Reform of the European electricity market: Should we prefer a price based on a weighted average of marginal costs with cross-subsidies?

Abstract

On the wholesale electricity market, the equilibrium price is set each hour on the basis of the marginal cost of the last power plant called, which is a gas-fired power plant a large part of the time in Europe. The surge in gas prices since the end of 2021 therefore largely explains the rise in the price of electricity. This paper analyses the reform projects proposed within the European Union to curb this surge in wholesale prices. It proposes then to reform the system by opting for pricing based on the weighted average hourly marginal costs, with financial compensation for power plants whose marginal cost is higher than this average. The quantitative study is conducted over the period January 1, 2020 through December 31, 2022 using ENTSOE hourly data. By implementing a compensation framework founded on average marginal costs, the market price experiences a significant decline, resulting in typically negative residual profits. Consequently, the fixed costs associated with the power plant fleet necessitate funding through the capacity market. This approach would enable French electricity consumers to align their payments with the structure of the national electricity fleet, specifically reflecting the average costs of power stations characterized by substantial fixed costs, such as nuclear facilities. The adoption of this proposed system is poised to expedite the energy transition toward a low-carbon economy.