Are prices driven by costs?

Recently, the National Energy Regulating Authority (ANRE) announced that the energy price would again short-circuit consumers’ pockets. The price will grow 10.34%, much less than the 80.2% demanded by Hidroelectrica and the 33.1% requested by Termoelectrica.

When suppliers announce a price growth, they like to justify it with “arguments” that the raise was determined by higher costs. Newspapers frequently print this kind of announcements and, indeed, cases are rare when they omit to voice the regret that the unfortunate step was taken due to high costs.

For instance, the energy price has gone up because of higher prices on imported fuel oil (A‚51.8%), domestic fuel oil (A‚11.6%) and imported natural gas (A‚44.4%). Therefore, we can assert that costs are also driven by prices. More precisely, we will argue here that costs always depend on demand.

Naturally, we can wonder whether it is fair for energy suppliers to expect the price per MWh to grow from 861,000 lei to 950,089 lei because the fuel price has gone up. What if households and consumers are unwilling to pay more per MWh, how could the fuel price have grown at all?

The price consumers are willing to pay for energy is an important factor in establishing cost – that is, the price of fuel needed to produce energy. Consequently, energy producers, Hidroelectrica and Termoelectrica, will get paid more for their services. Is this the reason why producing energy is so expensive? Not really.

The causality relationship also works in the opposite way. It is true that people are willing to pay more per MWh, which is what makes it so expensive to keep production facilities running. These “production sites” are relatively few (especially since the drought reduced hydropower output by 7.75%).

This is the reason why demand for energy is increasing suppliers’ revenue, instead of increasing the number of production centres. But, for any consumer (household or industrial), the cost of energy supplies is dependent on others’ demand for energy.

Within this reasoning, we have attempted to find how costs of production resources (in our case, energy and fuel) are driven by demand.

Quantities of energy supplied or demanded depend on the choice people make after evaluating their chances. The energy supply depends on the cost of its delivery but the cost of this delivery is the value of chances lost in the act of delivery.

This concept of cost is expressed in economic theory in the statement that all costs relevant in decision making are the costs of chances. In other words, they represent the value of chances abandoned by selecting one line of action instead of another.

To the extent to which resources used to produce energy (for instance, fuel) can sometimes be procured with auctions, which are based on competition, production costs will reflect the value, for owners of resources (oil, gas or water) of using alternatives to these resources.

This line of thought makes the assumption that energy producers will want to suppress auctions for resources they use (oil, gas, water) and if they can identify an effective way to do it, they will.

The above suggests that many “disagreements” on the real costs of one thing or another could be resolved by recognising the fact that “things” cannot have costs. Only actions determine what chances are sacrificed and, therefore, only actions can have costs.

Consequently, costs are always the value of chances these people sacrifice. Contradicting statements on the costs of alternative decisions can often be reconciled with an agreement on the ones whose costs must be taken into consideration.

The energy price will grow to the level of chance, to the extent to which the owners of the said resources demand to have their value repaid out of their best use possible. This discourages the reckless use of resources and allocates resources for the uses which people value most in terms of money.

This is why resource owners should be offered higher prices – so they are prompted to transform a current activity into a chance they are willing to sacrifice. Demand helps establish costs. Costs contribute to establishing prices. Demand for fuel oil can influence demand for gas. In terms of the cost of chance, everything depends on each other.

Therefore, the economic manner of judging phenomena does not recognise “objective costs” such ass those argued by Hidro- or Termoelectrica. Of course, this offends the “common sense,” which teaches us that things should have “real costs.” For instance, the cost of energy is reflected in the cost of fuel.

The fastest way to disarm “common sense” is to point out that “things” don’t have costs attached. Of course, we are talking about relevant costs for the fuel supply – costs which have an impact on people’s decisions to deliver such goods. But things cannot have costs in that sense. Only actions have such costs.

For instance: what is the cost of one MWh? “$44.19,” you will say (assuming an exchange rate of 21,500 lei/$). But you mean $44.19 is the cost of acquiring a MWh from an energy producer (thermal or hydropower). Since the purchase of energy by consumers is an action, it can determine the sacrificed chances and, therefore, has a cost.

Remember, therefore, the association of the action to the determination of cost. In the case of other actions, the cost of energy changes. The cost of producing the energy is completely different. Its sale also has a different cost.

Largely, the sterile reasoning of the “real cost” of things, comes from the mistake of not knowing that only actions can determine different costs for different people. Therefore, decision makers are confronted with alternatives (and choose among them), and their options are a reflection of the comparison of benefits anticipated from each alternative.

The cost to the producer for supplying one MWh will be determined by what the producer must pay to obtain these resources (fuel oil, gas, water, etc.). And since these resources also have other chances of usage, the producer must pay a price that covers the value of “the best chance.”

The value of the lost chance thus becomes one of the production costs incurred in making one MWh. This is of particular importance because the significant cost in obtaining another MWh is the value of what must be abandoned, sacrificed or lost in order to obtain that additional kWh.

Take the example of this unit of energy – kWh. A part of the production cost is the fuel (fuel oil or natural gas – domestic or imported). Since the demand for energy remains, and drought has affected hydropower output, thermo-power stations have been forced to acquire a larger amount of fuel.

If this is a factor that drives the fuel price upwards, the cost of making one kWh will grow. Nothing has happened that would physically affect the resources involved in energy production, but its production cost has gone up. Since energy made with fuel is now more valuable than before, the energy producer must pay a higher cost of chance for the fuel it had to acquire.

Failure to understand these phenomena often inspires economic journalists “to criticise” (to the general public agreement) higher energy prices (two months after the latest price growth).

Why did the energy price shoot up in the last two months faster than inflation? Because the people who want producers to supply energy should be willing to pay enough to keep them in business. Since productivity in energy production has not changed, only a higher price per each MWh can prompt them to keep working.

We, with our refrigerators, televisions and computers, have raised the cost offered per each MWh to cover the growing cost of chance for the energy producers, of working in a sector where productivity has not grown in the latest months.

If a resource is someone’s property, there is no one to claim that potential users of that resources must pay the value of chances sacrificed through its usage (in our case – fuel).

Consequently, the resource will tend to be undervalued. And undervalued resources tend to be used less carefully and recklessly. Therefore, the saving incentive is weak when the cost of usage is low.