Instrat: Energy market – to be fixed or rewritten?


Instrat took part in the European Commission’s public consultations on the reform of the EU’s electricity market design. In our view, past efforts to liberalise and integrate European energy markets have, in principle, both translated into a more efficient operating structure for the existing generating capacities and created the right incentives for electricity producers and consumers.

However, the positive effect of the market was limited by barriers such as low competitiveness in less developed markets, protectionism practised by the Member States, legislation blocking the development of renewable energy capacities and, until recently, excessively low prices for emission allowances, which should be the main driver of the decarbonisation of the European electricity industry.

Instrat welcomes the desire to improve the regulatory framework for products and services that better suit the needs of market participants and the electricity system as a whole, such as PPAs, long-term contracts, but also local balancing or energy storage services. At the same time, we call for a critical look at existing interventions, such as the Polish capacity market. In contrast, more radical changes, such as the obligatory sale of RES energy only under the PPA formula or under public contracts for difference, should not be implemented without a longer process of analyses and consultations.

Energy market consultations

The ideas for reforming the structure of EU energy markets are a response to the European crisis, in particular the extremely high electricity prices that occurred temporarily in mid-2022. In order to mitigate the effects of these fluctuations, Member States have introduced an unprecedented package of interventions and protective measures (e.g., a price cap for energy from different sources, frozen prices for selected groups of consumers). The reform under development is expected to lead to more long-term changes that will prevent such crises from occurring in the future. Analysing the European Commission’s announcements, the following goals can be identified:

  1. Reducing electricity price volatility by reducing dependence on short-term fossil fuel price fluctuations,
  2. Supporting a faster development of renewable energy sources,
  3. Optimising energy markets to the realities of electricity systems based mostly on production from weather-dependent RES systems.

These different goals may not necessarily be compatible. The price caps for renewable energy, introduced in 2022, reduced the impact of high gas prices on consumers’ bills, but their influence on the long-term development of the renewable energy industry was arguably negative (reducing revenues and increasing regulatory concerns). On the other hand, RES support instruments may conflict with the proper functioning of the market – in Poland, the prosumer photovoltaics settlement scheme has translated into a rapid development of new capacities, but it does not motivate beneficiaries to use or store energy efficiently. Such objections concerning particular instruments were often raised by consultation participants.

Stable energy prices for Europeans

Although electricity from gas covers a small portion of European demand, its high prices have skyrocketed electricity prices in both spot and futures markets. Coal, nuclear or RES power plants could therefore expect windfall profits. The European Commission’s consultations pertained to the greatest extent to instruments allowing to reduce such a phenomenon in the future.

In principle, Instrat does not support a long-term maintenance of regulated price caps for individual technologies (setting them at a very high level is less detrimental to the development of RES, but does not lead to achieving the desired goal).

Long-term contracts for electricity supply from renewable sources can be an effective alternative. These can take the form of PPAs (power purchase agreements), but also forward markets with adequate liquidity.

Instrat supports efforts geared towards increasing access to such products by simplifying the regulatory framework and reducing transaction costs. We are already seeing high interest in those types of contracts.

At the same time, we express our doubts as to the proliferation of PPAs through costly state support (e.g., taking on the cost of risk management) or partial or full obligation to sell energy this way. If the use of PPAs becomes too extensive, this could lead to weakened short-term markets and suboptimal price incentives. Given the high differentiation of the needs of individual market participants, they should be able to manage the risks associated with future energy prices on an individual basis.

The proposal to further promote public bilateral contracts for difference for the purchase of renewable energy, however, brought more controversy among the consultation participants. The idea is to have a mechanism similar to the current RES auctions in Poland. Since the resulting long-term contracts assume, in practice, the sale of at least some energy at stable prices, this translates into a lower market vulnerability to crises such as those of recent quarters. However, there is no guarantee that this will lead to lower energy costs over the life of the contract, especially if the rapid development of green technologies would otherwise result in lower energy prices on wholesale spot markets.

Financing for new RES capacities

A more common use of long-term and forward contracts than hitherto would also, according to the Commission, be one of the measures leading to the rapid development of renewable energy sources. Indeed, PPAs allow for broader involvement of private capital and appropriate risk sharing between electricity producers and consumers. RES auctions, on the other hand, are a form of state aid – even though contracts are concluded in competitive auctions, they are still generally more attractive to investors than full exposure to the wholesale market.

In the past, such auctions have been necessary in view of the lower technological maturity of solar and wind power industries and the low price of emission allowances. Under current market conditions, however, RES are among the cheapest new sources of electricity. Is public support in the form of contracts for difference still needed?

In its position paper, Instrat points out that public assistance may soon be needed more in other areas, such as the modernisation of grids and the development of new technologies. Contracts for difference should be regularly reviewed for reasonableness and optimality, especially since they can lead to certain inefficiencies (e.g., optimising investments for volume rather than the market value of energy produced).

Instrat also stresses that cost-effectiveness is not a key barrier to the development of new RES capacity at this time. Both in Poland and elsewhere, the key barriers are overly restrictive regulations, lengthy administrative processes and a backlog in the development of power grids. The European Commission is right to emphasise these issues as part of its efforts to implement the REPowerEU package – in Instrat’s view, this is where Member States’ efforts should be focused.

A market for a decarbonised energy system

While the idea of reforming the structure of the European energy market is directly triggered by the ongoing energy crisis, the proposed changes are part of the long-running debate on adapting the way energy is traded to the realities of systems based mainly on weather-dependent renewable capacities.

The debate points out, among other things, that founding energy prices on variable costs, as it is at present, will lead to long periods with very low prices (during favourable weather), which may even hinder the returns on investment costs and may further translate into new investments being stopped. Long-term contracts in the format of PPAs or contracts for difference are one of the proposed solutions because of the possibility of including investment costs. According to Instrat, we need a stable legal framework for such forms of energy contracting that are attractive to both parties of a PPA transaction. However, we should not, at least at this stage, arbitrarily impose such solutions on market participants.

A power system based mostly on weather-dependent RES requires appropriate adaptation of power grids, the development of local system balancing services, increasing the flexibility of electricity demand, and providing a business model for the weather-independent sources that are started up less frequently. Without appropriate changes, connecting more solar and wind power will become increasingly difficult, and imposed RES production curtailment may occur more frequently.

According to Instrat, the energy market should evolve to include these investments and services more broadly, in order to create appropriate price incentives and opportunities for private capital involvement. In principle, such a direction of development also stems from current EU regulations and is also being implemented in Poland. However, either grid expansion or flexibility of demand is still less subject to market incentives than the electricity production itself.

In the context of energy policy instruments, a constant reference point should be the real needs of the physical energy system. For example, the usefulness of controllable capacities, including from fossil fuels, will increasingly depend on their flexibility. Supplementing the volatile RES generation by the operation of old coal-fired units will be increasingly inefficient. Adequate consideration of the real needs of the system will result in the development of a market for energy storage or flexible demand. Nonetheless, conventional sources will still be needed for a long time as a hedge against extended periods of inclement weather (but not for day-to-day operation).

Polish government in favour of capacity market for coal

The Polish government also expressed their views in the current debate, publishing a short non-paper. Its key demand is the inclusion of the power market as a permanent component of the multi-commodity energy market, which should be able to be used by the Member States without restrictions. The government is advocating for allowing capacity contracts for coal-fired power plants after 2025 to reduce the use of natural gas. According to Instrat, this is a problematic demand.

In the past, the capacity market functioned in practice as a state aid for coal-fired power plants. Capacity contracts not only lead to the availability of these sources in a crisis situation, but subsidise the daily operation of these power units, which distorts the competitiveness of the energy market, crowding out alternatives such as RES development, cross-border trade or consumption adjustment. This leads to higher emissions and costs.

The usefulness of unmodernised coal-fired power units for the daily operation of the Polish power system will diminish each year as a result of their low flexibility. According to Instrat, supplementing the current energy trading with other instruments geared towards ensuring the implementation of appropriate investments and system services may be reasonable. However, this must not be an excuse for politically motivated state aid to a specific sector which is disadvantageous for the system as a whole.

The Polish government’s other proposals are, in principle, in line with the direction set by the European Commission. The government rightly points to the usefulness of long-term contracts, while noting that major RES generation technologies no longer require public support to the extent they did just a few years ago. The proposal also points to the need for greater consideration in the energy market of services such as reserves and transmission capacities, in order to create appropriate price incentives and optimise investments and operations. It is unfortunate that in the current regulatory policy of the Polish government, the commitment to these legitimate goals is not always apparent.

Let’s streamline the energy market

According to Instrat, the main causes of the European energy crisis are not related to the structure of energy markets. Member States have unreasonably blocked low-carbon energy (e.g., Poland’s 10H rule). CO2 allowance prices have only recently, as a result of the ETS reform and the international situation, reached levels that effectively support the green transition.

Many EU countries also underestimated the geopolitical risks posed by Russian gas supplies. In this context, blaming energy markets for temporary price extremes and the emergence of windfall profits may have the character of “blaming the messenger.” During the crisis, European energy markets allowed the most efficient use of available generation capacities, including through flexible international trade.

Energy markets need further change – an important first step will be to fully implement existing regulations, ensure adequate competitiveness and move away from mechanisms that support fossil fuels. Being in mid-crisis is not necessarily an appropriate time for undertaking the more radical changes proposed by Spain or France, among others. Nor does it seem that there really is a widespread belief in the necessity of them in the Member States – Germany and the northern European countries led by Denmark have warned against chaotic moves that could undermine the achievements made so far in integrating and liberalising EU energy markets.

You can read Instrat’s detailed responses in this file.

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