Electricity Market: Will the Patchwork Hold?
OpinionOpinion by ZEW President Achim Wambach and Axel Ockenfels, Professor at the University of Cologne
With the phasing out of nuclear energy, the agreed-upon exit from coal, and the expansion of renewable energy, ensuring supply security in the electricity sector has become an increasingly pressing problem. To address this, the government has established the Climate-Neutral Electricity System Platform. The industry demands “advance payments for new reliable capacity” (“Neubau-Vorschüsse”). However, the proposed concepts have so far failed to convince.
Twenty-five years after the liberalisation of Germany’s electricity market, the state has regained substantial control: There are hardly any market entries and exits that are not politically or regulatory driven. In day-to-day power trading, political forces prevent electricity prices from reflecting regional shortages, despite the fact that this would lower overall electricity costs and enhance supply security. The state reaps seemingly excessive profits and cushions impending losses through subsidies. An industrial electricity price is intended to keep costs low for energy-intensive industries, while so-called contracts for difference are likely to result in solar and wind energy being increasingly decoupled from market dynamics and subsidised. These interventions, although well-intentioned, create fractures in the electricity market’s architecture, necessitating further repairs. Consequently, the market exists as a patchwork quilt, trapped between liberalised competition and government interventions.
Security of electricity supply is increasingly jeopardised
As a result, the security of electricity supply is increasingly at risk. Dozens of gas power plants are necessary when wind and solar fail to generate electricity. However, no company seems willing to invest. If supply security is lost, Germany will also fail to achieve its climate and economic policy goals. Therefore, a massive new patch is now being inserted into the electricity market: the government plans to introduce gas power plants with a capacity of around 25 GW as a “strategic reserve”. However, doubts persist regarding the adequacy of both the volume and the conceptual viability of this plan. Upon scrutiny, the strategic reserve falls short in delivering satisfactory results.
The strategic reserve is both inefficient and costly. Unlike a strategic oil reserve, which is held back and only made available during crises, a gas power plant designated for crisis situations can operate during normal times as well. However, the strategic reserve can only generate electricity when the market is on the verge of collapse, leaving its capacity unused and potential contributions to financing and reducing electricity prices untapped. While withholding capacity in regular electricity markets is rightfully seen as exerting market power and subject to sanctions, the state rewards this behaviour when it comes to the strategic reserve.
Moreover, the simple equation that more strategic reserve automatically leads to greater supply security is flawed. True supply security results from the secured capacity accessible to the entire market. However, if the strategic reserve displaces investment activities in the regular market, the desired effects on supply security could partly dissipate.
High electricity market prices are not unusual in shortage situations
Furthermore, the state’s role doesn’t end with the construction of new power plants. With each deployment of the strategic reserve, the government must also determine electricity prices during scarcity situations. High electricity market prices are not uncommon in such cases, but they are politically unattractive. Yet, if the government keeps prices low, it undermines investment, production, and incentives for flexibility within the electricity market. Experience has also shown that managing a strategic reserve poses regulatory challenges. The existence of numerous gas power plants alone does not guarantee a sufficient incentive to ensure electricity production in times of extreme scarcity. During the catastrophic blackout in Texas in 2021, caused by unusually cold weather, a significant number of gas power plants failed due to inadequate winterization of pipelines, resulting in freezing.
Not all proposals for ensuring supply security include new power plants as part of the strategic reserve. One such proposal, put forward by network operator TransnetBW, suggests an “advance payments for new reliable capacity” scheme that links subsidies to the contribution a newly built power plant makes to grid stability. However, it is important to distinguish between grid stability and supply security, as they present distinct challenges requiring different solutions. In the one case, short-term operational incentives are decisive, in the other case long-term investment incentives. By blending the two, as in the case of the “advance payments for new reliable capacity”, the incentives for power producers to contribute to grid stability may be compromised. Receiving guaranteed payments can undermine their motivation to contribute when it is truly needed. Additionally, it is worth noting that both the advance payments for new reliable capacity and the strategic reserve focus solely on the supply side of the electricity market, overlooking the potential contributions of large electricity consumers who can reduce their demand during periods of scarcity. Introducing advance payments for new reliable capacity would simply be another makeshift solution in an already fragmented electricity market.
Capacity market has many advantages
Over the years, numerous piecemeal mechanisms have been added to the electricity market in the name of supply security. However, concerns have not abated; if anything, they have grown. Therefore, it is crucial to consider comprehensive and coherent mechanisms that promote market flexibility, encompassing a wide range of technological and flexibility options on both the supply and demand sides. One potential solution could be the implementation of capacity markets, widely adopted in other countries to strengthen the resilience of their electricity markets. While a comprehensive capacity market presents its own challenges, properly designed, it offers several advantages: It would take into account investments in storage and demand-side flexibility; it wouldn’t withhold power plants from the regular market; it guarantees the entire secured capacity; and it compensates for additional capacity only when investment incentives in the regular electricity market fall short.
It remains to be seen whether the Climate-Neutral Electricity System Platform, set to release its first report in late summer, will recommend further piecemeal adjustments or present a cohesive and comprehensive concept capable of restoring a sturdy foundation to our increasingly fragile electricity market.
This opinion was first published as a guest article in the Wirtschaftswoche.
