European electricity markets are in critical condition, with wholesale prices higher than retail prices on an almost daily basis and financial stress across much of the system.
We must not waste this crisis, but rather use it as a chance to reform and put in place an electricity system that allows us to move quickly and efficiently to a clean energy world.
How did we come here? For a market to function efficiently, there must be a large number of buyers and sellers of a product, all able to react quickly and efficiently to changes in price. Otherwise, you tend to get price volatility, which causes stress for everyone in the market.
This is exactly the situation in European electricity markets today, where ‘demand’ is not able to react to price changes quickly and efficiently, and where a very expensive fuel on the supply (i.e. natural gas) determines electricity prices for all players.
This in turn causes inflationary stress for all energy buyers and allows many power producers, including those receiving government-backed subsidies, to generate excess profits.
As we move towards a world where, at certain times of the day, too much electricity is generated in the form of variable wind and solar power, we need to rethink electricity markets to ensure that these clean power plants are built in a cost effective manner and to ensure that the distributable generation, flexibility and storage are in place to maintain system resiliency.
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Finally, the Ukrainian-Russian crisis has added an additional element to the need to decarbonize: energy security.
Four main steps are necessary:
Use a lender of last resort
Most sellers and large buyers of energy use financial instruments such as futures contracts to hedge their risk and lock in the price they receive or pay for that energy. These markets need “margin” or liquidity to move from one party to another through an exchange such as the European Energy Exchange to ensure counterparty risks are met.
We see massive fluctuations in electricity prices every day, from low (when it’s windy and sunny) to high (when gas plants are due to come on stream) and this volatility is only increasing. the amount of margin companies must place with stock exchanges.
This leads to liquidity problems in the whole system and the bankruptcy of a player relevant to the system could have very serious repercussions. It was therefore very welcome that the German public development bank KfW provided emergency liquidity to two utilities, Uniper and LEAG, and launched an emergency loan program for struggling 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 needed by traders and producers in the energy landscape.
Involve the consumer
There is a huge amount of government intervention in energy markets across Europe, much of it designed to protect customers from high energy prices. Many of these measures may win votes in the short term, but they do not address the cause, which is that we are burning too many fossil fuels, most of which are imported.
Engaging and enticing the consumer to move away from fossil fuels must be a priority, especially in this environment of high prices and ongoing “economic warfare” with Russia. Consumer assistance is needed to ensure the lights stay on and all of our buildings are heated and at reasonable costs. Instead of shielding everyone from energy prices through market intervention, low-income consumers should be helped and specific industries should be helped by enabling them to invest effectively and efficiently in energy efficiency measures.
A key initiative is to build flexibility into the power system to enable participants to dynamically interact with each other to maximize resources, minimize costs, as well as increase resilience, energy security and safety. .
Concretely, we must introduce smart meters and dynamic pricing and enable a digital world where consumers, whether small or large, are incentivized to delay non-critical consumption such as electric vehicle charging and to use all other flexibility available in the home or business, such as hot water storage or electric vehicle batteries, to benefit the whole system.
These measures would have the benefit of lowering prices for all customers as well as reducing price volatility in energy markets, which is essential to enable effective risk management in the market. Allowing flexibility in energy demand would go a long way to making the electricity demand curve more elastic, which would make it easier to find a more rigid equilibrium price. This in turn would allow for more efficient capital investment decisions.
Changing the way we promote zero carbon energy
The key to reducing the cost of the energy transition is to put in place measures to ensure that the cheapest capital is used to finance investments in nuclear, wind and solar. The reason for this is that these technologies have zero or near zero fuel costs and therefore the main driver of electricity generation costs is Capex and the related cost of financing it.
To allow low-cost capital to flow, it is essential to reduce the investment risk for investments, which means putting in place something like a competitive procurement mechanism based on a long-term PPA, such as a contract for difference (CFD) which gives the necessary financial incentives. .
What we shouldn’t do is put in place feed-in tariffs that don’t have a price cap because they allow producers to make windfall profits far beyond the tariff they receive. This is exactly the case in Germany where a “market premium” is paid in the form of a subsidy to cover the difference between a renewable price set by the government and the wholesale market price. This means that a wind producer who is quite happy to receive €60/MWh in March this year received an average price of €250/MWh. This represented 2.3 billion euros in windfall profits for these producers in March alone, or around 2.50 euros per German household per day.
Reform the merit order system
The wholesale electricity market follows a so-called merit-order system, which means that everyone receives the same price for the electricity they produce at any given time. The actual price is determined via auctions where marginal power plants, which are the most expensive power plants allowed to produce during a given period, set the price for everyone for that period.
Gas and coal-fired power stations set prices three-quarters of the time, yet produce less than a fifth of Europe’s electricity.
In practice, this means that gas and, to a lesser extent, coal-fired power stations set prices three-quarters of the time, while producing less than one-fifth of Europe’s electricity. More concretely, a hydroelectric producer who received €50/MWh last year with production costs of €40/MWh could, if he had not sold this electricity in advance, receive a profit of €100/ MWh because wholesale prices, due to higher gas prices, are at €150/MWh.
One possible way to reform this pricing system is to put in place maximum prices for fixed-cost renewable and nuclear players that allow them to have their necessary returns on capital but do not allow them to make windfall profits.
This is in a way what the Spanish government is now trying to do by imposing a cap of €67/MWh on the prices producers can receive for their electricity. However, this is a retroactive change and will only prevent investors from investing in new energy infrastructure in Spain or increasing the cost of capital for any investment that takes place. This is a futile victory for consumers.
What needs to be considered is how best to reduce the length of time that natural gas is the marginal supplier and price setter. An extreme short-term measure would be to cap the price of gas by giving gas-fired power plants some form of subsidy. This would lead to lower wholesale electricity prices for all, but it would also distort the market, especially in the medium term. The most sustainable alternatives are to use different forms of generation such as nuclear, hydro, biomass as well as storage and better use of the electricity grid.
We must ensure that French nuclear power plants are repaired as quickly as possible and we must also consider life extensions of existing nuclear power plants. In addition, we need to put in place incentives to ensure that biomass and hydropower plants have sufficient built-in flexibility to allow them to respond quickly to changes in energy markets. Incentives will also be needed to ensure that storage capacities such as batteries and pumped hydroelectricity are built and that regulations allow more efficient use of existing storage (such as electric vehicles and hot water tanks).
Finally, the transmission grid needs to be built from northern Europe (which consistently has the lowest electricity prices) to southern Europe and from west to east so that low-cost wind can moving through the system from windy to non-windy areas as a weather front. crosses Europe.
Gerard Reid is co-founder of energy-focused corporate finance advisory firm Alexa Capital and a member of the World Economic Forum‘s Future Energy Council.