Structural Changes in Energy Markets and Price Implications

The 2021-22 energy crisis contains key lessons for financial regulators regarding energy price components and the transition. This paper by Miguel Gil Tertre finds the crisis was primarily driven by record-breaking rises in wholesale gas prices, which translated into higher wholesale electricity prices.

He stresses that to stabilise prices regulators should tackle the disproportionate price-setting role of natural gas, increase the share of renewables in the energy mix, reduce overall energy consumption, and maintain stable and cheap electricity prices.

Gil Tertre, chief economist of the Directorate-General for Energy at the EU Commission, states that the euro area only contained the passthrough of wholesale prices to consumers through “decisive” policy action.

This included an EU-wide market correction mechanism, which enacted bidding limits for gas futures and forward trading, and a change of course in EU energy strategy, as outlined in the REPowerEU plan. The plan committed to accelerating the deployment of renewables and energy efficiency measures by upgrading targeted infrastructures.

Gil Tertre assesses the transition’s price implications through a multidimensional analysis which considers how the various structural changes caused by the transition can be managed through policy. His analysis also distinguishes between the longer term structural effects of transition and short-term fossil fuel price spikes caused by mismatched supply and demand.

Increasing the share of renewables is likely to have a downward and stabilising impact on prices, says the author. As renewable energy progressively crowds out more expensive sources,such as oil and gas, electricity prices and the impact of fossil fuels as price setters are predicted to decline. About half of the additional renewable capacity foreseen by the European Commission’s central MIX scenario is estimated to reduce wholesale power prices between 1.5% and 9% by 2025.

For renewables to set prices in proportion to their greater deployment, supply and demand fundamentals must be carefully managed. During the transition, marginal volumes of natural gas will still be needed for electricity generation during peak hours.

To avoid price shocks caused by sudden supply and demand mismatches, fossil fuel demand must be reduced at a pace that is commensurate with the decrease in global supply, says Gil Terte.

Gil Terte discusses five other dimensions which may raise prices unless carefully managed:

1. supply of transition critical minerals – green technology is mineral intensive, so cheap and stable access to resources is needed to avoid supply shortages and higher electricity prices
2. carbon taxes and prices – increasing carbon costs may increase prices but macroeconomic costs can be limited by revenue recycling measures such as targeted fiscal support for vulnerable households and reduced taxes on electricity
3. replacement of capital stock – poorly managed decommissioning and regulation of assets could generate costs that are passed onto consumers
4. policy uncertainty – poorly sequenced or erratic changes may cause volatile prices
5. infrastructure investment – the transition will require massive upfront investment which may initially raise prices. However, if properly managed, this will create lower ongoing costs.