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| 1 minute read

Energy crisis

Europe is getting more of its power from renewable sources every year but, as the current crisis has shown, power markets remain at the mercy of increasingly volatile gas prices. The EU Commission has recently proposed a plan to relieve the crisis by decoupling electricity and gas prices. But the plan must strike a balance between addressing skyrocketing prices and protecting the cross-border power market the EU has been rolling out across its member states since the 1990s.

A key feature of liberalised power markets is marginal cost pricing. Gas-fired power is often the most expensive source of electricity, and if this kind of plant is required to balance supply and demand it becomes what’s called the marginal plant, which effectively sets the price for the entire power market.

Pricing at the margin 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 are provided with clear signals about scarcity, giving them the ability to adjust their consumption in line with changing conditions. In the long run, persistently high prices provide incentives for efficient plants to push the expensive generators out of the market, thus reducing costs for consumers.

More recently, however, this electricity market model has exacerbated the energy crisis for consumers. As gas prices have soared, power prices have followed. German futures – a key European power market benchmark – would normally trade at €40-50 (£35-44) per megawatt hour (MWh), but surpassed €1,000/MWh for the first time in late August 2022.

As a result, power sources whose costs are not affected by changes in gas prices such as wind, solar and nuclear – so-called inframarginal plants – have all seen their revenues rise significantly due to the higher prices. This situation has been framed as electricity producers extracting unreasonable profits, exploiting vulnerable consumers, and benefiting from the Russian invasion of the Ukraine. Amid the present energy crisis, this is clearly politically unsustainable and so European politicians have had to act.