The European Commission’s latest electricity market reform proposals
The European Commission’s latest electricity reform proposals address a key weaknesses in the design of the existing wholesale energy markets by encouraging the availability and use of long term pricing solutions. Long term pricing contracts will protect consumers, support investment and bear down on funding costs. However, these benefits will occur over time and as such they will not provide consumers immediate relief.
The European Commission’s latest electricity reform proposals are designed to establish secure, clean and stable power generation at an affordable price
The proposals address a key weaknesses in the design of the existing wholesale energy markets by encouraging the availability and use of long term pricing solutions. Long term pricing contracts will protect consumers and provide transparency and stability to power generators and that in turn will support investment and bear down on funding costs.
The proposals address a key weaknesses in the design of the existing wholesale energy markets by encouraging the availability and use of long term pricing solutions. Long term pricing contracts will protect consumers and provide transparency and stability to power generators and that in turn will support investment and bear down on funding costs.
However, these benefits will occur over time and as such they will not provide consumers immediate relief The European Commission has a wide range of reforms to the electricity market. These reforms are a direct response to the energy crisis that has unfolded in the European Union over the last two years.The trigger for the crisis was the disruption to gas supply from the war in Ukraine and the international sanctions on Russia in February 2022. Those disruptions were amplified by shortfalls in hydro and nuclear power generation in Europe as well as design flaws in the electricity market system. The result was high and volatile energy prices for households and businesses. It is against this background that the European Commission has proposed a set of reforms. The overarching objective of these reforms is to achieve (i) energy security by developing a high degree of domestic energy production - mainly from renewables and (ii) stable and affordable prices for consumers and businesses. In the remainder of this note we outline the features of the wholesale electricity market followed by a brief discussion of the main reforms proposed by the European Commission.
The European Electricity Market
The wholesale electricity market is the link that connects power generators with consumers. The system had worked well for consumers and producers until the recent flare up in energy prices. The system has unique features that result in particularly unfavourable outcomes for consumers when input costs of a major source of energy rise substantially. More specifically, the market has an established pecking order that favours low cost electricity producers over high cost producers. When it comes to supply, power from low cost generators, which tends to be from renewable sources, is prioritised over high cost producers. However, all producers, receive the same price which is the marginal cost of the highest cost supplier, regardless of the cost of production. As a result, in periods when the price of an important fuel source, such as gas, shoots higher, the renewable power producer enjoy windfall profits. The consumer is obliged to pay the marginal cost of the highest energy producer. At face value a market such as this should favour low cost renewable energy producers. However, this is not the case because the government steps in with regulation (windfall taxes) in periods of extreme price volatility which in turn creates uncertainty with knock-on effects on investment, especially in the renewable energy space. The EC proposals will not upend the existing arrangements. Instead, they encourage further investment in renewables and the use of longer term contracts.
Investment in Renewables
The EU must increase the speed of clean energy deployment by a factor of three to achieve the goals set in the Green Deal and REPower EU. To that end the Commission has proposed a number of policies and instruments to encourage investment in this sector. These initiatives can be split into three broad groups:
Investment certainty: Short term price volatility is an intrinsic feature of the wholesale market. That volatility creates uncertainty and that in turn raises the cost of capital for energy producers. Indeed ,judging by the Bloomberg compiled weighted cost of capital on wind power champion Orsted ,the WACC has risen from 6% average in 2021 to 8.3% at the end of 2022, while Orsted actually has a very predictable pricing through the use of purchase power agreements (PPA) and hedging. The latest proposals look to expand the scope of longer term pricing instruments such as PPA’s, contract for differences and forward contracts. Long term contracts provide investors a stable and predictable source of revenue which in turn helps lower financial risk and the cost of capital. The lower cost of capital will result in a lower renewable energy price which can support demand but of course, this is conditional on the credit risk of the buyer. To address that, the EC also proposes the development of instruments that guard the power generator from such defaults.
Technical constraints: A key disadvantage of renewable energy is intermittency. System operators and consumers need to work with this intermittency. For power producers this implies that generation can be switched on or off, for distributors this implies adequate storage capacity and for consumers this implies a pricing mechanism to respond flexibly to electricity supply.
Integrating renewables into the grid: Renewable energy producers often face delay and bottlenecks to connect to the grid. This is often because of capacity constraints with the grid. The new EC proposals requires transmission and distribution companies to publish reliable and updated information and grid supply capacity for investors looking to invest in renewable projects. Renewable power producers also struggle with connection delays. To address these drawbacks, the EC proposes that electricity system operators publish timely information about the status of applications for connecting to the grid within three months of submission of the request.
Protecting consumers
The EC has outlined a wide-range of proposals that are designed to widen consumer choice and protect vulnerable households. The most important of these is the right to select a contract that best suits the specific needs of the consumer. The choice will include secure fixed price contracts as well as dynamic pricing contracts where the price of power varies depending on the balance between demand and supply. A dynamic price contract will allow consumers to use electricity when it is cheaper. Dynamic pricing will play an important role in demand management when the bulk of electricity is produced from renewable sources such as solar and wind. The EC has outlined specific reforms to ensure continuous supply of electricity for consumers. A consumer is vulnerable to supply disruptions when a supplier fails or because of energy poverty when prices spike higher. Maintaining a continuous supply of energy is of utmost priority. To achieve that, Member States will be required to identify a supplier of last resort that will step-in to ensure continuous supply to consumers at a regulated retail price. Finally, the new proposals will also encourage energy sharing by empowering households to share energy that they generate (e.g. rooftop solar panels) with neighbours.
Enhance competitiveness of industry
Companies in the EU suffered a significant weakening in competitiveness as a result of the energy crisis and here again, the EC favours mechanisms and instruments that stabilise prices by decoupling energy prices from short term volatility. The EC strongly favours longer term Power Purchase Agreements between companies and energy suppliers where Member States play an active role in establishing a market-based credit guarantees for these instruments. The EC has also proposes the use of 2-way contract-for-differences where Member States help stabilise prices by establishing a minimum and a maximum price for power generators. Any revenue earned by power generators when prices are in excess of the maximum are returned to the government. Likewise, the government compensates power generators when prices fall below the minimum price.
Conclusion
The EC reform agenda is designed to establish secure, clean and stable power generation at an affordable price in the EU. If implemented, these proposals will help achieve the RePower EU target which is to substantially increase the share of renewable electricity to 70% by 2030. The proposals are however, not designed to provide immediate relief to the consumer. The European Parliament and the Council will have to discuss and agree the proposals before they comes into effect.