The EU energy policy has long been a mess - here's why

As we grapple how to urgently do something about the EU’s dependency on Russian oil&gas, it is worth reminding everybody that this situation is a direct, obvious result of longstanding core elements of EU energy and competition policy and that as long as this is not acknowledged, it will be really hard to do something about it.

A first point to note is that we do have a strong example of what a solid energy policy in the face of stark, structural, dependency on imports of energy can be - that of France in the 70s and 80s. People will think “oh yes, lots of nukes” but that’s not really the core of it, and not the most important part.

France actually has a well-thought out, comprehensive energy policy:

On the gas side, where France needed to import most of its needs, the issue was tackled by ensuring supply was never too dependent on a single source, and each import flow was treated as a strategic, national issue. Gas was imported by Gaz de France which, as its name suggests, was the national state-owned gas company (now a small part of engie, more on that later). Unless bought from friendly countries like Norway, the Netherlands or the UK, it was purchased under long term contracts directly negotiated with the state bodies from the exporting country, whether Algeria, the Soviet Union, Egypt or elsewhere, and treated as a essential part of the bilateral relationship - ie any wilful material default under the contract would be a state matter very quickly . No country was allowed to take too large a share of the overall market, and not a single contract’s disappearance would cause massive hardship. Diversified gas import infrastructure (including pipelines and LNG terminals) was built, as well as significant storage capacity, fully controlled by Gaz de France. The long term contracts included strong commitments from each side (obligation to deliver, and obligation to purchase, minimum volumes) and stable price formulas not subject to the day to day volatility of energy prices (they were typically indexed on average oil prices for the past 6 or 12 months). These contracts still exist, and it is worth noting that Russia has never (and still hasn’t, despite the sanctions) defaulted on them. And Russia has never durably provided more than 25% of French gas use.

On the power side, there was an obvious strategy to move towards a more homegrown form of energy, nuclear (even if imports of uranium still need to be managed, but it’s a slightly easier issue than oil and the same strategy as for gas above has been applied). But what’s important here is that there was a plan for energy generation as a whole, done in a centralized and coordinated way. Plants were financed at the low cost of capital of the State, which was an essential part of keeping electricity cheap for such as capital-intensive technology as nuclear (where a large part of the investment is upfront and running costs are relatively low) and an explicit public choice was made as to the generation mix, with non-nuclear plants chosen to complement the generation profile of baseload nuclear - including a lot of hydro, both in France and in neighboring Alpine countries, which acts as a giant battery that supports the system.

On the demand side, a lot of effort was put to implement policies that would shape and reduce consumption. With a lot of baseload electricity available, electrical heating was pushed, as well as a lot of measures meant to move consumption from daytime to nighttime (such as electrical water heaters programmed to function at night and benefitting from a lower price of electricity). Industry was offered year-long cheaper electricity if they accepted the possibility of being switched off on the rare occasions where demand would peak (very cold winter evenings for instance) - demand cancellation instead of peaker plants. Energy savings were pushed as part of national policy, and encouraged via tax incentives and other schemes. Taxes on energy were steadily increased so that energy demand would be reduced, and the impact of price movements on the underlying commodity would be more muted.

A lot of that relied on having a consistent state policy and State-owned companies that implemented that policy. In other words, “communism” - and indeed, the workers of these companies were well treated via various perks - but that was a trade-off against high technical competence and full availability in case of emergencies - ensuring security of supply was a value shared by all employees as well.

And, as it turns out, despite being provided by a State-owned behemoth beholden to communist unions, electricity in France was very cheap - essentially the result of technocrats’ choices to benefit from economies of scale, cheap financing at the sovereign discount rate rather than that of private investors, with buy-in from the workers and the population.

On the oil side, there were policies to favor smaller cars with high fuel efficiency (remember how ads in the 80s focused on mileage and fuel efficiency?), strong public transport and, again, steadily increasing taxes both to reduce demand and make underlying price movements less impactful.

So France had an energy policy that focused on security of supply and energy independence, managed to deliver cheap energy and was (but that was not really the objective at the time) low-carbon energy too.

The only thing many people seem to have learnt from that is that we should do more nuclear power - especially as it is indeed low carbon and thus also addresses the climate change issue which has raised in prominence in the meantime.

But what matters more is that this was a fixed-cost generation technology, and it was possible to not worry about market prices for electricity (or gas, which, in most liberalised systems, drive them, as I’ll explain in more detail in a future post). Retail prices could be set knowing that generation costs were largely fixed. Marginal pricing (invented by Marcel Boiteux who then went on to be the boss of EDF) was used within the company to select the most efficient plant to cater for demand, but not as the core mechanism to choose investments.

Which takes us back to the EU energy policy, which was largely designed in the 80s and 90s when the push towards market liberalisation, originating in the US and the UK, moved to the rest of Europe and found a home in the EU Commission, and, willfully or not, set out to destroy every aspect of French policy.

Liberalisation focused on creating spot markets that would reflect the “real” price of electricity at any time and ensure the balance of the system in the most economically efficient way at every instant. It pushed for separation of generations and grid '(“unbundling”) to ensure proper competition and avoid that incumbents favor their own plants against that of competitors.

On the generation side, it led to massive investment in gas-fired generation plants, as they were the most flexible and adapted to this new environment: with relatively low upfront investment, most of the cost of generation came from the cost of fuel:

With low price for gas in markets like the US and the UK, thanks to (at the time at least in the UK) plentiful domestic production, the switch to gas was a no-brainer.

It also presented the not so trivial advantage of being highly friendly towards Wall Street and the City - it created new power markets that brought in traders, and the need for new hedging and financing instruments beyond the boring needs of stodgy old utilities. The push towards unbundling of grids and generation created massive new opportunities for M&A advisors, to separate existing corporations into separate ones in the various sub-sectors, and then push them to merge, acquire competitors, and recreate horizontal scale as opposed to the vertical one that existed before.

With marginal pricing done by the market, power markets became increasingly correlated to gas markets, as the exemple below, from the USA, shows, creating structural demand for more gas in the power sector (and elsewhere).

The EU matched these policies and went on a decades-long efforts to break everything from the old models, exemplified in the case of energy by France, by imposing things like the operational and financial separation of grids from generation, the specific and unique obligation for EDF to offer some of its nuclear electricity to competitors of a fixed price (the infamous ARENH), the obligation to allow third party access to privately-owned infrastructure like gas pipelines or storage and more arcane things like the interdiction of destination clauses in long term gas contracts that deliberately made the contracts with Gazprom and others less attractive for its buyers, which were encourage to move their purchases to the spot markets

In effect, in the name of “competition” that was meant to promote lower cost energy (and even though French electricity, despite the lack of domestic fossil fuels, was the cheapest in Europe), energy policy turned into a massive mechanism to promote the use of gas, and the decentralized control of investment in the sector away from States and towards decentralized private market players who cared very little about security of supply (they cared about their own security of supply, which they could elect to protect via contractual mechanisms, but not about the overall market’s).

In parallel, the climate change issue started to grow in prominence, and along with it the political pressure to do something about it, and in particular to promote renewables. The issue with renewables was not so much that they were expensive (as the graph above shows - in 2004, the cost of generation from wind was already quite close to that from competing technologies) but that they are a fixed-cost technology, mostly sensitive to the cost of capital, and not adapted to by-then dominant spot markets.

The EU now wanted to be green, and thus markets had to be “tortured” to allow for investment in renewable generation - via priority dispatch and feed-in tariffs. Essentially, a partial carve out from market rules was created to make these green investments possible. This generated easy (and lazy, and largely false, except for early projects in solar and offshore wind) accusations that renewables were subsidized and uncompetitive, and more importantly, it generated a lot of hostility from existing incumbents, who has made a lot of efforts already to adapt to the new market landscape, and were suddenly seeing these new players being given exemptions at their expense (the real dirty secret of renewables was that the investment was not paid for by the consumers, but by the incumbents, through lower prices for their generation, as supply was artificially increased and renewables came first - the rest had to fight harder to stay in the game, and got lower prices).

So you still had market designs that structurally favor short term price competition and thus gas, promoting fossil-fuel burning assets, but then you added hurdles against that to promote renewables in complex ways that make renewable illegitimate and annoying in the eyes of a large part of the industry, and more expensive than they could be, and make fossil fuel assets arbitrarily worth less on incumbents’s balance sheets or even become stranded (that may be a good thing long term from a policy perspective, but it has an immediate impact on the existing businesses and it’s not surprising that they would fight it if all it does is cost them money))

So - expensive power if you don’t have plentiful gas (which you structurally don’t if you are an importer), long term security of supply ignored or blocked in favor of short term market-driven supplies, and convoluted and impossible to explain mechanisms to support renewables, who end up looking like subsidy-gorged luxuries supported only by hippies against the serious people of the industry (who are, after all, tasked with the vital role of ensuring that the lights don’t go out), and thus insufficient success in reducing carbon emissions.

It’s a pity that it takes Russia going crazy to (hopefully) change this, but there we are. I’ll write about what could be done in the short term in a later post.