Preparing for the EU’s Power Provisions

While the debate rages, energy buyers are caught in a rapidly changing market of new regulations, environmental standards, cross-border cooperation, increased uncertainty, volatility and complexity—each with their attendant risks

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Michael HintonMichael Hinton

By any measure, the European Union’s plans for a fully integrated electricity market are ambitious: a single, deregulated electricity market across 28 EU member states and 500 million energy consumers, which meets stringent environmental targets while protecting electricity users from supply issues.

It’s been a relatively slow and steady process: Since 1996, a series of directives have chipped away at monopolistic utilities, enabling new business models and new players to challenge incumbents. As most energy suppliers, including fossil fuel, nuclear and renewable, can attest, the electricity market is now all but unrecognizable. To take just one example, industrial and commercial tariffs are almost fully deregulated with feedstock procurement now a market-based activity.

EU initiatives to promote competition, efficient price formation and, consequently, more efficient use of electricity itself have largely paid off. However, the market is not without its technical problems. Regulators divided the EU electricity market into bidding zones that assume limitless intra-zone trading opportunities. That has not proved to be the case, and the zonal design is recognized—at least by academics—as an obstacle to more efficient use of resources.

This system is increasingly problematic, as the EU’s decarbonization agenda picks up the pace. More intermittent renewables alongside the expectation that transport, heating, and industry will all experience greater electrification, requiring substantial new infrastructure. Considering how best to direct investment toward storage, demand response, more interconnection and distributed energy resources, exposes the cracks in the current scheme.

A Proposal for Change

Market redesign has therefore moved out of academia and onto the political agenda in the form of the recently approved Electricity Regulation and Directives. These new power market provisions set out how the EU plans to make energy markets more consumer-focused and reiterate its commitment to a well-functioning, competitive and undistorted market that is fit for purpose.

The new directive includes legal principles for price formation and for trading electricity on balancing, intraday, day-ahead, and forward markets. Specific measures allow at least 70 percent of trade capacity to cross borders, making it easier to trade renewable energy.

There are also measures designed to encourage more “prosumers”—energy users who also produce their own supply, which has implications for large energy users who have developed their own generation capacity. They also establish the means to phase out subsidies of fossil fuel-powered power stations that are kept on standby.

If all these measures achieve their goals, then the market will be transformed once more: not just for utilities and energy suppliers, but for their domestic, commercial and industrial customers, as well.

Caps, Carbon, and Capacity

However, success is far from guaranteed. Market players, commentators, analysts and policymakers have weighed in, generating more heat than light. Partial elimination of price caps, treatment of renewables under “priority dispatch” mechanisms, and TSO’s role in cross-border provision are all subject of debate. However, it is capacity markets and strategic reserves that are proving particularly contentious.

Europe’s market, theoretically, is currently energy only (an EoM). Absent regulatory or political interference, an EoM allows wholesale energy prices to rise when resources are scarce—reflecting the value society places on uninterrupted supply.

However, many EU member states do not yet trust the market to keep the lights on. They prefer capacity mechanisms and strategic reserves to manage their political and technical issues. The schemes vary, but the principle is the same: paying for standby supply— just in case.

For every expert that points out that capacity markets protect wholesale energy buyers from exposure to the true marginal cost of power, another cites the distorting effect on price signals and the negative impact on cross-border trade.

In these debates, experts often cite Texas’s ERCOT model as evidence of an EoM that can ensure reliable supply without exposing customers to intolerable levels of volatility and risk. In Texas, suppliers enter into bilateral contracting to manage market risks and create a cushion between buyers and the market. Those buyers can then choose how and whether to manage their exposure to energy price volatility—including the use of CTRM systems.

However, the two situations are not directly comparable. The EU is attempting to integrate 28 disparate systems that depend on diverse energy sources and were already at different stages of deregulation and differing societal expectations.

In other words, it’s a political problem as much as anything else. Experts on the Nordic States, for example, suggest that balancing demand and supply without capacity markets is perfectly possible because those countries have accepted that they are dependent on each other. The rest of the EU is not quite there.

You’re in the Market Now

All this means that predicting the final outcome of the current regulatory upheaval is closer to spinning a roulette wheel than many would like to acknowledge—particularly as the European Parliament goes to the polls in May and European Commission personnel will change from November. Nor is it clear whether “pure” energy pricing is yet politically and socially viable.

While the debate rages, energy buyers are caught in a rapidly changing market of new regulations, environmental standards, cross-border cooperation, increased uncertainty, volatility, and complexity—each with their attendant risks. It is worth noting that the last year alone has seen the Governance of the Energy Union Regulation, the revised Energy Efficiency Directive, the revised Renewable Energy Directive, and the Energy Performance of Buildings Directive enter into force.

Buying energy has real consequences for quarterly earnings and annual profitability. Steering a course through a market while the route continues to change, the landmarks shift, and the final destination is unknown is hair-raising at the best of times. Doing so without specialist navigation tools is equivalent to making the journey blindfolded.

This is perhaps the most helpful way to view next-generation energy trading and risk management (ETRM) systems: as navigation tools that provide position visibility, risk management, controls, regulatory compliance and clarity when buying, selling, producing, using and accounting for electricity. Putting transparency, digitalization, data and advanced analytics in the hands of energy market participants enables timely, compliant and informed decision making when it is needed most: as the EU energy market transforms itself once more. That’s the real power of next-generation ETRM systems.

Michael Hinton is chief strategy and customer officer at the Allegro Development Corporation.

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