What the Electricity Market Really Needs


Opinion by ZEW President Achim Wambach and Axel Ockenfels, Professor at the University of Cologne

ZEW President Professor Achim Wambach, PhD and Professor Dr. Axel Ockenfels, Professor at the University of Cologne are discussing the electricity market, the power supply and the energy crisis.

The European Commission is consulting on the reform of the European electricity market design. This is triggered by dissatisfaction with the high energy prices, which have led to numerous interventions in the energy markets in European countries. Proposals are aplenty. However, a key problem of the electricity market design, i.e. the insufficient provision of flexible generation capacity, is being overlooked.

According to the Commission, the European electricity market has served well over many years. However, the current high burden on households has been identified as a weak point. It is surprising that this is a cause for reform, as the current state of crisis is likely to be temporary. The high prices mainly reflect the current war-related gas shortage. At the same time, however, the crisis also points to a weakness in the market design, which the Commission only marginally addresses in its proposals: It turns out that the incentives for producers to ensure a reliable supply of electricity are insufficient.

Germany’s electricity market design does not ensure a reliable power supply

Germany has chosen the market design of an energy-only market. This is the classic textbook market, in which electricity producers offer their electricity on the market and the large electricity consumers and utilities buy it there. In an energy-only market, investments in production capacities must be financed via the market price for electricity.

This market form was already criticised when it was adopted in 2016, including by the authors of this article. It was unclear whether the design would provide sufficient incentives for investments in generation capacities. In particular, the focus was on flexible generation, i.e. generation that is independent of weather conditions. The question here was whether companies would be willing to invest in storage or new gas-fired power plants. Proponents of the concept argued that the expectation of high revenues to cover fixed costs in times of scarce generation capacity due to high electricity prices would encourage companies to invest.

The critics countered that this standard textbook argument could not be reliably applied to the electricity market. The scarcity situations in the electricity sector that are absolutely necessary for this market form to work entail economic and social risks. For one thing, electricity can fail in the event of great scarcity. In the event of an involuntary blackout, however, there is no price that the market could determine. So when electricity is most valuable, the electricity producer cannot rely on market prices – a market failure. Secondly, political intervention is almost inevitable, especially in crisis situations. Prices in the electricity market can quickly reach very high levels, as it is difficult for electricity consumers to drastically curb their consumption. These high price dimensions, the associated social distortions and the market power of producers that comes with scarcity make price-curbing policy interventions likely. Even though we have a lot of experience with liberalised electricity markets worldwide, it is unlikely that the market will be able to determine a price in the crisis that sets the ‘right’ investment incentives.

To counter concerns about political intervention, the then Minister of Economics, Sigmar Gabriel, published a joint declaration with his eleven ‘electrical neighbours’ in 2015: “The neighbouring states have agreed to place greater focus on flexibilising supply and demand by making use of strong market signals and by using price peaks; they have agreed to refrain from introducing legal price caps and to eliminate barriers that stand in the way of greater flexibility.”

The agreement of the twelve neighbouring countries lasted exactly until the energy crisis last year. The rise in electricity prices led to numerous market interventions, including the skimming of profits. It is to the credit of the German government that it spoke out against price interventions for a long time. However, the development in Europe could not be stopped. An electricity market whose reliability depends on high scarcity prices is economically and politically too fragile to function. Companies and investors have anticipated this – since the introduction of the electricity market, no new power plant has been built in Germany on their own account. The government therefore had to announce in its coalition agreement the construction of necessary gas-fired power plants until sufficient supply security was covered by renewable energies – the market did not deliver.

European reform of the electricity market should focus on supply security

Ensuring a sufficiently secure supply of electricity should therefore be the first priority of a market reform. Proposals for a more robust electricity market design are available. This includes price signals in wholesale electricity trading that adequately reflect scarcity – also through politically unpopular regionally differentiated pricing. It is particularly important to strengthen long-term electricity contracts and investments. One possibility would be a capacity market, as exists in England, for example, but not yet throughout Europe: power plant operators bid in competitive tenders for contracts to provide flexibly available electricity, which must be backed up by physical generation capacity. Such a bidding procedure leads to the capacity market making itself redundant if the electricity market already generates sufficient investment incentives on its own. Bidding could be done not only by electricity producers, but also by storage operators and flexible consumers, e.g. from industry, who commit to curbing their demand. At the same time, the futures markets on which long-term electricity supply contracts are traded should be further developed. With a suitable design, security of supply could be made possible and price peaks avoided.

The consultation of the EU Commission is mainly concerned with instruments that promote renewable energies. The Climate Neutral Electricity System Platform that has just been set up in Germany to develop proposals for a more fundamental reform of the European and German internal electricity market should focus on the lack of financial and physical safeguards to deal with scarcity situations. The electricity supply is fragile. The necessary transformation towards renewable energies and the increasing weather extremes due to climate change lead to further systemic risks that are not addressed by the current electricity market design. Investment incentives in storage and flexible generation are insufficient. Incoherent energy policies and nervous repairs to the electricity market design add to the problem. A solid incentive for secure electricity supply is needed. A good option would be mandatory long-term contracts for flexible generation and electricity demand for security of supply, as they have a sound economic conceptual basis.