Europe’s electricity market, which has some of the highest renewable energy shares in the world, is suffering from a profound investment crisis. Sonja van Renssen spoke with top experts from government, business and academia about the causes and possible solutions. Conclusion: “tinkering around the edges” won’t do – “a complete makeover” of Europe’s market design is needed. Courtesy of World Energy Focus.
The European electricity market today is not fit for purpose. “All the EU’s liberalisation packages concentrated on opening up markets,” says Philip Lowe, Vice Chair of the Energy Trilemma study at the World Energy Council. Few people know more about European energy market rules than Lowe, for many years a top official at the European Commission. His assessment of the EU’s legislation is remarkably critical. “They didn’t build into that market design the two other components of our energy policies, which are security of supply and low-carbon. The need to move to a low-carbon economy has changed the parameters of the [energy] challenge.”
Public support should be concentrated not on subsidising production, but on the pre-competitive phase
Europe’s climate goals require a substantial share of variable solar and wind power, even if nuclear power and carbon capture and storage (CCS) were to grow significantly. The problem is that the market is not well suited to integrate this growing shares of (subsidised) renewables.
“Electricity markets are designed to reflect and optimise the cost structures of conventional technologies we are familiar with from 20th century electricity systems,” says Malcolm Keay of the prestigious Oxford Institute for Energy Studies (OIES) in the UK. European electricity markets are “broken”, he argues in a paper published in January. “They are not suited to the systems we are developing to meet 21st century needs and circumstances, and they do not give effective signals in situations where, as at present, one set of technologies is receiving support from outside the market, while other technologies are expected to remunerate themselves from the market – yet both sets of technologies are operating in the same market.”
He warns that this problem is structural. “Even if the cost of wind or other renewable sources attains ‘grid parity’, and even if there is a significant carbon price, the current energy market will not provide a secure basis for remunerating investment in intermittent renewables.” This is because solar and wind produce power at near-zero marginal cost and as they both tend to generate the most electricity in the middle of the day, they flatten the intraday price curve, wiping out profit margins for all types of generation. This creates a profound investment crisis for renewable as much as for fossil fuel-generators. The flattening of the price curve has the additional effect of discouraging flexible demand from consumers – just when such demand response is becoming more viable through smart grid technologies.
The investment crisis in the European utility sector has led to an intensive debate on how the “broken” market should be “redesigned”. So far, this debate has focused mainly on capacity mechanisms, which some countries have set up (or are considering setting up) to ensure that supply will not fail. They are not a new idea. “Until EU policies were put in place, the electricity system was based on energy components as well as capacity components,” explains Marco Margheri, Senior Vice President for Public and EU affairs at Edison, and also Vice Chair of the World Energy Council’s Italian Committee and leader of the World Energy Council’s Market Design Task Force for the Europe region. This group will feed the European Commission with ideas from March onwards, to help shape legislative proposals on market design which the European Commission in Brussels is expected to announce by the end of the year.
What is already clear is that capacity markets are part of the discussion, but cannot be the whole solution. “We at the World Energy Council believe there is a broader scenario to be taken care of,” says Margheri. “For instance, in the long run carbon pricing will be paramount to get the economics of climate policies straight. And technology will evolve at a faster pace than we have experienced so far.”
Keay believes that in the longer term, EU Member States are headed for what are called ‘investment markets’, which focus not on competition in the wholesale market, but competition to stimulate investment before power is even delivered to the market. This is also one of Lowe’s recommendations for market redesign: “Public support should be concentrated not on subsidising production, but on the pre-competitive phase.” He sees two roles for subsidies: one, to encourage the development and roll-out of new technologies and two, to stimulate large investments that are too risky for private capital. He also believes policymakers need to create a market for security of supply. For him, this comes down to a forced restructuring of the energy industry: “You have to ask companies to bid to provide energy 100% of the time. The implication is that the price they offer will include the costs of ensuring there is adequate capacity.” These bids should underpin long-term contracts that give investors a return on investment security.
The Brazilian route
Interestingly, such long-term contracts are already the norm in Latin America. This continent has a “fundamentally different” approach to electricity markets, explains Carlo Zorzoli, Head of Latin America for Enel Green Power. “It’s more a competition on investment than competition in the real-time market,” he says. “In Europe, you compete every minute, 15 minutes or hour to sell a certain volume. Here, you compete to deliver 20 years of energy at a defined price. The real-time market is mainly used to settle deviations between expected demand and supply.”
Countries like Brazil have gone down this route because they have large quantities of low-marginal cost hydropower (85% share in the Brazilian energy mix), which are incompatible with the marginal cost pricing model that rules in Europe. “Nobody would build large hydro projects without the security of getting revenues and the same applies to other low marginal cost renewables,” Zorzoli says. He denies the suggestion that long-term contracts somehow impinge on competition: “You have fierce competition. Actually you have much more competition because you also compete with power plants that do not yet exist.” He adds: “I think this is what Europe will need for decarbonising the economy.”
But Europe has been “rather resistant” to long-term energy contracts, remarks Keay. In a 2015 paper prepared by its Economic and Financial Affairs department, the European Commission talks about the possibility of “an EU-wide market for long-term contracts based on average cost pricing”. This would entail a dramatic shift away from its current marginal pricing model. But is this compatible with EU competition law? “It should be made compatible,” says Lowe, who was Director-General at the Directorate-General of Competition in Brussels before he got the same job at the Directorate-General of Energy. Long-term contracts could pose a problem only if for example bidding consortia had huge market shares (e.g. more than 50-60%) or if they were very long indeed (e.g. more than 10-15 years), he believes.
For Keay, the problem lies elsewhere. “They are not ultimately compatible with full competition because however you organise them, someone centrally is making all the decisions. [It should be] individual consumers who do this.” His preferred option is a two-market approach with an “as available” price (low price, available when plenty of supply) and an “on demand” price (more expensive, always there). Leave it to the customer to decide what degree of reliability they want (and are prepared to pay for). In contrast, says Keay, the conditions for long-term contracts are ultimately set by governments, who define the energy mix they want, and bid for by utilities, with the information and capacity to deliver.
Tinkering around the edges
In Latin America, the aggregation of small consumers to buy long-term is “rare”, admits Zorzoli. But “I don’t think there are many small European users that have a supply contract directly with a big generator [either]”, he says. The entire demand-side remains – with the exception of large energy consumers – underdeveloped the world over. The possibility for demand side management is lower in Latin America than in Europe because of the cost and technological sophistication required to make the grid smarter, Zorzoli suggests.
Margheri is convinced that demand will eventually be put on a par with supply. The demand side is growing strongly, he notes. In Italy, there were 1,000 production units connected to the high-voltage grid at the beginning of the last decade; last year, it was over 650,000. Moreover, the boundaries between supply and demand are becoming blurred. Battery technologies are making consumer storage a major component of system balancing, while demand response, also through aggregation, will offer customers the opportunity to reap benefits from their flexibility potential and more control over their consumption. The digital revolution promises further transformation because it creates “the possibility to decentralise intelligence to customer homes”, says Margheri. “The Ubers of electricity may emerge very soon.”
In Europe the risk going forward is that the European Commission does too little. Keay fears a tinkering around the edges that amounts to “software patches on a fundamentally flawed operating system”. Lowe, Keay and Margheri all agree that a key priority must be carbon pricing. It is climate policy that will shape the energy market and indeed must define the parameters of long-term contracts, Lowe says. He believes the EU should also set standards for genuine security of supply and update state aid guidelines for energy subsidies. And it needs to do more to integrate the demand side.
In short, the European energy market needs a makeover, not touching up at the edges. Keay sums it up nicely: “If you intervene in part of the system without thinking about effects on the whole, you get a mess. And that’s what we’ve been doing until now, lurching from one intervention to the next until the whole system falls apart.” Other parts of the world would do well to take notice.
This article was first published in the February issue of World Energy Focus, a free monthly publication of the World Energy Council produced by Energy Post.