How are EU electricity prices formed and why have they soared?

EU energy prices have followed a marked increase from July 2021. As the economy recovered from COVID-19, the growing energy demand started to push prices on an upward trend last year. Moreover, Russia’s invasion of Ukraine followed by its decision to cut natural gas supplies to Europe have then considerably shaken the energy system and triggered a sharp rise in inflation. The cost of natural gas imports continues to have severe impact on the customers, and the overall economy. Why do European electricity consumers feel the pinch? To find out the answer, it is important to understand the electricity value chain, as well as the basics of power markets. 

What is the electricity value chain?

The value chain is all the companies or entities that play a role in the electric ecosystem. Traditionally, it includes:

• Generators - companies with generation assets, namely power plants running on wind, solar, hydro, coal, gas, nuclear and any other kinds of fuel. They produce electricity and sell it on the wholesale market
• Transmission system operators or TSOs – entities which manage the transmission networks, i.e., high-voltage power lines linking generation assets and transformers. A non-exhaustive list of their responsibilities includes among others: assessing demand, informing generators about short-term (day ahead, for instance) and long-term needs for electricity (both baseload and peak demand); manage the flows on interconnectors.
• Distribution system operators or DSOs – entities which operate the distribution network typically medium and low-voltage lines, bringing electricity to customers. They make sure there are no congestions, re-establish the connection in case of power cuts, and cooperate with TSOs to enable the effective participation of those connected to the grid in retail, wholesale and balancing markets. Their role becomes ever more critical to the functioning of growing numbers of heat pumps and electric vehicles, to the connection of renewable plants, and the further decentralisation of the energy system. It is expected that by 2030, 70% of the additional renewable capacity to be connected at distribution level.
• Suppliers – companies that sell electricity to consumers, providing competitive rates. Since the liberalisation of the electricity market, customers can freely choose their supplier and change should a better offer or service be made available.

The system is now becoming more complex, as many more participants emerge. For instance, prosumers – i.e. consumers who have installed generation capacities, such as solar panels on rooftops at home or in commercial buildings - are now able to inject electricity into the network. This is transforming the traditional functioning of the grid, which is shifting to bi-directional flows.

How does the EU electricity market function?

The electricity market follows the economic principles of demand and supply, aiming at ensuring that demand is served at any moment in time in the most cost-effective way. In very basic terms, electricity generators sell their production on the wholesale market. This is further sold by suppliers to consumers via the retail market.

What are the frameworks that govern the EU electricity markets?

Between 1996 and 2009, three packages containing Electricity Directives and Regulations have established a set of common rules for internal energy market. EU Member States intended to put an end to the traditional monopolies by organising competitive power exchanges, both within the countries and across their borders. This would offer customers, be they citizens or businesses, competitive prices; give efficient investment signals and higher standards of service; help maintain security of supply and contribute to sustainability goals.

In 2019, the Clean Energy Package brought new changes to reflect the higher decarbonisation ambitions. For instance, it deciding the phase-out of subsidies to generation capacity emitting 550gr CO2/ kWh or more. Moreover, it put consumers at the centre of the clean energy transition, enabling their active participation in the electric ecosystem.

In light of the energy crisis that has hit Europe mid-2021, several EU Member States have questioned the functioning of the market, proceeding with ad-hoc interventions to limit the impact of higher prices on consumers. Regulators have assessed the situation and confirmed the proper functioning. European Commission launched a process to reassess the design of electricity markets and is expected to come with a new legislative proposal in 2023.

Electricity wholesale prices – explained

Wholesale electricity prices are the formed as a result of the competition between generators who bid in the intraday, day-ahead and forward markets, striving to sell their production and meet the demand forecasted by transmission operators (TSOs).

The day ahead delivery, TSOs make provisions for every single hour of the following day, assessing how much generation capacity will need to produce and serve demand. Based on this forecast, generators inform if they are able to produce electricity for the various slots and at which price.

As the system is built to serve demand at the lowest price, generators are dispatched from the cheapest to the most expensive, until the supply and demand curves meet. Generators will bid, and the wholesale price will settle at the rate proposed by the last power plant (i.e. the marginal plant) activated to serve demand. The wholesale power price will thus be equal to the variable marginal cost of the last power plant needed. Each generator who supplies during that time frame will be paid at the same level as the last activated producer. This is called inframarginal rent and it is used to ensure a return on fixed investment costs.

When supply meets demand, the market is cleared – and that defines the wholesale price. This system is called pay-as-clear and has been under scrutiny since Russia started tampering with natural gas flows, ahead of its invasion of Ukraine.

What is the wholesale merit order?

The merit order is the ranking of power plants according to their respective generation costs. It is established based on the variable costs of each power plant, calculated in €/ kwh. Renewables have the lowest variable costs, as sun and wind are for free.  The merit order therefore ranks renewables first, followed by nuclear, gas, coal, and oil fuel.

The more solar and wind generation comes online, the lower the wholesale power prices will be. They can even lead to negative power prices, whose occurrence has grown from zero in 2010, to 375 hours in 2018 and 1827 in 2020. 

Looking at other technologies, we know that nuclear power generation has lower operational costs than fuel-based plants, uranium being less expensive in €/ kwh than gas, coal and oil. Fossil fuels are not only exposed to commodity pricing, and external volatility, but they are also subject to CO2 pricing – having to pay for each ton of carbon emissions.

For instance, 100 kwh of coal-based electricity produces on average one ton of CO2, while 100 kwh of gas-fired electricity emits 0,2-0,3 tons of carbon. This cost is part of the variables considered when generators make their bid in the wholesale. The carbon price in the EU Emissions Trading System has increased in recent years, in response to Europe’s increased decarbonisation ambitions. 

With the exception of some European countries, such as Cyprus or Estonia, that still rely on oil capacities to cover 95% and 58% their electricity demand, these oil fuelled assets are most often used as peaking plants, to serve peak demand for a limited number of hours over the year.

As the energy crisis unfolds, oil-based generation assets are likely to play a more prominent role to save on natural gas. But given their high operational costs, low efficiency and environmental constraints, this thermal capacity will not make a comeback into the baseload mix.

Why are electricity prices so high?

The spike in electricity rates initially resulted from a higher energy demand than what was planned for a COVID-19 recovering economy. Yet, this further accelerated as it soon became clear that the main cause were the supply disruptions in the gas market, as well as the high volatility this commodity is exposed to when trading. 

Retail electricity prices

The retail electricity price is the amount that a customers pay per kwh of electricity used during a certain period of time. The bill includes the electricity price - reflecting the consumption-, the transmission and distribution network tariffs, as well as taxes and levies.

In Europe, the electricity component represents 31% of the electricity bill, while network tariffs account for 28% and taxes and levies reach 41%.

Changes in the wholesale rates  have a direct impact on the retail price. Latest data presented in the Power Barometer shows that wholesale raised by 532% between January 2021 and August 2022. As a result, retail price offers made to customers living in capital cities jumped by 84% between January 2021 and June 2022.

As the crisis continues, the best policy solution remains the adoption of targeted customer support measures – such as energy vouchers and a VAT reduction plan – coupled with energy efficiency incentives to mitigate the impact on households.

In is important to note that while customers cannot do much about the network fees and the taxes and levies, they can always compare the offers and services provided by their suppliers. Since the market liberalisation, customers are free to switch providers and opt for the utility with the best solution for their needs.

What is the difference between fixed and variable fees?

Customers with fixed rates pay a set unit price over the duration of their contract. In this case, variations in the wholesale price are not  reflected in the unit price paid monthly or annually, depending on the contract.

A variable tariff means that the unit cost can increase or decrease at any time. This tariffication system incentivises consumers to use energy when prices are low and supply plentiful.

In some countries, a price cap exists to prevent variable rates to go above a certain threshold, thus reducing the risks for consumers.

The network tariffs

The network cost encompasses the expenses associated with transmission and distribution. In most EU countries, this is a regulated tariff meaning that users pay a fixed rate, irrespective of their consumption. But in some countries, for instance in Ireland distribution tariffs include a per unit component as well as a fixed “standing charge”.

“These fees do not depend on suppliers. They are collected by suppliers and further passed on to the relevant entity to help cover the costs of building, maintaining and operating networks.“

Multiple options for structuring the network tariffs exist. They can be flat, volume or capacity based, as well as static, or dynamic - reflecting the time of use (TOU). Each option has a different potential to provide economic signals that drive electrification and an efficient use of network services, as shown by Eurelectric’s report “Powering the Energy Transition through Efficient Network Tariffs”.

Eurelectric’s report highlights that cost-reflective time-of-use network tariffs can coexist effectively with flexibility markets and can incentivise a sustainable and efficient use of the electricity system. Hence, a cost-reflective pricing of services would enable grid operators to better manage the network, retailers to diversify their offers, and consumers to efficiently use the network by adapting their consumption to tariff variations.

Tariffication systems that vary by time of use can act as a catalyst in the transition to a net-zero emissions economy. They have the potential to prompt consumers to change they way they use energy, by offering lower prices in hours when supply is plentiful, or demand is generally lower.

Going forward, investments in physical infrastructure must be paired with digital solutions, including the deployment of smart meters.

The benefits of time-of-use (TOU) tariffs

Static time-of-use (TOU) tariffs improve cost-reflectiveness and provide better price signals than other network tariff options.

The benefits of time of use tariffs are to:

• reduce grid losses, reinforcement needs and congestion costs, while deferring investment costs.
• promote innovation in retail markets and demand response, improving the offer of service for new energy uses, like EV chargers, electric heat pumps with storage or electrolysers.
• enable electrification.