How to deal with cross-border externalities? The case of capacity markets in the EU

On 20 November, Emma Menegatti, FSR researcher and PhD candidate, presented her recent paper, co-authored with Leonardo Meeus, in the last episode of the 2024 FSR Insights series. Two adequacy experts joined the discussion: Elina Spyrou, lecturer at the Imperial College of London, and Derek Bunn, professor at the London Business School.

The starting point of the discussion was that national capacity markets for electricity keep gaining momentum in the EU. They are already present in five Member States, and at least three more Member States are considering introducing one over the coming decade. The Electricity Market Design reform adopted in 2024 (Regulation 2024/1747) recognizes the role of capacity remuneration mechanisms and foresees a streamlining procedure to facilitate their deployment. However, operating capacity markets at the national level can lead to problematic cross-border externalities in the context of integrated wholesale markets, as it is in Europe. Menegatti and Meeus explore four of these cross-border externalities in their paper. In particular, they observe that introducing a capacity market can displace generation capacity from neighbouring countries, thereby increasing neighbouring consumers’ costs, and potentially endangering their security of supply. The increasing perimeter of capacity markets and the foreseen expansion of EU interconnections imply that such cross-border externalities could be magnified over the coming decade. Therefore, finding appropriate mitigation measures appears crucial.

Cross-border participation: a false hope for fixing capacity market externalities?

In the paper, Menegatti and Meeus evaluate whether the current EU regulation, which mandates explicit cross-border participation in capacity markets, could mitigate such cross-border externalities. By allowing foreign generators to receive capacity remuneration revenues from neighbouring capacity markets, EU policymakers hoped to partly restore investment incentives abroad. However, the model-based analysis presented shows that explicit cross-border participation fails to deliver the expected results, as revenues received by foreign generators participating in the capacity market of a neighbouring country are close to zero.

Reacting to this important result, Elina Spyrou questioned Menegatti on whether there might be better ways to implement the explicit cross-border participation rule. Menegatti argued that among the four options identified, which are described in a separate Policy Brief, none was really able to mitigate the capacity market cross-border effects. The capacity market always attracts an oversupply of generators located in the neighbouring countries without any capacity mechanism. The result is that their revenues end up being very limited.

As highlighted by Derek Bunn, the role of interconnectors and the TSOs operating them is crucial in effectively ensuring the availability of imports during times of scarcity. Hence, it might be economically relevant to provide them with investment and operational incentives through explicit cross-border participation. However, Menegatti argued that in the EU adequate operational incentives should already be provided by congestion revenues recuperated by TSOs through the coupling of wholesale energy markets. Regarding investment incentives, most interconnectors are owned by TSOs and benefit from a regulated return. Deciding on when and where to invest in interconnectors is done through EU-level assessments and cost-benefits analysis (see TEN-E regulation), and does not really depend on market revenues. In any case, the payments that interconnectors would get from explicit cross-border participation in capacity markets would be distorted, as they would reflect the asymmetry between national market designs, rather than the value of the interconnection capacity per se.

Additionally, the implicit cross-border participation rule, which consists of simply deducting imports from the capacity market demand, performs as well as the explicit one. Therefore, Menegatti and Meeus recommend to streamline capacity remuneration mechanisms by tolerating implicit cross-border participation. Indeed, the latter is much simpler to implement and achieves comparable results. Reflecting on this result, Spyrou questioned whether explicit cross-border participation could provide more guarantees to the capacity market consumers than implicit cross-border participation. According to Menegatti, this is unlikely to be the case in the EU: foreign generators contracted through explicit cross-border participation are not really “booked”, i.e., their generation is not delivered first to the country with the capacity market in case of concomitant scarcity. This missing link between long-term capacity procurement and short-term curtailment allocation principles, mainly defined in the day-ahead algorithm EUPHEMIA, suggests that explicit participation won’t necessarily provide consumers with more guarantees than implicit participation.

Towards a European approach

Eventually, national capacity markets do not work well in a highly interconnected context, as they only displace generation capacity from neighbouring market zones. The long-term recommendation is, therefore, to move beyond national capacity markets towards a European approach. Asked by the audience about the feasibility of harmonizing and integrating capacity mechanisms at the European level, Menegatti observed that capacity mechanisms remain today highly heterogeneous and tailored to the needs of each Member State. Therefore, there are many technical, legal, and political barriers to a European approach to adequacy. Identifying these barriers and the route towards capacity markets’ integration will be the next step in her ongoing PhD research.