The dysfunctions of the European free market behind the gas flashes

Jose A. Bernat Bacete via Getty Images

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On Tuesday at least three ships (two US and one Nigerian, according to Refinitiv Eikon) loaded with liquid natural gas bound for Asia unexpectedly turned their bow to head for Europe because they were attracted by the record prices on the markets of the Old Continent. Yesterday the price of methane broke through the wall of two dollars per cubic meter, exceeding 185 euros per megawatt hour, after the interruption of the flow of gas from Russia to the EU through the Yamal-Europe pipeline. “Fault” of Moscow and its state monopolist Gazprom which supplies Europe with 40% of its gas and which in recent months, for a long series of reasons (post-Covid recovery, stiffer last spring, Asian competition, political tensions on Nord Stream 2 and in Belarus) has occasionally reduced supplies and sometimes interrupted. But the problem that has been recorded for weeks on the price of gas, to which electricity is closely connected, comes from afar and concerns the functioning or, as in this case, the dysfunctions of the market in Europe.

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Even Prime Minister Mario Draghi, in the conference at the end of the year, made a vague hint: “The big energy producers are making fantastic profits” but the cost of hydroelectricity and that of renewables “have nothing to do with that of gas and yet it is sold entirely at the price of gas “. Translated: who today produces electricity through gas sells it at high prices because gas is expensive. But those who produce it from hydroelectricity, renewables and even nuclear power resell it on the markets at the same price as those who produce it with gas, despite having much lower operating costs. These are the “producers” who are “making fantastic profits” right now. And this is the reason why some EU countries, including Italy, have asked to intervene on the functioning of the energy market, clashing with the opposition of some northern states, led by Germany.

Therefore, it is not only the main EU supplier, Gazprom, that has to do with it. In Russia the system of pricing of natural gas is different from that adopted by Western European countries in recent years after the liberalization of the market. The price of gas on the Russian market in long-term contracts is pegged to that of oil (at a discount and with moving averages). On the European market for several years it has been decided to decouple the price of gas from that of crude oil, making it determined by the meeting of supply and demand (price hub). In this way, the aim was to privilege market dynamics, greater competition between producers, less dependence on long-term supplies and mitigated the impact that the sometimes marked fluctuations in oil prices due to geopolitical tensions in the Middle East or elsewhere they had on the cost of energy in Europe.

A system that has certainly made it possible to reduce costs in Europe for several years compared to prices oil-linked, but which nevertheless suffers from the natural volatility of the markets linked to cyclical dynamics (such as those of the post-lockdown), and which is now presenting the bill, even feeding fears of possible blackouts in Europe. For Italy it is particularly salty since, according to Arera 2020 data, over 60% of the energy it produces is thermoelectric in nature, with gas plants dominating over coal, and only 12% from solar and wind, 18% from hydroelectric, 10% from geothermal. But electricity prices have exploded all over Europe, even in Germany where production from renewables can represent over 40% of the total, or in France where nuclear power can represent 30% of national production. How is it possible?

Most electricity trading transactions occur in the Day Ahead Market (MGP) session, where hourly blocks of wholesale energy are exchanged for the next day. Producers offer blocks of energy at a given price that reflects their production costs. All these offers are organized by the electricity market operator (in Italy, for example, Gme) and obviously have variable prices and quantities. Those who produce from renewables, for example, will offer a lower price than those who produce from gas, which have far higher operating costs. The same goes for the purchase offers that are collected and organized by the manager.

It works like this: All valid sales offers are “sorted by price growing“In an aggregate supply curve on the one hand, while all valid demand bids received” are sorted by price decreasing in an aggregate demand curve “. In this way supply and demand intersect and at the intersection point the marginal price is defined, which represents the equilibrium of prices and volumes. In other words, renewable energy plants are currently pushing the price down, while gas-fired plants, with the cost of raw materials at levels never seen before, are pushing it far higher. Here arises the temporary dysfunction that the market is paying for in these days of gas shortage. Because the marginal price, today strongly influenced by methane, means that all producers are paid the same price, regardless of whether it is the result of production from renewable sources or from thermoelectric power. In a nutshell, those who produce a gigawatt hour from renewable sources will be remunerated in the same way as those who produce it from a gas plant, and it does not matter that the former has operating costs much lower than the latter. All will receive roughly the same price, even if they had offered to sell at lower prices. This is the market dynamics that Draghi referred to in the press conference when he said: “The cost of hydroelectricity and that of renewables have nothing to do with that of gas and yet it is all sold at the price of gas”.

The logic of these dynamics comes from afar and is linked to the desire, several years ago, not to penalize the presence in the market of the “new” gas plants compared to the coal-fired ones that were by now consolidated. And today it remains standing because, combined with systems of penalties for the most polluting productions in the green acceleration desired by Brussels (such as the ETS), it is hoped that it will push member countries to favor productions with less emissions. Today, however, renewable sources are unlikely to be able to establish the marginal price in countries that are still very unbalanced on thermoelectric production, and even in those where they are more developed they are still affected by adverse weather conditions.

These dynamics naturally apply to the markets spot such as the Day Ahead Market, the Intra-day Market and the Market for the Dispatching Service, but this does not exclude the possibility of long-term contracts between seller and buyers outside the power exchanges (OTC). At this rate, however, the rush in the price of gas can pose a serious threat to the post-Covid recovery, and Spain has understood this. The Government of Madrid has returned to ask for a reform of the market: “Two things are essential – said the Minister of Ecological Transition Teresa Ribera – Open an alternative of political options on how to react in exceptional situations. Second: to open a debate that will allow us to revolutionize the European electricity market and the energy markets in general to favor an adaptation to a reality that is completely different from ten to fifteen years ago. Some doors have opened, particularly in the gas market with the inclusion of hydrogen. Now we have to work on the rest of the components of the regulatory market ”. Tomorrow, the average price of electricity in the wholesale market in Spain will once again exceed all previous records, rising to € 383.67 per megawatt hour tomorrow, compared to € 360.02 at today’s latest all-time high. In just one week, the price increased by an average of 26.8 percent.

According to Ribera, the new record will be conditioned by the increase in demand from France caused by the temporary shutdown of three plants. About 30% of France’s nuclear capacity will be inactive since the beginning of January.

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