Righting Europe's energy wrongs

Europeans are finally getting a breather from sky-high gas prices. Thanks to declining demand by industry and households – driven by energy-saving efforts and a milder-than-usual winter – coupled with increased alternative sources, like wind and nuclear, gas prices have dropped to levels not seen since before Russia invaded Ukraine last February. But prices might rise again – and governments should let them.

Across the European Union, electricity generation and gas are inextricably linked. Gas is the most flexible fuel for thermal power stations, making it indispensable during peak hours. But it is not particularly efficient. In fact, gas requires at least two megawatt hours of calorific content to produce one MWh of electricity.

Last year, when nearly half of France's nuclear reactors went offline, more than 50 terawatt hours of nuclear power were lost. To make up for the shortfall, some 100 TWh worth of additional natural gas would have had to be imported. With gas prices averaging over €100 ($106) per MWh – owing partly to the loss of nuclear power – the implied cost was more than €10 billion. One key reason for the recent decline in gas prices is that some French nuclear reactors have been restarted.

More fundamentally, however, electricity prices are now falling because of Europe's so-called merit-order system, whereby the price of electricity is determined by the most expensive source. Of course, marginal-cost pricing was also the reason why wholesale electricity prices rose sharply in Europe after the war began, while remaining constant in the US. But those high prices were not a bad thing: they provided an incentive for users to consume less, thereby reducing the need to import gas. The problem is that only wholesale prices – those paid by industry and utilities – are determined by the merit-order system. Retail rates are often heavily regulated, resulting in large price discrepancies between countries.

In Germany and Italy, where electricity costs have been less heavily regulated, retail prices have roughly doubled since the war began, according to data from the Household Energy Price Index. In France, by contrast, the government has decreed that retail prices should remain essentially constant, and in Spain, subsidies have caused the prices paid by households to decline, despite the war-fueled rise in costs.

Government efforts to shield households and businesses from the impact of higher costs have obvious benefits, not least mitigating inflationary pressures, with headline inflation running much lower in France and Spain than in Germany and Italy. But the indirect economic costs are much larger, beginning with removing the incentive to save energy. (Price caps on gas are based on a similar logic, and have the same undesirable effect.)

Moreover, subsidies drive up public debt – something that neither France nor Spain can afford, given that both are already facing record-high debt levels. Efforts to ease price pressures also contributed to France's recent nuclear troubles. The state-owned nuclear producer Electricité de France suffered massive losses last year, after the government forced it to sell a significant share of its output below cost.

But France and Spain are not content only to keep retail prices low; they are now pushing to abolish the merit-order system at the EU level. They complain that marginal-cost pricing keeps electricity prices high as long as gas prices are high, even if the share of low-cost renewables increases. Consumers, they argue, should get to reap the benefits of investment in renewables.

The problem with this populist-minded stance – which the European Commission has also adopted – is that it ignores the important function served by high energy prices in reducing demand for gas and boosting investment in renewables. There are other ways to support households' purchasing power.

Yes, Europe's merit-order system will need to be rethought when zero-marginal-cost renewables crowd out all fossil fuels. But it is the ideal system for the transition to net-zero emissions. That transition will take too long for countries to be able to afford to continue providing subsidies, especially if prices are not allowed to rise high enough to spur the needed investment.

Unfortunately, that could happen, because the quality of policymaking in the EU is declining. The Commission used to be a bulwark against attempts by member states to launch politically motivated interventions in the economy. It now seems to have abandoned this role, not only with regard to energy policy, but also when it comes to limiting state aid.

This fits with the Commission's self-perception as a "geopolitical" body. But even from a geopolitical perspective, efforts to control gas and electricity prices do not make sense. As the costs of state intervention in the energy market climb, the EU's geopolitical standing will decline.

Daniel Gros is a distinguished fellow at the Centre for European Policy Studies. 

Disclaimer: This article first appeared on Project Syndicate, and is published by special syndication arrangement.