The electricity market design is back in the headlines. To many in Brussels who followed the recently closed review, Ursula von der Leyen’s hints to a possible reopening of the legislation felt a bit like “Groundhog Day”, the 1993 movie where the protagonist relives the same day over and over again.
Only time will tell whether Europe is heading towards yet another reform of #EMD. As the next European Council on 19-20 March gets closer, the debate around marginal pricing is once again gaining momentum.
In this #FridayFeature edition, we aim to bring some clarity amid the noise. And to do so, we are joined by a very special guest: Lion Hirth, Professor of Energy Policy at Hertie School and author of the explainer “Marginal Pricing and the ‘Merit Order’”, developed in cooperation with Eurelectric.
How electricity wholesale prices are formed
In electricity markets, electricity is traded, bought, and sold between producers, suppliers, and consumers, following the economic principle of demand and supply. Because electricity is difficult to store, it is produced and consumed almost at the same time. To align with supply, markets operate in different timeframes: day ahead, intraday and forward markets.
In the wholesale market, generators sell their production to suppliers and traders. Generators are dispatched from the least expensive – most often renewables – to the most expensive energy source until supply is met, following the so-called merit order. This means that only the cheapest sources of electricity needed to meet demand is called upon. Alongside taxes and levies, network costs and carbon costs, these purchased volumes then make up the retail price of electricity paid by consumers, such as businesses and households.
Don’t touch the market: reopening the discussion won’t solve the problem
Eurelectric has been a strong advocate of the marginal pricing system, for a simple reason: there is no alternative that can deliver efficient markets while keeping prices competitive. Marginal pricing is the standard mechanism through which prices are formed in free markets. It does not only apply to electricity, but also other commodities such as oil, gas, and metals.
Reopening the electricity market design legislation risks creating uncertainty and could delay the investment decisions needed to decarbonise the EU’s energy system, while safeguarding the competitiveness of European industry. This message was recently reaffirmed by the Eurelectric Presidency in a letter sent to EU Heads of State and Government. President Markus Rauramo (CEO of Fortum), Catherine Fiamma MacGregor (CEO of ENGIE) and Georgios Stassis (Chairman and CEO of PPC S.A.) called for regulatory stability and reaffirmed the merits of marginal pricing in Europe’s electricity market ahead of the upcoming European Council Summit.
The Faustian bargain
The letter came against a backdrop of renewed discussions on marginal pricing, as well as worrying proposals to lower energy prices recently put on the table by two Member States. Two approaches have recently been put forward:
The Italian Approach
Italy proposed a compensation mechanism for natural gas generators similar to the Iberian Mechanism introduced by Spain and Portugal during the 2022 Energy Crisis. The mechanism would cover the variable component of gas network tariffs, the portion of gas tariffs linked to general system charges and cover the CO₂ costs created by the EU Emissions Trading System. The effective impact of this is to enable gas-fired power plants to lower their variable costs, encouraging the generators to submit power bids in the wholesale market and therefore reducing the wholesale electricity price. The costs of the subsidy are then recovered through a levy on electricity consumption.
The Austrian Approach
Austria proposed a market split into two segments, fossil plants and renewables, thereby decoupling electricity and gas prices. Under the current marginal pricing system, all generators are paid the price set by the marginal plant, which is most often a gas-fired rather than a renewable generator. In a split market, renewables would therefore receive a lower price, reflecting their lower production costs.
Both options, however, would do more harm than good.
- The Austrian proposal raises fundamental questions about how such a system would work in practice – particularly with regards to market coupling, intraday trading and balancing.
- The Italian proposal, meanwhile, would incentivise increasing generation from natural gas over renewables – making Italy’s energy mix more reliant on fossil fuel imports, whilst also penalising consumers who have hedged their electricity purchases on forward markets. These consumers would still have to pay the new levy without necessarily benefiting from lower prices. In effect, this could discourage hedging and leave consumers more exposed to price volatility. It would also affect Europe’s electricity market coupling by altering the balance of Italy’s electricity imports and exports.
“The Iberian Mechanism penalizes consumers who have hedged their electricity purchases and will make consumers more vulnerable to future price volatility. Moreover, if an intervention successfully lowers wholesale prices, the overall cost burden does not disappear” explains Lion Hirth.
“First, the subsidy paid to gas plants is recovered through a new levy, increasing final electricity prices. What is more, support payments to renewable generators are often structured to adjust automatically when wholesale prices decline. As a result, lower market prices increase subsidy payments, which are ultimately financed by taxpayers or electricity consumers“ he adds.
The case for staying the course
As discussions resume ahead of the European Council, the renewed scrutiny of marginal pricing reflects broader concerns about energy affordability and Europe’s economic competitiveness. But reopening the electricity market design legislation risks addressing the symptoms rather than the underlying challenges, as Eurelectric’s Secretary General Kristian Ruby highlighted in this op-ed on FORESIGHT Climate & Energy.
Marginal pricing remains the most efficient way to manage electricity markets. By ensuring that the cheapest available generation is dispatched first, it delivers efficient system operation while providing transparent price signals for both consumers and investors. These signals are essential as Europe accelerates the deployment of renewable energy, expands electrification and invests in the flexibility needed for a decarbonised power system.
Proposals to artificially suppress wholesale prices or split the market may appear attractive in the short term, but they risk distorting market signals, discouraging hedging and increasing regulatory complexity. In the long run, this could undermine investor confidence and slow down the investments required for the energy transition.
At a time when Europe must simultaneously decarbonise its power system, protect consumers and maintain industrial competitiveness, regulatory stability matters more than ever. Rather than reopening a market design that was only recently reformed, the priority should be to implement it effectively and allow markets to deliver the investment needed for Europe’s energy future.
This blog post was originally published as part of Eurelectric’s LinkedIn Friday Features. Subscribe here to stay updated and never miss an edition.
Disclaimer: This article is for communication purposes only and may not reflect Eurelectric positions. Any positions taken in this article shall not be attributable to Eurelectric’s official positioning. Official Eurelectric positions are reflected only in position papers published here.