EU leaders must be ready to rethink the design of the electricity market

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After two mammoth days of summits in Brussels that saw US President Joe Biden come in for NATO, G7 and EU meetings, late Friday afternoon European prime ministers and presidents were exhausted – this is saw on their faces. However, one question kept them debating until late in the evening: whether to decouple the prices of electricity and gas.

It sounds technical, but it could have a huge impact on the price that households are paying for energy right now, which are rising due to soaring natural gas prices. The EU uses a “merit order” system to determine electricity prices, in which the most expensive power plants set the overall price.

The price of the electricity exchange varies according to the amount of energy available from different types of sources and at what price. In times of high inflow of low-cost renewables (such as sunny or windy days), coal and gas become so expensive in comparison that they are shut out of the market – but these most expensive plants still set the price global electricity. This removes the price incentive to switch to renewables.

Spanish Prime Minister Pedro Sanchez fought hard to secure an agreement to change the price of electricity. (Photo by European Council)

Compromise after conflict

For months, Spanish Prime Minister Pedro Sanchez has been pushing for this system to be changed so that the price of electricity is decoupled from the price of gas. This is particularly important for Spain and Portugal, which have very high renewable electricity production and are almost completely decoupled from the rest of the EU energy market due to poor interconnections over the Pyrenees.

Sanchez won support for his idea in Italy, Spain and Belgium – but met fierce resistance from Germany and the Netherlands. Opponents say the current system is not perfect but is the best way to manage prices, and changing it could have undesirable long-term effects. They say any form of intervention in the energy market could mean that suppliers decide to sell their gas elsewhere, which would only exacerbate the energy crisis.

They also point out that prices fluctuate and that intervening in the market by changing the merit order system or imposing a price cap could backfire because if the price set may be lower than the current market price, it could be higher in the future, leaving European consumer countries paying more for electricity than they otherwise would have.

On March 25, European leaders agreed that the European Commission will examine the pros and cons of a Europe-wide electricity market reform. In the meantime, Spain and Portugal can already temporarily decouple electricity and gas prices, subject to analysis by the Commission to ensure that this does not disrupt the rest of the electricity market. EU energy in a manner “contrary to the common interest”.

“The Iberian Peninsula has a very special situation,” Commission President Ursula von der Leyen said after the compromise was finally reached on Friday evening. agreed on a possible special treatment for the Iberian Peninsula so that the Iberian Peninsula can deal with this very specific situation in which it finds itself.

The compromise doesn’t give Sanchez and Portuguese Prime Minister Antonio Costa all the flexibility or certainty they’ve been looking for, but it does allow them to take immediate steps they say will lower energy bills for people in Spain and the rest of the world. Portugal, where energy prices are generally higher than in the rest of Europe. They held a joint press conference after the summit claiming at least a partial victory.

“We led the debate, and the goal we set for ourselves, we fulfilled in this Council,” Sanchez told reporters. “Our conversations and the proposals raised with the energy ministers have borne fruit in a very beneficial agreement for the Iberian Peninsula.”

Bolder action is needed

In the end, it was a face-saving compromise where both sides could claim victory, but the intransigence of Germany and the Netherlands left many people frustrated, and feeling that at least some leaders are not taking the growing energy price crisis seriously enough. That some northern heads of state have such unshakeable faith in the market, even under extreme circumstances, does not show a very high level of creative thinking.

Belgian Prime Minister Alexander De Croo, who is a liberal, voiced that frustration as he entered the summit on Friday. “The prices today have nothing to do with reality,” he said. “I know intervening in the market is not an easy thing to do, but we are at war.”

De Croo backed Spain in its intervention on electricity prices and separately lobbied for a deal to have joint EU gas purchases, as he did with Covid vaccines, to prevent price increases from each EU country bidding against each other. The idea has also met with fierce resistance from Germany and the Netherlands in recent months, but they dropped their opposition after Russia’s invasion of Ukraine and the initiative passed on Friday.

Not finished yet

However, on electricity prices, skeptics insist on further study. “We looked at various options to cushion the impact of high energy prices on consumers and businesses, measures such as income support or state aid, vouchers, tax reduction, price caps, price modulation, contracts for difference,” von der Leyen said after the summit. “All of the options we presented have pros and cons.”

It will present options in May on the issue of decoupling gas and electricity prices, as part of a broader proposal to respond to energy price increases, which will also contain the framework for gas purchases in common. However, European sources said they expected Dutch and German opposition to market intervention to remain equally fierce.

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Friday’s compromise gave Sanchez and Costa something to come out of the summit with after insisting they wouldn’t leave without some sort of consumer relief. After the summit, they said they would quickly come up with proposals to reduce energy bills.

Sanchez was right to go to the mat for it, even when it caused frustration from others at the top who felt he was hijacking the proceedings. Energy prices are a huge chunk of consumer spending, and they’re rising rapidly when people can least afford them. Extraordinary times call for extraordinary measures. German and Dutch orthodoxy in protecting energy market principles, even in the face of war, does not bode well for leaders’ ability to find creative solutions to this crisis in the months ahead.

If the Commission returns to leaders in May with the conclusion that decoupling is both feasible and desirable, further resistance from Berlin and The Hague should not be politically tenable. Old ways of thinking are falling by the wayside as the Ukrainian war enters its second month. This should also be the case for the reflection on the European energy market.

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