Impact of oil price on electricity prices

Summing up, the most important factors influencing electricity prices are:

 Electricity generation mix, including share of renewable energies: different technologies and different fuels impact the marginal electricity generation costs, which through the merit order curve are the basis for the price setting mechanism;  Supply/demand balance: the price is set where the supply/demand curve intersects

the merit order curve of electricity generation;

 Prices of fossil fuels for power generation: fuel prices notably for coal and gas, but also for oil where it has a relevant share in the national electricity mix impact the merit order curve;

 Interconnection capacities with other Member States: interconnections enable import of electricity from lower cost sources; influence on national prices will depend on interconnection capacity and on generation capability in neighbouring countries;  Price of CO2 emission allowances (EUAs).

Direct impacts

How important is the oil price as a determinant of electricity prices? As shown above, between 2007 and 2013 the Pan European Power Index (PEP) seems to follow the crude oil price with a time lag of about a quarter year. However, the correlation is only moderate. Oil price changes have a direct impact on electricity prices where oil itself is used as a feedstock for power generation. Only about 3% of all EU electricity is produced from oil products, strongly limiting the extent of this type of impact. Only a few Member States (notably Malta and Cyprus) are particularly vulnerable to oil price changes in this regard. Indirect impacts

The most important indirect impact is the oil price’s impact on natural gas through oil indexed contracts (see section 2.3). The relatively small impact of oil prices on coal stemming from coal extraction and inland transport (see section 2.4) provides for only a small indirect impact on electricity prices.

Since about 25% of all EU electricity is generated in gas-fired turbines, electricity prices are closely tied to gas prices (see section 2.5.2 above). Moreover, gas-fired power plants are more often price setting than coal-fired power plants making gas more relevant for electricity prices. Electricity prices therefore tend to also follow oil prices since, as discussed above, gas and oil prices are linked through various mechanisms including most notably oil indexation.Power utilities are in this sense no different from gas utilities; they buy gas from wholesalers through a mix of oil-indexed and spot-market prices (with the actual mix varying from country to country). However, there is one key difference between power and gas utilities: the former generally have access to a wider range of alternative energy sources.

While gas retailers only have a very limited range of alternatives to natural gas (mainly bio- gas), power utilities generally have the option of using other fossil resources (coal or oil) or non-fossil power sources (nuclear, renewables). In theory, they can therefore react to rising gas prices by increasing their use of non-gas power generation assets; although in practice the scope for such arbitrage is limited due to various barriers. For example, coal is not an ideal substitute to gas when lowering CO2 emissions is a major policy imperative. Renewables cannot replace all natural gas power generation due to their higher degree of intermittency (as well as generally higher cost). Nuclear power plants are expensive and difficult to build in today’s political context. This leaves oil, which is of course tied to oil prices (as well as being more CO2 intensive than natural gas). The negotiating power of natural gas buying power utilities is therefore limited, although the ability to switch from gas to coal (due to the currently weak constraints on CO2 emissions) presently allows them to exert some pressure on their gas suppliers.

What is more, power generators have more to lose from sudden gas price movements than gas distributors, since the “take-or-pay” clauses that usually accompany oil-indexed contracts can lead to severe losses if electricity prices fall below a given threshold (the purchaser will be forced to buy gas at times when power prices will not cover fuel prices). Since electricity prices are determined by a range of factors, including the price of coal. As electricity is not easily storable, it is possible that electricity prices fall while gas prices increase. If competing power retailers are able to secure cheaper electricity (e.g. from nuclear sources), they will put pressure on the gas dependent utility to lower its prices and thus incur losses.

Another point that can be made is as follows. Since oil indexation tends to lead to higher gas prices, it may have the effect of discouraging power generators from investing into gas-fired power assets. Switching from coal or oil to gas always involves substantial costs; if the price advantage of gas is lessened, so will be the incentive to switch. All other things being equal, this could result in higher electricity costs and/or CO2 emissions. In the USA, where gas prices have fallen dramatically, many power generators switched to gas and thus initiated a movement that led to low electricity prices and CO2 emissions.

Also, the rigidity of oil indexed prices can be a strong disincentive to invest into gas power plants if retail prices are deregulated, since utilities are forced to commit to minimum purchase volumes (as per the so-called take-or-pay contractual terms). If gas prices increase faster than electricity prices, utilities will be penalised. According to (Melling 2010), the higher share of oil-indexed gas supplies in Eastern Europe may help explain why this region invests less in combined-cycle gas turbine power plants than the UK and other North Western European countries. Melling goes on to argue that given the increased importance of the power sector in gas markets, its greater need for flexible price mechanisms may be the main driver of de-indexation, i.e. the transition toward spot pricing.

In summary, the cost of generating electricity in Europe is linked to oil mainly through the impact of the latter on gas prices though indexation contracts. As there are other electricity generation technologies including nuclear and renewable power plants and different national electricity mixes, the impact of the oil price on electricity prices through natural gas (strong link based on oil-indexed contracts) and through coal (weak link through fuel costs in extraction and inland transport) overall is limited. The moderate correlation found between oil price and electricity prices, and the rather large variations in national electricity prices are a consequence of this.

2.6. Oil products