When gas prices surged last year, electricity prices in many countries followed suit. The reason for the increase in home heating gas prices is clear, but why did electricity prices also rise? Many countries, including the UK, now incorporate significant renewable energy sources into their grids. The operating costs of wind and solar farms are minimal once constructed. So, why didn’t these renewable sources exert downward pressure on electricity prices instead of allowing gas to dictate the market? This article provides a simplified explanation of the underlying mechanisms driving electricity prices.
Wholesale Electricity Costs, Not Green Taxes, Drive Price Hikes
The primary driver behind the recent surge in energy bills is the increase in wholesale energy prices – the cost of generating electricity. A breakdown of the UK’s capped energy price reveals that the substantial increase in 2022 was primarily due to wholesale costs. Green levies and supplier profits constitute a relatively small percentage of consumer bills. Therefore, contrary to some proposed solutions, eliminating green levies would have a negligible impact on consumer bills. The core issue lies in the wholesale price of electricity.
Marginal Pricing: How Electricity Prices are Set
Many electricity markets employ a pricing model called “marginal pricing” or “marginal sourcing.” In this system, the most expensive energy source required to meet demand sets the overall price for electricity. Let’s consider a simplified scenario with three electricity sources: renewables (solar and wind), nuclear, and natural gas. Renewables have the lowest generation costs, followed by nuclear, and finally, the more expensive natural gas.
Electricity producers submit their generation costs to the market. The cheapest sources, renewables, are prioritized, followed by progressively more expensive sources until demand is met. The final electricity price is determined by the most expensive source needed, even if only a small amount is used. This “marginal” source sets the price, rendering the costs of cheaper sources irrelevant in the final price calculation. This process occurs every half hour to accommodate fluctuations in demand and renewable energy generation throughout the day.
When gas prices spiked, the marginal cost of electricity rose accordingly, driving up wholesale electricity prices.
The UK’s Reliance on Gas Sets Electricity Prices
The UK consistently utilizes natural gas in its electricity mix, even if it’s a small percentage. Because of marginal pricing, this small amount of gas often sets the overall electricity price. Research indicates that gas was the marginal price-setting source in the UK approximately 98% of the time in 2021, despite only accounting for 40% of electricity generation.
Lower Demand or Increased Renewables Could Lower Prices
To mitigate the impact of gas on electricity prices, either demand must decrease, allowing renewables and nuclear to meet needs, or the supply of renewables and nuclear must increase to minimize reliance on gas.
However, the intermittent nature of renewables necessitates backup power sources, often gas, for periods of low renewable generation. Effective energy storage solutions are crucial to address this challenge.
Marginal Pricing: A Common Market Mechanism
The marginal pricing system, while seemingly counterintuitive, is a standard practice in commodity markets, reflecting basic supply and demand principles. While ensuring the utilization of the cheapest available resources and promoting low-carbon energy use, this system links electricity prices to volatile fossil fuel markets, hindering the cost benefits of renewables from reaching consumers. This price volatility discourages the widespread adoption of electric vehicles and heat pumps, essential for decarbonizing the economy. Addressing this issue requires a reevaluation of the current electricity market system.
