Across Europe, households have felt the pain of dramatic increases in electricity prices, reflecting the surging cost of gas due to the war in Ukraine. This has led governments to spend large amounts of money to insulate households, especially vulnerable ones, from the worst effects of the exceptional inflation.
While the second half of the year should bring some relief for consumers, as gas prices are now well below their August peak, these prices nonetheless remain a multiple of what they were two years ago, and are likely to remain at an elevated level for the foreseeable future.
Due to the way European electricity markets are structured, while consumers will inevitably continue to pay higher energy prices, some electricity producers have enjoyed windfall profits at the expense of consumers.
Recent events have crystallised a problem that already existed with European electricity markets. The market rules were designed to deal with a fossil fuel world, where a large part of the cost of generation was the price paid for the coal, oil and gas. To ensure supply matched demand, the price by the hour needed to reflect the cost of the most expensive fuel used. In recent years, gas has been the priciest fuel in many countries.
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When wind can supply all or most of energy needs, like on a blowy summer’s night, the price falls to zero, and wind turbine operators may make nothing on what they sell
With the price set by the most expensive fuel, electricity producers with lower costs of generation made a profit, which helped pay for their generating equipment. But this profit margin was not enough to pay for new generating capacity. Therefore, to maintain and grow capacity, a substantial additional payment is made to generators in the Irish market to cover capital costs. Over the past year, however, exceptional gas prices meant exceptional profits for some electricity producers.
A renewables world is very different. When the wind blows it comes for free, and all of the cost of wind or solar electricity is in the equipment – running costs are minimal. When wind is supplying only a small fraction of demand, renewable operators do very well in principle, as the price they get is based on the most expensive fuel in the marketplace. When wind can supply all or most of energy needs, like on a blowy summer’s night, the price falls to zero, and wind turbine operators may make nothing on what they sell.
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Although some wind and solar operators have made exceptional profits over the past year, they would be better served by a system that provided steady remuneration for their capital costs, without having to rely on occasional hourly peaks in prices that are driven by the cost of fossil fuels.
Nuclear generators are in a similar position to wind and solar. Once they start up, they are always on. In the short term, French nuclear operators did very well out of the surge in electricity prices, as their costs of production didn’t rise. However, it will be extremely expensive to replace ageing French nuclear plants. An energy market that provided reasonable certainty about covering the repayments on capital costs would facilitate replacement capacity to be built.
Capital investment
With the rise of renewables, the design of electricity markets will need to give greater focus to covering the costs of capital investment, rather than our current formula that generates windfall profits when fossil fuel costs are high. If those investing in electricity generation capacity can be reasonably certain they will earn their money back, it makes that investment less risky and reduces the cost of financing it.
To date, reform of the EU and British electricity markets to meet these challenges has been ad hoc. In some cases the fixes adopted have made things worse
A reformed market must also provide a strong incentive for firms to supply flexible generation that can cover the gaps when the wind does not blow or the sun does not shine. It should also incentivise firms to develop new technologies to provide the necessary storage and backup in a climate-friendly manner.
To date, reform of the EU and British electricity markets to meet these challenges has been ad hoc. In some cases the fixes adopted have made things worse. Today’s mix of support mechanisms for producers is one that’s unnecessarily costly for consumers.
For these reasons, Spain and Greece are pushing for a major reform of the EU market. Ireland should support this. A system for remunerating those who generate electricity, which focuses more on how to meet capital costs, can help drive the roll-out of renewables at minimum cost for consumers, and support replacement of ageing plants.
With an all-island market for electricity, we need Stormont’s agreement in order to sign up to any sensible EU reform in this area. Another reason to want the Executive back up and running.
