EU Market Design: setting the direction for Europe's electricity decarbonisation

Since the energy price spikes and volatility in electricity markets last year, precipitated by rising wholesale gas prices, the EU Commission has looked to a reform of market design as a systematic answer to the impact of these prices on Europeans. Following the short-term crisis measures adopted in 2022 to combat these acute price and energy security concerns, European Commissioner Kadri Simson committed to work to reform the electricity market. Reforming the electricity market is intended to both shield consumers from the worst of wholesale price volatility, and facilitate the achievement of EU decarbonisation goals, in line with the European Green Deal and the REPowerEU Plan. The reforms went to consultation earlier this year: stakeholders were asked views on various interventions - from the use of Power Purchase Agreements (PPAs) and Contracts for Difference (CfDs) to support renewable energy, to future crisis response measures.

One of the key elements of the plan is the focus on CfDs. CfDs have been used in UK renewables generation since 2014, but remain relatively rare in continental Europe. A CfD is essentially a forward contract between renewables generators and states. Typically, the generator will have the ‘hedge’ side of the contract, where they are guaranteed a minimum price for their output. If the wholesale price falls below the contractual price, the state subsidises the difference. The state typically has the ‘long’ side of the contract, where they capture the surplus when the wholesale price exceeds the contractual price. These are known as two-way CfDs. Under the Commission’s proposal, new low-carbon projects, where supported by Member States’ public financing, should take the form of a two-way CfD. The argument from proponents, including the Commission, is that CfDs can incentivise investors with a guarantee that revenues will remain consistent. It also provides a boost of the liquidity of the forward markets, allowing suppliers and consumers to better be protected against excessively volatile prices.

Whilst there was much qualified support from stakeholders in the responses we reviewed, nearly all were opposed to mandatory CfDs for new installations. Many trade associations and industry groups, whilst acknowledging the certainty provided to investors may make low-carbon installations a more attractive proposition, stress that CfDs should be used as only one tool in the pursuit of decarbonisation objectives, and the price must be set at the appropriate level. Stakeholders also suggested that any CfD would have to be carefully designed: currently, costs for some low carbon technologies have decreased dramatically, but others are still novel technologies that benefit from support to enter the market.

This reflects the discussion in the UK government’s consultation which closed last month, which posed questions on the definition of floating offshore wind, to ensure that emerging developments in technology were not precluded from the CfD, whilst also question whether (conventional) offshore wind phasing was still required given the advancements in the sector. Any CfD implemented by member states of the EU at this point, needs to consider how emerging technologies can best access the market, and that state support is deployed effectively for this, whilst also ensuring consumers do not subsidise established technologies.

Beyond ensuring investment in renewable energy developments, the Commission is also keen to ensure support for the deployment of Demand Side Response (DSR). To achieve this, the Commission instructs transmission system operators to design a peak shaving product, enabling demand response to contribute to decreasing peaks of consumption in the electricity system at certain hours of the day (peaks). The product aims to reduce and shift electricity consumption, and so the scope of the product has been limited to demand side response. The Commission is clear that a peak shaving product should not overlap with the activation of balancing products, and that the peak shaving product should be deployed against a baseline to verify demand reduction achieved.

When reviewing responses from stakeholders, the benefits of non-fossil flexibility solutions such as demand response and storage were acknowledged, especially in the context of an increasing share of renewables. Their market participation should be facilitated. Stakeholders were clear that they did not see a role for DSR only in a crisis, but that it should be incorporated into normal system business as usual. Networks stakeholders especially suggested that whilst a transitory ancillary services model for DSR may be appropriate for a short period, it should eventually participate in existing markets. Whilst the peak shaving product can be welcomed as an extra revenue stream for DSR, the highest-priority should be for Member States to properly implement the Electricity Directive, which would facilitate better DSR participation in markets through non-discrimination provisions and a role for aggregators. By siloing DSR into a specific product, the Commission may not be providing the boost it intends to give the technology.

The interventions proposed by the Commission for supporting renewables installations and DSR make sense, and are useful tools in guaranteeing Europe’s future energy security, decarbonisation, and protecting consumers from price hikes. However, some Member States and stakeholders are rightfully disappointed with the level of ambition. Despite novel interventions such as the instruction on the peak shaving product, the Commission has proposed incremental, rather than wholesale changes. The limited role provided for DSR reflects this. To promote renewable energy, the Commission also needs to ensure that member states are carefully designing their CfD support schemes. At this point, some low carbon technologies are at an advanced stage of maturity, whilst some are nascent industries which would benefit from government support. Balancing the need to incentivise as much low carbon power as possible, with ensuring consumers aren’t footing the bill, will be challenging.