6 principles for a market design that enables the energy transition

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Does the classical business model of utilities have a future in Europe given the transition towards a decentralized energy system? This was the key question discussed by different economists at the Université Paris-Dauphine on invitation by Prof. Keppler. Among the experts were very renowned economists like Prof. David Newbery from the University of Cambridge, Prof. Glachant from the Florence School of Regulation and Prof. Haucap, the former head of the monopoly commission in Germany. The experts in the panel (presentations can be accessed here) stressed how the economic environment for energy utilities is changing in Europe and the US. In this post, we want to focus on one specific aspect that was raised by Prof. Newbery from Cambridge University in his presentation: What are the basic principles for a good market design that facilitates decentralization, decarbonization and digitalization? The whole presentation by Prof. Newbery can be accessed here. The following analysis is based on a working paper Prof. Newbery has recently published with his colleagues (Newbery et al., 2017). 

The six principles for an efficient and future proof market design

In his presentation in Paris, Prof. Newbery summarized six key principles that can be used to define an efficient market design. This summary is illustrated in figure 1 below.

 Figure 1: Six principles for market and tariff design,  Newbery (2017)

Figure 1: Six principles for market and tariff design, Newbery (2017)

Basically, these principles serve as an orientation for policy makers on how to get closer to the ideal market design for the energy sector. Newbery et al. (2017) provide a nice and comprehensive definition of the ideal market design:

  • Time: electricity prices are determined at a very granular temporal level, e.g., second by second, now and for trade in the future, up to 10-30 years hence;
  • Space: prices vary at a granular spatial level – perhaps at each connection point in the network, reflecting how demand or costs differ across locations;
  • Carbon and other emissions: climate and air pollutant damages are priced at their social cost and thus incorporated into decision-making by companies. (Newbery et al, 2017)

In the following, we will dive deeper into each of these principles to develop a better understanding of the fundamental arguments and implications behind each principle.

Principles 1 and 2: Correct market failures close to source and allow for appropriate cross-country variation in market design across MSs rather than a one-size-fits-all solution.

We discuss these two principles together as they are linked very closely. Basically, the idea behind these two principles, as they are defined by Newbery et al (2017), is that the definition of market rules should be a task for member states in the EU to secure that the national market design addresses the specific market failures in each member state. Importantly, this implies that market design should be harmonized in Europe. Rather, the general set of rules should be defined in Europe to secure interoperability of markets, but detailed rules to address local problems should be defined by member states.

From our perspective, this principle has an additional implication: While the market design should be specified on the European level with additional adaptations made by the member states, decentralization of generation and provision of flexibility (ancillary services) results in a decentralization of market failures as well: While a centralized energy system may face market failures that occur all over the state independently  from the specific location of the market parties, a decentralized energy system is more likely to face market failures that differ between regions in the member state (e.g. the coordination between generations and the networks as we have discussed in this post might not result in inefficiencies (i.e. market failures) in all parts of the member state, but in some specific regions). Therefore, the market design on the member state level should be capable to address regional market failures as well, meaning that the national market design allows for regional adaptations, as long as this does not reduce interoperability within the overall system (national and between the member states). Regional flexibility markets, as we have discussed in this post for the EU and this post for Germany, can serve as one example for such a regional differentiation of the market design.

Principle 3: Use price signals and regulated network tariffs to reflect the value of all electricity services and deliver the least system cost solution.

We have discussed earlier here on enerquire that prices should be used to coordinate the network with the market based parts of the electricity supply chain, generation and retail (for details see this post). Importantly, prices cannot only differ between customer groups and in time (e.g. day and night tariffs), but can have a locational component as well. This is of particular importance in systems with increasing shares of distributed renewable generation that is connected to the low voltage distribution grids. Basically, Newbery et al (2017) state correctly that prices provide a signal to the market parties to compare the value of all electricity services in a market. For the coordination of generation and network management this has two dimensions as noted by Newberry et al (2017):

  • long-run: prices should secure that generation (especially from intermitted renewables) are located at the right spot within the network to reduce overall system costs (i.e. generators should be located in that area of network where the new generator incurs the least costs for the network)
  • short-run: prices should secure that each resource that is connected to the network is dispatched efficiently

From our point of view one of the most significant shortcomings of the existing market design in Germany is actually the quite poor fulfilment of principle 3, which puts the following question at the heart of the current debate in Germany: How do we develop a market design that uses price signals to efficiently operate the system in the short- and in the long-run? It seems clear that we need more flexible prices that reflect the current balance between generation and consumption; we further need these prices to include information about the system costs of the network connection. Different approaches could be used to reach efficient price signals that allow a differentiation in time and location. Today, though, in most energy systems, the basic energy tariff is a uniform price for energy and network usage. Network usage is paid for by a postage-stamp fee that is calculated per voltage level and thereby the total network costs (including costs for congestion management and balancing) are socialized via a system of network charges. Theoretically, network costs could be covered by generation and load (demand), but today most if not all energy systems rely on a system where the load covers the costs of the networks and generators use the networks free of charge. Though there exist some energy systems where flexible tariffs are already offered to the consumers today, uniform pricing is still the rule and locational differentiation in consumer prices is only applied in very few energy systems today. If you are interested to learn more about different schemes for flexible prices we can recommend a paper written by our colleagues who discuss the pros and cons of different flexible tariff scheme for systems with high shares of renewables (available here) (Brunekreeft et al. 2011).

 

Principle 4: Collect the difference between the regulated allowed revenue and efficient prices in the least distortionary way from final consumers.

This principle specifies how the cost recovery for network costs should be distributed among generators and consumers. Newbery et al (2017) stress that finance principles tell us that costs should be recovered from the beneficiaries of the system, namely the consumers. Though in general we agree with this approach, the question needs to be raised whether the complexity of distributed systems requires an adaptation of this cost recovery approach that solely focuses on the consumers. This seems to be especially true in systems where single grid connections fulfil both functions, consumptions and production, e.g. when private households feed electricity (e.g. from solar PV) into the networks at certain times in the course of a day. To us, the notion in the principle, that final consumers should pay the bill for the networks might be true for traditional centralized energy systems, but does it still hold for distributed systems? If not, what are the alternatives and what are the pros and cons of these approaches? Again, you can find more about this discussion in a paper by Brunekreeft et al (2011).

 

Principle 5: Efficiently “de-risk” the financing of low-carbon investment as the electricity system becomes more capital-intensive.

A general challenge for renewable-based energy systems are the high capital costs required by this system. Though in the long-run the total costs of a renewable-based energy system are likely to be lower than a fossil-based system (AgoraEnergiewende, 2017 english summary p.7), the upfront costs are very high. Compared to conventional generation, which - from an investor’s perspective - gains from higher shares of fixed and flexible operation costs (as these costs are discounted in the investment calculation), renewables face a higher investment risk, as most costs are not discounted in the calculations. More information on the differences in risks between conventional and renewable generation can be found in the paper by Hirth & Steckel (2016). Due to the higher capital intensity of investments in renewable generators, the risk for the individual plant operator can be (too) high. Therefore, Newbery et al (2017) stress the importance of risk-sharing among the beneficiaries of a renewable-based energy system, which again are (or at least should be) the consumers. Basically, principle 5 suggests that consumers should carry some of the risk of the investment in renewables (as they benefit from it e.g. via reduced CO2-emissions, climate mitigation). As the risk then is shared among a large number of people, the individual risk is rather low compared to the individual risk each plant operator has to face. At the same time, plant operators should have the right incentives to manage that risk to secure an efficient market design. 

6: Retain flexibility to respond to new information on the attractiveness of different low-carbon technologies.

The last principle defined by Newbery et al (2017) is the least concrete, but from our perspective, it points at an imperative for the general approach of an efficient market design for renewable based energy systems: Create a flexible system that allows to adapt to new technologies, data and information available in the future that might unlock new efficiency potentials. Newbery et al (2017) specifically point out that in the future we will gain new insights into the costs and benefits of new technologies and flexibility potentials and that the market design needs to be able to adapt to these new findings within a short period of time. This is a significant point for a new, adaptive and future proof market design: While clean technologies might take a long time before entering the mass market at profitable price levels, data driven business models evolve much faster. This increasing speed of innovation and mass-market adoption can be observed in many markets that have already achieved a higher degree of decentralization than the energy system. But with new technologies like smart metering, distributed ledger technology and artificial intelligence on the rise, digital innovations might dominate the next decade of energy systems as well. Therefore, the market design needs to be able to quickly adapt to new technologies and data driven business models. If you are interested in the question how governance systems (like the market design) can facilitate innovation and provide the necessary flexibility required by distributed and digital energy systems we recommend this paper for details (Buchmann 2017).  

The energy transition requires a flexibile market design that allows to correct local/regional market failures

With these six guiding principles for a good market design Newbery et al (2017) provide a basis to further develop an appropriate market design. Based on the inputs by Newbery et al (2017) we identify three guidelines for the market design that are of particular importance for energy systems that develop towards more decentralization and digitalization:

  1. prices should provide a basis to compare all energy services with each other. This includes that prices vary with respect to time, volume, location and provide information about new services (like flexibility) as well
  2. The market design needs to be able to tackle market failures close to its source. With decentralization, this requires that the market design is capable to address different market failures in different regions (either on the member state level or even within a member state) with different measures to achieve efficient solutions.
  3. Especially digitalization but also decentralization require that the market design is flexible and capable to adapt fast to new innovations. With an increasing speed of (digital) innovations, a fast responding market design is necessary to achieve efficient markets

 

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