A question of energy and balance
Energy has been in the headlines the past week for good reason. In the UK, last week we found out about the energy price cap rising over 80%, with predictions of a further doubling likely.
In Germany, state governments have mandated that pools go cold, lighting is turned off, and industries cut back as they attempt to reduce gas usage by 20%. This has driven wholesale power prices to surge in the past week, peaking at €1,050 / MWh in Germany on Monday! For context, in 2019, prices hovered around €35 - €55 / MWh.
And this is all during the month of August … the hottest month of the year when gas usage should be at its lowest! So why has the electricity market in Europe gone so crazy recently?
The way it works…
I’m sure those of you out there who are more commodity-minded than me will be aware of the following, but the hotness of the topic made me curious at how wholesale electricity prices are set. Previously, I assumed they were based on a blended average of the cost of production, with different sources having different costs, and cheaper renewables keeping the average cost low.
But it turns out the wholesale price is set by the last marginal unit of electricity needed to satisfy demand. The mechanism is called “priced to clear,” and this informative blog post from EDF helps explain how it works and why we can end up in situations like we did a few years ago where electricity prices went negative, and in situations like we’re in today, where prices are spiking.
… and why it works this way
The “priced to clear ”mechanism means all producers are paid the highest necessary price to get the last marginal unit necessary to meet demand. If, say, wind/solar are sufficient to satisfy demand, everyone gets paid the marginal price of wind/solar, which hovers near to 0. But if coal or gas is needed, everyone (including wind/solar producers) is paid the rate of the most expensive source of power. It’s essentially a reverse Dutch auction.
Normally, gas is cheap, so this isn’t a problem. But, given world events, gas in Europe today is expensive, and the spiking price is feeding into the power market.
The market was structured in this way for a few reasons. First, it provides an incentive for producers to invest in cheaper renewables. Wind/solar producers make money as their production costs are near zero and they sell power at high spot prices. Second, it ensures Europe remains competitive in the global market for LNG, especially in competition with Asia.
The political reality
The auction process is great for balancing out localized changes in supply/demand within the European grid, and higher prices are definitely a vital driver for long term investment in renewables. But, in the short term, supply is unfortunately very inelastic. Natural gas is much harder to transport over long distances than oil. So even though natural gas is 10 times more expensive in Europe than in the US…but there is only a finite amount of liquified natural gas available for export and the US is already exporting as much as it can. Building LNG import terminals to accept more capacity will take 3-5 years. Building up capacity from other sources of power such as nuclear or renewables will take much longer.
The political reality of sharp price increases in the short term is hard to ignore. Hence, this summer, some have been pushing to de-link electricity and gas prices.
The first calls came from Spain and Portugal, who generate huge amounts of wind/solar, and have little connectivity with the rest of the European grid. They secured something called the Iberian Exception from the European Commission (EC), which allowed them to impose a cap on gas used for electricity generation. Gas used for heating would still be subject to spot prices, but it removed the pricing mechanism that allows wind generators to get paid huge premiums when power prices are high. In a way, this achieved something similar to a windfall tax.
Given the recent price action, the UK and the rest of Europe are pursuing a similar strategy. And fair enough. Looking over the fence at what your neighbours are up to is a European speciality. Hence, other nations are seeking the same assistance. As times worsen and electorates struggle to pay their bills, expect more requests like this.
A balancing act
The concerns and subsequent actions are understandable. The cost of living crisis in the UK is being driven, in no small part, by the surging cost of energy, so something needs to be done or else it could be a catastrophic winter for millions. It was good to see this week that energy prices pulled back following promises from the EC that it would do all it could to intervene.
But getting a balance between providing relief for consumers in the short term by creating “structural reform of the electricity market,” as the EC said this week, whilst maintaining incentives for investment in renewables won’t be easy.
It’s tempting in times of short term trouble to tear up plans to fix larger, long term issues. The want to get in shape in your late-thirties so you don’t have a heart attack in your late-fifties can be overwhelmed by the promise of that blowout, late summer long weekend to Ibiza! Similarly, governments face the unenviable task of keeping electorates happy (and warm in winter) whilst ensuring they don’t inflict greater long term damage by tearing up sustainability goals.
Sure, survival must come first. But survival means thinking about the state of our planet in both 1 year and 100 years. Hence the complicated balancing act for our leaders and politicians, and it’s an immensely challenging one.
