How energy markets actually work (and why prices behave the way they do)
Introduction: why energy prices feel opaque
Energy prices are often treated as something that can be adjusted directly — raised, lowered, capped, or corrected through policy decisions. When prices move sharply, public debate tends to assume either failure or manipulation. Yet the way energy prices behave is less the result of individual decisions than of how energy markets are structured.
Energy markets are not simple marketplaces where supply meets demand in real time. They are layered systems that coordinate physical production, financial contracts, infrastructure constraints, and expectations about the future. Prices emerge from the interaction of these layers, not from a single control point.
Understanding energy prices therefore requires understanding energy markets as systems — not as switches that can be turned up or down at will.
What energy markets are (and what they aren’t)
Energy markets are not a single market. They are a collection of interconnected mechanisms that coordinate the production, delivery, and pricing of energy across time.
It is useful to distinguish between three layers:
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Physical markets, where energy is produced, transported, and consumed
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Contract markets, where future delivery is agreed in advance
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Financial markets, where risk, expectation, and price exposure are traded
These layers interact continuously. Physical supply influences prices, but prices also reflect expectations about future supply, demand, and risk. As a result, prices can move even when physical conditions appear unchanged.
Energy markets do not exist primarily to set prices. Their function is coordination — ensuring that energy is available when and where it is needed, while distributing risk across participants. Prices are the outcome of that coordination, not its purpose.
Why energy is traded differently from most goods
Energy behaves differently from most traded goods because of a combination of physical and economic constraints.
First, much energy — particularly electricity — is difficult or costly to store at scale. Supply must closely match demand at any given moment. This makes markets sensitive to small imbalances and increases the value of flexibility.
Second, demand for energy is relatively inflexible in the short term. Households and firms cannot easily reduce consumption in response to price changes without affecting daily life or economic activity.
Third, energy systems are capital-intensive and infrastructure-dependent. Production, transport, and distribution rely on assets that take years to build and decades to amortise. This ties pricing to long investment cycles rather than short market swings.
These characteristics make energy markets less responsive to short-term intervention and more sensitive to expectations about the future.
How prices are formed (without assuming manipulation)
Energy prices are shaped not only by current supply and demand, but by expectations about future conditions. This is why prices can rise even when production appears sufficient, or fall despite tight supply.
In many energy markets, spot prices reflect immediate conditions, while futures prices reflect expectations about availability, demand, policy, and risk. These expectations are influenced by factors such as weather forecasts, infrastructure maintenance, regulatory changes, and broader economic conditions.
Price formation often follows a marginal logic: the cost of meeting the last unit of demand sets the price for all units. This can lead to outcomes that appear counter-intuitive, particularly when higher-cost sources are required to balance the system.
Prices therefore function as signals — communicating scarcity, risk, and uncertainty — rather than as direct reflections of production cost alone.
Energy prices respond not only to current supply and demand, but also to expectations about future conditions, including inflation expectations and financing conditions.
Why energy markets are global even when energy isn’t
Not all energy is traded globally. Electricity grids are largely regional, while fuels such as oil, gas, and coal are more easily transported. Yet prices often move together across regions.
This is because energy markets are linked through substitution and benchmarking. When one fuel becomes more expensive or scarce, demand shifts toward alternatives. Contract pricing and reference benchmarks transmit these pressures across markets, even where physical trade is limited.
As a result, local energy prices can be influenced by global conditions, even when local production is stable. Energy markets coordinate risk and expectation globally, even when delivery remains local.
This is one reason energy prices can appear disconnected from domestic supply conditions.
Even when delivery remains local, energy pricing reflects global coordination systems that transmit risk and constraint across markets.
How policy and regulation shape markets indirectly
Governments influence energy markets, but rarely in direct or immediate ways. Regulation affects incentives, risk, and investment decisions rather than setting prices outright.
Policies such as taxes, subsidies, price caps, and market rules alter the environment in which market participants operate. Their effects are often delayed, uneven, and mediated through expectations about future conditions.
Short-term interventions can reduce price volatility temporarily, but they do not remove underlying constraints. Over time, persistent misalignment between policy signals and market structure can create new pressures elsewhere in the system.
This is why political intent does not always translate cleanly into market outcomes.
Energy markets and the transition problem
Periods of transition place particular strain on energy markets. Existing systems continue to supply most demand, while new capacity requires large upfront investment and long development timelines.
Markets must therefore balance declining legacy assets with emerging alternatives, often under conditions of policy uncertainty. Price signals reflect this tension, as markets attempt to allocate capital amid shifting expectations.
Volatility during transition is not necessarily a sign of failure. It reflects the difficulty of coordinating long-term investment decisions while maintaining short-term reliability.
What energy markets adapt to — and what they resist
Energy markets adapt relatively well to gradual change. Predictable regulation, steady demand shifts, and long-term price signals allow participants to adjust investment and behaviour over time.
They struggle with abrupt intervention, unclear policy direction, and conflicting objectives. Sudden changes increase uncertainty, raise risk premiums, and can delay investment rather than accelerate it.
Understanding these limits helps explain why well-intended interventions sometimes produce unintended effects.
Conclusion: prices as system feedback, not failure
Energy prices are often interpreted as problems to be fixed. In practice, they are feedback mechanisms — signals generated by systems operating under constraint.
Volatility reflects tension between demand, infrastructure, policy, and expectation. Stability emerges not from suppressing prices, but from aligning these elements over time.
Seeing energy markets as systems rather than levers clarifies why prices behave the way they do — and why durable change is slower and more complex than it often appears.
