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How the energy transition is shaping the electricity market
Why electricity prices are soaring when renewables are often cheaper than coal and gas

Electricity is meant to be invisible. But in future, one ‘colour’ is to be particularly preferable: green, or in other words – sustainable. The necessary changes to our energy system are already well under way. Electricity produced by conventional power plants and fossil fuels the world over is being replaced with renewable energy from wind and solar. However, power from renewable sources is inherently subject to weather-based or seasonal fluctuations, giving rise to challenges that effect the entire system, and can also have an impact on trade. In the first part of our miniseries, we took a closer look at basic market mechanisms. Now, we’ll be focussing on the ways in which the system itself can support the energy transition.

Let’s start with the good news: in recent years, solar and wind technology has become significantly more cost-effective. With the result that generating power with renewables is often cheaper than when using fossil fuels. In fact, PV solar energy is now thought to be the cheapest way to produce electricity. However – and here comes the bad news for consumers – this has little impact on electricity prices. In fact, household bills have actually recently risen in many EU countries, although market mechanisms have only played a small part in this increase.

Fossil-fuelled reserves and grid expansion drive electricity prices upward

In fact, these rises are largely due to the transition itself: it is currently not possible to make green electricity available 24/7, vast storage capacities would need to be built first. This is because storage is the only way to use wind and solar power when the wind isn’t blowing, and the sun isn’t shining. Until then, fossil fuel power stations are needed to secure supply during these periods. However, these stations are not cheap to operate, particularly if they are only used as operating reserve with minimal full load hours.

Power prices for households in Europe between 2011-2021

in cent/kWh with an annual consumption of 2500-5000 kWh, source: Strom-Report.de

As the energy transition continues to drive the use of renewable energy, our power supply will become increasingly decentralised. Millions of panels, mounted on roofs and spread across fields will generate electricity instead of large power plants. And as the electrification of a growing number of industries accelerates in order to reduce CO2 emissions, demand for electricity will only keep on growing. Needs that cannot be met with today’s network infrastructure. This means that electricity grids need to be massively expanded, which drives network charges up.

These expenses are passed on to consumers via fees and taxes, causing household electricity bills in the last 10 years to rise by 14 percent in the EU, according to Eurostat. In 2021, the average price for a kilowatt hour (kWh) was 21.9 cent.

Renewables enjoy advantages on the electricity market

So how is the energy transition affecting electricity markets? Wholesale electricity prices are defined by the marginal costs of the most expensive power plant needed to meet electricity demand. And since the marginal costs of wind turbines and photovoltaic plants are virtually zero, and thus generally lower than those of conventional power plants, they can lower the wholesale price on the market – because the higher the proportion of low-cost electricity sources, the fewer power plants with higher marginal costs are needed. Particularly during periods when renewable electricity is available in abundance, these sustainable plants pip their fossil fuel counterparts to the post – a mechanism known as the merit order effect. However, many EU states go beyond this and assign feed-in priority to renewables, specifying they should only be throttled if there is a danger of overloading the grid.

Marginal costs

Marginal costs are the costs added by producing additional electricity. In the case of a conventional power plant, for example, they can include expenses for fuel or emission certificates. Differences between the marginal costs of the different power plants are key in electricity trading. This is because the power plant with the most expensive marginal costs – the marginal power plant – determines the price on the exchange for all power plants involved. The marginal power plant is the last power plant deployed to cover demand and is the most expensive to run.

Merit order principle

The merit order principle is a way of ranking generation capacity to determine the order in which the respective facilities should be brought online to meet increased demand. The principle ranks the power sources by ascending order of price, wherein the plants with the lowest marginal costs are prioritised to cover as much demand as possible. Once the capacity of the cheapest source has been exhausted, the next cheapest source is brought online. The principle states that suppliers are progressively added until electricity demand is covered in full. The last plant to be brought online determines the electricity price, as it has the highest marginal costs.

Negative electricity costs

When weather conditions are particularly favourable, feed-in from wind and solar power can exceed demand, leading to short-term negative electricity prices on the day-ahead and intraday markets. Rather than be compensated for feeding electricity into the grid, the producers themselves have to pay for the privilege. The aim here is to encourage the operators of fossil fuel power plants to tailor their generation to the availability of renewables, while also spurring renewables to base their generation on demand. The system also incentivises the further expansion of flexible storage solutions.

Operating reserve –  a safety net for security of supply

The balancing market exists to help balance the challenges of a volatile electricity supply. If there is a shortage of power, participants make electricity available at short notice (positive balancing power). In times of oversupply, they take electricity from the grid (negative balancing energy). The reserves can be used to cushion grid fluctuations at 15 minutes’, five minutes’ or 30 seconds’ notice. In continental Europe, up to 3,000 megawatts (MW) can be generated or consumed in this way.

Types of operating reserve

own diagram
Type of control energyPRL/ FCRSRL/ aFRRMRL/ mFRR
Provision byENTSO-EÜNBÜNB
ActivationFrequency controlled: Independent measurement/intervention on site by providers of PRL By ÜNB responsible for control areas - replaces PRL automaticallyBy ÜNB responsible for control areas - manual request by ÜNB
Full PowerWithin 30 secondsWithin 5 minutesWithin 15 minutes
Period to be covered after fault0 to 15 minutesFrom 30 seconds to 15 minutesFrom 15 minutes to 60 minutes
Remuneration Power priceOutput and workpriceOutput and workprice
Size of the minimum offerFrom +/- 1 MW (symmetrical)5 MW positive or negative*5 MW positive or negative*
Daily productsPositive and negative: 6 time slices over 4 hoursPositive and negative: 6 time slices over 4 hoursPositive and negative: 6 time slices over 4 hours
*A bid size of 1 MW, 2 MW, 3 MW, or 4 MW permitted provided that a minute reserve provider submits only one bid per product time slice of positive or negative MRL in the respective control area.

Price formation on the balancing market

An availability fee remunerates participants for their willingness to act as operating reserve. If the electricity is used, then the utilisation fee is added, which is determined via an auction: whoever submits the best bid wins the contract. Since 2018, this has covered both the availability fee and utilisation fee. The way in which the fees are weighted depends on a number of factors, e.g. how likely it is that a market participant’s balancing energy will be called for. Normally, the prices are higher than the market price, which is why participation can undoubtedly be lucrative. At the same time, the participating plants must meet certain technical requirements, which takes some stations out of the running.

Close networking in Europe

The European electricity market is becoming more and more closely networked, not least to forgo the need for expensive operating reserves. This has led to formation of the ‘Joint Allocation Office’, where long and short-term contracts are concluded between trading partners on the European electricity market.

In day-ahead trading, the markets of different countries are linked via a market coupling mechanism. Market participants continue to only take part in auctions in their respective country, however the auction process also generates cross-border bids. In the event of price differences, countries with lower prices supply electricity to states where power is more expensive, with the aim of levelling out prices.

If the price is right

In trading, there is no way to distinguish between electricity from fossil fuels or renewable sources. The price alone is decisive. Particularly since electricity is fed into the same grid either way. In over-the-counter (OTC) trading – i.e. off-exchange trading – buyers are theoretically able to favour contracts with green electricity suppliers. However, this does not ascertain that they are actually buying renewable energy.

Green power certificates and PPAs

Renewable energy producers receive guarantees of origin for the amount of electricity generated. However, these guarantees are traded independently of the electricity market. Companies looking to buy renewable electricity can only do so via this workaround – at least in exchange trading – because grid electricity is always ‘grey’. Direct supply agreements with green power suppliers, known as power purchase agreements (PPAs), offer an alternative to this. However, these contracts can only be concluded as off-market transactions.

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