Price Formation in Energy Markets

Energy price fluxes have an impact on inflation and on economic activity as a whole, which affects the country’s competitive position. The extent of this impact depends on the extent to which the market structure, production system and economic cycle are energy dependent. Of particular importance are the variations in oil prices, whose fluxes are a source of frequent and profound impacts affecting the stability of global economy. Private consumption/production system compositional structure together with the dollar exchange rate, directly influence the extent of the inflationary effect exerted by an increase in oil prices.

From a microeconomic view point, an increase in energy prices alters companies’ running costs. The decision or the ability to translate higher costs into price increases depends on many factors, among which figure market structure, efficiency and competitiveness and elasticity of demand. From a macroeconomic viewpoint, regarding supply, the increase in running costs leads to a reduction in profits and, additionally, the margins allocated to investment in capital goods, which brings on a decline in production capacity, R&D, and production in the long run. With respect to demand, rates of consumption fall, thus having a contractionary impact on aggregate demand.

Oil markets are international markets sensitive to developments of an economic and geopolitical nature, and they play an increasingly important role. The prices of different types of crude oil are set from the price of reference crudes, Brent and WTI, by the application thereto of a premium or a discount based on differences in quality compared to benchmark crude. Thus, features such as oil density, sulphur content, distillation profile or geographic location are variables that will influence the price. Petroleum products have their own markets with their own market drivers. Factors such as seasonality, relative abundance or scarcity of the product in a given geographical area, or the prices of substitutes all determine fluctuations. Moreover, prices consumers pay incorporate tax charges, which may represent up to 70% of end prices.

Gas markets take the form of national and regional markets, with different characteristics. Gas transport is of great technical complexity, very costly and with inflexibility of destination, which explains this set up and the rigid business relationships based on long-term contracts that dominate international trade in gas. The prices of these contracts respond not only to the need to make investment projects viable, but also to keep prices competitive with other alternative energy sources. They are not, therefore, prices that reflect production costs.

Electricity markets are in some cases national, but most are, or are moving towards, regional markets. Liberalising trends are shaping competitive electricity markets, albeit marginally in the case of Spain. The different technical and economic characteristics of the kind of technologies generating electricity are what finally determine market prices.

Retail markets for both gas and electricity are fully liberalised. However, for certain consumers –mainly domestic consumers– legislation allows a choice between being supplied by the free market or by a last resort retailer at a controlled price called a “last resort tariff”. Gas and electricity prices are partially set administratively to remunerate the activities required for provisioning, which are controlled, given their nature, and are paid for by all consumers equally, regardless of the supply mode chosen. For the system’s economic stability, it is essential that the end price, paid by consumers, is sufficient to cover costs, thus avoiding the emergence of deficits and funding-related problems.

Maria Teresa Costa Campi. Professor of Applied Economics at the University of Barcelona (Spain).
Nuria Alonso-Borrego. Economist (Madrid, Spain).
© Mètode 73, 2012.

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