Five trends reshaping European power markets

European power markets have entered a period of unprecedented change. Power prices have touched new highs: base load week-ahead prices have raised above €200 per megawatt-hour (MWh) in a number of European countries about four times the average historical level. That increase has been prompted largely by a surge in natural-gas and carbon prices, which currently exceed €100 per MWh and €60 per metric ton, respectively. This development has affected the cost of power produced by natural-gas power plants, which broadly set prices in European markets.

At the same time, price volatility is reaching new heights as a result of the uncertain output of renewable assets and a tight supply-and-demand balance in the European power system. Navigating this next normal will be a key challenge for utilities, traders, and large power consumers, and that highlights the importance of developing resilient power-asset portfolios and managing risk.

What’s ahead for the European power sector?

The European power market is undergoing major changes. Five trends underpin these developments.

Sustained growth in power demand, supported by climate-related targets

Electricity demand is expected to increase steadily in Europe, at a CAGR of about 2 percent until 2035. The main factors behind the surge will be the electrification of transport and a ramp-up in the production of green hydrogen through electrolysis, requiring renewable power.

How can market players respond?

The European power market is entering uncharted territory. When utilities and large power buyers face that kind of uncertainty, strategic risk management becomes a matter of survival. In the United Kingdom, recent defaults of power and gas retailers, following the surge in gas prices, illustrate the high stakes. Here are some steps players can take to address the uncertainties:

Investing in best-in-class risk-management models. These would cover market-price risks along with the nonlinear volume or shape risks of day-ahead and intraday power markets. For example, players could make more use of advanced stochastic profit-at-risk or cash-flow-at-risk models, such as running them in quasi-real time to best inform hedging strategies. Ad-hoc stress tests will also be critical to run on a periodic basis.

Pursuing flexibility in portfolios. To reduce exposure to price surges in wholesale power markets, players could source more flexibility both on the demand and supply sides of portfolios, including, for example, demand-side response aggregation and investments in gas-peaker assets, grid-scale batteries, and virtual power plants (VPP).

Developing an active presence in the most liquid European power hubs. Germany is expected to remain the most liquid market and an ideal place to optimize hedging strategies across Europe for example, by employing proxy hedges and cross-border hedges in the event of strong market coupling and limited liquidity in other markets.

Using power purchase agreements with partial or full fixed-price arrangements. Companies could use this strategy to hedge long-term power purchases or sales, thus reducing exposures to volatile power prices.