European Electricity Market Reform

Due to its economic characteristics - large-scale storage issues, very different cost structures between players, demand that is not very responsive to prices and is unstable in the short-term - the electricity market cannot operate like a normal economic market.

It was therefore necessary to invent, at European level, a specific and regulated market structure that can minimise the average cost of production while protecting consumers against supply disruptions, and to do so, guaranteeing a minimum level of prices for producers to invest. This is what drives the design of the European Electricity Market.

However, the recent energy crisis has highlighted that the short-term focus of energy market design – including the excessive influence of fossil fuel prices on electricity prices - can distract players from broader, longer-term goals. 

Following the short-term measures aimed at providing a rapid response to the energy crisis in 2021 and 2022, the EU institutions considered that it was necessary to  “optimise the electricity market design by complementing the short-term markets with a greater role for longer-term instruments, allowing consumers to benefit from more fixed priced contracts, and facilitating investments in clean technologies“^[1].

The Reform

In March 2023, the European Commission (Commission) presented a proposal for the revised rules for the European Electricity Market Design^[2]. 

The proposal includes measures addressing concerns over exposure to volatile short-term fossil fuel prices by improving the design of the electricity market and emphasising long-term instruments, alongside the boosting of renewable energy investments, protecting and empowering EU consumers and enhancing the competitiveness of the industry in the EU.

On 14 December 2023, a provisional agreement was reached during the interinstitutional negotiations, the proposal will have to be formally adopted^[3].

Who is likely to be affected?

The reform of the European Electricity Market Design is set to be relevant for everyone active on the EU’s short-term spot market as well as anyone planning investments into renewable energies (including nuclear energy) in the EU. This especially encompasses all major European energy companies.

At a glance

The European Electricity Market Reform introduces a number of measures. An overview of some major topics is detailed below.

No Fundamental Reform:

There will be no fundamental reform of the short-term wholesale electricity market. The merit order principle which fixes electricity prices to the most expensive energy source sold at a given moment, will remain intact.

In its April 2002 report, the European Union Agency for the Cooperation of Energy Regulators (ACER) had argued for maintaining the link between gas prices and electricity prices: the problem for ACER, at the root of the energy crisis, was the short-term price of gas and not the fundamental structure of the electricity market. The recurring argument being that if gas prices are lowered, by way of regulation, gas consumption will automatically increase.

On this basis, the Commission has refused to implement a genuine structural reform of market regulation. The idea is therefore to encourage investment in renewable energy production capacity, which would ultimately help to limit demand for gas.

Changes can be expected in the form of the shortening of the intra-day gate closure time, to improve the ability for participation by renewable generators, and more granular products for trading in day-ahead and intra-day markets are planned (e.g. smaller minimum bid sizes), to allow for participation of more diverse players.

Long-Term Planning:

The Commission proposes the use of long-term contracts to overcome high prices on the short-term market, in the form of Power Purchase Agreements (PPAs)^[4] and two-way Contracts for Difference (CfDs – two-way means that the contract provides both minimum remuneration protection and a limit to excess remuneration)^[5]. 

With the help of these contracts, the Commission hopes that the volumes traded on the wholesale market - where prices are often determined by gas prices - would therefore fall sharply. But the market logic would not totally disappear. 

Through PPAs, private investors contribute to the development of renewable and low-carbon energies while setting low and stable electricity prices over the long-term. Similarly, through CfDs, public entities can achieve the same objective on behalf of consumers.

• PPA: With PPAs there is a proposal for the reduction of off-taker credit risk and mandatory supplier hedging to boost the use of this long-term option. 
• CfDs: With two-way CfDs, generators would be guaranteed a set strike price regardless of the market price the electricity produced is actually sold at. Direct support schemes will only be possible in the form of two-way CfDs or of equivalent schemes with the same effects for investments in new power-generating facilities. There will be a transitional period of three years (five years for offshore hybrid assets). 

These schemes shall apply to investments in generation of electricity from the following sources: wind energy; solar energy; geothermal energy; hydropower without reservoir and nuclear energy.

CfDs would ensure that producers' revenues from new investment in publicly supported electricity generation become more independent of the volatility of fossil fuel electricity generation prices, which generally sets the price on the daily market.

The obligation to use CfDs does not apply to aid schemes that are not directly linked to electricity production, such as those relating to storage, and that do not involve direct price support, such as investment aid in the form of initial subsidies, tax measures or green certificates. 

In order to further mitigate the impact of higher electricity prices on consumers' energy bills, Member States should ensure that revenues collected from producers subject to direct price support schemes in the form of CfDs are passed on to final customers.

Electricity Price Crisis:

When certain conditions are met, the Council may decide on the declaration of an electricity price crisis. Conditions are namely a high average wholesale electricity price with a minimum threshold of 180 EUR per MWh or an increase in retail prices of about 70 percent. Member States could apply price interventions once the crisis is declared, notably to aid households and Small and Medium Enterprises. 

Flexibility:

Member States will be required to assess their needs for power system flexibility from non-fossil fuel sources, such as demand response and electricity storage, and establish means necessary to meet these needs. Capacity Renumeration Mechanisms will become a more structural element of the electricity market. It has been agreed upon to introduce a potential and exceptional derogation from the application of the CO2 emission limit for already authorised capacity mechanisms.

Outlook

Deep market interventions, especially in the form of structural reforms of the spot market have been minimised to adjustments to existing processes. This will come as a relief to many market players, fearing major changes could change standing investment plans and deter investment needed in renewable and low-carbon energy. 

It remains to be seen whether the efforts at strengthening the long-term market have the intended effect or will lead to unintended consequences as a variety of existing electricity market arrangements and processes rely on the spot markets. Giving up short-term market liquidity for less established long-term purposes may have unintended consequences. While PPAs and two-way CfDs establish a set pricing that should allow for plannable profit for a set duration, the absorptions of “excess profits” by way of the strike price, could potentially cut wins significantly when relying on government support schemes. However, there will no mandatory CfDs or similar schemes for already existing power plants. 

As ensuring reliability and investments in the renewable energy sector is essential for meeting the expansion targets set out, it remains to be seen if the Electricity Market Reform manages to sooth worries over volatile electricity markets.

It should be noted in this respect that the question of the implementation of these measures into national law will be essential and then will have to mobilise the attention of the players.

Our teams would be more than happy to support you on your energy transition and regulatory journey and discuss any aspects with you. Please feel free to contact your usual Freshfields contact or one of the key contacts below if you have any questions.