Why does the price of gas drive electricity prices, including renewables?
Why does the price of gas matter for renewable electricity suppliers like Good Energy? And how are gas and electric prices linked?
To answer this, we will first explain how electricity is bought and traded.
In the UK, there is one wholesale market for electricity, where generators (renewable and non-renewable) sell electricity to suppliers for particular periods of time. Like any commodity, there must be enough supply to meet demand at any one moment in time.
This means that there are negotiations throughout every single day between generators and suppliers to secure power. The price tends to fluctuate in every half hour period in response to factors such as availability and the time of day traded.
With renewables now supplying up to 40% of the UK electricity demand, big fossil fuel generating plants have had a diminishing role in the market. In addition, the greater volume of renewable generation is also altering how we decide which generation type is chosen when they are all available to meet demand.
The crucial reason for why the price of gas is so influential, comes from something called the ‘merit order’.
What is the merit order?
Think of it like ranking an order of preference. When every generation type is available to meet demand, the system has to decide which technology is brought ‘online’ first.
The good news is that renewables are always chosen first when they are available because they are the cheapest to run.
This is great for reducing emissions but it is also logical to meet demand with the cheapest generators available at the time.
Unlike fossil fuel generation, which has a high marginal cost to run because they are burning something, the marginal cost for renewables is practically zero.
So, how is gas setting the price?
Gas sets the price of electricity, because the electricity price in every half hour period is set by the marginal cost of the last generating unit to be turned off to meet demand – which is invariably a gas power plant with high marginal costs.
To provide an analogy, think of a penalty shootout in a sporting competition. A team will select a list of individuals in order of preference, with the best individuals selected first (i.e., renewables). But it’s the individual who steps up last who has the final say, deciding the fate of the result.
Generation types are like players in a penalty shootout. Renewables get selected first. But when the pressure is on, gas steps up to the spot. And its score determines the result.
The problem we have at the moment is that whilst renewable capacity has grown significantly, natural gas is still responsible for 38% of our electricity generation in the UK.
When we have periods of low winds for example, the system will often turn to gas generators to fill that demand. But that comes at a high price, and even more so recently with the record prices on the wholesale gas market.
As we move to a high renewable powered electricity system, it doesn’t make sense to have gas generators setting the price.
How does this impact Good Energy?
The good news is, by being a Good Energy customer, you are already part of the solution, ensuring more renewable energy is powering our grid.
Our power purchase agreement (PPA) backed model, buying power directly from over 1700 independent renewable generators, matches 100% of our customers’ demand across the year, as well as supporting domestic UK renewable generation.
PPAs also provide a natural ‘hedge’ against market volatility. They tend to be a set price agreed over a long period — crucial for renewable developers to plan and secure finance, but also valuable to us in that they lock in the price we pay generators whatever the market is doing.
However, renewables like wind and solar are dependent on the weather. Even when we have bought ahead more than enough power for our customers, a PPA does not guarantee the wind will blow or the sun will shine. After over 20 years’ experience in forecasting output based on the weather, we have become extremely effective at predicting how much power we will get from our generators and matching it against our customer demand.
In the last five years, we have been able to match our customers’ demand to renewable generation in every half hour period 92% of the time on average – something we are incredibly proud of. Our customers and generators are effectively providing a blueprint for a future high renewable energy system. Providing invaluable insight into how 100% renewable, 100% of the time could be achieved on a national scale with more renewable capacity and storage.
But today, this still leaves some periods where we have to make short-term trades on the wholesale market, where gas-driven volatility is ultimately setting the prices.
How can we reform the market in the long-term?
If we are to fundamentally change how the price of electricity is set, a full reform of our wholesale markets will be required.
Should the government decide to make changes, possible reform options could include decoupling renewables from the wholesale market altogether, in effect having separate power markets.
Other ideas include taking an average price, which has been suggested in some European countries or moving to a model of locational pricing (nodal), which could see prices set at a much more local level and reflective of the costs of your local generator powering your home. Ultimately, however the market is designed, we need to accelerate the building out of a diverse mix of renewable infrastructure. The quicker we do this, the quicker we end our reliance on volatile fossil fuels setting the marginal price.