The European Union is trying to deal with the most difficult energy winter in recent history that risks becoming the most basic factor in popular discontent and delegitimization of European governments. And the problem it has to solve is that to do that it needs to bring big changes to an energy market that it created itself and that took a long time to shape.
The reason is that the energy market in Europe is affected not only by the war in Ukraine and how it affects gas flows in particular, but also by the way energy is priced.
Europe remains highly dependent on natural gas, especially since it has been qualified for years as the critical “transitional” fossil fuel until the full transition to renewables. Coal collides with its large environmental burden and nuclear energy with the reactions of societies that have led in most European countries (except France) to political commitments for denuclearization.
But Europe is obliged to import huge amounts of natural gas, either from Russia – which it wants to be independent of in response to the war in Ukraine and which is also “turning off the tap” in response to European aid to Ukraine – or from international markets where already increased demand – boosted by the turbulence brought on by war – is driving up gas prices.
But that is one side of the problem. More correctly, one dimension of the problem, that is, the price of natural gas has soared and this beyond the production of electricity, greatly increases the cost for the industry, but also for the households that use it for heating.
The other dimension is that natural gas plays the crucial role in shaping the price of electricity.
The European energy market
For a long time in several European countries there was no “electricity market”. Electricity was produced by large public companies that used a mixture of different sources (coal, nuclear power, oil, natural gas, hydro) and set the price based on an average cost and often with political and social criteria. After all, they were companies that owned both energy production and distribution.
One of the EU’s goals for decades has been to liberalize the energy market. This was done by decoupling energy production and distribution and introducing competition and market forms into energy supply. This was thought to boost investment, help investment in renewables as well and make it easier for the consumer.
All this was combined with the parallel existence of the market for pollution rights and the emphasis on the existence of a cross-border energy market.
This gradually led to the current configuration of what is described as the target model, which is applied in most European countries. This includes two markets that act as auctions – the morning market and the intraday market), the futures market and the balancing market that caters to the system’s unforeseen needs. In Greece, the first three are managed by the Hellenic Energy Exchange and the fourth by ADMIE.
Although the operation of the model is quite complex, it nevertheless has at its core an element that is found in all goods markets where there may be scarcity: the price of the good – in this case electricity – is formed at any moment based on the price of the marginal of the quantity supplied that manages to cover the demand. If two fields produce wheat and the quantity of both is necessary to cover the demand, then the price of wheat will be formed based on that of the field that has a higher cost, as it will be able to produce there, while the other, which produces with less cost he will have more profit. This is very typical e.g. in oil where the price is shaped by the extremely low extraction costs of Saudi Arabia but e.g. the considerably more costly North Sea oil.
In the case of electricity in Europe, the problem is that the marginal price is that of energy produced from natural gas, which even when it is only part of the overall “fuel mix”, nevertheless determines the price as a whole. And when the price of natural gas multiplies exponentially, this also drags down the prices of electricity, as we are currently seeing in Europe.
The dilemmas of the European Union
But, at the same time, for the European Union, the formation of this very energy market was considered one of its greatest achievements. It was thought to have freed up markets, boosted investment and allowed greater investment in renewables, which would normally have a smaller profit margin. This also explains why ACER, the EU agency responsible for energy, has already insisted since April that the current form of organization of the wholesale energy market in Europe should not change. So do other think tanks. But the IMF had also insisted that there should be no major interventions in how the markets work, effectively opposing the subsidization of the most vulnerable social categories.
Until now most governments have mostly pre-empted forms of consumer subsidy so that they don’t have to shoulder the whole of the big increases. But, it is clear that there are limits to how much this can be applied, and this explains why the debate is opening to change the pricing mechanism.
This explains why the proposals that have actually existed to decouple the price of natural gas from the pricing of electricity are being studied, or why the effectiveness of the experience of the Iberian countries that received a form of “exception that allowed a cap on the price of natural gas” is being examined which is used to produce electricity (while subsidizing the gas companies on the basis of energy production charges). On the other hand, there are always voices that argue that if there is a major upheaval in the organization of the energy market in Europe, this will create bigger problems and they mainly oppose the short-term taxation of surplus profits to subsidize consumers. At the same time, there are voices that insist that beyond the need for social support, it is important that the price mechanism is also an incentive for consumers to reduce energy consumption, based on the goal set by the EU.
It remains to be seen whether the two milestones that have been set, the meeting of energy ministers on September 9 and Ursula von der Leyen’s “State of the Union” speech to the European Parliament on September 14, will present the new overall plan.