State of play of capacity markets in Europe Eurelectric Conference 'Capacity markets - delivering security of supply in the IEM' 04 March 2015

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1 State of play of capacity markets in Europe Eurelectric Conference 'Capacity markets - delivering security of supply in the IEM' 04 March 2015

2 Overview What is the problem? What are the options? Who does what? What issues for the IEM? What does the EC think? 2 Frontier Economics

3 What is the problem? What are the options? Who does what? What issues for the IEM? What does the EC think? 3 Frontier Economics

4 We first need to identify the problem Focus of CRM debate Evolving market environment Political intervention EOM (design) failure Potential reasons For example: Economic crisis = low demand For example: Massive renewable support For example: Externalities/SoS as nonexclusive good? Prohibitive price risks? Missing money by regulation? Symptoms / Implications Power plants currently not profitable Generation capacity insufficient in the long-term Design options No actions needed Stranded cost compensation? Amendment of the EOM design Introduction of a CRM? to find the appropriate remedy 4 Frontier Economics

5 % des Base Today s energy-only market (EOM) already provides a capacity price element Why does today s EOM contain capacity elements? How is the provision of capacity enforced? Today s electricity contracts include an unconditional obligation to supply (or at least to nominate) Supply ought to be provided at any time (including in scarcity periods) Market participants that are not able to provide energy despite their obligation (or using more electricity than procured) have to pay a price for balancing to the SO Balancing system is essential for security of supply How does this translate into financing capacity? Market participants hold available own capacity or contract capacity at payment of capacity prices (per MW) Market participants are prepared to pay high prices in case they are short of energy in scarcity periods 300% 250% 200% 150% 100% 50% 0% historisch Price peaks increasing over time Stunde 5 Frontier Economics

6 Does the EOM provide for enough security of supply? Capacity price elements in EOM Possible market distortions In principle, EOM can guarantee sufficient security of supply without explicit capacity payments Supply gap due to external effects in case of brownouts Supply gap due to high market risks for investors Political risk and Missing Money Welfare loss due to abuse of market power Spill over of foreign capacity mechanisms Potential market reforms (without CRM; selection) Facilitating market entry for demand flexibility and unconventional power generation (e.g. emergency generators) Improving the rules for balancing e.g. compensation schemes for capacity available in critical situations Explicit political commitment to accept price peaks Stable political framework (e.g. RES support, climate policy) Further CRMs required? The problem or its perception and with it the answer vary by country (next slide) 6 Frontier Economics

7 The problem or perception may differ by country Ireland issue the desired but lumpy incremental investment undermines required returns for all generation sets in the market Transit system Policy makers fear risks involved in reliance on neighbouring system Empirics Controversial debate, but ultimately political concern of observed reserve margins falling to levels regarded as politically critical No fundamental issue, but some deficiencies in the details of the EOM and a residual risk of market failure Electricity in spatial heating risk that winter peak load not matched by generation capacity Hydro system - The local market is not capacity constrained, but energy constrained. Perception that CRMs distort the energy market 7 Frontier Economics

8 What is the problem? What are the options? Who does what? What issues for the IEM? What does the EC think? 8 Frontier Economics

9 Scope of the included capacity What are the options if going beyond EOM reform? Centrality of the capacity mechanism Strategic Reserve Energy not (directly) offered in energy market Focussed capacity market (e.g. LBD/Öko-Institut) Decentralised performance obligation Dec. obligation + Auction (e.g. PJM) System-wide centralised capacity market (e.g. central auction or reliability options) Energy still offered in energy market capacity traded on decentralised market (no administrative rule how cost is passed to consumers) capacity traded in centrally organised auction (and capacity price passed on through an administrative levy) 9 Frontier Economics

10 What is the problem? What are the options? Who does what? What issues for the IEM? What does the EC think? 10 Frontier Economics

11 Who does what (or is planning to)? Strategic reserve Decentralised mechanisms System wide central mechanism Capacity payment RoI/NI: Considering to move to a system wide central mechanism (reliability options) Variation in models reflects the issues and political perceptions 11 Frontier Economics 11

12 Different CRMs have different justifications Strategic reserve To back up SoS in a reformed EOM Decentralised performance obligation To make capacity product and price more explicit (expect that capacity market trades forward up to 3 years) System-wide centralised capacity market To provide long term contractual certainty for generators 12 Frontier Economics

13 What is the problem? What are the options? Who does what? What issues for the IEM? What does the EC think? 13 Frontier Economics

14 The European dimension Issues Options Targets and objectives Lending each other reliability Interaction between capacity regimes How to define security? What level of security do we aspire to (and do we need transnational consensus)? To what extent can we rely on our neighbours? To what extent are we obliged to help our neighbours? How to handle that any national mechanisms has indirect effect on neighbours (via the interconnected energy markets) How to enable x-border reserves? Input based (in MW) or output based (in probabilities) National versus EU targets Implicit or explicit recognition of foreign capacity (or offers by IC operators) Does some of my capacity actually count as reserve for my neighbour? Regulate under State aid law? unlikely to lead to optimal economic outcome Develop a common EU policy? Could infringe on subsidiarity raises further issues 14 Frontier Economics

15 Cross border participation raises specific issues Participation Obligation Derating of capacity over IC IC capacity reservation Options Generators and/or interconnectors Physical delivery or Availability for physical availability and for coincident stress in host system Explicit physical capacity reservation or No reservation Consideration Want to incentivise expansion where the bottleneck lies By country, this can be generation or IC capacity With gen participation: ICs can benefit indirectly Availability rule distorts despatch less Absent full ETM implementation, availability may not be a fully effective criterion The technical availability of ICs limits how much can be imported In case of coincident stress, capacity may not be able to support both countries Reserving IC capacity for shortage events is inefficient But if IC capacity is ignored, there is risk of too optimistic adequacy outlook and given distinct technical challenges, market/liquidity conditions and political attitudes, national solutions (when taken in isolation) may differ See ENTSO-e (2015): Cross-border participation to capacity mechanisms, Policy paper, 13 February 2015 and Frontier Economics (2014): Participation of interconnected capacity in the GB capacity market, report for DECC, Sep Frontier Economics

16 Linking regimes with delivery obligation in one country can result in suboptimal despatch (an example) Suppose generator in GB is incentivised to deliver in stress event and is high cost Other permutations are possible that would also lead to inefficient despatch Suppose further that generator in France is low cost ~ ~ If GB is in stress but France is not, generator in GB is incentivised to generate (to meet its delivery obligation) even if it is out of merit This is a distortion to trade between Member States. even if it might only happen infrequently (Testing arrangements may create similar incentives even outside stress) 16 Frontier Economics

17 What is the problem? What are the options? Who does what? What issues for the IEM? What does the EC think? 17 Frontier Economics

18 Some guidance from the EU on CRMs a b c d e f Well-defined objective of common interest (Art. 107 (3) TFEU) Need to intervene: Remedying a market failure Appropriateness of measure Incentive effect: Measure should change behaviour of undertakings Proportionality: Minimum amount need to incentivise behaviour Avoid undue negative effects on competition and trade Certain categories may be subject to ex-post evaluation. EC may limit duration of schemes (indication: 4 yrs) and decide on prolongation. EC s presumption (155) ( ) mechanisms that ensure that certain generation adequacy levels are met at the national level may constitute State aid in the meaning of Art. 107 (1) TFEU. ( ) Source: European Commission, Guidelines on environmental and energy aid for (Brussels, June 2014). but so far this is a list of don ts that allows for national fragmentation and not an EU market design 18 Frontier Economics

19 Conclusion Some arguments pro market failure and CRM may not be well founded but some uncertainty remains if EOM will fully deliver Subsidiarity dominates - The TFEU currently only provides a mandate to define a list of no goes, but does not offer the EC authority to define a common or target CRM Risk of inconsistency - Even when all abide by the EC guidelines set under state aid laws, an incoherent patchwork of CRMs can result that could undermine the efficient functioning of the IEM Regional coordination is key Voluntary regional coordination between member states is key - given the complexities it is more realistic to expect regional rather than EU-wide harmonisation Guidance from EC on x-border participation would help Participation (generators and/or interconnectors?) Compliance (physical or availability?) Reserve IC capacity for CRM? 19 Frontier Economics

20 Selected References ENTSO-e (2015): Cross-border participation to capacity mechanisms, Policy paper, 13 February 2015 European Commission, Guidelines on environmental and energy aid for , Communication from the Commission, Brussels, 28 June 2014). Frontier Economics/Consentec (2014): Impact Assessment of Capacity Mechanisms, Report for the Federal Ministry for Economics Affairs and energy, September 2014 Frontier Economics/FORMAET(2014): Electricity market in Germany Does the current market design provide security of supply? Report for the Federal Ministry for Economics Affairs and energy, September 2014 Frontier Economics (2014): Participation of interconnected capacity in the GB capacity market, report for the UK Department of Energy and Climate Change (DECC), September 2014 LCP/Frontier Economics (2014): Capacity Market Winter 2018/ What can we learn from the pre-qualification results?, bulletin October Frontier Economics

Dr. Christoph Riechmann Frontier Economics Limited www.frontier-economics.com e-mail: christoph.riechmann@frontier-economics.

21 Dr. Christoph Riechmann Frontier Economics Limited mobile: Cologne: switch: direct: fax: London: switch: direct: fax: Kranhaus Süd, Im Zollhafen 24, D Köln, Germany High Holborn, London WC1V 6DA, United Kingdom Frontier Economics Limited in Europe is a member of the Frontier Economics network, which consists of separate companies based in Europe (Brussels, Cologne, London and Madrid) and Australia (Melbourne & Sydney). The companies are independently owned, and legal commitments entered into by any one company do not impose any obligations on other companies in the network. All views expressed in this document are the views of Frontier Economics Limited. 21 Frontier Economics

22 FRONTIER ECONOMICS EUROPE LTD. BRUSSELS COLOGNE LONDON MADRID Frontier Economics Ltd, 71 High Holborn, London, WC1V 6DA Tel. +44 (0) Fax. +44 (0) Frontier Economics

Cross border participation in CRMs Presentation materials. 30 June 2015

Cross border participation in CRMs Presentation materials 30 June 2015 Interaction between CRMs is important to ensure least cost to customers Objectives of IEM demand is met by the cheapest resources