Preview.
The current energy crisis in Europe has accentuated the need to reform the functioning of the electricity market. The marginalist market with the previous generation structure worked efficiently. The new generation structure with a higher share of renewables and the volatility of gas prices has resulted in the market not functioning efficiently:
- It does not reflect the real average cost of generation of the electricity mix.
- It does not offer the right signals for investment in renewable energies.
- It does not offer signals to invest in firm capacity and demand flexibility.
- Generates extraordinary benefits for producers with generation costs below the electricity market.
- Transfers volatility in commodity markets to end consumers.
The reform proposed by the government aims to establish Contracts for Difference (CfD) for marginal technologies that attract renewable investments: The CfD will reflect the average cost, avoiding the generation of extraordinary benefits caused by price volatility.
Europe's view of the electricity market reform
There is currently great interest in the reform of the electricity market at European level. So much so that on February 13 the public consultation period on the design of the electricity market closed and more than 300 proposals were received.
The objective of the reform, according to Kadri Simson, EU Energy Commissioner, is to present a new model that considers the following three aspects:
- How to send clear investment signals to accelerate the green transition. PPAs and CfDs are the solutions that could help in this regard.
- Enable consumers to participate in energy management, and in the establishment of bilateral contracts in the medium and long term.
- Consumer protection.
In January, Spain went ahead of other countries and proposed to Brussels a comprehensive reform of the wholesale market, now under study. Spain's approach is to centralize the management of the energy system in all its stages, i.e., a de facto nationalization, leaving the state even the power to set prices.
The Spanish government proposes three major changes:
- Massive introduction of the so-called forward contracts for differences, CfD.
- agreed prices for nuclear and hydro,
- and capacity contracts
What does the Spanish proposal consist of?
The Spanish proposal aims to correct the imbalances in the current system: mitigate price volatility that makes bills more expensive, encourage the competitive implementation of renewables, guarantee supply and avoid windfall profits.
The main objective is to reduce the volatility associated with daily and intraday markets which, although they will continue to exist, will reduce their weight in price formation in favor of forward contracts.
The design suggests combining the existence of the short-term market with forward energy contracts that currently have high costs and capacity costs necessary to ensure continuity of supply and which are possible by regulation, but always as something exceptional and temporary.
Short-term market
In the case of renewables, particularly those of new implementation, the government proposes that they be carried out through contracts for difference or CfD, a voluntary system similar to the auction system already in place in Spain. These contracts would be signed by the regulator with each of the successful bidders in the auctions and would represent a commitment by the developer to supply a certain amount of energy for a certain period of time at a pre-established price. In exchange, the electricity system undertakes to purchase that energy, so that the quantity risk is covered for the producer at a pre-established price.
This is articulated through the integration of this energy in the daily market through the CfD with a price that is the one that results after the award of the auction. The operation is analogous to the current operation of renewable energy auctions.
For existing nuclear and hydroelectric plants, CfD with an availability incentive is proposed. Spain also proposes that each Member State be allowed to establish a pre-agreed remuneration with an availability incentive, a suggestion that does not fit with current EU regulations and would therefore have to be adapted.
Marginal technologies such as gas will continue to go to the day-ahead markets to sell energy without prejudice to the possibility of establishing forward contracts with traders or end consumers.
Capacity market
The proposal also considers incorporating capacity markets into the new energy market design. Capacity markets are allowed by EU legislation but only as a last resort. This mechanism contemplates various designs from strategic reserves, capacity auctions, reliability options and decentralized obligations depending on the peculiarities of each Member State.
Why is the reform proposed?
The design of the current wholesale system is not prepared for situations of high volatility or for the massive penetration of renewable energies or resources such as storage or demand management.
The current system was designed more than 20 years ago when the energy mix was composed entirely of conventional technologies with high variable costs. The contribution of renewable energies is currently almost 50% and the PNIEC forecast for 2030 is 74%.
Market volatility, the war in Ukraine and the need to accelerate the energy transition has put the need for market reform on the table.
The reform aims to gradually reduce electricity price volatility. As the volume of energy contracted under the new system increases, price volatility will be reduced.
The market currently operates on the basis of marginalist pricing in which the latest technology is the one that determines the value of the price of electricity in each hour; therefore, situations of high volatility in the price of gas end up directly affecting the electricity market.
Energy employers reject the proposal
The reaction of the energy employers' associations (Aelec, Appa, AEE, Aedive, afbel, aprie, aepibel, Elecpor) to the government's proposal has not been long in coming. In a document agreed by all of them, they reject the centralized management proposed by the Spanish government, establishing pre-assigned prices for nuclear or hydro, or tenders directed by the regulator to establish long-term supply contracts for differences (Contract for Differences, or CfDs).
The associations' document criticizes that an "electricity market model based on centralized purchases of most of the infra-marginal energy (renewables, nuclear and hydro) with fixed price energy contracts could affect the market and commercialization, fragmenting the internal market and discouraging the development of system flexibility".
The associations ask that the reform of the electricity market "must preserve legal certainties for consumer investors without allowing retroactive changes that alter already agreed economic flows or the existing legal framework, in order to preserve a climate of confidence in the financial markets".
Conclusions
The current market design is not adequate to meet the challenges of decarbonization and the increasing volatility of commodity markets.
The proposal presented by Spain is based on a highly liquid and transparent short-term market (daily and intraday) combined with a forward energy market and capacity and flexibility services adapted to the particular needs of each national market. The implementation of the energy market reform is associated with the need to modernize the internal market directive among other European regulations.
In the coming months we will see how the reforms proposed by the European Union will be implemented and how Spain's proposal will fit in.
Laura Garcia Garcia