Source: EURACTIV

However, the focus on long-term contracts risks locking some EU countries into costly deals that will make the green transition more expensive, he warns in an interview.

Georg Zachmann is a senior fellow at the Bruegel economic policy think-tank, focusing on energy and climate policy. 

INTERVIEW HIGHLIGHTS:

• The focus on long-term contracts is the main novelty of the European Commission’s proposed reform of EU electricity market rules, presented on 14 march
• However, the proposal risks deepening inequalities, as some EU countries have less credibility on financial markets and will find it more difficult to secure long-term contracts with investors
• Governments in these countries could come under pressure to commit to very high electricity prices for the next 20 years
• Another issue is that long-term instruments do not ensure coordination of cross-border investments, leading to sub-optimal allocation of energy assets at the European level
• The proliferation of national remuneration schemes also lacks a European dimension to ensure decisions in one country do not negatively affect others
• For consumers, the renewed focus on fixed-price contracts may have unintended consequences by prompting greater concentration among energy retailers, which could push prices up

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Who are the winners and losers of the EU’s electricity market reform, presented by the European Commission on 14 March?

Consumer protection was the dominant narrative pushed forward by the European Commission.

But the big news for me is Article 19 of the directive, which talks about investment instruments and long-term contracts, for which no direct European framework existed before.

In the past, the hope was to unify the EU’s internal market with electricity-only markets. Now, the Commission essentially formalises that member states can support the technologies of their liking with long-term contracts that are backed by the state – be them Contracts for Difference (CfDs), Power Purchase Agreements (PPAs) with state guarantees, or forward contracts that energy market operators might now be obliged to buy and sell.

Did this come as a recognition that short-term markets were too volatile and did not deliver the investments needed for the green transition, which requires long-term price signals?

That is fair to say, yes. The Commission’s analysis is that we didn’t develop the long-term markets that were meant to protect consumers and secure investments. And therefore, the Commission realised it had to do something.

Now, on a national level we had a lot of instruments such as capacity mechanisms or support schemes for renewable energies. In Germany, there are network and capacity reserves, which are pseudo capacity mechanisms. And in France, the ARENH regulates the price EDF obtained for much of its nuclear electricity output.

So member states already did have a wide array of idiosyncratic long-term contracts. And the ideal in the past was to get rid of that through the European short-term markets on which specific financial instruments would be built, in order to deliver investments for the long-term.

Now, the desire of member states to do this themselves essentially prevailed. And the Commission has acknowledged this. So that is for me the paradigm shift – the door is opened for ultimately handing the responsibility for delivering long-term investment signals to the member states.

Do you think this focus on long-term contracts will eventually reduce the volatility in electricity prices?

This will depend on the details of how it’s going to be implemented. The Commission has made those tools available and every member state can play with them.

But it also made clear that those long-term contracts – CfDs and state guarantees for PPAs – will need to be vetted by the Commission’s competition authority.

You have argued that the Commission’s proposed reform is a quick fix that does not really address the underlying issues with the EU electricity market. Can you explain why? And when will a new reform be needed in your view?

The big issue is getting substantially higher investments into electricity supply. My big worry is that some EU countries will find it more difficult than others to roll-out those state-backed contracts, because they have less credibility on financial markets.

We might for example see issues with subscription to those contracts in some countries, where investors will doubt the ability of the state to provide financial guarantees over a 20-year period.

Those governments could therefore come under pressure from investors to sign long-term contracts where they commit to very high electricity prices for the next 20 years. Eventually, governments may find this unaffordable, meaning investments risk not being made at all.

Now, if the transition gets expensive, if we lock in investments at high prices, we will have to live with this problem for decades to come.

Do you see other potential issues with long-term contracts?

Another issue is that long-term instruments do not necessarily deliver the products we need to decarbonise the electricity system on a European level.

In a decarbonised electricity system, power prices will be very low for 70-80% of the year because renewables will run at full speed. And the remaining 30% of the of the time, you will have rather high prices because you need to curtail demand or run your hydrogen plants.

However, too simplistic long-term contracts only remunerate the production of bulk electricity – the amounts of kilowatt-hours being produced. Then investments are going first to wind capacity in some scarcely populated windy regions, or in sunny regions where a maximum of kilowatt-hours can be produced at lowest cost.

But this may not be suitable to cover electricity demand when and where it is most needed. This is why more cooperation between member states is needed – to ensure coordination within the power system.

That in the past has been delivered by the short-term markets, at least to some degree. If you now take away this coordination function away from short-term markets, it means you will have to do it elsewhere. And for the moment, it’s not clear who or what is going to fulfil that essential role.

This is why I believe another reform will be needed at some point: to ensure cross-border coordination of power system investment.

Cross-border cooperation was already an issue when the last power market reform took place in 2018: interconnectors were being utilised at around 30% of their capacity because transmission system operators essentially do not really trust each other… Has this changed?

With the energy crisis, EU countries have realised the value of cross-border cooperation. France, for instance, was essentially supplied by the rest of Europe last year when its nuclear reactors experienced widespread failures, whereas it was a net exporter of electricity the years before.

The Commission didn’t acknowledge the French situation in its electricity market reform and only referred to the Russian aggression against Ukraine, which I find interesting in terms of narrative.

More broadly, getting the right co-dimensioning between infrastructure and generation across 27 countries is like five-dimensional chess – there are many parameters to consider.

To manage this complexity, I believe the EU needs some sort of European electricity system modelling – something that is done by an independent EU agency, not the national Transmission System Operators (TSOs) like it is done now. This would allow checking what the member states are proposing and have some sort of benchmark to understand whether we are on the right track or not.

And currently, we don’t have that. The US has a public energy data and modelling agency, the Energy Information Administration, and I think Europe should have one too. At the moment, we are more and more outsourcing energy analytics to the International Energy Agency (IEA), which is doing a great job. But a sovereign Europe might at some point want to rely on an EU institution in such a strategic policy area.

Doing this would require a federalist leap forward, giving away more national powers to the European level, no?

Implicitly, it would be a push for a more coordinated approach. But constitutionally, it would not require changes to the way competences are shared between the EU and the member states – I don’t think it would require changing Article 194 of the EU treaty, for example.

And some of the provisions are in fact already there – the Commission is empowered to check the National Energy and Climate Plans put forward by the member states, for example. The Agency for the Cooperation of Energy Regulators (ACER) is also empowered to check what the TSOs are proposing.

The only problem is that they don’t have the tools to conduct those checks. And so, we should give them the tools, it would be a relatively soft and low-cost approach to get to a more consistent system.

Doing this will make it more explicit that there is an EU aspect to energy infrastructure planning. But I think we need to make those things explicit and discuss them.

If the result of the discussion is that we allow the French to build an electricity system relying on nuclear for 80% or 90%, then so be it. But at least we should understand what it means for the neighbouring electricity systems that are connected with France and how we can ensure a low-cost and efficient system complementing national policy choices.

The European Commission placed a lot of emphasis on consumer rights in its proposal, with more options to choose fixed price contracts for electricity and a new right for consumers to share self-generated electricity. Do you think this is a step in the right direction?

It sounds good in principle but there might be unintended consequences.

For instance, if EU regulators force retailers to offer fixed price contracts to consumers or forces them to formally hedge their portfolios, will it make electricity cheaper or more expensive?

Not all retailers will be able to do that. So it will force them to become bigger to be able to hedge their positions. With fewer, bigger players, will consumers benefit? Or will that lead to a situation where energy retailers become more systemic? It’s not clear at this stage.

My fear is that retailers will find it difficult to hedge against the variability of renewable power generation. Because currently there are no liquid hedging-products out there guaranteeing that consumers will get electricity even in the hours when the wind is not blowing or the sun is not shining.

And that’s the kind of product consumers would need in a system where renewables become the dominant form of electricity. Because, as a retailer, it’s easy to buy a PPA from large wind and solar developers. But when they are not producing, all your customers with solar panels on their roof are calling for a lot electricity because they are not producing themselves. And during those hours, electricity is going to be super expensive.

This is a double problem and the corresponding hedging products still need to be developed to ensure consumers get electricity at all times. This is a gap that needs to be filled, either by regulators or the market. But it’s clear to me that such products will be needed.

About consumers’ right to share energy, do you believe this will help lower prices?

The right to share energy is a good idea in principle but it also raises new issues.

If the two of us share electricity because you have a solar panel and I have a battery, that allows us to buy less electricity from the grid. And potentially, that could mean that we stop paying for grid services.

But in case the solar panel does not produce for some weeks – in winter for example – we will have to draw electricity from the grid instead. And then somebody else that doesn’t have solar panels will have to pay grid services for us during the rest of the year.

So we need to be careful with these energy sharing services, to make sure they don’t have negative distributional consequences for people who are unable to afford a solar panel or a battery.

One of the objectives of the reform was to introduce more ‘flexibility’ in the market by requesting EU countries to define national objectives for demand-side response and storage. What are your views on this?

There is no doubt that the electricity system needs more flexibility – be it demand-response, storage, grids or more flexible generation units.

What’s not clear in the Commission proposal is how to prioritise these options and ensure the cheapest are selected in an optimal way. Member states are essentially asked to tick boxes and install certain amounts of flexibility assets in a very simplistic way that is not optimised as a portfolio of systems.

And my take is that this can be substantially more expensive. Now, I cannot prove it because I haven’t modelled it myself. But I think the Commission should model it, actually.

This is linked to the broader question of remunerating those flexibility services, whatever they may be. Has this been addressed?

There are different types of remunerations schemes – the wholesale market, capacity mechanisms, flexibility mechanisms, etc. Then you might have Contracts for Difference (CfDs) and guarantees for PPAs which come on top of this.

This means power plants sometimes get three to five different cash flows, which they optimise internally. But does this lead to an optimal power plant park at European level? If every member state does it differently and cross-border trade is free, that makes the whole electricity system extremely complex.

And at the moment, there is no consistent picture at European level of how the electricity system should look like.

Do you think more harmonisation is needed on national remuneration schemes?

Not necessarily. Regulators could leave remuneration schemes largely up to EU member states knowing that, in the end, there is some sort of kind of catch-all European instrument that acts like a like a rubber band and pulls it all together.

What’s missing is a European mechanism to ensure that remuneration schemes decided at national level do not create problems elsewhere. And that question is left unaddressed in the Commission’s proposal.

One of the novelties in the Commission proposal is a new ability for TSOs to introduce ‘peak-shaving’ products on the market to decrease electricity consumption at peak hours. Do you think this is a good idea?

Variable electricity tariffs are already commonplace, for example to incentivise night-time consumption.

The challenge is when these pricing mechanisms overlap with existing ones. In normal conditions, the electricity-only market should provide extremely high prices in times of scarcity, which is supposed to incentivise peak shaving.

Now, if you introduce special peak-shaving products, you might end up depressing the wholesale market substantially, thereby reducing incentives to build those flexibility resources.

In the end, the wholesale market might be more efficient at providing those services. So, the added-value of creating a new peak-shaving product needs to be clarified. Why create something new when the wholesale market already does it?

A key aspect of the Commission’s reform proposal is to encourage long-term contracts like Power Purchase Agreements (PPAs) and Contracts for Difference (CfDs). Do you believe this is something that will reduce price volatility?

Short-term price volatility is a good thing because price spikes send a signal to market players that they should consume less or produce more.

What we don’t want is this short-term volatility to be reflected in household energy bills. And here, fixed-price contracts for the bulk of household consumption are a step in that direction.

Now, long-term contracts between generators and large buyers of electricity might help lowering prices if they lead to more investment in new generation capacity. So, in that sense, they could make a positive contribution.

Two-way CfDs are now becoming the norm whenever state support is involved. Does that mean the end of Germany’s feed-in tariff for renewables? And the end of the regulated price of historical nuclear power in France, the ARENH?

I don’t believe this would be a big thing in Germany. The country has a floating premium system, which is pretty similar to a CfD.

In France, the ARENH – which establishes a selling price for legacy nuclear output – is supposed to run out in 2025. And the CfDs could fulfil a similar function, so I don’t see this as a big issue either.

My sense is that politics will prevail anyway. Nobody in Brussels will be crazy enough to tell the French they cannot repair their nuclear power plants.

One open question with the CfDs is how the money potentially collected from energy suppliers will be used. The Commission said the surplus money will need to be “channelled back to all consumers equally according to their consumption” but they did not say more than that. What are the options for redistributing that money?

My main concern about CfDs is not how to use the surplus money. My worry is that the CfDs that we sign now risk looking extremely expensive a few years down the road when renewables start cannibalising themselves by lowering electricity prices in the hours when they are producing. I wonder what people will say in 2030 about this.

Regarding the surplus money collected from CfDs, the big question is whether it should be targeted at specific consumer groups. Every member state has their has their own preferences – Germany for instance wants to introduce a special industrial power tariff, others might want to support vulnerable households, etc.

My understanding of the Commission proposal is that the money will have to be redistributed back to consumers in proportion to their consumption. So if the price of electricity is €0.5 per kilowatt hour and the contract is €0.7/kWh, then €20 goes to everybody per megawatt hour.

In a country like France, could a public company like EDF use this money to finance further investments into nuclear or renewables?

This is a question for lawyers, I believe.

What is the least known aspect of this reform that has been overlooked by commentators and deserves more attention?

When I spoke to industry, some were concerned about the creation of regional hubs for forward markets. The good element is that this encourages cross-border trading for example by allowing a French energy retailer to hedge its portfolio by buying transmission rights for solar power coming from Spain three years in advance.

And as electricity will become the main form of energy in Europe, a liquid asset representing “European electricity” might serve hedging needs at a more macro-economic level. But some in the industry seem not too happy with this Commission proposal, saying it is impeded by physical constraints.

Are these the regional trading hubs that the Commission always wanted to create and would this be a step towards a more Europeanised electricity system like the one you have called for?

The direction looks very good. But, as always, the devil is in the detail. Last year for instance, Uniper lost a lot of money because they hedged their German products with Nordic electricity that they weren’t able to bring over because of congestion. So, these topics need to be dealt with.

Do you believe there is a chance that this reform can be concluded before the winter of 2023-2024, as the Commission wants?

The proposal did not trigger a huge outcry from member states, which is a sign that things could be concluded rapidly.

Countries like France and Spain, which had initially called for a decoupling of gas prices from electricity spot prices did not complain. And Nordic countries are not unhappy either because the reform doesn’t go too far.

So, it seems the Commission managed to hit a political sweet spot by essentially allowing more nationalisation of electricity markets.

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