Europe is getting more of its power from renewable resources every year but, as the current crisis has shown, energy markets remain at the mercy of increasingly volatile gas prices. The EU Commission recently proposed a plan to ease the crisis by decoupling electricity and gas prices. But the plan must strike a balance between tackling skyrocketing prices and protecting the cross-border energy market that the EU has been implementing in its member states. since the 1990s.
A key feature of liberalized energy markets is marginal cost pricing. Gas power is typically the most expensive source of electricity, and if this type of plant is required to balance supply and demand, it becomes what is called the marginal plant, effectively setting the price for the entire gas market. Energy.
Margin pricing is a feature of all commodity markets, and there is a clear economic logic to this model. Marginal prices send signals to producers who switch between different generation sources as supply and demand needs change. Consumers receive clear signals about scarcity, giving them the ability to adjust their consumption according to changing conditions. In the long run, persistently high prices provide incentives for efficient plants to drive expensive generators out of the market, thus lowering costs for consumers.
More recently, however, this electricity market model has exacerbated the energy crisis for consumers. As gas prices have skyrocketed, energy prices have followed. German futures, a key benchmark of the European power market, would normally trade at €40-50 (£35-44) per megawatt hour (MWh), but they were above €1,000/MWh. for the first time at the end of August 2022.
As a result, energy sources whose costs are not affected by changes in gas prices, such as wind, solar and nuclear, the so-called inframarginal plants, have seen their revenues increase significantly due to higher prices. This situation has been framed as producers of electricity extracting unreasonable profits, exploiting vulnerable consumers and profiting from the Russian invasion of Ukraine. In the midst of the current energy crisis, this is clearly politically unsustainable, which is why European politicians have had to act.
The Commission has launched a proposal to tackle rising energy costs in member states ahead of a meeting of EU energy ministers scheduled for September 30, 2022. A key part of this plan aims to tackle the problem by decoupling gas prices and energy.
choose a solution
The Commission’s preferred approach, which was first proposed by the German government, is to introduce a cap on the revenue that inframarginal plants (those that do not set the price) get from selling power on the market. The proposal would prevent these low-cost plants from obtaining above €180/MWh from the market for the next six months. Governments would use excess revenue to support vulnerable businesses and consumers. But this is not the only option on the table.
A separate joint idea from Spain and Portugal targets marginal plants. A cap is placed on the price that gas plants offer in the market, marking the price of energy offered by these generators at a gas price below the market. Generators are then compensated for the difference between the cap level and the wholesale gas price they face. This temporary measure was introduced in the Iberian market in June 2022 for one year to ensure that gas generators submit lower offers in the electricity market, which would depress prices.
This model is adapted to the specificities of the Spanish market in particular, since a relatively high proportion of national consumers have short-term contracts and are therefore highly exposed to market volatility. A disadvantage of this idea is that it distorts the price signal to consumers and, in the absence of other measures, would lead to higher gas consumption and potentially gas rationing.
The Greek government has also proposed a solution. This implies a more structural reform that splits the electricity market in two, based on the different cost structures of low-carbon and fossil fuel sources. Low-carbon sources operate “when available” and are remunerated based on long-term costs. Fossil fuel generators, along with flexible providers such as those that store electricity or provide demand response services (which encourage large consumers to adjust usage to accommodate changes in demand), operate “on demand” and they trade on a market designed around marginal prices. Consumers pay a weighted average in the two markets, which minimizes their exposure to high prices set by gas plants.
There is a growing interest in Concepts of “divided market” in the energy economics and policy community, but structural reforms cannot address the immediate crisis. It could take years to implement such a change due to the complexities and transition risks involved.
A plan for everyone
The Commission favors the German model because it preserves the marginal price signal, which is an important feature of the cross-border trading system. A measure like the Iberian model, which interferes with this pricing mechanism, could see capacity artificially limited at cross-border interconnectors, as countries will not want to see their subsidized energy simply exported to neighboring markets where prices are Taller.
The Commission wants to present its solution as pragmatic and practical. But energy markets are very complex, as trading takes place in multiple places and different time frames. As such, any intervention is likely to have unintended consequences. For example, it is not clear whether a revenue cap would interfere with the operation of crucial balancing markets and threaten security of supply. It is likely to hurt the investment case for flexible plants that can be scaled up and down to meet demand and are not dependent on gas.
there is already skepticism on the current revenue cap proposal, and it is believed that some Commission officials are in favor of the Greek model. There is a risk that the process becomes too politicized and makes countries go their own way. The European Commission is now under pressure to find a solution that member states can implement uniformly so as not to undermine the coherence of a market it has spent nearly three decades building.