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Are high electricity prices here to stay?

Record high energy prices, the growing profits of energy producers and concern about the forthcoming winter are raising more and more questions among consumers and companies about the reliability and functioning of the existing electricity market system. The bottlenecks in the electricity market, along with a lack of transparency, have triggered public debate on the potential need for changes to the market. The key questions are what can be done to improve the current model and whether Estonia should withdraw from the Nord Pool electricity market altogether.

Estonia’s joining of Nord Pool Spot power exchange

In April 2010, Estonia and the other Baltic States joined the Nord Pool Spot (NPS) power exchange.[1] This was part of the European Commission’s plan to connect the Baltic energy markets to the Nordic countries, Germany and the United Kingdom in order to ensure an efficient common market for electricity trading.[2]

In practice, trading via Nord Pool Spot takes place on two markets – the Elspot day-ahead market and the Elbas intra-day market.

On the Elspot market, energy is traded for the following day and prices and quantities are fixed for the next 24-hour period. Market participants place orders on an hourly basis via an online system where electricity producers make offers in their production area and electricity purchasers make bids in areas where they wish to resell electricity. When the Elspot market closes at 15:00 Estonian time, trading opens on the Elbas intra-day market. The aim of Elbas is to ensure market balance and cope with unexpected last-minute changes, such as an increase in demand due to extreme weather conditions or reduced production due to the temporary closure of a power plantt.[3]

Pricing of electricity sold on Nord Pool exchange

As is typical of a market economy, the electricity prices on the power exchange are calculated based on supply and demand – namely, upon achieving a balance between the two, with all suppliers being paid a uniform price (the uniform-price auction model). To the dismay of politicians, consumers and the majority of entrepreneurs, this uniform price is the highest price offered by the last bidder (whose electricity is needed to fully satisfy demand every hour of the day). A few weeks ago, the market price reached 4,000 EUR/MWh: the maximum price allowed according to the Nord Pool rules[4]. Media coverage gave the impression that someone actually made the market an offer at this high price. According to Nord Pool’s subsequent explanations, this was not the case: as the market could not cover demand at that specific point in time, the power exchange’s technical price cap was automatically applied instead. Considering the record-breaking exchange prices of electricity, there are increasing demands to revise this (unfair) pricing model, which is viewed as generating excessive profits for producers[5] or to take even more drastic measures.

As a result, we come to an unavoidable question: why do market participants who offer to sell at a lower price also get the price offered by the highest bidder of the day? In other words, if 10 producers are needed to satisfy demand and nine of them offer electricity at a price in the neighbourhood of 10 to 50 EUR/MWh, but the last one does so at a price of 500 EUR/MWh, then all producers can sell electricity at that price i.e. 500 EUR/MWh. Unfortunately, both the state and the exchange have failed to provide a convincing answer to this key question, having simply responded with assurances that “this is the best model”.

Last bidder’s uniform-price model

Two main price models are used in the organization of power exchanges: uniform-price auctions; and pay-as-bid auctions. Nord Pool uses the uniform pricing model described above, which differs from the pay-as-bid model, wherein each producer is paid the asked-for price. The price offered in the Nord Pool auction must be based on the marginal pricing principle: the variable costs of the producer incurred in generating electricity, i.e. without taking into account, for example, the investment cost of building a power plant.

There are a number of reasons why the uniform-price auction model was chosen:

  • A price based on variable costs ensures a simple bidding structure and equal opportunities for both large and small producers to participate on the market.
  • In the case of pay-as-bid auctions, producers attempt to estimate the maximum market price. In the long run this would lead to an increase in prices compared to the uniform-price auction model.
  • It ultimately ensures the fairest price from a socio-economic point of view.

The uniform-price auction model, which is deemed to be the most cost-effective for society in the long term, has been thoroughly analysed[6]. It has been found that although the pay-as-bid model may bring prices down in the short term, it is not beneficial to electricity buyers in the longer term and makes people less inclined to invest in new production capacities. Despite the foregoing, not all experts who have analysed this issue agree[7] on which is the best model. Moreover, despite being subject to supervision, one of the perceived theoretical risks of the uniform-price model is the opportunity it presents for market manipulation, i.e. refraining from offering available capacities to the market or offering them only selectively.

Possibility of changing the existing price model

The pricing model applied by Nord Pool was established by the European Union with a regulation of the European Commission that applies to all Member States.[8] Changes to the design of the wholesale power market, including the price model of auctions, would require Member States to reach a common understanding. Formally, changing the regulation is within the competence of the European Commission. Its proposals for changing the situation on the electricity market (the Joint European Action for more affordable, secure and sustainable energy) support maintaining the current uniform-price auction model.[9] The Commission’s latest proposal (dated 14 September 2022) is to reduce electricity consumption at peak hours, to establish a revenue cap for electricity producers with lower marginal costs and to create a temporary solidarity payment on excessive profits, where the revenue generated would be directly allocated to energy consumers.[10] In Estonia, the Universal Electricity Service Act has been passed, obliging the state-owned energy provider to sell electricity as a universal service to household consumers and electricity distributors until the end of April 2026. The provisionally approved price is 154.08 EUR/MWh, although the final price with VAT and the addition of suppliers’ profits and margins will ultimately be in the range of 191.5 to 192.4 EUR/MWh, depending on the provider.[11]

Based on analyses of the price models, it can be concluded that although transitioning to the pay-as-bid auction model could bring down prices in the short term, it is not clear whether greater changes in market design would lead to the expected benefits in the long run. All of this has not been explained to the public with sufficient clarity.

In addition, obtaining a more comprehensive overview of the reality of price formation on the electricity market requires drawing attention to the principle of an interconnected electricity market between countries, where cheaper electricity is directed to the more expensive price area.  Here, the best example is from Tuesday 13 September 2022, when the transmission lines between Estonia and Latvia underwent maintenance, causing a significant drop in regular transmission capacity. Thus, the electricity exchange price between 8:00 and 9:00 was 88.78 EUR/MWh in Estonia and 585.12 EUR/MWh in Latvia (the price also being influenced by the connection with Finland). In previous weeks, when the transmission connection operated as normal, the price was comparable in both countries. As such, it must be understood that a common electricity market can also be described as a large-scale solidarity project where, in simple terms, countries help their neighbours who lack production capacities.

Summary

One of the key questions regarding the reasonable functioning of the energy market as a whole in the future is the adequacy of the pricing model used on the power exchange. Opinions have also been voiced that the current model only functions if there is a sufficient number of bids on the market (i.e. production capacities) to cover demand. During peak consumption hours, high prices are mainly caused by the need to switch on the most expensive gas-powered plants. It is generally agreed that there is a lack of capacities with reasonable costs to cover consumption during peak times and that the share of controlled production capacities will be further reduced in the future as large plants are closed.

One can only agree that the challenges related to the electricity market are highly complex, including producing electricity in an environmentally friendly manner, maintaining balance between production and consumption, ensuring the distribution of capacity, maintaining sufficient transmission capacities, making investment decisions for the establishment of new plants, pricing questions and more.

It is said that one of the most important benefits of the uniform-price model is that it guarantees motivation to invest in new capacities – those who doubt in the exchange system have been told that there is no point in disputing its efficiency, as it has ensured (extremely) cheap electricity for many years. Paradoxically, emphasis has simultaneously been placed on the fact that since the prices were so low, there was no incentive for anybody to invest in new capacities.

In a world of more stringent environmental requirements, a great number of controllable capacities have now been closed and this deficiency will not be able to be eliminated any time in the coming years. If the existing market model cannot be changed or if doing so is not reasonable and high prices are here to stay, this should be clearly communicated to the public. Otherwise it will create a favourable environment for critics of the European single market and advocates of a strictly regulated market.

The reality that prices will remain (very) high is supported by the fact that there is a lack of capacities, that not enough new capacity has been added (partly) because of the customary low prices, and that a drop in prices would not incentivize anyone to establish new capacities. Thus it cannot be ruled out that the current exchange model will no longer function in a way that satisfies society and that strict regulation of prices will be applied instead of the invisible hand of the market, albeit while still considering the basic principles of the rule of law.

Ain Kalme
Attorney-at-Law at TRINITI, joint head of the Transport and Infrastructure working group

Madlenne Timofejev
Lawyer at TRINITI, intern in the European Commission’s Energy Cabinet (March-July 2022)

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[1] No. 24/2010 NPS – Estonian market successfully opened during Easter. Nord Pool. 6 April 2010. https://www.nordpoolgroup.com/en/message-center-container/newsroom/exchange-message-list/2010/04/No-242010-NPS–Estonian-market-successfully-opened-during-Easter/.

[2] Tuohy, E., Visnapuu, K. Nord Pool Spot and the Baltic Electricity Market: Difficulties and Successes at Achieving Regional Market Integration. June 2015, pp 1-2. https://icds.ee/wp-content/uploads/2014/Emmet_Tuohy__Kristiina_Visnapuu_-_Nord_Pool_Spot_and_the_Baltic_Electricity_Market.pdf.

[3] See the previous reference.

[4] Nord Pool Day-ahead Market Regulations, p 4.5 https://www.nordpoolgroup.com/499347/globalassets/download-center/rules-and-regulations/day-ahead-market-regulations_sdac-11.05.22-.pdf

[5] https://www.err.ee/1608680893/ots-nord-pooli-elektriborsi-reeglid-vajavad-reformimist

[6] See e.g. https://www.tse-fr.eu/sites/default/files/TSE/documents/conf/2022/energy/yu.pdf

[7] See e.g. https://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.365.2514&rep=rep1&type=pdf

[8] Commission Regulation (EU) 2015/1222 of 24 July 2015 establishing a guideline on capacity allocation and congestion management, art 38(1) https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A32015R1222

[9] REPowerEU: Joint European Action for more affordable, secure and sustainable energy. 8 March 2022. https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=COM%3A2022%3A108%3AFIN.

[10] https://ec.europa.eu/commission/presscorner/detail/en/ip_22_5489?fbclid=IwAR3yCGtGOQ2W3aoHMprH1-iqiP3BEfGwv_Ievy57BBsfDVC4p41FKbeuLDY.

[11] https://news.err.ee/1608734155/universal-electricity-price-provisionally-set-at-15-4-cents-per-kwh