Consumers could be protected from future price shocks by hedging through the retail market, public payments or investments – at costs that need to be carefully considered, writes Lion Hirth.

The unprecedented spike in electricity bills that European electricity consumers faced during the 2022 energy crisis was not only a huge financial burden on citizens and businesses but it also triggered massive ad-hoc policy interventions, many of which had severe side effects.

The 2021 Texas energy crisis is a reminder that it doesn’t require a war to send power prices through the roof; a cold spell can do the job, too.

While large industrial and tech companies have the possibility to protect themselves from price spikes by engaging in forward contracting and power purchasing agreements (even if many decided not to make use of this option in the past), such professional price hedging is out of reach for small consumers.

So what can be done to protect retail consumers from spiking electricity bills?

The energy crisis triggered an intense debate on electricity market design. This question, while arguably the single most important blind spot that the crisis exposed, receives oddly little attention.

Much of the electricity market discussion centres around long-term contracts between governments and generators, in particular so-called contracts for differences. That might come as a surprise, since by themselves such contracts do not protect a single consumer from price shocks. So what can be done?

I can see three principal options to hedge retail consumers against price shocks: through the retail market, through government payments, and through investments.

Each of these has important trade-offs and requires a significant change of current regulation. And each of them could, if not implemented carefully, derail the transition to a decarbonized economy.

Hedging through the retail market

The first option is to protect consumers through long-term retail tariffs, providing price certainty for maybe 2 to 5 years. Retail suppliers would, in turn, hedge themselves through forward contracts and power purchasing agreements.

Providing price shock insurance through electricity retailing requires answers to three questions. First, should long-term contracts be mandatory or voluntary?

In other words, should consumers decide themselves the volume and time horizon they would like to hedge? Individual risk preferences suggest so, but it seems a lot to expect from citizens to assess long-term price risks on electricity markets when even experts fail at this task.

Second, how should retail tariffs be designed? A fixed cent-per-kWh tariff, locked in for a few years, seems like a simple answer, but that turns out to be too simple.

While such tariffs protect against price risk, they also mute any incentives to conserve energy in times of crisis or provide demand-side flexibility, such as charging electric vehicles at times of abundant power supply.

It is difficult to imagine how we can build an energy system based on wind and solar energy when wasting the huge pool of decentralized flexibility. Instead, we need real-time pricing with built-in price insurance.

Under such “smart tariffs”, consumers pay an agreed-upon price if they consume along an agreed-upon profile, while deviations from expected consumption are settled according to the current spot price. For example, consumers would then earn the full financial benefit if they chose to charge their EV late at night rather than during the evening system peak.

The third question on long-term retail tariffs is how they square with retail competition and consumer protection. Utilities can only hedge long-term themselves through forwards and PPAs if they have a corresponding long-term retail contract.

Otherwise, during times of low power prices, customers would switch to an unhedged competitor, pushing their old supplier towards bankruptcy.

This is why simply mandating utilities to hedge long-term cannot work: retailers can only commit to a price for what they buy if they also get a commitment for the price of what they sell.

Long-term retail contracts, however, are problematic from a consumer protection perspective, because they could leave customers locked in with suboptimal contracts for extended periods of time.

This is precisely why laws across Europe limit contracts to two years, in energy, telecommunications and media.

This trade-off between hedging, competition and consumer protection could be solved by specifying a termination fee when customers switch contracts, paid from the new supplier to the previous one. The termination fee would compensate for the (positive or negative) value of hedges made by the former retail supplier.

Hedging through public payments

The second possibility to protect consumers from price shocks is through public payments. Such public payments should be rule-based per-capita lump-sum transfers from governments to citizens in case of high electricity prices.

Payments could be financed from the general budget or from contracts for the difference the government has signed with generators.

Payments should be lump sum in order to maintain efficient incentives to save energy and provide flexibility. Per-capita payments also tend to be progressive, i.e. benefit low-income households relatively more than the rich.

This could be enforced by making them taxable, i.e. apply progressive income taxes on payments. Per-capita payments are also simple and easy to explain. However, they cannot accommodate differences between individuals in consumption volume, e.g. in the case of electric heating, and do not address the needs of businesses.

Payments should be distributed as direct cash transfers from governments, but could also be channelled through electricity retailers if retailers have information about the number of persons served through each contract.

Payments need to be financed somehow. One option is to use the public budget. In this case, the instrument should be regarded as a fiscal or social policy and not be specified in electricity market regulations.

Alternatively, financing could come from public long-term contracts with power generators, such as contracts for differences: during episodes of high wholesale power prices such contracts generate revenues that are then paid out to consumers in form of lump-sum payments.

Public lump-sum payments then could be thought of as the “downstream” side of CfDs.

Hedging through investment

A radically different approach would be to enable citizens and businesses to directly invest in power generators in order to hedge electricity bills: consumers can invest in a public or private “PPA pool”, which engages long-term contracts with power generators.

Consumers would earn a return on their investment that is correlated with their electricity bills: during times of high power prices, they pay larger bills but also receive a higher return.

This line of thinking essentially extends the idea of self-generating electricity to the many Europeans who do not own a rooftop where they could install solar modules (or a field where they can install a wind turbine).

A PPA pool could be organized entirely outside the electricity market and would not require reforming it. While this approach is attractive in being voluntary and adaptable to consumers of different sizes, it comes with the obvious problem to require an initial investment and hence does not address the needs of low-income households.

Key takeaways

Apparently simple ways to protect European citizens and businesses from power price shocks, such as mandating utilities to hedge or to provide fixed cent-per-kWh tariffs, are likely to break either retailers or demand-side flexibility.

Instead, hedging could be organised through retail markets, state transfers, or investments.

All three avenues have important limitations and trade-offs and require careful assessment and significant political reform.

But we cannot let history repeat itself: If and when another energy crisis hits, European power consumers must be protected from skyrocketing electricity bills.