D-Day is dawning for Europe's electricity markets

In the early years of liberalisation the focus of regulatory scrutiny concentrated mainly on short-term market efficiency and competitiveness. As the first territories to liberalise — among which are England and Wales — have now reached the end of their first investment cycle, much attention is being paid to assessing the long-term performance of the liberalised electricity industry. In particular the question of whether liberalised markets will incentivise adequate generating capacity in the long run. Will investments be adequate and timely to maintain security of supply, and what can be done to improve investment prospects in European liberalised electricity markets?

Some electricity markets are just starting to absorb surplus capacity inherited from pre-liberalisation, so that the decisive test for liberalised electricity markets remains ahead. This is the case in the more mature European continental markets such as The Netherlands, Germany, and the Nordic countries.

It is essential to distinguish short-term security of supply (matching supply and demand in real time and over a few hours every day) from adequate longer-term generation capacity, which requires maintaining an optimal level of investment in the long run. These two concepts are to some extent related, as increased capacity facilitates the task of ensuring supply security in the short term, while economic incentives for long-term investment in generating capacity rely on efficient price signals from the real-time markets.

Ensuring efficient security and adequacy of supply in a liberalised market involves defining the rights and responsibilities of the various market parties, and designing markets that allow market participants to efficiently trade these rights.

There is a consensus that the solution to the short-term security-of-supply problem requires a single central regulatory authority to balance supply and demand. In practice this is commonly dealt with by designating this responsibility to the system operator (in the UK, National Grid) which maintains national supply security through the procurement of short-term reserve generating capacity, and by demand management — encouraging intensive electricity users to reduce their use when the margin between supply and demand is tight.

In the different European markets the system operators are all responsible for balancing their electricity system on a real-time basis, but the mechanisms for balancing the national electricity systems vary largely between countries. If the EU is to integrate national systems into larger regional systems then it will need to harmonise the working of these balancing mechanisms. But the question of who is responsible for ensuring adequate longer-term generation capacity is more controversial. Under the 2003 Internal Electricity Market Directive investment decisions are left to market forces, but the Directive also gives governments the right to tender for new electricity generating plant.

While some countries, such as the UK or the Nordic countries, have committed not to interfere with market forces, other countries faced with potential capacity shortages, for example Ireland or Greece, have used tenders to maintain adequate generating capacity.

While in theory adequate generating capacity could be achieved by relying on pure market incentives, various market imperfections are often raised to question the ability of the current industry framework to deliver appropriate long-term generation incentives: uncertainty of environmental regulation, risk aversion and myopic investment behaviour, the failure of balancing markets to convey scarcity signals, and the ambiguity of system operators’ responsibilities and incentives for ensuring adequate generation capacity in some markets.

Moreover, the current commitment to retail competition embedded in current EU legislation makes long-term contracts between generators and suppliers unattractive, and therefore the financing of new generation projects risky. Vertical integration and concentration have been the dominant way to mitigate risks in the European market.

But do these market failures constitute a strong enough case for regulatory intervention to support investment? Is there any best-practice market design that can ensure adequate longer-term generation capacity at least cost while minimising regulatory interference with the market?

There is as yet no consensus among regulators or academics on which provides the best long-term investment incentives. There have been concerns that when the system is tight energy prices might not be high enough to prompt adequate investment, particularly in capacity to meet peak demand.

In response some regulators have implemented various investment support schemes, ranging from placing requirements on the system operator to contract for additional reserve generation capacity, to building various capacity mechanisms into the market rules— for instance, paying generators in exchange for the undertaking to supply electricity if required.

In one version, known as ‘capacity payments’, the regulator sets a price for capacity and lets the market determine the amount of capacity available. This approach has been used in Spain and in the former British Pool (1990-2001). In the other version — ‘capacity obligations’, which are used in the eastern pools in the US — the regulator sets the amount of generating capacity that has to be available and lets the market determine its price.

However, experience has shown that such capacity support measures carry their own costs, and that their implementation presents significant problems in practice, in particular in interconnected systems.Furthermore, the predictability of calculated capacity payments can lead to manipulation in markets with a few dominant players, as the British Pool experience demonstrated, resulting in its abandonment and the establishment of the New Electricity Trading Arrangements (NETA) in 2001. Most importantly, capacity payments or mechanisms can be thought of as targeting the symptoms rather than the cause of the aforementioned electricity market failures.

Therefore, if investment in new capacity appears insufficient, one should investigate the cause of such shortfall, and evaluate carefully the costs and benefits of alternative potential institutional or market design changes, paying particular attention to the degree of competition in the market. If generators have significant market power, they might be tempted to strategically defer investment to raise prices, in which case granting additional rewards through capacity mechanisms will be unnecessary. Instead, regulators should concentrate on monitoring market participants’ behaviour and possibly on taking action to increase competition in the market.

In conclusion, the concerns about maintaining adequate generation capacity should primarily be addressed by resolving the potential flaws of existing markets. In particular, designing balancing and reserve markets which properly signal scarcity to spot markets and inform contract markets without distortion is key to providing adequate incentives for investment in capacity. Efforts to develop a system for market monitoring and transparency across European markets should be continued, both to provide an early-warning system for the need for regulatory intervention and to guide investments of market parties. Regulatory uncertainty needs to be reduced: the incentives and duties of the system operator versus market players with regard to adequate long-term generation capacity need to be clarified and potential barriers for investment arising from uncertainty regarding future environmental policy should be addressed. Finally, further integration with neighbouring markets would be beneficial to share reserve capacity and thereby increase the resilience of the system.

Together these measures ought to be sufficient to ensure that the market provides adequate generation capacity in the long-term. However, if policy-makers’ risk aversion requires stronger adequate generation capacity guarantees then alternative institutional and regulatory arrangements should also be examined, from the least disruptive — such as giving a clear duty to the system operator to maintain a certain reliability level — to more radical solutions such as market design changes (‘capacity payments’ or ‘capacity obligations’), or even retaining or reintroducing the domestic franchise with long-term contracts on behalf of their domestic customers.

Each electricity system has its own peculiarities, making it less likely that there is a ‘one size fits all’ solution to ensuring there is adequate generation capacity, although in an interconnected system there is merit in working towards a compatible and perhaps common solution.

Dr Fabien Roques is a member of the International Energy Agency, Paris and of the Electricity Policy Research Group, University of Cambridge.