By Gemma Osborne
The problem of price volatility in the energy market has become more pronounced in recent months, with energy prices, particularly over Europe, quickly soaring to record highs. The World Bank Energy Price Index estimates that energy prices have risen by 26.3% from January 2022 to April 2022. These quick and large fluctuations in price are indicative of a volatile market.
This recent surge in energy prices in Europe can be partly attributed to restrictions on the supply of natural gas imposed by Russia, who supply 40% of Europe’s gas consumption, as a response to the tariffs imposed on its exports by Western economies due to its war with Ukraine. The effect of this can be seen in Germany, who imports over half of its gas from Russia through the Nord Stream 1 pipeline, where prices for daytime electricity peaked over €1500. In France they rose to an even greater extent, at over €2500, when the typical price is €50 per megawatt hour. The situation in France may also be explained by declines in its generation of nuclear power due to a series of shutdowns as a result of varying maintenance issues, and through which it generates 70% of the electricity supply. The Covid-19 pandemic may also be partially responsible for this increase; the unprecedented bounce-back of demand for energy that suppliers have been unprepared to meet.
These circumstances illustrate how numerous unpredictable factors affect the prices of energy, with the overriding determinant of price being scarcity of resources. The increased instability of suppliers of fossil fuels combined with the entrance of variable renewable technologies has certainly injected a sense of uncertainty in the market for energy.
Energy price volatility is the tendency for the market price to fluctuate, and the variability of these fluctuations from the overall trend. The level of volatility in a market reflects the uncertainty of the agents participating. Prices in the market for energy are typically more volatile, due to the inability for consumers to substitute for another alternative if the price becomes too high, or at least not quickly enough in response to the changes in price. This volatility does not necessarily mean high prices for energy, but the occurrence of frequent and large fluctuations between the extreme high and low prices.
The result of this volatility is wide-reaching negative implications for economies and individuals. Oil and gas prices are very hard to predict, which causes uncertainty. Due to increased uncertainty, this can mean firms delay investment which impacts negatively on economic growth, and reductions in consumer spending due to lower levels of household consumer spending if prices reach too high. Other negative impacts can be seen in developing economies, whose revenue depends heavily on exports of oil and gas. Due to the volatility in oil prices, the governments have to commit large proportions of their budgets to subsidising oil in order to protect firms and individuals.
With many countries realising the negative environmental impact of the use of fossil fuels, governments are looking at transitioning to a greener supply of energy. This includes such sources as solar, wind, nuclear and hydropower. This move is made more certain for the future with legislature such as the Paris Climate Agreement, which states that participating countries will collectively limit global warming to under 2 degrees Celsius. This will be achieved through a transition to greener sources of energy across the board, such as the Netherlands aiming to generate 75% of its energy from renewable sources by 2030.
However, the impact of this on the volatility of the market for energy has to considered, as it may only serve to exacerbate the fluctuations. It seems as though this transition may serve to increase volatility, due to the intermittent nature of the supply of green energy. During the day and year, supply quickly swings, dependent on weather and storage capabilities. With price being based on marginal cost, as production swings between different sources during the day, so will the price as some sources are more costly than others, such as natural gas being relatively expensive and wind power relatively cheap.
Renewable energy production has the issue of dependency on the climate and time of day. Solar will produce most energy during a bright, cloudless and long summer day, while producing little on a gloomy winter’s day, and nothing at night. This means that prices for solar will increase during the night and winter, and decrease during the day and summer, along with supply, as we cannot simply provide solar farms with more sunshine to prop up production during these times of day or year. Wind power is also dependent on weather and geographical location, with windspeeds being unpredictable and differing seasonally. This high variation causes uncertainty in the market, which will feed volatility.
Variable renewable energy (VRE) technologies such as these wind and solar projects have almost zero marginal cost for generation, so at times when VRE technologies are generating a lot of energy, prices will be much lower than otherwise. It was found that in Denmark, the use of wind power decreased the volatility of prices, while in Germany, it increased volatility, due to its stronger impact on their off-peak prices. However, solar power decreased price volatility in Germany, demonstrating the unpredictable nature of VRE. This study concluded that the higher the weekly wind power participation in the energy supply, the higher the weekly price volatility. Furthermore, it has been the international experience that as the share of energy produced through renewables has increased that there has been an increase in volatility.
The contrast found on the impacts between Denmark and Germany could be due to the fact that Denmark has access to large hydropower reserves, whereas Germany has limited access to flexible capacity. This highlights how technologies that enable the supply of energy to be more flexible around the intermittent sources can greatly improve the problems associated with transitioning to green energy, and even help to decrease the volatility.
This, however, is a generalisation to all green energy production methods, and ignores the nature of the supply of nuclear power. This method produces no greenhouse gas emissions, so is a green source. Nuclear supply is more flexible, as it is not dependent on weather or time, so can respond to changes in the seasonal production of other methods when implemented in conjunction with them. This means that it can be the key to keeping the supply and demand balance that makes for a less volatile market.
Recent high prices at least have one advantage, in that they may prompt governments to spend more on investment into the innovation of technologies. This aims to make the supply of energy more flexible, so that once implemented, the transition to green energy is cheaper for the public and create more stability, through which investment is fostered, and helping to reduce reliance on imports for energy.
The most important advances in technology around this would be in storage, with electricity at this point in time not able to be stored at scale. Better battery technologies will enable more short-term storage, while advances in hydrogen and thermal would allow the long-term storage of energy. This would enable excess energy to be stored during times of peak production to supplement the supply when production dips. This means that excess supply won’t have to be wasted and can be used instead to keep prices more stable.
As economies transition to green energy, economies may have to consider which proportion of production each resource should supply to the market in order to keep the price balance, by using nuclear as a reliable source and VRE technologies to keep prices low. New storage technologies will have to be developed in order to avoid the same volatility seen in the current energy markets. These technological advancements will help to solve the problem of variability in supply, enabling a greener and stabler supply and a more certain market for energy in the future.
The views expressed in this article are the author’s own, and may not reflect the opinions of The St Andrews Economist.