An electricity market design reform to support a well-functioning, interconnected electricity system

During the unprecedented 2022 EU energy crisis, governments intervened to help consumers pay their bills with different emergency measures and thereafter the European Commission (EC) was tasked to draft a market reform proposal in record time, with the dual objective of securing European energy sovereignty and achieving climate neutrality. Published on March 14^th 2023, the proposal complements the existing EU electricity markets with regulatory measures to address the main concerns that emerged during the crisis.

FSR closely followed the discussion on the reform: from the Policy Brief of December 2022 recognising the need to improve electricity markets, to the summary of the proposal of March 2023 and, finally, to the Policy Brief of May 2023 discussing it. To open the discussion to the energy stakeholders, FSR organised 2 online events: FSR Talk ´EU electricity market design reform: check-in before boarding´ and FSR Debate ´The Energy Market Design Proposal: risking re-regulating the Internal Market?´. The purpose was to go deeper and review the content of the proposal to understand what has been addressed, but also what is missing for the EU to secure a safe sailing to Net Zero while tackling the consequences of the energy crisis.

Background to the electricity market design reform

The energy crisis that started in 2021 and was further aggravated by the 2022 Russian invasion of Ukraine resulted in sustained high electricity prices and still has direct and severe consequences on EU citizens and the EU economy. To shield consumers from these serious impacts, Member States (MSs) implemented over 400 emergency measures (e.g., the taxation of inframarginal rents; price caps). Some interventions appeared to be better designed, admitted Michael Pollitt, such as the rising block tariffs, which consist in capping the price for a fixed part of the average electricity demand and leaving the quantity above this threshold dependent on the market price, allowing consumers to still face incentives to reduce consumption. This measure allows to control inflation as well as electricity demand, added Leonardo Meeus. The EU did not have an organised way of responding to the crisis and MSs implemented heterogeneous measures. Should the EU face a similar crisis in the future, it can learn from past experiences and move towards more harmonised responses.

During the crisis, many questioned the well-functioning of the EU electricity market design. In fact, the geopolitical scenario shed light on the resilience of an interconnected electricity system, but also helped identifying some flaws to be tackled. The electricity market design reform proposal by the EC followed these debates, taking into account the impacts of the market design on the wider economy.

Short-term efficiencies and longer-term contracts for hedging

One element that the reform preserved is the short-term electricity price signal. Characteristic of an electricity market that has been built over the past 20 years and that delivered its benefits, the signal supports the movement of electricity flows where most needed, pointed out Meeus. We saw this effect during the crisis: France, historical exporter of electricity, became an importing country, with a short-term price that directed electricity towards French consumers. For the future, due to the intermittency of renewables (RES), short-term price signals will be even more needed to incentivize the activation of demand side flexibility and storage.

If short term markets function properly, on the other hand, long term price signals and hedging strategies are needed and envisaged by the proposal, acknowledged Catharina Sikow-Magny. During the crisis, neither consumers nor retailers were sufficiently hedged against high prices. Consumers with dynamic electricity tariffs, linked to the spot price, suffered the volatility of the spot market and were not adequately informed about the characteristics of such contracts. It is crucial that both consumers and suppliers are fully informed in order to hedge themselves and the EC proposal ensures that consumers appropriately understand the features of different types of contracts.

The insufficient hedging of retailers led some of them to bankruptcy and others to pass the high prices to their customers. The EC proposal includes an obligation for suppliers to hedge and foresees that, due to improvements in forward markets, it will be possible to hedge up to 3 years in advance. Meeus welcomed the margin left to MSs to regulate hedging strategies, however further guidance is also desirable.

2 key instruments with hedging effects for both consumers and producers, whose deployment is encouraged in the EC proposal, are Power Purchase Agreements (PPAs) and Contracts for difference (CfDs). PPAs consist in contracts between a private producer and consumer, both benefitting from the stability of a pre-agreed price. This contract can be particularly suited to some consumers with a specific consumption need (e.g., industrials). PPAs are not a novelty in the energy sector; however, with the recent price spikes, consumers became more attracted to them. The proposal makes sure that more people have the opportunity to enter PPAs, improving their availability with state-backed guarantees and encouraging developers to contract with consumers.

On the other hand, CfDs allow public actors to support low-carbon electricity production by ensuring a stable revenue to the producer through a pre-agreed strike price. The proposal encourages 2-way CfDs, by which the producer receives from, or gives to the public actor, the difference between the wholesale market price and the strike price. Prices significantly above the CfD strike price will generate funds for the public actor, providing the possibility to relief consumers. However, according to Frédéric Gonand, one can wonder about the temptation to use these funds for other purposes than helping consumers.

Gonand also underlined the consensus between the authors of the report for the CRE on the reform of the EU electricity market design on the fact that CfDs and PPAs can both be efficient, for different purposes and situations. It is not predictable how much MSs will promote one type of contract or the other; what is certain is that the more money is directed to support PPAs and CfDs, the more freedom MSs retain to allocate it, which, in turn, could lead to more distortions. This is especially true considering that the reform delegates the implementation of CfDs to MSs, which will have room for maneuver in their design and, so far, there is no consensus on which rules and parameters are the most efficient (e.g., the contract’s length).

RES and consumer engagement

During the crisis consumers became more aware of the environmental and financial advantages of RES, in particular solar photovoltaics (PV), engaging in prosumption of electricity (production from PV panels and consumption). The proposal built on this consumer-centric trend strengthening the provisions of the Clean Energy Package on energy sharing. However, to achieve the decarbonisation objectives of the Green Deal, RES must be deployed at an unprecedented rate and this path towards energy independence would also help with price stability for consumers, which is the aim of the EC proposal. Sikow-Magny stressed that access to cheap RES is crucial for several reasons: (1) to reduce EU’s dependency on Russian energy imports; (2) to support electrification, which needs not necessarily cheap, but at least affordable electricity. Nevertheless, RES are capital intensive and the market price plays a significant role in supporting their penetration; any measure that makes it difficult to assess future revenues may slow down investments in a period when the rate of deployment of RES must grow exponentially: Pierre Tardieu mentioned that, for what concerns wind power, in 2022, 16 GW of new wind power capacity were installed, but 30 GW per year are needed to reach the objective of 42.5% share of renewable energy in the EU’s overall energy consumption by 2030 foreseen in the revision of the Renewable Energy Directive. The few GW installed in 2022 can be attributed to the uncertainty around electricity market rules and MSs interventions on the electricity market.

Looking forward: adequacy issues and capacity mechanisms

As noted by Meeus, the proposal does not reopen the discussion on capacity mechanisms (CMs) since it is not possible to address such a complex matter in a short time frame, but this is something the next EC could engage in. Sikow-Magny added that there is currently no acute need to review CMs; they are already in place in several MSs. Moreover, when the European Resource Adequacy Assessment (ERAA) developed by ENTSO-E will be approved, it will become a useful tool to map EU adequacy needs. The assessment and possible resolution of adequacy issues remain largely the responsibility of individual MSs, in charge of defining the desired level of security of supply. Jorge Vasconcelos admitted that adequacy would be better assessed, quantified, and monitored at European level: a balance between the freedom of MSs and the public good nature of security of supply must be found.

The debate on CMs continues to be fueled by the lack of consensus among academics on whether CMs are per se efficient or not. For example, the report presented by Gonand recommends these mechanisms only for small and poorly interconnected systems, such as islands, stating that more CMs at the EU level may not be theoretically justified and would be very difficult to implement.