Why and How to Reform the European Electricity Market ?

The President of the European Commission, Ursula van der Leyen, told MEPs on 8 June that a radical reform of the electricity market was needed. For her, “the electricity market is no longer working and requires a huge reform to meet all the challenges posed by the structural transformations associated with the low-carbon transition (…). It must be adapted to the new reality of dominant renewable energy sources (RES) because the electricity market was designed twenty years ago when RES were marginal”. Faced with the crisis in electricity prices linked to that of the gas market, Emmanuel Macron spoke out on 28 June for a completely different reason in favour of an overhaul of the European electricity market, citing an “absurd” mode of pricing in a country with a dominant production by nuclear and hydraulic fleet, which allows a narrow coupling of power price and gas price on the spot market.

The meaning of such a market reform remains to be clarified in the face of the various challenges associated with the transition of the electricity system, namely 1) the protection of consumers, both households and industry, against the risk of a prolonged price crisis, which is a priority in France, but much less so in Berlin and Brussels 2) the effective development of low-carbon technologies, variable renewable energies [VRE] (namely wind and solar PV), but also nuclear power in some ten Member States, and 3) the security of supply (SoS), which is being jeopardised by the closure of many dispatchable production facilities and the development of variable RES generation at large scale. 

The shortcomings of market design for the low carbon transition

Because of its specificities, in particular its non-storability, electricity is a very particular good with markets that are necessarily organised on an hourly basis. Through competition, producers are led to align their hourly price offers with the fuel cost of each generation unit to give themselves the best chance of being selected by the market. In this scheme, average annual prices have no reason to be aligned with the average full costs of the means of production, unlike regulated tariffs in the former regime of public service monopolies.

Moreover, the high volatility of prices makes it impossible for a potential investor to make long-term anticipation of revenues and assess the net present value of assets to be invested in capital-intensive low-carbon equipment with long lead times and long life cycles (several decades), such as nuclear, offshore wind, hydro, etc. Moreover, VRE capacities to be developed require the development of grid infrastructures and flexibility means (storage, electrolysers, gas turbines) for the security of supply and the stability of the system, all of which being with high fixed costs equipment, whereas investors have no certainty of stable and anticipatable income flows on the various markets related to the power market architecture (infra-day, balancing, auxiliary services, nodal access, etc.).

Adding patches to the energy only market

To meet the challenges of security of supply and transition to net zero emissions, the market architecture has already been modified by adding various “patches”. For security of supply, mechanisms for remuneration of capacity (and not energy) have been put in place during the 2010s in different European countries and north American jurisdictions. Some of them, which are based on long-term contracts as in some US states and in the UK, Italy and partially in France, have proved to be the most effective in encouraging producers to invest in peaking units and some demand response programs. It is planned that the scope of these contract-based schemes will be extended to include flexibility sources in the next future. 

To ensure the development of VRE, which is currently very competitive regarding the metrics of LCOE (levelized cost of electricity), most countries have set up arrangements guaranteeing them long-term revenues such as feed-in Tariffs (FIT) and now long term contracts with public powers. Since 2017, policy makers have been inspired by those implemented in the United Kingdom, namely financial-type contracts of options with a public entity, known as contracts for difference (CfD), which are awarded by auctioning. They have been extended to nuclear projects, but in a negotiated way. In these contracts, a reference price is set, which is supposed to cover the fixed costs of the VRE developer Under such a contract, the VRE producer collects or disburses the difference between the hourly market price and this reference price (strike price is the technical term), depending on whether the former is higher or lower than the latter. This is the principle behind the “remuneration supplement contracts” which have replaced feed-in tariffs for large renewables installations in the EU. 

The solution that will be adopted to accelerate the transition to a net zero emission system is to increase the number of these contracts awarded by auction with VRE developers by accelerating their frequency. At the same Ntime investors need for a long-term price signal that allows the triggering of investments in flexibility sources (including storages of different types, electrolysis for coupling with the gas sector with green hydrogen). It would also be a question of “deepening the markets” where the services offered by flexibility sources are valued (balancing, system services, etc.) and decentralizing the transmission pricing (by zones or by nodes) for improving price-signal to loclaisation of decentralised renewables. This is the orientation of reflections currently taking place in Germany within the platform “Towards a climate-neutral electricity system” set up by the Ministry of Economic Affairs (see, for example, the Agora-Energiewende 2022 proposal). However, there is no recognition of the need for capacity mechanisms, which Germany seems yet to be hostile to, nor worry about increase of the price volatility, knowing that hourly prices on the spot market will increasingly depend on the gas and CO₂ prices, in particular because periods of moderate wind will increase with the climate change (this was observed throughout this last summer).

• The objective of consumer protection

France has the same objectives of adaptation of the market design for accelerating the transition, but adding the concern of finding a solution of decoupling wholesale prices and retail prices to get those quite stable. Indeed French consumers merit to have price reflecting the French mix production by low-cost low carbon sources (nuclear, RES) without having to bear the consequences of episodes of high gas prices. The market architecture should be coherent to lead to end-use prices aligned with the long-term costs of the low carbon producers, while sending a long-term price signal to invest in such technologies.

We have developed the design of such an electricity market model in a recent paper published in the Revue de l’énergie (n° 662, June 2022), which we have entitled Long-Term Central Buyer model. A public entity to be installed would be in charge of signing CfDs or capacity  contracts with all producers (RES, nuclear, fossil), bundling them and selling almost all wholesale electricity to suppliers and large consumers at prices aligned with the long-term costs of all technologies. This will allow her to have control over the producers’ long term costs, and so to be in position to sell to the suppliers the bulk of the generators’ production at transfer price aligned on these transfer costs.

• The Long Term Central Buyer model, a coherent solution

The hourly markets still ensure short-term coordination and economic integration with the other systems. The independent public entity (the Agency thereafter) that would be installed would have to assume four main functions:

– sharing market risks with low carbon producers through CfD contracts for each equipment and through capacity  contracts with flexible units (storages, gas turbines, etc.);

– organising the long-term market for the allocation of these contracts by auctioning in order to maintain competitive pressure, the auctioning being separated by type of technology;

– the purchase on the spot market of the whole of MWhs produced by  the equipment covered by the financial contracts, 

– the sale of all the electricity it acquires in this way, to suppliers at transfer prices aligned with long-term costs, the definition of which is to be specified by the regulator. This function means that the agency hedges the price risk for the suppliers.

By combining the revenues from its sales on the spot market and those from the contract for difference (CfD) with the Agency, a new generator has a guaranteed revenue stream that should allow it to invest in the long term. In other words the Agency assumes the price-risk for the developers, which help them to access to a large financing by debt, which is propitious to lower the cost of capital.

On their side the suppliers, which source their energy on identical and transparent bases, will then compete on the basis of their service offers adapted to the different load profiles of their customers; so they will contribute to the flexibility of the system by offering real-time price contracts, load shaving contracts, etc.

This new market model would respond in a coherent way to the three major objectives of accelerating the energy transition, security of supply and consumers protection. The adoption of this model by a Member State would enable the electricity sector to be given real economic and institutional coherence on the opposite of the present design made on cumul of patches. An independent public agency with commercial status has to be created, with functions inspired by those of the British LCCC (Low Carbon Contracts Company), which groups together all the CfD contracts signed with the ENR and new nuclear producers in the UK and via a subsidiary, the forward capacity contracts 

It would be legitimate for this model to become an option to be opened to Member States, especially those who choose to pursue a transition based on all low-carbon technologies, nuclear as well as RES. It does not run counter to the main body of European rules, with short-term exchanges inside systems continuing to take place on a competitive basis, and between systems with highly integrated markets.

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