Energy UK Explains: Why marginal pricing is the cheapest way to run our electricity market

What is marginal pricing and how does it work?

• In competitive markets, prices are set by the cost of the last and most expensive unit needed to meet demand at any given moment.
• This is not unique to electricity. This is how all commodity markets work, including oil, gas, metals and others. It is not a policy choice imposed on the market; it is a description of how competitive markets naturally function.
• In electricity markets, generators submit bids based on their cost of production, which are then ranked from cheapest to most expensive.
• Generation is called on in that order (the merit order) until demand is met and the price paid to all generators is set by the cost of the last unit needed.
• In practice, this often means that when a gas plant is needed to keep the lights on, its cost sets the price for every technology, including cheaper generators like wind or nuclear.
• This approach ensures that:
  • The lowest-cost generation is used first
  • The system meets demand at minimum total cost
  • Prices reflect the true cost of supplying electricity at a given time.
• Marginal pricing is used across electricity markets globally because it delivers efficient dispatch and transparent price signals.

Why marginal pricing is efficient

• Marginal pricing supports several critical features of a well-functioning electricity system.
• Cheapest first: The system always uses the lowest-cost generation available before turning to more expensive sources, ensuring the country never pays more than it needs to at any given moment.
• System flexibility: As electricity systems decarbonise, flexibility becomes increasingly important. Flexible generation, including gas, storage and demand response, plays a critical role in balancing variable renewable output. Marginal pricing appropriately values this flexibility by rewarding assets that can respond when supply is scarce.
• Electricity flows where it is needed: If prices are higher in one country than in a neighbouring one, electricity automatically flows to where it is most needed, replacing expensive generation with cheaper alternatives and in some cases preventing blackouts. This works precisely because marginal pricing is used consistently across major electricity markets worldwide, including throughout Europe. Maintaining that alignment supports efficient cross-border trading, well-functioning regional markets, and investor confidence.
• Clear investment signals: Electricity markets rely on investment in new generation and flexibility. When the prices are high, it shows that electricity is scarce and there is a need for more capacity; when prices are low, it shows an abundance of supply. This scarcity pricing incentivises investment in new generation, storage and flexibility where it is most needed.

Why the energy price crisis is not a market failure

• The political pressure for market redesign stems largely from the energy price crisis of 2021 to 2023, when wholesale electricity prices rose sharply across Europe.
• The cause was an extraordinary spike in international gas prices driven by supply constraints and the aftermath of Russia’s invasion of Ukraine, and was not a failure of market structure.
• Redesigning the market in response to a gas price shock does not address gas price volatility. It simply changes who bears the cost and how it is distributed, without making energy any cheaper or more secure.
• As the share of renewables grows, gas will naturally set the marginal price in fewer periods. The problem is self-correcting over time as more renewables financially ‘decouple’ gas from electricity prices.

The UK’s experience: lessons from REMA

• The Review of Electricity Market Arrangements (REMA) was one of the most comprehensive reviews of electricity market design ever undertaken in the UK, examining in detail whether the wholesale market, including marginal pricing, needed fundamental reform. The answer was ‘no’ due to several reasons.
• The UK looked hard at this question and reached a clear conclusion. After extensive analysis and consultation, the government concluded in March 2023 that split market proposals, including the ‘Green Power Pool’, were not workable. As a result, the second consultation focused on retaining short-run marginal pricing and pursuing targeted reforms, rather than undertaking wholesale market reforms.
• The problems were real, but the diagnosis was wrong. REMA identified that high prices and weak locational signals were genuine issues, but concluded these were better addressed through targeted interventions within the existing market framework.
• Investor confidence was decisive. A key finding was that fundamental market redesign would make it significantly harder for developers to price long-term investment, increasing the cost of capital at precisely the moment the UK needs record levels of private investment to deliver clean power. The complexity and investor uncertainty associated with wholesale market redesign were judged likely to outweigh any potential benefits.
• The link with gas will naturally decline. Even with marginal pricing, the proportion of time that gas sets the price will fall over time as renewables and other low-carbon generators represent an increasing share of electricity generation. In addition, Contracts for Difference provide a natural hedge against gas price spikes. Generators with CfDs pay back revenue from power sold at market prices higher than their strike price.

What can the UK learn from other countries?

• The international evidence consistently points in the same direction – that the link between gas and power prices can be decoupled by increasing investment in low variable (largely low-carbon) cost generation and sufficient storage, as well as enabling customers to shift demand.
• Many of the policy ideas currently being discussed are not new, and their limitations are well understood.

The Iberian mechanism

• Introduced by Spain and Portugal during the 2022/2023 energy crisis, the ‘Iberian mechanism’ reduced wholesale prices by subsidising gas-fired generation and recovering the cost via levies on consumers.
• It did not reduce overall system costs, instead redistributing them, and introduced distortions to price signals, investment incentives and hedging behaviour.^[1]
• The unintended consequence of this mechanism was that by lowering wholesale electricity prices, interconnector flows changed, meaning that Spain and Portugal spent a significant amount subsidising French energy bills.
• Given the substantially higher interconnection between the UK and Europe, this effect would likely be higher were the UK to adopt a similar model.

The Italian Energy Decree

• The Italian Energy Decree largely replicates the Iberian mechanism by lowering the marginal cost of gas generation (in Italy’s case, via subsidies on transport and carbon costs) to reduce wholesale prices.
• However, the underlying economics remain the same: costs are shifted rather than reduced, with similar risks around market distortion, fiscal burden, and weakened investment signals.
• Recent analysis from ICIS highlights how this proposal would have limited benefits, as making gas power artificially cheap increases demand for gas, raising gas prices for everyone – including gas generation.^[2]

Further thinking

• Other ideas, such as market splitting or administrative price-setting, raise even more fundamental concerns around market functioning and feasibility.
• More technical proposals, such as Austria’s transparency mechanism, or emerging concepts like integrated CfDs for industry, attempt to address symptoms of price volatility without fundamentally altering the market design.
• While less distortive, they are either incremental or still at an early stage, with significant design challenges unresolved.
• Overall, the debate reflects a recycling of previously tested or well-understood interventions.
• The evidence to date suggests limited value in pursuing these approaches at scale, particularly given their trade-offs and the risk of undermining investment and market integration.
• This is also the view of the European Commission – a recent letter from Ursula Von Der Leyen, President of the European Commission, concludes that “a market-based system built on marginal pricing delivers clear benefits overall.”^[3]
• Policy focus is therefore better directed toward strengthening existing frameworks, such as long-term contracting, system flexibility and infrastructure, rather than revisiting interventions that primarily reallocate costs rather than reduce them.

What are the risks of reopening fundamental market design questions?

• Investor confidence takes an immediate hit: even opening the debate is enough to cause investors to pause or re-price risk on long-term energy infrastructure projects, increasing the cost of capital at precisely the moment the UK needs record levels of private investment to deliver clean power.
• We introduce far greater complexity in an already heavily regulated market.
• We already have a windfall tax or wider taxes to prevent excessive profits around various parts of the energy sector, as our explainer shows.

Conclusion: We need to reform the operating environment, not the market

• The case for marginal pricing is strong, well-evidenced, and supported by the UK’s own exhaustive review process, which Energy UK supports.
• The primary challenge that we face is that the UK remains highly dependent on international markets over which it has little control. Accelerating the transition to clean homegrown energy can ensure our long-term energy security and insulate us from international markets.
• Redesigning the pricing mechanism would distract from this agenda, undermine investor confidence, and risk making the problem worse.

For more information, please contact Energy UK at MPSupport@energy-uk.org.uk.

References

1 Oxford Institute of Energy Studies (2023), The Iberian Exception: An overview of its effects

2 ICIS (2026), System wide impact on consumers of Italian Energy Decree measures on the power sector

3 European Commission (2026), Open letter from European Commission President