Electricity trade dividends

ON 29. SEP 2022
BY STIG ROAR HAUKOE LUNDEBY

The record prices of electricity last winter prompted the government into swift action. Already in December 2021, the government introduced a price subsidy on electricity. The subsidy would pay 55% of the price exceeding 0.7 NOK per kWh up to a limit of 5 000 kWh per month. In January 2022, the subsidy was increased to 80% and then further to 90% in September 2022. Obviously, with a large price subsidy, incentives are distorted. For instance, with the current policy and a market price of 2 NOK per kWh, the consumers would face a net of subsidy price of only 0.83 NOK per kWh (0.7 plus 10 percent of the difference between 2 and 0.7). In other words, if 2 NOK per kWh is the new “normal”, the present value of any investments the consumers might make to cut their electricity consumption (e.g. installing heating pumps, replacing leaking windows, improve insulation etc.) is more than halved!

What is more, the incentive distortions get worse with higher prices. With an electricity price of 5 NOK per kWh, the net of subsidy price faced by consumers would be about 1.13 NOK per kWh. This is quite problematic as very high electricity prices signals that electricity is extremely scarce. It is precisely when prices are very high that it is most important to give households incentives to cut their consumption, but under the current policy, those are the times when their incentives are distorted the most.

If the government wishes to compensate households for the rising energy prices, they should do so in a way that preserves incentives. Luckily, there is a way to do this – simply pay households lump sum transfers independently of how much electricity they consume. Households could in principle receive exactly the same transfers as now, but for any kWh reduction in consumption, they would save the full market price in costs. Thus, every household would be at least as well off as they are currently.

In practice, the government would not be able to give each household the same transfer as they would receive under the current policy without distorting incentives. However, they could decide on something far simpler. Take whatever amount the government currently spends on subsidies and divide it equally among all people living in the areas eligible for price subsidies now (i.e. areas with a price above 0.7 NOK per kWh). The government currently estimates that it will spend 41 billion NOK in electricity support in 2022. With about 4.5 million people living in the three price regions eligible for support, that would imply a lump-sum transfer to every adult and child of 9 100 NOK in 2022, or 36 400 NOK for a household with two parents and two children. On average, households would then receive the same transfer as they do now. However, households that consumes less (more) electricity would receive more (less) in transfers than they do currently.

The proposed lump-sum policy has two main advantages over the current policy. First, it preserves incentives for households to lower their energy consumption. Second, with lump-sum transfers, a rich and a poor household with the same number of members, would receive the same transfer. The current policy on the other hand, rewards households that consumes more electricity more than those who consume less. On average, wealthier households consume more electricity than poorer households (they have larger houses, heated driveways, large electrical vehicles etc.). The current policy is therefore regressive – on average it pays larger subsidies to wealthy households than poorer households.

Obviously, the proposed policy is but a sketch. There are tweaks that could be made to make it fairer or more targeted. For instance, there might be good reasons to believe that there are some benefits of scale in a larger household. Thus, perhaps the transfers should be higher for the first member of a household and lower for additional members, so that a four-person household receives a bit less than four times the transfer to an individual household. What is important is that the policy should be fairly simple and preserve incentives for energy efficiency.

An even more important question is how we should structure the electricity market going forward. A number of politicians have spoken in favor of regulating exports or implementing a price ceiling for domestic consumers. Such policies would be even worse than what is currently in place. First, a price ceiling that is equal or lower than 0.7 NOK per kWh, would distort household incentives even more than the current policy. Additionally, if applied to corporations, their incentives would be distorted as well. Worse still, would be to apply the price ceiling to the electricity producers, as this would in all likelihood lower electricity production and investment in new projects.

Second, it is well known in economics that free trade generates net gains for the economy as a whole, especially for small economies. The problem is that markets do not ensure that gains from trade are distributed fairly. In the electricity market, producers have large gains from trade as electricity prices are generally higher abroad. Since most producers are owned by the state, counties and municipalities, and the government collects corporate and value added taxes, the main beneficiary is the state itself. On the other hand, left uncompensated, consumers will almost certainly lose from trade as Norwegian prices will approach European ones. The gains to households are at best indirect in the form of improved public services and/or lower taxes than would have otherwise been the case and an electricity supply that is more robust to years with low rainfall. Since these gains might be hard to see and quantify for some households, we run the risk that trade in electricity lose support in the population.

As the state is the main beneficiary of electricity exports, it should be fairly easy to implement a policy that makes the gains from trade evident to the majority of the population. The government could make lump-sum, monthly transfers, let us call them “electricity trade dividends”, equal to its proceeds from the electricity market to every individual. Transfers would then tend to be high (low) whenever prices are high (low), thereby acting as an insurance to households. Net of transfers, household energy expenditure would then on average be lower the more we export, thereby garnering public support for trade which benefits the aggregate economy.

Even domestically, we see some resistance to improving trade across price regions. Currently, the north-south transfer capacity is quite limited, causing prices to diverge between southern and northern Norway, with the latter enjoying much lower energy prices. As a consequence, some northerners are skeptical of new infrastructure that would improve transfer capacity, as this would tend to increase their prices. If implemented smartly, “electricity trade dividends” could help gather public support for improved transfer capacity within Norway. For example, one could take the proceeds to the government from the electricity market within each price region and pay that out in lump-sum transfers to the inhabitants of that region. Transfers would then be high in regions with high electricity prices. With this policy in place, northern households could on average be fully compensated for price hikes following improved transfer capacity.

In summary, high electricity prices and large exports should not be viewed as a problem for Norway, but rather an opportunity to make the majority of the population better off. Especially in times like these, when energy prices are record high, can we make record gains from trade. The issue is not about free trade or free markets – both of which create great gains to Norway as a whole – but rather how we ensure that most people benefit (and see that they benefit) from these gains.