Natural gas, high prices and the electricity market

Natural gas, high prices and the electricity market

2021 was a turbulent year for energy markets across Europe. The skyrocketing natural gas prices have created a sense of crisis and will lead to cost-of-living problems for many families, as wholesale costs feed into the retail prices of gas and electricity over the coming months.

This has created immediate challenges for governments, but should also encourage us to rethink the fundamental design of our energy markets as we strive to transition to net zero.

The energy crisis was driven by a combination of factors: the easing of Covid-19 lockdowns across Europe increased demand, while cold weather early in the year reduced storage levels and contributed to increased demand from Asian economies. A number of technical issues and supply-side constraints have also been combined to limit imports of liquefied natural gas (LNG) to the continent.

Europe’s dependence on pipeline imports from Russia has again come into question, as Gazprom refused to bail out, fulfilling only its previous contracts. The combination of these and other factors has led to record prices – the European benchmark price (the Dutch TTF gas future contract) reached nearly €180/MWh on December 21, with next-day average electricity prices exceeding €300/MWh across Much of the continent in the following days.

Countries that rely heavily on natural gas as a source of electricity generation were particularly at risk, as governments quickly applied pressure to intervene in the market.

In Spain, the government and large energy companies have clashed over a proposed surprise tax on energy producers. In Ireland, where wind and gas meet most of the country’s growing electricity demand, the government is proposing a €100 discount to all domestic energy consumers in early 2022; The UK government is currently negotiating a sector-wide bailout for the energy supply sector.

This comes on the heels of the collapse of a number of suppliers who based their business models on attracting customers at low prices by buying cheap in the spot market. Rising wholesale prices, along with the retail price cap previously introduced by Theresa May’s government, have led to its collapse.

While individual governments have little control over prices in the increasingly globalized and interconnected natural gas market, they can exert an influence on electricity prices as these markets remain largely national and are heavily influenced by local politics and regulations. As a result, the intersection of gas and energy markets has become a major site of controversy and comment about the government’s role in mitigating the effects on consumers of higher fuel bills.

Given that renewables make up a growing share of production capacity, many are now wondering why gas prices play such a critical role in electricity markets.

As I outline in my next book, making energy marketsA special feature of the “European model” of electricity trade liberalized since the 1990s is the reliance on spot markets to improve the efficiency of electricity systems. The idea was that higher marginal prices – often set by expensive gas production plants – would signal when capacity limits were reached, providing clear incentives for consumers to reduce or delay demand in these peak periods.

This will, in theory, lead to a more efficient system in general, and in the long run, if average prices exceed market entry costs, new investment will be made, thus pushing the most costly and inefficient factories out of the system.

The free market model was established during a more stable era when coal from domestic sources, along with gas purchased on long-term contracts from European sources (North Sea and Holland), made up a much larger proportion of electricity generation.

While prices were volatile, they were within a fairly predictable range, and provided a consistent benchmark for long-term contracts that underpin investment decisions. This is no longer the case as energy markets become increasingly volatile and disruptive during the energy transition.

The idea that the formation of free prices in a competitive market, with retreating governments, would benefit electricity consumers and lead to more efficient systems, is rooted in sound economic theory and is the foundation upon which other major commodity markets, such as minerals and agricultural crops, are regulated. decades ago.

The free-market model applied to electricity had obvious limitations, as the majority of domestic consumers were not directly exposed to real-time price signals. While this is changing with the introduction of smart meters in many countries, the extent to which the average consumer is willing or able to reduce demand in a predictable manner during peak periods remains uncertain.

Also, experience shows that governments often come under pressure to intervene in markets if prices rise sharply during periods of scarcity, undermining one of the basic tenets of the market model.

Given that gas continues to play a critical role in balancing electricity supply and demand, the options available to governments are limited. One approach is to maintain confidence in a liberalized market model, with limited interventions to help consumers in the short term, while ultimately relying on innovations in demand-side technologies and gas alternatives as a means of balancing systems with high shares of variables. sustainable energy.

An alternative scenario may see a return to the old pattern of national pricing policies, including a move away from marginal pricing and spot markets. In the past, particularly during the post-World War II decades, and until markets were liberalized in the 1990s, governments followed such an approach, setting prices centrally based on the costs of delivering long-term system plans. Operating gas stations and purchasing fuel will become a more regulated activity under this model.

Many argue that this ‘traditional model’ fits better in a world in which governments have committed to long-term decarbonization goals, and zero marginal cost sources, such as wind and solar, play a dominant role in markets and begin to drive down prices.

The critical question for energy policy makers is how to exploit this deflationary effect of renewable energy and save costs for consumers, while ensuring that lamps stay lit.

Despite the promise of storage technologies such as grid-scale batteries and hydrogen produced from electrolysis, apart from highly polluting coal, no alternative to natural gas from international sources as a means of balancing our electricity systems and ensuring our energy security is immediately available.

This fact, above all, will constrain governments’ ambitions to fundamentally change energy markets.

Written by Ronan Bolton, Lecturer in the School of Social and Political Sciences at the University of Edinburgh and Co-Director of the UK Energy Research Centre. writing The Making of Energy Markets: The Origins of Electricity Liberalization in Europe Published by Palgrave Macmillan in 2022.

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