Towards an electricity market design that rewards investments in flexible generation

08 September 2022

Only three years ago, the new Regulation on electricity markets entered into force. Some of its provisions have not been fully implemented yet and, despite this, the topic of electricity market design is already back on the agenda. While the current exceptional circumstances might require exceptional measures, a quick redesign of some markets will however not be a solution.

Rushed solutions should be avoided

The fact that energy markets are a hot topic today is hardly surprising. The Ukraine war has sent natural gas prices skyrocketing and will require energy saving efforts and state support for households and businesses. However, the current gas crisis should not lead us to rushed solutions that endanger the building up of European electricity markets.

The current political discussion focuses on the impact of gas prices on the electricity wholesale or “spot” markets. But the spot market is only one out of several electricity markets. Any market re-design should be carried out as an inclusive and thought-through process. On the contrary, any “quick fixes” that tinker with the functioning of markets and with basic market mechanisms could endanger energy security and the energy transition.

Market design needs to be adapted in the long term

In addition to the immediate challenge caused by steep electricity price increases as a result of high gas prices, there are further future challenges to be solved. The current market design, build for a base-load market, is not adequate any more to trigger investments in all the areas necessary for a reliable renewables-based electricity system.

Increasing shares of renewable capacity lead to increased price volatility on spot markets, making it difficult for investors to calculate a clear business case. They also further increase the need for different flexibility assets. This was both shown in the recent ACER report on wholesale markets and also in other publications such as the IEA’s World Energy Outlook.

Unfortunately, at present, investments in generation capacity that provide increasing flexibility and ancillary services to the system are still held back by an insufficient remuneration. At the same time, lower running hours will also be pushing firm capacity (that is, large flexibility assets) out of the market.

Renewable gas power plants as electricity system insurance

In a decarbonised energy system, power plants running with renewable gases could act as a key insurance mechanism to balance energy supply and demand in the short-, medium- and, especially, in the long-term. Indeed, an increasing number of organisations and experts are recognising the need to build up firm, low-carbon capacity to cover longer periods of low wind and solar output.

As gas power plants move from merely being the price-setter in wholesale markets to acting as an essential market insurance, their running hours will reduce. It will therefore certainly be very difficult for them to recover their costs only through the spot market. Other services and markets will need to be looked at and potentially be developed to further promote flexible capacity.  

Multiple energy markets offer multiple solutions

As very well explained by the Florence School of Regulation, the physical characteristics of electricity explain why there is not just one electricity market: in addition to the wholesale or spot market, where electricity is traded for the next day or on the same day, electricity is also sold through longer-term contracts, which help to hedge against price fluctuations. Balancing markets exist to keep supply and demand symmetrical in the (very) short term, while capacity markets make sure electricity will still be available even if the supply provided by other sources drops unexpectedly, especially over longer periods of time.

The list above is not an exhaustive one and the relative importance of all those markets varies from one country to another. Nevertheless, all those different markets need to be taken into account when studying the present and the future business case for a given type of power plant.

Redesign is needed – but in the long term, price caps will not do

With increasing shares of variable (not on-demand) electricity, the relative importance of the different markets is evolving too. For example, balancing and redispatch markets are growing, and so are intraday markets. At the same time, some markets may not yet be fully ready to accommodate new technologies such as hydrogen-ready power plants or others.

All those issues will need to be addressed if we want to encourage essential investments in renewables and in flexibility. Heavily regulating spot markets by capping prices might help in the very short term but risks scaring off investors in the long term.

A market design that is fit for a decarbonised future will need to be carefully though through and devised as an inclusive process. Power plant manufacturers are ready to take part.

Towards an electricity market design that rewards investments in flexible generation