The European Wholesale Electricity Market: From Crisis to Net Zero

This report aims to examine wholesale electricity market design and the proposed changes and interventions in light of Europe’s current energy crisis and carbon neutrality goals. While much of what the report discusses is motivated by the current crisis, any short-term action may have lasting repercussions, and we draw out some initial learnings on what this means for energy market regulation as Europe tries to move out of this crisis and towards Net Zero.

Several points about the European gas and electricity markets are clear from the start:

• First, Europeans are in this together at the level of the wholesale market, and this crisis calls for a joint approach. Despite diverging national proposals, EU solidarity mechanisms have been activated, and new common approaches proposed by the EC and backed by the Council.

• Second, as we approach the winter when gas supply could be very tight, it will be Russian gas-dependent countries that will especially need the integrated energy market to support them.

• Third, the gas and electricity price crunch has been worsened by the effect of climate disasters on the energy value chain and electricity output. Weather conditions are important considerations in the design of future electricity markets.

• Fourth, markets deliver security of supply by raising prices in times of scarcity, creating windfall profits for some, and leaving some market parties exposed to unhedged high prices or certain customers’ inability to pay.

• Fifth, political concern about the distributional impact of high prices on European households and industry is inevitable, especially in a context of high inflation and monetary policy tightening. The competitiveness of national industries is a concern for the whole internal market. Such impact should be adequately addressed, on a temporary basis.

• Sixth, such a large rise in prices and volatility has raised concerns about whether the current market design for electricity is working and fit for Europe’s net zero ambitions.

Current design

The current European market design has resulted in an integrated, or “coupled”, European market where generation and supply are undertaken by a range of different companies competing for customers. They drive the price up or down to signal scarcity or abundance and encourage producers and consumers to adjust accordingly.

Investment in generation capacity is also in principle market-based but has in recent years to a very large extent been driven by government interventions, including capacity markets and various forms of incentives for renewable energy. If the ambitious climate and energy targets are to be achieved, government support will be required.

Discussing suggested interventions

The authors look at the proposals put forward by ACER, Great Britain, Spain, Greece, and the European Commission to deal with the crisis. Some suggested design changes to the operation of current electricity markets are sensible in the long term, but even in aggregate, they do not offer the likelihood of significant short-run reductions in prices. Being clear about the timeframe of suggested interventions and their likely impacts is therefore important.

Two surprising observations are that, despite the European Commission’s efforts and sensible recent proposals for electricity and gas demand reduction, more has not been done across Europe to prioritise actual demand reduction for electricity and gas, and that completion of the single market to protect periphery countries in both electricity and gas is not being further accelerated.

The Crisis, Net Zero and Market Design

We find that:

• The impact of design on market outcomes is small, the day-ahead auction rules do not matter much. Market outcomes are determined mainly by market fundamentals and structure.
• Policies aimed at paying firms different short-run prices for what is in essence the same product inherently increase system costs and expectations consumers will have to pay for the overall system costs, which are higher if markets are inefficient.
• RES production relies on the availability of scarce natural resources. This does not require a change in market design. High returns can be captured by profits taxes.
• One option is to require all RES investors to sign long-term energy contracts with the government, which include some risk and output-sharing agreements. Auctions for PPAs are a good way to lock in lower costs for consumers.
• We expect that the use of long-term contracts by private parties will increase in the net zero scenario, due to the higher price volatility, the phasing out of government price guarantees for RES, and stricter regulation of the retailers’ risks.
• There are good arguments for government intervention in the contracting market such as: regulating the risk of retailers, standardising contracts to simplify netting, improving transparency on contract prices and positions, and contracting on behalf of small consumers. However, an important role remains with private contracts between generators and large customers.
• Whether member states provide long-term government-backed financial PPAs, should be left to the subsidiarity principle, and depends on the preferences of individual member states.
• The energy sector currently has some characteristics of a war economy and skimming the windfall profits of RES and nuclear generators might be justified for equity reasons. The best method to tax windfall profits is one that keeps incentives for efficient operation of the spot market intact and focuses on the genuine inframarginal rents of firms.

Legal aspects

In the context of the current debate, and when assessing the need to revise EU market design legislation, regulatory intervention can be split between short-term (toolbox for crisis management), mid-term (risk management and adjustments), and long-term (towards market reform) processes. Any short-term intervention should not jeopardise the functioning of the internal energy market, in a time where solidarity and complementary are required. As concerns market reforms, two main sets of proposals are identified, focusing on “price formation” and “market behaviour”.

Concluding thoughts

• Maintaining and deepening European electricity market solidarity is important. Short-term changes to the single electricity market should not undermine its continuing long-term operation and threaten the central part it needs to play in net zero.
• Any short-term action aimed at high energy prices should be carefully designed and executed at the European level. It is critical to avoid go-it-alone decisions that undermine solidarity and market integration.
• Reducing the demand for gas is key to reducing electricity prices and reducing electricity demand has a disproportionate effect on prices. Ambitious policy and regulatory approaches can drive such reduction.
• A consistent suggestion is that low carbon generation should be moved to long-term fixed-price contracts. It is important to recognise that all such contracts represent a bet on the future and the nature of discount rates. The extent of the signing of long-term contracts by the state for power should be a matter of national preference.
• The actual reduction in the net present value of the flow of financial payments to low carbon generation over the long run will likely involve some sort of appropriation of revenue via increased profits taxes.
• Marginal regulated retail prices should reflect wholesale prices, to incentivise demand reduction and energy efficiency investment. This could be done this winter with well-calibrated rising block tariffs.
• Regulatory barriers to additional low carbon generation and distortionary taxes on marginal electricity production should be removed.
• Some of the suggestions for electricity market reform are sensible but will not address the magnitude of the energy crisis in the required time frame. However, accelerating some of them would bring forward their benefits. Such changes would have to be looked at in the medium run in the context of the road to 2030 and 2050 climate goals.