How should power markets work and what must be left to policy?

DISCLAIMER: All opinions in this column reflect the views of the author(s), not of EURACTIV Media network.

Do power markets have specific characteristics compared to other commodity markets? The answer is yes. [Shutterstock]

For almost 20 years since the liberalisation in the power sector, governments around the world have been struggling to find a durable market design, even before subsidised renewables entered the stage, explains Graham Weale.

Professor Graham Weale is honorary professor of energy economics and politics at Ruhr University, Bochum, and a former chief economist for RWE AG.

Nowhere has a design been conceived that adequately remunerates plants, whether thermal or renewable, and can lay claim to be a general-purpose blueprint for future decades.

We have now more than enough evidence to ask the questions: do power markets have specific characteristics compared to other commodity markets? Does a system relying on the wholesale price to remunerate investments stand little or no chance of working, even without the introduction of subsidised renewables?

The answer is yes!

There are several features which separate the power market from all other commodity and most industrial markets, but we focus on two. First, there is the very large gap between the Short-Run Marginal Costs (SRMC) and the Long-Run Marginal Costs (LRMC), which is growing since the share of zero-cost renewables.

As a result, the SRMC of power (the wholesale price) is most unlikely to reach the level necessary long-term to cover the full cost of a new plant.

Second is the fact that as demand is varying by the hour over a very wide range, there can at best be relatively few hours each year, when the steep end of the merit-order curve is reached and plants with lower SRMC benefit from the high prices set by peaking plants with high variable costs.

Conversely, in most commodity and manufacturing processes when capacity becomes tight, then the high SMRC plants will be setting the price not just for a few hours but over months or even longer until new low-cost capacity is brought on line.

The SRMC-LRMC gap is so large and the contribution from the steep end of the merit-order curve so limited, that the expectation increasingly voiced by governments that scarcity-pricing can ever bridge it should be completely excluded.

Despite their promises not to cap prices, politicians do not like to see tight markets, which would produce such high prices, and are likely to intervene before they emerge. In addition, the predictability of such contributions is so low that no investor would count upon it.

As if the market basis for sustainable power system investment was not already doubtful, it has been further rocked by strong outside-market policies, which the EU and other governments have introduced – renewables and efficiency targets.

Market failure is a common phenomenon and it cannot necessarily be expected that a market has the foresight or financial means to develop technology which is crucial for coming years.

The need to decarbonise the power system is a classic example and it is most unlikely that without policy intervention power generators would have had the incentive to develop zero-carbon technology at the rate required to meet decarbonisation goals. The ETS, whilst intellectually elegant, still faces a considerable challenge to prove that it can deliver stable long-term price signals, which would convince bankers and shareholders to undertake major investment projects.

The policy to introduce renewable technologies with a second source of income is meeting a strong societal desire and bringing new forms of technology needed for the future to reach maturity much more quickly than if left to the market alone.

The rate of cost reduction of PV panels and wind turbines is truly breath taking and the policy is delivering multiple long-term benefits for society – zero-carbon energy, import independence and progressively cheaper energy.

Efficiency policies also have their place for similar reasons, although care must be taken to apply them discriminately. Excessive emphasis on them would weaken further the ETS system, and in respect of electricity, as this product becomes decarbonised the need to reduce electricity consumption for environmental reasons is no longer compelling. Moreover, measures should not stand in the way of allowing electrification to play its economically correct role in the wider decarbonisation goals.

However, the EU and other governments need to face up to the stark choice to be made between relying on policy prescription and markets to achieve the desired targets. The terms “markets”, “renewables and efficiency targets” all figure prominently in their vocabularies but like oil and water they do not mix well.

It is therefore important to sort out what can be properly the job of markets and where at least the wholesale market will have its limits so that a second stream of income will be necessary for the investments required by policy.

The role of the wholesale market, helped by increased coupling across the EU, has been a spectacular success in achieving the optimal dispatching of plants across the continent and therefore the lowest possible wholesale prices. The questions arising now are: what other tasks may the wholesale or other recognisable markets be able to fulfil?

Or can headline policy objectives (renewables, supply security and efficiency) only be achieved by the recently introduced competitive tendering process (so far only for renewables) with a second income stream, for which the label “state aid” appears inappropriate, given the latent inability of the wholesale market to fully remunerate investment?

The Clean Energy Package presented at the end of last year needs to be much clearer in this respect, where the word “market” appears to have three different uses:

  • The wholesale market;
  • The entire power supply system;
  • The presence of several players (rather than a single dominant player) at different stages in the supply chain (e.g. participating in a renewables auction).

The next version of the Package would benefit from greater clarity in this respect so that those implementing policy understood exactly what was meant, and that the expectations from different parts of the supply chain would be realistic.

EURELECTRIC is holding a high-level conference on the 7 June in Brussels and EURACTIV.com is a media partner.

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