This article is part of our special report Capacity markets for electricity.
It’s a contradiction that policymakers are currently struggling to resolve. But fossil fuel back-up plants are probably necessary in the short term in order to give EU countries the confidence to bring in higher shares of renewable electricity, says Michael Pollitt.
Michael Pollitt is Joint Academic Director at the Centre on Regulation in Europe (CERRE), an independent think tank based in Brussels that specialises in the energy, mobility and digital sectors. He is Professor of Business Economics at the Judge Business School, University of Cambridge, and Associate Director of the Energy Policy Research Group (EPRG).
- Capacity schemes give EU countries confidence in fossil fuels availability when renewables aren’t there
- However, they often ignore the EU dimension and may support more capacity than needed
- Need for back-up fossil fuel will decrease as storage and other flexibility solutions become available
- Ideally, moving towards an EU-wide standardisation of capacity markets would make sense but it takes time
- In the longer run, there is a case to delegate responsibility to an independent transnational system operator (ISO), like in the United States
Why does the European Commission want to reform capacity markets? How does that fit with the EU’s broader objectives in the energy transition?
I think the Commission has realised that capacity markets are going to happen whether it likes it or not. And it decided it was preferable to get ahead of the issue rather than let capacity markets pop up all over Europe with different designs.
Can member states just put up capacity mechanisms like this?
Well they have been doing that, haven’t they? And they’re difficult to stop because capacity markets can always be portrayed as energy security measures. They are fundamentally aimed at addressing national concerns about lack of capacity but that often ignores the European supply and demand dimension.
For instance, Germany might be concerned about the closure of their own capacity but the reality is they could probably retire a good part of it if they relied on interconnection with other countries.
So it can conflict with what’s happening at the European level. And in aggregate, these national mechanisms may support far more capacity than is actually needed.
What is the role played by capacity markets in reducing CO2 emissions? Do they help or do they actually increase emissions?
The argument in favour of CO2 reduction is that, by providing support for fossil fuel capacity, capacity markets allow EU countries to go towards higher percentages of renewable energy production. It gives them the confidence of having backup capacity when wind and solar are not available.
That sounds contradictory: Countries need fossil fuels in order to increase their share of renewables…
Not exactly: you need confidence in fossil fuels capacity in case renewables aren’t available. The mechanisms are about capacity, they’re not about energy. And they become more important as the share of fossil energy declines.
Over time, you would expect the utilisation of capacity by fossil fuel energy will decline as the share of renewable energy rises.
And the idea is to end the capacity schemes when renewables will have reached a level where they don’t need backup anymore. Is that right?
There is no absolute requirement that the share of renewables in electricity goes to 100%. It would be nice but it’s technically very challenging given the intermittency of renewables both within the day, across the seasons and even year-to-year. You would need enough storage capacity, combined with renewables or nuclear, to make fossil fuel free electricity possible.
This means capacity markets are here to stay, even with high shares of renewables?
With existing technologies, some fossil fuel backup seems to make a lot of economic sense. Even if you could imagine electrical energy storage becoming very cheap. Or if we had enough pumped storage hydropower.
But that doesn’t answer the question of where the energy would come from when you need it. Even if you had sufficient non-fossil fuel capacity available, you would still need fossil fuels for the foreseeable future to actually give you the energy that you need at certain times.
Capacity mechanisms are sometimes portrayed as a subsidy scheme to help otherwise unprofitable power plants running – often coal or gas-fired. Is this a fair description or a gross exaggeration?
This actually boils down to one question: what are you actually paying for in the capacity mechanism? And what exactly is the capacity product?
One feature which is up for negotiation is the contract length offered to bidders in capacity markets. And often that contract length – say four years – can look like a subsidy. Because you’re offering long-term assurance to some fossil fuel capacity on the grounds that if you don’t give them the long-term contract, they’re going to shut.
But we don’t really know whether some of these contracts are necessary or overly generous. What I’m more convinced of is that we need short-term operating reserves in the electricity system – that is true. And some shorter-run contracts would seem to be more suitable to providing that. The value of these longer-run contracts is not clear to me.
Do capacity schemes help or hinder the attainment of EU climate goals under the Paris Agreement?
Capacity mechanisms have arisen both in Europe and the United States because politicians get very worried and expect excess capacity to meet peak demand when renewables aren’t available. And that’s a genuine political worry. They seem less keen to rely on high short-term energy prices, short-term operating reserves or short-run ancillary markets (for frequency control, voltage support etc.)
In that sense, capacity markets have gone along with commitments to reduce fossil fuel energy shares. So this may be the price that we have to pay. But maybe there are better ways to do that.
How can the ongoing reform of capacity markets help reaching the goals of the Paris Agreement? Can it prevent unnecessary fossil fuels from being kept artificially alive?
One would expect that the job of the Commission is to keep an eye on the single market as a whole. And to check that the criteria for calculating available capacity in each national mechanism makes sense – that there isn’t too much capacity in it.
Isn’t that done by ENTSO-E in its adequacy forecast?
Yes, but one would expect a standardisation in calculations to evaluate the supply of capacity. And some limitations on political interference in choosing the level of demand for capacity or perhaps the different types of energy generation, demand response and interconnection that may be allowed in the mechanism.
Also, one would expect the Commission to keep an eye on total capacity across the Union. Because one of the key aspects of the single market is to economise on capacity and encourage trading.
One of the dangers of national capacity mechanisms is that they keep lots of capacity on the system which could and should be rationalised at the European level. And that could represent a distortion of trade between different countries.
If you keep old dirty plants on the system via a national capacity mechanism, and allow them to continue trading – that’s distorting cross-border flows of electricity. Take an old coal power plant in Poland that the Polish capacity mechanism is paying to stay on the system. That plant can produce electricity at times when the system isn’t stressed and trade it outside of Poland, even though it may not be necessary from a European point of view. And then you’re detracting from the European energy and climate targets. I think that is the danger – that you keep a lot of unnecessary plants on the system from the perspective of the single market.
Does this mean capacity markets don’t give the correct long-term price signals and should therefore be phased out from a sustainability perspective?
The requirement for back-up fossil fuel capacity will fall over time. Electricity storage will become more significant, there should be better integration of the single market, better access to – say – Norwegian hydro, or more flexible demand, which will help decrease the need for capacity. And in the longer term, maybe there could be other options in the form of hydrogen or other long-term storage.
The problem is not capacity, the problem is energy. It’s not that we can’t build enough megawatts that are zero-carbon. The problem is where the energy comes from. If we have a cold, dry, not very windy winter across Europe, where’s our energy coming from?
The divergence of energy mix across EU countries is striking: France relies heavily on nuclear, Poland on coal, Nordic countries on renewables, etc. How can a “Europeanisation” of capacity markets be envisaged with such wide divergences?
This is where you get to the heart of the conflict between member states and the Commission. Everybody is very keen to cooperate on short run optimisation of the electricity system. But actually cooperating on longer-run rationalisation – that is really challenging.
So getting to a situation where you have a European capacity market, meaning several member states would have less capacity than their total demand – that’s a big ask. And virtually no member state is in a position to do that at the moment.
It is a question of trust in a way…
It is a question of trust and cost. Are governments willing to pay to have that extra bit of political security? As long as those extra plants are cheap enough, the answer is yes.
Can capacity mechanisms play a supporting role in the transition to a more European market for electricity? Or do they hinder this goal?
I think they do both. They are a way of reassuring politicians about the dangers of increased renewables shares. So they’re probably good for promoting higher levels of renewables and commitment to decarbonisation. But in the short run, they probably slow down the growth of energy trading between European countries.
It’s a tough calculation to make.
Who is supposed to do this calculation? Is it ENTSO-E in its adequacy forecast? Or is it the Commission?
There is good analysis conducted by ACER on the extent of cross-border trading and the degree of integration between national markets.
Can ACER influence national decisions regarding capacity?
They are a regulatory body. They don’t have a mandate to force member states to change their national energy policy. But clearly, they can draw attention to areas where the Commission might take action.
When discussions took place in the Council, member states were reluctant to hand over more responsibilities to ACER.
Yes, absolutely. This is about subsidiarity. ACER focuses on cross-border issues, not on what happens within the member states.
Would you say that capacity mechanisms increase or reduce costs for final customers? Or is that something that needs to be looked at with each country individually?
At a simple level, they must increase costs. The question is what you get in exchange, whether they promote renewables, decarbonisation, and so on. But they almost certainly do increase costs.
The analysis that the UK government made on the capacity market in Great Britain showed that it did increase costs, i.e. that it would have been cheaper to have relied on an energy-only market in terms of total systems costs.
So are they worth taxpayer’s money or not?
It depends what the alternative is. If the alternative is that politicians don’t commit to higher level of renewables without capacity markets, then it could be a price worth paying.
Over the past two years, the European Commission has given a green light to several capacity mechanisms – including France, Belgium, Germany, Italy and Poland (see DG COMP’s website). The decision to clear the Polish scheme was criticised as an EU blessing for coal subsidies. Is that also how you would describe it?
No. Clearly, any national capacity market is always going to end up supporting whatever capacity is in place at the time. In France, it will support nuclear. And in Poland it will support coal. So it wouldn’t be fair to characterise the Polish scheme in this way.
The real issue is the extent to which national capacity markets perpetuate overcapacity in those countries and whether it should be rationalised at European level.
Looking at the Commission’s individual state aid decisions, the Commission made a distinction between strategic reserves (Belgium, Germany) and capacity markets (Italy, Poland). Was the Commission justified in making this distinction?
In theory it’s always better to support all generation capacity rather than make distinctions between things that fall in the mechanism and others that don’t.
So the mechanism should be targeting all capacity. If the long term end-game is to have a European capacity mechanism where you standardise the rules across all member states, it would be helpful to converge on one definition.
Initially, the Commission probably has to tolerate a number of national capacity mechanisms in the hope that, over time, they will converge.
Regarding governance aspects, how should the national, regional and EU level be involved in decisions regarding capacity mechanisms?
Ideally, moving towards EU-wide standardisation of capacity markets would make sense but it takes time. So you need to use existing institutions and think about how you allocate oversight responsibilities.
In Europe, we’ve encouraged electricity trading by setting up regional markets and putting regional security coordinators in place for the use of transmission infrastructure. The question is where the capacity mechanisms fit within these institutional arrangements that we’ve got. And I’m not clear that we’ve yet moved beyond national capacity schemes. So we’re still at an early stage of coordinating them.
Will the ongoing reform change this?
Now that more and more member states have got a capacity scheme in place, one could imagine that member states will move towards greater regional coordination of mechanisms. It would certainly make a lot of sense where there is a lot of interconnection between two countries. So let’s see how things develop.
But politically, if a black-out occurs, it will be national governments taking the blame…
There is an interesting precedent in the United States, where capacity markets like the PJM cover multiple states and is overseen by the independent system operator. The advantage for politicians is that it’s clearly not their responsibility anymore, it’s the responsibility of the independent system operator (ISO). Now, whether voters will see it like that in Europe remains to be seen. But there is a case to delegate this to an independent transnational system operator .
Over time, you could imagine regional ISOs emerging around Europe and being given oversight of capacity mechanisms, along their oversight of ancillary services markets more generally.
Would you say this is a likely perspective?
Well, it’s certainly possible and potentially very desirable. It’s a question of trust but also of technical competence. We’re in a situation where electricity demand in Europe is falling. Shortage of capacity is not the problem. And so it makes sense to rationalise existing capacity, make better use of interconnectors, and increase interconnection to support the increasing share of intermittent renewables.
By 2030, we will probably live in a much more interdependent European electricity system. We will become more conscious that at certain times of the day, week and year, we are more dependent on electricity exchanges between regions.
Regional SOs could be for the next round of reform?
Yes, absolutely. And as we move towards perhaps 50% renewable electricity by 2030 across Europe, you will potentially have a much more interconnected and interdependent electricity system.
And even if governments have a desire to have reserve capacity to satisfy their national market, the reality will be that there will be big power flows across the whole of Europe. So satisfying national demand won’t make sense any more since power flows won’t be respecting national borders, they will be driven by the interaction of weather and demand across Europe.