How the energy transition is shaping the electricity market

Electricity is meant to be invisible. But in future, one ‘colour’ is to be particularly preferable: green, or in other words – sustainable. The necessary changes to our energy system are already well under way. Electricity produced by conventional power plants and fossil fuels the world over is being replaced with renewable energy from wind and solar. However, power from renewable sources is inherently subject to weather-based or seasonal fluctuations, giving rise to challenges that effect the entire system, and can also have an impact on trade. In the first part of our miniseries, we took a closer look at basic market mechanisms. Now, we’ll be focussing on the ways in which the system itself can support the energy transition.

Let’s start with the good news: in recent years, solar and wind technology has become significantly more cost-effective. With the result that generating power with renewables is often cheaper than when using fossil fuels. In fact, PV solar energy is now thought to be the cheapest way to produce electricity. However – and here comes the bad news for consumers – this has little impact on electricity prices. This is because market mechanisms only play a small part in this.

Fossil-fuelled reserves and grid expansion drive electricity prices upward

Currently, the change itself is more of a price driver: it is currently not possible to make green electricity available 24/7, vast storage capacities would need to be built first. This is because storage is the only way to use wind and solar power when the wind isn’t blowing, and the sun isn’t shining. Until then, fossil fuel power stations are needed to secure supply during these periods. However, these stations are not cheap to operate, particularly if they are only used as operating reserve with minimal full load hours.

As the energy transition continues to drive the use of renewable energy, our power supply will become increasingly decentralised. Millions of panels, mounted on roofs and spread across fields will generate electricity instead of large power plants. And as the electrification of a growing number of industries accelerates in order to reduce CO₂ emissions, demand for electricity will only keep on growing. Needs that cannot be met with today’s network infrastructure. This means that electricity grids need to be massively expanded, which drives network charges up. These expenses are passed on to consumers via fees and taxes.

Renewables enjoy advantages on the electricity market

So how is the energy transition affecting electricity markets? Wholesale electricity prices are defined by the marginal costs of the most expensive power plant needed to meet electricity demand. And since the marginal costs of wind turbines and photovoltaic plants are virtually zero, and thus generally lower than those of conventional power plants, they can lower the wholesale price on the market – because the higher the proportion of low-cost electricity sources, the fewer power plants with higher marginal costs are needed. Particularly during periods when renewable electricity is available in abundance, these sustainable plants pip their fossil fuel counterparts to the post – a mechanism known as the merit order effect. However, many EU states go beyond this and assign feed-in priority to renewables, specifying they should only be throttled if there is a danger of overloading the grid.

Negative electricity costs

When weather conditions are particularly favourable, feed-in from wind and solar power can exceed demand, leading to short-term negative electricity prices on the day-ahead and intraday markets. Rather than be compensated for feeding electricity into the grid, the producers themselves have to pay for the privilege. The aim is to encourage operators of fossil-fuelled power plants to adapt their generation more closely to that of renewables, while at the same time encouraging producers of renewables to manage their generation more closely in relation to the demand for electricity.The system also incentivises the further expansion of flexible storage solutions.

Operating reserve –  a safety net for security of supply

The balancing market exists to help balance the challenges of a volatile electricity supply. If there is a shortage of power, participants make electricity available at short notice (positive balancing power). In times of oversupply, they take electricity from the grid (negative balancing energy). The reserves can be used to cushion grid fluctuations at 15 minutes’, five minutes’ or 30 seconds’ notice. In continental Europe, up to 3,000 megawatts (MW) can be generated or consumed in this way.

Types of operating reserve

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*A bid size of 1 MW, 2 MW, 3 MW, or 4 MW permitted provided that a minute reserve provider submits only one bid per product time slice of positive or negative MRL in the respective control area.

Price formation on the balancing market

An availability fee remunerates participants for their willingness to act as operating reserve. If the electricity is used, then the utilisation fee is added, which is determined via an auction: whoever submits the best bid wins the contract. Since 2018, this has covered both the availability fee and utilisation fee. The way in which the fees are weighted depends on a number of factors, e.g. how likely it is that a market participant’s balancing energy will be called for. Normally, the prices are higher than the market price, which is why participation can undoubtedly be lucrative. At the same time, the participating plants must meet certain technical requirements, which takes some stations out of the running.

Close networking in Europe

The European electricity market is becoming more and more closely networked, not least to forgo the need for expensive operating reserves. This has led to formation of the ‘Joint Allocation Office’, where long and short-term contracts are concluded between trading partners on the European electricity market.

In day-ahead trading, the markets of different countries are linked via a market coupling mechanism. Market participants continue to only take part in auctions in their respective country, however the auction process also generates cross-border bids. In the event of price differences, countries with lower prices supply electricity to states where power is more expensive, with the aim of levelling out prices.

If the price is right

In trading, there is no way to distinguish between electricity from fossil fuels or renewable sources. The price alone is decisive. Particularly since electricity is fed into the same grid either way. In over-the-counter (OTC) trading – i.e. off-exchange trading – buyers are theoretically able to favour contracts with green electricity suppliers. However, this does not ascertain that they are actually buying renewable energy.

Electricity market reform promotes CfD

Two-sided contracts for difference (CfDs) play a central role in the electricity market reform in 2024. These contracts are concluded via tenders. States offer producers a fixed price for renewable energy. The producer then sells the electricity regularly on the market. If the price is lower than the price set in the CfD, the state pays the difference. If, on the other hand, the electricity is sold at a higher price, the state receives the difference. The model promises greater planning security – especially for investments in new renewable energy plants.

It is evident that energy trading mechanisms are already doing their bit to integrate volatile renewable electricity into the system and are helping to drive the European energy transition forward. That being said, experts believe this is just the beginning when it comes to the electricity market and are pushing for more far-reaching changes to the workings of the market. Find out more in the fourth and final instalment of our miniseries.

Note from the editors: This article was updated in June 2024.