effects.

Capping production from the Groningen gas field would be a policy measure to increase the lifetime of the capability of this field to serve demand in a severely cold winter. option is also highly expensive. Despite this conclusion, the question remains whether capping production from the Groningen field would be efficient if this issue is analysed from a broader perspective than that of meeting extremely high demand. In order to answer this question, additional research should be conducted.

Substituting gas fired plants by wind turbines or nuclear power plants is not an efficient security of supply policy either. Investments in nuclear power plants may be efficient if the latest techniques are used in combination with an exceptionally high load factor.

Introduction of measures giving private parties incentives to invest in extra peak capacity appears to be expensive as well. We have assessed the costs and benefits of three options aimed at increasing the reliability of electricity production: capacity markets, reserve contracts, and capacity payments. We have found that each of these options induce high costs; capacity markets and reserve contracts because capacity is left idle, and capacity payments because of large welfare costs induced by price increases. The policy options are not efficient in preventing price spikes as the welfare costs of price spikes are lower than the costs of the policy options, unless price spikes occur at an implausibly high frequency.

Encouraging cutting down the use of electricity, for instance by raising the rates of the energy tax, is an option to reduce the vulnerability of the economy to abuse of market power by producers. Our analysis shows that a price increase of 50% during one year should happen at least once every 4.2 years to make this policy option efficient. The result is fairly robust to changes in assumptions; it suggests that the policy is not viable from a supply security point of view.

Finally, we stress the importance of independent functioning of networks in order to reduce the risk of execution of market power by regional generators.

Eventually, the decision whether or not to implement measures is a political one in which the attitude of society towards risk plays a crucial role. If governments are risk averse, for instance because of a suspected effect of a crisis on the reputation of politicians, or if societies as a whole are risk averse, the interpretation of the break-even frequency shifts in favour of the policy measures.

Read also the accompanying press release and Special Publication 'Energy policies and risks on energy markets; a cost-benefit analysis'.

In the system of capacity markets, the transmission system operator (TSO) requires traders to back their own peak load plus a prescribed level of spare capacity with contracted capacity, the latter being tradable at secondary markets. With reserve contracts, the TSO contracts spare capacity from producers, holding it to be dispatched in case of a crisis. Capacity payments are a subsidy on capital costs, giving producers an incentive to build more capacity.

These measures prove to be inefficient in preventing price spikes, as the welfare costs of price spikes are lower than the costs of the policy options unless price spikes occur in an implausibly high frequency. Capacity payments cannot prevent black-outs, as they do not induce enough investments in spare capacity. Black-outs can be prevented by capacity markets and reserve contracts, but at a high cost. Even if a 24-hour black-out of the Randstad area occurred every five years, it would be cheaper to accept the consequences of the black-out than to prevent it.

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