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Europe’s power market: acceptable energy costs and long term security of supply needs today’s rules reshaped

This opinion editorial was co-authored by Artur Świętanowski, Head of Risk Management Bureau at PSE and Maciej Jakubik, advisor at PSE and former director of Central Europe Energy Partners (CEEP).

This opinion editorial first appeared on energypost.eu and was reprinted with permission from the authors.

In the past months, unusual turbulence in the electricity and gas markets in Europe could be observed, particularly the price spike for electricity, gas and coal. This was due to a combination of several factors, such as the quick recovery of the economies after COVID, a cold and long winter, weak winds this autumn, Asia increasing demand, or Gazprom taking advantage of its dominant position on the European natural gas market. We can multiply similar excuses but none of them gets us closer to the point. Europe’s current exposure and vulnerability to such risks should be blamed mainly on the electricity market design, which does not support energy security in any dimension of this notion.

The International Energy Agency defines energy security as the uninterrupted availability of energy sources at an affordable price. In turn, the US Department of Energy identifies the energy sector resilience as the ability to anticipate, prepare for, and adapt to changing conditions and recover rapidly from disruptions. Taking into account the current situation in the energy markets, can we say that we are equally secure and resilient? Is the energy mix based on renewable energy sources (RES) in one third or half of the generation resilient, when a weather forecast for a period longer than several days is still a computational problem too big to be solved in an economical way? Is a market with no incentives for the provision of services essential for a transmission system operator to manage the grid within safe margins compatible with our needs for resilience? And is this really a surprise that natural gas consumption in the EU rises during the winter and adequate gas storage needs to be secured months in advance?

The spike in the prices has demonstrated two issues. Firstly, a competitive electricity market is not free of the risk of contagion, as the price spike is transferred from the natural gas market into the electric power market. Secondly, the more gas-fired plants within the system, the more dependency on import price fluctuations.

Should we continue on this path towards sustainable energy, via coal-gas switching, and become even more dependent? What should be the share of a particular electricity generation method to achieve overall energy supply security? Global commodity markets have their own rules of play and they ship to the regions which pay the highest price and have better contractual terms. Europe is not always the front runner.

We trust too much in the neoclassical economists’ beliefs and practice their idealisation of marginal prices, diminishing returns, as well as sloping demand and supply curves. One of the main problems with the energy crunch starts just here – in a strong belief in the truthfulness of our academic textbooks on microeconomics and industrial organisation. We even do not dare to think that there can be a failure in market design, caused by an erroneous choice of the very theoretical foundations of the regulations governing the market.

For instance, a merit order curve, which creates a hierarchy of generators’ bids according to the increasing “marginal cost” of generation, necessarily assumes the prevalence of the law of diminishing returns, for example, it assumes that the efficiency of any individual generation unit’s decreases in the function of its output (megawatt-hours injected into the grid). The problem with such an assumption is its incompatibility with Carnot’s and Rankine’s thermal efficiency equations, and the theory, as well as the design practice of thermal engines. The efficiency of any steam or gas-fired turbine increases in the function of the output, and therefore, an individual curve of marginal cost should have a negative slope. This applies directly to all power plants that rely on the transformation of thermal energy into electricity or motion (natural gas, coal, oil, nuclear fission, geothermal, solar thermal). That is why engineers want to build them big and operate them at the highest power capacity as much of the time as possible – there are technical (not megalomaniac) reasons for that.

The key problem with the merit order is comparing the energy production marginal costs of renewable and thermal units. It reflects a lack of understanding of their role in the system, as they provide completely different, and to some extent complementary (rather than substituting), commodities. The big thermal units are capable of providing inertia and frequency containment reserves (for example, an ability to react momentarily on system frequency deviations), as well as a valuable ability to balance the grid in the case of low wind and low solar irradiation. Renewable generators require and consume those essential services but generally cannot provide them.

There are a lot of comments stating that, since gas was identified as the culprit of price spikes, we should invest yet more in renewables, energy storage (such as batteries) and demand-side response (DSR).

More renewables mean fewer hours left for thermal capacities and thus less economic incentives to make them stay online. More storage means more opportunistic market players, who do not bear any variable costs related to generation but rather focus on an opportunity cost. Hence, under the current market design, there is a high risk that increased penetration of battery storage will put us into yet bigger fluctuations of energy market prices.

Others claim that the issue might be solved by DSR. But it is just a last resort solution to restore the grid balances by a transmission system operator. That is why, entities (not excluding households) that are ready to constrain their demand for electricity, ask for very high compensation for their services. The cost of DSR should oscillate near the value of the lost load, which is a considerably high amount of money. This brings us to a prospect of a Russian roulette economy, where the prices are usually near-zero thanks to renewables participation, with occasional spikes, exceeding those we have experienced this autumn by as much as one hundred times.

From the system operation point of view, there is a need for a reliable, long term base supply that will provide sufficient energy to the system, regardless of any external fluctuations at the global commodities markets or weather surprises. But how can a single commodity market provide thermal generators with incentives to even operate? After all, it forces thermal units to compete with renewables, without any resemblance of a level playing field (they compete only with the cost of producing an additional megawatt-hour, which in the case of renewables is near zero). Should they just rely on repeatable price spikes and deem their return on investment in generation dependent on such random occurrences? An electricity market designed to operate as a high stakes casino has very little in common with resilience.

Some may insist that a magical pill of scarcity pricing could heal European energy markets and incentivise investments. But when a spike occurs, one could expect strong opposition from the governments and insolvency of numerous suppliers. Instead, it proves that an energy-only market is not the best option for the sustainable development of the European economy. It does not provide sufficient investment signals, nor does it ensure the security of supply.

Considering all of the above observations, is the current design of electricity markets in Europe appropriate for a future with a growing share of renewables and a rapidly decreasing share of dispatchable generation? Do we still really believe the energy-only market delivers sufficient guarantee for system stability and security of supply?
The existing shape of the European electricity markets may have been good enough to respond to yesterday’s needs but is far from sufficient for the sustainable energy future.

Now, it just complicates the daily operation of energy businesses, including system operators. It also merely increases the costs for the consumers. Since the costs of the whole value chain are paid by electricity end-users, they also bear the costs of bringing order books and ledgers produced daily by power exchanges in line with the capabilities of the grid. According to current regulations, electricity purchase and sale transactions are carried out by market participants regardless of most network constraints. The costs of making the impossible (or unsafe) transactions possible by remedial actions such as redispatching, curtailment and counter trading, run in hundreds of millions of euros per year and are constantly increasing. TSOs have much more burden and are exposed to constant operation on the margins of power system safety and reliability.

If Europe wants to succeed with the energy transition, further develop renewables, while keeping the system secure and resilient, it should move towards a more location-aware (or network-aware) pricing system. A power system dominated by zero-marginal cost generators will be fundamentally different from the existing one, so another market model needs to be adopted.

Under current conditions, it is already difficult to provide long term generation investment signals to prepare relevant grid infrastructure and mitigate congestion. A more location-aware market design would allow a much better grid utilisation without going beyond the boundaries of secure operation. It would save the European consumers’ money spent now on building more grids, which wouldn’t be used in an energy system where distributed supply and demand locations are coordinated via market mechanisms.

Therefore, it is necessary to introduce long term solutions which would ensure both reliability and adequacy. A multi-commodity market better fits today’s requirements. Capital intensity is yet another difference between renewables and thermal generation. The capital expenditure required for the latter is incomparably higher than this claimed by the former. Therefore, a proper toolbox would include a set of incentives and instruments that are needed to create more stable conditions for investing in new nuclear and thermal generation resources, and thereby to ensure long term security of electricity supply. Capacity markets are market-based and cost-effective solutions that can deliver sustainable development of the European power system.

In the Fit for 55 package, the European Commission proposed a rapid growth of RES in this decade, amounting to up to 60-65 per cent in electricity generation by 2030. But whatever is necessary for the climate will create serious operational concerns for the management of energy systems. There is a limit of RES share beyond which it does not bring additional value (measured for instance as a marginal decrease in CO2 emissions) but continues to require both operating costs and capital for asset maintenance. We can, of course, continue to daydream about the fantastic future of hydrogen, the great role of large scale battery systems, or flexible markets. But none of those dreams is guaranteed to go online by the end of this decade on the massive scale required. We must plan for continuous functioning of the system, based as long as necessary on those technologies that exist and provide energy. We must have reliable electricity to even execute the transition. Vague promises to deliver energy will not suffice. Consequently, it seems that conventional plants will continue to be needed for quite some time if we want to avoid outages, power shortages, blackouts and generally want to keep the lights on.

In the past, energy security was mainly subject to risks related to the supply of fossil fuels and their price fluctuations. Today, we see that it goes much beyond that definition: weather conditions, critical raw materials availability, cybersecurity, physical attacks, geopolitical dependencies of supply chains and so on. Apart from fossil fuel supply uncertainty, we must also tackle new challenges and threats.
However, we will not solve them with yesterday’s tools and models based on empirically disproven academic theories sourced in the neoclassical economy. Reshaping the market rules towards a future-proof power system and securing stable generation is a must for the success of the energy transition in Europe.

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