Renewed geopolitical tensions have sparked fear of a new energy crisis and higher prices. As a result, some EU member states have started questioning the marginal pricing system, presenting it as the cause of high energy prices. Based on a new explainer by Neon Neue Energieökonomik for Eurelectric, this article seeks to:
- debunk some misconceptions around marginal pricing,
- explain why proposed interventions on the electricity markets could ultimately harm consumers
What is marginal pricing?
Marginal pricing is the system used in wholesale electricity markets to determine the price of electricity. It sets the market price using the cost to produce the cheapest unit of electricity required to keep the lights on. This is the marginal unit.
Electricity supply depends on power generation and changes constantly, but it must match demand in real time. To reflect these changes, wholesale market prices are frequently updated (every 15 minutes).
The resulting price is the market-clearing price, where producers supply the same amount of electricity that consumers demand. If producers set prices too high or too low, the market would deliver either too much or too little electricity.
Marginal pricing is not unique to electricity. Many competitive markets like oil, gas, metals, and agricultural products also use it. Moreover, the wholesale electricity price represents only one part of the final electricity bill. In 2024, it accounted for 48% for household consumers. Other elements include:
- Network costs
- Taxes and levies
- Carbon costs
How marginal pricing works: the Merit Order explained
Electricity generators offer their power to the market based on their variable production costs, mainly fuel and carbon costs. Then operators dispatch power plants from the lowest cost to the highest cost. We call this ranking the merit order. Typically:
- Renewable energy sources such as wind and solar have very low marginal costs, so operators dispatch them first.
- Nuclear follows as it has higher fuel costs
- Coal and gas usually appear at the top of the cost curve as they have both fuel and carbon costs
The point where demand intersects this cheapest-unit-first supply curve sets the price. This clearing price is paid to all the generation required to meet demand at the given point in time.
If governments forced prices below this level:
- demand would exceed available supply,
- They would need to ration electricity
- market coordination would break down
Why marginal pricing is efficient
Marginal pricing has several key advantages:
- First, it always uses the lowest-cost electricity first, which minimises overall system costs.
- Second, it provides clear signals for investment and flexibility. High prices indicate when there’s a need for additional capacity, storage, or flexible generation.
- Third, it allows generators to earn contribution margins when prices exceed their variable costs. Some label these margins as “windfall profits.” In reality, they are essential for covering fixed costs, upfront investment and maintenance costs of power plants.
Without these revenues, investors would not have incentives to build and maintain the clean electricity infrastructure needed to keep the lights on and reduce Europe’s exposure to fossil fuel imports.
Why marginal pricing is not the problem behind high power prices
2022 vs. today: Europe is not in an energy crisis
During the 2022 energy shock, forward prices exceeded 1,000 €/MWh as result of Russia’s weaponisation of gas supply. However, the situation today is substantially different. Before the 2022 crisis, Europe imported 155–170 bcm of gas from Russia. Today, Qatar’s LNG accounts for only around 4% of our imports, meaning the scale and risk exposure to increased gas prices are generally far smaller.
The current design is not the cause of high prices
Some critics argue that marginal pricing leads to higher electricity prices in Europe. However, many other electricity markets use marginal pricing as well. For example, Texas operates a system based on locational marginal pricing, which is an even more granular version of the same principle.
Despite this, the Neon Neue Energieökonomik explainer shows that, at the time of writing, electricity prices in Texas are currently around €45/MWh, compared with roughly €80/MWh in Germany.
The main reason is simple: natural gas is roughly three times cheaper in the United States. The difference in electricity prices therefore, reflects energy costs, not market design.
Common misconceptions about the merit order
The explainer identifies eight widespread misconceptions. Some of the most common ones are:
- The Merit Order Model is mandatory or prescriptive. False: the Merit Order Model illustrates how independent, profit-seeking firms act in open, competitive markets.
- Marginal pricing is a fabricated, arbitrary rule. In reality, it’s the sole price that supports true market equilibrium. Choosing another price point needs rationing. This means keeping out some consumers or force generators to produce.
- The pay-as-bid system would lower prices. If we were to modify an auction’s pricing rule, market participants would promptly adapt their bidding behaviour. The final clearing price would likely shift only marginally, if at all.
- Electricity prices are legally tied to gas prices. They do not always move together. When gas-fired power is not needed to meet demand, gas prices have little effect on power prices. For instance, in Spain, where renewables dominate the electricity mix, gas influenced the price of electricity in only 15% of hours in 2026 up to March, resulting in lower power prices – compared to the majority of the time in many other countries.
What happens if we change the system? The risks of proposed interventions
Recently, some policymakers have proposed different state interventions in wholesale electricity markets to depress prices and reduce the energy bills. This section discusses the proposed interventions and the consequences they would have.
The Iberian Mechanism 2.0
Italy proposes subsidising gas or carbon costs to artificially lower the wholesale electricity price. But this requires imposing a new levy on consumers to finance the subsidy. It only works under very specific conditions (as in Spain-Portugal in 2022), which are not met in most of Europe today.
Problems with this kind of intervention include:
- Hedged consumers pay the levy without benefiting from lower prices.
- Renewable subsidies automatically increase when wholesale prices fall.
- Depending on how such schemes are designed, as Europe has a single cross-border electricity market, national interventions can lead to a significant impact on interconnector flows between different countries.
The result: consumers “save” on wholesale prices but pay more through levies, taxes, or grid tariffs.
Market split
Countries like Austria have proposed to separate the renewable and fossil markets. This proposal is unclear and raises many unresolved issues, including:
- How would it be decided which consumers would receive power from renewables, and which would receive power from fossil sources, given that there would be different prices for both?
- How would cross‑border trading be managed?
- What happens to intraday and balancing markets?
Market interventions like this will only lead to a reduction in market efficiency and undermine investor confidence at a time when the value of clean homegrown electricity is increasingly clear.
Why marginal pricing should stay
European wholesale electricity markets are functioning as designed, and there is no structural failure that would make state interventions necessary.
Changing the system would not solve the real challenges: fossil fuel dependency, high gas prices, slow grid expansion, or little possibility for consumers to adjust electricity use when prices change. Instead, interventions would increase long-term costs, limit necessary investments in clean domestic energy and infrastructure, and make our electricity supply less secure.
The current marginal pricing system coordinates millions of power plants and electricity users and sends important investment signals. When some power producers earn higher revenues because their costs are lower, this is not simply a “windfall profit.” These revenues help cover the cost of building power plants and maintaining them over time. This structure is important to encourage new investments and ensure that enough electricity is available in the future.
How to actually reduce electricity costs
Overall, lasting price stability comes from reducing the hours when natural gas sets the marginal price on spot markets. This is possible with:
- More renewables and low-carbon sources in the energy mix
- Faster grid expansion to deliver the electricity to end consumers,
- Demand flexibility, and flexibility solutions to use variable electricity from RES as efficiently as possible
- Further integration of Europe’s electricity system through new interconnection
- Lower taxes and levies on electricity.
Conclusion
Marginal pricing remains the most effective, transparent, and economically sound way to run modern electricity markets. Attempts to replace or distort it (whether through subsidies, caps, or artificial market splits) would introduce inefficiencies, weaken investment signals, and likely raise costs for consumers in the long term.