Renewable electricity prices could be decoupled from gas prices without all the market interventions European countries are currently resorting to, writes Arpad Cseh.
Arpad Cseh is the founder of Climate Moonshot, a non-governmental, non-commercial initiative focused on creating the political will for tackling climate change and aiming at reaching a world with a safe and just climate.
The pressures created by high energy prices have been greatly exacerbated by the fact that wind and solar power prices are linked to gas prices in European electricity markets. Prices paid by consumers for renewable electricity soared even though their cost has not changed.
Governments have been addressing this discrepancy through price controls, taxing windfall gains and supporting consumers. While such market interventions can relieve acute pressures in the short-term, they should not be viewed as long-term solutions as they lead to undesirable consequences. New market designs can offer better solutions.
Shortcomings of the current wholesale market design
Under pay-as-clear market rules the price of all electricity sold in the wholesale market is determined by the most expensive unit of energy.
This approach offers important benefits and has served the electricity system dominated by dispatchable generators and significant variable costs well, ensuring efficiency as generators respond to price signals.
However, its suitability and sustainability is questionable as the share of renewables increases. Their output cannot be increased or decreased in response to short-term price signals, negating the efficiency gains of linking their price to the marginal cost of other resources.
Looking ahead, even when wind and solar energy become the largest source of electricity, the electricity price will be linked to the gas price much of the time, a situation that will increasing feel like the tail wagging the dog. Recent price spikes simply accentuated the issues this market design creates for various stakeholders:
- Consumers – unless generating their own renewable energy – do not fully benefit from the declining cost of renewables. They are also exposed to the high volatility of gas prices in contrast with the more stable and predictable cost of renewables.
- Renewable projects face a range of risks: exposure to volatile power prices which weakens their risk profile and increases their cost of capital; the risk of price cannibalisation, i.e. that prices will be depressed when they sell power as an increasing renewable fleet generates power at the same time; and the risk of political interventions which limits potential upsides when prices are high, highlighted by the experience of this year, without mitigating the downside risk of falling prices. These risks could hamper the deployment of solar and wind even as their costs continue to fall.
- Fossil fuel generators also face declining profitability as renewables capture a growing market share. Their gross margin from energy sales will decline and their economic viability will suffer even though their services will be required during the transition.
- Politicians and regulators in turn face the pressure to intervene and prevent energy companies from benefiting from high prices at the expense of consumers.
What an alternative market design could look like
A separate market for renewable electricity, which complements and hence retains the efficiency benefits of the current market for dispatchable resources, could decouple the price of renewable power from gas. The market for renewables should be a long-term one to align with the typically 25-30 year project lives and to create a long-term price signal for renewable capacity, which can drive investment decisions in contrast to the short-term power price signal.
Historically, subsidy schemes such as feed-in tariffs created a separate market for renewables, but with their increasing cost competitiveness these markets are being phased out. There also exists a market for fixed priced power purchase agreements (PPAs), but currently its extent is rather limited. PPAs typical cover only a fraction of a project’s life; counter-party risks, transaction costs and regulatory hurdles reduce its efficiency; and most end consumers cannot access PPAs.
One way to build out a separate market for renewables could be for governments, regulators and development banks to actively support the expansion of the PPA market in terms of scope and scale. They could provide credit support instruments to mitigate the long-term counter-party risk both sellers and buyers face with PPAs. PPA syndicates, spreading the risks of bilateral PPAs and broadening the number of market participants, could be encouraged. Energy suppliers could be mandated to cover a portion of their long-term energy needs through long-term renewable PPAs. Regulators could facilitate the standardisation of PPAs in order to reduce transaction costs and to enable a secondary market and thus liquidity for PPAs.
Alternatively, a centrally organised market for long-term, as-generated renewable power could be established. Products in this market would have to reflect the differences in the generation profile of specific technologies, geographies and seasons. To take a simplified example, a product traded might be the solar energy delivered by a typical 1MW capacity project in Sicily in July 2025. Prices in this market would thus be decoupled from the spot market as well as forward markets which are linked to spot prices. Similar to PPAs, the market’s liquidity could be supported by requiring suppliers to cover part of their long-term energy need through renewable power.
Besides building out a separate long-term market for renewables, it also needs to be accessible to all end users not only traders, suppliers or large corporates, otherwise households and businesses would still face the high and volatile electricity prices linked to gas. PPAs – or contract for difference schemes that continue to support some renewables – do not necessarily pass through renewable prices to end consumers. A requirement for suppliers to offer pricing plans reflecting the cost and increasing share of renewable power would not only ensure access for all consumers, but would also support the development of a long-term market for renewable power and reduce suppliers’ exposure to price volatility, the importance of which is highlighted by the recent bankruptcies.
A thriving long-term market for renewable electricity could thus reduce the link between power prices and volatile gas prices, could ensure consumers benefit from the declining and predictable cost of renewables and could support the deployment of renewables. It could also be an important pillar of an electricity market designed for the area of renewables and the energy transition.
Notwithstanding the difficulties posed by the energy transition and exacerbated by the current energy crisis, governments and regulators must not lose sight of the promise the transition holds: the resolution or at least amelioration of the energy trilema by reducing the trade-offs between energy security, economic affordability and environmental sustainability over the coming decades.
The energy system can at the same become more secure, as renewable resources are more equally and widely distributed than fossil fuels reducing the dependence on fossil energy rich countries; more affordable, as the cost of solar, wind and other enabling technologies continues to decline; and more green, as the share of renewables grows.
