Europe's electricity market design clash set to intensify in 2023

A battle is brewing over Europe's electricity market design, with defenders of nearly three decades of liberalization ranged against reformers intent on decoupling natural gas prices from power prices.

Driving the debate are urgent calls from EU member states, backed by the European Commission, to neutralize the malign influence the war in Ukraine has had on wholesale gas prices.

For politicians and consumers, allowing crisis-hit gas generator costs to set the price for all generation is madness -- hence short-term interventions to cap generator revenues, and longer-term calls to reform the market.

For the power sector, existing energy-only markets deliver transparent, short-term optimization that, according to power association Eurelectric, has delivered Eur34 billion/year in consumer benefits.

"European wholesale markets are working perfectly as intended, pricing scarcity and allowing flows between markets to guarantee security of supply," said S&P Global Commodity Insights' analyst Coralie Laurencin.

"The focus on breaking the gas to power price link is very much the result of Europe's current shortage of gas in the wake of plummeting Russian flows, but as supply from other sources expands, pressure will ease in the power market. Rushing into a new market design carries risks," she said.

Early 2023 proposals

In December the European Council called on the European Commission to assess the impacts of reform and formulate proposals by early 2023 for a market "fully fit for a decarbonised energy system and facilitating the uptake of renewable energy."

This was accompanied by a vow from the upcoming Swedish presidency of the EU to "continue efforts to tackle high and volatile energy prices while addressing long-term energy market reform."

The options are various (see graphic), with proposals to split the market garnering support from Greece, Italy and France.

In late October the EC put forward its own thinking, suggesting renewables and other inframarginal generators like nuclear and hydro would be remunerated under Contracts for Difference, independently of the marginal price (invariably set by fossil fuel plants).

"The price of these [CfD] contracts would typically be established by tendering and will be a direct function of the actual production costs of the relevant technologies," the EC said in an Oct. 25 discussion paper.

This could be established almost immediately for new renewables. For existing generators, the EU's short-term inframarginal cap of Eur180/MWh could be directly integrated into wholesale markets to encourage existing generators towards a long-term pricing structure based on CfDs, it said.

This would be complemented by a short-term market for gas plants with storage and demand response offering competition over time, ensuring the cheapest, most efficient technology was used.

Advocates of the internal market, like Denmark, have urged caution on these proposals, while European regulatory body ACER went further, saying in late April that far from being to blame for the crisis, the EU's internal energy market rules "have to some extent helped mitigate the current crisis, thus avoiding electricity curtailment or even blackouts in certain quarters."

Stimulating liquidity

Nevertheless, it is broadly recognized that in future Europe's electricity markets will have to support both a massive rollout of renewable generation with high upfront investment costs, as well as the flexible assets (notably dispatchable generation) that have significant operational costs.

In this context ACER has proposed 13 measures to improve the current design, including accelerating electricity market integration, improving access to power purchase agreements, improving renewable investment support schemes and stimulating market-making to increase liquidity in long-term markets.

Similarly, in a Dec. 13 letter to the European Council, Eurelectric said a refined market design should aim to offer a more balanced choice of short-term and long-term price signals.

This could be achieved "by removing legal and administrative barriers and stimulating liquidity in the long-term markets, with products ranging from 2-4 up to 10-15 years or even longer," it said.

An expansion in the use of long-term contracts would provide reliable signals for developers and enable the market to attract the vast investment needed to achieve net zero, it said.

UK's parallel lines

These EU options as well as the potential for locational pricings mirror aspects of the UK's parallel Review of Electricity Market Arrangements.

In terms of scope, REMA encompasses the wholesale and balancing markets, ancillary services, the current CfD scheme and the Capacity Market.

On wholesale markets, the UK government is to explore a move away from marginal pricing, but "these options are novel, and in some instances only theoretical," the Department for Business, Energy and Industrial Strategy warned in July.

Nevertheless, it recognized, as does the EU, that the marginal pricing model may become less desirable as markets move to majority renewables.

Renewables' costs are focused on construction rather than operation. A model that incorporated this "could better reflect the underlying characteristics of the system and provide benefits such as protecting assets from price cannibalization," BEIS said.

One option involves splitting the wholesale market, with renewables receiving an average price independent of the marginal cost of production. However, given the scale of change this would entail, "more evidence is needed on their deliverability and impact," it said.

Locational signals

Locational pricing is also being explored by European and UK rule makers as a means to encourage generation, flexibility and demand in areas of the network where they are most needed.

"A nodal, location-based, wholesale market leads the ESO's range of operational redesign options to unlock opportunities for low-cost, low-carbon electricity to be harnessed when and where it is abundant," UK system operator National Grid said.

Locational signals could be introduced via zonal or nodal wholesale pricing, or renewable support schemes and capacity adequacy mechanisms, or via imbalance pricing or network access and charging reforms.

There is a major political stumbling block, however, as increasing locational signals will result in winners and losers, as would be the case between resource-rich north Germany and power-hungry south Germany.

Short-term price cap

While market redesign and implementation are likely to span over the next decade according to S&P Global's Laurencin, 2023 will see short-term interventions address generator super profits.

As noted, the EU has provided a framework agreement on a Eur180/MWh inframarginal price cap to June 2023, but countries have opted for tailored implementation, with revenue caps ranging as low as Eur67/MWh in Spain for nuclear, renewables, hydro and biomass.

The UK's Electricity Generator Levy, meanwhile, is to apply a 45% tax on returns above GBP75/MWh from renewable, nuclear and biomass assets, and run for much longer -- through to 2028, during which time it could raise GBP14.2 billion, according to Treasury estimates.

"While there are fears that the length of the UK EGL scheme relative to the EU inframarginal revenue cap may see investment flows attracted away from UK towards the rest of Europe, there remains a risk that revenue caps of some form may be extended as long as wholesale gas and power prices remain supported, and countries look to maintain household and industrial support measures," S&P Global analyst Raymond Shi said.

The UK levy may see projects look to re-optimize existing short-term PPA deals towards longer-term arrangements, which would bring the annual capture price down to or below the GBP75/MWh cap level, Shi said.

"Based on S&P Global Commodity Insight's November long-term forecast, average solar and offshore wind capture prices fall below the benchmark threshold under a 10-year deal beginning in 2023, with average onshore wind capture prices below the benchmark price for a 11-year deal," he said.