Electricity markets must be redesigned for our new reality

How to lower the price of energy in the medium to long term is one of the biggest challenges facing governments around the world. Subsidies have been used as a short-term fix to the supply shock caused by Russia’s invasion of Ukraine, but a more sustainable solution is required.

The current crisis has thrown into sharp relief the way wholesale electricity markets work. Under EU energy regulations, which were transposed into UK law following Brexit, the price of electricity is determined by something called the “merit order principle”. 

Generating companies submit bids to supply electricity to the grid, which are accepted in price order. At the end of every trading period, all generators are paid the cost of the last unit needed to meet demand. 

Where there is insufficient renewables capacity (which is often the cheapest source), higher-priced fossil fuel power enters the mix. On an average day in the UK, gas generates just over 20% of electricity.

European governments act to reduce electricity prices

In a period where the price of gas has risen to seven times its usual level, a range of measures are being introduced in a bid to lower the cost of power. The EU will, among other things, recoup “surplus revenues” from non-gas generators and electricity traders – redistributing the proceeds to ease pressure on consumers – while member states will take steps to cut demand during the winter months.

The European Commission has also allowed Spain and Portugal to introduce temporary gas subsidies that limit the price of electricity on the Iberian market.

The UK government, too, has published its Energy Prices Bill, which aims to reduce the impact of gas costs on electricity prices and controversially includes measures to cap revenues from renewable generators. You can read our analysis of the EPB here. 

Looking further ahead, adding more renewable capacity and scalable reserves such as nuclear – as the U.S. is trying to do via the Inflation Reduction Act – will both improve security of supply and help mitigate future price shocks. 

It is, though, an unavoidable truth that our electricity pricing model needs to change. The current approach was developed decades ago for a world of centralised supply and cheap gas. Today electricity comes from a diverse range of sources with gas no longer the obvious benchmark, and so the market must be redesigned to better reflect this reality.

Long-term market reforms on the horizon?

In the EU, discussions on longer-term reform of the electricity and gas markets have only recently begun. Things are more advanced in the UK, where the government is consulting on a new model via the Review of Electricity Market Arrangements (REMA). 

Here, options on the table include decoupling the price of electricity and gas, allowing consumers to opt for cheaper renewable power and only pay for more expensive gas-fired electricity during periods of peak demand.

Although very difficult to achieve – and only truly effective with widespread adoption of smart meters – this would create an incentive to add more low-carbon capacity.  

Other alternatives include switching to the zonal pricing model favoured by countries such as Italy (whereby electricity prices vary between regions), or the more granular system which operates in some U.S. states and sets prices at hundreds or even thousands of local nodes.  

Away from market reforms, there are other ways for governments to cut the cost of power. Some developers who built wind farms, biomass- and waste-to-energy plants during the past decade were incentivised with contracts guaranteeing them a price for their electricity above that set by the spot markets. 

There are hundreds of these contracts in the UK alone, yet as they pass their midpoint there may be appetite among generators to accept lower-price deals that extend over a longer period, with the increased price certainty enabling them to refinance debts in a way that makes commercial sense.

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