Europe’s Electricity Market Design: where are we and where are we headed?

The development of the European electricity market design has been a gradual process, shaped by different factors and actors over time. As the world economy moved on from the experience of covid-19 lockdowns and energy demand began to rise, so did the price of electricity.

This dynamic was intensified in Europe by the outbreak of war in Ukraine. Calls to change the electricity market design to better protect customers from price distortions have led to the start of a reform process in Europe. But how did we get here, and what kind of market design is best suited to providing a reliable, sustainable, affordable power supply?

Eurelectric will discuss these key questions at its upcoming event on an Electricity Market Design Fit for net zero.

What’s the history of the European market design?

In the early 20th century, electricity was primarily produced and distributed by state-owned companies. These national systems were characterised by a vertically integrated structure, where a single entity controlled the entire value chain from generation to distribution. The goal was to provide reliable electricity to citizens, with little concern for competition or market efficiency.

In the 1980s and 1990s, however, the European Commission began advocating for the liberalisation of the market. The idea was to introduce competition and incentivise efficiency, as well as to create a single market for electricity that would facilitate cross-border trade and increase security of supply.

This led to a wave of privatisations and the unbundling of the electricity industry across Europe, with many state-owned companies required to separate their generation, transmission, and distribution activities into separate legal entities. This process was intended to prevent the potential for monopolistic behaviour and allow for more market-driven pricing. In addition, the transition to a more market-based system required the creation of new regulatory bodies, as well as new trading platforms and market rules.

Liberalisation has largely been successful in achieving its goals. The creation of a single market has facilitated cross-border trade and increased security of supply, and the separation of generation, transmission, and distribution activities has allowed for greater competition and market efficiency.

Overall, the development of the electricity market design has been a complex and ongoing process, yet its evolution has led to a more dynamic, market-driven system that is better suited to the needs of modern society.

How does the European electricity market work?

Today, the European electricity market is governed by a set of rules and regulations that are designed to promote competition, ensure security of supply, and incentivise investment in renewable energy sources. These rules are overseen by the European Union’s Agency for the Cooperation of Energy Regulators (ACER), based in Ljubljana, and enforced by national regulatory agencies in each member state.

At the heart of the electricity market is the wholesale market, where electricity is bought and sold between generators, traders, suppliers, and aggregators. The price in this market is determined by supply and demand, with prices fluctuating based on the amount of electricity being produced and consumed. This principle aims to ensure that demand is served at any moment in time in the most cost-effective way. The power is then sold by suppliers via the retail market.

How are wholesale prices formed?

Wholesale prices are formed as a result of the competition between generators who bid in the day-ahead, intraday, and forward markets, striving to sell their production and meet the demand forecasted by transmission operators (TSOs).

The market operates by fulfilling demand at the most affordable cost possible. The generators are dispatched in an order starting from the least expensive to the most expensive energy source until the energy supply meets the demand. The generators submit their bids, and the final price is set at the rate proposed by the last power plant that was activated to fulfill demand, known as the marginal plant.

As a result, the final price equals the variable marginal cost of the last power plant that was required. All the generators that supplied energy during that period will be paid the same rate as the last activated producer. This payment is referred to as inframarginal rent, and it ensures that the fixed investment costs are covered.

The advantage of this system is that it encourages investment in solar and wind power, which have very low marginal costs, and incentivises an efficient use of different generating assets in relation to their carbon emissions.

How are retail prices formed?

The retail bill refers to the cost that a customer has to pay for every kilowatt-hour (kWh) of electricity consumed during a specific timeframe.

The largest component of retail prices is usually the cost of the electricity itself which is influenced by the wholesale market price but is ultimately agreed between the customer and supplier. Consumers can adhere to either a fixed or variable price depending on their energy needs and degree of flexibility.

In addition to the wholesale price of electricity, retail electricity prices can also include a range of other charges and fees that are designed to cover the costs of transporting and distributing electricity to consumers. These charges may include fees for transmission and distribution, as well as fees to cover the costs of metering and billing.

Retail electricity prices also feature various taxes and levies, which can vary between countries. These taxes and levies can be used to fund renewable energy programs, support energy efficiency measures, or cover other government expenses.

While customers cannot do much about their bill’s network fees, taxes, and levies, they can always compare the offers and services provided by their suppliers with their competitors. Thanks to market liberalisation, customers are thus free to switch providers and opt for the utility with the best solution for their needs.

What is ACER’s role?

As the new market design rules foresee much more cross-border cooperation, the lack of regional, cross-border oversight could have created potential problems, with the risk of diverging decisions and unnecessary delays. This is why ACER was founded.

In addition to coordinating the action of national energy regulators, ACER was established to monitor those regional areas where fragmented national decisions of cross-border relevance were likely to lead to problems for the internal energy market.

Why is market integration important?

Establishing an integrated energy market in the EU is the most economical method to guarantee that citizens have access to reliable and reasonably priced energy. By implementing common energy market regulations and building cross-border infrastructure, energy generated in one EU country can be distributed to consumers in another country. This approach maintains competitive prices by spurring competition and providing consumers with the option to choose their energy suppliers.

By permitting the free flow of electricity to areas where it is most in demand, society will increasingly benefit from cross-border trade and competition. This would in turn translate into:

o   Greater efficiency and more competition between suppliers as obstacles are steadily broken down between closed national systems, creating the space for the emergence of innovative companies and services.

o   Incentivised investment in capital-intensive clean technologies, both in terms of the generation and the distribution of electricity. Securing these investments is essential to Europe meeting its decarbonisation ambitions as it provides the flexibility and firm capacity needed to complement variable renewable energies and facilitate their integration into the distribution grid.

How has the current energy crisis impacted markets?

Inflation began to rise as the continent emerged from the Covid crisis and economic growth rebounded, coupled with a steady increase in energy prices starting from July 2021. This situation was compounded by Russia's military aggression in Ukraine and its tighter control over oil and gas supplies. Natural gas prices soared, leading to a decline in industrial output, an increase in household bills, and further driving up inflation.

As the global demand for fossil fuels surged, electricity prices began to rise noticeably from June to September 2021. This trend persisted throughout 2022, with average EU day-ahead prices peaking at €405/MWh in August 2022, a staggering 532% increase from January 2021. By late 2022, these changes had begun to impact retail prices.

The energy crisis was precipitated by Russia's deliberate actions to disrupt Europe's energy supply. As a result of the limited flow of gas into Europe, we are experiencing a supply crisis that has directly affected European electricity markets. Furthermore, there have been shortages in nuclear and hydropower generation, exacerbating the situation.

It is crucial to recognise that the high electricity prices are not caused by the current market design. On the contrary, the market has delivered significant benefits. Rather, the current energy price surge is the result of a gas crisis that is having a significant knock-on effect on electricity prices, despite the fact that most of the measures and interventions adopted in the EU are focused on the electricity market.

The reform reaction

The existing market design remains essential in providing vital investment signals. However, due to increasing investment requirements and the ongoing gas shortage, electricity prices are having a disproportionate impact on customers' bills, necessitating further changes in the market.

European leaders have been discussing the future of the electricity market design for nearly a year, and in the first quarter of 2023, the Commission is expected to adopt its proposal for a new market design.

As political pressure has mounted on national and European lawmakers, a range of interventions has been proposed, from immediate emergency measures to calls for structural market reforms. However, some of these interventions may be counterproductive. Some countries are proposing a state-led reform of the EU market, while others are stressing the need for the Commission to avoid radical change.

Fixing something that isn’t broken

The Internal Energy Market is reflecting the disturbances of supply, not causing them. The current market design, based on the merit order and marginal pricing, ensures the optimisation and operation of the energy system while delivering significant benefits for consumers. Thus, it is essential to retain the underlying features of the current market design and assess any possible changes considering their long-term benefits, rather than the impact of the current crisis.

From this strong foundation, Eurelectric suggests adding three new pillars to the current market design:

1. a consumer contracting and engagement framework to more consistently transfer the benefits of cheaper clean and renewable energy to consumers;
2. a market-compatible investment framework to ensure the right investment signals for capital-intensive renewable and low-carbon technologies;
3. a security of supply framework to meet the evolving power system requirements.

An essential element in the proposal is to extend the possibilities to use long-term contracts and hedging instruments for consumers, suppliers, traders, and producers. For producers, this can provide clearer long-term investment signals. For customers, a mix of long-term and short-term price signals can limit the impact of price shocks.

Once introduced, these adjustments can help ensure that the EU has an electricity market design that is sustainable, reliable, efficient, and, ultimately, fit for net-zero. To achieve it, the upcoming reform should:

• Introduce more diverse long-term hedging products reaching beyond the current time horizon of forward markets (usually around 2 years), reaching up to 10-15 years;
• Remove existing barriers to long-term contracts such as power purchasing agreements (PPAs) by lifting any legal obstacles, promoting standardization, and transparency;
• Define common indicators, methodologies, and responsibilities to expand system planning framework and support increasing renewable rates, flexibility, and firm power needs.