The power market design column - Market myths debunked

The design of the electricity market will continue to be intensively discussed in the coming months. High time to debunk some myths. Because:

• the EU market model is not built on the principle that price formation is determined by marginal costs of production,
• a market for flexibility does not exist and is not necessary,
• balancing is not the exclusive domain of TSOs,
• a blackout will come at some point and then probably have nothing to do with market failure.

(This article is based on an article that has been published earlier in?Energeia.)

Energy markets are here to stay

Free markets are under pressure. Liberalization and privatization are no longer en vogue and a strong government is now being advocated instead of a withdrawing government. But a fundamental turnaround in the energy supply is out of the question. Cooperation in the EU is based on the creation of an internal market and European legislation dictates how the liberalized electricity and gas markets should work. That will not change. On the contrary, Member States are incorporating the latest package of market rules (the Clean Energy Package) into national legislation. And a market for hydrogen is expected to develop into a European market with cross-border trade, just like natural gas and electricity, as can be read in the so-called “Decarbonisation Package” recently?proposed?by the European Commission.

Although market forces are a given for the time being, it is relevant to look at the correct design of the energy market. For the electricity market, this is a discussion that has been ongoing since the introduction of liberalization in 1999. The question always was whether electricity producers should also be compensated for having capacity available, or whether a so-called Energy Only Model is sufficient. This discussion was further fueled by the growing share of solar and wind production with zero marginal costs. But lately, the discussion has also been fueled by high market prices.

High prices trigger European discussion on the market design

In the Netherlands, recent high prices did not lead to market interventions, but in Spain a tax was introduced to skim off windfall profits from producers who produce electricity without CO2 emissions. In France too, there were calls for mechanisms to stop exposing consumers to volatile market prices. The European Commission reacted quickly and presented a toolbox with measures that the Member States themselves can take. To accommodate Member States who expressed concerns on the well functioning of the market, an investigation was announced. The Commission says that there is not yet clear evidence that an alternative design of the wholesale electricity market would lead to lower prices and better incentives, but is instructing ACER to analyze the advantages and disadvantages of the current design. In doing so, ACER should also consider the options for addressing situations of extreme price volatility in the gas markets and the measures available to mitigate that volatility while ensuring a cost-effective energy transition.

The preliminary?analysis?has now been presented by ACER. For example, it is explained that especially countries that are highly dependent on natural gas and have relatively few interconnections, such as Ireland, Spain, Portugal and Italy, show the highest electricity prices. ACER also warns against concluding too quickly that the transition from long-term gas contracts based on oil price indexation to purchasing at gas hubs (such as TTF) should be reversed. Purchasing based on long-term oil price indexed prices would indeed have been much more beneficial in recent months. But in the ten years before that, those contracts were increasingly expensive than gas hub prices. ACER notes that prices are expected to fall again in April next year and has so far found no clear indications of market manipulation.

ACER then describes the current design of the European electricity market. ACER speaks highly of three characteristics of the market design: the pay-as-clear principle, the importance of price volatility and market integration or market coupling. The pay-as-clear principle means that one price, the equilibrium price or the price at which the quantity supplied is equal to demand, applies to all buyers and sellers. ACER states that the pay-as-clear principle gives producers an incentive to offer at real costs and that it enables producers to recoup fixed costs. Price volatility is necessary to trigger investments that level off the increasing volatility resulting from intermittent sustainable production. Increasing market integration or market coupling is ACER's flagship product. ACER states that coupling the day-ahead and intraday markets provides EU citizens with a benefit of EUR 1 billion per year and that further market integration could yield another EUR 300 billion over the next ten years.

Finally, ACER indicates which matters will be further investigated for the report due in April 2022. The questions that ACER asks itself are:

• Is the current market design, which focuses mainly on short-term optimization and cost efficiency, able to provide investment signals for large-scale production and demand response?
• Are there appropriate price signals showing the need for flexible capacity to mitigate price volatility?
• Are there sufficient instruments for market parties such as suppliers and traders to cover risks?
• Are final customers sufficiently informed and possibly protected against excessive price fluctuations?
• Are there opportunities to better link the gas and electricity markets??

This column focuses in particular on the first three questions.?

Price does not equal marginal cost of production

ACER steps on a slippery slope in its plea for the pay-as-clear principle. First, ACER argues that this principle gives producers an incentive to offer at a real cost. However, this incentive has nothing to do with the price mechanism. Instead, it is the result of competition. The pay-as-bid principle, so the principle whereby the seller receives the price for which he is offering, in principle leads to the same prices. After all, sellers will estimate the costs of competitors and what buyers will be willing to pay. The pay-as-clear principle excels in simplicity but is not essential.

Secondly, the pay-as-clear principle is only prescribed in the European rules for the pricing of balancing energy. This principle is also applied in the organized day-ahead market, but there is no obligation to participate in that market. Pay-as-bid is applied on the futures markets and also on the intraday market.

ACER states that the pay-as-clear principle is equivalent to the marginal pricing method. ACER says that the producer with the highest costs, still offering below the final clearing price, sets the price. The latter is not so much wrong, but misleading. It ignores the demand side of the market and the role of storage. They can also determine the price. Storage of electricity already plays a role in many countries and it will become increasingly important. We are discussing??the market design for the future, so storage should not be forgotten. The question then is, what are the marginal costs at which storage should offer? These costs are almost entirely determined by opportunity costs, which in turn are determined by expected market prices in the future.

This is also relevant for production from PV and wind with marginal cost that appear to be zero. But if offered on the day-ahead market, a commitment is made to deliver the next day. There is then a risk that the agreed quantity cannot be produced due to malfunctions or changed weather forecasts. In the worst-case scenario, the producer is exposed to the imbalance price, which will be significantly higher than the day-ahead price if more producers face the same problem. This risk must therefore be priced in.

Due to these two aspects, the role of storage and demand response and the pricing in of opportunity costs and imbalance risk costs, it is not at all likely that market prices with a large share of solar and wind will often be zero Euro/MWh in the future.

Textbooks on the theory of power markets should be read with understanding of the practice

The idea that the price equals marginal costs of production is so persistent as it can be taken from many textbooks like the recently?published?Handbook on Electricity Markets edited by Glachant, Joskow and Pollitt. Chapter 3 of this book explains the concept of peak-load pricing. It distinguishes two configurations: off-peak, when production is lower than installed capacity, and on-peak when production and consumption are exactly equal to installed capacity. The off-peak price is set by the variable generation cost. And the on-peak price is set by the value of the marginal MWh, that is the MWh such that cumulative consumption equals capacity. The theory is undisputed. But practice is more complex. One may come to the wrong conclusion that as long as load shedding is not needed, prices will equal variable costs of generation. Wholesale power markets consist of many segments, or as the authors write, exist for multiple dates. They write that “this introductory chapter does not open the ‘black box’ of complexities associated with wholesale price formation in practice and assumes that a single wholesale spot price exists for a particular hour”. Well, fair enough, but then the reader should not assume that peak-load pricing can be observed in day-ahead markets.?

A market for flexibility does not exist and is unnecessary

Flexibility is a characteristic of capacity. The more flexible production capacity (or storage or demand response capacity), the more revenues can be obtained in the electricity market. The value of flexibility, or rather flexible capacity, is embedded in the prices for the various products that are already traded on the electricity market. The entire pallet of products, from forward to day-ahead, intraday and balancing products plays a role in this.

Still, the idea that something is missing in the current market design is persistent. It is obvious that all kinds of flexible capacity, such as storage and conversion (electrolysis and electric boilers) will play a bigger role in the future and many assume that the market would not be able to realize these kinds of solutions. The argument for this is that the development of solar and wind was not left to the market either. The latter is of course true, but sustainability and CO2-free electricity production are goals that must be pursued. Increasing flexibility is not an end in itself. Taken in isolation, these are installations that consume energy, which is not very sustainable. Subsidies for storage can mean that less subsidy is needed for solar and wind. But it is unlikely that less subsidy will be needed in total. That's also because there are a whole range of different storage and conversion solutions. It is wiser to let the market determine what the most promising options are. This requires that barriers, if any, be removed and that the interaction between the various energy carriers (electricity, heat and hydrogen) can be played on a level playing field.

Incidentally, the business case for storage is getting better and better. Value is increasing, and costs are steadily decreasing. If a subsidy is now introduced for relatively small home batteries, there is a chance that more efficient storage systems will be pushed off the market. The net result is then no extra flexibility, but more costs for the taxpayer.

One caveat must be mentioned. As long as production from solar and wind is subsidized, that production will not be ramped down if prices are moderately negative. The fact that negative prices sometimes arise now means that storage is indirectly supported. In the future, when there is no longer a subsidy for sustainable production, this will no longer be the case. Negative prices are then not, or hardly to be expected anymore, because production from sun and wind can easily be ramped down.

Balancing is not the exclusive domain of TSOs

Flexibility and the electricity market often refer to TSOs and the special products that TSOs procure to maintain the balance in the electricity supply system. Attention then quickly turns to the pilots that has been run, for example to aggregate demand response by parties that can operate independently of the suppliers.?

However, this focus on the TSOs’ role is not justified. TSOs ensure that the power balance is continuously in balance. But at the same time, the market itself is also active, also in the balancing domain. This is called system support balancing. The market is trying to have a balanced energy program on a quarter-hourly basis, while the TSO monitors the power balance. I explained in my previous column that this interplay between actions by the TSO and by the market parties works well in the Netherlands.

Finally, balancing is not just a matter of reacting in real time. The intraday market, the day-ahead market and even the forward markets play an equally important role in balancing supply and demand. These are market segments in which TSOs obviously do not play a role.

Market failure is not the main concern

In the discussion on security of supply, the importance of the correct market model and the risk of market failure must be put into perspective. Households in the Netherlands are interrupted for an average of half an hour a year. For many years now, the reason for such disturbances has always been a problem in the grids. Cable damage as a result of excavation damage is normally the main cause. That has nothing to do with market failure. The tense situations, when the European synchronous system broke down into parts, such as on January 8 this year or on November 4, 2006, were caused by negligence of some TSOs. There was no question of an imminent shortage of production on those days.

Then there are disasters. A winter storm early this year caused blackouts in Texas. If the Netherlands is hit by large-scale black ice in combination with storms, things will go wrong seriously. In addition to natural disasters, the consequences of a cyber-attack can be mentioned. In such situations, capacity markets, strategic reserves or incentive components in the imbalance price are all pretty useless. Consumers for whom a reliable power supply is essential should take measures and arrange for a good emergency power supply, and households should always have candles, matches and a flashlight in the house.

And finally, there is the relationship with a reliable gas supply. Gas-fired power stations will play an important role for the time being if production from sun and wind is low. In Belgium and Germany, new gas-fired power stations will replace nuclear and coal-fired power stations. So if there is no gas, there is no electricity.?

This is my 32nd?column on power market design issues. The earlier columns covered the following topics:?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

[email protected]