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Natural gas is setting electricity prices despite being only 40% of production

© ShutterstockRise in natural gas prices.

As the energy crisis continues to affect the cost of living crisis, a new INET and UCL study argues reform of current electricity pricing mechanisms is needed if we are to effectively transition to a cheaper, domestically sourced electricity system.

New study warns that failure to address pricing formula in energy pricing hides the low cost benefit of renewables.

Energy pricing is set by short-run-marginal-cost-on-all pricing and further policy action is required to ensure energy security and affordability – fossil fuels are not the answer.

New renewables not only offer domestic sources of power but are currently offering power at a quarter of today’s current and projected electricity prices.

Energy crisis is driving cost of living crisis – but it’s driven by the price of natural gas

As European economies and households reel from rising energy costs due to the double whammy of heat waves and reduced gas supply from Russia, a new paper argues that politicians and regulators are missing a unique opportunity to transition towards low-carbon renewable alternatives.

As it stands today, the cost of gas-powered generation feeds through to electricity bills, on the principle of marginal cost pricing. That means that the price of gas is usually key to the price of electricity despite the fact that, certainly in the UK, it only accounts for 40% of generation. Combined with the steep decline in wind and solar costs over the past decade, this has resulted in an unprecedented degree of ‘cost inversion’ in the electricity system.

Marginal cost pricing is a risk to cheapest generators

This is the main argument of a new working paper, published jointly by the Institute for New Economic Thinking (INET) and the University College of London’s Bartlett Institute for Sustainable Resources. The paper shows that current electricity pricing procedures based on marginal cost pricing mean that increases in the price of gas drive up the returns of all producers, whether they use natural gas or not.

According to the study’s author, Michael Grubb, “fossil fuels set the electricity price for most of the time, at levels which are now much higher than the energy cost of at least half the system (recent renewables and existing nuclear) – so the price of electricity is way above the average cost of generating it.”

The short term focus on exploiting new sources of oil and gas has been driven by concerns about the impact of the energy crisis and the knock on effects of cost of living. Even if we ignore the energy security benefits of sourcing energy from domestic renewables, storage and effective grid management, a core market challenge is that the current pricing model obscures the economic benefits of renewable energy.

Grubb wrote: “Thanks to innovations, renewable energy is now much cheaper than in the past. A redesign of the pricing process for electricity would, accordingly, result in a far better price and more climate-friendly power generation. Lower-cost renewables, which are priced on long-term contracts instead of marginal cost pricing and under far less volatility than fossil fuels, would offer “an opportunity that could be seized by substantial changes in electricity market design.”

The study concludes by outlining principles for restructuring the European energy market so as to increase the use of renewable energy sources.

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