Economies across Europe face unprecedented energy-economic challenges, with cost-ofliving/inflation impacts which hold the prospect of turning into major social and political crises. 

In the UK, without any intervention, total household consumer expenditure on energy is set to  rise from £64bn in 2021 to around £200bn – an increase exceeding defense and education  expenditures combined. This is dominated by expenditure on electricity and gas, split (on  average) roughly equally between the two. Energy costs are a prime factor driving general  inflation in the UK to at least 10%, whilst poor households face cost-of-living increases of  almost 20%. 

The proximate causes – a Covid-recovery surge of global demand relative to supply in global gas  markets, followed by the Russian invasion of Ukraine - are well known. In addition, the  unprecedented heatwaves and drought across Europe – in line with the expected foothills of  accelerating climate change - have curtailed output from nuclear and hydro sources, adding  further pressure to electricity prices even aside from other more direct impacts of the extreme  weather. 

However, underlying these proximate causes is the generalized application in energy of an  economic principle of marginal cost pricing, far beyond its appropriate limits. This principle which in energy markets could be more precisely termed short-run-marginal-cost-on-all pricing means that fossil fuels still predominantly set the wholesale price of electricity, which over the  past eighteen months, has risen from around £50/MWh to around £200/MWh.1 At the same time,  European electricity systems are in the midst of a transition from the internationally traded  commodity of fossil fuels, to mainly domestic assets – notably, renewable energy sources. 

Aside from the cost and distributional consequences, such an approach to pricing is also  demonstrably inappropriate for driving investment in non-fossil fuel assets; indeed, it is  obscuring the growing success of a transition which has seen rapidly rising volumes of  increasingly cheap renewable energy. The UK in 2013 initiated a system of long-term fixedprice (“CfD”) contracts for renewables. The initial rounds combined cheaper onshore wind &  solar with less mature & hence more expensive offshore & biomass energy, but the investment  stimulated huge cost reductions particularly in offshore wind. The large offshore windfarms  coming onstream this year cost around £70/MWh, and the subsequent contracts for offshore  wind – agreed in 2019 and 2022 for delivery in the next few years – cost around £46/MWh and  £38/MWh respectively. 

The result is a striking ‘cost inversion’. Such sources, based on contracts outside the market,  offer power at under a quarter of current and projected wholesale electricity prices. They presage  a future of predominantly non-fossil, asset-based electricity with entirely different economic (as  well as environmental) characteristics. Aside from the proximate causes, navigating the crisis by exploiting this transition is the fundamental task facing policymakers.