No Price Caps in the Electricity Wholesale Market! 

No Price Caps in the Electricity Wholesale Market! 

The FINANCIAL -- This article is about a highly technical matter. To avoid losing all our readers in the very beginning, let us start with a famous doctrine by Montesquieu: Les lois inutiles affaiblissent les lois nécessaires.

This principle, literally meaning “useless laws weaken the necessary laws”, should always be kept in mind by lawmakers and politicians. If a regulation is not beneficial, then it is almost surely beneficial to get rid of the regulation. Some great Georgians endorsed this principle, like Kakha Bendukidze, who is widely praised for having erased many unnecessary rules from Georgia’s legal codes. Yet, a one-time eradication of useless laws is not enough. An efficient government will regularly put into question every single statute so as to relieve the society and economy from toxic legal ballast.    

We found a harmful regulation in the form of price ceilings in Georgia’s energy sector, which is regulated out-and-out. To understand the point, we need to delve a bit deeper into the intricacies of Georgian electricity market regulation – but do not stop reading here. An enthralling economic analysis awaits you!

Double-edged electricity prices

Shortages do not occur often in a market economy, but sometimes, the suppliers of a certain good do not keep up with the demand. There may be a shortage of taxis on a rainy day or the stores may run out of fans during a hot summer. Yet, these temporary scarcities usually do not cause major problems. Shortages are much more of a nuisance when it comes to electricity – blackouts are not only highly unpleasant but have the potential to disrupt most routines and activities in a society and cause considerable economic damage (many Georgians know this all too well due to their experiences in the 1990s). Consequently, one reason for regulating the electricity market is to provide a maximum security of supply. 

Another reason is the fact that one part of the energy sector, namely electricity transport and grid operation, is a so-called network industry. One electricity grid is enough for the whole society, and it would be economically inefficient to have two separate electricity grids. Hence, the market outcome is clearly suboptimal: either, there is competition between multiple separate companies building parallel grids, which is obviously a waste of resources, or there is a monopoly, which also causes market failure. For these reasons, electricity markets in Georgia, as well as all over the world, are highly regulated. 

Yet, the regulator, the Georgian National Energy and Water Supply Regulatory Commission (GNERC), faces a dilemma. If electricity prices are too high, poor people cannot afford to purchase this vital good. Therefore, Georgia has multi-part tariffs for electricity consumption. There is a threshold up to which each kilowatt hour (kWh) is rather cheap, but usage in excess of that threshold costs more (the same pricing scheme, by the way, is applied for water usage in Israel). With this system in place, the poverty-stricken person who just needs electricity for illuminating their apartment pays less per unit than the affluent consumer who needs electricity for, say, air conditioning. Moreover, low electricity prices may be a reason for certain industries, notably from the manufacturing sector, to do business in a country. Bitfury, the blockchain computation company that recently made a huge investment in Georgia, is an example for this (though they do not do classical manufacturing).

On the other hand, low electricity prices are also risky, as they take away the incentives to invest in the energy sector. This does not only affect new investments (which would be very valuable for Georgia) but also maintenance and replacement. The infamous California Electricity Crisis of 2000-2001 was, among others, caused by a regulation that made it unprofitable to invest in the energy sector.     

Harmful Price Ceilings

In Georgia, the prices for consumers of electricity are directly set by GNERC. The grid operators, of which there are three, serving different geographical regions, must sell their electricity at these prices. The grid operators buy the electricity on the wholesale market from the electricity generators, which in Georgia are mainly hydro power and thermal power plants, covering 69% and 21% of Georgian electricity consumption, respectively (ESCO 2015). 

And now comes our point. On the wholesale market, GNERC caps the price that can be charged by the electricity generators per kilowatt hour. For example, the two largest power plants of the country, Enguri and Vardnili, which together make up for 36% of Georgian consumption, cannot receive higher prices than 1.19 tetri/kWh and 1.17 tetri/kWh, respectively.  Similar restrictions apply to the majority of power generators in Georgia and even to import prices, though for thermal generation the ceilings are much higher. 

What is the advantage of having those price caps? Apparently, GNERC wants to prevent that generators charge prices which are so high that the grid operators decide not to buy (with power shortages resulting). However, without price caps, the bargaining over the price between power generators and grid operators would never lead to such an outcome. Clearly, the grid operators will never buy electricity for a price that is above their retailing revenue minus some operating cost, and as the retailing price is known to anybody, it is credible – also for the generators – that there is a maximum price they cannot exceed without incurring losses. Could it happen that the generators would nevertheless demand prices that are higher than what the grid operators are willing to pay, so that the market will break down? Such a behavior of the generators would only be rational if somebody else would be willing to pay more for their electricity than the Georgian grid operators. Yet, due to technical reasons, the amount of electricity that can be exported is extremely limited, and almost all of the electricity produced in Georgia must be sold domestically. Hence, there is no such risk. Moreover, the existing price ceilings induce the generators even more to sell their electricity abroad, as no price caps apply to exports. They are just counterproductive if one wants to make sure that Georgian generators serve the Georgian market first, as they increase the incentive to not sell on the domestic market. 

With or without ceilings, the generators have nothing better to do than selling their electricity to the Georgian grid operators, and hence there will be a bargaining solution where the right amount of electricity, covering the Georgian demand, is traded. The only thing the price caps achieve is an additional rent for the grid operators, lifting their profits above what they would earn in a free negotiation process, and this goes at the expense of the generators.     

On the other hand, the ceilings severely curb investment in the Georgian electricity sector. The problem is not solved by the fact that power plants built after 2013 are exempt from the price caps. If the largest share of Georgian electricity is kept at an artificially low price, the bulk of the demand is covered by the cheapened price, and only the residual demand can be served by those new market entrants at higher prices. 

To sum up, instead of increasing energy security, the price ceilings reduce investments in the energy sector. For Georgia, it is strategically hazardous if the production capacities do not keep up with the constantly rising demand for electricity, and it is a pressing issue to remove this unnecessary regulation. Laissez faire, as Montesquieu would have said!