Climate policy and government support of renewable energy are often blamed for the current crisis in the European electricity market. In reality, however, this crisis is caused by changed market fundamentals as well as the inadequacy of the existing market design, argue Andreas Rüdinger and Mathilde Mathieu of the Institute for Sustainable Development and International Relations (IDDRI). What is needed is better integration of climate and electricity market policy.

It is well-known that the EU power market has been hit by a “perfect storm”, but the reasons for this crisis have not always been properly understood. We can distinguish three factors that need to be taken into account.

First of all, it should be stressed that the impact of the economic crisis and the resulting reduction of demand, combined with the growth of both conventional and renewable capacities, provides the main explanation for the current situation of overcapacity and low wholesale market prices. Current consumption levels are about 300 TWh lower than in a counter-factual “no-crisis” scenario (figure 1).

This has not only caused problems in the present, but it has also led to a fundamental revision of electricity demand assumptions for the long term. Between 2003 and 2013, the European Commission’s projections for electricity demand in 2030 have decreased by 22% from 4500 TWh to 3500 TWh. This means that systemic conflicts between existing carbon-intensive assets and new low-carbon capacities will only become more intense and will have to be politically addressed. The issue is not about new investments anymore, but also about “disinvestment”.

The second problem is that wholesale market prices have declined considerably. This is due to the overcapacity in the market, but also to the fact that the real generation costs of renewables are not reflected in wholesale prices. In most markets, price levels are not sufficient anymore to allow for new investments in low-carbon generation or efficient conventional generation (gas-fired power plants) and to provide for timely replacement of the significant share of generation assets that will reach the end of their lifecycle in the next decade (see figure 2).

This situation also raises a more fundamental question of whether the existing pricing mechanisms based on short term marginal costs can still deliver a meaningful investment signal for the market, considering in particular the cost structure of capital-intensive low-carbon technologies.

The third problem we are facing is that, as most people know, due to significant changes in commodity prices for gas and coal and the low-carbon price signal provided currently by the EU Emission Trading Schem (ETS), coal-fired generation is increasingly replacing gas. Along with increased renewable generation and stagnating demand, this has resulted in a sharp decline of full load hours and power generation from gas power plants and a switch to coal-fired generation across Europe (Figure 3).

The current difficulties of gas power plants are often ascribed to the increase in renewable capacity, supposedly illustrating the negative impact of climate policy on the electricity market. However, if policies had been enacted to protect the competitiveness of gas relative to coal, the market would most likely have performed just as planned, with renewables and efficient gas plants pushing old carbon-intensive plant out of the market. This would have established the role of gas capacities in securing supply and flexibility in the transition to a low-carbon power sector.

Getting out of the storm: combining the electricity market and climate agendas

So how can we get out of the storm? Two major conclusions can be drawn from our analysis. Firstly, the recent difficulties in the European electricity market are related to nature of the existing market design, which was established two decades ago. Secondly, a strengthened climate and energy framework can be one of the drivers to restore a competitive market environment. It has failed to do so up to now because of a lack of responsiveness and coordination between the two policy fields.

There is thus a clear necessity to coordinate and combine these two agendas to avoid negative overlaps and reap the benefit of potential synergies. To make this possible, several challenges have to be addressed simultaneously.

The role of the EU ETS must be clarified. The ongoing debate on the EU ETS mostly focuses on additional measures to strengthen the price signal (see for example this article on Energy Post) but often fails to address the more structural question of what should be the actual role and objectives of the EU ETS within the evolving power market. Under current circumstances, achieving a uniform (and sufficiently high) price signal to cover all objectives seems unlikely. Complementary instruments will be needed, in particular to ensure economic viability of new low carbon investments. However, the EU ETS should play an important role in optimizing short-term dispatching, providing a signal to progressively push carbon- intensive assets out of the market and reducing the premium paid for low-carbon generation.

The design of the electricity market should be adapted to the challenges of the transition. The current market design is based on the technologies (thermal power plants with high OPEX) and objectives (competition and optimization of short-term dispatching) that were predominant during its creation in the 1990s. In view of the rapid and structural technological transformation linked to long-term decarbonization, pricing mechanisms have to evolve reflecting the long-run costs of new supply and the capital-intensive cost structure of low-carbon technologies. This also requires a fundamental rethinking of support mechanisms for low-carbon generation in order to enable their market integration. Indeed, according to the EU commission’s impact assessment on the 2030 package renewable generation will account for between 47% and 66% of total generation by 2030. This means that the core function of the market has to evolve from dispatch optimization to the efficient integration of the rapidly increasing portfolio of low-carbon and to a large extent variable generation assets.

New solutions for flexibility and generation adequacy should be provided. The EU market can and should play a central role in providing not only generation but also the flexibility and adequacy services needed in the future to allow for an efficient integration of renewable energy sources. In this process, large-scale energy storage should only be the last option. With the necessary adjustments, the electricity market can provide a lot of flexibility options itself through reduced gate closure delays, higher liquidity, optimal use of transmission capacities and a better integration of balancing and generation markets. However, these adjustments will not be automatic and must be supported by a coherent policy framework that enables the market to realize this potential.

Reinforcing EU level governance and cooperation

Against this background, future challenges for the 2030 European climate and energy framework should be considered along two lines: the balance and coordination between market forces and regulatory intervention, and the interplay between national and supra-national (regional or EU) approaches. The increasing mutual dependence and interactions between Member States clearly require reinforced governance mechanisms to provide more visibility on national choices and their implications on neighboring countries and the EU market. In this regard, it appears crucial to shift the focus of future adequacy and flexibility measures towards the regional market and EU level, rather than the national level. However, such governance mechanisms will only be considered legitimate if they are linked to a credible and strong policy framework that effectively addresses the challenges experienced within the different countries.

Editor’s Note

This article is based on a study recently published by the Institute for Sustainable Development and International Relations (IDDRI Paris): “Getting out of the perfect storm: towards coherence between electricity market policies and EU climate and energy goals”, which can be found here.