Paying consumers who save most energy could tame gas prices

The European Commission has sought to address the impact on consumers through, among other measures, the application of caps on the revenues of some electricity generating plants and windfall profit taxes on energy companies. However, a large share of the windfall profits are captured by gas producers which reside outside the EU, and member states cannot tax those.

Hence, various proposals have been made to cap the wholesale gas market price, with the commission landing on a gas price cap of €275 per megawatt hour for month-ahead title transfer facility (TTF) contracts.

The commission's "market correction mechanism" aims at limiting episodes of excessive natural gas prices which are unrelated to prices at other gas exchanges. This mechanism would be activated if the month-ahead TTF derivative settlement price exceeds 275 €/MWh for two weeks and the TTF European Gas Spot Index is €58 higher than the reference price during the previous 10 trading days. When activated, orders for month-ahead TTF derivatives with prices above €275 would not be accepted.

Some member states have already criticised this, claiming that it is insufficient. As discussed in a recent policy paper by EPICO, more ambitious price caps on gas would result in an increase in gas demand and could cause gas supply shortages.

In addition, if a cap or corridor is applied on the TTF gas price index, gas companies which sell gas at a price linked to the TTF may argue that that index no longer reflects the true market value of gas, and will sue for a change in the index used in the contract if the mechanism has a material impact on their sale price.

Further, while the mechanism would help reduce gas price volatility, it would not reduce the gas-price level, and sellers could circumvent them simply by moving to over-the-counter (OTC) transactions.

Russia has also threatened that it would cease all energy exports to the EU if a cap were to be applied, which would be problematic for member states which are still reliant on Russian gas imports. Worse, if the cap is applied, sellers of liquefied natural gas might divert their cargoes to other countries, potentially causing severe gas supply shortages in the EU.

In contrast, measures aimed at reducing gas demand would reduce gas imports, therefore reducing the market price of gas and electricity across the EU. The problem is that while all member states would benefit from a reduction in gas prices resulting from a reduction in gas demand, they have incentives to free-ride, waiting for other member states to reduce their own national demand.

Gas reduction auctions

As a solution, the commission could hold centralised pan-European gas demand reduction auctions.

Consumers could participate in these auctions, reducing their gas and/or electricity demand by some amount, in exchange of a payment for each unit of gas demand reduced (electricity demand reductions translate into gas demand reductions to the extent that gas is used to produce electricity).

Successful bidders would be paid a price that could be higher than the market price of gas, recognising the fact that their reduction in gas demand reduces the market price of gas across the EU.

Through the auction, consumers could be paid several times the market price of gas for not consuming gas. That may seem counterintuitive, but it simply reflects the fact that there is an 'externality' when consumers reduce their demand: not only do the consumers who reduce their demand benefit from the fact that they buy less gas, but all other consumers also benefit from the interlinked demand reduction and lower gas price — the 'externality' in this case.

As a result, for example, if the market price of gas is €100/MWhg, it may make perfect sense to pay consumers up to €1,000/MWhg for each MWHg of avoided gas demand (i.e. 10 times the market price of gas).

Member states would have to contribute to the funding of these auction payments in proportion to their own annual gas demand, regardless of where the consumers who reduce their demand are located. The reason is that all member states will benefit from the auction in the form of lower gas prices, and the benefit for each member state is in direct proportion to its own national gas demand.

The volume of 'demand reduction' accepted in the auction need not be a fixed or even a predetermined amount, but could be determined dynamically, taking stock of the situation in the gas market on an on-going basis.

To allay concerns about employment impacts, industrial consumers who commit to reducing their gas demand because of their participation in the auction could be required to continue paying workers while they themselves receive payment for reducing their demand.

Free-riding could be further discouraged in the case where the consumer does not reduce its demand by agreed target amount for which they were paid. In that case, the consumer would not get paid (or would have to return money received from the auction administrator) and the penalties specified in the auction rules would apply. The precise level of the penalties is not important; all that matters is that the penalties are sufficient to discourage participation by consumers who do not intend to reduce their demand.

However politically challenging it may be for member states to endorse such a centralised measure, they would all gain from it. It would achieve an immediate reduction in the price of natural gas (as traders anticipate that less gas will be needed in the future) and reduce the risk of gas shortages, to the benefit of consumers across the EU.