WHY IS OUR ELECTRICITY EXPENSIVE?

 

By Drakoulis Goudis

29/09/2024

In this two-part article, we will today investigate the reasons European citizens saw their electricity bills skyrocket the last few years, analyze how the electricity market works, why natural gas has a disproportionate impact on the price, and in the 2^nd part we will explore what can be done to shield consumers from rising prices.

The Electricity Market

The price consumers pay for the electricity they used is called retail price. This price is made up of three approximately equally large components, although the exact weight of each factor varies between countries: Retail price = price for power consumed + network charges + taxes & levies.

The largest component of retail prices is the cost of the electricity itself (price for power consumed) which is influenced by the wholesale market price. As the Commission and Eurelectric explain: “The wholesale market is a system of marginal pricing, also known as a pay-as-clear market, where all electricity generators get the same price for the power they are selling. The generators are dispatched in an order starting from the least expensive to the most expensive energy source (merit order) until the energy supply meets the demand. The generators submit their bids, and the final price is set at the rate proposed by the last power plant that was activated to fulfill demand, known as the marginal plant.”

The following visualization by the Jacques Delors Institute is a representative example:

 

Why do we follow the pay-per-clear model?

At first glance, this model looks as if it is designed to keep the prices high and generate insane profits for energy producers. Why are we using it then? Here are the 2 main reasons it was adopted in the first place:

• Physics!

Large quantities of electricity cannot be stored. This means that a balance must be struck between supply and demand at any given time, so that we avoid blackouts. This is also the main reason the European electricity grid is getting more and more interconnected, so that electricity can flow e.g. from Germany to Denmark when Germany has excess supply compared to demand and Denmark has excess demand compared to domestic supply. The need to have a constant balance between supply and demand is called security of supply, and it means that energy producers need to be incentivized to always produce energy. This model ensures that every producer whose energy enters the grid at minimum covers the generation cost, thus will not remove their plants, so that security of supply is achieved.

• Boosting investment in renewable sources

Before Russia dropped all pretenses and transitioned from “shady partner” to “rogue state”, gas was so cheap that there were fears that there wouldn’t be significant investment in renewable energy sources because the profit margin was too narrow. For a long time, the gas price was not volatile, the pay-per-clear model was working smoothly, the wholesale prices remained relatively stable and the renewable producers were making a profit and were incentivized to increase their capacity.

The 2nd condition is obviously not applicable anymore, and there have been voices calling for a switch to a pay-per-bid model. This isn’t a great idea, both because it would endanger the security of supply, and because producers (including cheap renewables) would simply bid at the price they expect the market to clear instead of their generation costs, leading to a higher marginal price.

 

Why did the retail price rise the last years?

• Gas became expensive. The most obvious reason (of which most people are aware to a certain degree) is that gas prices increased, as can be seen by the Standard and Poor data:

Europe is unfortunately very reliant on gas imports. In 2021, 40% of total gas imports were coming from Russia. With the Russian invasion of Ukraine and the weaponization of Russian gas, Europe rushed to diversify its imports, and the percentage of gas imported by Russia dropped to 8% in 2023. The devil hides in the details though: replacing Russian gas meant increasing imports of Liquified Natural Gas (LNG), whose imports rose from 20% in 2021 to 42% in 2023. As stated in the Draghi report, LNG procurement for European energy producers is more expensive than pipeline gas in the spot markets due to liquification and transportation costs, but also because of the need for Europe to compete with other destinations. In 2022, US LNG shipments were around 50% more expensive than average pipeline gas imported into the EU.

 

• Expensive gas became the price-setter of the spot market. As seen in the example graph of the Jacques Delors Institute in the previous section, gas represents only a small share in the electricity mix (20%), but it is very often the marginal plant, thus setting the price (63% of the time in 2022). High gas prices therefore mean high wholesale electricity prices!

 

 

• Higher Carbon Cost. Another factor raising the gas price (but also the oil and coal price) in Europe is the higher carbon cost the EU’s Emissions Trading System (ETS) implements in comparison with other regions of the world. As marginal price-setters are often a carbon-intensive technology, their carbon intensity is added to the price (amounting to EUR 20-25/MWh for gas-fired generation).

 

• Intra-EU competition. The stubbornness of certain national governments, their fear of anything starting with the phrase “common EU procurement” combined with an “every man for himself” mentality when push comes to shove, led to a bidding war to ensure security of supply regarding gas at the first months of 2022, which expectedly drove the price even further up. On top of that, the amount of public and private entities competing for the same resources in an interconnected grid is denying the EU the opportunity to leverage its market position–to put it bluntly, to push the importers to a lower price otherwise nobody would buy their gas. This requires common EU procurement, which for now isn’t happening.

 

• Overexposure to the spot markets. There is a way to shield against the whims of the gas prices: Power Purchasing Agreements (PPAs). PPAs are long-term contracts which allow market participants to negotiate a fixed price for part of their energy demand, thus avoiding excessive exposure to short-term market prices. This type of contracts is underutilized by European actors, mainly out of fear that they will be tied for many years (or decades) to a fixed gas price (even if it is indexed) while technological leaps and changes in global market conditions will offer much cheaper energy solutions. They are risk-averse, thus passing down the risk of price volatility to the consumer. In the following graph, it can be seen how much cheaper 1MWh of gas would be from 2021 to 2023 if it was procured through an indexed PPA

• Underdeveloped grid infrastructure. As anyone can tell you by looking at the Jacques Delors Institute graph, the wholesale price will drop if we produce more energy from renewable sources so that we do not need any gas to cover the demand. What if we told you that our existing solar panels and wind turbines can produce more? At peak production hours, they can produce more energy, but we have to curtail them because our grid cannot afford a huge load without overheating and cannot send the amount from the location of supply to the location of demand (e.g. not enough cross-border inter-connectors to send a large amount of solar power to a neighboring country). To summarize, we have to cap the renewable production at the maximum power the grid can afford, which is often lower than the maximum power the resource can provide at peak production hours.

 

• Needlessly slow and complex permit procedures. For both upgrading grid infrastructure and onboarding new renewable plants, the amount of national and European legislation in combination with the tardiness of administrative services in multiple countries lead to huge delays, and to different type delays depending on the country, which discourages investment, homogenization of the grid conditions and increased flexibility.

 

How can the situation change?

There are ways for the EU to act in order to protect its citizens from rising electricity prices, most of them included in the already famous Draghi report. Stay tuned for Part 2 next week!