As the European Green Deal aims at carbon neutrality for Europe by 2050, recent geopolitical developments have posed serious challenges to regional energy security and affordability. In the wake of the Russia-Ukraine war, the European Union (EU) energy market witnessed significant price fluctuations in 2022. In terms of electricity prices, the European Power Benchmark recorded Euro 339 per MWh on average in the third quarter of 2022, marking a significant increase of 222 per cent compared to the previous year. The high gas prices had a ripple effect on electricity prices, primarily due to the merit order system, also known as marginal pricing. The system determines the price of electricity based on the last fuel utilised to complete the energy mix.
The EU took some immediate measures to address the price volatility and supply security concerns. It introduced the Euro 210 billion REPowerEU plan in May 2022, which included legislation and other initiatives aimed at reducing dependence on Russian fossil fuels, generating energy savings and accelerating the roll-out of renewables. The plan raised the 2030 target for renewable energy sources from 40 per cent to 45 per cent. For this, 592 GW of solar PV and 510 GW of wind capacity are required by 2030, implying average annual additions of 48 GW for solar PV and 36 GW for wind.
It is widely recognised that the EU has maintained an efficient and well-integrated electricity market for over two decades. It has allowed consumers to enjoy the economic benefits of a unified energy market while ensuring supply security and facilitating the decarbonisation process. However, recent developments, particularly the 2022 energy crisis, have resulted in the European Commission (EC) working swiftly to address the structural reform of the electricity market, which aims to achieve two primary objectives – securing energy independence in Europe and achieving climate neutrality. It intends to accelerate investments in the deployment of renewables and the phase-out of gas, make consumer bills less dependent on volatile fossil fuel prices, protect consumers from future price volatility and potential market manipulation, and make the EU industry clean and more competitive.
To this end, on March 14, 2023, the EC proposed revisions to EU legislations, particularly the Electricity Regulation, the Electricity Directive and the REMIT Regulation. It introduces provisions to incentivise longer-term contracts with non-fossil power generation and bring more clean flexible solutions, such as demand response and storage, into the system to compete with gas. This will ensure that the lower cost of renewables is reflected in consumer electricity bills and decrease the impact of fossil fuels. Further, the proposed reform will foster open and fair competition in the European wholesale energy markets by improving market transparency and integrity. This latest reform, which is part of the EU’s Green Deal Industrial Plan, will also allow the European industry to have access to a renewable, non-fossil and affordable power supply, which is a key enabler of decarbonisation and the green transition.
Overall, the EC proposal aims to address consumer, industry and investor concerns regarding exposure to volatile short-term fossil fuel prices by optimising electricity market design and focusing on longer-term tools such as power purchase agreements (PPAs), contracts for differences (CfDs), forward contracts and flexibility schemes. Meanwhile, the EC is looking to bring incremental improvements to short-term markets, expand non-fossil flexibility solutions and reinforce consumer protection.
Notably, some of the revolutionary changes proposed by different stakeholders and a few member countries during the consultation period in early 2023 did not make it to the final proposal. The EC’s proposal does not fundamentally modify the price formation process in the day-ahead wholesale market. It does not extend the revenue cap and taxation beyond the cap, also known as the windfall profits tax, which was initially implemented as a temporary emergency measure to curtail windfall revenues for certain generators (mainly non-gas) and remains in effect until June 30, 2023. The proposal also does not require the conversion of existing public support for renewable projects to a two-way CfD framework.
Reduction of exposure to short-term price volatility
The key objective of the reform is to reduce consumer exposure to the price volatility in short-term electricity markets. Initially, there was speculation that the EC would reform the marginal pricing model by decoupling short-term electricity prices from natural gas and other fossil fuel prices. However, it was concluded that the current marginal pricing model offers valuable price signals and should be preserved, particularly due to the lack of viable alternatives. The EC has instead proposed to address price volatility and pass through the benefits of cheaper renewables to consumers by emphasising the role of long-term markets and contracts.
Development of PPA markets and improved functioning of the forward market
The proposed amendments to the Electricity Regulation support the development of long-term PPA markets, which can protect both developers and consumers from price volatility. The credit risk for the offtaker under the PPA could be reduced by state guarantees. Tenders for public support should allow generators to reserve a part of the project’s capacity for a market-based revenue stream under PPAs. A project could have access to both CfDs and PPAs, which have been mutually exclusive in some EU countries.
Further, mandatory hedging provisions are proposed to be inserted into the Electricity Directive to support the PPA market. For this, the EC proposes the creation of reference hubs or virtual hubs for forward contracts to increase price transparency. Such a hub would bring together all the bids and offers for forward electricity products in a particular region to create a single reference price for several countries. PPAs could refer to this, and it is likely to be more stable than the potentially volatile day-ahead market price reference. The aim is to improve the functioning of the forward market up to three years ahead to create deeper and more liquid hedging opportunities and incentivise the development of fixed-price contracts. Further, to provide market participants with certainty on their exposure to potential congestion between bidding zones, transmission system operators (TSOs) will be required to offer financial transmission rights (FTRs) for at least three years in advance. In case of curtailment of offshore hybrid renewable generation delivery to the market due to transmission constraints, TSOs must appropriately compensate the offshore project operator using congestion income.
Changes in CfD design
Publicly supported schemes must be implemented through two-way CfD schemes, ensuring that generators receiving CfDs will receive additional revenue when the market reference price falls below a pre-agreed minimum price, or return-to-consumers revenue when the market reference price is above that price. This will bring price stability to consumers and support renewables and other low-carbon generators. While the EU State Aid Rules for new renewable projects already allow this, the novelty in the EC’s proposal lies in paving the way for public support for investments in repowering or lifetime extensions for low-carbon electricity generation, which includes nuclear power.
Enabling energy-sharing schemes
The EC proposes to introduce an energy-sharing framework to enable consumers, particularly households, and small and medium enterprises that are unable to develop behind-the-meter generation to contract directly with renewable energy sources. Under this framework, consumers can self-consume renewable energy generated or stored off-site, which can be deducted from their metered consumption to calculate the energy component of their bill.
Improving short-term market efficiency
The EC recommends certain improvements to make short-term markets more liquid and create a level playing field for all participants. For instance, it proposes to reduce the intra-day gate closure time to accommodate renewable energy generators that are not able to effectively participate in intra-day, day-ahead and balancing markets given their non-despatchable nature. The Electricity Regulation will undergo amendments to reduce the cross-border intra-day gate closure from the current one hour before real time to a maximum of 30 minutes before real time by January 1, 2028. Further, the EC proposes to introduce more granular products (with minimum bid sizes of 100 kW or less) for trading in day-ahead and intra-day markets to enable the active involvement of demand-side response, energy storage and small-scale renewables.
Incentivising non-fossil flexibility
To enhance the flexibility market, the EC has proposed several measures. It plans to amend Article 18 of the Electricity Regulation, which governs how network tariffs are set by the National Regulatory Authorities (NRAs). The aim is to incentivise system operators to develop innovative solutions for optimising existing grids and procuring additional flexibility services. Further, the EC proposes allowing system operators to use sub-meter data for the settlement of demand response and flexibility services to support the development of these services. This will facilitate the participation of prosumers in electricity markets. To foster demand-side flexibility, storage and peak shaving solutions, NRAs should set a national objective for non-fossil flexibility such as demand response and storage. System operators will be allowed to develop a peak shaving product to incentivise consumption reduction at peak time. It also proposes to promote the participation of low-carbon flexibility providers in capacity mechanisms.
Consumer protection and empowerment
To better protect consumers from high and volatile prices, the EC proposes to give them new rights and a wider contractual choice. This includes the right to fixed-price contract (which cannot be unilaterally modified) and hedging obligations for suppliers to ensure more stable prices. Consumers will have the right to have multiple contracts and share renewables with neighbours. Notably, the proposal also includes the obligation for EU countries to establish suppliers of last resort, ensuring that consumers have access to regulated retail prices in a crisis and protecting vulnerable consumers from disconnection.
REMIT provides the framework for monitoring wholesale energy markets and prohibits insider trading and market manipulation. The EC’s proposal seeks to bring changes to the REMIT framework and expand the role of the EU Agency for the Cooperation of Energy Regulators (ACER) in its enforcement. Due to the growing interaction between financial and energy markets, the EC proposes that the REMIT framework should be better aligned with the financial market legislation. For this, it adjusts the definitions of market manipulation, inside information and wholesale energy product.
Further, to enhance data reporting and market monitoring, the EC has introduced several new requirements. This includes mandating organised marketplaces to disclose their full order book data to ACER, and registered reporting mechanisms to provide transaction details to ACER. It also introduced a new category called “persons professionally arranging and executing transactions (PPAETs)”, which replaces the existing “persons professionally arranging transactions”. PPAETs are tasked with reporting suspicious transactions that breach insider trading and market manipulation prohibitions.
ENTSO-E’s position on EC proposals
In April 2023, the European Network of Transmission System Operators for Electricity (ENTSO-E) published a position paper on the EC’s legislative proposals on electricity market design reforms. Broadly, ENTSO-E supports the EC objectives of the proposals to optimise the current electricity market design for a decarbonised energy system and to improve affordability. It highlighted that the priorities outlined by the EC are aligned with ENTSO-E’s Vision of a Power System for a Carbon Neutral Europe published in 2022. The objective of avoiding distortions in short-term markets to ensure system balancing and security is appreciated, along with the provisions to enhance demand response and consumer protection as well as recognise the role of flexibility needs assessment. ENTSO-E also welcomes an improved regulatory framework for TSOs, which duly recognises their anticipatory investments and operational expenditures, and promotes innovation and the use of flexibility solutions.
ENTSO-E believes that certain key elements are missing while others that have been included without a proper impact assessment may have detrimental effects on market functioning, system security or costs borne by consumers. These concerns are outlined below:
- Market mechanisms to ensure adequacy should be reinforced. The framework for capacity remuneration mechanisms (CRMs) must be simplified to allow their quicker and more stable introduction. The need for CRMs to secure investment in flexible generation, which is essential for system security, must be recognised. National granularity and sensitivity analyses are needed to address specific locational scarcities for adequacy, transmission capacity and ancillary services provision.
- While welcoming the EC objective of improving forward markets and cross-zonal hedging, ENTSO-E states that implementing regional virtual hubs would require long implementation periods of five to 10 years, and lead to significant costs and risks for TSOs, grid users and market participants. Further, virtual hubs should not be imposed as a target model for the entire continent without a more in depth assessment. The adoption of FTR obligations, along with the extension of maturity and potentially full firmness, poses significant financial risks for TSOs, particularly during an interconnector malfunction. This should be thoroughly assessed and adequate cash flow measures and regulatory cost recovery mechanisms will be required to mitigate such risks. ENTSO-E suggests that more practical solutions can be implemented in a shorter time frame to improve current forward markets. These include organising more frequent auctions for monthly, quarterly and yearly products; offering additional product durations and developing secondary markets; and assessing the FTR obligations, ensuring that counterparty risks and financial implications for TSOs are effectively addressed.
- The use of congestion income to support offshore generators in hybrid projects is discriminatory, as this implies a non-transparent subsidy paid by consumers to specific producer categories. As an alternative solution, it is recommended to build on existing support frameworks, such as two-sided, capability-based CfDs or financial CfDs. Such CfDs decouple remuneration from actual injection and can fully cover the volume risk of generators without market distortions and any discriminatory use of congestion income. Using congestion income to increase transmission capacity or reducing tariffs must remain the rule.
- ENTSO-E strongly warns against the inclusion of specific timings for intra-day gate closure in the regulation, especially without a proper impact assessment on system security, cost and CO2 implications. It states that reduction of the intra-day cross-zonal gate closure to 30 minutes ahead of real time by 2028 is inadequate at this stage. Such a change would have severe consequences for several European TSOs, necessitating a complete overhaul of operational procedures and potentially compromising system security. TSOs that employ a proactive balancing approach will witness a shortage of flexibility resources since generation units requiring over 20 minutes to activate will no longer be viable, leading to a substantial increase in system operation costs. ENTSO-E believes that it is important to avoid including specific timing requirements in primary regulations as these matters are better addressed through the methodologies outlined in the Capacity Allocation and Congestion Management Guideline.
- The strengthening of the REMIT should be accompanied by a balanced approach that carefully considers the proportionality of the new obligations. For instance, ENTSO-E is concerned that the proposed changes assume that the surveillance performed by PPAETs will be the main source to identify market abuse. However, surveillance performed by PPAETs must be only a supplement to ACER and NRAs, which have full access to market data and areas including over-the-counter markets. Further, adding new obligations, such as monitoring the publication of inside information, to PPAETs instead of ACER and NRAs will result in overlapping responsibilities while leaving certain gaps.
The way forward
As part of the next steps, the proposal will undergo the legislative proceedings of voting and amendments at the EU Parliament and the EU Council. Spain seeks to reach an agreement on the power market reform during its six-month council presidency, which concludes on December 31, 2023. Meanwhile, the EC strives to have the rules ready before the winter and hopes that a general approach among EU countries will be agreed upon during the Swedish presidency, concluding on June 30, 2023. Modifications to the different EU regulations will be applicable as soon as the amending regulations come into effect. The modifications will then have to be transposed into national energy laws, which can be a time-consuming process.
Some concerns have been raised regarding the effectiveness of the emphasis on strengthening long-term markets and PPAs as the existing market arrangements rely on spot markets. ENTSO-E has expressed its concerns regarding the potential for market functioning distortions, system security issues and increased costs borne by consumers.
The EU is facing time constraints as it strives to achieve it energy targets, which requires the deployment of renewables to triple by the end of this decade. The energy crisis has brought about new market dynamics, compelling the EU to undertake reforms in electricity market design to ensure energy security at affordable prices.