The market also provides incentives to use power when it is cheapest to generate.
Currently, prices are lowest at lunchtime and in the night.
The transition to renewable energy means that prices will become more volatile.
But that volatility is what drives innovation and investment in storage, smart meters and hydrogen.
A high-capacity battery, and the storage it provides, will be most useful when prices oscillate between extremes.
For a while, it looked as though the problem with Europe’s market was that prices were too low.
With more and more renewable energy entering the market, the price of electricity sometimes fell to zero and even turned negative.
The question was how marginal gas power plants—that might be needed to cover a windless, cloudy winter day—could make enough money during the rest of the year to survive.
Some countries opted to add a capacity market; that is, they auctioned off payments to generators just for being there.
Others stuck with an “energy-only market”.
The question now is very different.
Europe’s markets face sky-high prices for electricity, as the result of a war.
It is a situation for which they were not designed.
Thus policymakers face three challenges.
The first is to preserve the marginal-price signal, for both generators and consumers, in the face of political pressure to weaken it.
Lowering prices, for example by subsidising gas used in electricity generation, as Spain and Portugal have done, would elsewhere require some other form of rationing to allocate scarce energy.
(Spain and Portugal can get away without rationing because Spain is an important gas hub, so can easily import more.)
The second is how and if to redistribute profits.
The German government has recently decided to grab those it considers excessive, while leaving the price signal alone.
(The European Commission may advise countries to do something similar.)
It will do this through what is essentially a windfall tax that limits the share of the spot-market price that suppliers can keep.
The problem is that generators have hedged their exposure to differing degrees, meaning the true recipients of the windfall profits may prove hard to find, and may in fact sit outside the energy market.
The third is to ensure that Europe’s energy market is ready for the next crisis, and to do so without sacrificing its advantages.
At present, the spot market efficiently allocates capacity and provides signals on energy scarcity, offering an incentive for investment in renewables.
But to guard against sustained shortfalls in capacity, and thus another price crunch, Europe’s energy markets must adapt.
Long-term hedging markets are not very liquid, because consumers used to see little need for price security.
In the future, they will probably see more.
Regulators could help.
A proposal by researchers at the Massachusetts Institute of Technology advises them to buy “affordability options” from generators, a form of insurance that would return profits from excessive prices to consumers, in effect creating an automatic windfall tax.
How politicians would love to have something like that in place now.