Soaring electricity prices across Europe have laid bare the shortcomings of a market in which fossil fuels predominantly continue to set the price, regardless of their decreasing overall contribution to the energy matrix, research shows. 

The war in Ukraine has driven up gas prices and heat waves have crippled hydroelectric and nuclear energy generation in Europe since the beginning of the year. However, “underlying these proximate causes is the generalised application … of the economic principle of marginal cost pricing (MCP), far beyond its appropriate limits”, reads a paper authored by Michael Grubb, a professor of energy and climate change at the University College London, and published on September 6.

“Such an approach to pricing is also demonstrably inappropriate for driving investment in non-fossil fuel assets; indeed, it is obscuring the growing success of a transition which has seen rapidly rising volumes of increasingly cheap renewable energy.”

[Marginal cost pricing] is obscuring the growing success of a transition which has seen rapidly rising volumes of increasingly cheap renewable energy. 

Michael Grubb, University College London

The MCP model is the mechanism for price discovery in the wholesale electricity market in the UK and across Europe. According to MCP, meeting the total electricity demand requires price-matching the cost of the most expensive operating plant required to do so – otherwise that plant would not run.

The marginal cost of low-carbon electricity sources (renewables, nuclear and hydropower) is close to zero, while the cost of power from gas-fired plants soared to more than €600 per megawatt hour (MWh) in many European countries at the end of August, when Russia further tightened gas supplies and policy markets scrambled to stock up supplies for the winter. While the role of low-carbon sources has grown across the board, their intermittent nature calls for countries to find ways to plug the hole through baseload fossil-fuel generation or imports. Inevitably, plants running on the more expensive fossil fuels — namely gas and coal — end up setting the market price for all electricity in a market based on MCP. 

In the UK, natural gas accounted for around 40% of generation in 2019, but set the price for 84% of the year, with imports keeping the price down for almost all the rest (15%), according to Behnam Zakeri, a researcher with the Austria-based International Institute for Applied Systems Analysis. Non-fossil sources set the price less than 1% of the time, despite generating about half of the UK’s electricity in that year (wind and solar accounting for around 25%).

This trend is mirrored across Europe, with the notable exceptions of France, Denmark and Ireland. Across most of the continent, fossil-fuel generators set the market price for more than 75% of the year, despite non-fossil sources and electricity imports accounting for more than half of electricity generation.

Unfortunately, the solution is not as simple as setting market prices by cost of renewables, as this would cause the price of electricity to plummet to near zero, leaving generators little room to cover their high up-front investment with market revenues.

Besides, generators using renewable energy are often locked into long-term contracts outside the market, designed to secure them a reliable stream of revenues throughout the course of the project life. Over the years, the strike price for these contracts has come down meaningfully. In the UK, the large offshore wind farms coming onstream this year cost around £70/MWh, and the subsequent contracts for offshore wind – agreed in 2019 and 2022 for delivery in the next few years – cost around £46/MWh and £38/MWh, respectively.

“The result is a striking cost inversion,” the paper reads. “Such sources, based on contracts outside the market, offer power at under a quarter of current and projected wholesale electricity prices. They presage a future of predominantly non-fossil, asset-based electricity with entirely different economic (as well as environmental) characteristics. Aside from the proximate causes, navigating the crisis by exploiting this transition is the fundamental task facing policymakers.”

Authorities across the region are already calling for reforms to decouple the two markets. Greece presented a proposal to the EU’s energy council in July, while Germany’s government has also confirmed it is looking for alternatives “to decouple the development of end-customer prices for electricity from the rising price of gas,” a spokesperson for the German Economy and Climate Action Ministry told pan-European media network EURACTIV on August 26.