The EU in a hard gas crisis: what reform of its internal electricity market?

On Monday, 23 January 2023, the European Commission launched a consultation for the reform of the existing electricity market to cope with the hard crisis that has hit the gas supply chain. Let’s take a step back to understand why this proposal came to be and what is the path forward.

Today, the European electricity market suffers the consequences of a tremendous natural gas crisis. Electricity is not a primary energy resource. It is an energy vector which is generated by transforming primary energy resources into flows of electrons. At the time the EU internal electricity market was created, about 25 years ago, gas was the most promising primary energy resource for electricity generation (that time was nicknamed as the ‘dash for gas’). In a few years’ time, combustion cycle gas turbines (CCGTs), running on natural gas, became a dominant feature of many European electricity systems and are still so today. Because of this feature, the EU wholesale electricity market propagates to electricity buyers the currently very high gas prices it meets in the wholesale gas market. However, the EU wholesale electricity market does not just propagate high gas prices. It also exacerbates them, because CCGTs need approximately two MWh of gas to generate one MWh of electricity. This means that when the price of one MWh of gas increases by 100 euros, the new normal in the year 2022, the price of CCGTs’ electricity output increases by 200 euros per MWh. Finally, the existing pricing mechanism in the EU wholesale electricity market also amplifies the effects of the rising cost of gas on the wholesale gas market, because it gives the price corresponding to the highest accepted bid to all the winning sellers of electricity. This wholesale pricing rule is called ‘marginal pricing.’ If the highest bidder is frequently a CCGT and electricity demand cannot be met without any CCGT output, all the sellers get the same ‘gas cost-based’ price despite not all of them buying gas to generate electricity. 

Public opinion and the public authorities can look for ways and tools that can block the transmission of a genuinely higher gas cost to electricity or the generation of windfall profits in the wholesale electricity market. Many emergency actions are possible for the EU Member States: spreading the payment of wholesale price increases over a longer period, prohibiting any retail price increase, using ‘claw-back’ mechanisms in the wholesale electricity market, taxing ex-post the extra profits made by energy companies, regulating the wholesale electricity prices, capping the wholesale revenues in ‘contracts for differences’, regulating the price of gas used to generate electricity, capping the wholesale price of gas, transferring revenues to energy consumers, etc… 

As the EU is not short of emergency tools to deal with a genuine gas price shock or an electricity price shock, one wonders how to balance the use of emergency tools to deal with emergency phenomena and the use of structural remedies (as in an EU market design reform). In other words, what is the best way to deal with emergency phenomena? With emergency tools or with structural remedies? 

A pragmatic answer can be the following. It will take a minimum of one year (if we are lucky) to agree at the EU level on a draft market reform, and two years more to have this new EU frame transposed into national law. This takes us to the end of 2025, with a new EU Parliament being elected in Spring 2024 and a new Commission being formed in Autumn 2024 – not a very effective way to address a gas or electricity price shock supposed to calm down from 2025. 

A more analytical answer looks at the characteristics of the aims and tools, and analyses whether they match. Let’s assume that the aim is to deal with a gas price shock which is expected to decrease from winter 2025-26 (as a warm beginning of January 2023 also suggested), and to protect some categories of consumers from its direct (gas price) and indirect (electricity infra-marginal rent) redistributive effects. Using emergency redistributive tools seems, a priori, the best option as it permits national authorities to better define their own particular national aims and better control for the adequacy of the national outcomes. The variety of emergency tools available gives the EU countries many alternative national choices, which a single uniform EU mechanism can hardly match or beat. 

Furthermore, changes made to the electricity market framework are rarely unidimensional. Reducing by reform the price of a commodity when we face a direct shortage (as with gas) or an indirect shortage (as at peak electricity demand) does not cure the roots of the problem but feeds them. Any structural reform of the electricity market has to take this into consideration. More generally, the core rationale for a market reform cannot be to avoid passing on to consumers the total cost of supply, including a normal profit. Voluntarily unbalanced retail pricing schemes, if they become the norm, have strong long-term effects on the structure and evolution of the electricity sector. The typical long-term effect is termed ‘low equilibrium’: low quality of service, low security of supply, low investments, etc., exactly the opposite of what the EU wants. The EU electricity sector has strong primary goals of high quality of service, high security of supply, high levels of investment, high shares of electrification of final energy consumption, and fast and deep decarbonisation of electricity generation. All these primary goals call for preserving the short-term (i.e., day-ahead or intraday) EU electricity market from intrusive price regulation and keeping its two legs working as they do now (short-term efficiency in the ranking of assets generating at each moment; and long-term financing of fixed costs neglected in the marginal bidding of each generator, via the receiving of infra-marginal rents). 

In the EU, the existing daily electrical energy market plays another fundamental role which also has to be carefully considered. This daily exchange platform is the core of the European internal electricity market, because it allocates daily the cross-border transmission capacity to the sellers of electrical energy. This daily functioning of the EU internal electricity market among countries is fully automatized. Delivery of electrical energy between countries is executed according to market equilibria realised in the various power exchanges. This automation of European cross-border delivery is a key feature and an important result of the Europeanisation of the electricity trade. It would be irresponsible to break or breach this remarkable ‘electricity system first aid’ tool. For example, in the December 2022 cold snap, France got up to 20% of all its electricity consumption from neighbouring countries, and 15 TWh net from Germany in the whole year 2022, without any drama, threat or diplomatic crisis thanks to this common mechanism known, practised and trusted by the hundreds of companies working in the European electricity industry. 

Even if emergency tools are able to deal with unwanted consequences of the current gas price shock or of the infra-marginal electricity rent shock, public opinion and public authorities can still wonder whether structural reforms could better prepare the EU electricity market for future energy shocks. Can the EU internal electricity market be made more resilient to price shocks? It is what I will look at in my next instalment of this Opinion. 

 

 

Reference

The corresponding whole paper is accessible on our FSR Website and at the EUI Library: Jean-Michel Glachant Reforming the EU internal electricity market in the middle of a huge energy crisis : an absolute short-term emergency or preparation for the future? | Florence School of Regulation

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