The 5th EU electricity market reform: a renewable jackpot for all Europeans package? 

This is the second instalment of the Topic of the Month: Reforming energy markets

Electricity prices are extremely high. We are short of gas in Europe, and gas power plants are pushing up the prices of electricity. It is also unfortunate that an unprecedented number of nuclear power plants are under forced maintenance in France, which increases electricity prices even further. Consumers are suffering, and some producers of electricity are making unexpected profits. 

Many emergency measures have been taken to protect consumers and to claw back windfall profits. Beyond these short-term measures, the process towards an electricity market reform for the medium to long term has also started. This could become the fifth EU electricity market reform. Working title: Renewable jackpot for all Europeans package.[1] 

In the ongoing debate, some have argued that electricity markets are broken and that we should suspend or radically change them.[2] The objectives of this revolution are to decouple gas and electricity prices, eliminate windfall profits, and give consumers access to cheap renewables. Many revolutionary proposals have been made, like splitting the market into groups of technologies according to their characteristics and to price or regulate them separately. With these proposals, we risk going backwards in the European electricity market integration process by introducing new obstacles for cross-border trade. This would be unfortunate because the market integration benefits are increasing with the ongoing transition to renewables. 

The good news is that going backwards is not necessary. The Renewable jackpot for all Europeans can be organised with the electricity markets we have jointly developed over the past two decades.[3] We “only” have to complete these markets, and we have to combine them with a few instruments that have already proven their usefulness during the current crisis. These instruments could be at the centre of the market reform. It could become a revolutionary reform, but one that goes forward instead of backwards. 

To illustrate this point, I will discuss electricity markets and the following instruments: Contracts for Difference (CfD), Power Purchase Agreements (PPA), Capacity Remuneration Mechanisms (CRM), Energy Communities, and Demand-side Flexibility. The discussion is organised in three steps: 1/ introduction; 2/ performance during the crisis; 3/ lessons learned for the reform. I do not claim that this is an exhaustive scope for possible reform, but it is at least a start.  

Note, to conclude this introduction, that the fourth electricity market reform took several years to develop with studies, impact assessments and public consultations. The European Commission’s work plan foresees a reform proposal in 2023, which would be much faster than usual, and the European Council in October 2022 asked the Commission to speed up even more.[4] Speed is important, the crisis requires us to move, but are we not confusing reforms with emergency measures? 

The good news is that going backwards is not necessary. The Renewable Jackpot for all Europeans can be organised with the electricity markets we have jointly developed over the past two decades. We “only” have to complete these markets, and we have to combine them with a few instruments that have already proven their usefulness during the current crisis. These instruments could be at the centre of the market reform. It could become a revolutionary reform, but one that goes forward instead of backwards. 

 

1. Electricity Markets  

Introduction. In Europe, we have a sequence of electricity markets from forward to day-ahead, intra-day, and balancing markets. These markets allow us to exchange electricity across country borders with standardised contracts from a few years ahead of delivery all the way to real-time. We have discovered that this is very beneficial because we are saving billions of euros every year [5]. This achievement is unique in the world, and it is an important asset in the transition towards a more sustainable energy system. 

Performance during a crisis. When market integration started, Belgians feared transits would increase between France (exporter of nuclear power) and the Netherlands (importer of power) with limited benefits for Belgium. A few years later, Belgium faced power shortages in winter, and the country was saved by imports. Today France is short of power, so the market is helping to save France. Electricity markets in Europe are a stabilising factor in times of crisis, and also organise solidarity among countries. If we were to suspend electricity markets, it would be up to governments to organise that solidarity. We risk short-sighted and expensive blame games with limited solidarity. In the current debate, the market is seen as the problem, but the problem would be much worse if it were not for energy markets that organise the flow of energy to where it is most needed. Sharing our resources across borders via markets (and cross-border network infrastructure) will be even more important in a future with renewable energy. The alternative is that each country invests in their own backup systems and flexibility, which would be way too expensive, and also unnecessary as long as we do not close our borders within Europe. 

Lessons learned for reform. The crisis has been a wake-up call for the importance of hedging and the regulatory framework for long-term investments. We all wished we had entered into a fixed-price retail contract or another insurance against high prices, and some retailers have gone bust during the crisis because they were not sufficiently hedged. Academics have long talked about completing the EU electricity markets with better functioning forward markets. There are many ideas to do that, like introducing regulated incentives for consumers and retailers to hedge, or coupling forward markets across borders. Each of these ideas deserves to be looked at in more detail. 

 

2. Contracts for Difference (CfD) and Power Purchase Agreements (PPA) 

Introduction. As renewable energy has matured, subsidy schemes have also evolved. We gradually integrated renewables into electricity markets. Many countries started with fixed “feed-in” tariffs and no exposure to market prices for renewable developers and then evolved towards “premium” schemes with the support that comes on top of market prices. More recently, countries started to introduce Contracts for Difference (CfDs) to support renewable energy. The developers compete via tenders for the price they need to cover their investment costs. If market prices turn out to be lower than the awarded price, governments cover the difference; if market prices are higher, developers pay back the difference. These contracts have to be two-sided (or symmetric), and they can also be tweaked to make them compatible with short-term markets, to preserve the incentives for the developers to respond to prices, while still capping their revenues. 

Performance during the crisis. Renewables have been blamed for making windfall profits during this crisis. Retroactively taxing them or capping their revenues is difficult and creates a lot of distortions. Meanwhile, government entities that entered into CfDs with renewable developers have already experienced a renewable jackpot, which is for example the case in Denmark, France and the UK. When entering into these contracts, governments probably did not anticipate earning so much money. In the current crisis, the public money that governments hand out to compensate for high prices is much larger than the money they collected with CfDs, but this could change in the future if these contracts become the standard, and if we improve our consumer support schemes. 

Lessons learned for reform. The more we invest in renewables, the more we decouple the price of electricity from the price of gas. If we want to guarantee that consumers have access to cheap renewables, governments could further develop CfDs on their behalf. We then need to think about how the money that these contracts raise during a crisis can be used to support consumers in periods of high prices. The support should target those most in need, and it is also important that we preserve the incentive to save energy during a crisis.[6] Another option would be to have an entity mandated by member states to act as an intermediary so that consumers can buy these contracts as insurance against high prices. Note that some large consumers and suppliers already entered into Power Purchase Agreements (PPA) with renewable developers, but these agreements can be indexed to spot prices, which does not help in times of crisis (and in retrospect also does not benefit developers who now face measures against their windfall profits).  

 

3. Capacity Remuneration Mechanisms (CRM) 

Introduction. Utilities have long argued that electricity markets need to be supplemented with capacity remuneration mechanisms to make sure that there are adequate investments. Even if we complete our shorter-term electricity markets with better-functioning forward markets, these markets do not necessarily guarantee that we have enough investments. However, before the crisis, the common concern was that these mechanisms would be abused to favour certain technologies, or to provide state aid to utilities that are not able to recover the investment costs of outdated and dirty technologies.  

Performance during the crisis. The costs of being short of energy are so high, that I think we are all willing to pay a bit more to avoid another supply shortage with extreme prices. As we expect demand to go up due to the electrification of transport, heating and industry, we seem to be more worried about under-investments than over-investments. If we use CfDs to accelerate the investments in renewables, we can use capacity remuneration mechanisms to ensure that we have enough investments in backup power and flexibility, which can be a combination of low-carbon dispatchable generation, energy storage solutions and demand response. 

Lessons learned for reform. The EU Clean Energy Package paradigm was to avoid the abuse of capacity mechanisms. The package also made sure that these mechanisms are designed in a way that minimises the possible negative impact on short-term electricity market signals. If we change the paradigm and consider these mechanisms part of the electricity market target model, we can go a step further in harmonising and integrating them. This could be achieved through network codes and guidelines, which is a process that has also been successfully used for other aspects of electricity markets. 

 

4. Energy Communities 

Introduction. The EU Clean Energy Package introduced a regulatory framework for individual and collective action by citizens to take ownership of the energy transition. Energy cooperatives have been around for a while. Several of them were initiated by activists that wanted a greener and more local supply of energy, and took matters into their own hands. Their purpose is primarily driven towards social and environmental benefits rather than financial profitability. Members of such communities are often willing to pay a premium for greener energy.  

Performance during the crisis. Most energy communities co-invest in renewable energy, some also source their energy with long-term power purchase agreements from local renewable energy producers. This business model was not designed to be a hedge against extreme prices during a crisis, but it turned out to be cheaper than market prices in recent times. Co-investing in renewables is also cheaper and more efficient than doing it alone. Of course, the hedge against market prices is not perfect, communities still have to source some of their energy from the market, but it can contribute to protecting consumers from high market prices. Energy communities can help consumers to take ownership of the transition. 

Lessons learned for reform. If more citizens want to join a community, and if we want to make sure that they have access to renewable projects, we need to strengthen the regulatory framework for renewable production, energy sharing and supply. Some countries have enabled communities’ participation in tenders for large renewable energy projects; maybe they could also be given access to CfDs and receive a role in public-private partnerships. Local authorities could give energy communities access to public buildings to invest in PV panels, and they could make sure that vulnerable consumers are integrated in these communities. Energy communities can be involved in social housing projects, and many other best practices that are emerging across Europe. To upscale these initiatives, further technical assistance, capacity building and awareness-raising activities for communities and citizens should be developed.  

 

5. Demand-side Flexibility  

Introduction. The EU Clean Energy Package represented a big step forward to engaging consumers and modernising networks and system operations. Consumers are for instance entitled to a smart meter in combination with a dynamic retail price contract. TSOs are increasingly welcoming aggregated flexibility in balancing markets. DSOs are increasingly engaging with flexibility service providers at the local level to manage congestion in their grids.  

Performance during the crisis. For the moment, extreme prices have solved our shortages. In countries that did not cap retail prices, domestic and industrial consumers did respond by saving energy, we only wished that demand would be more flexible and respond at lower prices. However, we are also reminded that we are not yet well-organised to deal with emergencies. If everything is voluntary, and people are not responding enough to the price signals, we would need to ration energy. We have load-shedding plans to organise rationing in case of emergencies. We always hope that we will never need to implement these plans. For instance, in the winter of 2021, Texas did have to activate their load shedding plans, which led to a lot of chaos and public outrage. People did not understand why they were cut off from the electricity system, while others could continue to consume unlimited volumes. The rotation of the power cuts was unclear, and some grid users also discovered they were never cut because they happened to be connected via the same feeder of a hospital or another protected consumer. 

Lessons learned for the reform. The EU Clean Energy Package’s paradigm was to focus on voluntary flexibility, which is incentivised via cost-reflective network tariffs, dynamic retail prices and market-based procurement of flexibility services by the system operators. For emergency situations, it would be useful to get a step further. We should be able to reduce everyone to basic energy consumption, which would be less painful and more acceptable than rotating power cuts. Grid users could also volunteer to be cut in case of emergencies in exchange for compensation. We could ask all retailers to offer subscriptions with different levels of guaranteed supply. Hedging can then be about volume as well as price. We could ask all TSOs and DSOs to offer firm and non-firm connection agreements, or different levels of discounted non-firm connection agreements. It would imply that we evolve from voluntary flexibility towards a combination of voluntary and smart mandatory (backup) schemes. This will be necessary to deal with (temporary) bottlenecks in electricity networks, and could also save us from chaotic rolling blackouts in case of emergencies. 

 

Notes

[1] Title inspired by an article in Les Echos (July 18, 2022): “Eolien, solaire: vers un jackpot d’au moins 8,6 milliards d’euros pour l’Etat ”. Available here.

[2] President von der Leyen, in her State of the Union address (September 14, 2022) “This is why we will do a deep and comprehensive reform of the electricity market”. Available here.

[3] Have a look at our open access book: Leonardo Meeus, 2020. The Evolution of Electricity Markets in Europe. Edward Elgar. Available here.

[4] European Council conclusions from 20-21 October. Available here.

[5] The savings are documented and explained in the ACER/CEER annual market monitoring reports. Available here.

[6] See also the FSR policy briefs by Pototschnig et al. (2022): “Recent energy price dynamics and market enhancements for the future energy transition” (available here) & “Consumer protection mechanisms during the current and future periods of high and volatile energy prices” (available here).

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