Gas has been getting more and more expensive for a year now, and the price of electricity in Europe is also rising significantly. Are these prices related and what role does which power plant play in this?
Gas shortage. Why is the price of electricity rising at all?
Since in Germany, as in the rest of the world, electricity is mainly generated by fossil fuels, the price of a kilowatt-hour naturally depends on the basic price of gas, coal, oil and, to a certain extent, uranium. If the prices of fossil energy sources rise, the price of electricity also rises.
How have energy prices developed so far?
Concerns about a shortage of gas supplies from Russia have driven gas prices ever higher, and not only in Germany. Power plants paid almost 227.0 percent more for natural gas in June 2022 than in the previous year. The gas bills of many end consumers have tripled. Alongside these rapid increases in prices in the gas market, electricity prices have also risen at the same time. Within one year, for example, the price of electricity on the Leipzig European Power Exchange (EEX) has increased 10-fold (as of August 2022) - from 50 to 565 euros per MWh. Of course, this also has a knock-on effect on consumers: the electricity price for new contracts in mid-November 2022, for a consumption of 4,000 kWh incl. basic fee, was 0.427 euros per kWh - and the trend is uncertain.
And what about electricity from renewable energies?
Electricity from renewable energies is by far the cheapest way to generate electricity. Once wind or solar power plants are built, they consume almost no resources for direct electricity production. However, they do not supply electricity continuously. This means that although energy from these sources is cheap, it is not constantly available everywhere without large storage facilities and well-developed electricity grids. Does the price of electricity fall when more electricity is fed into the grid from renewable sources? No, unfortunately it is not that simple. This is because the electricity market works according to the "merit order" principle.
Definition: Merit order
The merit order is the order in which power plants are deployed, which is determined by the variable electricity production costs. The cheapest power plants are switched on first to meet demand, and the last power plant with the highest marginal costs needed to meet demand determines the price. The merit order thus determines the electricity price on the energy markets.
In a simplified way, this means: All power plants offer their production capacities until enough electricity is produced in Europe to cover demand. However, no distinction is made in the type of generation: All suppliers receive the same price, determined by the most expensive power plant on the grid. In the merit order principle, for example, it does not matter at all how cheaply the renewable electricity was generated. Subsidies for the expansion of renewable energies do not count either.
Thus, at present, a single gas-fired power plant on the grid is enough to greatly increase the price of a kilowatt hour of electricity, regardless of the low costs of other energy sources or "power plants" at that time.
So why is there a "merit order"?
In a conventional market, supply and demand would determine the price - until the time when a product is no longer available. As a result, however, gas-fired power plants would then almost never be in operation, as cost-covering operation is not guaranteed. The "merit order" balances this out so that there is always enough electricity available to meet demand and the grids remain stable.
Each producer offers its electricity in such a way that its costs (marginal costs) are covered. All offers are then successively made until demand is covered - the most expensive power plant used then determines the price for everyone. This power plant only covers its marginal costs, all others make profits. The resulting price is called the marginal price.
Marginal costs are the costs incurred to produce the next commodity or, in this case, the next megawatt hour. Investment or capital costs are not included, but fuel costs, for example, are.
On the energy market, it generally applies that the "product" electricity must not be "sold out", as otherwise the energy supply can be disrupted and, in the worst case, a local or area-wide blackout could occur.
Who invented the merit order principle?
"The marginal price (found through the merit order) is not an artificial rule that someone made up," Lion Hirth elaborates in the Stuttgarter Zeitung. Lion Hirth is junior professor for energy policy at the private Hertie School in Berlin and managing director of the energy consulting company Neon. "It is not an arbitrary choice between alternative market designs, but the natural way prices form in free markets," he continues. Other commodity markets also function according to this principle - "no matter whether it is oil, gas, copper, milk or solar plants", says the energy expert.
What is happening at the moment?
Currently, several developments are coming together: Firstly, about half of the 56 nuclear power plants in France are currently out of operation due to maintenance work or technical defects. Secondly, the low water level of the rivers is hampering the supply of coal to the coal-fired power plants. And thirdly, the gas price is at a high level and, as described above, influences the electricity production costs.
Will coal, nuclear power and renewable energies not suffice?
Unfortunately not. On the one hand, this is because the current capacities of hydropower, wind power and photovoltaics are not sufficient to cover the entire electricity demand, neither in Germany nor in Europe as a whole. In addition, as described above, many conventional power plants are currently shut down or can only be operated to a limited extent.
Furthermore, there is a lack of transmission grid capacities across Europe. Often, for example, the electricity generated on the windy North Sea coast in Germany cannot be transported to the energy-hungry south of Germany. The Federal Network Agency reacts to such a bottleneck with a "Redispatch": the output of wind turbines is reduced in the north and the output demand of the power plants is increased in the south so that an overload of the electricity grid is avoided. Gas-fired power plants, which can adapt their electricity production particularly flexibly and quickly, are often used here. Of course, this also has additional effects on the electricity price.
Opportunities for action and risks
The increased gas price, mainly caused by the war in Ukraine, is also driving up electricity prices. Since electricity is included in the prices of many other products, including breakfast rolls, this is fuelling inflation. For weeks, there have been many discussions on how the price increase could be stopped.
"A discussion about redistributing profits and relieving the burden on consumers, but maintaining savings incentives, i.e. not a simple price cap, is in my opinion the way to go in the short term," says Christoph Maurer, Managing Director of the Aachen-based energy consulting firm Consentec. However, a fundamental change in the market design should definitely not be decided in the short term, he warns. "The risk of then arriving at solutions that have not been thought through and possibly even intensifying the crisis is very high" Maurer, an energy expert, told the Stuttgarter Zeitung.
References: The magazines: "Zeit, Standard and Stuttgarter Zeitung", the technical magazine "Chip", Wikipedia and own research.