EU power market reform should improve resilience and drive renewable energy investments

Ahead of the European Commission’s proposal for a reform of the EU’s wholesale electricity market, climate and energy think tank Agora Energiewende outlines recommendations for measures that strengthen the market’s resilience and drive renewable energy investments.

Frauke Thies, Executive Director at Agora Energiewende said:

“We need a short-term reform to avoid the kind of electricity price hikes that we saw in 2022. But the decisions taken today need to be consistent with Europe’s transition to a decarbonised power system. It is important to focus on measures that are quick to adopt but that bring structural benefits by boosting renewable energy and energy efficiency investments.”

The think tank proposes that the short-term reform focuses on establishing voluntary two-sided contracts for difference (CfD) as the standard approach in government policy and on strengthening the environment for power purchase agreements (PPAs). In acute crisis situations, the EU should apply a coordinated approach to skimming-off of windfall profits. The above elements combined could ensure that consumers are shielded in a targeted manner from power price shocks due to high fossil fuel prices, while also preserving a well-functioning wholesale electricity market.

Scaling up renewables as a structural response to the crisis

CfDs and PPAs ensure predictable revenue streams for renewable energy investors and stabilise prices for consumers. They can significantly accelerate the deployment of renewable energy capacity which is crucial for reducing Europe’s dependence on fossil fuel imports and keeping it on track for climate neutrality by 2050. To achieve its climate targets, the EU needs to triple the annual onshore wind deployment and quadruple annual offshore wind and solar PV deployment by 2030.

“To scale renewable investments quickly, it is paramount that investors can decide on a voluntary basis, whether they prefer to use government-backed CfDs or to develop merchant-based renewables projects, for example through power purchase agreements,” said Frauke Thies.

Preserving a well-functioning European electricity market

In an increasingly renewables-based power system, marginal pricing on wholesale markets is key to enable efficient real-time coordination between production and consump­tion. It encourages cost-optimal dispatch, because market participants have an incentive to offer electricity based on their short-term marginal production costs. Furthermore, cross-border market integration helps to mitigate the effects of variability in wind and solar feed-in, as Europe’s diverse weather regimes smoothen out fluctuations in electricity generation.

Frauke Thies:

“Marginal pricing on wholesale markets must be kept in place as it is central for a well-functioning renewables-based power system. It ensures efficient use of electricity, balances supply through cross-border trade and enables demand-side flexibility and storage.”

A harmonised approach to windfall profits

In autumn 2022, EU governments took emergency measures to cap revenues of electricity producers and to re-distribute them to vulnerable households and companies, particularly hard hit by excessive electricity bills.

However, the cap has been applied differently in member states which brings uncertainty to the market and can therefore scare off renewable energy investors.

While the inframarginal revenue cap is not included in the latest draft of the Commission’s proposal, Agora Energiewende recommends a harmonised approach to maintain investment certainty if similar measures are adopted in potential future crisis situations.

An outlook on a deeper power market reform

Europe’s fully decarbonised power system will be much more decentralised and rely on renewables, flexibility, and an active demand side. To accommodate that, in addition to short-term crisis measures, the current market framework will need to be reformed more comprehensively.

This includes measures to improve locational signals in power markets as more granular pricing brings market and system operation closer together, increasing operational security. Also, the Commission should review bidding provisions of power plant operators. In an increasingly renewables-dominated power system, they might need to be adjusted from portfolio-based to location-specific bids.  Furthermore, any capacity mechanisms need to support deep decarbonisation and enhance power system flexibility. As the EU will need to double the overall transmission capacities of electricity interconnectors by 2050, an independent body should be set up to lead a holistic infrastructure planning and to steer the necessary investments.

The Commission should therefore initiate a well-prepared debate on the necessary medium-term adjustments to the power market rules during the legislative period that starts in 2024.

The policy brief "How Europe can make its power market more resilient - Recommendations for a short-term reform" is complemented by a report by Guidehouse on the fundamental elements of the EU’s power system and the EU power market design, commissioned by Agora Energiewende.

The 17-page policy brief and the Guidehouse report are available for free download below.