Electricity markets and net-zero: which reform for which result?

Since European Commission President Ursula Von der Leyen called for a reform of the EU electricity market, several Member States have made headlines with their own reform proposals. From the radical Spanish and French non-papers to the more conservative joint letter from Germany and six other Member States, the debate has reached the highest levels of EU policymaking. At stake is Europe’s path to net zero.

Sticking to this path will require the build-up of more than 700 GW of new renewable capacity by 2030 along with enhanced flexible and firm capacity, additional storage, and expanded demand-side response to ensure security of supply. A market affected by uncertainty and rising inflation will not deliver them alone. Nor will a market where government interventions and disruptions in the name of combating price volatility are a regular occurrence.

What market design can better deliver the benefits of low-cost, low-carbon energy to consumers, attract investment, and ensure security of supply?

Eurelectric has detailed how to solve this trilemma in its response to the Commission’s consultation that ended this week.

“In reforming Europe’s electricity market, we should follow a two-step approach.”

- explained Eurelectric’s Policy Director Cillian O'Donoghue earlier this week at Wind Energy Ireland’s Annual Conference, adding -

“We should preserve the current European wholesale markets based on merit order and marginal pricing while developing at the same time a long-term market to reduce the influence of gas on prices and promote the necessary level of investment.”

For decades, the current market has enabled the short-term optimisation of the power system, by prioritising the dispatch of the cheapest and most efficient energy sources, such as renewables and nuclear, before turning to more emitting sources. This design has enabled clear price signals to spur investment in renewable sources and has ensured cross-border trade between countries, thereby reinforcing the EU internal market and the EU’s security of supply.

Yet, the current energy crisis, triggered by Russia’s induced gas crunch, prevented consumers from benefitting from renewables’ low and stable prices, as record-high natural gas became the price setter. This event called for mitigating the impact of short-term markets on the price of electricity paid by consumers without destroying the short-term price signals necessary to direct investments. To achieve this, the market should envisage a greater role for long-term hedging instruments and contracts.

Long-term contracts such as a market-based Power purchasing agreements (PPA) or a state-mediated contracts for difference (CfD) allow market participants to negotiate a fixed price for part of their energy demand thus avoiding excessive exposure to short-term market prices. These contracts provide clear long-term price signals that reassure investors. By offering long-term visibility on returns and stable revenue, such contracts help investors and encourage them to reinvest in renewable generation or additional storage and flexible capacity.

A well-balanced market reform should facilitate the development of such tools on a voluntary basis. It should not impose requirements that would hamper private initiatives and constrict investors’ freedom of choice.

Forward hedging offers another solution to mitigate part of consumers’ exposure to the short-term market. Yet, these markets are not liquid enough to provide the long-term visibility needed for the capital-intensive investments required for the energy transition. Their time horizons are mostly limited to one or two years and requirements to enter forward contracts are too stringent for investors to foresee a stable revenue.

These are just some of the barriers that hamper the development of long-term hedging and contracts. Lengthy permitting procedures, regulatory and administrative barriers, risk of State interventions, and the lack of creditworthiness are also discouraging the use of PPAs. In Spain, for instance, renewables contracted under PPAs have decreased from 8GW in 2021 to 6.6GW in 2022 since government interventions started.

Reverting these trends requires:

• Contract standardisation for PPAs;
• State-backed guarantees to protect generators and lenders;
• Pooled demand through multi-buyer consortiums to sign PPAs on behalf of numerous smaller consumers, jointly responsible for the contract;
• Freedom for suppliers to adapting their hedging strategies to their costumer portfolio by avoiding a one-size-fits-all approach to CfDs and hedging strategies;
• Removal of regulatory disincentives to forward hedging for generators such as renewables support schemes exclusively linked to spot prices.