Analysis: it all comes down to how electricity is generated in Ireland and how the electricity markets operate

By Joseph Collins, Kieran Mulchrone and Andreas Amann, UCC

Electricity and gas prices for residential customers have seen significant increases over the past year and around 40% of a residential customer's bill is directly attributable to energy costs. The impact of the Russia and Ukraine war, which has resulted in a spike in European energy costs, is evident in household bills.

Approximately 25% of Ireland’s gas supply is indigenous and the remainder is sourced via pipelines from Britain. As a result, the price of gas in Britain directly influences the price of gas in Ireland. While Britain has its own indigenous gas supply, it also sources significant amounts of gas on international markets. Fluctuations in gas prices on international markets casued by the Ukraine war and associated gas supply fears influence British gas prices, which in turn influence Irish gas prices.

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But this does not explain the correlation between Irish gas prices and electricity prices. To understand that, we first need to understand both how electricity is generated in Ireland and how electricity markets operate.

Over the course of 2021, around 46% of Ireland’s electricity demand was met by gas fired generators, wind generators met approximately 29% of electricity demand and coal generation comprised 11%. Given the high proportion of gas fired electricity generation, the correlation between gas prices and electricity prices in Ireland, as illustrated in the following graph, seems intuitive.

Average monthly electricity (Irish) and gas (GB) prices from January 2020 to end of March 2022.

To move beyond this intuition and develop a deeper understanding of the link between electricity and gas prices in Ireland, let's look at marginal pricing. Imagine a scenario where you decide to open a shop selling fidget spinners.

There are two fidget spinner manufacturers, A and B, who have excess stock available. They are willing to sell you this excess stock at their respective production costs. Manufacturer A has 3,000 units available to sell at a production cost of €5 per fidget spinner, Manufacturer B also has 3,000 units available to sell, but it has a production cost of €10 per fidget spinner. You would like to buy 5,000 fidget spinners and are willing to pay up to €15 per fidget spinner.

When you apply marginal pricing in this example, the sources of supply are arranged from cheapest to most expensive, as shown by the blue and yellow boxes (and blue line) below. The dark green line represents your demand. The market price is determined by where the supply (blue) and demand (green) lines intersect (red star). Every unit that is sold (or purchased) receives (or pays) this market price.

In this example, the market price is €10 per fidget spinner.

  • You purchase 5,000 units at a cost of €10 each i.e. total outlay of €50,000.
  • Manufacturer A sells 3000 units at €10 per fidget spinner, given it had a production cost of €5 per fidget spinner it has a net profit of 3000*(10-5) = €15,000.
  • Manufacturer B sells 2,000 units at €10 per fidget spinner, but it has a production cost of €10 per fidget spinner, hence it has a net profit of 2000*(10-10) = €0.
  • 1,000 units belonging to the more expensive manufacturer B remain unsold i.e. 6,000 units available but only 5,000 units of demand.

While this example might appear convoluted at first glance, it is the basis on which short term electricity markets in Ireland and across Europe operate. Each day in Ireland, an auction is held that enables companies to buy or sell electricity for delivery the next day. It uses marginal pricing to determine electricity prices for each hour of the following day.

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By and large, the current dynamics of these auctions are that gas fired generators are playing the role of manufacturer B. That is, the production cost of gas fired generators is higher than the production cost of other generation types. Given that gas fired generators are required to meet demand, these generators will typically set the market price.

Production costs for gas fired generators have increased significantly as a result of Ukraine war, which in turn has had a direct upward pressure on electricity prices. Meanwhile, wind, solar, coal and other generation types are playing the role of manufacturer A with lower production costs.

What are some of the things that governments and policymakers are doing to respond to these electricity market dynamics? For a start, they are trying to increase the amount of lower priced generation. In our fidget spinner analogy, this is akin to sourcing as many units as possible (if not all) from manufacturer A in the hope that it will reduce the reliance on the more expensive manufacturer B.

Production costs for gas fired generators have increased significantly which has had a direct upward pressure on electricity prices

Spain and Portugal have introduced a mechanism capping the production cost of gas fired generators. In our fidget spinner analogy, it would have the effect of artificially reducing the production cost of manufacturer B. In Britain, they are consulting on a potentially significant restructuring of the electricity market (one option under consideration is creating a separate market for the renewable low priced generation).

In the longer term, the continued build out of renewable generation and the retirement of older (carbon intensive) thermal generation assets is required to meet various climate change targets. Outside of the physical challenge of building and running such a system, there is the challenge of participating in an increasingly dynamic supply and demand environment. Without sufficient amounts of electricity storage given current market structures, it is likely to lead to a continued volatility in prices.

Joseph Collins is a PhD student at the School of Mathematical Sciences at UCC. Dr Kieran Mulchrone is a senior lecturer in Applied Mathematics at the School of Mathematical Sciences at UCC, He is director of the MSc in Mathematical Modelling and Machine Learning course. Dr. Andreas Amann is a senior lecturer in Applied Mathematics at the School of Mathematical Sciences at UCC. He is a former Irish Research Council awardee.


The views expressed here are those of the author and do not represent or reflect the views of RTÉ