When gas costs rule power prices. Merit order pricing, Europe’s energy crisis and reform options

Summary

As gas prices have doubled since the beginning of the war in the Middle East, concerns about electricity costs are returning across Europe. Why, despite the rapid growth of low-cost renewables, do gas prices still have such a strong impact on power prices? Mostly because of merit order pricing, which implies that flexible gas-fired power plants often set market prices when demand exceeds non fossil supply. Yet it was designed to encourage investment in low cost power sources and efficient technologies. Short-term fixes such as subsidies or price caps may provide temporary relief but also carry risks. To keep (wholesale) electricity prices durably low, the electricity system must be decarbonised further and made more flexible, while electricity markets must become more competitive.

Highlights

Gas still rules Europe’s power prices
Gas-fired power plants generate less than one-fifth of EU electricity but set wholesale power prices in more than twice the percentage of hours. Gas accounted for 85% of Europe’s power price surge in 2022. Even as renewables grow, flexible gas remains dominant. Without adequate storage, grids, demand flexibility and a balanced wind solar mix, low-carbon energy transition remains fragile.

Short-term fixes also carry significant risks
The Iberian model (gas subsidies) works only in isolated markets, while Italy’s refunding of ETS carbon costs risks locking in gas reliance. Austria’s transparency push and WIFO’s proposal to refund the portion of wholesale power prices attributable to ETS carbon costs above a specified threshold could risk distorting futures markets. Greece’s dual pricing shields consumers but adds complexity.

A flexible low-carbon electricity system keeps prices low
Renewables acceleration and demand flexibility that shift electricity use to periods of abundant non-fossil generation are important steps forward. But Europe must also scale power storage and grids to break the pricing grip of gas. Otherwise, power price volatility and fossil fuel reliance will persist, threatening both affordability and climate goals.