Why Gas Prices Drive Electricity Costs in Britain

The surge in gas prices after geopolitical tensions, notably following events such as Russia’s invasion of Ukraine, has had a profound impact on Britain’s electricity market. The government acknowledged the anomaly where electricity prices are heavily influenced by gas, despite a significant portion of renewable energy contributing to the power supply. This longstanding issue prompted a series of consultations aimed at reforming the electricity market, yet nearly four years on, substantial changes have not materialised.

Data indicates that day-ahead electricity prices have increased from an average of around £70 per megawatt-hour (MWh) before the recent conflict to over £110 per MWh. Furthermore, long-term contracts for electricity show similar trends, with prices jumping from approximately £68 to over £90 per MWh. These rising costs will inevitably reflect in consumer bills upon the upcoming revisions of the price cap.

The correlation between gas prices and electricity costs is not entirely surprising. Gas-fired power plants accounted for 27 percent of UK electricity generation last year. When operators of gas plants face increased costs, these expenses often cascade through to electricity prices, as they remain integral to the power supply balance. Despite a growing focus on renewables, gas continues to play a critical role in electricity generation.

Interestingly, the pricing dynamics are governed by a system known as marginal pricing. In this framework, electricity prices are determined by the highest-cost generator required to meet demand. Consequently, when gas prices increase, all generators, including renewables, receive the same inflated prices regardless of their lower operational costs. This results in higher electricity prices across the board.

Several proposals have been considered to reform this pricing structure, yet implementation risks and market stability concerns have hampered progress. The government previously explored options to separate gas from the electricity pricing mechanism but ultimately rejected them, fearing investor hesitation and potential negative fallout.

The trajectory indicates that as the UK gradually increases its renewable energy output, reliance on gas influences may diminish over the coming years. It is anticipated that by the end of the decade, gas will only determine prices around 30 percent of the time. Despite this optimistic outlook, current economic realities necessitate immediate action to address the pressing issue of energy affordability.

The government has sought to introduce new mechanisms to incentivise investment in renewables, including contracts for difference (CfDs) that guarantee fixed prices for power generated. However, negotiations to extend these contracts to existing renewable power sources have faced challenges, limiting their potential benefits for consumers.

As Britain navigates the complexities of energy supply and pricing, the intersection of geopolitical events and market dynamics remains a focal point. The urgency for reform in the electricity market continues to grow, with the call for a more sustainable approach to energy generation that minimizes vulnerability to global fossil fuel prices becoming increasingly critical.