The current energy market structures, including the short-run-marginal-price-on-all nature of the current wholesale market, are not fit for a transition to a renewables-dominated system.
The present emergency responses to the energy crisis across Europe are unsustainable and are generating acute economic and political tensions, which could grow. The UK moved from targeted fiscal supports to a more general price cap on electricity, which, due to its cost (to government) is now set to end after this winter, with a search for new approaches. In the EU, following an acute focus on gas prices, attention is turning to the scale of unequal cost burdens and windfall profits in the European electricity market, precipitating urgent debate about reforms that could also align with the need to further accelerate the move away from fossil fuel generation.
In our new paper “Separating electricity from gas prices through Green Power Pools: Design options and evolution” we look beyond the immediate emergency measures to outline how opportunities for structural reforms in the electricity sector could also be harnessed to help address near-term concerns. Its core focus is on the UK, and specifically the opportunities potentially offered by a Green Power Pool to meet dual objectives: to help relieve the current and future pressure for general government support on electricity prices; and to evolve electricity market structures. The UK is in the midst of an ongoing government Review of Electricity Market Arrangements (REMA), stimulated by the recognition that the current structures, including the short-run-marginal-price-on-all nature of the current wholesale market, are not fit for a transition to a renewables-dominated system. Many of the issues and options examined are, however, relevant across the continent and beyond.[i]
Where are we heading?
Without reforms to electricity markets, the cost of fossil fuel-based generation will continue to serve as the primary driver of wholesale electricity prices in Great Britain and across most of Europe. Gas prices are volatile, but forward contracts indicate that for many years to come average electricity prices across Europe are expected to remain well above levels of the previous decade.
In the coming years, the contribution of renewable energy will continue to grow rapidly, whilst the average cost of renewables continues to fall. Worldwide, the large majority of new electricity capacity installed in 2021 was renewable. Across Europe, non-fossil generation overall already exceeds 60% of electricity generation. Over the next five years this is projected to rise to close to 75% – overwhelmingly driven by rapidly rising input from variable wind and solar energy supply, which, on current plans, would provide up to half of all electricity generation by 2030.
Emerging from the energy crisis with sustainable solutions, including increased resilience to fossil fuel supply and price volatility, requires electricity market reforms which align with the resulting opportunities and challenges. Our previous paper examined and critiqued some of the fundamental issues in electricity market design, which are largely commonplace across Europe, explaining why the current design is simply not fit for this future. From this, we suggested five guiding principles for assessing market reform options for electricity transition in the context of the energy crisis, as summarised in Box ES-1.
|Box ES-1: Five guiding principles for, assessing market reform (source: see note ii)
1. The growing prevalence of lower-cost renewables is not an aberration in electricity markets but a fundamental feature, and offers opportunities for responses to the energy crisis that align short- and longer-term needs by:
a. Making better use of existing low-carbon generation in the context of energy crisis.
b. Recognizing that the most rapid and extensive progress has been due to investment based on long-term contracts, which have been mostly outside the current wholesale market. The implication is that seizing opportunities requires substantial developments in electricity market design to support the move beyond a fossil-fuel-led system.
2. Structural solutions are required to separate the average price of electricity from the short-run marginal-gas cost and risk-based premium pricing of current wholesale markets.
3. Governments need to consider whether vulnerable groups – in both households and business – can or should be priority beneficiaries of the revolution in cheap, clean electricity.
4. Seizing the opportunity of low-cost renewables ultimately requires market structures which apportion backup and balancing costs appropriately and proportionately.
5. Along with supporting infrastructure, pursuing the energy transition will require new policy approaches and institutional structures to engage consumers across all energy uses, to enhance investment in energy efficiency, innovation, and electrification with flexibility.
Contribution and limitations of current approaches to renewable electricity
Some key government support mechanisms for renewable energy already reflect the first of these guiding principles, with tailored policies that have driven expansion and cost reductions. In Great Britain, Contracts-for-Difference (CfDs) have also started to decouple the average cost of low-carbon generation from the short-run marginal price (the second guiding principle). As the current wholesale price far exceeds the ‘strike price’ of many CfDs, especially the most recent ones, renewable generators on CfDs are now returning substantial excess revenues back to offtakers (suppliers) – sums likely to reach £730 million for October to December 2022 alone.[ii]
This valuable progress has, however, been achieved largely by separating financial terms for investment from the signals provided by the electricity market, rather than reforming the markets in ways aligned with renewables investment. For the most part, consumers cannot directly access this generation at or near their costs. For CfDs, the complex process of recycling surplus generator income – from sales into the wholesale market back to suppliers – limits the ability to address the other three guiding principles listed above. For other low marginal cost generators (including existing nuclear and renewables with ‘renewables obligation certificates’), the government’s stated intent is to limit windfall profits accruing to them with a ‘Cost-Plus Revenue Limit’ in ways yet (at the time of writing) to be specified.
Alongside government-backed contracts, the private sector has been making an increasing contribution, particularly through bilateral renewable energy Power Purchase Agreements (PPAs). Despite growth and vibrant innovation in PPAs, their contribution to clean investment remains limited by a range of factors including high transaction costs, contractual complexity, counterparty suitability and risk sharing, and wider regulatory hurdles to project development.
In effect, electricity generation has already moved away from a single homogenous market – the dominant wholesale market is accompanied by fixed-price CfD contracts (for larger non-fossil generators), and PPAs. Feasible reforms should build on these foundations.
A Green Power Pool based on Contracts-for-Difference
In a 2018 report, we first outlined an approach which would enable consumers to access cheap renewable energy through a ‘green power pool’, which can be most simply conceived as a combined volume of electricity from many renewable generators, made available to consumers directly rather than through the current wholesale market.[iii] The aggregator – the ‘pool operator’ – would offer contracts to consumers based on the average cost of this generation, including through suppliers licenced for this purpose. To provide reliable power to its customers, the pool operator would buy electricity from the wholesale market when there was insufficient renewable generation and sell back to the wholesale market when the pool generates more electricity than needed by its customers.
In Great Britain, a natural starting point could be to re-direct the sales of electricity already produced by generators with Contracts-for-Difference. This could be achieved without significant changes to the financial terms of CfD contracts that have so successfully supported the growth of large-scale renewables, hence maintaining investor confidence. Such a ‘CfD-derived pool’ would, at least initially, have to be targeted to key consumer groups. This could help support vulnerable consumers with low-cost electricity and reduce or remove the need for future government support. More specifically, the volume of CfD-derived electricity already available could be offered to two groups of high political and welfare concerns:
- Industrial consumers whose international competitiveness is directly threatened by the differential between electricity prices in GB compared to countries where electricity prices are directly regulated
- ‘Fuel poor’ domestic households – groups already targeted for previous government supports, or otherwise defined for this purpose, potentially including electricity-only households or those otherwise exposed due to exceptional electricity requirements
In both cases, the price to these consumers (either with direct contracts or indirect contracts, through suppliers) would necessarily be regulated to reflect the cost of generation, independent from price developments in the wholesale market (with network and other applicable costs to be added to produce the final retail price of the CfD-derived electricity). The creation of such a green power pool would be entirely independent of, and compatible with, modest reforms to new CfD contracts already being considered.
Balancing a Green Power Pool
To provide electricity whenever required (“firm”), the Pool would require balancing from ‘on demand’ sources, when there is insufficient wind or solar to meet Pool demand.[iv] This need for such complementary balancing – through purchases from, and sales to, the wholesale market - has implications for the design and accounting of the Pool’s operations, including emissions accounting.
As noted (ref 1, section 3.3), efficient balancing and backup is ultimately a property of the system, not individual sources of power generation. Ensuring reliable supplies of electricity requires the Pool to trade with the wholesale market. Buying these balancing requirements from the wholesale market meets our guiding principle #4 (i.e., that these costs should be allocated appropriately and proportionately). There are several options for how these costs – and benefits from selling any ‘surplus’ generation into the wholesale market - are distributed to participants in the Pool.
The simplest approach to contracts is summarized in Table ES-1. The basics of the operational relationships in a green power pool are set out in section 5 of our paper, along with design principles for more complex, ‘cost-reflective’ contract structures that preserves the signals provided by marginal pricing through ‘two-tier’ contracts.
Table ES-1: Physical and consumer cost states in the Green Power Pool – Simplified consumer cost model
Physical flows and payments with wholesale market
Pool generation is surplus to pool demand
Pool/generators sell surplus power to wholesale market
Pool consumers pay the ‘assured price’ for all their electricity consumption
Pool generation is insufficient to meet pool demand
Pool buys additional power from the wholesale market to meet demand
Additional costs passed through to pool consumers, applied to demand exceeding their ‘proportionate’ share of Pool supply, as either
· a changing unit price as the volume of purchase required by the pool grows, or
· “two-tier” pricing, i.e., with the proportionate power at the assured price, additional power charged at the wholesale market price (if suppliers have capacity for such contracts)
Coverage and costs
Based on CfD contracts already allocated through competitive auctions (i.e., awarded since January 2015), the current average generation cost of these renewables is well under half the current price of wholesale electricity, and would continue to decline; by 2026/27 the weighted average price would be below £60/MWh, far below the cost of forward contracts and close to the average wholesale price of electricity in Great Britain across the 2010s. The volume by then would be around a quarter of all UK power generation, similar to the volume of renewable generation already supported by Renewable Obligations.
Institutionally, this would require a government-backed body to act as Pool operator, amendments to the operational terms of CfD contracts such that generators are required to sell their electricity through the Pool, and regulation to set the parameters for demand-side contracts. Targeting CfD-derived electricity at the most vulnerable groups of consumers is bound to add complexities. However, it may offer a more economically sustainable and robust way to protect these groups from high energy costs than other means of support yet adopted or proposed.
Expansion and consumer engagement
In return for offering low-cost, renewables-based contracts to vulnerable business and ‘fuel poor’ consumer groups through a CfD-derived Green Power Pool, the government or implementing agency could engage directly with recipients of this cheaper electricity. This could, for example, include support to enhance energy efficiency and install smart meters.
The current generation capacity on CfDs is limited, though growing rapidly. One option to enlarge the pool would be to move other low-marginal-cost generators on to CfDs. The EU has moved to cap the revenues of such generators, and the UK has indicated plans to do the same. Another option in the UK could be to move renewables that have benefited from the Renewables Obligations (which are economically akin to ‘feed-in premiums’ used in other European countries) to long-term fixed-price contracts. If they were moved on to CfD contracts – and so potentially to a government-backed Green Power Pool – the volume of renewables covered by the Green Power Pool would then easily match the present electricity demand of at least two additional consumer groups, who could be natural customers for renewable electricity. These include:
- Business, public and private consumers who are already signed up to ‘green tariffs’ – many of which are based on RO-supported renewable generation. They would then be directly purchasing renewable energy, unlike the present system in which most renewables sell through the wholesale market, and ‘green tariffs’ reflect the gas-driven wholesale price.
- Consumers who are contributing to reducing fossil fuel dependence through, for example, industrial or commercial electrification, electric vehicles, and heat pumps.
We also outline a related approach, through which government could in parallel help to foster more effective and efficient private sector Power Purchase Agreements through standardisation of private long-term contracts. This could potentially draw on lessons from the development of consumer contracts under a Green Power Pool but should also build on innovative approaches to consumer engagement in the PPA market.[v]
As widely noted, the future energy system will need efficiency and flexibility as electrification proceeds. Market reforms adopted in the context of the energy crisis should align with these longer-term needs, to help forestall future crises. Along with maintaining the investment efficiency of long-term contracts for generators, they should both encourage and support consumer engagement.
Ultimately, creating routes through which consumers can meaningfully buy and, indeed, increasingly demand competitive renewable energy can only accelerate the transition in the electricity system and electricity markets that is demonstrably required.
Notes to the Executive Summary:
[i] This paper builds directly on our previous study of economic fundamentals relating to the electricity transition in a time of energy crisis: M. Grubb (2022a), ‘Navigating the crises in European energy: Price Inflation, Marginal Cost Pricing, and principles for electricity market redesign in an era of low-carbon transition’ - Working Paper #3 in UCL-ISR Series Navigating the Energy-Climate Crises (NECC #3), at https://www.ucl.ac.uk/bartlett…, co-published as INET Working Paper 191. The paper focuses particularly on the challenges and opportunities arising from the rapidly rising volumes of cheap renewable electricity. The paper does not take a position directly on some other debates in market reform, such as locational market signals and detailed reforms to long-term generator contracts, either of which could proceed largely independently of our core proposition.
[iv] Note that in reality, since no equipment can operate with 100% reliability, such ‘balancing’ is required for any generation either implicitly (through the wholesale market) or explicitly (e.g. bilateral PPAs). A green power pool offers a mechanism for balancing renewables output more efficiently, by first aggregating renewables output e.g. as weather systems sweep across the country.
[v] Government could work directly with the associated business groups to structure standardised forms of long-term PPA contracts, acting as a coordinator and providing elements of contract standardisation which are currently lacking. The design of such contracts – with contract lengths potentially matching the outstanding duration of the RO-contracts – could form part of the negotiations for moving RO-based (or premium-FiT) generation to long-term fixed-price contracts. If the design can be sufficiently standardised, such contracts would embody a generalisable commitment to deliver low-carbon electricity at a fixed price for a given duration, and could be tradeable, reducing counterparty risks. We aim to explore these possibilities in future research.