On Reflection: We must not recreate the wrong market model

EUROPE: The EU's proposal for a new Electricity Market Design turns a blind eye to the elephant in our midst. Operating wholesale electricity markets that set payments based on the marginal cost of generation is an energy model that needs a rewrite.

The more the wind blows and the sun shines, the more electricity is fed into the market, driving down prices as demand is saturated. Low prices might sound like good news for electricity customers, but for generators they are anything but. Even wind producers with no fuel costs need to pay off their loans and turn a profit.

Periods of very low or negative prices occur ever more frequently in energy markets where marginal cost sets the price and renewables' content is growing, such as Denmark and Germany. The marginal cost of energy reflects the cost of generation here and now; it excludes the lifetime capital and running costs of the plant. Wind turbine owners in Denmark are feeling the pinch. The more wind production there is, the less they earn.

For fossil generators who need to buy fuel the situation is already dire. Solar and wind out-compete their fossil-fuel competitors on energy-only markets. With low operating overheads they can generate at zero marginal cost. Reports of wind meeting all demand for periods of 24 hours and more are becoming the new normal. In July, wind in Denmark reached 140% of demand, with the excess exported, driving down prices to their lowest level yet. On the Nord Pool spot market the price dropped to EUR3.88/MWh on Sunday 26 July, the lowest in 17 years.

In wholesale electricity markets, the marginal price rises and falls as demand changes over the day. The lowest price bid for any one hour or so decides the price paid to all generators. In displacing fossil fuel, wind becomes the price setter. It drives down the average price and the marginal peak price. For fossil-fuel generators that rely on occasional extreme price peaks to maintain a certain average price (and profit), lower prices are problematic. For wind they are life threatening. When wind is the price setter, price peaks are most likely in periods of high demand and low wind production, when other generators can score to make up for low prices, but wind cannot.

The marginal-cost market model is clearly bad for fossil fuels on a decarbonising electricity market, but it is also bad for renewables, even where they are competitive. Earnings drop and there is no incentive to invest in future capacity. A total rethink is needed. But Europe's just released proposal for a new electricity market design appears to follow the long pursued "target model" that relies on the marginal-cost pricing principle at its heart.

It is good that the EU proposal recognises that accommodation of variable renewables requires a flexible electricity system, one in which customers are paid to reduce demand, price signals are intended to stimulate the right kind of generation at the right moment, and sufficient reserve is maintained to ensure security of supply. But it largely turns a blind eye to the fundamental dilemma of attempting to operate an electricity market based on the marginal price of production when that price is frequently zero.

The good news is that elsewhere disparate energy policy professionals have opened their eyes to the marginal-cost elephant. Ideas are forming for a whole new approach to electricity markets for a low-carbon world. Some of the inspiration is from Latin America. Its fraught experience with a marginal-cost market based on renewable energy, hydropower, has spawned exciting solutions. What the emerging ideas have in common is consideration of parameters other than energy on which generators can compete while avoiding the introduction of market distorting mechanisms and seeking to facilitate more customer influence.

For these ideas to gain traction, the wind industry has to get behind them. It must seize the initiative provided by the EU consultation to support these bold new ideas, or see fossil fuel and nuclear continue to have it their own way. Now is the moment.

Catherine Mitchell is the current chair of the Regulatory Assistance Project and professor of Energy Policy at the University of Exeter, UK

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