The unorthodox model of risk pricing behind the UK EMR #1: introduction

The UK government released its Electricity Market Reform (EMR) White Paper today. One of the central goals is increasing the share of low carbon electricity generation in the UK mix. The central premise is that the current price of carbon is too low, but also that a number of key institutional features of the electricity market create additional obstacles to investment in low carbon generation. Risk plays a big role in these additional obstacles. The institutional reforms proposed in the EMR transfer risk from corporate investors to the UK public, either as consumers or as taxpayers. The EMR claims that this risk transfer is beneficial to society.

I plan to use a series of posts to scrutinize in detail the EMR’s analysis of risk, investment in generation capacity and the costs and benefits to society. My central complaint is that the EMR’s analysis of the cost of risk is an unorthodox one, completely at odds with modern financial markets theory. It is only by baldly abandoning traditional financial calculus that the EMR is able to produce numbers that show a benefit to society. In fact, the proposed reforms threaten to load society with very costly risk that consumers and taxpayers may later regret.

The arguments made in the EMR have been kicking around among UK policy circles for a while, and I discussed the issue at a general level in a 2009 presentation at the London Energy Forum hosted by the London Business School available here. But the publication of the EMR White Paper and supporting documents offer the opportunity to examine the issues in more careful detail. The pressure to produce substantive numbers forces the advocates for these reforms to be more concrete in their analytic tools, and so it is easier to call attention to how the argument is so at odds with modern finance theory. Stay tuned.

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  1. […] week, the UK government submitted draft legislation on its Electricity Market Reform (EMR).  In a series of blog posts from last July, I critiqued the central premise underlying this insurance proposal. The touted […]

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