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Electricity: why are you so complicated?

To better understand the commercial nature of electricity, one can think of it as a simple commodity, just as gold, oil and coffee are. However, it is the inherent characteristics of electricity that make it differ substantially from commodities in other markets. It is therefore useful to provide an overview of what the electricity markets in Europe are and how they are organised, but above all what the future holds.

written by Tommaso Tiozzo Bastianello and Duccio Baldi *

Electricity is characterised by three macro-components: the energy transported (on the bill this is reported in kWh, the unit of measurement corresponding to 1000 watts per hour), the transmission capacity, and the flexibility with which it can be delivered. Each of these characteristics is associated with a problem.

Going in order, large volumes of electricity cannot (for the time being) be stored efficiently and, above all, cheaply. Therefore, electricity has a different value over time. Returning to the comparison with commodities, if the price of coffee varies a couple of times a year, electricity takes on a different value every hour of the day, making time a major obstacle. Problem number two, location. Electricity flows must be constantly monitored and transmission components must be operated within safe flow limits to avoid the risk of cascading failures and blackouts. Transporting electricity from the production source to the end user is not so simple, counting also system losses (electricity that is lost ‘on the way’ due to conversions between high, medium and low voltage), electricity therefore takes on a different value in space. If I go down to the basement, I want to be able to turn on the light and avoid tripping in the dark. The energy system must therefore be flexible enough to always match demand and generation. Otherwise, there is a risk of blackouts. The increasing fraction of energy produced from renewable sources in the national energy mix, with its varying availability depending on weather conditions, implies an adaptation from the previous system where a coal-fired power plant remains on all day without interruption. This variation in time is not the end of the world, but simply requires an adaptation on the part of the market. Let us not forget that even fossil-fuel power plants can suddenly fail, causing major disruptions. Therefore, the ability to change electricity generation/consumption at short notice is of considerable value (and price).

These components explain why there is not just one electricity market, but how electricity is then traded in multiple markets until it is actually delivered in real time. Figure 1 shows a schematic overview of the electricity markets currently existing in the European Union. 

Figure 1. Please note that while electricity markets have been liberalised in the EU, other regulatory models may be in place in other parts of the world.  

The different types of energy markets in Europe

European electricity markets, as shown in the figure, are divided into: long-term markets, wholesale markets, balancing markets and finally re-dispatch markets.

The long-term energy markets (yellow boxes in the figure) start approximately four years up to one month before delivery. A selected financial exchange organises the electricity trade, where energy quotas can be bought and/or sold. The traded energy prices are denominated per supply zone, which in most cases has different values for different zones within national borders. If an operator wishes to buy energy quotas between trans-national bidding zones, long-term inter-zonal transmission rights must be acquired separately. Furthermore, if deemed necessary and under certain conditions, Member States may decide to establish a capacity market. This measure allows the purchase of electricity from selected power plants at any time to meet unplanned energy demands.

The volumes traded on wholesale markets (red boxes in the figure) are only a fraction of the final volume of electricity produced. The day-ahead market consists of a pan-European auction that opens at 8 a.m. and closes at noon, where hourly blocks of energy for the next day’s 24-hour period are traded. Again, trading is organised by one or more exchanges per Member State. After the previous day’s market has been closed, the intraday market opens, which provides for transactions by continuous trading in some countries (as in a stock exchange) and by auctions in others. In addition, wholesale prices serve as a price reference in long-term contracts.

After the close of trading in the intraday market, the balancing mechanism (green boxes in the figure) is activated to ensure that supply and demand always match in real time. Each state has an entity responsible for the transmission of electricity on the high and extra-high voltage grid, called a TSO (Transmission System Operator). In Italy, this role is played by Terna, which takes care of the real-time balance in its control area. The various TSOs conclude contracts at least one year in advance up to one day before delivery to ensure that there is always sufficient energy.

Redispatch (blue box in the picture) is mainly used in regions with a high percentage of renewable energy production. As soon as schedules are received, TSOs perform a so-called load flow or grid load calculation to prepare an overview of the expected grid feed-in and consumption for the next day. They analyse the dispatch to determine whether certain parts of the electricity grid could be negatively affected and to what extent. In order to minimise the number of short-term grid stabilisation interventions on the following day, the transmission system operator may instruct plant operators to postpone planned energy production based on the next day’s load flow calculation to avoid grid bottlenecks. Some Member States have merged the balancing energy and dispatching markets to simplify operations.

What is happening in the markets

Bearing in mind what has been explained about the markets in Europe, let us try to analyse the developments in recent months. On the one hand, electricity consumption in Europe returned very close to pre-pandemic levels in the second quarter of this year (ed. 2021), thanks in part to an increase in economic activity in response to the relaxation of the Covid19 freeze measures, although it remained slightly below 2019 levels (-0.5%). On the other hand, energy prices rose to all-time highs. Indeed, the perfect storm was created by an unfavourable intersection of factors: a sharp rise in commodity prices (mainly gas) in combination with an increase in energy demand linked to the economic recovery and temperature fluctuations in Europe, which led to a harsher-than-expected winter in the first half of the year, halving European gas reserves.

To a lesser extent, the strengthening of carbon prices also contributed to the price increase. Specifically, the European CO2 taxation system (ETS – Emission Trading System) imposes a payment on plants producing electricity from fossil fuels (e.g. gas and coal), which has led to a further price increase. So the ETS does not work? Far from it, with the money collected from these taxes, energy projects from renewable sources are massively financed. It was the combination of factors that broke the bank, leading wholesale electricity prices to rise by 180% (year-on-year in August) and five times the lowest prices recorded during the pandemic.

A glimpse of Italy

Among the most affected electricity markets, Italy has certainly recorded one of the largest increases in Europe. As explained above, rising commodity prices, especially gas, played an important role in the price surge, especially in a context of continental supply shortages. And Italy, as one of the largest producers of electricity from gas in the EU (gas accounted for 48% of total generation in Italy during Q2 20211), recorded the highest level of monthly average electricity prices since 2008. Italian spot prices spiked in June, as record high gas and ETS prices kept wholesale prices high, while the easing of blocking restrictions and warm weather (increased use of cooling systems) boosted consumption, supported by a drop in annual wind and solar generation. The subsequent peak in July 2021 (€102/MWh) was surpassed in August, September and finally October, reaching a record price of €218/MWh. But the price rally did not stop there, as the Gestore dei Mercati Energetici (GME) calculated a historical price of 289 €/MWh on 24 November 2021. Figure 2 shows the development of average electricity prices in three European countries. 

Figure 2. History of the average Single National Price (PUN) in Italy, Scandinavia and France. Source: GME (IPEX). 

What the future holds

Europe started the process of harmonisation and integration of national electricity markets with the first electricity directive in 1996. Since then, we have seen a lot of progress. The future will see the growth in demand for electric vehicles, which will be powered by more renewables in national energy mixes. Renewables, combined with other low-carbon sources and increased energy efficiency efforts, would make fossil fuels less significant in fluctuating wholesale market prices and thus European countries less dependent on gas imports.

Moreover, better interconnection between Member States will lead to greater price convergence and thus single market theory predicts that prices will fall. Facilitating this decrease in costs are increased efforts to achieve greater energy efficiency in conjunction with the creation of flexible demand through the implementation of smart meters and smart grids. Overall, a well-functioning and well-integrated EU energy market, continued investment in renewable technologies and energy efficiency improvements are key to keeping prices under control for all consumers.

* Duccio Baldi and Tommaso Tiozzo Bastianello are two energy engineers specialised in renewable energy and energy systems modelling. After both completing their master’s degrees abroad (Duccio in the Netherlands and Tommaso in Denmark) and subsequently gaining international experience in organisations such as GIZ (German government), IRENA (international renewable energy agency) and the European Commission, they decided to return to Italy to actively contribute to the energy transition, founding a start-up that focuses mainly on energy communities: Enco – Energia Collettiva.

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