Electricity distribution in an urban setting

Decentralised reliability options - securing European electricity markets


Ed: This article predates November 2019, when ÅF and Pöyry came together as AFRY.

Energy markets are being challenged by new uncertainties

Traditionally, new capacity was built assuming near-baseload operation. Price risk arising from commodity price movements was hedged through forward trading, long term PPAs, or vertical integration with a retail portfolio. Volume risks were low. Capacity margins in European countries are generally high, and baseload operation for new thermal plants is no longer reality. Volume risks will be far higher, and thermal plants will have to rely disproportionally on high prices at times of scarcity to recover fixed costs.

However, higher risk of brown outs and potential price spikes are often unacceptable from political and regulatory perspectives, and any resulting market intervention (real or threatened) can result in ‘missing money’. Traded markets have not adapted to deal with volume risk.

Is infrequent scarcity pricing a credible basis for investment? Do traded contracts allow both price and volume risk to be hedged?

Nationally based Capacity Remuneration Mechanisms can distort their markets

Recognising the importance of security of supply to individual states and the national inclination to implement a local solution, Capacity Remuneration Mechanisms (‘CRMs’), are now being implemented in several European countries and seriously debated in many others. However, they are nationally‑based, each is different in design, and they have no arrangements yet in place for cross-border participation.

So while energy markets are integrating, capacity markets appear to be diverging and this could undermine the Internal Market for Electricity. Uncoordinated CRMs risk distorting spot electricity prices, especially over critical peak periods, and by extension may distort cross-border electricity trading and investments as well as damaging demand side response.

Are national CRMs undermining the target of the Internal Market for Electricity?
If CRMs damp scarcity energy prices, will this lead to inefficiency?

A coordinated approach to CRMs could be highly beneficial

CRMs should not stand in the way of creating ‘smarter’ electricity markets with a more active role from the demand side. They should work with minimal distortions even at boundaries between markets with and without a CRM. A common CRM blueprint, which allows a wide degree of freedom for changing design parameters to meet national needs, without causing distortions between markets, and requiring any country to adopt a CRM, could be beneficial.

Reliability options can be a solution

Reliability options are a hybrid between a physical commitment and a commercial option. The physical commitment delivers security of supply and creates a supplementary revenue stream to deliver missing money, in the same way as other market-wide CRMs. The commercial option has an important impact: it should protect customers from scarcity prices in the spot markets while allowing capacity providers to hedge price volatility. This means reliability options can reduce ‘missing money’ both directly and indirectly. Protecting consumers against price spikes through an option contract means regulators can remove underlying price distortions to reveal price volatility, which unlocks the potential for demand-side management, interconnection and flexible capacity.

Why operate on a decentralised basis?

A central agency for each country may tend to procure too much capacity at the expense of customers. So while security of supply is more assured, the process is likely to prove less efficient. Efficiency gains would be realised from a more decentralised approach in which the timing and the terms of procurement are determined by the market participants. Central procurement of simple, standardised products means a common route to market for all and should naturally promote greater liquidity. A decentralised approach may raise concerns about liquidity, but it has other attractions. The principal advantage of decentralised reliability options is that they can be struck against different markets and with different contract terms. This freedom allows for the value of different types of capacity to be revealed, with the market revealing the premium for flexibility, without undermining the trading of energy over different timeframes. Overall, decentralised reliability options are more in line with the philosophical basis for most European electricity markets, which value bilateral trading and place responsibilities on market participants rather than central agencies.

Way forward

Pöyry has outlined a credible design for a CRM.  Decentralised reliability options could provide the required adaptability to meet national needs, without threatening the Internal Market for Electricity. Such a concept follows EC guidance and has the potential to limit future regulatory and policy risk. It would be consistent with a more active role for market participants and customers in delivering the required level of security. These ideas could be further considered and developed to support the efforts for a single European electricity market. Pöyry intends to continue discussing, developing and disseminating these concepts to inform and influence discussions on CRMs and the future of the European electricity markets, and we seek the support of a range of stakeholders to continue the work.

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Stephen Woodhouse - Director, AFRY Management Consulting

Stephen Woodhouse

Director, AFRY Management Consulting

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