The European Commission's preliminary findings on electricity capacity mechanisms

On 13 April 2016, the European Commission published its interim report in its sector inquiry into capacity mechanisms in the electricity sector. The interim report sets out the Commission's preliminary findings, which are being consulted on until 6 July 2016. The Commission aims to publish a final report in the last quarter of 2016. In this briefing, we have summarised the Commission's key findings and their potential implications for the power industry in the EU.

What You Need to Know

• The European Commission has published its interim report, summarising the initial findings of its sector inquiry into electricity capacity mechanisms in 11 EU Member States.
• The Commission has identified shortcomings and inconsistencies in the methods applied by Member States to assess whether capacity mechanisms are necessary.
• The Commission considers that Member States must be more thorough when designing capacity mechanisms to ensure that they are well-targeted and cost-effective.
• The preliminary findings are being consulted on until 6 July 2016, with the final report to be published in the last quarter of 2016.
• The Commission's final conclusions will inform its proposed legislative package relating to electricity market design and security of electricity supply in the EU, which may have a future impact on capacity mechanisms in the region.
• The final conclusions will also give Member States and market participants greater clarity on how the Commission will apply EU State aid rules to capacity mechanisms in the future.

Background

The Commission notes that there has been an increased interest in, and use of, capacity mechanisms in recent years. This has resulted from Member State concerns that in the coming years the electricity market will not produce the investment signals needed to ensure a generation mix that is able to meet demand at all times. In short, the concern is that the lights will go out. This partly results from reduced reliance on conventional "dirty" power and greater reliance on intermittent renewables, pursuant to decarbonisation objectives. Member States have therefore taken measures to support investment in additional capacity to ensure an acceptable level of security of supply. Under these mechanisms, producers are paid simply to make capacity available.

The Commission launched a sector inquiry into capacity mechanisms on 29 April 2015. Pursuant to the provisions of the State Aid Procedural Regulation (Regulation 734/2013), the Commission can carry out an inquiry into a particular sector if it has a reasonable suspicion that State aid measures in that sector may materially restrict or distort competition. As stated in its interim report, the Commission's concern is that "when introduced prematurely, without proper problem identification or in an uncoordinated manner, and without taking into account the contribution of cross-border resources, there is a risk that capacity mechanisms distort cross-border electricity trade and competition". The Commission therefore commenced an investigation into the planned or existing capacity mechanisms in 11 Member States: Belgium, Croatia, Denmark, France, Germany, Ireland, Italy, Poland, Portugal, Spain and Sweden. The UK is notably absent from the list of Member States covered by the inquiry. This can be explained by the fact that the Commission approved the UK's capacity mechanism, introduced as part of the Electricity Market Reform package, under the State aid clearance process in July 2014.

It should be noted that the interim report does not directly assess individual capacity mechanisms for compliance with the State aid rules (specific rules for this are set out in the Commission's Guidelines on State aid for environmental protection and energy). In this regard, the Commission has opened a separate detailed State aid investigation into the French capacity mechanism.

The Commission intends that its findings will contribute to the development of its new electricity market design initiative, launched in July 2015, as well as its review of Directive 2005/89/EC on the security of electricity supply. The market design initiative will involve new EU regulations to facilitate an increase in the volumes of intermittent electricity production from renewable sources, greater interconnection between EU Member States, reliable price signals for investors and increased competition.

The Commission's interim findings

The interim report notes that increasing generation capacity (in particular, renewable capacity) and decreasing demand have led to generation capacity exceeding peak demand and lower wholesale prices. This does not provide an attractive market for investment. The Commission recognises that capacity mechanisms can have positive effects by increasing security of supply, but considers that these effects can be outweighed by potential distortions of competition and trade. Such distortions can arise as capacity mechanisms may provide only short-term solutions to supply problems, instead of tackling market design features. For example, capacity mechanisms may distort investment signals in favour of countries with more generous capacity mechanisms and/or result in over-procurement. They may also bolster the position of incumbents and result in over-compensation.

The Commission has found that these distortions are more likely to arise where capacity mechanisms: (a) are not open to all capacity providers; (b) do not take into account electricity that can be provided across EU borders; and (c) are not designed in consideration of longer-term implications, including the impact on nonsubsidised generation technologies.

The Commission's key message is that, in order to avoid unwarranted distortions of competition, many Member States need to be more thorough in assessing both whether: (a) capacity mechanisms are necessary; and (b) any proposed mechanisms have been designed to ensure cost-effectiveness. The specific findings are considered in turn below.

As noted above, the interim report does not pre-judge the Commission's assessment of the compatibility with EU State aid rules of any individual capacity mechanism. It does, however, call for a common approach to security of supply across the EU's 28 Member States.

Methodologies to establish the need for capacity mechanisms

The Commission has found that many existing capacity mechanisms have been set up without a proper assessment of whether a security of supply problem existed in the relevant market. In addition, where there has been an assessment of security of supply, the methodologies used have varied widely between Member States. Common problems include: (a) not always taking into account the possibility of cross-border supplies; and (b) divergent approaches to defining generation adequacy and reliability standards (i.e. the level of generation adequacy that is deemed acceptable).

The Commission has emphasised the need to assess effectively the capacity gap before rolling out a capacity mechanism model. It calls for harmonised and transparent methods of determining electricity capacity levels and reliability standards, so that the need for intervention in different Member States can be assessed and compared objectively.

Wide range of models

The Member States covered by the inquiry apply a broad range of capacity mechanism models, with the strategic reserve model proving the most popular. The main capacity mechanism models are summarised in Figure 1 on the next page. Figure 2 summarises which models apply or have been considered in the 11 Member States considered.

In summary, the Commission concludes that the various types of capacity mechanism are not equally well-suited to addressing capacity problems, with the optimal choice depending on the nature of the generation adequacy problem and the structure of the relevant electricity market. However, the Commission considers that the risk of overcompensation is greatest when Member States implement mechanisms offering market-wide capacity payments or targeted capacity payments.

Figure 1: Capacity mechanism models

Targeted mechanisms: where the mechanism provides support only to the additional capacity needed beyond what would be brought forward by the market. The three main models of targeted mechanisms are:

1. Tender for new capacity – the new plant receives support once it is constructed.
2. Strategic reserve – the top-up capacity is contracted and then held in reserve outside the market. It is only run when specific conditions are met. Interruptibility schemes are a subcategory of strategic reserves, whereby, in most cases, beneficiaries are paid a fixed price for each MW of demand response made available, as well as a price for demand reductions actually made.
3. Targeted capacity payment – a central body sets the price of capacity which is paid to a subset of capacity operating in the market (for example, only to a particular technology).

Market-wide mechanisms: where all capacity required to ensure security of supply receives payment, including both existing and new providers of capacity. The three main models of market-wide mechanisms are:

1. Central buyer – the total amount of required capacity is set centrally and then procured through a central bidding process in which potential capacity providers compete so that the market determines the price.
2. De-central obligation – an obligation is placed on electricity suppliers to contract with capacity providers to secure the total capacity they need to meet their consumers' demand. There is no central bidding process, but market forces should still establish the price for the required capacity volume.
3. Market-wide capacity payment – the price of capacity is set centrally, based on central estimates of the level of capacity payment needed to bring forward sufficient total capacity and then paid to all capacity providers in the market.

Model must address specific problem

Significantly, the Commission recognises that other than the need to ensure that the price of capacity is determined through a competitive process, there is not a single "one-size-fits-all" model that is preferable. Rather, the capacity mechanism adopted should address and target the particular capacity problem in the relevant Member State, with different models being appropriate depending on whether the capacity shortage is temporary or long term, market-wide or local.

In particular, the Commission considers that:

• Tenders for new capacity and strategic reserves may be appropriate to address a transitional capacity problem. A tender allows new investment, while a strategic reserve is typically used to prevent existing plants from closing. However, while these may be appropriate "stopgap" measures, they should be accompanied by a plan to address capacity issues in the long-term.
• The central buyer and de-central obligation mechanisms may be appropriate to address capacity problems in the long term, depending on the level of competition in the underlying market. These two models are better able to attract new capacity and allow direct competition between generation and demand response, thus creating stronger competition for the remuneration being offered and revealing the real economic value of capacity.
• In all cases, capacity mechanisms must be transparent, have open rules for participation, and must not undermine the functioning of the electricity market. In particular, it is important that electricity prices should continue to signal when capacity is scarce so that electricity is imported from other Member States at the right times.

Conclusion

As EU Member States take steps to diversify their electricity generation to address the need for carbon reduction and security of supply, it seems clear that capacity mechanisms will continue to be used. However, the Commission's preliminary findings indicate that, in the future, all 28 EU Member States will need to be more rigorous when designing capacity mechanisms if they are to obtain the Commission's approval under the State aid rules.

Figure 2: Capacity mechanisms in the 11 Member States considered by the inquiry