Spain leads call for change in dysfunctional energy pricing

Europe Letter: Energy to spark difficult debate as 27 EU leaders meet in Brussels

The talk in Brussels is that Spanish prime minister Pedro Sánchez needs to bring home a result from this week's European Council – or his political future may be at stake.

Spain is at the sharp end of a surge in energy and fuel costs. Truck drivers say it costs so much to refuel that they lose money making deliveries, and have gone on strike, dismissing a government subsidy offer as inadequate. Supply chains are at risk. Supermarket shelves have emptied, as the effect of the strike combines with bulk-buying behaviour due to rising food prices and concerns about the war in Ukraine.

In addition, roughly one-third of households in Spain are on electricity contracts that link their bills directly to spot market rates. Those rose 400 per cent between April and October 2021 – before Russia’s invasion sent them even higher.

What makes the situation additionally painful is that almost half of Spain’s electricity was from renewable sources last year. Only 10-15 per cent was from gas. Despite flowing in for free from the sun and wind, electricity from renewables is priced at the same rate of gas, because of how the European Union’s energy pricing system works.

Electricity prices are set when distributors buy from producers on the wholesale market. The electricity is sold one day ahead on a trading platform, in 24 one-hour lots. Offers from buyers and sellers are matched by computer.

The cheaply produced renewable energy is offered for the lowest prices and is snapped up first. Then the more expensive fossil fuel electricity begins to find buyers. The most expensive electricity is usually left unsold. At the end of the lot, the highest level paid by any buyer is fixed as the price for all electricity sold for that hour.

Scorchingly expensive

In normal times, it’s viewed as an efficient system that guarantees the lowest electricity price each hour. Indirectly, it encourages investment in green energy, because selling at fossil fuel prices means renewable producers make almost pure profit after their initial investment.

But due to the specific role gas plays in the EU as an energy source, this pricing system has now become dysfunctional. Gas is a near-inescapable fuel in Europe:  it was designed to be the backstop that kicks in when the sun doesn't shine or the wind doesn't blow. It used to be cheap and abundant. But now that it has become scorchingly expensive, that ubiquitous presence is setting a cost floor for all electricity, no matter how it's produced.

EU countries widely acknowledge the system has broken. But they disagree on what to do about it.

Spain has led calls for the electricity pricing market to be changed to remove the role of gas. Belgium has called for gas prices to be capped. Italy, Greece, and Portugal back them up.

Ireland is among the countries cautious about interfering in the market for fear of unintended consequences. Critics object that the renewable energy producers who are currently raking it in will suffer if the market is interfered with. And if gas prices are capped, governments will need to make up the difference to suppliers, or they will simply sell their fuel elsewhere (this would result in a defacto EU "Gazprom fund", one diplomat predicted).

Green transition

Denmark, Ireland, the Netherlands and others argue that it all makes the case to speed the transition to green energy. Bulgaria, Hungary and Poland disingenuously argue that climate measures caused the price rise, and therefore the green transition should be delayed.

Poland has also led calls for the EU to stop buying gas from Russia outright. German chancellor Olaf Scholz has ruled this out, saying the resulting shortages would plunge Europe into recession, risking "entire industries" and "hundreds of thousands of jobs".

Asked to come up with solutions to please all, the European Commission has offered joint procurement of gas, as was done with vaccines, to prevent member states bidding against each other, and has proposed mandating that countries keep their gas storage facilities full. It's aimed to bring gas prices down but leave the market as it is. Previously, the commission laid out ways that governments could tweak taxes to reduce energy costs for citizens.

But the Spanish government insists that EU action is required. Mr Sánchez has made rounds of calls and visits to leaders to make his case, and to try to secure an agreement on something he can take back to Madrid, and save his political skin.

It won’t come easy. The 27 leaders are scheduled to start discussing energy in Brussels at 9.30am on Friday. One diplomat suggested that come Saturday morning, they may still be at it.