After the sudden demand reduction during the COVID-19 pandemic lockdowns in 2020, energy prices started to bounce back in direct correlation with the robust economic recovery of 2021. In the wake of Russia’s invasion of Ukraine and Russia’s tightening of natural gas supplies to Europe, this price increase has accelerated ever more rapidly, leading to a massive energy inflation that affects all types of consumers.

Energy price developments

The energy commodity price escalation has been most pronounced in natural gas, with a 30 x increase from €12/MWh in early 2020 to more than €350/MWh at its peak in 2022. Wholesale power prices developed accordingly. On average, they increased up to five-fold, with individual swings going much further. However, as the study authors note, while price deviation has increased significantly in absolute terms, relative price volatility remains in the long-term average range (2015 – 2022). This implies that energy markets continue to function without excessive volatility, albeit at a much higher price level.

In this context, it is important to differentiate between the complex succession of components of the European energy system. They vary in terms of liquidity and temporality. As electricity for future consumption is procured now, retail energy prices are expected to remain high for a long time, despite short-term measures and as both spot and forward markets are under severe price pressure.

Fundamental aspects of the crisis

Oil, natural gas, and coal-fired power stations account for 50 percent of Europe’s dispatchable power capacity. This means that energy prices are highly dependent on commodity markets, especially on natural gas prices, as gas-based power is particularly influential under the current “pay-as-clear” pricing mechanism. In this mechanism, the highest winning bid sets the price for all offers, including lower bids. The price-setting unit is typically a dispatchable power producer, while renewables rarely play this role due to a current lack of capacity and flexibility.

Even so, flashes of extremely high day-ahead prices remained relatively rare. This implies that the electricity crisis is not a result of market failure, but of natural gas price inflation. The influence of natural gas on electricity prices is heightened even more by the switch from coal to gas, whereby gas is meant to function as a bridge fuel toward a low-carbon economy. The theoretical gross margin of gas power (“spark spread”) dipped below the margin of coal power (“dark spread”) when the energy crisis started in 2021 and has remained there almost constantly, indicating the high profitability of remaining coal-fired power plants.

Further fundamental causes of the crisis are the recent decrease in French nuclear power generation due to technical issues and the exceptionally dry summer of 2022 which slashed hydroelectric power generation. While these aggravating factors are expected to subside going forward, the root causes persist and therefore the European electricity system urgently needs to become more resilient.

Electricity market policy proposals

Policymakers are currently discussing a broad range of market interventions aimed at keeping energy affordable for consumers. However, besides affordability, acceptability (consumer and industry protection) and long-term adequacy (supply security, decarbonisation) should also be considered when deciding on measures. Four types of policy proposals dominate the debate:

1. Power demand reduction: On paper, energy rationing is the most effective way to reduce electricity prices. However, demand has historically proven to be rather insensitive to prices. Up to now, only a few percent savings have been achieved despite high prices. Because of the pay-as-clear pricing mechanism, savings would need to be much higher for prices to noticeably decrease. Mandatory consumption reductions may be necessary to achieve meaningful price reductions, but they are politically challenging to implement.
2. Wholesale power markets intervention: Another proposed measure consists of a gas price cap combined with subsidies for power producers. This would lower the price for consumers and also the extra profits of low-cost electricity producers (“inframarginal rent”). Downsides include a lack of incentives to cut back gas-based energy consumption. Further proposals in this category include a power market split (“when available” vs. “on demand”) and pay-as-bid price setting in energy auctions, but would require many months before being implemented.
3. Welfare redistribution (windfall tax & subsidies): Market revenue caps targeting lower-cost producers (“inframarginal units” such as nuclear, biomass, oil, most renewables) would unlock additional revenue for redistribution, for instance to vulnerable consumers, while also guaranteeing reasonable margins for producers. However, there are concerns regarding implementation practicality and revenue uncertainty. European countries would benefit differently depending on their energy mix. Energy exports pose another challenge. Unilateral implementations of a cap may lead to market distortions and inefficiencies. Therefore, additional measures such as direct consumer support may be necessary: reduction of taxes and levies on electricity bills, regulated tariffs, one-off payments and block tariffs for baseline consumption. On a European level, a “solidarity contribution” might help to collect additional funds for redistribution, targeting taxable profits of companies in the oil, natural gas, coal and refinery sectors.
4. Regulatory environment: Another type of proposal aims to increase the reduction of energy prices by regulatory measures, such as toning down CO2 pricing, accelerating permitting processes (e.g. for LNG terminals), and nationalising power producers.
   

Assessing the options

These proposals and measures vary considerably in terms of effectiveness, political acceptability and long-term adequacy. This new Deloitte study provides a more granular assessment in its appendix. Potential options for utilities and consumers are also discussed in more detail, for instance the increased installation of power storage facilities (pumped hydro), or regulated incentives for Power purchase agreements, e.g., structured as Contracts-for-Difference (CfD), which help to establish a future price corridor. For more insights into the European electricity crisis, download the comprehensive Deloitte study “Facing the electricity crisis in Europe” here.

Download the Deloitte report “Facing the electricity crisis in Europe” and learn more.