Unleashing Europe’s 2023 Energy Revolution: Strategies & Disagreements

1. The EU’s Response to an Unprecedented Energy Crisis

At the start of 2021, a global energy crisis began. It was caused by economic recovery, extreme weather, and reduced investment. This crisis made the cost of power in Europe go up. The European Union (EU) tried to control rising energy costs and supply problems in October 2021. They made a plan named “Tackling Rising Energy Prices: a Toolbox for Action and Support”. They suggested some short-term and long-term actions. For the short-term, they offered income support and tax cuts to consumers, and help for businesses. For the long-term, they focused on investing in renewable energy and improving energy storage. But, these actions did not fix the crisis.

In early 2022, a conflict between Russia and Ukraine made Europe’s energy problems worse. It caused the price of natural gas and electricity to be much higher than usual. The EU had to switch from a positive attitude to dealing with a long-term crisis. They made several new plans, including one called “REPowerEU”, to rely less on fossil fuels and speed up Europe’s energy change.

As time went on, the energy crisis affected more parts of the economy. Companies had to make other goods and services more expensive because of the high energy costs. In October 2022, inflation in the euro area reached its highest level since the euro was created, at 10.6%. Ursula von der Leyen, the President of the European Commission, said that the EU must reform its energy market to tackle the worst energy crisis in decades.

Von der Leyen said the current electricity market design, which is based on merit-order selection, is no longer fair to consumers. They have not benefited from low-cost renewable energy. So, she said it was necessary to make electricity prices less dependent on natural gas prices to ensure fairness and sustainability in the market.

On March 14, 2023, the European Commission proposed a draft to reform the European electricity market. The aim is to improve the design of the electricity market, enhance products, services and the regulatory system. This will reduce worries about short-term electricity price fluctuations and promote renewable energy development, thus enhancing Europe’s overall industrial competitiveness. The European Commission also gave some suggestions on the development of energy storage. It pointed out the important role of flexible services using non-fossil fuels and the key role of energy storage in building a safe energy system and helping the EU reach its decarbonization goals.

The draft for the power market reform needs to be reviewed and agreed upon by the European Parliament and Council before it can be officially effective. Right now, the member countries have not yet agreed on the draft. The main disagreements are about how each country’s government will support coal and nuclear power plants. The European Commission thinks everyone needs more time to discuss because the reform is very important. They hope to end negotiations and start the reform plan in the fall of 2023.

2. Shortcomings of the Current Electricity Market Design

Right now, the design of Europe’s electricity market focuses on the short-term. It uses spot markets and unified power markets as its main structure. But, the EU has raised its greenhouse gas reduction goal to at least 57% by 2030. It also wants to increase its renewable energy goal to 45%. To reach these carbon-neutral goals faster, EU countries need to clean up their energy production and use more electricity. Specifically, they need to use more renewable energy for power generation. They also need to invest in flexible resources that do not use fossil fuels, like energy storage and demand response. This will lessen the impact of renewable energy’s changes on power system operations. Besides, they need to pass the lower power generation costs of renewable energy to electricity prices. This will encourage electricity use in transportation, heating, and manufacturing, helping to reduce carbon.

However, achieving these goals is challenging under the current power market design. As renewable energy grows, the wholesale price of electricity faces downward pressure, and negative electricity prices are not uncommon in Europe. This situation weakens the motivation to invest in renewable energy. Even though the EU’s current power market can find short-term energy prices well, it is not enough to encourage cross-border power trading and sharing of backup resources. Also, it does not recognize the value of the capacity of flexible resources enough. This leads to a lack of liquidity in the long-term market and makes it hard to hedge price risks, stabilize price fluctuations, and form stable investment signals.

So, the current reform draft focuses on improving the liquidity and reliability of the long-term market. It seeks to fully recognize the value of flexible resources that do not use fossil fuels and provide a fair return on investment. Improving the long-term efficiency and sustainability of the power market is the key direction of the reform.

3. Key Suggestions for the EU’s Power Market Reform

The European Commission (EC) has proposed a market reform to deal with concerns about short-term electricity price fluctuations. This proposal changes some EU rules to make electricity prices more independent of fossil fuel prices. It also encourages the development of non-fossil fuel flexible services and strengthens consumer protection. Specifically, the EC made the following suggestions:

1. Adjust trading times and sizes to make the short-term market more efficient.To make the short-term market work better, the EC suggests changing trading times and sizes. They believe that improving market rules can increase competition and make sure all resources are used effectively. Because renewable energy cannot be controlled, it has less chance to participate in the short-term market. To fix this, the EC suggests making the closing times of the cross-regional day-ahead market closer to real-time. This would allow more renewable energy generators to participate in the short-term market. The EC also suggests setting the minimum bid size for day-ahead and intraday markets to 100 kilowatts or less. This would give small renewable energy and storage resources more trading opportunities.
2. Improve the long-term electricity and capacity market mechanisms to release stable investment signals through the long-term market.The EC suggests several measures to encourage long-term investments. They encourage renewable energy generators to sign long-term power purchase agreements (PPAs) and government-authorized Contracts for Differences (CfDs) to reduce short-term price fluctuations. They also suggest creating a low-carbon capacity compensation mechanism to encourage investment in non-fossil fuel flexible resources. The EC hopes to set a lower carbon emission limit and increase flexibility requirements. This would ensure that only those power resources that meet low-carbon requirements can participate in the capacity market. It would also ensure that non-fossil fuel flexible resources like energy storage and demand response can provide flexibility support in the power system and get corresponding benefits.
3. The reform proposal also made suggestions to protect households and small and medium enterprises:(1) Offer fixed-price retail contracts: The proposal suggests offering fixed-price retail contracts to lower the energy costs of households and small and medium enterprises. This would allow consumers to enjoy the low-cost benefits of renewable energy and provide predictability and stability.(2) Price intervention in emergencies: The proposal suggests intervening in prices for households and small and medium enterprises in emergencies to ensure their power supply and the stable operation of the electricity market.

4. Member State Disagreements Over Power Market Reform Draft

While creating the EU electricity market reform draft, member countries had serious disagreements. Some countries like France and Spain support a major change to the electricity market. They want to disconnect electricity prices from natural gas prices. However, countries like Germany and Denmark want to make small changes to the current market to avoid disturbing its normal operation. After the reform draft was published, these disagreements continued. They mainly focused on:

1. Whether government-authorized contracts should apply to current electricity suppliers. France, a big nuclear power country, wants to use Contracts for Differences to extend the life of nuclear reactors. They see nuclear power as a key resource for energy transformation. But other countries like Germany oppose this. They worry that supporting nuclear power will reduce investment in renewable energy like wind and solar power. Smaller member countries also worry that more subsidies for France’s nuclear power industry will give France a competitive advantage.On June 30, 2023, Sweden, which was then the rotating president, proposed a compromise. Government-authorized contracts would apply only when new investments covered at least 50% of the asset value after the investment, and the facility’s life was extended by at least ten years. This proposal was not accepted.
2. The other focus of disagreement is coal power subsidies. Countries like Poland say they need more flexibility in phasing out coal power. They want to extend national subsidies for coal power to ensure energy security. These countries want to extend coal power subsidies beyond 2025. Sweden proposed a plan to allow EU countries to extend capacity subsidy mechanisms for coal-fired units under certain conditions. But countries like Germany, Luxembourg, and Spain opposed this. They believe it will hinder Europe’s decarbonization goals.

Given the need to ensure electricity supply security in each country and maintain fair competition within the EU, the EU believes that member countries need more time to discuss the power reform draft. Negotiations on nuclear and coal power subsidy schemes will continue in search of a consensus and a balance of interests.

5. Long-Term Measures and Challenges in the Power Reform Draft

The European Commission hopes to learn from recent energy crises through this reform draft and improve its ability to handle them. However, the draft mainly revises and supplements current electricity market rules. For the top-level design of the electricity market, it only provides suggestions and directions. The selection and implementation details of policy tools need to be clarified and improved.

1. The draft doesn’t offer long-term measures to alleviate high electricity prices. Even though the EU Commission and member governments have taken emergency measures to combat high prices, the draft doesn’t fundamentally solve this issue. The draft does not adopt the “revenue cap” proposed by radicals to limit the excess profits of non-marginal units during high-price periods. At the same time, it allows member states to regulate retail prices in emergencies for the protection of residents and small and medium enterprises. But it’s unclear who will bear the resulting price difference. This could lead to many electricity companies going bankrupt, like in the California electricity crisis.
2. The implementation of long-term tools in the reform draft needs further refinement. The EU Commission encourages the use of long-term electricity market tools like long-term power purchase agreements and Contracts for Differences in the draft. But it does not make specific suggestions for the choice and design of tools. Each tool has its applicable situations.For example, long-term power purchase agreements have poor liquidity, low transparency, low competition, and high entry barriers. Contracts for Differences have clear advantages like lower default risk, good liquidity, and low prices, as they are backed by the government. However, they can also cause problems like grid congestion and add to public fiscal pressure. They may squeeze out private investment.To balance the physical characteristics, economic characteristics, and market position of different types of generator units, the contract design should strike a balance between long-term stable income and short-term market participation. For instance:(1) Two-way Contracts for Differences can be used for non-dispatchable renewable energy. This will protect these energy sources from short-term price fluctuations and limit their excess profits during high-price periods.

   (2) Contracts for Differences with a sliding premium can be used for dispatchable renewable energy. This encourages these energy sources to generate electricity during peak times, improving the short-term electricity market’s efficiency and reducing overall electricity system costs.

   (3) For base load sources like nuclear and hydroelectric power, Contracts for Differences with a sliding premium can be used. The one-way sliding premium in Contracts for Differences will motivate these power sources to participate in dispatching during peak periods, maximizing their electricity income.

3. More detailed capacity mechanisms are needed for different types of flexibility resources. While the reform draft proposes a more complete capacity market mechanism, there’s no agreement yet on whether capacity subsidies should be given to coal and gas units. The focus of this debate is on balancing the safety of the electricity system and decarbonization goals. Some countries like Poland argue that coal and gas units are still important for ensuring a safe power supply. However, other countries, represented by Germany, believe that excessive subsidies for these high-carbon units contradict decarbonization goals.To balance the safety and decarbonization goals, a targeted capacity compensation mechanism can provide reasonable incentives and returns for different types of flexibility resources. For non-fossil flexibility resources like energy storage and demand response, a renewable capacity market mechanism can be used to provide capacity compensation. For older fossil flexibility resources like coal and gas units, they can be included in strategic reserves through capacity bidding. However, to reduce their carbon emissions, these units must be used only at peak times by the dispatch agency to avoid excessive use of high-carbon units.