The General Court of the European Union annulled the European Commission’s decision not to investigate or object to the subsidy scheme, suspending the market responsible for "keeping the lights on" in the UK.
The case was brought by flexibility services provider Tempus Energy, which successfully argued the capacity market discriminates against energy consumers who want to deliver energy demand services to the grid, in favour of gas, nuclear and coal power stations.
Tempus argued the short length of contracts offered for demand-side response services compared to new-build plants, which can claim 15-year deals, was discriminatory.
Sara Bell, CEO of Tempus Energy, said the ruling should force the UK government to "maximise climate-friendly renewables."
Climate Action Network Europe (CAN) said the ruling "casts doubt" over many capacity mechanisms in place across Europe, such as Poland’s which is modelled on the UK’s and estimated to cost Polish taxpayers up to €14bn mostly supporting existing coal plants.
Coal policy coordinator at CAN, Joanna Flisowska, said the court ruling "confirms that in practice capacity mechanisms are used to hand out money to fossil fuels rather than for security of supply. This casts doubt on other capacity markets, especially the Polish one."
The ruling comes as negotiations between MEPs and member states over controversial electricity market reforms remain deadlocked, unable to agree an an end to subsidies for coal-fired power generators.
Member states, including Poland and UK, are opposed to ending subsidies.
Flisowska said: "At the upcoming trilogue negotiations the EU must correct its faulty rules and exclude immediately the most polluting plants, and coal in particular, from capacity mechanisms."