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Electricity market design: a balancing act for all

By Lucy Whitford, Managing Director – UK&I at RES

Future market design is occupying a lot of thinking across the energy industry as the volume of electricity generated by renewables increases. For example, in the UK, four in five energy industry participants agree that the current electricity market arrangements are not fit for purpose and will not deliver a decarbonised power sector by 2035, according to a recent UK government consultation response. The European Union’s assessment of its electricity market design is somewhat more tempered, concluding that the current energy crisis has ‘showed certain shortcomings’.

With relatively widespread agreement that market design changes must be made, the question now is to what, by how much, and when. Should we rip up the rule book and fundamentally redesign the market, or continue to make incremental changes?

With several options to consider, deciding the way forward is highly complex, but what we do know is that whatever the solution, it has to move us closer to providing all consumers with affordable, zero carbon energy. However, this must also be met with a measure of balance. A radical redesign risks shaking investor confidence, and even a short investment hiatus could set the UK’s decarbonisation journey back by years. Yet, if it does not go far enough, investors will not receive sufficient signals to invest the billions of private investment required with the rapidity needed to reach decarbonisation by 2035.

Decoupling from gas

One of the key premises of any new design is solving how we decouple the cost of electricity with that of gas, so that the market properly values the contribution of renewables, and consumers benefit from the cheapest sources of power.

One option consulted on in the UK’s recent Review of Electricity Market Arrangements (REMA) was the introduction of a green power pool, the cost of which would be made up of the long-term marginal cost of renewables. It’s a complicated option that is not without its flaws, however it offers a clear and viable pathway of decoupling the electricity price from gas.

Around half of respondents to REMA agree that splitting the wholesale market in this way could be a workable option, but concerns remain around liquidity, efficient market operation, and market participation, and any solution will require a great deal of industry collaboration to design, assess, and deliver it. Despite the complexity, thoughtful decision making, with close industry cooperation should deliver the best outcomes for everyone. Further, some of the necessary uncertainty could also be dealt with by grandfathering some features of the existing market design to maintain investor confidence – while the new market design would apply to all future investments.

Increasing signals for flexibility

At its heart, any market design changes must increase demand for electrification and flexibility. Green hydrogen will play a big part in achieving both. It’s flexible, can be stored, used to decarbonise hard to electrify industries, and make use of excess wind and solar power.

More broadly though, we need to increase investment in flexibility and operability, and incentivise good behaviour from all energy generators. It starts with smart meters and access to data and stretches right across to the types of flexibility services offered by the TSOs (Transmission System Operators). The European Commission recently recognised the importance of this in its Electricity Market Design reforms that will require member states to have a greater focus on their flexibility capabilities. The proposal requires Member States to assess their needs for power system flexibility and establish objectives to deliver on these needs. Member States can design or redesign capacity mechanisms to promote low-carbon flexibility.

In an ideal energy ecosystem, anyone connected to the grid would be able to provide flexibility, and there are signs that this is beginning to happen in the UK at least. Earlier this year a major energy supplier pioneered a trial that asked domestic customers to reduce usage at times of peak demand. Similarly, this summer, UKPN will begin calling on generation turn-down (or demand turn-up) within its local flexibility market, helping to incentivise more renewables to connect and generate electricity.

Those examples aside, we need to see more of these types of innovations come forward faster. The introduction of the Optional Downward Flexibility Management in response to lower demand because of COVID-19 is a testament to how quickly new flexibility services can be designed and introduced. Indeed, the proposed European Electricity Market Design proposals puts significant emphasis on flexibility, and gives certain powers to members states to incentivise flexibility; for example, through peak shaving products. So, what are we waiting for?

Greater flexibility is a pre-requisite to achieving decarbonisation by 2035, so it is vital that we find a way to scale flexibility quickly while maintaining a stable investment market. To drive more efficient outcomes, generators should be incentivised to be flexible and match demand rather than to generate. Meanwhile introducing alternative market mechanisms will be important for enabling a fair price for renewables and address price cannibalisation, alongside ensuring that the gas price no longer sets the wholesale market price. These are just a few of the core values we believe must be taken into consideration for electricity markets redesign.

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