The Marginal Pricing Mechanism for Electricity in Europe
In the European electricity market, prices are set through a marginal pricing mechanism. Power generators submit bids indicating the price at which they can produce electricity, ranked from the lowest to the highest cost. The price for a given period is then set by the last (i.e., most expensive) unit of electricity required to meet demand—a concept often known as the merit order (European Commission, 2020a).
Because many renewable energy sources, such as wind and solar, have near-zero marginal costs, they are dispatched first. However, during periods of high demand or low renewable output, the market turns to fossil fuel generators with higher operating costs. These generators set the marginal price that all market participants pay, regardless of which source produced their electricity.
High Electricity Prices and Their Impact on Energy-Intensive Sectors
The reliance on fossil fuel plants to set market prices means that electricity costs in the EU tend to be high during peak demand periods. Indeed, even if fossil fuel plants are more expensive to operate and have significant carbon costs under the EU ETS, they are required when renewable energy supply is insufficient (European Commission, 2020b).
Compensation for Energy-Intensive Sectors
Industries highly sensitive to electricity prices, such as aluminum, iron/steel, and hydrogen, are particularly affected by these high costs. To ensure these industries remain competitive and prevent carbon leakage, the EU has implemented compensation mechanisms. These funds help to mitigate the financial burden imposed by high electricity costs resulting from the marginal pricing system (European Commission, 2021).
Policy Scenarios: Keeping Compensation vs. Expanding CBAM Scope
Currently, CBAM excludes indirect emissions from aluminum, hydrogen, and iron/steel after 2026. However, two policy paths are possible:
Scenario 1: Maintain Compensation & Keep Indirect Emissions Outside CBAM
- Avoids Disrupting Industry Practices: Industries may prefer stability and logistical clarity instead of restructuring compliance systems.
- Ensures Ongoing Support: Compensation funds would continue to offset high electricity costs.
Scenario 2: Expand CBAM to Include Indirect Emissions & Remove Compensation
- Reduces Public Spending: Eliminating compensation programs would allow the EU to save funds while shifting industry support to CBAM revenue.
- Preserve the Carbon Leakage Protection: Covering indirect emissions in CBAM would ensure a level playing field by preventing imports from benefitting from lower electricity costs.
Regulatory Outlook: A Decision That Will Shape Industry Competitiveness
While CBAM is currently set to exclude indirect emissions after 2026, policymakers must weigh the trade-offs between continuing compensation programs or expanding CBAM coverage. If indirect emissions remain outside CBAM, the EU will need to keep sustaining its compensation programs. However, if CBAM is expanded, industries would shift from receiving direct financial support to relying more on CBAM revenues as protection against carbon leakage.
References
- Climat.be. (2024). Updated Use of Default Values in the Context of the CBAM. Retrieved from https://climat.be/cbam-en/news/2024/updated-use-of-default-values
- European Commission. (2020a). The EU Electricity Market: How It Works. Retrieved from https://ec.europa.eu/energy/topics/markets-and-consumers/electricity-market_en
- European Commission. (2020b). EU Emissions Trading System (EU ETS). Retrieved from https://ec.europa.eu/clima/policies/ets_en
- European Commission. (2021). Carbon Border Adjustment Mechanism (CBAM) – Frequently Asked Questions. Retrieved from https://ec.europa.eu/info/energy-climate-change-environment/standards-tools-and-labels/eu-green-deal/clean-and-energy-efficient-europe/carbon-border-adjustment-mechanism_en
- Directorate-General for Energy. (2020). Energy Pricing and the Impact on Industrial Sectors. Retrieved from https://ec.europa.eu/energy/publications