Call for reform of EU power market rules

The ongoing electricity price hike fuelled by the gas crisis makes a reform of EU power market rules more urgent than ever, argue friends of EiD Mike Parr, director of PWR, and Simon Minett, founder of Challoch-Energy in an article on the EURACTIV website.

 

High electricity prices, renewables and windfall profits – all paid for by EU citizens

In our previous contributions to EURACTIV (here and here,), we called for an urgent reform of electricity markets as part of the transition to a zero-carbon economy.

The current high electricity prices, caused by surging gas prices, adds urgency to the need for reform.

Since October, the EU’s Agency for the Cooperation of Energy Regulators (ACER) has been tasked with reviewing the functioning of this market, given the surge in electricity prices. In its preliminary report published in November, the organisation forecast that high electricity prices (€90 to €160/MWh) will be with us for at least two years.

This forecast is reflected in hedging activity by owners of renewable plant with prices for 3rd quarter 2022 of around €90/MWh (source: EEX).

While undertaking its review, ACER might wish to consider the fact that EU citizens because of current market structures, are being “taxed” twice: Once via VAT, an element in all electricity bills, and twice via the increase in power prices which delivers windfall profits to companies and in some cases governments.

These windfall profits being a direct result of the marginal pricing system used to “form” the price of wholesale electricity in all EU member states.

Under marginal pricing, the cost of the most expensive generator, (at the moment gas power plants) defines the price for all generators. Windfall profits occur because of the link between marginal pricing and the way in which renewables are remunerated.

Renewable subsidies

More fundamentally, other developments have happened in the past years on electricity markets. Between 2000 and 2014, most renewables were remunerated via “feed-in-tariffs” (FiTs), a direct subsidy unrelated to wholesale market prices. Two changes then occurred.

First, from 2014 (in Germany), renewable projects were moved to a direct-marketing system. Under this, a renewable project sells the electricity generated directly to the wholesale market.

A “market premium” is then paid to cover the difference between a renewable reference price (defined by the government) and the wholesale market price (averaged per month).

The assumption was that for the foreseeable future, wholesale prices would be much lower than the cost of renewable electricity. Hence the need for a “market premium”. No consideration was given to average wholesale prices being higher than renewable reference prices, as they are now.

Second, in 2016-2017 there was a move towards auctions for renewable projects. The auction price defines the cost of a given renewable at that date. Germany used auctions from 2017 to define the reference price, but stuck with its “direct marketing and market premium” system.

Other countries in a similar time frame, such as Spain and the UK, combined auctions with a contract-for-difference (CfD) system. Under CfDs the winners of the auction sell their electricity directly to wholesale markets. However, if wholesale prices at any point are less than the strike price of  the auction, the government pays the difference.

If wholesale prices are higher than auction prices, money flows from the renewable project owners to the government. Under such a system energy companies make no windfall profits from renewables.

In 2018, the German Institute for Economic Research (DIW) published a paper that argued for using CfDs for all future renewable projects in Germany since this would lead to lower costs for consumers of electricity. In 2020 the German government rejected a 2020 Bundesrat proposal to introduce CfDs for offshore wind projects.

What’s the damage of high prices?

The high wholesale electricity prices currently being experience in the EU and UK benefit one of two groups: companies with renewable assets or governments funding renewables via auctions and CfDs.

Since September 2021, electricity wholesale prices in most member states have hovered between €150 and €250/MWh with the occasional oscillation up to €620/MWh or down to minus €2/MWh depending on the availability or not of renewables and how much demand needs to be met.

This contrasts with renewable auction prices for wind and PV of circa €50-60/MWh and €35-50/MWh respectively (Germany and Spain).

Taking Germany as an example, average monthly day-ahead wholesale prices are shown below plus the amount of on-shore wind generated in that month. (source: ENTSO-E).

In Germany, EEG reference values for wind sit at around €60/MWh both for historic FiT funded wind (most of which transitioned to “direct marketing”) and for wind built under the auction system (which started in 2017).

Given that in each month the average wholesale price was far greater than the reference value, no “market premium” was paid in the period September 2021 through to January 2022. The situation is less extreme in the case of PV installations since they produce less in winter.

In most EU Member States, when the levelised costs of renewables (LCOEs) were greater than “normal” wholesale prices (1990 through to September 2021), citizens were called on to fund the difference i.e. the difference was socialised in the interests of decarbonising the power sector.

By contrast, renewable windfall profits are now being enjoyed by energy companies because the electricity market continues to use marginal pricing to form wholesale prices.

If the way in which wholesale prices are formed is changed to a basket price approach, the inherently lower costs of renewables will have a downward influence on wholesale prices even if gas prices were high. In turn there would be minimal windfall profits for renewables.

In Germany (and proportionally in other countries) citizens are funding renewable windfall profits to the tune of €10million to €50 million per day, i.e. around €1 per day per household (in Germany) – far more than the reduction in their EEG charge.

All this brings up a number of open questions.

  • To politicians and regulators: are windfall profits an acceptable situation? Is it fair that households pay for them? Or is this an example of markets functioning badly? And if so, what can be done?
  • To the public: do politicians and regulators work in the interest of companies, or citizens? Do politicians understand how electricity markets function, or not? In the case of Belgium, the answer seems to be no.

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3 thoughts on “Call for reform of EU power market rules

  1. I have read with interest what has been said by Mike and Simon (from Calloch-whom I have had in the past some exchange of views on cogeneration and other issues) and I would start with this final question, quoted:
    “…• To the public: do politicians and regulators work in the interest of companies, or citizens? Do politicians understand how electricity markets function, or not? In the case of Belgium, the answer seems to be no…”
    I can guarantee Belgium is not at all alone !…and I would dare to say, that, even for some “regulators” still the “power market” has a lot of white/blank areas.
    Now, there is an urge to create an “European Energy Bank” (perhaps like EU Central Bank ?!), then, the logic will lead to the conclusion that we must have “local central banks”(!?), to monitor and strictly control “the financial market”?! …now, are we talking somehow about extending the features of “National Dispatching Centers !?”….
    In my humble opinion, I believe that until we will fully understand and accept that “power” is not a “commodity” (for “market”), but instead it is a “system”, then, always we will have “economists” from EU regulators imposing “market rules” from elsewhere (like from “potatoes market”) to the engineeres and energy economists of power systems….and we already see what happens having the concept of “marginal pricing”…the base and heart of “power market”.
    I was trying to understand why Romania has experienced huge surge (unjectified !) in price electricity increases (highest in CEEurope), since, we have the second lowest emission factor CO2/capita (after Sweden, according to Eurostat), having in the power mix 15% nuclear, 30% hidro, 10% renewables, 25% Cogen-gas (own resources) and 20% lignite (own resources !)…and less than 10% export/import…I have made some simulations and, it is absolutely not justifyiable to have such price variations, at least for our case…something must be very wrong in the “design of the power market”…the “pandemia of marginal price” have spread very quickly through “the interconnections with the “power market”…(if our National Bank sees any inflation increase, will immediately take harsh measures…so, why not thinking to limiting “power market exchange”, to keep not only technical stability, but also, financial stability !?…and avoid the spread of “disease”, because this is what we have now).
    Each “power system” has it own characteristics/fuel mix/technologies/COSTS (!) and cannot be compared so easy each other, so, treating them all over the same “market”, it is the first step to major errors !
    Why somebody should care too much about Germany’s own power system (or, power market) problems, as example ?!

  2. Thanks for the response. Our position is both clear and simple: when the cost inputs for all fossil and nuclear generators are known (they are!), when the cost of all RES gen is known (they are), then marginal pricing is irrelevant from a “social fairness” point of view since it causes wholesale prices to oscillate such as to cause windfall gains (RES) on one side and “pay twice for the same elec” on the other. Basket pricing suppresses all this and delivers a close-to “real price” for real inputs/outputs. Thanks for citing the example from Romania, which rather reinforces the point we were making. Regarding “don’t care too much about Germany” we used it as an example of a power system that is fairly heterogeneous (vs France – which ain’t). Fair point about contagion – which we agree with and indeed have made this point to others.

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