Europe's energy crisis has exposed the need to reform the electricity market. An analysis of the Spanish government's proposal: CfDs and set prices for nuclear and hydro.
Europe's energy crisis has sharpened the need to reform how the electricity market works. Under the previous generation mix, the marginal pricing market functioned efficiently. The new mix — with a far higher share of renewables, and against a backdrop of volatile gas prices — has left a market that no longer works efficiently:
- It does not reflect the real average generation cost of the electricity mix.
- It does not send the right investment signals for renewables.
- It does not send signals to invest in firm capacity or in demand flexibility.
- It generates windfall profits for producers whose generation costs sit below the market price.
- It passes commodity market volatility straight through to end consumers.
The reform proposed by the government would establish Contracts for Difference (CfDs) for marginal technologies capable of attracting renewable investment: the CfD reflects average cost, preventing the windfall profits that price volatility creates.
How Europe sees the reform
There is considerable interest in electricity market reform at European level. The public consultation on market design closed on 13 February, drawing more than 300 submissions.
According to Kadri Simson, EU Commissioner for Energy, the reform aims to present a new model addressing three points:
- How to send clear investment signals to accelerate the green transition. PPAs and CfDs are the solutions that could help here.
- Allowing consumers to participate in energy management and in establishing bilateral contracts over the medium and long term.
- Consumer protection.
In January, Spain moved ahead of other countries and put a comprehensive wholesale market reform to Brussels, now under review. Spain's approach is to centralise management of the energy system at every stage — de facto nationalisation — leaving the state with the power to set prices.
The Spanish government proposes three major changes:
- Large-scale introduction of forward contracts for difference (CfDs).
- Agreed prices for nuclear and hydro.
- Capacity contracts.
What the Spanish proposal involves
The Spanish proposal seeks to correct the imbalances of the current system: mitigating the price volatility that drives up bills, encouraging competitive deployment of renewables, guaranteeing supply and preventing windfall profits.
The main objective is to reduce the volatility associated with day-ahead and intraday markets which, while they will continue to exist, would carry less weight in price formation in favour of forward contracts.
The design suggests combining a short-term market with forward energy contracts — currently carrying high costs — and capacity contracts, which are necessary to guarantee continuity of supply and permitted by regulation, but always as something exceptional and temporary.
The short-term market
For renewables, particularly new-build, the government proposes Contracts for Difference (CfDs), a voluntary system similar to the auction scheme already in place in Spain. The regulator would sign these contracts with each auction winner, and they would represent a commitment by the developer to supply a given quantity of energy over a set period at a pre-established price. In return, the electricity system commits to purchasing that energy, covering the producer's volume risk at a pre-established price.
This works by integrating that energy into the day-ahead market through the CfD at the price resulting from the auction award. The mechanism is analogous to how renewable energy auctions currently work.
For existing nuclear and hydro, the proposal is a CfD with an availability incentive. Spain also proposes allowing each Member State to set pre-agreed remuneration with an availability incentive — a suggestion that does not fit current EU regulation and would therefore require amendment.
Marginal technologies such as gas would continue selling into the day-ahead markets, without prejudice to establishing forward contracts with suppliers or end consumers.
The capacity market
The proposal also considers incorporating capacity markets into the new market design. Capacity markets are permitted under EU regulation, but only as a last resort. The mechanism allows for several designs — strategic reserves, capacity auctions, reliability options and decentralised obligations — depending on the particularities of each Member State.
Why reform is on the table
The current wholesale system was not designed for high volatility, nor for the massive penetration of renewables, nor for resources such as storage or demand-side management.
It was designed more than 20 years ago, when the energy mix consisted entirely of conventional technologies with high variable costs. Renewables now contribute close to 50%, and Spain's national energy plan (PNIEC) forecasts 74% by 2030.
Market volatility, the war in Ukraine and the need to accelerate the energy transition have put market reform firmly on the agenda.
The reform aims to reduce electricity price volatility gradually. As the volume of energy contracted under the new system increased, price volatility would fall.
Today the market works on marginal pricing, where the last technology dispatched sets the electricity price for each hour. That means periods of high gas price volatility feed directly into the electricity market.
Industry associations reject the proposal
The reaction from energy industry associations (Aelec, Appa, AEE, Aedive, afbel, aprie, aepibel, Elecpor) was swift. In a jointly agreed document they reject the centralised management the Spanish government proposes — pre-assigned prices for nuclear or hydro, or regulator-led tenders to establish long-term Contracts for Difference.
The associations' document argues that "an electricity market model based on centralised purchasing of most inframarginal energy (renewables, nuclear and hydro) through fixed-price energy contracts could affect the market and retail supply, fragmenting the internal market and discouraging the development of system flexibility."
They ask that electricity market reform "must preserve legal certainty for investors and consumers, without allowing retroactive changes that alter economic flows already agreed or the existing legal framework, in order to preserve confidence in financial markets."
Conclusions
The current market design is not equipped for the challenges of decarbonisation or for the growing volatility of commodity markets.
Spain's proposal rests on a highly liquid and transparent short-term market (day-ahead and intraday), combined with a forward energy market and capacity and flexibility services adapted to the particular needs of each national market. Implementing the reform brings with it the need to modernise the internal market directive, among other European regulations.
The coming months will show how the European Union's proposed reforms take shape, and how Spain's proposal fits within them.
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