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Figuring out how to reform the EU’s power market

Change is coming to the EU’s energy market.

Soaring natural gas prices — one of the blowbacks from Russia’s invasion of Ukraine and subsequent throttling of deliveries to Europe — and the resulting surge in electricity prices is creating a growing conviction among political leaders that the current market structure is no longer fit for purpose.

“Energy prices are breaking record after record. The consequences for households and companies are not sustainable,” European Commission President Ursula von der Leyen said Tuesday at the Baltic Sea Summit in Denmark.

“We need to address this — together and urgently,” she said as she joined politicians from eight countries bordering the Baltic Sea.

That’s bolstering the hopes of longtime skeptics of the EU’s power market, which sets prices according to the so-called merit order, with the last input needed to balance daily demand setting the price for the whole market. That’s recently been very expensive gas.

“The proposals we are making to change the price formation mechanism are falling on increasingly fertile ground,” Polish Prime Minister Mateusz Morawiecki said at the summit. He said he had talked to the leaders of Denmark, Finland and Estonia, “and all three agree that we really need to bring about a change” that will free the energy price from being dependent on Russian gas.

Faced with the worry that Russia will shut off its already diminished gas flows this winter, the EU is rapidly beefing up its storage — it’s now at 80 percent, the level that was planned for November 1.

That’s calmed prices a little. German one-year electricity contracts fell to €625 per megawatt hour on Tuesday from a high of over €1,000 per MWh on Monday. Dutch TTF gas futures, the European benchmark, fell to €250 per MWh on Tuesday from a peak of €339 per MWh on Sunday.

Weighing options

Reforms are up for discussion during next week’s emergency summit of EU energy ministers. What’s still not clear is just how a change to energy markets would work.

Any short-term intervention is likely to take the form of some sort of price cap, and would come on top of the tangle of national measures already brought in by EU countries, said Cillian O’Donoghue, policy director at Eurelectric, a trade association representing 3,500 European utilities. 

“Gas prices have a major role in the electricity price, and gas prices are exceptionally high — seven times higher than they normally are,” he said. “So finding an efficient way of delinking them has some added value.”

A similar system is already in place in Spain and Portugal. The two countries got Brussels to agree to a so-called Iberian exception in June that allowed them to decouple the price of gas from power for one year by setting a maximum gas price of about €50 per MWh. 

“It’s definitely reduced Iberian prices” on the wholesale market, said Cem ​​Bektas, an energy market analyst at the ICIS consultancy.

But it has seen a surge of electricity exports to France, where power prices are higher.

That means that Spanish taxpayers — whose money is collected by the government and then redeployed to keep prices low — are effectively subsidizing power for French households. Madrid and Lisbon have earmarked €8.4 billion for the measure.

The system would work better if it covered the whole bloc, so there wouldn’t be that type of leakage.

Another option would be imposing a windfall tax on energy producers or utilities — something Spain, Italy, Romania and Greece have already done and an idea that’s gaining traction in Germany — although it’s causing tensions in the ruling coalition.

Von der Leyen also wants to revamp the power market’s design over the longer term — raising even more unknowns.

One option, initially proposed by Greece, would split the market into renewable energy and fossil fuel producers. It would then fix the price for power coming from renewables to allow generators to profit but less than they do currently from gas prices — while keeping the rest of the market as it is. Consumers would then pay an average of the two prices.

Although this would reduce prices for power, prices would still be relatively high while gas also remains expensive, said Glenn Rickson, head of European power analysis at S&P Global. It could also disincentivize investments in renewables by making them less profitable.

Another option is a “pay-as-you-bid” system, where producers place bids for power contracts that depend on their generating costs — which are much lower for renewables than fossil fuels including gas.

But producers are likely to just guess the price that gas suppliers are putting forward and place their bids just under that, Rickson said, which would again fail to reduce prices drastically.

This shows a need to address “the root of the evil” — Europe’s dependency on fossil fuels from unreliable partners, said Eurelectric Secretary-General Kristian Ruby.

“We need to also focus on where the real problem lies and try to address the fact that right now, electricity market reform … will not change the flow of money that’s currently going to Russia,” he said.

This article is part of POLITICO Pro

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