Since the end of summer 2021, the whole of Europe has been hit by an unprecedented energy crisis. The causes are manifold, and geopolitical tensions have been perpetuating price developments.
A malfunctioning power market?
The high prices we currently witness in Europe hurt end-consumers and businesses alike. The wholesale power markets quickly moved into the focus of the public debate, with policymakers claiming the EU spot power market had become “inadequate” and its “malfunctioning” was to be blamed for the crisis. But in reality, this is not the case. Electricity is a commodity that cannot be stored efficiently. Therefore, EPEX SPOT operates short-term markets that balance supply and demand, with delivery of the traded electricity on the same or on the following day. These short-term markets with physical delivery are also referred to as spot markets. The derivatives market is another type of market where electricity is traded. It provides financial contracts to mitigate risks of changes in spot prices and trading takes place up to several years before delivery.
Power markets in general and the spot market in particular reflects a fundamental supply and demand situation expressed via a price signal. It is called price signal for a reason, since it contains important information.
In Europe, the price formation process of the spot power market follows a mechanism that favours the use of the least expensive generation technologies while securing supply for European end-consumers.
How is the wholesale spot price for electricity calculated? Why is the spot market price signal important and how do we cope with the crisis? Here are some answers to the most pressing questions.
The price formation process
This price for power is based on prices on the wholesale spot electricity markets, which are operated by EPEX SPOT. The wholesale power market brings together producers that sell electricity, and suppliers that buy electricity, to then have it delivered to their customers.
Source: ACER 2021
Marginal cost and merit order
Price formation on the EU Day-Ahead spot power market is based on marginal cost, which indicates how much it costs a producer to generate one additional MWh of electricity. Power plants are put on the market by the order of their marginal production cost, starting with the least expensive up to the most expensive plant, activated in that order to meet demand. The last activated plant sets the price. All producers are paid the same price €/MWh for the same product: electricity.
The least expensive marginal production costs are usually renewables, the most expensive plants are gas and coal plants. In addition, the use of coal and gas generation in Europe needs to be covered by CO2 certificates, creating a direct connection between electricity pricing and CO2 pricing, as well as prices for coal and gas.
The marginal cost pricing system
- ensures that demand is always met at the lowest possible cost, because cheap producers are dispatched first
- enables all generators to always cover their costs, ensuring security of supply. If producers know they can always cover they cost, then they have an incentive to run their units when they are needed.
- incentivises generators to offer their production at a price not higher than their actual operating costs. If they did offer electricity at a higher price than their true marginal cost, then they would risk not to sell at all, because orders of other producers who bid at their true marginal cost would be executed to meet demand.
The power market as a barometer
Unlike other commodities, electricity cannot be stored efficiently. This makes the electricity market an essential tool to balance the overall system and ensure that supply matches demand at all times. The Day-ahead and Intraday power markets operated by EPEX SPOT are physical markets. Unlike on financial markets, every single transaction on the power spot market leads to a physical delivery of electricity. The electricity price is determined by EPEX SPOT 24/7, and for the whole of Europe.
The electricity price surge we have been observing since Autumn 2021 has different causes, some of which are:
- High global gas demand as a consequence of the post-covid economic pickup
- Low supply, meaning low wind, lower-than-usual gas storage, hydro-reservoirs levels, and nuclear availability
- High CO2 prices, that drove up further the costs of ramping up conventional power plants.
The prices of the power market fully reflect these challenges that developed in the past two years. Instead of “breaking the barometer” by interfering in the price formation process, it is crucial to address the real causes of the price surge while taking measures to protect the vulnerable end-consumer.
Dealing with the energy crisis and the high prices
Build on the existing solid market infrastructure
Instead of throwing overboard what has been achieved over more than 20 years, stakeholders should focus on the following:
- To further integrate the European electricity market, as it is key for Europe’s energy security. This means offering new products – like Pan-European Intraday Auctions and developing further cross-border trading and flows. Europe’s power exchanges ensure the optimal use of all interconnections.
- To move away from fossil-fuelled generation by investing massively in renewables and flexibility sources and efficiently integrate these green energy sources in the market. Tailor-made trading solutions to achieve this already exist on all EPEX SPOT markets.
- To allow reliable and transparent price signals to emerge, to trigger investments in decarbonised technologies. Price signals should also help electricity consumers to adjust their consumption behaviour.
- To monitor measures such as a revenue cap on inframarginal technologies or a price cap on gas for bidding in the power market. Such measures do, theoretically, not directly impact the price formation process on the wholesale market, but if and how they have an indirect impact on the efficiency of the market highly depends on the details of their implementation.
- To protect vulnerable consumers – such measures are indispensable. They should, however, not undermine the efficiency of the wholesale market, because market distortion would in the end generate costs that would be passed on to the end-consumer. The European Commission has developed and implemented several proposals that provide relief for end-consumers, such as the REPower EU package
If governments suddenly change the rules on how prices are set, this would freeze all investments in renewable generation and as a consequence decrease security of supply. Furthermore, consumers should have sufficient information to choose their preferred level of risk exposure and be enabled to cover this risk.
The pan-European electricity market is the most efficient one in the world build up over more than 20 years and it acts as a model for other regions. EPEX SPOT is contributing to the well-functioning of the market and facilitates the energy transition by continuously working on innovations.
The Energy Crisis - Q&A
Is the power market failing?
The market is not failing. It reflects the fundamentals of demand and supply as accurately as possible. In these times of turbulence, the market is providing strong price signals. The move away from fossil fuels has become even more pressing in the recent geo-political context.
Transparent and reliable price signals that correctly reflect market fundamentals are the best tool to trigger efficient production and consumption decisions and to drive investments in the right generation capacities. Measures to regulate or structure the market would not preserve this investment signal but distort it, necessarily leading to a standstill of the much needed transition.
What is the Merit order and why is it important?
The price formation process on the pan-European Day-Ahead market follows the merit order principle. This principle guarantees the lowest possible prices to satisfy demand on the power market, as the generation with the lowest costs (or the willingness to sell at the lowest price, to be more precise) is dispatched first.
According to the merit order principle, the most expensive unit that has to be activated to meet the demand sets the price. In turn, this also means that the cheapest units, often wind and solar, are dispatched first.
The actual market price is where the supply of power matches demand. In the Day-Ahead market, which also produces the settlement price for the derivatives markets, a uniform price is determined where the curves for supply and demand intersect, at a total volume that is derived from the optimisation of overall social welfare. Among the successful orders, this price represents the highest price that a buyer is willing to pay and the lowest price a seller is willing to accept. This allows generators that are able to produce at lower prices to recover their investment costs. When criticising high prices, one should also consider that they deliver investment signals, promote energy efficiency, and that they make additional public support unnecessary.
Should the gas and electricity prices be “decoupled”?
The question should rather be if they are truly coupled, and when? Only when demand cannot be met with the cheapest production methods, the higher priced units such as gas-fired units are activated. This means that there is no compulsory link between the electricity and the gas price. Gas units only set the electricity price in certain times, i.e., in hours, when all cheaper production units have been fully exploited. With more renewable generation able to satisfy demand, the expensive gas units would have to be activated later – or not at all.
Why is marginal pricing important for the energy transition? Should we abandon it because of the crisis?
The least expensive unit in terms of marginal costs are usually renewables, the most expensive plants are gas and coal plants. However, the initial investment and maintenance costs for renewable plants are rather high, while the investments and maintenance costs for coal and gas plants are one-time and rather constant. This is why it is important that also generators with low marginal costs like renewables can recover their investment costs.
The marginal cost pricing system enables all generators to cover their costs, ensuring security of supply, while incentivising generators to offer their production at a price not higher than their actual operating costs.
Only by reducing our dependence on fossil fuels, we can secure supply at reasonable prices for Europeans. Especially in a situation of scarce supply, the price formation mechanism has an essential function of information and coordination. It can reveal more efficiently than any other mechanism which use of the scarce resource energy has highest economic value. To deliberately discard or modify this information would be a huge loss.
Are we paying also for the energy bills of our European neighbours?
The integration of European markets (Market Coupling) creates net benefits for European consumers. It optimises the use of energy resources across borders and increases security of supply. In 2021 the European Union Agency for the Cooperation of Energy Regulators (ACER) estimated the annual social welfare benefit for market coupling up to 34 billion EUR/year, which illustrates its importance.
Why are the energy prices so volatile at the moment?
In addition to the high prices, the electricity market has seen increased price volatility, which is an indicator for the need for more flexibility in the system. Flexibility is the capacity of actors to ramp up or down their demand or their supply.
Further flexibility in the system can be enabled in the form of even closer interconnection between the already well connected markets. It can also be in the form of incentives for certain established technologies, such as battery storage or demand-response units that can flexibly ramp up and down their production and consumption. With the right price signals, we can ensure that the flexibility is used in an efficient manner and that providers are remunerated.
Is the Iberian model a better option to regulate the electricity price? Shouldn’t we just extend this model to the whole of Europe?
The so-called Iberian model is a modification of the power market design that is specific to the Iberian Peninsula. It has been in place since June 2022 and mainly consist of a €40 MW/h cap on gas used for power generation, gradually increasing every month This cap has lowered electricity prices in Spain and Portugal, but only by 15%. In addition to this, gas usage is higher than before the crisis. The payments made to gas-fired production units to make up for the difference between the real gas price and the artificially capped gas price are financed by the end-consumer.
Could such a cap make sense across Europe? The answer is no. Especially if applied only by few EU Member States, this cap would distort cross-border flows of electricity, putting at risk security of supply and the optimisation of the European electricity system. Through Market Coupling, low supply in one country raises the power price, attracting power flows from the neighbours. A price cap would hide such supply shortage signal by making prices artificially lower. This artificially cheap European power would then mechanically be exported and flow to neighbouring countries, aggravating the supply shortage in Europe. In addition, the cap would burden taxpayers’ finances.
The same would happen if this mechanism was to be extended to the whole of Europe. The gas scarcity wouldn’t go away but it would be made worse because more artificially cheap- gas would be used than the produced electricity, which in the end would be exported to higher-priced regions outside of Europe.
A measure like this disrupts the meaningful price signal and Market Coupling mechanism at a European level and endangers the decarbonisation path not only in Iberia peninsula, but in the whole European market.
Should we change our pricing model from pay-as clear to pay-as bid?
Today, the price formation mechanism in the European Day-Ahead auction follows a pay-as-clear model based on marginal pricing. Via this mechanism, the cheapest generation capacities are always activated first (in the so-called “power generation merit curve”), ensuring demand is always met at the lowest possible cost. Power plants are put on the market by the order of their marginal production cost, starting with the least expensive up to the most expensive plant, and activated in that order to meet demand. The last activated plant sets the price. All producers are paid the same price €/MWh for the same product: electricity. Everybody receives the so-called Market Clearing Price in this pay-as-clear model.
This mechanism gives investment signals in new clean technologies and allows power generators to cover their costs, eventually ensuring security of supply.
An alternative market setup, as implemented on the Intraday continuous market (an adjustment market complementing the Day-Ahead reference market), is ‘pay-as-bid’. This means that sellers submit bids and as soon as a buyer accepts, the transaction is executed. The market reference price would then be seen as an “average bidding price” set by the market participant, as opposed to the marginal price set by generation costs.
If the pay-as-bid mechanism was applied in the Day-Ahead market, market participants would try to anticipate the market clearing price and bid above their marginal costs in order to maximize their profits. Hence, the power generation units activation priority would be based on the traders’ ability to best forecast the market price, instead of on their economic and environmental efficiency. This is why a shift from marginal pricing would generate negative consequences but not lower energy prices.