Climate Neutrality requires a strengthened, not a curtailed European electricity market

“We will do a deep and comprehensive reform of the electricity market.” The message was clear in Commission President von der Leyen’s annual State of the Union address in September 2022. After months of rocketing electricity prices, she reacted to calls from several Member States to overhaul the Electricity Market Regulation. Spain and France amongst others, where concerned with consumers’ soaring energy bills.

In March 2023, however, the Commission settled for a less comprehensive and a more targeted proposal, adjusting the existing legislation rather than starting an energy revolution - much to the relief of Member States such as Germany, The Netherlands and Denmark. Why did the Commission settle for a more incremental reform? The short answer: the electricity market works. The slightly longer answer is that the current market setup can be improved on, but it delivers on key parameters. It allows electricity to flow semi-freely across borders and it incentivizes the expansion of renewable electricity production and the electrification of key sectors.

The electricity market works

In 2022, drought and war abruptly reduced the EU’s energy supply. However, even in the face of dramatic events, 2022 confirmed that the European electricity market supported a high security of supply even when access to energy was abruptly reduced. The market also gave effective incentives to invest in new renewable energy and to curtail consumption when needed. While vulnerable consumers suffered from periods of high costs (and should receive financial support to shoulder these burdens and avoid energy poverty), the electricity market actually benefits European consumers to the tune of 34 bn. EUR annually. Those gains are the result of current cross-border flows of electricity and of the merit-order system. The system, which prioritizes the access of the cheapest electricity to the market. 

Three points to watch for in the ongoing negotiations on electricity markets

In the coming weeks of negotiations, there are caveats for the European Parliament and the Council. They should be careful when considering the Commission’s proposal to make two-way contracts for difference mandatory for repowering of existing renewable energy projects. This could bring legal turmoil and further reduce investor certainty at a time when the US is already challenging the EU’s ability to attract investors and thus deliver on its ambitious climate and energy ambitions. Legislators should also provide Member States with flexibility by allowing exemptions for already planned projects to support fast deployment.  

Second, decision-makers should avoid any calls for decoupling the price of natural gas from the price of other forms of electricity production, which has been proposed by several Member States and members of the European Parliament. Such changes could do more harm than good by increasing consumer prices and reducing investments in renewable energy. Instead, Member States should seek to reduce natural gas consumption through investments in energy efficiency and heat pumps. Notably, 2022 was a record-year for heat pumps, so Europeans are already taking action to reduce fossil fuel consumption.  

Thirdly, Parliament and Council should focus on phasing out coal as quickly as possible. The ETS makes coal more expensive each year, but Member States such as Poland still provide life support to coal. This is given through state aid, including the so-called Capacity Mechanisms that allow governments to pay operators extra to generate electricity. Coal is facing trouble as the existing regulation ends capacity mechanisms for coal by mid-2025 (legitimately, coal can still be used for the more limited strategic reserve). It is important to dismiss Poland’s new attempt to extend the phase-out date if the EU is to reach its climate ambitions. 

An electricity market fit for climate neutrality

Looking at the current mandate, the EU does not need a deep reform of its electricity market. But what it does need is a better framework, which supports the electricity market. The market must facilitate the comprehensive electrification required, which will more than double the EU’s electricity demand, as well as the forecasted tripling of wind and solar capacity already by 2030. To get there, three concrete steps should be taken. 

1) Construct proper bidding zones that reflect geography and physics. Bidding zones are geographical areas with unison prices. Failure to construct them properly causes severe bottlenecks within and across borders that halt wind turbines, increase consumer prices and cause enormous societal costs to pay operators to curtail production. To make matters worse, large-scale hydrogen production in Europe could double the pain of ill-constructed bidding zones; if the market incentivizes producers to place facilities close to consumers rather than close to producers of renewable energy, transmission grids will have to carry an even heavier burden than today. 

2) Make optimal use of interconnectors between bidding zones. The EU’s agency tasked to monitor the electricity market (ACER) concluded that the electricity market remains incomplete. Several Member States fail to make 70 pct. of capacity available for cross-border trade, as set out in the 2019 Electricity Market Regulation. To ensure a high security of supply in an economy based on renewable energy requires fully integrated markets without bottlenecks on borders. ACER’s resources should therefore be strengthened, and the Commission should put its enforcement tools to better use. 

3) Invest in the grid to phase out fossil fuels. With electrification of transport, industry and buildings, the Commission estimates, that grid investments of more than 500 bn. EUR are required by 2030. Notably, investments are needed in both transmission and distribution systems, the latter supporting the switch to electric vehicles and heat pumps in households and SMEs in particular. 

In conclusion, legislators in the European Parliament and Council should avoid pitfalls such as enforcing mandatory tendering designs retroactively, overhauling the merit-order system and extending capacity mechanisms for coal. Looking beyond 2024, Parliament and Council should work with the Commission towards a better functioning of the European electricity market, allowing electricity to flow freely so that all Europeans can benefit from the vast amounts of affordable wind and solar resources of the European Union.