The European Commission’s electricity market reform proposal, published 14 March, is a response to record-high electricity prices in 2022 and concerns over supply security. But it also brings forward a debate that was anyway looming: upgrading the design of Europe’s electricity market to encourage the investment needed to transition smoothly to a climate-neutral economy.
The proposed reform’s main thrust is to encourage more long-term contracts. The idea is straightforward: investors can be more sure of demand, which helps them access cheaper capital and invest more, which ultimately brings down power prices for consumers. Moreover, consumers with long-term contracts are less exposed to price shocks.
But it is a challenge to bridge the mismatch between producers that want to secure prices for their output for decades ahead and consumers who often cannot commit to buy electricity at a certain price for more than a few years in advance. The Commission therefore proposes four instruments that EU countries would be able to use to support investment in parts of the power system:
- Support for private long-term contracts between producers and consumers (power purchase agreements, PPAs); governments should be able to shoulder some of the risk arising from these contracts.
- Permission for governments to support non-fossil investments with long-term price guarantees known as contracts for difference (CfDs). Under these, electricity producers receive a fixed price. If market prices are below the fixed price, producers receive a top-up; if market prices exceed the fixed price, producers pay the excess to the government (which uses it to compensate consumers).
- Forward markets in which more fungible products are traded would be encouraged. This would be done by creating more liquid regional hubs and possibly forcing market operators to act as market makers (ie they have to make an offer to buy (eg at 95) and sell (eg at 105) a certain product).
- National flexibility support schemes would pay providers of demand-side response and storage capacity.
The proposal also contains significant provisions that would constrain retailers, and some adjustments to improve short-term market functioning.
The proposed electricity market reform is hard to grasp
The proposed reform continues the past path of market-based integration of European electricity systems, defending the idea of ensuring optimal dispatch through marginal-price settlement in short-term markets and calling for cross-border participation in national instruments.
However, the proposals on investment heralds a paradigm shift. Under the guise of fairness considerations, European market signals on the value of electricity in specific locations and points in time would lose their relevance for steering investments. This function would be broadly delegated to a set of mainly national instruments. Hence, EU governments might be relatively free to design these instruments to align best with national stakeholder preferences. In the process, national governments, the European Commission, and national and European network and market operators and regulators are given partial responsibilities for designing and allocating individual long-term instruments (PPAs, CfDs, forward markets, flexibility schemes).
While the supply of and demand for these traded products overlaps, and spills across borders, it is not immediately clear how this interaction will be managed. Accordingly, it is unclear whether the remaining European market signals will be strong enough to correct for substantial misallocations stemming from ill-designed national schemes.
So, to some degree, the Commission formally acknowledges that EU countries have and will devise national support instruments for investments in the power system. This does not need to be a bad thing, but what seems to be missing is a mechanism to ensure a basic level of consistency of national choices. There would be more state involvement in the electricity system, but in an uncoordinated way, both on the supply and demand side. And responsibility could be even more diluted. This impression is reinforced as the Commission does not provide a consistent picture of how old and new market instruments will work together.
Unsurprisingly therefore, the political discussions on the proposal might become long and complex. Preferable would be to move ahead quickly with the consumer-protection elements (and some of the house cleaning), while preparing more diligently a consistent and well-argued proposal on ensuring efficient investment signals. About €80 billion in investment in the European power system per year is needed and the stakes are just too high to risk getting the incentives wrong.