Demand-based pricing stabilizes the electricity market of the future

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As the urgency for global decarbonization ramps up, countries are working hard to reduce greenhouse gas emissions, largely through widespread electrification of energy use.1Global Energy Perspective 2023, McKinsey, October 18, 2023. Renewables such as solar photovoltaics (PV) and wind could help meet this demand while reducing reliance on fossil fuels. However, the intermittent nature of these types of renewables can lead to a variable supply of electricity, with moments of over- and undersupply.

This shift from dispatchable power, which exactly meets demand, is transforming the dynamics that govern power markets. To reimagine a market that was designed for a fossil fuel system, several options are available to update market designs and balance security, affordability, and sustainability—as discussed in the recent article, “Four themes shaping the future of the stormy European power market.”2Four themes shaping the future of the stormy European power market,” McKinsey, January 27, 2023.

The widescale build-out of installed renewable capacity creates new challenges and opportunities. At times, much more power will be generated than consumed, often described as “free power.”3 Finding ways to use, rather than curtail, the available power could help accelerate the transition toward more widespread electrification, helping to achieve net-zero goals across sectors.4 Harnessing this oversupply could lead to a potential multibillion euro supply opportunity. Some business models already capture this value, but others may require action from suppliers, offtakers, grid operators, and policymakers.

This article looks at a merit order of flexible demand options across power, heat, and hydrogen to compare the business cases for different technologies that can use the oversupply of electricity from renewable generation, exploring the willingness-to-pay for various sectors (see sidebar, “Using a merit order in power markets”). Drawing on the Netherlands as a case study, the article assesses the challenges and opportunities that arise from oversupply of renewable power and suggests possible solutions that stakeholders can take to unlock this untapped value from renewables’ flexible production model.

The challenge: Supply-demand mismatch arising from growing renewable capacity

In many regions, renewables could become the main source of power in the next decade, which could lead to more variability in energy supply systems.5Global Energy Perspective, 2023.

While this is vital to meet global goals to reduce emissions of power systems, without forethought it could cause a significant mismatch in the hourly supply of, and demand for, electricity. By 2030, the renewable peak capacity in the European Union could exceed the average demand of 320 gigawatts (GW) by a factor of three to four, leading to times of significant oversupply of electricity.6Global Energy Perspective, 2023.

Demand, on the other hand, maintains a constant profile across days and weeks, with fluctuations of no more than 50 percent from the 320 GW average.7Global Energy Perspective, 2023. In the Netherlands, based on current expectations of offshore and onshore wind and solar PV build-out, by 2030 renewables could match base power demand for approximately half a year (Exhibit 1).

In a given year, there could be both under- and oversupply from renewables, with oversupply expected to increase over time.

The Netherlands is not the only country that will have periods when supply is either above or below the demand for power. Countries around the world are adding variable, nondispatchable renewable energy sources.8Global Energy Perspective, 2023. As the build-out of these sources grows and they become the main source of electricity, the times of oversupply will likely increase.

To illustrate this shared challenge, McKinsey compared three fundamentally different renewable energy systems: Australia’s New South Wales’ (NSW) grid, which has high solar penetration; Canada’s Quebec system, which relies on hydropower; and the Netherlands’ wind-dominant system (Exhibit 2).

Oversupply will increasingly occur in power systems across the globe as intermittent renewables becomes dominant.

Parts of Australia could see significant peaks in solar PV supply as it becomes the dominant source of power, meeting or exceeding baseload demand (that cannot yet be redirected to other use cases) for approximately a third of the time by 2030.9 In parts of Canada, the system draws on dispatchable hydropower, meaning there are limited periods of oversupply of electricity in the system.10

Globally, power systems are currently still limited in their ability to manage these variable supply profiles. With the majority of industry demand operating in a steady state with very little variability, industries largely follow baseload demand profiles, driven by the optimization of assets and time-of-use grid electricity costs.11Global Energy Perspective 2023: Industrial electrification outlook,” McKinsey, January 16, 2024. Consumers, meanwhile, continue to use power whenever they wish as they have no clear incentives to do otherwise.12 In future, both industry and consumers are likely to shift their largely inflexible baseloads from fossil fuels to electricity for their heating needs.13Global Energy Perspective 2023: Industrial electrification outlook,” January, 2024. This, in turn, will increase the demand for electricity, compounding the inflexibility problem.

With the shift to electricity, industrials, consumers, and third-party providers may adopt management measures on the demand side. Examples range from smart e-boilers in homes to commercial freezers in supermarkets that overcool when prices are low, or systems using thermal mass in processes, to move demand around.14 While these measures are highly profitable at the moment and an important lever to reduce the supply-demand mismatch, they are currently not widespread enough to fully resolve the variability in systems, as expressed in the large fluctuations in power prices.15

This supply-demand mismatch will need to be solved for the energy transition to accelerate and make the business case for new-build renewables viable. There are two challenges to address. First, if customer flexibility cannot match oversupply, the share of electricity curtailed will likely increase further, reducing the amount of electricity sold. Second, in current market circumstances, if power supply exceeds demand, power prices could decrease significantly, which would amplify the variations in prices over time in day-ahead markets—prices are low during moments of oversupply and high during moments of undersupply.

The opportunity: Potential alternative uses for oversupply of electricity

The oversupply of electricity from renewables can be consumed flexibly during moments of high supply. For example, oversupply from renewables could go into electrolyzers that produce green hydrogen, another low-carbon solution that is set to replace grey hydrogen.16

Alternative use cases could all help to accelerate the transition through additional electrification on top of baseload use, but also hold economic value. The value that this oversupply of electricity offers differs by application, such as heat, power, and hydrogen. To demonstrate this using a real-world case study, McKinsey looked at the Netherlands to compare the business case for different flexible uptake technologies (Exhibit 3). The merit order of these technologies, from most economically viable to least, is as follows:

  • Aligning demand for power with moments of high renewables supply. This is the most viable option as it saves having to buy high-cost electricity without significant investments being made. An example is charging electric vehicles in the afternoon when it is the sunniest rather than during the morning or evening peak when power prices are high. The business case is attractive, as the cost of the electron changes significantly while only requiring a small software update and no capital investment. In the Netherlands, although this is an appealing option, its potential impact is limited as the expected total load that can be moved around in 2030 could be restricted to between 1 and 2 GW, whereas the system could face 50 GW of oversupply of electricity at peak times.17Global Energy Perspective, 2023.
  • Using oversupply of electricity for hybrid heating and thermal storage. This use case, which pertains to major natural gas consumers, has significant potential when compared to gas-based heating with a CO2 tax—this is because relatively low investments are required and it offers a high-conversion efficiency (such as running an e-boiler or heat pump during moments of electricity oversupply and running a natural gas boiler during moments of undersupply).18 Additionally, due to the large heat demand in some countries, the total flexible capacity that can be unlocked from direct heating and thermal storage is very large, potentially up to 20 GW in the case of the Netherlands.19Global Energy Perspective, 2023.
  • Storing or transporting oversupply of electricity as power. Adding grid capacity or installing battery storage would require increased investments but enable the sale of electrons at times of higher prices.20 For example, the oversupply of electricity stored in the afternoon could be used in the evening. Alternatively, intercountry connections allow balancing across countries or storing electrons elsewhere (for example, Norway’s pumped hydro storage).
  • Producing green hydrogen from an oversupply of electricity. On a pure cost basis, the business cases based on green hydrogen provide the least value, due to the relatively large investment required, the low utilization of this investment if only used during peaks in power production, and low overall energy conversion efficiencies.21 Of the hydrogen business cases, switching from grey hydrogen (that is used in refining and the production of ammonia) to green hydrogen is the most viable.22 Using green hydrogen instead of grey, natural gas-based hydrogen displaces more natural gas compared to green hydrogen in power and heat use cases.23
There is a clear merit order in flexibility options, going from heat to power to green hydrogen.

A potential multibillion-euro opportunity

Despite the clear order of potential value, all solutions will likely have a role in a decarbonized society, with each one helping an aspect of the transition. For example, batteries could be used to provide ancillary services and resolve grid congestion, providing an additional revenue stream to increase their potential value. Similarly, legislation being discussed in the European Union (for example, REDII-III) currently contains language around demand for green hydrogen, which could result in a price premium for hydrogen.24

Our analysis shows that both offtakers and producers can create significant value by using this oversupply of electricity: €7 billion to €14 billion annually in the European Union, based on 700 terawatt hours (TWh) of oversupply of electricity, and a margin between €10 and €20 per megawatt hour (€/MWh) after deducting the cost of production.

The question of how to capture most of this potential value depends on the price at which electricity is traded. Whereas the marginal cost of a producer has set prices historically, in the future it will likely be the offtakers’ willingness to pay that sets the price for the oversupply of electricity.

Players across the value chain could, however, take steps to use this oversupply of electricity to accelerate the transition toward renewables-based energy sources, with attractive use cases:

  • Producers, depending on what an offtaker is willing to pay, could increase their share of the value at stake by actively seeking offtake agreements, such as power purchase agreements (PPAs), that allow them to fully match their generation profile. This includes more variable PPAs, delivering electricity only at times of peak generation.
  • Offtakers could increase their value by both maximizing their potential willingness to pay for the oversupply of megawatt hours (MWhs) and through developing the capabilities to purchase this power when available.
    • Heat-based flexibility options, such as e-boilers and heat pumps that are installed next to fossil fuel systems have strong business cases with relatively low upfront investments. These business cases would require strong trading capabilities to monetize on price fluctuations, either in-sourced to industrial players or through collaborations with energy players.25A new age for energy and commodity trading,” McKinsey, June 2, 2021.
    • Power-based flexibility options are either relatively limited but low cost, such as software to steer electric vehicle chargers, or high capital expenditure (capex) with larger potential, such as export cables and power-to-power storage options.26Exploring consumer sentiment on electric vehicle charging,” McKinsey, January 9, 2024; “Battery 2030: Resilient, sustainable, and circular,” McKinsey, January 16, 2023. Many of these opportunities are greenfield, requiring developers to step in.
    • Hydrogen-based flexibility options have large potential but are currently costly due to limited flexibility in electrolyzers, coupled with high capex. Government subsidies and hydrogen premiums might improve these business cases in the future. Hydrogen developers and offtakers in industry (driven by regulation) and utilities (driven by backup needs) are better positioned to capture the value of hydrogen production when baseload energy costs can be minimized, rather than through variable, low-cost, peak loads. This could be realized through strong PPA agreements or integration with a producer.27Global Energy Perspective 2023: Hydrogen outlook,” McKinsey, January 10, 2024.

The actual savings for energy producers and offtakers depends on the energy sourcing strategy, the total installed renewable production capacity, flexible uptake capacity, and the grid connection cost and taxes.28 Specifically, when sourcing oversupply of power in addition to the power price, grid connection costs can be high enough to make the business case uneconomical. Depending on the local context, it is possible to reduce these costs, but this would require a fundamentally different market design.29

At present, individual players in the market tend to regard the issues that they face as someone else’s responsibility to solve. For example, both baseload generators and battery storage operators feel that regulations are preventing more flexible uptake forms.30 However, by acting in unison, the whole chain could operate more efficiently, accelerate the global shift toward more electrification, and do so more economically (Exhibit 4).

All players can have a role in unlocking the value of flexibility

The current electricity grid market design may need a fundamental shift to deliver a successful and orderly energy transition. The current market design is optimized for baseload production—thus heavily penalizing infrequent use of oversupply of power, as users get charged per kilowatt (kW) peak.31 Energy players, renewable developers, grid operators, and energy offtakers who take action soon could overcome these major roadblocks. There are various actions each one could take:

  • Offtakers of the energy industry could find themselves well positioned if they invested in assets and systems for hybrid electrification—for example, using an electric boiler when electricity is cheaper than gas, and switching to a gas-powered one when electricity is more expensive. By developing capabilities to optimally source energy or partner with renewable developers, offtakers could maximize their production value while decarbonizing. Large-scale industrials could hybridize their production systems—to (partly) electrify their heat—with direct electrification and heat storage.32Decarbonizing the chemical industry,” McKinsey, April 12, 2023. Users of electricity could further optimize behind the meter, combining usage and storage with their own renewable production. Finally, users could source power optimally along different wholesale markets—including day-ahead, intraday, and imbalance—combined with additional revenue from ancillary services such as the automatic Frequency Restoration Reserve capacity fees.33
  • Renewable developers and utilities could optimize their generation and client portfolios, combining generation and storage, and implement advanced analytics tools to improve production value—provided they carefully manage the increased merchant risk of having a relatively fixed cost and variable price set by the market. Greater renewables generation can reduce the capture price, decreasing the attractiveness of investment and increasing the merchant risk. Developers can optimize the value from produced wind by finding customers for both firm capacity and flexibility, while renewable assets can be incorporated into a portfolio of generating assets and customers, potentially coinvesting at client sites to jointly create arbitrage opportunities. To navigate the increased volatility in power markets, and to maximize the value from imbalance, developers could make use of production forecasting, trading strategies, and active development—for example, determining what kind of turbines could be used and which direction solar PVs could face.
  • Grid operators, often highly dependent on grid regulation, could take a more forward-planning approach where possible, driving more efficient use of the existing grid and targeted expansion through more flexible connections. The market design could shift from a baseload focus to an emphasis on using the peaks produced by the world’s future renewables-based system, optimizing flexible power consumption both in space and time—for example, the use of the Netherlands’ offshore wind power close to the coast or during the night. There are opportunities for grid operators to take a more proactive role here, guided by the timing of renewables build-out and by determining optimal locations for production, storage, and uptake. This can reduce congestion while providing more MWhs and prevent costly, after-the-fact, expansion.
  • Tariff setters and policymakers can look at how regulations and tariffs can support the adoption of these oversupply use cases, thereby helping reduce emissions. Concretely, this could be achieved by introducing new offerings to match new connection types, such as nonguaranteed connections or opportunistic capacity. For example, they could provide for time-bound connections such as restricted use during moments of outages or maintenance, or additional capacity during moments of underused grids during the night or afternoon, or through location-based connection types such as coastal connections. This could increase the overall use of the grid by allowing increased demand only at times when it would not worsen congestion on the grid. An example of this is the nonfirm capacity contracts now proposed by the regulators in the Netherlands, decoupling the connection cost from the peak capacity.34
  • Distributed and smaller-scale assets, owned by households and individuals, could also unlock further behind-the-meter flexibility (for example, smart electric vehicle charging and heat pumps) by allowing the power consumption of these appliances to be adjustable remotely. To scale up the participation of these assets to flexibility markets, processes and interoperability standards could be simplified and harmonized, such as prequalification and metering requirements, that currently take months to obtain for individual, small assets.35 Prequalification and already certified “flex-ready” assets with fewer strict requirements on latency could reduce the time and cost to get these assets to the market. Metering is another critical enabler of widespread, small-scale, flexibility. Smart, connected meters and the platforms to unlock their data could enable the exchange of qualified data that allow capacity and power price markets to function for these kinds of assets.

For a successful and orderly global decarbonization journey, the speed of the transition needs to align with renewables build-out. To make this happen, grid infrastructure and the operating environment requires an update to accommodate the increase in renewable power. However, the variability of the supply of electricity that will accompany this increase in demand need not be a stumbling block. It can hold significant value, both to accelerate the transition by using renewable electricity in new ways to reduce the loss of electricity that otherwise might be curtailed and to implement these measures in economically attractive use cases. This will require players in the energy market—who are able act on the opportunities—to take steps to ensure that renewable energy’s potential is unlocked.

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