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Energy crisis: Can the EU tame soaring prices?

August 30, 2022

Pressure is building for an EU-wide cap on the cost of gas and electricity, as prices soar. How does the power market work and can it be reformed to avoid so much volatility?

A picture of a trader at the European Energy Exchange in Leipzig, Germany
Surging electricity prices at the European Energy Exchange in Leipzig raise concerns among consumers, industry and businessesImage: picture-alliance/dpa

The European Union first proposed a cap on the price of gas and electricity in March, after energy prices took off when Russian tanks rolled into Ukraine.

The European Commission, the EU's executive arm, said the bloc should consider "options for temporary market intervention in the short term to limit price increases."

Six months on, and despite the year-ahead contract for German electricity reaching €995 ($995) per megawatt hour on Friday — a tenfold increase from last year — an EU-wide cap has still not been levied.

In recent days, the leaders of several EU states have called for urgent action to tame energy prices, including Belgian Prime Minister Alexander De Croo who threatened to go it alone if the EU failed to intervene.

Austrian Chancellor Karl Nehammer said an EU solution was the best way to "finally stop the madness that is taking place in energy markets."

The Czech Republic, which holds the EU's 6-month rotating presidency, on Monday called an emergency meeting of EU energy minister for September 9 to look at price capping and market intervention.

How is electricity currently priced?

While some suppliers produce their own energy, most of the price that electricity firms pay is set by financial markets, where producers, utility firms and speculators compete based on supply and demand.

Electricity producers are paid the same price despite having vastly different expenditures. Gas power stations are much more expensive to run than wind or solar farms and, therefore, tend to set the overall market price.

Gas also commands a premium as it is used to respond to fluctuations in electricity demand. Gas power plants can be quickly fired up during periods of peak demand. The increasing use of wind and solar energy, which fluctuate depending on the weather, has increased the marginal or critical role of gas in times of need.

Prices hit a record last week after Russia said it would halt deliveries to Germany through the Nord Stream 1 gas pipeline for three days for maintenance.

However, the move is widely seen as a political power play. Berlin thinks Russia could cut supplies altogether in retaliation for Western sanctions over the war in Ukraine.

An aerial view of the gas power plant at Hamm-Uentrop in Germany
The merit-order principle means gas power plants with the highest marginal costs determine the electricity priceImage: H. Blossey/blickwinkel/picture alliance

When will prices come down?

While European leaders had hoped the energy crisis would be short-lived, some industry experts now believe prices will likely stay elevated for several years.

The CEO of energy giant Shell Ben van Beurden told a conference in Norway on Monday that high prices could last for "a number of winters" and spoke of the possible need for energy rationing. 

Belgium's energy minister, Tinne Van der Straeten, warned Monday that the next "five to 10" winters will be "terrible" if nothing is done to cap prices.

Nathan Piper, an oil and gas analyst at Investec, said in an interview for PA news agency last week that the "era of cheaper energy is over" as Europe cuts its reliance on Russian energy and boosts demand for liquefied natural gas (LNG).

A graphic showing the electricity mix in Germany

Would a price cap work?

The European Commission has yet to say whether the proposed cap would be on consumer prices, Russian gas or all gas imports into the EU.

A ceiling on gas-based power prices paid by consumers is already running in Spain and Portugal, while France has capped electricity price hikes.

The two Iberian countries got EU approval in June to pay gas power producers the difference between the market gas price and the capped price of €40 per megawatt-hour (MWh), rising by €5 per MWh per month after the first six months.

However, German economist Daniel Gros wrote last month in a blog post for the CEPS think tank that a consumer price cap would effectively be a subsidy of fossil fuels, "which is the opposite of what we need to reach net-zero emissions."

He said a cap on Russian gas would only make sense if Moscow doesn't cut supplies first.

Claudia Kemfert, an energy policy analyst at the German Institute for Economic Research said Monday a price ceiling is "not the solution," warning it could become a costly long-term subsidy. She called for targeted relief for consumers. 

Germany prepares for worst-case energy scenario

What else could be done?

The European Commission announced Monday that it was working on a longer-term structural reform of the electricity market.

"The skyrocketing electricity prices are now exposing the limitations of our current electricity market design," European Commission President Ursula von der Leyen told a forum in Slovenia.

EU officials are said to be considering measures to split electricity price setting from the gas price to take into account the much lower price of other energy sources.

German Economy Minister Robert Habeck has reportedly backed a price cap and on Sunday also spoke of a longer-term reform of energy markets so that prices are no longer set according to which form of power — gas at present — is the most expensive.

Habeck, who is also Germany's vice chancellor, told Bloomberg the Berlin government was working hard to "find a new market model."

"We need functioning markets and, at the same time, we need to set the right rules so that positions in the market are not abused."

Many EU countries have offered subsidies to households to offset some of the rising cost of energy, while some have also proposed windfall taxes on energy firms.

Habeck also hinted at the potential to recoup some of the additional costs , saying that the "extraordinary profits — profits which the companies never dreamed of — could be taxed a little bit higher and could be given back to the people."

Edited by: Uwe Hessler