The new triad: gas, carbon and renewables in power price formation

Gas, carbon, and renewables form a powerful triangle, setting the power prices of both today and tomorrow. As the actual carbon cost is realised, markets begin to transition from fossil-based marginal pricing to zero-marginal-cost systems. This can be seen in organisations such as Capstone, which are spearheading the small-scale renewable generation that is driving modern power markets. But, as the renewables share of the energy market increases and marginal technologies accelerate, so does the volatility of pricing. 

These developments have implications for both the overall investment in renewable energy and the policy that governs both fossil fuels and low-carbon alternatives. We’ll take a look at the crucial role of gas, carbon and renewables and how they may affect power price formation in the future.

How traditional price formation is evolving

As the energy landscape evolves, so must the price formation evolve to accommodate it.

The gas-carbon linkage under marginal pricing

Gas is one of the most expensive forms of power, which means that it strongly influences the price of energy. The relationship between carbon pricing and gas is closely linked, even when gas isn’t the primary source of energy consumed. When energy prices are higher, they also result in higher carbon emissions and, as a knock-on effect, lead to higher carbon pricing in carbon markets. 

Renewables’ influence on merit order dynamics

The predominantly lower cost of renewable energy compared to gas has a direct impact on price formations, because new financial mechanisms must be developed to accommodate these lesser costs. One solution could be to separate the pricing of fossil fuels from renewable energy and nuclear, adopting a more hybrid-led system that balances volatile sources like gas while ensuring market stability.

The combined influence of gas, carbon and renewables

The energy market is very finely balanced, and the rise of one power source can impact on the entire market pricing.

Interdependencies: gas price spikes, EUA costs, renewable variability

The use of more carbon-intensive energy sources, like coal, when other sources, such as gas, become more expensive, can lead to a rise in the price of carbon allowances (EUAs). The upside is that this can lead consumers to switch to renewable sources, which aren’t as carbon-intensive and therefore aren’t accompanied by the financial penalties of more carbon-intensive methods. An uptake in renewable energy can also make these technologies cost-competitive with fossil fuels. However, renewable sources are variable, and without energy storage solutions, they aren’t yet advanced enough to meet all of our energy needs, especially in emission-heavy industries like manufacturing and aviation. This means fossil fuels still have a part to play in our energy mix. 

Empirical relationships from recent data

Data has shown that consuming renewable energy can offset the carbon emissions produced by fossil fuels. This is because by choosing renewable energy (a lower-carbon form of energy) the amount of fossil fuels (a higher-carbon form of energy) consumed is reduced. The formula is simple: the more renewable energy we consume, the fewer carbon emissions are released into the environment.

Understanding clean spark and clean dark spreads

Spreads are a method of calculating profit margins, and two types are used to calculate gas and coal-fired plants. Clean Dark Spread (CDS) takes into account carbon emission allowances and the cost of the raw material used to fire a coal plant: coal. Clean Spark Spread (CSS) takes into account carbon emission allowances and the cost of the raw material used to fire a gas plant: gas. 

How spreads act as indicators of market stress or opportunity

These spreads can be used to indicate whether the profit margins of plant operations might necessitate an alternative fuel source. Higher CDS signals would indicate that a coal plant is economically viable, whereas a higher clean spark spread might suggest that switching to gas is the better financial option.

Regional spread comparisons (UK vs. continental Europe)

This method of profit determination helps feed into carbon pricing mechanisms such as the EU Emissions Trading System. But different regions have different spread ‘gaps’. For example, in the UK, there is a larger difference between gas and electricity prices, whereas in Europe, gas prices tend to be lower and therefore less sensitive to fuel costs. 

How renewables reshape the merit order

The introduction of renewables into the power market can impact the profitability of fossil fuel plants because fossil fuel plants incur no financial penalties for carbon emissions. These zero variable fuel costs after construction could make renewables more competitive with fossil fuels, making them less profitable overall. This could lead to price cannibalisation and negative pricing events, when the price of energy drops in line with the rise of renewable uptake. 

Flexibility markets and capacity payments

Incentives have been introduced to help balance the grid during its decarbonisation transition period of volatility. Much like being ‘on call’, capacity payments are awarded to providers who are in a state of readiness to generate energy, even if it’s not yet required. In contrast, flexible markets help reduce consumer demand for these services.

What future market design could look like

The direction of investment certainty in either fossil fuels or renewables, as well as the pace of decarbonisation in the energy industry, could depend on the importance of regulation and policy shake-up. If governments continue to incentivise renewable energy and penalise fossil fuels with future carbon reduction targets, investment in renewables becomes more desirable, increasing the pace of decarbonisation. 

One thing is for sure: the power market of the future will be shaped by the interplay of gas, carbon, and renewables, as well as by how regulators balance volatility, fairness, and investment signals.