The European Commission approved an Iberian exemption this week, allowing Spain and Portugal to limit gas prices for the next 12 months. The law is expected to be passed next week which should help to calm down the power market.
The political accord allows for the construction of a temporary mechanism that will cap gas prices at an average of €50 per MWh. On average, YTD day-ahead gas price in Spain is 97 EUR/MWh resulting in around a 50% discount vs. the market price.
According to the Spain government, all consumers will gain from this agreement. However, this might not be 100% true, especially for consumers with a fixed-price contract for the next 12 months.
Since last summer, the Spanish and Portuguese governments have been urging Brussels to take action to lower electricity prices, which have risen dramatically due to increased demand for natural gas, supply chain issues, and geopolitical tensions, including the recent war in Ukraine.
EU member states trade electricity on a wholesale market based on a marginal pricing structure and merit order. Everyone pays the same price for the electricity they produce, regardless of which technology the electricity is produced from, e.g. renewables or fossil fuels. The most expensive method of producing electricity is then used to determine the power market price. Gas and Coal are usually the most costly technologies to generate electricity. If you want to learn more about marginal pricing, you can check my prior article.
Spain and Portugal argued that because of their limited interconnection with the rest of Europe, the Iberian power market should be permitted to set gas rates for themselves. In addition, the two countries have a significantly lower reliance on Russian gas (which they mainly acquire from Algeria) and a robust renewable generation capacity.
So what impact will it have on the electricity market prices in Spain and Portugal?
In the previous article about the electricity marginal production costs, we have discussed how power prices are driven by the natural gas market. Each €1/MWh movement in gas price moves power by €2/MWh.
You also need to be aware that since this is only a temporary measure, it will mainly impact the OMIE spot market price. Still, the spot market price is unlikely to be lower than the historical average for electricity in Spain/Portugal ~40 EUR/MWh.
The YTD OMIE electricity market in Spain has averaged ~220 EUR/MWh so far in 2022. This is >5 times increase in the market price vs. the historical average. Obviously, the current power prices are not sustainable for many consumers, especially industrial clients. This is why Spain and Portugal have agreed on this temporally measure to cap the gas market price.
The price cap to gas generation is to be applied with a gas price of an average of 50 €/MWh. The preliminary understanding of the new law suggests that it will start with 40 EUR/MWh and be increased to 60 EUR/MWh in the twelve-month period. This gas price cap OMIE mechanism will operate for 12 months until Apr’23. Therefore, the future market prices for Cal23, Cal24, etc. are unlikely to be impacted by this law. This will mainly affect the OMIE spot market price.
How will it impact OMIE spot power prices in Spain and Portugal?
- The 50 EUR/MWh gas price is double the historical average. And as the electricity market price is based on the marginal costs of a gas power plant, its cost has increased by about 50 EUR/MWh vs. 20 – 25 EUR/MWh the historical average. 1 Eur change in gas = 2 EUR change in electricity. Hence, (50 – 25 EUR) * 2 = 50 EUR/MWh gas impact on the power price.
- Then we need to consider the CO2 cost, which skyrocketed from 25 EUR/t to 80 EUR/t this year. This has an additional impact on the power generation costs by ~30 EUR/MWh because 1 EUR change in CO2 = 0.5 EUR change in electricity.
- Considering the above, we can estimate Spain’s new OMIE spot market price following the gas price cap at 50 EUR/MWh. The new average spot power marker price is unlikely not be lower than ~120 EUR/MWh in Spain and Portugal in 2022 (40 EUR/MWh historical power price + 50 EUR/MWh gas impact + 30 EUR/MWh CO2 impact = 120 EUR/MWh, at least).
Of course, the 120 EUR/MWh is much better for an average consumer than the current OMIE price of 200-300 EUR/MWh, but it’s near close to what we have seen in the past before the EU gas market crunch in 2021. And this is very unlikely that the gas market balance will significantly improve shortly.
Therefore, a tight gas supply is expected for 2 or 3 years. Then, there’s also an additional price pressure from the Fit for 55 EU legislation that drives emission costs higher. As a result, the new market price paradigm is around 100-120 EUR/MWh, in the best case for the following years in Spain and Portugal.
Who is going to pay for this measure?
The compensation payment is to be provided to the “compensated” producers and likely distributed among all participants as a function of the final buying position. This is yet to be clarified.
As a result, consumers with a fixed price contract for the next 12 months will benefit the least from the new law because they already don’t have any exposure to the OMIE day-ahead electricity market price.
On the other hand, consumers with a variable price indexed to the OMIE spot market will benefit the most. In the end, however, all market consumers would need to pay for this measure. At this movement, the final charge is yet to be determined following the final law release. It’s expected that the charge can be somewhere around 10 to 20 EUR/MWh on top of the electricity bill. This, of course, is much better for an average consumer with a non-fixed power contract than paying 200-300 EUR/MWh OMIE day-ahead market price.
Also, it shall be noted that Spain has an electricity grid interconnector with France equivalent to the output of approximately three nuclear power plants (2.800 MW). As a result, France will be able to import cheaper Spanish power via the gridline, which can further inflate the charge.
If you want to learn more about the European gas market crisis, read my next article here.
