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Europe stands at a market design crossroad

Changes need to be made to how electricity markets are managed so that they can handle the pace of the energy transition, but there is little consensus about what tweaks are actually required

Regulators and lawmakers have to make a number of difficult choices to design an effective market


SPLIT MOVES
Greek regulators proposed splitting renewables and gas markets, to a lukewarm reception

JOIN HANDS
Cross-border grid buildout and more interconnections would make the energy market work better

KEY QUOTE
We have to adapt it to the new realities of dominant renewables


The global energy crisis sparked by Russia’s illegal invasion of Ukraine shed light on a difficult problem: cheap clean electricity prices are being inflated by more expensive fossil fuels. Decoupling affordable renewables from costly gas-powered generation has become a top political priority as a result, prompting politicians to demand that market rules be changed so that energy systems can be insulated against future unforeseen global events. Ideas on how actually to do that have ranged from the radical to the restrained as governments attempt to protect their national interests. Energy experts and the sector itself are sounding a note of caution though, insisting on evolution rather than revolution.

RADICAL SIGNALS
The European Union (EU) is embarking on a reform process that was rather unthinkable at the start of 2022, given that top officials had previously ruled out tinkering with the legislative architecture that underpins the whole market. However, after months of increasing energy prices, protracted talks about capping gas prices and governments committing huge chunks of budgets to energy subsidies, this was one of the solutions that garnered political support. The EU electricity market system does not work anymore. We have to reform it. We have to adapt it to the new realities of dominant renewables,” European Commission President Ursula von der Leyen said in June 2022. That u-turn and von der Leyen’s strong language suggested at the time that the Commission would propose a radical overhaul of the markets. Yet, as price spikes flattened out towards the end of 2022 and early 2023, and as political pressure waned, it became evident that rather than that radical overhaul, the EU executive branch would just propose targeted improvements to the current arrangements.


ROUTE AHEAD
Regulators and lawmakers have to make a number of difficult choices to design an effective market


MUTED ACTION
The EUs energy regulators agency, carried out a full assessment in mid-2022 of how the market was functioning and found that the current design is fit for purpose and worth keeping”. This was ultimately reflected in the Commission’s plan published in March 2023, in which it suggested that EU member countries should assess flexibility needs and set national targets for demand-side response and energy storage. Long-term contracts like power purchase agreements (PPAs) and contracts for difference (CfDs) will be made more attractive by market-based derisking guarantees. CfDs will only be mandatory if public money is involved. More revolutionary changes to the rules will have to wait until the next Commission takes over in mid-2024 after pan-European elections have been held in May of that year. The political makeup of the European institutions will then dictate how ambitious a full reform can be. Governments and members of the current European Parliament are assessing the plan that is now on the table and will try to shoehorn their own suggestions into the mix before attempting to broker a final deal before the end of 2023. What the Commission says and what members of the European Parliament want only go so far, as the real weight of the decision will be imposed by the Council of 27 member countries, many of whom have voiced jarringly different demands.

FOOD FOR THOUGHT
When the Commission launched its review, some governments wasted little time in outlining what they thought the reform should involve. Among those to propose more radical suggestions was Greece. The Greek proposal said that the best way to shield cheap renewables from expensive gas prices would be to split the market into two separate pools based on the type of energy generation provided. Low-carbon and renewable energy sources would be grouped together and managed by state-backed CfDs, while on-demand resources would make up the other pool. It is evident that a market designed to apply marginal cost pricing does not fit the purpose when the system is dominated by low carbon and zero marginal cost resources,” the proposal read. This leads to a systematic market failure: marginal costs persistently stay above total average costs and there is no way to make them converge, which is exactly what a well-functioning market must do,” the note added.

Michael Pollitt, a professor of business economics at Cambridge University, warns that the Greek proposal made a mistake in distinguishing between power technologies and paying them differently.

It makes little sense on spot markets and creates distortionary incentives and gaming opportunities,” Pollitt says, using the example of a battery operator who could buy power from the cheaper pool and sell it in the more expensive pool.


NEW DIRECTION
Commission president Ursula von der Leyen (above) signalled significant changes to electricity market design were required


FIXED PRICES

Spain and France also published their takes on market design, with a big focus put on mandatory CfDs. While Spain’s push for deep reform was largely rooted in the socialist government’s pledge to shield consumers from unmanageable energy bills, France’s call for big changes is partly aimed at wider geopolitical issues.

The United States’ Inflation Reduction Act, with its pledge of hundreds of billions of dollars for industries to go green if companies set up shop stateside continues to ruffle the feathers of more powerful EU countries like France.

President Emmanuel Macron’s support for reform hopes to make Europe as industry-friendly as possible by bringing down energy prices and providing long-term assurances that they will not spike again like in 2022.

France also wants to fuel its vast nuclear power plant fleet by using state-backed CfDs, which according to the Commission’s markets plan can be used for new low-carbon generation, as well as existing projects that need repowering or extending.

This provides the French government with a potential exit from a programme that allows suppliers to purchase nuclear-generated power at regulated prices, known as the ARENH mechanism.

ARENH, which enjoys an EU state aid exemption, is due to expire in 2025. All of these factors will come into play as governments outline their joint position on the reform later this year, as well as in the years to come.

EYES ON GERMANY

As is so often the case with European lawmaking, the direction of travel will be heavily reliant on what Germany is willing to support, given the political weight it still wields, the size of the country and its central location in Europe’s energy market.

The Bundesrepublik, however, insists that the current market design is not fundamentally flawed. Climate minister Robert Habeck told a meeting of industry players and academia in February 2023 that, Europe has one of the best functioning electricity markets in the world.”

While acknowledging that the current design must be made fit for the future”, the Greens leader also maintains that the positive achievements must be preserved”, illustrating the significant difference of opinion between northern and southern countries.

German industry agrees and largely welcomed the Commission’s light touch reform. However, renewable energy association BEE said the plan goes too far” and criticised provisions that would link public money with mandatory CfDs, urging the German government to push for a voluntary scheme instead.

In terms of timeline, it is at complete odds with France, Spain and the Commission itself, advocating instead for a slow approach that would only culminate after the next round of European elections.

Germany’s mighty fiscal resources and willingness to pump billions of euros in subsidies into industry and household coffers means that its appetite for reform is dull at best.



SPLIT IN TWO

Germany is likely to get its way and convince enough countries to play it cautiously but that support may come at a price if the government is pressured to finally fix some major flaws in its domestic market.

The government’s position on the functioning of the EU-wide energy market may well align with ACERs in this case but when it comes to its own house, there is an ongoing dispute that may soon come to a head. Germany has only one electricity bidding zone, where a single wholesale power price applies.

This has long proved to be contentious as issues like network congestion are never properly addressed. Northern states have a lot of renewable power capacity but little heavy industry to speak of, while the southern states, with their vehicle-manufacturing hubs and investment-cooling rules on clean energy deployment, are the polar opposite.

One solution is to build out grids, but all countries are lagging behind, Germany especially,” says Lukas Bunsen from Aurora Energy Research, an analytics provider.

People don’t like power lines, planning is difficult, there are lawsuits and so on. The power from the north as a result cannot get to the south,” Bunsen says, adding that the debate is now ramping up as renewables targets are continuously tightened.



IN THE ZONE

ACER has recommended that a zone split should be assessed and the EU is actively pushing for the German government to do something so that the market reflects the realities of the power grid.

Four different scenarios for Germany are being evaluated, which include splitting the bidding zone into two, three or four parts. Results are due by the end of 2023 but, according to grid operator Tennet, any reconfiguration would not be possible before 2027.

Industry in the south of Germany, as well as politicians keen not to impose higher prices on their electorate, are opposed to the idea. The federal government meanwhile is wary about Germany as a whole losing its competitive edge at a geopolitically delicate time.

Bunsen points out that renewable energy developers and investors across the North Sea will be cautious about messing with the status quo as it risks reducing the high price they can get for their green electrons.

Currently, the wholesale market clears and operators realise that the grid cannot handle all of the renewables so they are asked to ramp down and are then compensated. On-demand plants in the south, normally fossil fuels, are told to fire up to make up the shortfall,” he explains.

Neighbouring countries too will have mixed opinions about the proposed revamp. Some will be glad to free up capacity on their own grids, while others will miss the revenues generated by grid fees.



GRID IRON

Cross-border grid buildout and more interconnectors could well be a result of this new focus on making the energy market work better. There is plenty of room for improvement, according to the European Court of Auditors (ECA), a watchdog.

The ECA said in January 2023 that, Despite certain significant achievements over the last ten years, progress with integration was slow and uneven across market segments and regions,” and that none of the EUs binding guidelines had yet been implemented.

ACER insisted as part of its 2022 review of the electricity markets that the EU must meet its 70% cross-zonal capacity target by 2025 in order to boost the amount of power that can be shared between countries.

It really is a no-brainer to increase interconnection and the capacity for trade. The crisis has shown that interconnection is really valuable, as are shared resources,” says Pollitt from Cambridge University.

He adds that the Commission should have more oversight of interconnection and grid targets, plus each country’s energy and climate plans, known as NECPs, should be scrutinised more closely to make sure that interconnection is made a priority.

NECPs are due to be updated and assessed over the course of the next 12 months, as governments have to demonstrate how they will meet the raft of new and updated energy and climate targets that have recently been written into EU law.


POINT OF VIEW
UK advisors do not see the need for separate markets


ACROSS THE CHANNEL

The United Kingdom is also reviewing its market rules. In March 2023 the government published the results of a consultation that it intends to use in the ongoing reform process.

Surveyed replies broadly supported changing the rules to provide better protection from high energy costs and easier access to more renewable energy capacity but there was little consensus over the best way to do it.

The vast majority of survey responders supported the UKs target of fully decarbonising the grid by 2035 but the replies did not agree on whether the government should consider splitting the wholesale market or implementing nodal or zonal pricing.

There were enough dissenting voices for the government to rule out several options though, including local imbalance pricing, decentralised reliability options and carbon abatement auctions, known as a Dutch subsidy”.



Another consultation is due later this year. In a recent report, the UKs Climate Change Committee (CCC), an independent advisory body, outlined how the government can achieve its 2035 goal.

It is essential that in introducing changes to market arrangements, this is done in a way that does not deter the investment required to deliver a decarbonised system by 2035,” the CCC report insists.

Market reform should look to maximise economic opportunities; ensure fair access to and affordability of energy; support regional development; and provide appropriate protection for natural capital and ecosystem services,” it adds.

An expert group, convened by the CCC, says in a separate report that CfD design should evolve to address issues like dispatch distortions and the increasing volume of generation covered by CfDs should protect customers from high prices.

The group was not yet convinced of the need for separate markets for intermittent renewables (as available) and dispatchable generation (on-demand),” the report adds.


BOLD VISION
Greece’s market-splitting proposal received a lukewarm response


UNATTRACTIVE RESTRUCTURE

Market-splitting, as championed by Greece in its radical reform paper, is seen as a novel and possibly innovative solution to the problem at hand, as it would theoretically stop expensive gas generation from setting the wholesale price of electricity.

But the need to completely restructure markets is an unattractive prospect for regulators and other issues such as a reduction in renewable energy investment and discouraging new kinds of low-carbon generation also count against the idea.

Fully implementing this proposal would require significant changes to balancing regulations, regulatory design between countries to ensure interconnector flow, [an] unwinding of subsidy mechanisms and possible innovation in smart metering,” says a report by Citizens Advice.

Other proposals are still being worked out, like hybrid models that would not fully split the market, rather redesigning CfDs to make sure cheap power generators are paid a price that reflects long-term costs.

Energy from this so-called green pool” would then be targeted at specific groups, such as industry or at-risk households. Better data and criteria to identify those groups would have to be developed in order to make the policy work as intended, Citizens Advice adds.

Ideas are still being hashed out, discarded and perfected. It appears likely that countries will have to reach a tipping point with clean energy deployment before serious market design reform is properly considered.

When that will happen, however, is still being debated.


TEXT Sam Morgan PHOTOS Bernd Dittrich, Anatoliy Shostak, Zhi Xuan, Andre Benz