Cold spells, high prices of electricity and functioning of the electricity market

The current situation of high prices of electricity that is taking place in the Spanish electricity market in the first half of January, consequence of the fierce snow storm and cold temperatures that have hit hardly most of the Iberian Peninsula, has once again brought to the fore the (old) debate on whether the Iberian electricity market is functioning properly.

In a context where it is under scrutiny whether the behaviour of the agents participating in the wholesale market is in line with competition law, independently of the market supervision work carried out on an ongoing basis by the energy regulator (CNMC), it is appropriate to review some issues related to the fundamentals of the electricity market.

We must focus the discussion on those aspects that facilitate an adequate analysis of the functioning of the market and may lead to proposals to improve it where necessary, instead of encouraging debates that are more determined by ideology or an inadequate understanding of how electricity markets work.

Some reflections on the functioning of the electricity market

1. Firstly, in an electrical system with growing penetration of intermittent renewable energies, such as wind or photovoltaic, there will tend to be a greater number of market situations with price volatility that lead to relatively high prices in times of supply shortage (generation) and very low prices in times of excess generation (e.g. when there is a lot of wind and photovoltaic energy in periods of low demand). This is part of the normal functioning of an electricity market.

In some recent work, we have analysed at Orkestra both the theoretical foundations of the functioning of electricity markets (Fernández, 2020) and the role played by natural gas combined cycles in covering electricity demand (Fernández and Álvaro, 2020). Among the conclusions of these reports, two can be highlighted.

On the one hand, natural gas combined cycles (together with hydro plants with reservoir capacity and pumped storage units) is the generation technology that currently offers the flexibility required by the electrical system to guarantee a reliable electrical energy supply in a context in which the contribution of wind and photovoltaic energy can vary by several thousand MW in a few hours.

On the other hand, in order to ensure that there is sufficient flexible capacity available at the most critical moments in the electrical system (such as the one we are experiencing these days), adequate remuneration must be guaranteed for plants operating during peak hours.

If a reliable and secure supply is desired and, at the same time, prices are not to rise at times of generation shortages to levels close to the value of energy not supplied, mechanisms for the remuneration of available and unused capacity, such as capacity mechanisms, must be established.

In short, until sufficient flexibility is developed in the electricity system, provided by storage facilities, by more demand management and by the operation of smart grids, the only way to accompany the growth of renewable energies and to guarantee, simultaneously, a reliable and safe supply is to count on the flexibility of the combined cycles of natural gas. This situation will continue for many years to come, as it will take time to adapt the generation mix, the electricity network infrastructures and the equipment of final consumers.

2. Secondly, these high-price situations do not necessarily reflect a structural supply shortage either in the electricity market or in the natural gas market. There may simply be a number of circumstances in the electricity market which, as happens from time to time (recall the price peaks in the electricity and natural gas markets in the winters of 2001-2002 or 2013-2014, for example), generate either a one-off supply shortage or upward pressure on prices.

Among the many factors that can drive up electricity prices in the short term in the Spanish market are the following: (1) a high demand for electricity and natural gas as a result of an extreme heat wave or cold spell; (2) a one-off shortage of supply on the gas market; (3) a relatively low contribution of intermittent renewable energies (wind and solar) to the electricity generation mix; (4) a low contribution of hydraulic plants in the event of drought; (5) a high demand for electricity and natural gas in neighbouring countries; (6) possible restrictions on the supply of natural gas from North Africa; (7) limited capacity for importing electricity and natural gas from France; (8) high prices in the LNG spot market due to high demand for natural gas in Asia and in Europe as a result of low temperatures; (9) high prices of CO2 emission rights; in European markets; (10) high prices of other fuels such as coal, oil and oil products; (11) high unavailability of generation capacity or a situation of severe unavailability in the electricity grids; (12) low natural gas reserves…

When many of these factors coincide at the same time, as is the case with the electricity market in the first half of January 2021, electricity prices rise to levels well above the usual. This is most often part of the normal functioning of electricity markets, which use price signals to induce efficient operation of plants in the short term and an adequate generation mix in the medium and long term.

3. On the other hand, the impact of extreme price situations in the electricity market on the invoices of electricity consumers is very limited. Firstly, because the impact of high prices in 1, 24, 48 or 96 hours is not relevant in determining the average annual price paid by a consumer. Secondly, because the cost of energy represents a low percentage of the total invoice paid by domestic consumers, which includes other regulated costs (fixed costs related to energy supply, such as the cost of network infrastructure, etc.) and taxes (VAT, electricity tax, etc.).

Taking as an example the last electricity invoice that my family paid (although we are not intensive consumers of electricity, as heating and hot water work with natural gas), we have 4.4 kW of contracted power and the calculation yields relatively similar results to those of an average household.

It can be seen that, without including the cost of renting measurement and control equipment (0.93 euros, including VAT), out of a total of 47.14 €/month, including VAT (see Figure 1), 48.0% of the costs are "regulated costs" (incentives for renewable energies, cost of networks and other regulated costs), 21.4% relates to taxes levied and only 30.6% of costs relate to the cost of energy and the retailing margin for services provided (in more electricity-intensive households this percentage could be as high as 50%).

Figure 1. Breakdown of costs in an electricity invoice

 

Grafico factura luz okok

Source: author’s actual electricity invoice.

 

4. An additional issue that is relevant is the high positive correlation between high-price situations in the electricity and natural gas markets. Because it is the combined cycle plants that offer the capacity to cover demand at the margin, the price of the electricity market at times of generation shortage tends to be determined by the spot price of natural gas. This opens the door for the security of electricity supply to be linked, in critical moments, to the security of natural gas supply.

Since there is currently little domestic natural gas production (although there are unexploited reserves, such as those in Álava and other parts of the central and northern part of the peninsula), the gas system is highly exposed to spot prices for LNG and, specifically, the spot price of natural gas in the Iberian Peninsula will depend on the circumstances in the international natural gas market (interconnected through LNG).

Despite the fact that the global market is adequately supplied, there may be occasional situations of shortage of spot LNG that will increase prices to very high levels, as is happening in January 2021. To try to mitigate the effect of these situations, there are protocols in the gas system such as the Winter Action Plan, which allows for the use of operational reserves (mandated by regulation) of natural gas at critical times.

Conclusions

It is important to understand how electricity markets work in order to correctly identify the causes of high (or very low, or even negative) prices at specific times and to be able to properly assess the implications of certain market situations, such as those we are currently experiencing.

If the regulator and legislators seek to mitigate high prices in wholesale markets in situations such as the current one, establishing a capacity mechanism that adequately remunerates the available capacity of technologies such as natural gas combined cycles will avoid the need for prices to rise in times of generation scarcity to undesirable levels in order to facilitate the recovery of the fixed costs of these plants.

If, on the other hand, electricity prices for final consumers are considered to be excessively high, it is desirable to explore alternatives of a more structural nature that help to avoid unjustified interventions in the design of the electricity market.

For example, shifting some regulated costs not associated with electricity supply, such as incentives for renewable energies, out of access tariffs will have a large impact on electricity invoices. The creation of the National Fund for the Sustainability of the Electricity System (FNSSE, in Spanish) will make it possible to establish a new system for the allocation of regulated costs that should reduce electricity invoices.

If, in addition, there is concern about the security of supply or at least the impact that situations of relative (and occasional) scarcity in the global natural gas market may have on the energy market in Spain, the desirability form a social viewpoint of exploiting the natural gas reserves that exist in the Iberian Peninsula with methods that have a low environmental impact should be evaluated (i.e., without resorting to hydraulic fracture techniques) in order to have access to natural gas at the cost of production/extraction, instead of at the price of the international market, and with a lower carbon footprint because emissions derived from transport are avoided.

In any case, it must be accepted that, in the absence of alternative sources of flexibility that will take years to develop (essentially, electricity storage and demand management), combined natural gas cycles is the technology that should accompany the growth of renewable energies in the energy transition process.


Jorge Fernández PEQUEÑA03

Jorge Fernández

Senior researcher and coordinator for the field of energy at Orkestra since March 2018. PhD in Economics, Georgetown University (Washington DC), Jorge has broad experience in the energy sector.

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