The power market design column – From evolution to revolution?

Last week I attended a workshop “Reforming the electricity market, from evolution to revolution”, organized by Elia, the Belgian TSO. 28 experts gathered and were challenged to present their views in a 3 minute pitch after which the debate was opened. This Elia initiative was well timed. As I explained in my previous?column, Ursula von der Leyen presented in her State of the Union not only emergency measures to intervene in the power market but she also mentioned that a deep and comprehensive reform of the market design is needed.?On 20 October the Council invited the Commission to speed up the work on the structural reform of the electricity market. Most likely we will see a consultation by the EU Commission in a few weeks followed by legislative proposals early next year,

The workshop took place under the Chatham House rules, so I cannot give a detailed report, but it is a perfect excuse to present my personal views and impressions.?

Let’s clean things up

One attendee mentioned that he had always been arguing against the introduction of capacity markets, but that he changed his mind, with a view to the patchwork of different capacity remuneration mechanisms that has emerged. He now believes that such mechanisms must be part of the new design to ensure a harmonized implementation and to avoid fragmentation. This is a logical and understandable view, but some others pointed out that there still is a lot of dirt in the current design that needs to be cleaned up. We did not harmonize the Energy Only Market in 20 years, so one might be pessimistic in aiming at a harmonization of capacity mechanisms.

Germany has about 900 DSOs of which the majority is not unbundled and act as vertically integrated utilities. Germany faces serious delays with the smart meter roll-out, a prerequisite for demand side flexibility at household level. All the EU Grid Codes have been adopted but the actual rules are far from harmonized. There is no common rule to set the imbalance price, which is the corner stone for all price formation. The balancing philosophy, meaning the division of responsibilities for balancing over TSOs and market parties, differs among member states. Transmission tariffs are not harmonized and thus distort cross-border trade. The methodologies to calculate cross-zonal capacities and to share costs for cross-zonal congestion management in the Core-region are still being disputed. The 70% rule has been adopted to make sure that TSOs not unduly shift internal congestions to the border, but it is an artificial rule without economic justification, and it is understood and applied in different ways. Rules for market suspension in times of emergency are not harmonized. Et cetera.

I made the comment that we should simplify market rules. (See also earlier columns on this issue:?here?and?here.) Another expert mentioned the push of ACER on TSOs to implement flow-based capacity calculation in the forward timeframe and labelled it as being unnecessary and overly complex. I agree and I would like to point out that there is still low hanging fruit. Simple measures that add real value, like opening cross-zonal intraday trade in the last hour before delivery. It is still blocked for no good reason, although the last hour is the most important hour especially for wind and PV producers as their forecasts are strongly improving close to delivery. Wind and PV producers want to trade shortages and surpluses in that last hour. If cross-zonal trade is not allowed to contribute, opportunities are lost, and costs increase.

Other experts pointed out that complexity cannot always be avoided and more efforts must be made to provide transparency. That is a fair statement and some interesting?work?on the functioning of flow-based market coupling can be mentioned. Still, unnecessary complexity should be avoided and one should concentrate on the basics. Or as said by one of the attendees: Let’s wipe away the dirt and let the basics shine!

Let’s agree on the basics

Before to agree on a new market design, it is necessary to agree on the basics. Unfortunately, such agreement is not obvious, also not among experts. One expert stated that the current market design is based on the principles of the merit order and marginal pricing. He argued that the design is excellent for the short-term optimal dispatch, but not equipped to allow for investments and therefore this gap in the market design must be repaired by adding new elements, like an investment framework.

But that narrative is flawed. The EU market design is neither based on marginal pricing nor on the merit order principle. Instead, the EU market design is based on open market access for producers and consumers and contractual freedom with free formation of prices. Each grid user has access to the market, the right to contract whatever volumes with whatever duration and granularity at whatever price. This right goes hand in hand with the duty to carry balance responsibility, which means that a schedule must be submitted and any deviation between schedule and metered infeed or offtake is financially settled at the imbalance price. All this is facilitated by a grid operated by unbundled system operators. That’s it! The fact that marginal costs are setting the price is a market outcome, not a market design issue. The current market design is not just able to steer the best dispatch, it also steers towards making the right mix of technologies available. And likewise, the current EU market design does allow for long-term contracting. If there is a need for such contracts among buyers and sellers, then such contracts will emerge. Obviously, there is little liquidity in the forward markets, but nobody could mention a real barrier that needs to be removed. It is possible to stimulate forward trading and hedging. But the word “stimulate” will then by definition mean some form of support, if not an explicit subsidy, inevitably resulting in costs for society.?

Investors can invest in new generation and storage capacity and will do so if expected future revenues will outweigh costs. A proper market design does not require that all investments are backed up with long-term contracts.?

Let’s agree on the grid challenges

Arguably the biggest challenge to reach a zero-carbon electricity system is grid expansion. TSOs and DSOs are struggling to keep pace with the growing demand for electricity as consumers, both households and large industrial consumers need to electrify, and with the expansion of renewable generation plants, from large scale offshore wind to rooftop PV. Connection of new grid users is already delayed although the transition just started. We not only need to connect more offshore wind, a meshed, offshore grid is needed or even a fully-fledged EU overlay grid or supergrid. And the increasing demand for green hydrogen will mean a further boost to electricity consumption for electrolysis.?

Transmission capacity is scarce, so there are two solutions: increase the amount of transmission capacity and reduce the need for transmission capacity. TSOs and DSOs have the habit to concentrate on the latter, at least in the public debate. In their view the market design must be updated to improve locational signals. The idea is that through better locational signals, grid usage will be steered in such way that less transmission infrastructure is needed. All correct. At the same time the actual benefits are difficult to calculate. The notorious bidding zone review methodology, that is now being applied by the TSOs to come up with a recommendation for a new bidding zone configuration, does not give the slightest idea on how to assess the importance of improved locational signals of smaller bidding zones. Secondly, the relevance of better locational signals might be limited. After all, offshore wind will be located offshore not in the city of Amsterdam and the city of Munich will not move to the German coast. Moreover, developers choose a location for various reasons. Minimization of grid costs is not the overriding objective.?

In other words, locational signals are nice, but how on earth are we going to build the extra grids that are anyhow needed in due time? And who is taking the initiative to consider the development of a European overlay grid. The current governance seems inclined to look at strengthening national grids and its interconnections but seems unable to take a truly European perspective. Grid expansion is the real challenge, and it is not a market design question.

Obviously, the locational issue remains relevant as well. However, it doesn’t need not much market design discussion. There are a few instruments that can already be applied. These instruments are: a bidding zone reconfiguration, locational signals in transmission tariffs, procurement of flexible capacity by TSOs/DSOs in locations where grid expansion is difficult or expensive and finally - if subsidy schemes apply (like for renewable generation) - locational signals can be incorporated in the design of such schemes.

Let’s agree on proper market interventions

One might get the idea that I would reject any type of market reform. But that is not the case. Because, indeed there is a major investment challenge. For example we need dispatchable, CO2-free generation capacity: high CAPEX investments for power plants with limited number of running hours. The classical question is whether these investments can be possible as the investor has to rely on scarcity prices. In theory, there is no problem. But recent developments have shown that political intervention in case of high prices is a real risk. The cap on inframarginal rents is a textbook example of an ill-designed tax that will only increase costs for EU citizens. But there are more risks that are not market risks but risks caused by, for example, climate policies. Such policies are instable, almost by definition. The Belgium example where governments have over time decided several times to close and then prolong the lifetime of the nuclear fleet, is illustrative. In addition there are risks related to uncertain political and societal acceptance of technologies like nuclear, biomass and CCS. These are all risks that cannot be managed in the market. And thus there is a risk of underinvestments that would cause security of supply problems.

So the concern that necessary investments will not take place in due time, is not the result of a market failure. It is the result of governmental failure. To tackle this challenge, it is necessary to develop a framework to support investments. Developing such framework is not adding a gap in the market design. It is a market intervention. A market intervention that is undesirable but needed. It is undesirable as it means that goverments will, to some extent, decide on the amount of capacity and the type of technologies needed. The consequences of making imperfect choices will not be carried by the investor but will be socialized. Although such approach does have the benefit of lower costs of capital.?

At the Elia workshop, experts discussed the best instruments for that investment framework, in particular one-sided and two-sided Contracts for Difference (CfD’s). I am not the expert on these instruments. But it is clear, that if we would have applied two-sided CfD’s in the past to support the development of renewables, government would now have benefitted from the extremely high energy prices and we probably would not have had this monstruous cap on inframarginal revenues.?

Let’s face the political reality

Some attendees underlined that we have to face political realities. One expert commented on the idea to decouple electricity and gas prices. He argued that there is no point in discussing whether this idea is right or wrong, as the EU Commission and Member States would already have decided that such decoupling is needed and must be achieved with the upcoming market design reform. So the question would now be how this decoupling can be achieved while advising policymakers to still preserve the efficient functioning of the IEM.

Again, I argue that this representation of the challenge is flawed. It is possible to design and implement measures to protect consumers from price shocks. But any such measure is a market intervention and comes at a cost for society. Again, I am not a market ayatollah. I know very well that retail competition and active participation of household consumers is not a walk in the park. Retail markets are not sufficiently competitive in some Member States. And we have to realize that many household consumers, especially vulnerable consumers, are simply not interested at all to become active on the electricity market. Measures to protect consumers or to decouple electricity prices from gas prices, may be politically desirable or even unavoidable, be they should certainly not be presented as a missing element that must be added to complete the market design.

One attendee noted as personal take away of the workshop that the key challenge for market experts is to be able to make proposals that are meeting the political expectations. And that it is not about proposing the best theoretical market design, but rather to identify what works best while considering the institutional context and the policy objectives. I assume that nobody disagrees with that. At the same time, I would plead for a strict separation of roles. Market experts advice on market design, politicians make political choices. It is the task of experts to bring factual analysis to the debate. To mention pros and cons of different ideas. To be precise on terminology. To formulate in clear language but not to package advice in political acceptable language.?

My personal take away would be: we need a revolution to make the transition a success, but there is no reason to mess up the market design.

Thanks a lot Elia

I would like to end this column with a sincere thanks to Elia for initiating and hosting the workshop! It was an honour, pleasure and inspiration to participate. And I was very happy to meet friends, former colleagues and to get to know a new soulmate.

Elia is also one of the TSOs that is very active in contributing to the market design debate with elaborated proposals. The “Flex-In-Market Design” and the “Customer-Centric Market Design” are two examples that were also briefly discussed at the Workshop. The Flex-In-Market Design aims to bring nodal elements into the zonal market design with the objective to achieve a better utilization of the grid and interconnectors. It is a relevant idea, as a perfect reconfiguration of the bidding zones is anyhow utopic. The idea has already been launched some years ago but did not yet get sufficient support. Maybe it is too complicated to get sufficient traction.

The Consumer-Centric Market Design did meet with some opposition during the workshop. I am also not a fan as I have the impression that with that concept the TSO steps into the arena that should be left to retail suppliers and other market participants. But I could be wrong. In any case, it is to be praised that Elia does organize an open discussion, allows its views to be challenged and facilitates an exchange of knowledge and ideas.?

This is my 35th?column on power market design issues. The earlier columns covered the following topics:?EU market interventions,?review of the CACM Regulation,?market myths and price formation,?system support balancing,?Blackouts,?the importance of ACER,?Flexibility and foisonnement,?reliability and load shedding,?regulation of congestion income,?dynamic network tariffs,?energy communities,?scarcity pricing,?the Florence Forum,?active system management,?network planning & sector coupling,?off-shore assets,?intraday capacity hoarding and pricing,?interconnectors,?international comparison of market designs,?cross-border capacity calculation,?flexibility,?cross-border capacity,?electric time and unintended exchanges,?EU Network Codes,?price formation and zero marginal cost generation,?simplicity in the Clean Energy Package,?smart grids,?storage,?auto-generation,?balancing,?VoLL,?demand side response,?interconnectors?and the?Economist on market design.

Disclaimer: The views as expressed in this column do not necessarily reflect the views of Energie-Nederland

Paul Giesbertz

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