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Clear as mud
Why exactly is the EU so reticent about redesigning its failed energy markets?
The long-awaited final report from ACER, the EU’s Agency for the Cooperation of Energy Regulators, on the adequacy of EU wholesale electricity design landed late last week. Readers will recall that ACER was tasked with reviewing EU energy market arrangements last October in response to spiralling gas and power prices. In a nutshell, the regulator has concluded there’s nothing to see here and asked everyone staring at the remains of Europe’s war-bludgeoned liberalised energy markets to kindly move along.
The European Commission asked ACER, inter alia, to look into whether the EU’s system for setting wholesale power prices exacerbated volatility. Member states have been clamouring for a review since last summer’s spectacular post-Covid global gas rally pushed prices to record highs. EU wholesale energy prices went stratospheric in tandem, and stayed there.
At the time of writing, the month-ahead price of gas on the benchmark Dutch TTF hub is €106 per MWh. German baseload power futures are trading at €200 per MWh, and the forward curve is comfortably above that symbolic threshold out until April 2023. While prompt prices have cooled off somewhat since the post-invasion lunacy of late February and early March, German electricity is still up almost 400% in six months and showing no signs of softening. Something is very wrong here.
Before going any further, it is worth acknowledging that a fundamental tightening of global commodity markets inflated prices across the board. Liberalised energy markets all over the world are bleeding, regardless of their overarching design. Runaway demand and supply constraints pushed up fuel costs, which in turn pushed up power prices. It’s Economics 101.
But does that exonerate systemic failings? A closer look at the crux of the issue — the EU’s preferred mechanism for electricity price discovery — reveals shortcomings that have been apparent and well-documented for decades. That being so, are there ulterior motives that might explain dogmatic faith in the EU’s liberalised energy market design, even when its failings are plain for all to see?
Backlash in Brussels
Facing irate consumers and a wave of supplier bankruptcies, the Spanish, French, Italian, Romanian and Greek governments called for urgent action to ensure that consumers pay the ‘true’ cost of generating electricity. The European Commission stood its ground, defending the ‘pay-as-clear’ system as the least bad option for price discovery in electricity – a commodity that is hyper-sensitive to systemic inefficiencies due to the difficulty of storing electrons and the rapid feedback of outturn on dispatch decisions.
Brussels was not sufficiently convinced by its own rhetoric to merely stare down apoplectic member states, so ACER was wheeled out to take a cursory look and report back. Without undue cynicism, Energy Flux said at the time:
“The Commission says there is no evidence that ditching pay-as-clear for something else would improve matters, but tasked ACER to take a look and report back by next April anyway. Cue the deafening silence of inaction.”
ACER was not expected to call for root-and-branch reform and this week poured cold water on any misplaced hopes that it would. It said in November that marginal pricing under the pay-as-clear model is vital for renewables generators to be remunerated “above their marginal costs, sometimes quite significantly so”. That preliminary assessment set the tone for last week’s final report, which essentially defends the status quo save for minor tweaks at the margins.
No free lunch (or electricity)
As I’ve written previously, the EU’s preferred ‘pay-as-clear’ price setting system for the day-ahead electricity market pays all generators the same clearing price regardless of the amount they bid.
Wind and solar farms that have zero fuel costs get paid the same price for their power as a gas-fired thermal generator that must cover the cost of buying gas at €106 per MWh (or whatever the going rate is on the nearest gas trading hub, or in their gas purchase contract if they have one).
Paying all generators the marginal cost of production, which is set by gas, magnifies the impact of gas price movements on wholesale electricity prices. It maximises the benefit to consumers in times of plenty, and maximises the pain when feast turns to famine. It is the precise opposite to a strategic hedge against volatility.
As renewables come to dominate the EU power mix, there will be increasingly frequent and prolonged periods of zero marginal cost generation depressing wholesale power prices (and bouts of negative pricing). This is bad news for all generators.
While wind and solar have zero short-run marginal costs (SRMC), they must still service their debt obligations and pay for operations and maintenance. Being paid nothing doesn’t allow them to cover these long-run marginal costs (LRMC).
It is also bad news for thermal generators, which must recover their fixed costs over reduced running hours. The only way to do that is to bid up the wholesale power price whenever renewables can’t cover demand. So these periods of low pricing will then be punctuated by ever-higher spikes to make all generators whole.
There is a clear trend of rising power price volatility in the European power market. Price spikes increased by one-third between 2016/17 and 2019/20, with 2,369 price spike instances recorded in 2020. Negative pricing increased 170% over the same period, with more than 1,900 negative-price instances recorded in 2020.
That’s according to a policy brief published by the Florence School of Regulation in January (source), which ACER cited in defence of its final recommendation not to meddle with the EU’s energy market design. Pay-as-clear incentives more efficient power plant dispatch, ACER insisted:
“Whenever electricity prices rise considerably, one sees increased debate over the prevalent market model and pricing system. Past analyses tend to reach similar conclusions, namely that in day-ahead markets, a ‘pay-as-clear’ approach is more efficient than a ‘pay-as-bid’ approach.”
Under pay-as-clear, each participant in the day-ahead market can bid just above their SRMC, safe in the knowledge that they will receive the (usually much higher) clearing price.
This incentivises low bidding as there is no need to second guess others’ bidding strategy. The safety net of a higher clearing price also encourages smaller players to participate. And the resultant single price for each bidding zone makes ‘market coupling’ (i.e. integrating European power markets into the EU’s single market for electricity) a simple task.
Under pay-as-bid, generators would each be paid the rate they offer rather than the clearing price.
This incentivises them to bid above their SRMC but below the likely price of the highest bidder to avoid pricing themselves out of the market. This is tricker to do and calls for strategically bidding as close as possible to the cost of the marginal generator. The result is various prices for each zone, which makes market coupling more onerous. Other studies have concluded that pay-as-bid also increases the risk of market manipulation which might discourage market entry.
Less discussed is the fact that PAC gifts zero marginal cost generators (i.e. wind, solar, hydro) priority dispatch. Being able to bid at zero ensures them a place in the merit order, safe in the knowledge that gas generators will cause prices to spike often and high enough to remunerate them sufficiently over the course of each year. It is a subsidy in all but name.
The imperfect market
The argument that PAC is more economically efficient than PAB holds true only in the ‘perfect market’ scenario, characterised by the following:
There is a homogenous product;
There are sufficient levels of competition i.e. a large number of providers, with no party exercising market power; and
There is perfect information about the market available to all parties
When these conditions are not met, PAB can offer better outcomes to PAC. In fact, the British power market experienced 20-25% reductions in wholesale power prices in the first few months after shifting from the Electricity Pool, which operated under PAC, to the New Electricity Trading Arrangements (NETA), which operated under PAB, at the start of the millennium (source).
So, is the single EU electricity market a ‘perfect market’? It could be argued that electricity is inherently an imperfect market. Competitiveness is often determined by attributes such as location, ramp rate, reactive power capability etc. that are not explicitly priced into the auction (source):
“In some cases such heterogeneity leads to product fragmentation where the distinct products are procured through separate auctions ... Such fragmentation reduces the liquidity in each of the separate auctions to the point where some of the underlying assumptions favouring the uniform clearing price approach [PAC] may no longer be valid.” – Shmuel Oren, University of California at Berkeley
This is precisely why the British electricity market is divided up into numerous discrete auctions for balancing services, many of which operate under the PAB model. In fact, National Grid ESO, the UK system operator, modelled the impact of shifting from PAB to PAC for two key parts of the balancing market: the Balancing Mechanism (BM) and Short-Term Operating Reserve (STOR). It concluded that the shift would add around £48 million and £14 million in system costs, respectively (source).
And if one looks beyond the carefully curated literature provided by ACER to substantiate its position, one discovers that market manipulation is not the exclusive preserve of PAB markets. UK regulator Ofgem warned against generators gaming the system under pay-as-clear more than two decades ago:
“…under [PAC], generators can seek to increase market prices by bidding higher prices for marginal output whilst protecting their volume positions by bidding lower prices for infra-marginal output. Under pay-as-bid, prices received for infra-marginal output cannot be sheltered in this way: volume can only be protected by offering a better (lower) price to the buyer.” — Ofgem, 1999
Article of faith
In light of the above, what are we to make of the EU’s fixation with pay-as-clear and dismissal of alternatives? One theory holds that it would undermine the political argument that ‘cheap’ renewables bring down wholesale power prices. Imagine the difficulties commissioners would encounter defending a system that reveals the true cost of wind and solar power generation.
Unable to recoup long-run marginal costs under the veil of a single clearing price set by ‘expensive’ gas, renewable generators would have to bid at a price that covers their fixed costs. When electricity supply outstrips demand in renewables-heavy pricing zones, as frequently occurs on blazing summer days or mild and windy autumn nights, they would have to choose: do they bid below their long-run cost of production to guarantee a place in the merit order, or price themselves out of the market? If the latter, we could see wind farm operators switching turbines off for economic reasons and receiving zero compensation. It would be a genuinely free market for electricity.
In either case, would these generators then recover losses by bidding much higher when demand picks up – and risk being priced out of the market by an occasional glut of ‘expensive’ gas-fired thermal generation? In any case, being seen to bid at or just below the marginal cost of gas-fired generation would put a big hole in rhetorical arguments that wind and solar are ‘free’ sources of energy.
Certainly in today’s overheated EU electricity market there is zero chance of gas undercutting wind or solar. But gas is inherently cyclical and it is entirely conceivable that global markets tip back into oversupply later this decade, perhaps dramatically so, when the next wave of liquefied natural gas (LNG) projects comes online in 2025-26. When gas is no longer unburnably expensive, the economic calculus could look very different.
The EU nailed its colours to the renewables-at-all-costs strategy long ago. If this ultimately proves to be the right strategy, it could be for the wrong reasons. Abandoning priority dispatch for renewables would force these plants to compete ‘naked’ in wholesale power markets, exposing the costs of that strategy. So defending the status quo is as much a political objective as it is one rooted in the very real and pressing need to burn less natural gas while keeping the lights on without bankrupting the EU.
Seb Kennedy | Energy Flux | 5 May 2022
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