THE GERMAN GOVERNMENT PLANS TO INTRODUCE A PRICE CAP (ESSENTIALLY A TAX) FOR ENERGY PRODUCERS. THIS WILL LIKELY LEAD TO THE CURTAILMENT OF VALUABLE GREEN ENERGY PRODUCTION AT TIMES OF POSITIVE PRICES (WORST CASE). BEST CASE IT WILL INTRODUCE A MINIMUM PRICE FLOOR IN MARKETS EXACTLY AT THE LEVEL OF THE MARGINAL TAX RATE.
The Tax Problem
This sounds a bit complicated so let me break it down. The basic idea here for an energy producer is quite simple: whenever my expected tax payment is greater than my revenue from selling my product, I would rather not sell and avoid the tax. Renewable plants (this is true for all producers but in this blog post, I will stick to renewables) will simply shut down ("curtail") their production when prices drop below their anticipated tax rate.
Starting in the Past: How the Renewable Subsidy worked
Let’s take a step back into the past to illustrate the point from the opposite angle: before the energy crisis and the currently high price levels, renewables were benefitting from a price floor. We assume a price floor (feed in tariff / anzulegender Wert) of 120 EUR/MWh (12 ct/kWh) and a Reference Market Value, against which the subsidy is calculated of 30 EUR/MWh (this was the average Spot price level in 2020). The subsidy in this case would be calculated as
Price Floor – Reference Market Value = 120 EUR/MWh – 30 EUR/MWh = 90 EUR/MWh
So, if the actual Spot price in an hour is exactly 30 EUR/MWh, the plant receives
Spot price + Subsidy = 30 EUR/MWh + 90 EUR/MWh which is exactly its price floor of 120 EUR/MWh
(For the experts: I am ignoring trading companies/Direktvermarkter in this discussion whilst pretending that the asset owner and the trader are the same entity. This reduces complexity, however the main important points remain exactly the same).
Why Subsidies led to Production at Negative Prices
So, what happened, when prices turned negative i.e., the market signals that there is too much production? Say we have a Spot price of -20 EUR/MWh. Now the asset owner receives -20 EUR/MWh+ 90 EUR/MWh = 70 EUR/MWh. Thus, they’re still better off producing than shutting down and they keep producing. This changes when market prices drop below the (negative) subsidy level i.e., -90 EUR/MWh. Say prices are at -100 EUR/ MWh. Now the asset owner receives -100 EUR/MWh + 90 EUR/MWh = -10 EUR/MWh. This is no fun, so the asset owner would rather choose curtailment and shut down production. And that is exactly what they did. Figure 1 show Spot Prices in 2020 and one can see that prices never really dropped below -90 EUR MWh, because renewables would be shutting down production at this point and thereby prices could never really fall below the -90EUR/MWh mark.
Day Ahead Spot Prices in 2020
How a Subsidy Free market behaves rationally: No Interference; Production only at Positive Prices
Let’s move into 2022, when the price level increased a lot (I am using data until October and and up to this point we see an annual average of 238 EUR/MWh). See Figure 2:
Price levels 2018-2022
The calculation in 2022 changes:
Subsidy = Reference Market Value – Price Floor i.e. 120 EUR/MWh – 238 EUR/MWh = -118 EUR/MWh
This would be a negative value, and if Germany had a contract for difference (CfD), it would be the amount that the plant owner now needs to pay back. However, Germany does not have this system, so the subsidy simply decreases to zero. The question is what happened to the effective shut down price of the asset? You guessed it: it is at the same level of the subsidy i.e. exactly zero. When there is no subsidy, producers stop operating when they no longer receive revenue for their production.
Figure 3 shows the spot prices in 2022 and it is exactly as expected: there is a hard price floor at 0 EUR/MWh as production simply stops at this point just as it did at -90 EUR/MWh in 2020. Markets working like a charm; this should put a little smile on every economist’s face.
Day Ahead Spot Prices 2022
Turning to 2023: Introducing Price Caps
However, this brings us to the real question: what happens when production is not only subsidized at low prices but when “windfall profits” are taxed away at high prices. Imagine a situation in which government introduces a rule saying that all revenues above the guaranteed price floor of 120 EUR/MWh + a safety margin of 30 EUR/MWh + an anticipated management fee of 4 % of the Spot price would be taxed away and imagine further that January 2023 was trading at 300 EUR/MWh (which it is). The price cap for our asset would be set at
120 EUR/MWh + 30 EUR/MWh+0.04*300 EUR/MWh = 162 EUR/MWh
Jumping into the future, say January 3rd at 11am, we assume that power is trading at exactly 300 EUR/MWh. The asset owner will now pay
Tax = Reference Market Value – Price Cap = 300 EUR - 162 EUR/MWh = 138 EUR/MWh
The owner receives
Income = Market Price - Tax = 162 EUR/MWh
Essentially this is a backdoor CfD (Contract for Difference).
How Taxes turn into Wasted (Curtailed) Energy
Now let us jump back a bit to January 1st at 6am: everyone above 40 years of age is asleep, and it’s very windy outside: power prices drop to 120 EUR/MWh…, or can they?
At 120 EUR/MWh our asset owner will make 120 EUR/MWh in income and pay 138 EUR/MWh in tax. Profit = -18 EUR/MWh. As our asset owner trader does not enjoy losing money, they will rather shut down production and curtail the renewables asset. For 2023, simply imagine the 2022 graph pushed up from 0 to around 132 EUR. Why is this bad? Well, if the asset owner kept running, she would have made a negative return of -18 EUR/MWh. However, the government/DSO/society would have been paid 138 EUR i.e. there would have been a social welfare/value of running the plant of 138 EUR/MWh-18 EUR/MWh = 120 EUR/MWh. Therefore, the tax structure is giving the asset owner an incentive to waste 120 EUR of social welfare. Or to press this point harder: in the midst of an energy and climate crisis, we would be throwing valuable renewable energy into the garbage.
Figure 4 shows the values as I outlined them in this example:
2020 | 2022 | 2023 | ||
|---|---|---|---|---|
Reference Market Price for Subsidy / Tax | 30 | 238 | 300 | |
Price Floor / Guaranteed Feed in Tarif | 120 | 120 | 120 | |
Price Cap | = guaranteed feed in Tarif + 30 EUR + 4% reference Market price | 162 | ||
Subsidy | max = (0, reference market price - price cap) | 0 | 0 | |
Tax | max = (0, reference market price - price cap) |
|
| 138 |
Shut down Price | 90 | 0 | 138 |
Figure 5 shows the optimal shut down price for the described asset at various reference market price levels:
Shut Down Prices in Relation to Reference Markt Values
Shifting Reference Market Prices only helps a little
Obviously, the government knows this and will try some voodoo to lower the tax rate in times of low prices to avoid curtailment. However, the can is then only kicked down the road. If they use the hourly Spot price, instead of a monthly reference market as the Reference Market Value, we will see exactly the same effect that I have described above on the Intraday market rather than the Spot market. Only that our new Reference Market Value becomes the hourly Spot price instead of a monthly average.
Trying to keep Reference Market Values close to Real Time Prices may alleviate the Waste and avoid Curtailment
If everyone had the same subsidy scheme, the same incentives, and the same ability to react to incentives, I believe that the fact of positive shut down values would not be dramatic, as it would probably just push up minimum price levels in relation to the Reference Market Value. But there are multiple subsidy schemes and levels, various actors, and very different abilities to react to incentives, which will lead to a situation in which valuable power will be thrown away because of a tax on power in times of an energy crisis. There are no simple fixes to this problem.
However it is very clear that this problem becomes worse as the Reference Market Value against which the tax/subsidy is calculated moves further away from real market prices. Taking the average price over a year as reference would be terrible, against a month would be very bad and against hourly Spot would probably be the best one can do, as this only leaves the problem between hourly Spot and quarter hourly intraday.
Once again, we wish the regulators good luck with this issue and deeply hope that they do not force traders’ hands in curtailing valuable and green power. We would like to keep them running.
The owner expects a subsidy payment of 90 EUR in the 2020 scenario because price levels are low. Say market price is -50 EUR. So he gets a subsidy of 90 EUR and a negative price of -50 EUR. So in total he makes 90 EUR which is still better than zero. So he produces. This is true until the price reaches a level of -90 EUR. At the level he shuts off produciton.
Hi Amani, many thanks for your prompt response; much appreciated.
Just for sure, may I understand correctly that the shut down price in the 2020 described in Figure 4 is -90 not 90? Thanks.
yes
my mistake! it should read:
the owner expects a subsidy payment of 90 EUR in the 2020 scenario because price levels are low. Say market price is -50 EUR. So he gets a subsidy of 90 EUR and a negative price of -50 EUR. So in total he makes 40 EUR which is still better than zero. So he produces. This is true until the price reaches a level of -90 EUR. At the level he shuts off produciton.
Hi, many thanks for your feedback. Your second explanation is exactly what I had speculated and, so the shuts off price should be -90 EUR then. I don’t see any mistakes you had made in this regard.
Hi, could you explain why the shut down price of 2020, where the assets owner can earn 90, is 90 rather than -90?
I agree with Eva. This equation for the tax doesn’t make sense, as it should be applied to revenues only above the price cap. What is your reference for this calculation?
see above. Hope this helps
Is the tax actually fixed (in your example to 138 €/MWh) for every MWh sold?
Wouldn’t it be more sensible to only pay taxes for MWh sold above a price of 162 €/MWh, i.e. where does the formula “tax = reference market price – price cap” come from?
very good question. I didnt exactly define the Reference Market Value exactly on Purpose, because it is not yet 100% clear what they will use. But most likely the RMV will equal the monthly average spot sprice that a certain technology has obtained. Probably these ones: https://www.netztransparenz.de/EEG/Marktpraemie/Marktwerte. The cap will be calculated based on this and the plants individual subsidy level. The difference between the price cap and this FMV is what I called the “Tax”. So the Tax differs from plant to plant, however it can be quite easily anticipated.
However, they could also chose that the the RMV to be the hourly Spot Price, which would be better. But in this case you have the same problem on intraday. Basically you cannot solve the problem, that the price cap will always need to be set against some RMV which cannot be a representation of real market values, as market values change all the time.
Hi Eva, I had the exact same question and I think (but I don’t know if it’s true) that the problem is not the price cap itself but the situation that arises when the fixed price cap is broken down to individual hours (or quarters of an hour). So let’s assume you have a wind farm and we are in March 2023. The reference market price is set in the beginning of April when all hours of March are over and done with and the average price per MWh per energy source is calculated. So during March, as a wind farm operator (or his/her trader), you will always try to see if the current prices on the spot market are above or below the average monthly prices you project. At the end of March, you will have a pretty good idea where the monthly average will be. Let’s say you had 650 hours in March with prices above 300 Euros. So you are making good money and the reference market price is aiming at 300 Euros as well. You know you will probably be taxed for every hour you produce energy in March. Now the price on the spot market falls to 100 Euros for a couple of hours because it’s a holiday. For these hours you will actually not receive money (you’ll only receive 100 Euros from your trader and you’ll probably have to pay >100 Euros in tax) so you decide to curtail your wind farm. As I said, I am not sure if this is well understood (I am not a trader) but this is my educated guess…
Yes, that is exactly right. I think you may underestimate the ability of the trader to forecast the reference markt price. I would have a pretty good idea of this at the beginning of the month and would simply put a security buffer around my estimate to make sure I’m not curtailing in the wrong moments. Then my security buffer would simply decrease as I move through the month as my guess starts improving…
Thanks for getting back to me! So this security buffer in projecting the monthly average price is what you mean above with “a safety margin of 30 EUR/MWh”?
And another question: Wouldn’t this be completely solved if the price cap would be “set” on an hourly basis instead of a monthly basis? You hint in that direction at the end of the article but why isn’t this the solution to the dilemma? Let’s say the regulator fixes the price cap at 180 Euros per MWh:
March 15th, H14-H15: Power Price on Spot Market at 300 Euros means operator gets 300 Euros minus the difference to the price cap for that hour, so well in the positive range at 180 Euros and paying 120 Euros in taxes.
March 15th, H15-H16: Power Price on Spot Market at 180 Euros means operator gets 180 Euros and doesn’t curtail and pays 0 Euros in taxes.
March 15th, H16-H17: Power Price on Spot Market at 50 Euros means operator doesn’t curtail and gets 110 Euros (because let’s assume that is her/his subsidy level) while the government pays the 60 Euros in difference.
Isn’t the only problem the arbitrage between the current hourly price and the MONTHLY average price? Evaluating the tax on an hourly basis would simply take this arbitrage away, wouldn’t it?
Hi John,
To your first point: that was a bit of bad/confusing wording on my part. No I don’t mean the 30 EUR. I took those out of the last government proposal regardinng the structure of the price cap. Essentially, they want to leave the plant an extra 30 EUR to make sure not, to overtax them into making losses.
I meant a general buffer around my estimate of how the (monthly) RMV turns out. Say I start with 50% around my estimate and then decrease it doen to 0% as the month moves on.
Regarding your second question: well you solve a LARGE part of the problem, exactly as you describe. If you fix the “tax” hourly, the problem erodes on hourly spot, as there is no longer a difference between the RMW and the market value. However, then you push the problem into quarter hourly products and intraday. It’s exactly the same logic as between month RMW and houry spot; only that now you have hourly spot rmw and intraday market value.
But obviously the problem would be much smaller, as the price variance between a single monthly price average and 720 hourly market values on spot is greater than between an hourly spot price and 4 quarter hourly intraday prices.
Hope this helps…