EU Capacity Mechanisms May Be Badly Designed

The ECOreport reposts EU Competition Commissioner Margarethe Vestige’s interim report points to “room for improvement,” EU capacity mechanisms may be badly designed

Originally Posted on Energy Post

by Sonja van Renssen

EU member states are setting up capacity mechanisms that may be unnecessary, expensive and badly designed. This is the conclusion of the European Commission’s Competition Directorate in the interim report of its first ever “sector enquiry” into capacity mechanisms as a form of state aid for electricity producers. But the report shows that DG Competition has a different view than DG Energy about the future of the EU’s energy market design, writes Sonja van Jenssen from Brussels.

EU Capacity Mechanisms May Be Badly Designed

Margrethe Vestager presents sector inquiry electricity capacity mechanisms (photo Europe by Satellite)
Margrethe Vestager presents sector inquiry electricity capacity mechanisms (photo Europe by Satellite)

“There is a lot of room for Member States to improve how they assess whether capacity mechanisms are needed, and how they design them,” said EU Competition Commissioner Margrethe Vestager on 13 April in Brussels. She was presenting the interim report of a sector enquiry into capacity mechanisms that was launched nearly exactly a year ago. “Capacity mechanisms” covers all the arrangements by which Member States pay electricity generators (and occasionally consumers) extra to keep plants open or build new ones (or change consumption patterns) with the explicit goal of security of electricity supply. These schemes can distort competition and have to be approved by the Commission under state aid rules.

When the enquiry was launched, experts said it would show whether the EU is succeeding in keeping Member States on track to a single European energy market and indeed a single European energy policy, the Energy Union. It is the Commission’s first ever sector enquiry into state aid.

Fragmentation

Margrethe Vestager presents sector inquiry electricity capacity mechanisms (photo Europe by Satellite)
Margrethe Vestager presents sector inquiry electricity capacity mechanisms (photo Europe by Satellite)

Twelve months later, the findings are not great. The Commission examined 11 Member States – Belgium, Croatia, Denmark, France, Germany, Ireland, Italy, Poland, Portugal, Spain and Sweden – and found no less than 28 capacity mechanisms. Spain alone has four. Aside from a debate over what this means for the internal energy market, much more worrying is that “many” capacity mechanisms were designed without assessing whether or not there was a security of supply problem in the first place.

“Capacity mechanisms may be necessary, but cannot substitute for real market and regulatory reform”

In addition, nearly half the Member States did not define what level of security they actually wanted. When they did assess it, their methods varied “widely” and were often “purely national”. On top of this, most Member States did not decide the price of capacity payments through a competitive process and many simply excluded certain providers (for example, of demand response or from across the border).

All this hardly adds up to a thriving internal market abuzz with competition. Instead it suggests that national governments have found a new way to drive up electricity prices. Or rather, utilities have found a new way to prop up crashing revenues. So what is the Commission going to do about it?

Court cases and market reform

Vestager was at pains to stress that the report is an interim report, with a three-month period from now until 6 July for Member States and others to submit further comment. A final report will follow by the end of the year. She was also at pains to stress that there are no legal consequences to either report – these are not state aid decisions. Instead their findings will feed into state aid decisions on individual capacity mechanisms. So far, the EU has approved just one capacity mechanism in Europe – that of the UK in 2014. It launched investigations into two more – both in France – in November 2015. Vestager said the Commission is in informal talks with Germany. More investigations seem likely.

DG Energy and DG Competition are not on the same wavelength. They do not share the same vision of energy markets going forward

But Vestager emphasised too that: “A properly functioning electricity market should deliver sufficient supply. Capacity mechanisms may be necessary, but cannot substitute for real market and regulatory reform.” The sector enquiry’s results will help shape proposals on electricity market design that the Commission is preparing for the end of this year. Those proposals are ultimately about making the power market fit for the transition to a low-carbon economy. They include an overhaul of a 2005 directive on electricity security of supply. How will the enquiry’s results affect these plans?

A coherent vision

For many stakeholders, DG Energy and DG Competition are not on the same wavelength. They do not share the same vision of energy markets going forward. This means that while DG Competition’s state aid decisions may be perfectly coherent with its own vision of the future, that vision does not match DG Energy’s and the result is an incoherence between EU competition and energy policy. “DG Comp decisions are informed by what they know about the [energy] market,” explains Maria Kleis-Walravens, a state aid expert at ClientEarth, a group of activist environmental lawyers. “Decisions on capacity mechanisms within the wrong framework will be wrong.”

Schemes like Germany’s strategic reserve – the most common type of capacity mechanism in Europe – “do not solve generation adequacy problems on a long-term basis, and can in fact worsen the situation”

“It’s very easy to get frustrated with DG Competition,” says Michael Hogan, a senior advisor at the Regulatory Assistance Project (RAP), a global team of independent energy policy experts. He believes that EU policymakers can do a lot more to make the power market work – before making any decisions to resort to capacity markets. He cites the example of Texas: people are investing, it has a security of supply standard comparable to if not stricter than most of Europe, it has significant penetration of renewables, and it has no capacity market. There is however, an intervention by the system operator to adjust balancing prices so that real-time prices reflect the value of flexibility. In fact, Hogan says, all the capacity markets that have been running for the past decade, are shifting “to do more and more scarcity pricing like in an energy [-only] market.”

Controversy over the UK

In its interim report, the Commission gives a fresh thumbs-up to the UK capacity market. It concludes that these kinds of market-wide, volume-based capacity mechanisms “appear to be more appropriate to address a long-term, general problem of generation adequacy”. In contrast, schemes like Germany’s strategic reserve – the most common type of capacity mechanism in Europe – “do not solve generation adequacy problems on a long-term basis, and can in fact worsen the situation”.

The UK capacity market is trying to keep open exactly those power plants that a carbon price floor, emission performance standard and industrial emissions directive are trying to close

And yet, for Kleis-Walravens and others, the previous Commission’s approval of the UK capacity market is an example of a bad decision. Tempus Energy, a UK-based company with an innovative demand-side management and trading platform, has taken the Commission to court to demand an in-depth investigation into whether the UK scheme breaks state aid rules. Sophie Yule, Tempus’s General Counsel and leader of its legal challenge, says many of their concerns are actually there in the interim report. (Note that the Commission is not examining the UK scheme as part of its enquiry. Vestager claimed there was no “specific non-selection” of countries. But she has excluded the sole example of a capacity mechanism thus far approved under the EU’s new state aid guidelines on energy and environment.)

Yule says the UK capacity market is trying to keep open exactly those power plants that a carbon price floor, emission performance standard and industrial emissions directive are trying to close: “It sets a precedent in law that a 15-year fossil fuel subsidy affecting the market for 40 years is lawful state aid. We’re basically paying twice, to keep open and close the same coal plants.” Tempus expects an oral hearing either before or after the summer.

EU control

To approve a capacity mechanism, DG Competition first has to establish that there is a genuine security of supply problem. The key to this is a sound resource adequacy assessment. It is here that DG Energy has a powerful opportunity to support DG Competition. In its electricity market redesign proposals at the end of the year, it will “establish a range of acceptable risk levels for supply interruptions and an objective, EU-wide, fact-based security of supply assessment,” the Commission says in its interim report.

“If you don’t discriminate based on capabilities, it’s impossible to realise the real objective: security of supply at lowest cost”

For many experts, that is the key deliverable: a standardardised, regional methodology for assessing resource adequacy. Note the word is “resource”, not “generation”. This is one of Kleis-Walravens’s criticisms of the interim report: the Commission is doubtful about how member states assess resource adequacy and there seems to be an indication that it sees capacity markets only as a last resort, but “there is no mention of whether adequacy problems could be diminished through better energy efficiency, although demand response plays a role in capacity mechanism design”.

The Commission’s second big priority is to force the opening up of capacity mechanisms. It wants to propose a legally binding framework for cross-border security of electricity supply by the end of the year. (Just like it did for gas in February 2016.) So far only three capacity mechanisms are even a little bit open, according to a Commission source: in Belgium, Germany and Ireland. “But even these are not the type of cross-border schemes we see for the future,” the source added. One expert noted that the proposals for regional solidarity on gas are already running into Member State resistance however.

State aid interpretation

For many, the market redesign proposals at the end of the year are an opportunity too, to clarify that member states can be selective in what they want their capacity mechanisms to support. There is a call for technology neutrality in the EU state aid guidelines and confusion over how restrictive this is. Renewables advocates for example, do not want it forcing all renewables to compete against one another for support. With regard to capacity markets, some want high-CO2, inflexible generation (i.e. coal) to be excluded. Hogan explains: “If you don’t discriminate based on capabilities, it’s impossible to realise the real objective: security of supply at lowest cost.”

The big work now is on DG Energy’s desk. But DG Competition will always be right round the corner as long as there is public money in play

Others are pushing for the market design package to define “low carbon” – the state aid guidelines say capacity markets should give priority to this, without defining it further. A group of stakeholders including Italy’s ENI propose introducing a definition like that of the European investment Bank (550gCO2/kWh). More generally, ENI and its partners suggest that an EU-wide emission performance standard of around 1000g CO2/kWh would enable the power sector to deliver its share of the EU’s 40% greenhouse gas emission reduction target for 2030. DG Energy may model an EPS as part of its market design impact assessment.

And from DG Energy back to DG Competition. This is one of the most powerful departments of the Commission. It is chasing Gazprom with an anti-trust case. It could do a lot to iron out existing internal energy market distortions, such as price caps. But it needs the right policy framework otherwise it could end up tearing the market to pieces instead. The current cacophony of capacity markets is a problem. Europe needs to ask itself: does it want an internal energy market? If so, it is high time to implement in full the third market liberalisation package and beyond that, to start thinking about long-term contracts to secure new energy market investments. The big work now is on DG Energy’s desk. But DG Competition will always be right round the corner as long as there is public money in play.

Top Photo Credit: The European Commissioner for Competition Margarethe Vestager addressing ECR members from European Conservatives and Reformists Group Making Europe Work Again in January 2016 via Flickr (CC BY SA, 2.0 License)

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