How is electricity priced in Europe and how this may change

As energy prices soar around the world, Europe is in a particularly delicate situation. Its heavy dependence on Russian gas – in addition to droughts, heat waves, an unreliable French nuclear reactor fleet and a continent-wide transition to greener but more intermittent sources like solar and wind – has driven up electricity bills and fueled the highest inflation in decades. As Europe teeters on the brink of recession and the winter heating season approaches, officials are considering a major overhaul of the region’s electricity market to reflect the ongoing shift from fossil fuels to renewables.

1. What is the electricity price?

Unlike oil or natural gas, there is no efficient way to save a lot of electricity for use in the future. Large-scale commercial use of batteries is still years away. Thus, electricity prices were set based on availability at any given time. When there is a lot of wind or sun, for example, production is relatively cheap and prices are lower. If this supply decreases, prices increase as more generators come online to meet demand, powered by more expensive sources. The way the market has long worked is that it’s the end technology, or type of factory, needed to meet the last unit of consumption that sets the price for everyone. In Europe this year, that has generally meant natural gas.

2. What is the relationship between electricity and gas?

Very close. Across Western Europe, gas-fired power stations have been a vital part of the energy infrastructure for decades, fueled largely by supplies brought in from Siberia. Gas-fired power plants were relatively quick to build and the technology simple, at least compared to nuclear power plants, and burns cleaner than coal. Around 18% of Europe’s electricity was produced in gas-fired power stations last year; in 2020, about 43% of imported gas came from Russia. Even in the depths of the Cold War, there had never been a serious supply problem – until relations with Russia deteriorated this year after the invasion of Ukraine. Diversification outside of Russia, for example by increasing imports of liquefied natural gas, requires new infrastructure that is time and cost intensive.

3. Why does it work this way?

In theory, the relationship is no different from that with coal, for example. But production hiccups and heatwave brakes on power plants, from nuclear in France to hydroelectricity in Spain and Norway, have considerably changed the generation picture this year. Since coal and nuclear plants are usually running all the time anyway, gas plants were called upon more often – sometimes just to keep the lights on as summer temperatures hit record highs. And with the war in Ukraine leading to record gas prices, it has pushed up overall production costs. It is this relationship that has made soaring gas prices the driver of electricity prices. And since the mainland is fully connected, this has driven up prices across the region. The value of the European electricity market tripled last year, reaching a record 836 billion euros (827 billion dollars today).

4. What is envisaged?

With much of European industry on its knees and households facing hundreds of percent increases in their energy bills, the pressure on governments and the European Union to intervene has never been so strong. One of the main proposals is to impose a price cap on electricity from non-gas producers, the difference between this price and the market price serving to relieve consumers. While it sounds simple, such changes would destroy a market design that has worked for decades and could threaten future investments with unintended consequences.

5. How has this market evolved?

The Nordic region and the UK market were leading in the 1990s, then Germany followed and is now by far the largest. A trader can buy and sell electricity delivered later the same day in hourly increments or even up to 15-minute periods, to meet sudden demand or take advantage of price discrepancies. The price of these contracts is entirely determined by supply and demand, the amount of wind blowing or the coal-fired power plants in operation, for example. Demand tends to increase in the early morning and late afternoon. This system was designed when fossil fuels provided the bulk of energy. There are now more renewables, which are less predictable, and the proposed changes reflect that change.

6. What else have governments done?

There are also traders who focus on longer-term contracts covering periods of several years ahead, where broader factors such as expected economic output help drive prices higher. Sharp price swings this year have prompted countries like Germany, Sweden and Finland to earmark billions of euros in emergency cash loans to support utilities hit by sudden margin calls on their transactions.

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