The ongoing electricity price hike fuelled by the gas crisis makes a reform of EU power market rules more urgent than ever, argue friends of EiD Mike Parr, director of PWR, and Simon Minett, founder of Challoch-Energy in an article on the EURACTIV website.
High electricity prices, renewables and windfall profits – all paid for by EU citizens
The current high electricity prices, caused by surging gas prices, adds urgency to the need for reform.
Since October, the EU’s Agency for the Cooperation of Energy Regulators (ACER) has been tasked with reviewing the functioning of this market, given the surge in electricity prices. In its preliminary report published in November, the organisation forecast that high electricity prices (€90 to €160/MWh) will be with us for at least two years.
This forecast is reflected in hedging activity by owners of renewable plant with prices for 3rd quarter 2022 of around €90/MWh (source: EEX).
While undertaking its review, ACER might wish to consider the fact that EU citizens because of current market structures, are being “taxed” twice: Once via VAT, an element in all electricity bills, and twice via the increase in power prices which delivers windfall profits to companies and in some cases governments.
These windfall profits being a direct result of the marginal pricing system used to “form” the price of wholesale electricity in all EU member states.
Under marginal pricing, the cost of the most expensive generator, (at the moment gas power plants) defines the price for all generators. Windfall profits occur because of the link between marginal pricing and the way in which renewables are remunerated.
More fundamentally, other developments have happened in the past years on electricity markets. Between 2000 and 2014, most renewables were remunerated via “feed-in-tariffs” (FiTs), a direct subsidy unrelated to wholesale market prices. Two changes then occurred.
First, from 2014 (in Germany), renewable projects were moved to a direct-marketing system. Under this, a renewable project sells the electricity generated directly to the wholesale market.
A “market premium” is then paid to cover the difference between a renewable reference price (defined by the government) and the wholesale market price (averaged per month).
The assumption was that for the foreseeable future, wholesale prices would be much lower than the cost of renewable electricity. Hence the need for a “market premium”. No consideration was given to average wholesale prices being higher than renewable reference prices, as they are now.
Second, in 2016-2017 there was a move towards auctions for renewable projects. The auction price defines the cost of a given renewable at that date. Germany used auctions from 2017 to define the reference price, but stuck with its “direct marketing and market premium” system.
Other countries in a similar time frame, such as Spain and the UK, combined auctions with a contract-for-difference (CfD) system. Under CfDs the winners of the auction sell their electricity directly to wholesale markets. However, if wholesale prices at any point are less than the strike price of the auction, the government pays the difference.
If wholesale prices are higher than auction prices, money flows from the renewable project owners to the government. Under such a system energy companies make no windfall profits from renewables.
In 2018, the German Institute for Economic Research (DIW) published a paper that argued for using CfDs for all future renewable projects in Germany since this would lead to lower costs for consumers of electricity. In 2020 the German government rejected a 2020 Bundesrat proposal to introduce CfDs for offshore wind projects.
What’s the damage of high prices?
The high wholesale electricity prices currently being experience in the EU and UK benefit one of two groups: companies with renewable assets or governments funding renewables via auctions and CfDs.
Since September 2021, electricity wholesale prices in most member states have hovered between €150 and €250/MWh with the occasional oscillation up to €620/MWh or down to minus €2/MWh depending on the availability or not of renewables and how much demand needs to be met.
This contrasts with renewable auction prices for wind and PV of circa €50-60/MWh and €35-50/MWh respectively (Germany and Spain).
Taking Germany as an example, average monthly day-ahead wholesale prices are shown below plus the amount of on-shore wind generated in that month. (source: ENTSO-E).
In Germany, EEG reference values for wind sit at around €60/MWh both for historic FiT funded wind (most of which transitioned to “direct marketing”) and for wind built under the auction system (which started in 2017).
Given that in each month the average wholesale price was far greater than the reference value, no “market premium” was paid in the period September 2021 through to January 2022. The situation is less extreme in the case of PV installations since they produce less in winter.
In most EU Member States, when the levelised costs of renewables (LCOEs) were greater than “normal” wholesale prices (1990 through to September 2021), citizens were called on to fund the difference i.e. the difference was socialised in the interests of decarbonising the power sector.
By contrast, renewable windfall profits are now being enjoyed by energy companies because the electricity market continues to use marginal pricing to form wholesale prices.
If the way in which wholesale prices are formed is changed to a basket price approach, the inherently lower costs of renewables will have a downward influence on wholesale prices even if gas prices were high. In turn there would be minimal windfall profits for renewables.
In Germany (and proportionally in other countries) citizens are funding renewable windfall profits to the tune of €10million to €50 million per day, i.e. around €1 per day per household (in Germany) – far more than the reduction in their EEG charge.
All this brings up a number of open questions.
- To politicians and regulators: are windfall profits an acceptable situation? Is it fair that households pay for them? Or is this an example of markets functioning badly? And if so, what can be done?
- To the public: do politicians and regulators work in the interest of companies, or citizens? Do politicians understand how electricity markets function, or not? In the case of Belgium, the answer seems to be no.