The dangers of marginal cost based electricity pricing

Abstract

Led by energy and environmental policies the EU power sector is undergoing vast changes to achieve a market driven and sustainable future. Market based price discovery and different renewable support schemes are seen as key solutions in achieving the desired future production mix. Most liquid power markets use marginal cost based price discovery where the price is set by marginal costs of the last producer needed to cover all load, usually a fossil fuel power plant. At the same time the majority of new investments are made with significant help from government support schemes in renewable production capacities, which have very low marginal costs. The increasing share of renewable production will thus impact price levels in day-ahead markets. This paper analyses the potential impact of more renewable electricity production on price discovery in the NordPool Spot market, which already has a high share of renewable electricity traded. Results show that ceteris paribus NordPool Spot is likely to have very high price volatility in the future and alternative revenue sources are required for new investments.