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Price signals continue to be needed in the electricity market

The electricity market is not broken. Instead, it continues to function as expected, despite the ongoing energy crisis.

Across Europe, a lively debate has been sparked on the reforms needed in the electricity market.

The development that started in the autumn of 2021 as a consequence of the increase in the price of natural gas, as well as the supply restrictions that followed, brought about a previously unseen turbulence in the market. The combined effects of the Russian attack on Ukraine, the French nuclear power plant outages, and the low levels of hydro in Europe further worsened the electricity supply problems. These resulted both in high price spikes and extended periods of high prices in the electricity market.

After the rapid deployment of short-term measures, the European Commission has taken the functioning of the current electricity market model and its eventual development needs under review. The Commission’s consultation on the market model ended in mid-February, with the questions arising therein pointing to the various tools the Commission is considering in order to repair the current market design.

The electricity market is not broken, however. Instead, it continues to function as expected, despite the ongoing energy crisis. In fact, a balance has been struck in the market in terms of supply and demand.

The occasionally high prices have incentivized consumers to use electricity prudently.

At the same time, the high prices have signalled the tight supply situation and distributed the scarcity of supply across Europe, all while utilising the interconnectors in an efficient manner. There has been enough available electricity, and there has been no need to resort to the planned outages. Nevertheless, the occasionally high prices have incentivized consumers to use electricity prudently.

In various parts of Europe, including Finland, high electricity consumption savings have been reported. It’s likely that these would not have been realized without the steering effect of high electricity prices.

High prices and prolonged periods of high prices have caused concern and economic difficulties for households and businesses alike. The culprits for these problems have been sought from the marginal pricing applied in the day-ahead market to the lack of long-term contracts and hedging possibilities.

In marginal pricing, all the available cheapest bids are used, and the market price is set by the last bid needed to meet demand. The European day-ahead market combines the supply-demand balance with optimising the use of cross-border transmission capacities. This means that the current solution generated by the day-ahead market provides the most efficient market result, in which the price steers electricity generation, consumption, and flows throughout Europe.

To avoid high prices and price variations in the future, a solution has been proposed in which a buffer will be set up between the prices paid by electricity consumers and the prices emerging in the short-term markets. The instruments used in such a solution could include various long-term agreements that would fix the price paid or received for a long time in the future.

When the electricity market was liberalised in mid-90s, one issue causing discomfort for a long time was the host of long-term contracts that had been entered into before the market opening. They tied the hands of market actors in the changing business environment.

Careful consideration must be given to whether long-term constructs improve the functioning of the market or whether, in fact, they create new brakes as the electricity system continues to undergo rapid change. It would be important, instead, to focus development efforts on organised hedging markets, the liquidity of which has collapsed in a short time.

The profound change in the electricity system has been linked to a paradigm shift – from ‘generation follows consumption’ towards ‘consumption follows generation’, especially as the generation structure increasingly becomes dependent on intermittent wind and solar energy.

Consumption can also be flexible where possible.

It becomes important that consumption can also be flexible where possible. Through shifting electricity consumption to a point in time when there is an abundant and cheap supply of renewable electricity, the consumer will be able to purchase cheaper electricity at the same time as valuable flexibility is offered to the market.

The European debate on the electricity market design is now being confronted by several choices. What is certain is that the volume and share of renewable generation will grow alongside electricity consumption. Going forward, we will need significant investment in both generating and using clean electricity.

The laws of physics aren’t changing, and the electricity system needs to be in balance at any given moment. If the cost of electricity for consumers and the market price are decoupled or this link is significantly weakened, an important steering signal is lost.

The importance of the steering effect has become very clear this winter, there are no two ways about it, and we cannot afford to lose it – price steers and generates the most efficient market result.

Asta Sihvonen-Punkka
Executive Vice President, Fingrid Oyj


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