Overhauling Europe's energy system

Europe’s energy markets are stressed as never before. Prices are high and volatile, and EU citizens are calling for huge interventions.

The roots of this problem remain contentious. One point of view is that the markets are working correctly: that high prices are the result of physical constraints in gas supply and infrastructure, and are sending the right price signal to reduce demand and boost investment. However, with citizens falling into energy poverty and EU industries mothballing or even closing facilities (for example, until a slight dip in prices, ammonia production was operating at just 30% capacity), there is a huge political push to add stability and moderation to energy markets.

Delivering a future-proof design

In the context of extreme market conditions, an overhaul is tempting. One radical proposal posited by the European Commission would split Europe’s electricity markets in two. One ‘market’ would exist for renewables, with contracts for difference (CfD) guaranteeing revenues over a period of years (M-RES), and another more conventional market would exist for thermal generation to fill the gaps in variable energy sources such as wind and solar (M-FLEX).

Other policy options are also no doubt under consideration, which may alter the landscape even more radically. However, history is clear that caution is a virtue in the world of energy policymaking, and any market changes must be clearly and calmly thought through.

Adapting to a new reality

First, we must take a step back and set clear objectives. In June 2022, Ursula von der Leyen, president of the European Commission, surprised many (including others in the Commission) when she told the European Parliament that the marginal pricing model, which structures current markets, must end. However, such an action must be viewed only as a tool to achieve an objective – not an end in and of itself.

This may seem self-evident, but consider the multiple priorities facing policymakers today, some of which overlap and some of which compete. They must lower prices for consumers, lower prices for industries, reduce overall market volatility, maximise the deployment of renewables, increase Europe’s energy security, deliver energy efficiency, generate capital investment, innovate in new solutions such as flexibility, significantly strengthen interconnections and the single electricity market, and deliver all of this (plus much more) quickly. The marginal pricing model is a big factor in these conversations; however, it touches on each of them differently and is not the silver bullet for all.

If the European Commission is serious about overhauling Europe’s markets, it must abide by the regular policy process where options can be assessed against a clear set of objectives

Will a split market work?

As an example, let us consider the two-market approach against these objectives. If M-RES collects all fixed-price generation it could lower prices for consumers. However, it could also hollow out the market for power-purchase agreements, undermining a key pillar of many corporate energy and decarbonisation strategies. M-FLEX may lead to an efficient market that balances the needs of M-RES, but integrating new technologies such as energy storage may require policy and financial supports here, too, altering the purely economic approach envisioned.

On market integration, discussions about the application of a gas price cap at the European level have demonstrated the enormous challenges of finding a cohesive approach in a fragmented landscape; applying the two-market model would require a deeper level of cooperation and integration than governments have, to date, shown support for.

Investment is another area in which priorities compete. Right now, investment is not a challenge in the renewable space – bottlenecks exist primarily in the form of grid connection and permitting. Nonetheless, with higher costs of borrowing emerging from the macro-economic situation, the de-risking involved in moving for CfD could ease capital flows. At the same time, the value of the CfD itself, especially versus the market cost, will inevitably mean lower aggregate revenues for renewable technologies (if not, why are we doing it?). This may mean less profit for rich companies, or less investment in critical low-carbon generation. Without a solid evidence base and a credible consultation process, it is simply impossible to predict these impacts.

Reforms cannot be rushed

If the European Commission is serious about overhauling Europe’s markets, it must abide by the regular policy process in which options can be assessed against a clear set of objectives. This is likely to be slow, and indeed painful, but the market design set today will last for decades.

Furthermore, it is crucial that stakeholders, experts, regulators and the actors tasked with implementing this new system are given time to submit considered feedback. An extra year of process could mean a design that shaves multiple years off our three-decade decarbonisation trajectory – what is critical is to get it right, even if the political pressure is immense right now.

By Cillian Totterdell, Climate and Energy Policy Lead, FleishmanHillard

Image credit | Getty