Facing the electricity crisis in Europe

Russia's invasion of Ukraine has created turmoil in the European policy landscape and energy markets. Supply disruptions of natural gas have led to record-high electricity prices in Europe.

Electricity market pricing rules specify that the marginal unit, i.e., the most expensive power plant needed, sets the price for all others. Incidentally, gas-fired power plants are often the marginal unit. This has led to historically high electricity prices in the first half of 2022 (5–15x higher than in 2021). As a result, infra-marginal power plants (e.g., renewables, coal, or nuclear) have been making record profits while high electricity prices have been fuelling inflation in most sectors of the economy.

Our analysis indicated that electricity markets did not malfunction during this time, as prices remained aligned with market fundamentals. The predicament is, first and foremost, a natural gas crisis that spread to power markets due to the electricity sector's high reliance on gas-fired generation. This dependency has been reinforced by the plant and infrastructure investments made in the last two decades and is unlikely to be remedied in the short term.

The effects of these market developments on end-users, utilities, and retailers are not only unprecedented but also deemed unsustainable. Policymakers and regulatory bodies throughout the European Union (EU) have started to act, each proposing its own set of market interventions to alleviate the situation. Moreover, core EU market design principles are being fundamentally ques - tioned and reforms are back on the agenda at regional level.

One solution would be to reduce both natural gas and power demand to mitigate supply-side tensions. Saving as much natural gas as possible could help to avoid any scarcity during the winter months, and substantially reduce public and private crisis spending. Although power demand is noto - riously insensitive to prices, many opportu - nities to save energy exist and should be a priority for policymakers.

In addition, several mechanisms could be deployed to soften the impact of the crisis on residential and industrial electricity bills. Yet, market intervention should be limited as much as possible, at the risk of creating additional uncertainty and inefficiencies. A set of measures to redistribute excess profits from energy companies might be one way to soften the price shock. Since such actions risk diluting price signals, they should all be backed up by demand-reduction measures and investment incentives.

Short-term measures carry a risk: they often focus on mitigating the consequences of the crisis, rather than on tackling the root causes of the problem. Decades of delayed investments in new clean energy sources or grid reinforcements have worsened the current crisis. Governments should, therefore, make sure that crisis response measures accelerate the energy transition, reduce European energy and raw material depend - encies, and improve energy security for national economies. To this end, expanding renewable energy sources should remain a top priority in order to secure the region’s future, and the current situation should not undermine Europe’s determination to reach its long-term climate objectives.