Field: Infrastruktur & kompetensförsörjning
Effects due to the electrification and Europeanization of the electricity market
The report addresses two important processes, both with far-reaching consequences for both the electricity market and for the Swedish economy: the Europeanisation of the electricity market as well as the electrification of industry, the transport sector, and other integral parts of society.
In addition, we address the ongoing transformation of electricity generation towards wholly renewable sources. We draw upon economic theory, in particular cost-benefit analysis, and general equilibrium models. This allows us to shed an empirical light on the consequences of the ongoing processes and make recommendations concerning the role of the state in this context. Should the state promote electricity-intensive sectors directly affected by the coming changes on the electricity market? If so, how should interventions then be designed?
Electricity-intensive sectors have long played an important role in our economy with Sweden having had comparative advantages in both electricity generation and value-added electricity products (such as the pulp and paper industries). We have, therefore, exported both electricity and pulp, as well as other products with energy-intensive production processes. Historically, Swedish electricity prices have also been relatively low, in comparison with many of our competitors. The ongoing process of improving the international power transmission infrastructure is, however, creating a situation where demands for energy in other parts of Europe can be met by Swedish electricity generation. This is levelling out electricity prices, as it leads to comparative advantages for exporting electricity relative to using it in energy-intensive domestic industry in Sweden. This conclusion should be seen in the context of the larger planned investments in electricity-intensive processes such as “green steel” (steel produced without fossil fuel).
The report has two parts: a conceptual component in which we describe our framework for cost-benefit analysis and an empirical component in which we apply the analytical framework to describe possible consequences of the changes we can discern in the electricity markets. We apply the framework to the energy tax cut that was implemented in 2017 for data centres. Lastly, we use the framework to inform our discussion on the role of the state.
Our empirical analysis consists of five parts. The first describes the development of the electricity markets, drawing on over 100 years of the history of electricity generation, before looking at future developments. When viewed in a historical perspective, we see considerable challenges ahead considering the goal of doubling domestic electricity generation within 20 years to meet “needs” detailed in the so-called “Road Maps” for electrification. It is difficult to discuss “electricity needs” without a discussion on the price of electricity. We all “need” a variety of things, without necessarily being able to afford them. Given these circumstances, we maintain that on the future electricity market there is only a small risk for a shortage of energy, but rather an increasing risk for a shortage of power. On the other hand, many parties have indicated possible transmission-related bottlenecks. This may be accentuated by coming changes to the legislative environment, such as the reassessment of environmental permits for Swedish hydropower plants following the EU Water Framework Directive. Seen together, these circumstances contribute to raising questions as to the future price of electricity.
To understand the factors that determine electricity prices, in the second part of the report we penetrate the electricity market’s fundamental functioning in a partial equilibrium model. We demonstrate how electricity prices are determined in the four Swedish electricity price regions (SE1-SE4). The model is a way to understand existing price differences between northern and southern Sweden, as well as the consequences of electrification and Europeanisation. The converging electricity prices in Europe leads, according to the model, to higher prices (particularly in the north), which in turn stimulates more electricity generation, but slows electricity-intensive sectors (which has effects on other parts of the economy; knock-on effects are discussed below). Electricity exports replace, in some ways, steel exports (“value-added electricity”). The two processes in focus for this report are stimulating a structural transformation of the Swedish economy, albeit, in a different direction than is often discussed in conjunction with the ongoing investments in Norrland (northern Sweden) such as green steel, etc. This reasoning is based upon the results of a partial equilibrium model, best suited for analysing the consequences for one market. We will soon address a more general model.
We also use the partial equilibrium model to raise issues that fundamentally concern free trade. One way to mitigate the consequences of Europeanisation is to shift the focus from foreign transmission to strengthening the domestic electricity net. The most extreme example would be “cutting the cables”, even within the country. This would result in a much lower electricity price in the north (as there is often a generation surplus in the north) and a higher price in the south. This example may seem far-fetched but, truth be told, statements such as, “electricity is needed in the north”, can be heard today.
The third part of our empirical analysis dives deeper into how the coming changes can affect electricity-intensive industries. Our econometric analysis shows that the effects of increasing electricity prices on electricity-intensive industry are notable, assuming that increased prices cannot be passed on to consumers. In the electricity-intensive paper and pulp industry, we can expect significant (negative) effects on employment, investments, and production. We must also caution that parts of the paper and pulp industry have their own electricity generation capacity. The conclusion from the econometric analysis is, however, as expected. An increase in the electricity price has consequences for electricity-intensive industry if the cost increase cannot be passed on to customers/distributors. The cost increase varies across industries, depending on their electricity intensity.
An increased likelihood of power outages is a consequence of the transition to an electricity-generation system where a larger share of power generation cannot be planned. We look more closely at the costs of power cuts for industry in the fourth part of the empirical analysis. The willingness-to-pay (VoLL - ‘Value-of-Lost-Load’) to avoid power outages can be considerable, depending on which industry is affected. The willingness-to-pay per kilowatt hour (KWh) is the greatest for the automobile industry, the paper and pulp industry, and the chemicals industry (measured in losses per hour). The ranking according to VoLL per KWh says something about how to target electricity rationing, while VoLL per hour is a better measure for cost-benefit analysis of investments for increased energy security.
The fifth part of our empirical analysis uses a general equilibrium model. It is based on the idea that an economy consists of many inter-dependent markets. We put particular focus on international trade, which is natural, giving the issues addressed in this report. In contrast to the partial equilibrium model and the econometric analysis, it is now possible to allow costs to be passed-on both upward and downward in the value chain. The estimations described above can thus be seen as the upper limit for costs. General equilibrium models also address the fact that a price increase is negative for a buyer of a good, but positive for the seller. Productive resources are directed where they generate the greatest profit. In such a model with an increasing electricity price, we therefore see a shift of labour, capital, and other resources from electricity-intensive industry to electricity generation. We use the overarching objective of the European Commission’s legislative package, Fitfor55, to represent the increase in electricity demand. Its ambition is to achieve the EU’s goal of zero carbon emissions by 2050 through a 55 per cent decrease in net greenhouse gas emissions in 2030 (as compared with 1990). The package is comprehensive, and important elements for Sweden include expanding the emissions trading scheme and a revision of the forestry strategy. For the purposes of this report, the package represents the increase in demand for electricity as (i) fossil fuels are replaced with electricity and (ii) older technologies are replaced by new technologies based on electricity (such as green steel). The new technologies are not assumed to be profitable given today’s price on greenhouse gases, but they can become profitable as the price increases.
Our estimations indicate that the possibility to pass-on the increased electricity costs, and costs for the green climate transformation in general, are to be found on export markets. One such example is Sweden’s dominant position in iron ore production within the EU. Other electricity-intensive sectors can find it considerably more difficult to pass on price increases.
The impacts on competitiveness are complicated by the fact that we have comparative advantages in both electricity generation and electricity-intensive value-added products. The most important result of our analysis is that electricity generation is expanding, and electricity-intensive industries as a group will be impacted negatively by increasing electricity prices. This result corresponds with the predictions of our analytical framework. The more specific impacts on various parts of society and the economy depend on what assumptions we make. These include the assumption that the electricity market is wholly integrated (the so-called “copper plate electrical market”), that Sweden is a small, open economy with given prices on export and import markets, etc. Overall, we can conclude that we will see a structural transformation, shifting towards electricity generation and a relative decrease in the role of value-added electricity.
In short, the results of our analysis are as follows:
Our analytical framework can be used for a comprehensive analysis of various types of public subsidies for electricity-intensive sectors (a so-called general equilibrium model). We use the framework to examine the energy tax relief granted to data centres since 2017.
The analytical framework also provides a basis for discussing broader spillover effects on the economy. Whether or not a multiplier effect (such as how many jobs the investment creates in other businesses) should be applied depends upon the functioning of the market. If the markets function well, the multiplier effect is assigned the value zero, as the resources that are used by the investment have an alternative allocation with a value equal to their market price.
The electrification of industry and the transport sector, changes in the mix of electricity generation sources, as well as a Europeanisation of the electricity markets will, together, lead to not only a higher electricity price, but also a more volatile price. This has major consequences for electricity-intensive industry, primarily through increased prices.
Our estimations indicate a general negative impact on the competitiveness of the manufacturing industry, though the results vary across sectors.
The results for the different sectors depend, among other things, on whether they can pass on the increased costs. In other words, they depend on whether industry can charge higher prices on export markets to compensate for increased production costs.
Changes in the electricity market increase the risk for transmission interruptions in the form of power outages. The costs for these may be considerable, depending on the type of economic activity affected. A reliable electricity supply is central for the electricity-intensive industry, as the costs of power supply interruptions can be great.
Our recommendations are, therefore, as follows:
The state’s most important role in supporting electricity-intensive sectors is broad-based R&D subsidies. Subsidies can be motivated in the case of market failures, that is, when market mechanisms do not function efficiently. Subsidies for energy efficiency and correcting information failures may occasionally be motivated. A traditional argument for subsidies is that an “infant industry” can require support in its early development phase. However, overall, we find that subsidies should rather be focused on broad-based R&D programmes, than given as targeted tax cuts for specific sectors, such as data centres. For this reason, removing energy taxes levelled on electricity (for all end users) can also be motivated.
The quota system for renewable electricity and the associated electricity certificate system can in some ways be seen as an indirect subsidy for electricity-intensive industry as it contributes to increased electricity production and lower generation costs. The system is to be phased-out by 2035, and we have not seen that it merits an extension. The main reason for this is that it is difficult to identify positive externalities associated with subsidies for a specific type of electricity generation.
Several EU member states employ various types of subsidies for electricity-intensive industry and differences in electricity prices are thus, de facto, not as great as they appear to be in official statistics (Sweden appears to have some of the lowest electricity prices). The basic principle, from an efficiency perspective, should be to allow the markets to operate without subsidies.
Public investments should be as cost effective as possible and only made when benefits are deemed to exceed costs. If this principle is followed strictly, the probability increases that such investments are made in areas where they create the greatest benefits for society. This principle entails, for example, that investments in the transmission network are only made where they have a net benefit, rather than to satisfy energy policy objectives.
The government should implement the Swedish NAO’s recommendation from 2017 to consider soliciting a “second opinion” in the form of an impartial business impact assessment for state-owned companies, prior to making major investments. This would supply a broader analytical base for decision-making. In addition to a business impact assessment, a broader cost-benefit assessment for society should be made.
Value-added electricity produces no additional value beyond its market price. In light of state subsidy regulations, public aid for energy-intensive export industries producing value-added electricity should therefore be motivated should therefore be motivated in other ways.
Social equality issues, which are outside the scope of this report, merit analysis. Low-income households will probably prefer the lower electricity prices trade-restrictions on electricity will imply, whence “free trade” will inevitably lead to higher electricity prices in Sweden. On the other hand, the gains from free-trade means that there is a greater scope for compensating low-income households. We therefore maintain that Sweden should pursue the free-trade imperative also when it comes to electricity, combining it with a detailed analysis of distributional issues. In contrast with the government’s intended design of “electricity price subsidies” in 2022, our analytical framework demonstrates that it is better to use lump sums as compensation, rather than earmarking subsidies for specific electricity consumption levels or (as in Norway) to a specific electricity price.
Effects due to the electrification and Europeanization of the electricity market
Serial number: Rapport 2022:02
Reference number: 2020/233