The European Electricity Market Design Reform
3 interesting things and 3 odd things that will probably need some further thinking
I’m going to tell you a story. It’s 2023 and this village we will call Europe for fictional purposes, has managed to go through the winter thanks to relatively mild temperatures and some sacrifice. Spring is about to arrive and the first flowers start to blossom. Not a lot of snow on the mountains but enough to do some skiing (though some public support for typical winter-sport activities might be welcome). After two years were a pandemic forced the village population at home and a war still sending shockwaves at the border, the village can go back to some sort of normality. But there’s always another winter ahead so it needs to stack up the wood and prepare for that. And as every experienced fireman knows, you need both tinder and seasoned wood to light a fire and keep it burning. But the village does not have the tinder; it imports that by the country that is storming the neighboring village and the price went up massively. Some member of the village advocated for ways to price the fire differently, pursuing the idea that since Europe has mainly seasoned wood that should be the price of the fire. Something that in theory could make sense but that clashes with the stark reality that it still needs both to light the fire. This is the story of how the village is trying to change how a fire burns.
The premise
Over the past 18 months, the European energy market has experienced an unprecedent price volatility which has been translated into skyrocketing gas and electricity prices and has exposed households and companies to significant price spikes with effects on their electricity bills. If we look at the power sector alone, in 2022 the EU power bill went up by roughly 330 billion €, more than doubling compared to the previous year. And while high energy prices showed how vulnerable the EU energy market is to external sources, the extreme price volatility troubled lots of energy companies (eg. Uniper, EdF) that were de facto nationalized. We all know the root of the cause stems from the fact that Europe still relies on import for roughly 55% of its own energy consumption, share that rises to more than 80% for natural gas, and that exposes the continent to external fluctuations. Quite a variable when a war at your borders erupts and basically cut off 40% of your gas supply. Europe had to outprice the rest of the world last year in order to meet its energy demand.
In the energy space, 2022 will be remembered as the year when gas prices reached 350 €/MWh and the year where the EU Commission issued a record number of policy proposals (RePower EU, gas storage, demand savings, inframarginal price cap on electricity plants, new LNG benchmark and the notorious price cap) to basically try to put a lid on a boiling market.
And the first quarter of 2023 marks both the entrance into effect of the gas price cap (15.02) and the publication of the electricity market design. But give that the price of TTF has been falling since the beginning of the year, and it’s now trading below 50 €/MWh (lower than pre-Ukraine invasion), the big story now is the new EU electricity market design reform. A reform aimed at protecting European consumers from short-term shocks and any market manipulation, while accelerating the deployment and integration of renewables in the energy system.
I won’t spend time summing up what’s included and what’s not included in the Commission’s proposal (this post is going to be long enough already!). At ICIS we ran several analysis and also a podcast. Besides, there’s also plenty of material online (1, 2). This is a deep-dive into the 75 pages that were published on the 14th of March and some of the staff working material bringing to the surface 3 interesting things that are linked to the proposal and 3 odd things that will probably need some further thinking.
3 interesting things
The Commission did not bow to political pressures
Virtual hubs are possibly the most innovative proposal in the whole text but also the most complicated to implement
Peak shaving products as a way to boost the Demand Side Management market
3 odd things
Flexibility comes in the form of batteries and… no it’s only batteries
Security is addressed as more renewables but there’s no provision that resolves the forthcoming shortage of firm capacity (aka gas and coal)
Fixed price contracts or better flat price contracts
3 interesting things
1. The Commission did not bow
The market is safe. The most extreme measures (split market, revenue caps, mandatory CfDs for all, including existing generators and price caps Tope-way) are not there and the bulk of the proposal revolves around 1. protecting consumers from volatile energy prices (volatile = very high) and 2. accelerating investments in renewables in any possible form. We are in the evolution space rather than the revolution space. Given the nature of the proposal and the very limited number of controversial measures in there, the room to massively change it at Council and Parliament level should not be too broad and this could potentially speed up the negotiation process and its adoption. It’s a balanced and open proposal that leaves lots of room to Member States to pick and choose the best measures they deem fit for their market while providing common guidelines that should preserve the implicit goal of not wrecking the single market into several national markets.
2. Virtual hubs are the real innovation
While CfDs and PPAs might be seen as measures that could potentially reduce the liquidity of forward markets, the creation of virtual hubs might give the necessary boost to increase increase liquidity in the forward market. Virtual hubs, created by aggregating more bidding zones, could also prevent another side effect linked to CfDs or PPAs: an increase in the segmentation of national markets. As explicitly stated in the proposal “the establishment of regional virtual hubs with a view to overcome the existing market fragmentation”. The goal is that virtual hubs would reflect the aggregated price of multiple zones so providing a combined reference price. Stretching it to cosmic level, they could potentially make the life of energy companies and consumers easier in creating direct links to gas hubs, though it’s a bit of a blasphemy to say it loudly considering the moment and how gas is intentionally neglected in the whole proposal. Spoiler nr 1: possibly I am reading this incorrectly. Spoiler nr 2: as all attempt to create central EU platforms, it’s not going to be a picnic.
3. Peak shaving products a way to boost the Demand Side Management market
First of all what is peak shaving? Peak shaving is a way to reduce demand when it arises all the same time: eg. when everybody comes home from work and switches every possible appliance on. Given that we are all consuming electricity at 7pm, the price usually tends to spike at that time and ideally that should provide an incentive not to turn everything on. Demand Side Management is supposed to operate on this principle; by aggregating enough consumers willing to switch something off in exchange for a reduction in their bill, electricity demand should be less of a problem at times where cheap supply (renewables) is not available.
However, that’s hardly working right now, for multiple reasons, one being that electricity tariffs do not correctly reflect that disincentive. By creating peak shaving products, the Commission is looking at ways to let demand response business models emerge, therefore decreasing peaks of consumption in the electricity system in those critical hours of the day/week. And the scope of this product should be limited only to demand side response.
3 odd things
1. Flexibility comes in the form of batteries and…no it’s only batteries
It seems implicitly assumed that the cost of intermittency is not going to be borne by renewables anytime soon. Definitely an interesting decision that is in line with the recent history but does not provide any incentive to go into any other direction, especially the one California is currently witnessing by giving renewables asset owners the task of reducing their impact on the grid by pairing batteries or other options.
The EU proposal seems to address flexibility as a separate issue, with batteries competing in a different championship against DSM, which given technical and also economic limits (next point) it looks like batteries again.
However, if the short-term flexibility is a problem that batteries can technically solve, the longer-term flexibility (monthly/seasons) remains a complicated issue both from a technological point of view and from an economic point of view. Taking technology aside for the moment, it seems more intuitive to think that daily fluctuations and any balancing/ancillary service can provide the right economic incentive in a system largely dominated by renewables, where scarcity prices can easily give the right price signal. However, it seems much less intuitive to think about high monthly/seasonal price spreads, or at least high enough to cycle your battery just a few times a year. The economics are not there and as indicated by the study carried out by the JRC, gas-fired generation still seems to be the fittest technology for that.
2. Security of supply is still an open issue
Security is addressed as more renewables and the sooner the better. However there’s no provision that resolves the forthcoming shortage of firm capacity. The idea that DSM and batteries alone could guarantee system adequacy at all times, seems very ambitious to say the least. The mid-term issue of security of supply seems to be slightly overlooked. It’s left to existing capacity mechanisms to address that, with the provision that each Member State could redesign the capacity mechanism and make it greener, setting “technical performance standards and CO2 emissions’ limits that restrict participation in capacity mechanisms to flexible, fossil-free technologies”. Not an obligation, but the proposal seems to ignore that there is roughly 70 GW of firm capacity (coal, nuclear and gas) being decommissioned in the next 7 years or so, roughly 15% of the current firm capacity. And as experienced last summer, non-fossil firm capacity, like nuclear and hydropower, has become less firm. Something that Germany has started to address on its own and that as the ICIS power team recently analysed could bridge the country's looming supply gap.
3. Fixed-price contracts or better, flat-price contracts
For years there’s been a competition between two opposite business models for the retail industry: the flat price offer vs the dynamic price offer. With the advent of IoT technology and the interest of many tech company in the sector, lots of companies have looked at ways to flatten the power bill, with the idea of potentially embedding it into one service, whether that’s recharging your EV or something else. Something similar to what happened in the telco industry with smartphones. On the other side of the fence, other companies have followed the idea of introducing dynamic price contracts; contracts that could provide consumers the right signal and help energy companies and local distributors to manage the grid in hours of high load and resolve local congestions.
The proposal does not address this point directly but by looking at the measures proposed (CfDs, flexibility support schemes, capacity mechanisms, peak shaving products and more investments in grid infrastructures) it definitely leans in the direction of a higher share of levies in the power bill, with the weight of the energy component (which at the moment covers between 40 and 60% of the power bill) set to decline even further. This de facto paves the way to fixed-price contracts and most likely to flat-price contracts. Demand response is not something for private citizens to manage. Scale is needed and most likely a proper market for that which will hardly emerge naturally, especially because nobody wants to see his electricity bill goes up 10 times during the day for reasons that are not of particular interest to him/her.
(Credits: the image is produced by Dall-E as “electricity in a future world”)