Given the sharp increase in electricity prices across Europe this year, it is no surprise that politicians and policymakers are considering new measures to skim off corporate profits that are seen to be unjustified. But if such policies are not properly designed, they could do more harm than good.
MUNICH/COLOGNE – The energy crisis incited by Russia’s war in Ukraine has triggered intense debates in many countries about whether the windfall profits that energy companies are now making should be taxed. While this question concerns all companies that produce coal, gas, or oil, the focus currently is on electricity producers. Since a high gas price is driving up electricity prices across the board, suppliers with power plants that use other fuels or renewables can reap extremely high profits. And the immense burden of rising electricity prices on consumers has ratcheted up political pressure to tax “unjustified” profits.
Of course, windfall taxes face fundamental objections relating to tax symmetry and trust in applicable taxation rules. But, given the extent of recent energy-price increases, politicians want to skim energy companies’ profits nonetheless, just as they also want to protect other companies from unjustified losses associated with the crisis.
That is understandable. But if policymakers insist on taking this path, they will need to be mindful of the considerable implementation problems they will encounter along the way. Unless managed properly, any windfall profits tax that is imposed could make today’s energy shortages even worse.
Understanding the Industry
In the case of the electricity industry, critics have decried not only high profits but also the regulations governing price determination – that is, the so-called market design. Under the prevailing merit order system, the market price corresponds to the price offered by the most expensive power plant whose capacities are still needed. Currently, gas-fired power plants tend to have the highest costs because the price of gas is unusually elevated, whereas the costs of renewable energies and nuclear energy have hardly increased.
Since power plants do not offer their electricity below variable costs, and since a homogeneous product like electricity cannot have two market prices, it follows that in times of high electricity consumption, when gas-fired power plants are used, the electricity price will be at least equal to the very high variable costs (marginal costs) of the gas-fired power plants.
Accordingly, electricity producers using renewables or nuclear power will receive a price that is far above their variable costs. Under normal circumstances, the resulting surplus would cover fixed costs and serve as an investment incentive. Currently, however, the difference between the price of electricity and these suppliers’ marginal costs is so large that significant additional profits are often likely to accrue beyond the coverage of fixed costs.
Moreover, in large parts of Germany’s electricity market, at least, suppliers do not enter and exit the market freely, owing to regulatory measures that prevent investments in new nuclear and coal-fired power plants. A lack of investment incentives in the form of surpluses over and above variable costs is thus unlikely to create further distortions.
Ultimately, the same calculation underpinned the tax that the German government levied on nuclear power plant operators after the 2011 Fukushima disaster. But it is worth remembering that in 2017, the Federal Constitutional Court ruled against this tax and ordered the government to repay the money it had collected.
Some commentators see the merit order regime as a special market system that is unsuitable in the current situation. But this argument is misleading. The merit order is a normal supply curve that arises in competitive markets where homogeneous goods are traded. In markets for commodities such as copper or wheat, for example, there are usually producers with very different costs, but all receive the same price (in principle).
In the electricity market, this price must be based on the variable costs of the most expensive electricity-producing power plant. Production takes place in the order of costs – from cheap to expensive – and even the last producer needs a cost-covering price. This is true not because of any special electricity-market rule, but rather because that is how competition works. For analogous reasons, the price in a market equilibrium must not be greater than the smallest willingness to pay among those who purchase electricity. A market price equal to the average willingness to pay would be just as unattainable as a market price equal to the average variable costs.
Likewise, the often criticized “coupling” of electricity and gas prices does not follow from a special electricity-market rule or regulatory provision in the electricity exchange. Rather, it reflects the fact that prices depend on costs, and gas is a central cost factor for gas-fired power plants. Changing the merit order or the consideration of gas prices in the electricity market therefore cannot be achieved simply by changing the rules of the electricity exchange. While this does not mean that a windfall tax necessarily must paralyze the electricity market, it does mean that the matter is not as simple as some seem to believe.
Who Pays?
Additional profit taxes can be introduced in the energy sector in various ways, but a fundamental question is how to define the profits that are to be taxed. One option is to use the existing approach to profit taxation, where the first task is to define who falls under the regime. Then, an income-tax surcharge could be levied on energy companies, thus increasing the tax rate applied to their profits.
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If one proceeds this way, the main challenge is to determine which companies should pay the higher tax, and how much they should pay. At first glance, this seems straightforward. But energy companies that produce electricity or trade oil and gas often also pursue other activities as well. It is not easy to distinguish between activities that warrant a higher tax rate and those that do not, and the same issue applies to industrial companies that operate their own power plants – both consuming the electricity themselves and sometimes feeding it into the grid. Additional problems arise if one wants to tax revenues only above a certain profitability threshold.
Another set of proposals focuses on the electricity market and envisages skimming off part of the revenue from sales for which the price exceeds a certain level. This kind of levy would be made dependent on the type of electricity generation, with all power plants except gas-fired ones being subject to the tax. The threshold would be set above – but not too far above – the variable costs of the most expensive non-gas-powered plants.
If the electricity price exceeds the threshold, part of the difference between that price and the threshold value would be taxed. If the threshold value is set correctly, the tax would always be levied when electricity demand is so high that even gas-fired power plants, with their currently very high costs, must be used. To dampen the disincentive effect on investment, new power plants could be excluded from the tax – though investors might have already changed their outlook to anticipate additional excess-profit taxes in the future.
Beware of Unintended Consequences
One variant of this proposal is to introduce a tax-financed subsidy for gas-fired power plants whenever they are needed, so that the variable costs of gas-fired power generation fall and the market price for all other suppliers is equal to the price for the gas-fired power plants minus the subsidy. In a sense, the state would buy the electricity from the gas-fired power plants and sell it at a low price, thus depressing the market price.
A foreseeable problem with this method is that by reducing prices for consumers, it would also reduce the incentive to save electricity precisely when the gas-fired power plants are running. Households and businesses would consume more, and this demand would have to be met by using more gas in electricity production. The gas price would rise, gas would be lacking elsewhere, and governments would face additional costs, rather than generating revenue that could be passed on to the neediest. The more electricity that businesses and households consume, the more relief they would receive – until the supply runs out. As Spain’s recent experience with a variant of this idea shows, subsidies come with the considerable disadvantage of driving up energy consumption.
There are no such disadvantages with a tax on all power plants except gas-fired ones; but this approach creates challenges of its own. First, because electricity is often traded on futures markets, the wholesale price is not an indicator of the profits that actually accrue. An electricity producer that sold its electricity two years before production to hedge against risks cannot profit from high prices today.
Moreover, because the electricity sold on futures markets is usually not broken down by individual power plants, one cannot determine which revenue is generated with which technology. A solution to this problem could be to subject all electricity production to a levy, assuming, for example, an “average” hedging profile for a given power-plant technology, regardless of where and at what price the electricity was actually sold. Companies that can prove that their profits are lower than calculated with this method would then receive rebates.
An important risk associated with any form of profit absorption is that it can tighten the energy supply and thus aggravate the crisis further. In principle, an electricity supplier that reaps extraordinarily large profits will not cut production just because the profits are no longer quite as high after taxation, provided they are still substantial. But supply in a market can decrease if producers have the option to move their supply to other markets where profits are not subject to a windfall tax.
For example, if the tax is to be levied specifically in the day-ahead market, suppliers could easily avoid it by switching to other platforms such as balancing energy markets. They could also deliver energy abroad if the corresponding transport options are available. And, if the tax is applied inappropriately, the merit order could be upset, with less efficient power plants running first because the levy has not set their variable costs correctly. Experience with profit levies in the US oil sector shows that they can indeed reduce production.
Clear Priorities
As we have seen, a profit levy raises considerable legal and economic implementation problems. It would be met with evasive action, and design flaws would exacerbate the energy crisis. During implementation, authorities therefore would need to place particular emphasis on preventing the levy from reducing power supplies, increasing gas demand, or impairing the efficiency of the electricity market (especially since there is no discernible market failure in wholesale electricity trading). For example, the tax would need to be introduced across Europe, or at least in a larger group of countries.
The European Commission has already proposed a levy on excess profits accruing to energy companies outside the electricity sector. But the profits from oil and gas production in EU countries tend to be very limited, which suggests that the priority should be on profits in the electricity sector. Given all the problems with a direct levy on electricity prices, the best option is to resort to existing taxation instruments such as income taxes, or at least to use them as a supplement. At the same time, European policymakers must not forget that while the immediate challenge is to redistribute revenues and costs, the real solution to the crisis is an all-of-the-above expansion of the energy supply.
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MUNICH/COLOGNE – The energy crisis incited by Russia’s war in Ukraine has triggered intense debates in many countries about whether the windfall profits that energy companies are now making should be taxed. While this question concerns all companies that produce coal, gas, or oil, the focus currently is on electricity producers. Since a high gas price is driving up electricity prices across the board, suppliers with power plants that use other fuels or renewables can reap extremely high profits. And the immense burden of rising electricity prices on consumers has ratcheted up political pressure to tax “unjustified” profits.
Of course, windfall taxes face fundamental objections relating to tax symmetry and trust in applicable taxation rules. But, given the extent of recent energy-price increases, politicians want to skim energy companies’ profits nonetheless, just as they also want to protect other companies from unjustified losses associated with the crisis.
That is understandable. But if policymakers insist on taking this path, they will need to be mindful of the considerable implementation problems they will encounter along the way. Unless managed properly, any windfall profits tax that is imposed could make today’s energy shortages even worse.
Understanding the Industry
In the case of the electricity industry, critics have decried not only high profits but also the regulations governing price determination – that is, the so-called market design. Under the prevailing merit order system, the market price corresponds to the price offered by the most expensive power plant whose capacities are still needed. Currently, gas-fired power plants tend to have the highest costs because the price of gas is unusually elevated, whereas the costs of renewable energies and nuclear energy have hardly increased.
Since power plants do not offer their electricity below variable costs, and since a homogeneous product like electricity cannot have two market prices, it follows that in times of high electricity consumption, when gas-fired power plants are used, the electricity price will be at least equal to the very high variable costs (marginal costs) of the gas-fired power plants.
Accordingly, electricity producers using renewables or nuclear power will receive a price that is far above their variable costs. Under normal circumstances, the resulting surplus would cover fixed costs and serve as an investment incentive. Currently, however, the difference between the price of electricity and these suppliers’ marginal costs is so large that significant additional profits are often likely to accrue beyond the coverage of fixed costs.
Moreover, in large parts of Germany’s electricity market, at least, suppliers do not enter and exit the market freely, owing to regulatory measures that prevent investments in new nuclear and coal-fired power plants. A lack of investment incentives in the form of surpluses over and above variable costs is thus unlikely to create further distortions.
Ultimately, the same calculation underpinned the tax that the German government levied on nuclear power plant operators after the 2011 Fukushima disaster. But it is worth remembering that in 2017, the Federal Constitutional Court ruled against this tax and ordered the government to repay the money it had collected.
Some commentators see the merit order regime as a special market system that is unsuitable in the current situation. But this argument is misleading. The merit order is a normal supply curve that arises in competitive markets where homogeneous goods are traded. In markets for commodities such as copper or wheat, for example, there are usually producers with very different costs, but all receive the same price (in principle).
In the electricity market, this price must be based on the variable costs of the most expensive electricity-producing power plant. Production takes place in the order of costs – from cheap to expensive – and even the last producer needs a cost-covering price. This is true not because of any special electricity-market rule, but rather because that is how competition works. For analogous reasons, the price in a market equilibrium must not be greater than the smallest willingness to pay among those who purchase electricity. A market price equal to the average willingness to pay would be just as unattainable as a market price equal to the average variable costs.
Likewise, the often criticized “coupling” of electricity and gas prices does not follow from a special electricity-market rule or regulatory provision in the electricity exchange. Rather, it reflects the fact that prices depend on costs, and gas is a central cost factor for gas-fired power plants. Changing the merit order or the consideration of gas prices in the electricity market therefore cannot be achieved simply by changing the rules of the electricity exchange. While this does not mean that a windfall tax necessarily must paralyze the electricity market, it does mean that the matter is not as simple as some seem to believe.
Who Pays?
Additional profit taxes can be introduced in the energy sector in various ways, but a fundamental question is how to define the profits that are to be taxed. One option is to use the existing approach to profit taxation, where the first task is to define who falls under the regime. Then, an income-tax surcharge could be levied on energy companies, thus increasing the tax rate applied to their profits.
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If one proceeds this way, the main challenge is to determine which companies should pay the higher tax, and how much they should pay. At first glance, this seems straightforward. But energy companies that produce electricity or trade oil and gas often also pursue other activities as well. It is not easy to distinguish between activities that warrant a higher tax rate and those that do not, and the same issue applies to industrial companies that operate their own power plants – both consuming the electricity themselves and sometimes feeding it into the grid. Additional problems arise if one wants to tax revenues only above a certain profitability threshold.
Another set of proposals focuses on the electricity market and envisages skimming off part of the revenue from sales for which the price exceeds a certain level. This kind of levy would be made dependent on the type of electricity generation, with all power plants except gas-fired ones being subject to the tax. The threshold would be set above – but not too far above – the variable costs of the most expensive non-gas-powered plants.
If the electricity price exceeds the threshold, part of the difference between that price and the threshold value would be taxed. If the threshold value is set correctly, the tax would always be levied when electricity demand is so high that even gas-fired power plants, with their currently very high costs, must be used. To dampen the disincentive effect on investment, new power plants could be excluded from the tax – though investors might have already changed their outlook to anticipate additional excess-profit taxes in the future.
Beware of Unintended Consequences
One variant of this proposal is to introduce a tax-financed subsidy for gas-fired power plants whenever they are needed, so that the variable costs of gas-fired power generation fall and the market price for all other suppliers is equal to the price for the gas-fired power plants minus the subsidy. In a sense, the state would buy the electricity from the gas-fired power plants and sell it at a low price, thus depressing the market price.
A foreseeable problem with this method is that by reducing prices for consumers, it would also reduce the incentive to save electricity precisely when the gas-fired power plants are running. Households and businesses would consume more, and this demand would have to be met by using more gas in electricity production. The gas price would rise, gas would be lacking elsewhere, and governments would face additional costs, rather than generating revenue that could be passed on to the neediest. The more electricity that businesses and households consume, the more relief they would receive – until the supply runs out. As Spain’s recent experience with a variant of this idea shows, subsidies come with the considerable disadvantage of driving up energy consumption.
There are no such disadvantages with a tax on all power plants except gas-fired ones; but this approach creates challenges of its own. First, because electricity is often traded on futures markets, the wholesale price is not an indicator of the profits that actually accrue. An electricity producer that sold its electricity two years before production to hedge against risks cannot profit from high prices today.
Moreover, because the electricity sold on futures markets is usually not broken down by individual power plants, one cannot determine which revenue is generated with which technology. A solution to this problem could be to subject all electricity production to a levy, assuming, for example, an “average” hedging profile for a given power-plant technology, regardless of where and at what price the electricity was actually sold. Companies that can prove that their profits are lower than calculated with this method would then receive rebates.
An important risk associated with any form of profit absorption is that it can tighten the energy supply and thus aggravate the crisis further. In principle, an electricity supplier that reaps extraordinarily large profits will not cut production just because the profits are no longer quite as high after taxation, provided they are still substantial. But supply in a market can decrease if producers have the option to move their supply to other markets where profits are not subject to a windfall tax.
For example, if the tax is to be levied specifically in the day-ahead market, suppliers could easily avoid it by switching to other platforms such as balancing energy markets. They could also deliver energy abroad if the corresponding transport options are available. And, if the tax is applied inappropriately, the merit order could be upset, with less efficient power plants running first because the levy has not set their variable costs correctly. Experience with profit levies in the US oil sector shows that they can indeed reduce production.
Clear Priorities
As we have seen, a profit levy raises considerable legal and economic implementation problems. It would be met with evasive action, and design flaws would exacerbate the energy crisis. During implementation, authorities therefore would need to place particular emphasis on preventing the levy from reducing power supplies, increasing gas demand, or impairing the efficiency of the electricity market (especially since there is no discernible market failure in wholesale electricity trading). For example, the tax would need to be introduced across Europe, or at least in a larger group of countries.
The European Commission has already proposed a levy on excess profits accruing to energy companies outside the electricity sector. But the profits from oil and gas production in EU countries tend to be very limited, which suggests that the priority should be on profits in the electricity sector. Given all the problems with a direct levy on electricity prices, the best option is to resort to existing taxation instruments such as income taxes, or at least to use them as a supplement. At the same time, European policymakers must not forget that while the immediate challenge is to redistribute revenues and costs, the real solution to the crisis is an all-of-the-above expansion of the energy supply.