How the electricity price is determined

Prices on the electricity exchange have remained at a low level for a long time. Since the end of 2020, however, they have been rising significantly. If we look at the price development for the coming year, Frontyear Cal 22, for example, this price has almost doubled in one year to over 95 EUR/MWh. In addition to extremely high gas prices, the price development of CO2 certificates is currently pulling electricity prices upwards. Martin Koller, Head of Energy Economics at Axpo, explains how the electricity price is formed. 

Martin Koller, can, you explain us exactly how electricity is priced? 

Essentially through supply and demand on the short- and long-term electricity markets. Today, it is mainly power plants on the supply side with positive variable costs, such as gas and coal-fired power plants that set the price. If coal, gas or CO2 prices rise, price-setting power plants have higher variable production costs, which means that electricity prices rise as well. By comparison, wind, PV and hydropower plants barely have any variable costs at all, and for nuclear power plants they are very low, which makes them ‘price takers’.

Gas and coal-fired power plants determine prices today. What will this look like with the energy transition in the future?

In a long-term decarbonised world, power plants with synthetic fuels or with CO2 capture and storage will increasingly set the price on the supply side. The demand side, with its electrolysers and storage systems, will gain price-setting power. Fossil fuel-driven power plants without CO2 capture will become less relevant. Of course, it cannot be excluded that in the longer term new technologies with completely different cost characteristics will enter the market.

How does the short-term electricity price affect us compared to the long-term electricity price? 

The short-term electricity price determines the effective use of (pump) storage power plants and gas-fired power plants, while the long-term electricity price is important for securing long-term expected production from nuclear energy and hydro.

What is the significance of the variability of electricity prices over time?

The price of electricity can fluctuate considerably throughout the course of a day or week, driven by both demand and production conditions for renewables. With our flexible power plant portfolio, we benefit from a high level of price variability. The Power Purchase Agreements (PPAs – read more here) are designed to anticipate short-term price fluctuations caused by simultaneity of PV or wind production – which we call price cannibalisation – as accurately as possible, so we do not suffer financial consequences. Among other things, this requires detailed knowledge of all the power plants in Europe, expected extensions and demand situation.

As well as short-term electricity prices, the average annual electricity price can also fluctuate considerably in a multi-year comparison. These fluctuations in the long-term development of electricity prices are particularly critical for Axpo because they have huge leverage on our results and because you can’t really get around them.

What can we do to avoid being completely exposed to this long-term development of electricity prices? 

We sell electricity up to 10 years in advance, with the majority being sold two to three years in advance. This eliminates the electricity price risk and thus significantly reduces the overall risk, which is why we also refer to this as hedging. In principle, we would like to sell a larger amount of electricity four to 10 years in advance, but the demand for this kind of long-term product at prices that are profitable for us is as yet not very high, at least at the moment. 

To offer some context: over the past 10 years, long-term electricity prices first decreased by around EUR 50/MWh and then increased again by more than EUR 35/MWh. Those years showed how important it is to have a smart long-term hedging strategy, because at Axpo a +/-1 EUR/MWh change in the electricity price translates into around EUR 23 to 25 million per year at an average production volume of 23 to 25 TWh per year, excluding gas power plants. 

The price of CO2 certificates is currently at a record high – why?

 In recent years, the number of CO2 certificates has fallen significantly while reduction targets have continuously increased. We assume that prices will be significantly higher in the long term. However, that doesn’t mean that the price won’t drop significantly again for a long period in the interim.

What is the impact of the high CO2 price? 

It increases electricity prices. Despite the higher electricity price, a higher CO2 price also indirectly improves conditions for green hydrogen, which is produced from electricity. This green hydrogen can be used as hydrogen or as another synthetic molecule, as a substitute for various fossil fuels or can be used in industrial processes. A high CO2 price is one of the required conditions if there is to be a Europe-wide or worldwide market for green hydrogen. Our new strategy lays the foundations for us to play a decisive role in a world with numerous renewables and green hydrogen.