European power markets are in a critical state, with wholesale prices above retail prices on an almost daily basis and financial stress across much of the system.
We should not waste this crisis, but instead use it as a chance to reform and enable an electricity system that allows us quickly and effectively to move to a clean energy world.
How did we get here? For any market to work efficiently you need lots of buyers and sellers of a product, all of whom are able to respond quickly and effectively to price changes. Otherwise you tend to get price volatility, which causes stress for all market participants.
This is exactly the situation in Europe’s electricity markets today where the ‘demand’ side is not able to respond to price changes in a rapid and efficient manner, and where one very expensive fuel on the supply side (namely natural gas) determines the power prices for all players.
This in turn is causing inflationary stress for all buyers of energy and allowing many power producers, including those receiving government backed subsidies, to generate excess profits.
As we move to a world where at some times of the day too much electricity is produced in the form of variable wind and solar, we need to rethink power markets to ensure that those clean electricity plants are built cost effectively and to guarantee that the necessary dispatchable generation, flexibility and storage is in place to safeguard system resilience.
Finally, the Ukrainian-Russian crisis has added an extra element to the need to decarbonise – energy security.
Four big steps are needed:
Bring in a Lender of Last Resort
Most sellers and large buyers of energy use financial instruments such as forward contracts to hedge their risks and lock-in the prices they either receive or pay for that energy. These markets require ‘margin’ or cash to move through an exchange such as the European Energy Exchange from one party to another to ensure that counter-party risks are being met.
We are daily seeing massive swings in power prices from low (when it is windy and sunny) to high (when gas plants must be put on) and this volatility only increases the amount of margin firms need to place with the exchanges.
This is causing liquidity issues across the whole system and a bankruptcy of a system-relevant player could have very serious knock-on effects. It was thus very welcome that German state development bank KfW gave emergency liquidity to two utilities, Uniper and LEAG, and launched an emergency loan programme for troubled energy companies. That said, we probably need something more, and should consider allowing the European Central Bank or another European financial institution to provide any necessary liquidity that is needed by traders and producers across the energy landscape.
Involve the Consumer
There is a huge amount of governmental market intervention taking place across Europe in the energy markets much of which is designed to shelter customers from high energy prices. Many of these measures may win short term votes but they do not deal with the cause, which is that we are burning too much fossil fuel, most of it imported.
Involving and incentivising the consumer in moving away from fossil fuels needs to be a priority, particularly in this high-priced environment and continuing ‘economic war’ with Russia. Consumer assistance is needed to ensure that the lights stay on and that all our buildings are heated and at reasonable costs. Instead of shielding everyone from energy prices through a market intervention, low-income consumers should be assisted, and specific industries should be helped by enabling them to effectively and efficiently invest in energy efficiency measures.
One key initiative is to embed flexibility into the power system to allow participants to dynamically interact with each other to maximise resources, minimise costs, as well as to increase resilience, energy security and safety.
In practical terms, we need to put in smart meters and dynamic pricing and enable a digital world where consumers, be they small or large, are incentivised to delay non-critical consumption such as EV charging and to use whatever other flexibility that is available in the home or business such as hot water storage or EV batteries to benefit the whole system.
These measures would have the benefit of reducing prices to all customers as well as lowering price volatility in the energy markets which is critical for allowing efficient risk management to take place in the market. Enabling flexibility of energy demand would go a long way to ensuring that the demand curve for power becomes more elastic, making it much easier for a stickier equilibrium price to be found. This in turn would allow more efficient capital investment decisions.
Change how we incentivise zero-carbon power
The key to reducing the cost of the energy transition is to put in place measures that ensure that the lowest cost capital is used to finance investments in nuclear, wind and solar. The reason for this is that these technologies have zero or close to zero fuel costs and thus the major driver of electricity production costs is the Capex and the related cost of financing it.
To enable low-cost capital to flow, it is critical to lower investment risk for investments, which means putting in place something like a competitive long-term PPA based procurement mechanism such as a contract for difference (CFD) which give the necessary financial incentives.
What we should not do is put in feed-in tariffs which have no price ceiling as they allow generators to make windfall profits well beyond the tariff they are receiving. This is exactly the case in Germany where a ‘market premium’ is paid as a subsidy to cover the difference between a government defined renewable price and the wholesale market price. What this means is that a wind producer that is quite happy to receive €60/MWh in March of this year received an average price of €250/MWh. This represented €2.3bn in windfall profits to those producers in March alone which is about €2.50 per German household per day.
Reform the Merit-Order System
The electricity wholesale market follows a so-called merit-order system, meaning that everyone receives the same price for the electricity they are producing at any given moment. The actual price is determined via auctions where marginal plants, which are the most expensive plants allowed to generate in a particular time period, establish the price for everyone for that period.
Gas and coal plants set the prices three quarters of the time, despite producing less than a fifth of European electricity.
In practice, what this means is that gas and, to a lesser extent, coal plants set the prices three quarters of the time, despite producing less than a fifth of European electricity. More practically, a hydro producer who was last year receiving €50/MWh with production costs of say €40/MWh could, if they have not sold that power in advance, be receiving a profit of €100/MWh because wholesale prices, due to higher gas prices, are at €150/MWh.
One possible way to reform this pricing scheme is to put in place maximum prices for the fixed cost renewable and nuclear players which allows them to have their necessary returns on capital but does not allow them to gain windfall profits.
This is sort of what the Spanish government is now attempting to do by imposing a cap of €67/MWh on the prices that generators can receive for their power. However, this is a retroactive change and will only cause investors to shy away from investing in new energy infrastructure in Spain or to increase the cost of capital for any investments that do take place. That is a hollow victory for consumers.
What needs to be thought about is to how best to reduce the amount of time that natural gas is the marginal supplier and the price setter. An extreme short-term move would be to cap the gas price by providing gas power stations with some form of subsidy. That would bring wholesale power prices for all down but it would also distort the market, particularly in the medium term. The more sustainable alternatives are to use different forms of generation such as nuclear, hydro, biomass as well as storage and a better use of the power grid.
We need to make sure that French nuclear plants are repaired as quickly as possible and should also consider life extensions for existing nuclear plants. In addition, we have to put in place incentives to ensure that biomass and hydro plants have enough flexibility built in to enable them to react quickly to changes in the energy markets. Incentives will also be needed to ensure that storage capacities such as batteries and pumped hydro are built out and that regulations allow existing storage (such as electric vehicles and hot water tanks) to be more effectively used.
Finally, the transmission grid needs to built out from Northern Europe (which has constantly the lowest power prices) to Southern Europe and from West to East so that low cost wind can move across the system from windy to non-windy areas as a weather front goes across Europe.
Gerard Reid is a co-founder of energy-focused corporate finance advisory firm Alexa Capital, and a member of the World Economic Forum’s Future Energy Council
