The current marginal price system for electricity is no longer working when switching from predominantly fossil generation to predominantly renewable generation and will likely lead to price crashes, writes Mike Parr. Unfortunately, the expected move to Contracts for Difference (CfDs) will only make the situation worse, he argues.
Mike Parr is Director of PWR, a UK-based company providing market research and technical support in the renewable energy and energy efficiency sectors.
The current course of the EU electricity market reform (EMR) is to maintain the marginal pricing system that defines wholesale electricity prices, while mandating a mix of contracts for differences (CFDs) and power purchase agreements (PPAs) for all new renewable projects.
However, concerns have been raised about the medium and longer term consequences of this route. In addition, member states such as France, which are dissatisfied with the slow progress of the EMR, are threatening to go it alone with market reform.
Member States and CFDs
Some EU member states see CfDs as a source of income. They expect CfD prices to be largely lower than wholesale electricity prices, allowing them to pocket the difference between the wholesale price and the CfD price paid for renewable projects.
The rating agency Standard and Poor (S&P) and the European Commission are rather skeptical that CfDs will bring income to EU member states. In summary, As renewables financed by CfDs increase, this will in turn become one increase when wholesale prices collapse.
The Commission knows that more renewable energy will lead to further falls in market prices. In his view, far from Member States earning revenue from CfDs, electricity consumers will pay more for such price drops. Consumers therefore pay twice – first for the kilowatt-hours they use (usually fixed in the price), and then a second time to cover the difference between the zero or negative wholesale market price and the CfD price charged for a particular renewable project is promised.
An alternative to this situation is for electricity retailers to use “smart meters” to provide customers with real-time prices that reflect the wholesale price at which retailers purchase electricity.
However, the prospect of this happening in the next 5 to 10 years seems slim.
Limit price: The best before date has been exceeded
The core problem is maintaining a marginal pricing system while switching electricity generation from predominantly fossil fuels to predominantly renewables.
Marginal pricing is well suited to fossil fuel systems whose fuel costs are directly linked to the price of the electricity produced. In contrast, renewable energies have no direct cost entries; wind or solar do not represent an invoice.
Instead, renewable energy has an upfront capital cost that defines the fixed cost of a megawatt-hour from a given renewable project over the next 15 or 20 years. Marginal prices work and cannot work with renewable energy. The price turbulence in wholesale markets directly caused by renewable energy proves this.
Paris vs. Berlin: Bald men fighting over combs?
The dispute between France and Germany continues Electricity market reform has attracted the most public attention so far. While Paris wants to use CfDs to finance the life extension of its existing nuclear power plants, Berlin rejects this on the grounds that this would amount to an unfair subsidy.
Without an agreement, France threatens to go it alone. But tThe reality is that France is already going it alone in setting its wholesale price for electricity.
European electricity markets are heterogeneous in terms of the way wholesale electricity prices are formed across Member States. In France, the wholesale electricity markets are dominated by nuclear energy. The majority of it is sold in advance on futures markets. The French regulator estimates that the day-ahead market (which uses limit prices) represents only about 4% of the market volume and thus has a modest impact on real wholesale prices.
Next door in Spain, the day-ahead market accounts for 75% of electricity sold by volume and therefore Spanish day-ahead prices provide a very good overview of actual wholesale prices.
Germany is now somewhere between France and Spain.
PPAs, electricity supply agreements between a power producer and end consumers, promise to provide electricity at a fixed price over a set period of time, usually several years.
According to the Euractiv article, France could opt for a massive expansion of PPAs. However, reports from French regulators on French electricity markets show that electricity purchases on French wholesale markets are predominantly made through futures contracts, extending over months to years.
France therefore appears to already be using some kind of PPA. Given that France already uses a PPA-like instrument for most wholesale market contracts, the question arises: what does “massively expand” mean in this context?
The dispute between France and Germany may be to achieve more with two fundamentally different (and perhaps incompatible) approaches to wholesale electricity pricing.
Where does this lead us?
The marginal pricing system worked well until renewable energy came onto the market in market-disruptive quantities after 2015. Sticking to a limit pricing system that results in massive price crashes and price increases works very well for electricity traders who make money off volatility.
However, this is not in the interests of renewable project developers, EU member states or EU citizens.
The question to be answered regarding market reform is: will it be implemented promptly to support a renewable future in the EU and to provide EU citizens with electricity that truly reflects the cost of production? Or will the EU stick with a marginal pricing system that primarily benefits market traders and hinders the development of renewable energy, causing headaches and disappointments for member states?