“Electricity price Olympics”: how did we get here and where are we going?

Over the last few months, we’ve been observing some real‘'electricity price Olympics’ with day-ahead and intraday prices hitting a historic high across Europe.

The main questions that have been swirling in my and many others’ heads are:

1)????What drives prices to such heights?

2)????Are high prices ‘good’?

3)????Can we expect this trend to continue in the future?

What drives prices to such heights?

In the last 8 months, we’ve witnessed a substantial price hike across the EU countries, as the graphs of the average DA market prices for February, May and August show:

Source: EnergyLive 2021

The prices have reached the most extraordinary levels in the South of Europe (Cf. 25€/MWh in Spain in February and whooping 106€/MWh on average in August), which prompted the Spanish government to urgently approve a royal decree reducing or suspending some of the electricity taxes for small consumers. Even in the Nordics, where, thanks to very large installed hydro capacities, wholesale electricity prices historically have been noticeably lower than in, say, Central Western Europe, have experienced a tangible rise with prices exceeding 100€/MWh in some price zones.

So what happened?

The most obvious reason is the CO2 price that has been beating its own records since March 2020, as this 5-year price development shows:

Source: Trading Economics Aug. 2021

This is attributed not only to the expected EU ETS policy changes and the reduction of the number of allowances in circulation but also some speculative buying and links to the increasing gas price levels (higher gas prices lead to a higher demand for coal and that in turn increases the demand for emission allowances).

Gas price increase to exceed 49€ for Dutch TTF contracts in August 2021:

Some of the causes for this increase are low gas storage levels in the EU (remember that cold winter and spring?), high gas demand in Asia driving away LNG supplies coupled with production issues (e.g. maintenance in Norway and Russian Gazprom restricting capacity pending start of Nord Stream 2 operation).

What about RES expansion? Both new wind and PV capacity reached record levels in 2021 and renewables (including hydro) comprised 39% of total electricity generation in the EU, despite fairly poor wind conditions. Across the EU, electricity output from renewables thus exceeded the amount of electricity generated from fossil fuels by a few percentage points in the first half of 2021 and was 11% higher than in pre-pandemic 2019:

Source: Ember 2021

This was in particular driven by the explosive growth of solar namely in Spain, the Netherlands, Germany and Poland. Some of the positive factors are new RES-friendly national policies (e.g. in Germany and the Netherlands), growing PPA markets (e.g. in Spain and Sweden) and generous support schemes for distributed solar (e.g. in France and the Netherlands).

As most European economies rebound after COVID in 2021, electricity demand jumped up in comparison to the 2020 pandemic-driven slump, leading to numerous instances with high residual load and the need for gas generators and other fossil fuels to fill in the gap. Because of high gas prices, ?the so-called rate of coal-to-gas switching diminished, as a result of which, according to the IEA, coal generation levels returned to normal pre-pandemic levels already in Q1 of 2021.

Coal vs. gas fuel costs (incl. CO2 prices), source: IEA 2021

The main message is that RES expansion has been significant but still not fast enough to keep up with rising demand or meet the EU’s ambitious emission reduction targets. We thus often have situations in which ‘dirt-cheap’ renewables don’t get to bring prices down. If we think of some weather events such as an exceptionally cold spring in several European countries or higher likelihood of extreme-weather events such as disastrous heatwaves in Greece and Italy this summer, not only more renewables but also other venues, in particular demand response, are crucial to be able to address these recurring challenges in the future.

Finally, interconnection of the European electricity markets contributes to the price-distributive effects among neighboring countries. Interconnection works both ways: if it is insufficient, it leads to market splitting and a suboptimal economic outcome, but even in those situations when transfer capacity is sufficient to accommodate cross-border flows, other factors going well beyond the borders of a single country may prevent it from mitigating high prices.

Are high prices ‘good’?

The wholesale electricity market has been shown to deliver robust price signals to its participants. Price spikes are known as indicators of scarcity and play an important role as investment drivers into flexibility options, especially storage, and further grid expansion and interconnection as well as into more renewables. It is also important to keep in mind that not only the number of extreme-price events has been increasing but also the occurrence of negative prices with trends emerging beyond Germany, e.g. in the Netherlands, UK or Austria. Notably, the fast expansion of solar PV in several European countries seems to shift the timing of negative prices to afternoon hours.

I’ve seen some arguments about current high electricity prices affecting consumer bills. We need to distinguish between wholesale and retail electricity markets though: it’s hard to estimate the impact on regular consumers since most of them are on fixed-price contracts while dynamic pricing is still rare (individual countries obviously vary). That said, consumers are in most cases insulated at least to an extent from wholesale price volatility and therefore would likely not feel the effects of extreme prices or, say, benefit from negative prices – in the short term at least. Besides, the energy component is on average only a third of the total consumer electricity price (the rest being network charges, taxes and levies).

In any case, such ‘perfect storm’ situations as the one witnessed in August are likely here to stay. Now more than ever, flexibility from all possible sources on the supply but also on the demand side are crucial to address growing network vulnerability, achieving EU climate targets and offsetting some of the price spikes in the future.

What to expect?

The extent to which we can expect this trend to continue in 2022 will depend on the development of the underlying factors. It is reasonable to expect CO2 prices to stick to the upward trend considering the planned ETS tightening between 2021 and 2030, the exact speed of which will depend on the year of entry into force of Fit for 55 package. Gas prices are also expected to remain tight well into winter whereas, experts say, in 2022 gas supply is likely to improve. According to the IEA’s forecasts, RES expansion in the EU will continue to grow to forecasted 49GW installed capacity.

Electricity prices will also depend on a multitude of other parallel developments that will – at least indirectly – affect the overall trend, such as policy changes in individual countries (coal phase out in Germany, adjustments of RES support mechanisms), the speed of (hopefully full) recovery from COVID, storage and DER expansion rates as well as weather conditions and other non-structural factors. Their compound effect is next to impossible to predict even in the short term and if I learned anything from Daniel Kahneman’s latest book on the fallacies of judgement and decision-making, Noise, we shouldn’t fool ourselves that we (or even our models) are great at predicting medium or long-term future.?