THE RISE OF CAPACITY MECHANISMS:
ARE THEY INEVITABLE IN THE EUROPEAN UNION?

EGMONT PAPER 80

THE RISE OF CAPACITY MECHANISMS:
ARE THEY INEVITABLE IN
THE EUROPEAN UNION?
TANIA ZGAJEWSKI

September 2015

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Ta b l e o f C o nte nts
Executive Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5I.

The developments undermining the energy-only electricity market
model that point in favour of crms . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7

II.

The patchwork of capacity remuneration mechanisms in the EU . . . . .

15

III.

Ten criticisms of CRMs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

21

IV.

The European Commission’s initiatives . . . . . . . . . . . . . . . . . . . . . . . . . .

25

V.

Recent Member States’ collective initiatives . . . . . . . . . . . . . . . . . . . . .

31

VI.

Is the multiplication of CRMs the best strategy? . . . . . . . . . . . . . . . . . .

33

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

39

1

E XECUTIVE S UMMARY
Many EU Member States have established Capacity Remuneration Mechanisms(CRMs) in their electricity markets. These mechanisms aim to ensure that theelectricity system has sufficient capacity available to meet the electricity demand at
all times. They are not a new topic but until recently such mechanisms remained
limited to a very small number of Member States.
Their current proliferation is due to the growing doubts in many Member States
about the ability of their liberalised electricity markets to meet the electricity
demand in 2020 and beyond. These doubts are based on different factors thatnegatively affect the investment climate for generation capacity. This situation
obviously increases the risk of the occurrence of blackouts, rare in our industrialised
societies and economically very costly. To improve the prospects of adequate generation capacity and prevent the risk of blackouts, many Member States have thus
undertaken to remunerate firms for the provision of generation capacity, and thus
compensate the deficiencies of what is called the ‘energy-only’ electricity market
model.
CRMs have provoked many debates, comments and criticisms. They have proponents and opponents. Different questions need to be considered though. First, has
the market become more unstable to the extent that it requires new stabilisation
instruments? Second, if the answer to the first question is positive, are there options
other than CRMs and are they better? Third, if there are no alternative options, how
can CRMs be designed to reduce costs and not hurt competition or free trade?
One should not underestimate the huge changes undergone by the electricity system
in Europe during the last ten years. The introduction and quick development of
renewables has made the electricity system much more complex, since it relies now
on a greater number of primary energy sources, quite different in technical andfinancial aspects. Additionally, the capital needs of producers are extremely diverse.
Some have very high fixed costs. Others have much higher variable ones. In any case,the arrival of many new renewable electricity producers with very high fixed costs
requires more previsibility in a changed context that generally provides less of it. The
electricity production system has also been made more irregular with the rapid
development of renewables such as solar and wind. As a result, the reliability
challenges of the electricity system have changed and have increased. Furthermore,
the development of the energy single market has introduced an additional layer ofcomplexity. It is not difficult to understand why such a situation has provoked agrowing thirst for more security, and also rising calls for public intervention.
It is thus difficult to deny that, in the present context of decarbonisation, there is aneed to take measures to compensate the growing insecurity of electricity provi-3THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

sioning. Capacity mechanisms participate in that logic and aim to provide thatcompensation. However, if there were a real threat to the security of the electricity
system, this does not automatically mean that capacity mechanisms offer anadequate response. In fact, the growing instability is provoked by numerous andvarious factors, and not only by the growth of renewables. Any strategy aiming to
reduce electricity insecurity thus needs to deal with many instruments.
As there is limited practical experience of most CRMs in the EU and as some havebeen frequently modified since their introduction, it is too soon to provide a valid
assessment of their efficiency and impact. Clearly, however, they can have repercussions on free competition, on the single market principles and on further integration.
It is in fact paradoxical to define the guarantees of security at the national level,
without taking into consideration the impact for the EU market, while Member
States frequently invite all parties involved to complete the internal market, through,in particular, increased cooperation. As a minimum, the need for a viable and strong
EU framework clearly exists, to avert (or at least minimise) the potential damage that
could prevent a further integration of national markets. Fortunately, the Commission
has taken initiatives in that direction.

4

I NTRODUCTION
In recent years, the EU has seen the proliferation of Capacity Remuneration Mechanisms in many Member States. These mechanisms are employed to ensure that theelectricity system has sufficient capacity1 available to meet the electricity demand at
all times in the national markets. They depend on medium- to long-term projectionsof peak demand and the long-term projection of supply.2
Capacity Remuneration Mechanisms (hereafter CRMs) are a complex but not a new
topic. They already exist in other regions of the world (e.g., the United States orSouth America) and even in Europe (e.g., Russia). In the EU, however, they haveremained limited until recently to a very small number of Member States.
The cause of the current proliferation of CRMs in the EU lies, as surprising as it may
seem, in the fact that an increasing number of Member States entertain growing
doubts about the ability of their liberalised and restructured markets to meet theelectricity demand by 2020 and beyond.3 Their doubts are based on a combinationof factors that negatively impact the investment climate for generation capacity. In
other words, until now, there has been no clear answer to the question of whether
operators would invest sufficiently in new generation capacity in time to meetelectricity demand in the future. This uncertainty obviously increases the risk of theoccurrence of blackouts, which are rare in our industrialised societies and economically very costly. To improve the prospects of adequate generation capacity andprevent this risk, many Member States have thus undertaken to remunerate firms
for the provision of generation capacity, and thus compensate for the deficiencies ofwhat is called the ‘energy-only’ electricity market model.
Under this ‘energy only’ model (EOM), electricity generators are not paid for thegenerating capacity provided, but for the energy they sell. The (expected) energy
price is presumed to reflect operating conditions and to provide the right incentive
for investment in generating capacity. In other words, the price of the energy gener-

1

2

3

Capacity includes both generation and equivalent solutions such as storage or demand response, but for
convenience we will in this introductory paper often refer simply to generation. ACER’s Framework guidelines on electricity balancing of 18 September 2012 (p. 8) define Demand Response as ‘changes in electric
usage by end-use consumers from their normal load patterns in response to changes in electricity prices
and/or incentive payments designed to adjust electricity usage, or in response to the acceptance of theconsumer’s bid, including through aggregation’. Other definitions exist, however. See, for instance, Directive 2012/27/EU (Recitals 44 and 45) as well as the March 2015 Eurelectric paper entitled ‘Designing fairand equitable market rules for demand response aggregation’ (p. 7).
L. Meulman and N. Méray, Capacity Mechanisms in Northwest Europe. Between a rock and a hard place,
Clingendael International Energy Programme, Nederlands Institut voor Internationale Betrekkingen,November 2012, p. 9.
ENTSO-E in its latest scenario outlook and adequacy forecasts of 2015 foresees a 0.8% annual increase inelectricity demand from 2016-2025 due to electrification of heating and transport and the economic
recovery. These results are based on the transmission system operators’ highest forecast for electricity
demand growth.

5THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

ated is the key driver for investment decisions in capacity. Under the current conditions, this model fails to send the economic signals necessary to ensure investment
in capacity.
With the introduction of CRMs, Member States want to give a value to generating
capacity in order to protect their security of electricity supply (security of electricity
supply means different things in different contexts. In this introductory paper,
security of supply refers to generation capacity adequacy and the need for real-time
generation flexibility). They have decided to recognise via CRMs that the creationand maintenance of generating capacity, and not just output, need to be rewarded.
CRMs have provoked many debates and comments. There are proponents andopponents. It goes without saying that utilities, in particular those affected bystranded generation assets,4 have been largely supportive of the implementation of
CRMs. However, other questions need to be considered. First, has the market
become unstable to the extent that it requires new stabilisation instruments?
Second, if the answer to the first question is positive, are there options other than
CRMs and are they better? Third, if there are no alternative options, how can CRMs
be designed to reduce costs and not hurt competition or free trade?
This introductory paper concentrates only on the electricity sector and aims toprovide basic answers to these three questions. To this end, it will describe (I) the
main elements driving the implementation of CRMs; (II) the various forms of CRMs,
with examples of Member States which have already introduced them; (III) criticismsof CRMs; (IV) the Commission’s initiatives and (V) some Member States’ collective
initiatives, and finally, the question of their inevitability and potential alternatives(VI).5
Tania Zgajewski6

4

5
6

6

Generation assets become uneconomical to operate when their marginal cost of generation exceeds theprice for electricity over an extended period of time, meaning that they cannot generate profits through thesale of electricity. See B. Caldecott and J. McDaniels’ Stranded generation assets: implications for European
capacity mechanisms, energy markets and climate policy, Working Paper, Smith School of Enterprise andthe Environment and the University of Oxford, January 2014, p. 5.
Research for this introductory paper stopped mid-June 2015.
Tania Zgajewski is a Senior Research Fellow at Egmont.

I.

T HE DEVELOPMENTS UNDERMINING THE
ENERGY - ONLY ELECTRICITY MARKET MODELTHAT POINT IN FAVOUR OF CRMS

The Member States’ general distrust of markets stems from different developmentsthat appeared in the wake of the growth of electricity generation from renewableenergy sources (RES) that benefitted from support mechanisms (subsidization7 andpriority dispatch); the stagnation of electricity demand (due to the economic crisisand the implementation of energy efficiency policies); and last but not least the
insufficiently flexible power plant fleet. They reveal why market actors have not been
inclined to invest in generation capacity while remedies or solutions have not beenbrought forward.
The first development is linked to electricity trading on power exchanges. The latterproduce reference prices and cooperate in order to intensify cross-border electricity
trade between Member States. They have operated a process of market coupling forseveral years. Market coupling allows the optimisation of the available production
resources and the electricity needs by matching supply and demand on the energy
exchanges of the different coupled markets. This system increases the liquidity of theenergy system across a larger geographical area. However, it faces a major physicalobstacle: it has to take into account the insufficient availability and capacity of crossborder interconnectors.
But Member States are currently alarmed by what is taking place in the prices
produced in the context of these power exchanges.
Electric power is provided by generating facilities that serve a large number ofcustomers. They entail fixed and variable costs. Fixed costs are essentially capitalcosts to build the plant and land. They do not vary with the level of output (i.e., howmuch electricity the plant produces). Variable costs are complex and compound fuelcosts,8 pollution costs,9 and variable operational and maintenance costs. Theyfluctuate with the level of output and the power generation technologies used.
The variability of demand for power (with its daily, weekly and seasonal patterns)
and the limited ability to store electricity (although improvements are being made inthis area) require that every power system uses various generation facilities. Baseload plants satisfy the minimum demand around the clock and throughout the year.
78
9

For instance, through feed-in tariffs, which guarantee a fixed price per unit of renewable electricity generated.
It should be noted that fuel costs are driven not only by the cost of the fuel that is being converted to electricity, but also by the efficiency of the conversion process.
For instance, costs of airborne pollutants [i.e., sulphur and nitrogen oxides (respectively SO2 and NOx),carbon dioxide (CO2), particulate matters (PM2.5)] generated during electricity production.

7

THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

They are typically inflexible because it takes time to bring them up to full power andshut them down again. They bear low variable costs but high capital costs (e.g.,
nuclear and coal-fired plants). Intermediate plants can also operate for extended
periods at a time, but generally do not run all the time. They are typically combined
cycle combustion turbines (CCT) fuelled by natural gas with fuel oil as a back-up.
Peaking plants generally run only when there is high demand for power. This meansthat they step in on request during peak hours. For this reason, they are very flexible
and can commence and change output very quickly. Typically they are simple cycle
combustion turbines (CT), with low capital costs but high variable costs because theytend to have relatively low-fuel efficiency and relatively high air emissions per KWhof energy generated. Many of them are fuelled by natural gas with oil as a back-up.
The cost of producing each MWh (equivalent to 1,000 kWh) is called the ‘marginal cost’.
The generator is remunerated only through selling energy (remuneration per MWh).
So the price signal sent by the market will be extremely important because the profitability of power plants depends on the level of electricity prices. It is this level which
will allow them to make a profit and recover their fixed and variable costs.
However, a well-functioning and competitive power market produces electricity at
the lowest possible price. To achieve this, the merit-order (employment sequence ofgeneration facilities) is applied. Generation facilities with the lowest marginal costs
will thus be the first in line to meet electricity demand, and the number of generation
plants involved will increase up to the point where electricity demand is fully satisfied. The final price is thus equal to the marginal costs of the most expensive power
plant in use.
In theory, for base-load and intermediate plants, fixed costs are recovered by thedifference between the market price and the variable costs of the power plant (thisdifference is called the ‘infra-marginal rent’). By contrast, peak plants, which produce
only occasionally when demand is high (peaking), earn no infra-marginal rent. They
rely on their ability to increase their offer price to generate what is called a ‘scarcity
rent’. As a result, the electricity system experiences very high prices which are considered justifiable because peak plants operate in standby mode, and because the prices
allow them to recover their fixed costs. The increased occurrence of such price spikes
signals to investors that new investment in peak units would be profitable.
The penetration of RES (in particular, wind and solar) simultaneously with the liberalisation of the European electricity markets has upset this operating mode. Theircontinuously increasing share10 has become a source of distortion for the wholesale
electricity markets. On the one hand, this distortion has contributed to containing or
10

8

In the 2015 edition of the Scenario Outlook & Adequacy Forecast, ENTSO-E indicates that 22 countries will
have a RES capacity penetration level higher than 50% in their systems. In eight countries (Germany,
Denmark, Great Britain, Greece, Ireland, Northern Ireland, Netherlands and Portugal), demand could attimes be totally covered by renewable generation.

THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

lowering electricity prices in many wholesale markets by causing a shift in the meritorder.11 Indeed, green electricity generation is characterised by low or near zeromarginal costs since it has zero fuel costs (see Figure I).
On the other hand, it has also contributed to producing zero or even what is called‘negative prices’. Negative prices are not new but their occurrence has strongly
increased on the European energy exchanges since 2008. They are prices that fall
below zero. They indicate that consumers are getting paid by electricity producers
for consuming electricity. They are due to the simultaneous presence of twoelements: an abundant green electricity generation characterised by zero-fuel costs(thus upsetting the merit order) and a low electricity demand. They are also theconsequence of opportunity costs for certain types of generators – i.e., it is less costly
to operate the plant at even negative prices for a very limited period of time than toreduce the plant’s output. Many power exchanges (within and outside the EU) do notallow negative prices, however.
It should be noted that if their more frequent occurrence (especially in certain
Member States), is worrying, negative prices can be useful. They are an indicator oftense situations in the power system and convey information for market participants. In the short term, negative prices talk to energy consumers. They create an
economic incentive for consumers to shift their consumption patterns in order tocapture the opportunity of being paid, instead of paying, to receive energy. In thelong term, however, negative prices talk to energy producers, not to energy
consumers. Their emergence shows that the generating fleet encompasses too little‘flexible’ capacity, or that grid interconnections are insufficient to properly exploit
the spare, flexible capacity available within a market area.12
Figure I: Electricty Prices and the Merit-Order Curve(Source: https://www.google.be/search?q=merit+order&rlz=1C1CAFA_enBE627BE627&espv=2&biw=1258&
bih=859&tbm=isch&tbo=u&source=univ&sa=X&ved=0CCYQsARqFQoTCM-2-efLxscCFcNZFAodxVoMoQ)

11
12

For more information on this issue, see P. Deane (UCC) et al., ‘Quantifying the merit-order effect in European electricity markets, the INSIGHT_E project’, Rapid Response Energy Brief, February 2015.
See the article by Simona and Carlo Stagnaro published in the Energy Post on 27 May 2014 and entitled ‘The
case for allowing negative electricity prices’ (http://www.energypost.eu/case-allowing-allowing-negativeelectricity-prices/).

9THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

The impact of this first development is compounded by another. The increase ofsolar and wind capacities coupled with the stagnation of electricity demand (due tothe economic crisis and the implementation of energy efficiency policies) has engendered a reduced demand for conventional electricity production. This situation has
led to overcapacity in the electricity system for conventional power plants, because
they are under-utilized. Gas-fired power plants are the most affected as their situation has been compounded by changes in coal-gas fuel price spreads and by a weakcarbon price signal within the EU ETS, reducing the penalties for burning coal.
Needless to say, these two trends are damaging the revenues that should contributeto the recovery of conventional generators’ costs. As a result, they are discouraged
from investing in conventional power plants, which might suffer from low utilisation,or may not even be used once built. Meanwhile, the increased need for flexible backup units to cover the continuously growing irregular generation from RES (seeFigures II and III) and peak demands remains, as well as the need to replace old,
inefficient and polluting power plants or nuclear plants when nuclear phase-out has
already been envisaged. Therefore, the current overcapacity of conventional power
plants could well become undercapacity in the next few years or in the long run. This
undercapacity, if it occurs, could become more problematic with the growing intermittency due to the continuous development of RES capacity, since this intermittency could lead to tensions in the electricity system, even during off-peak periods.
Figure II

Source: Insight_e project study, ‘Quantifying the merit order effect in European electricity markets’, Rapid
Response Brief, February 2015, p. 9.

10

THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

Figure III

Source: Insight_e project study, ‘Quantifying the merit order effect in European electricity markets’, Rapid
Response Brief, February 2015, p. 9.

The third development is related to the ‘missing money’ problem. The missing
money problem concerns unsuitable price dynamics in peak load hours due toregulatory actions such as price cap measures. Price caps limit the highest prices.
They are problematic for peaking plants. By preventing prices from reaching highlevels during scarcity situations, these price caps reduce the payments that could beapplied to cover their fixed costs, to the point that some assets prematurely close or
are mothballed across the EU as profits are further eroded. Therefore, the resulting
missing money also reduces the incentives to maintain plants or build new generation facilities. The above-mentioned current capacity oversupply situation acrossmuch of Europe may provide a temporary buffer, but ultimately plant closure will
undermine security of supply.
If authorities are encouraged to adopt price cap measures, it is because they consider
very high prices politically unacceptable. But the primary reason for capping energy
prices is to mitigate generator market power in scarcity situations. This possibility of
exercising market power during scarcity situations comes from a lack of short-term
demand response.13 However, as the electricity market is not fully competitive, it isdifficult for these authorities to distinguish between peak prices which occur in real

13

See R. Meyer et al., ‘Analysis of capacity remunerative mechanisms (CRMs) in Europe from the internal
electricity market point of view’, Elforsk rapport 14:22, March 2014, pp. 1-2.

11

THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

scarcity situations, and market power abuses. The definition of the appropriate levelof a price cap is consequently always a delicate task.
In summary, the missing money, which has become more topical with the growing
penetration of RES, goes hand-in-hand with ‘missing incentives’, and alternative
approaches thus appear necessary to complement the EOM.
The combination of these three developments has prompted Member States tointervene by introducing CRMs as the best option to ensure adequate investment
signals, generation adequacy, and flexibility, as the electricity market seems to havecurrently lost the ability to do this for itself.
Some Member States have already put these mechanisms in place. Others areplanning or considering doing so. However, there is neither a standard design forcapacity mechanisms nor a common trading platform for capacity as a product inEurope.14
So the EU is thus in a peculiar situation, due to the accumulation of several developments. The electricity system has become more diverse. New electricity sources(such as wind and solar) have an intermittent nature and are variable in output.
Security of electricity supply is therefore – in the absence of appropriate andaffordable storage solutions – linked to an energy back-up system. The rapid andcontinuous growth of RES and their entry at zero marginal cost in the power generation mix have also substantially disrupted the modus operandi put in place, and havecreated huge challenges to conventional generation operators, even bringing into
question their business model. The situation is critical in particular because of thecurrent overcapacity induced by the economic slowdown in recent years. Furthermore, all this is happening in a strategic period. A lot of old and polluting capacities
have to be decommissioned and gradual nuclear phase-out foreseen. Finally, as
electricity is a key vector in a low carbon economy, it will play an increasingly central
role in the energy mix in the future, while renewable generation will continue toprogress and to increase the challenge to system flexibility. There is thus a strong
need for a long-term vision for a new electricity system, since this is indispensable foroffering the proper investment incentives. (See Figure IV).
As emphasized by the International Energy Agency (IEA), the mounting role of renewables in the electricity system engenders mounting problems with investments inpeak power plants.
‘The variability of electricity demand and the need to meet peak demand has
always been a concern for system operators. During a few hours of peakdemand, efficient electricity wholesale hourly prices are volatile and much

14

12

J. Grigorjeva, Capacity Mechanisms in the EU: Nationalizing energy security, Jacques Delors Institut Berlin,
Policy Paper 134, 21 May 2015, p. 12.

THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

Figure IV: Requirements in new dispatchable plants according to an extrapolation of
decommissioning

Source: COWI/THEMA Study, Capacity mechanisms in individual markets within the IEM, June 2013, p. 65.

higher than the yearly average wholesale price: efficient peak prices reflect
the costs of the plants needed to meet peak demand. With high shares ofwind and solar power, new investment in capacity, including generation
plants, demand response, storage capacity will be needed. However,
attracting sufficient and timely investment in peak capacity and incentivizing
demand response has proven to be a problem for several OECD electricity
markets.’15
Clearly, given the increasing need for decarbonisation, even well-designed and regulated energy markets do not suffice to offer the proper incentives for investment.

15

M. Baritaud, Securing power during the transition, IEA, 2012, p. 11.

13

II.

T HE PATCHWORK OF CAPACITYREMUNERATION MECHANISMS IN THE EU

The CRMs put in place, planned or considered by Member States vary strongly. Thesevariations often result from the specific context of the country concerned (energy
mix, political sensitivity, power generation industry). Given the different characteristics of Member States’ energy markets, there is thus no single fix to the problem that
CRMs are intended to address.16 Consequently, their classification is difficult.
According to the Agency for the Cooperation of Energy Regulators (ACER), there arebroadly three major categories of CRMs: Capacity Payments, Strategic Reserves andCapacity Markets (i.e., the ‘capacity auction’ model regarded as a centralised mechanism, or the ‘capacity obligation’ model seen as a decentralized mechanism or ‘reliability option’ rarely used in the EU).17 The first two categories are complementary
tools in the framework of the EOM. The third category creates a new and separate
market alongside the EOM.18 The first category includes price-based mechanisms,
while the last two categories include quantity-based mechanisms (also calledvolume-based mechanisms). Within these three categories, there can be manydifferences in structure and in implementation.
Capacity Payments. The principle is to give a direct payment to the available
capacity. In other words, each MW installed receives ex-ante determined payment
for its availability. The payment is estimated by the competent authority and may
differ according to technology or the definition of availability. The costs are borne byconsumers in the form of taxes or capacity surcharges. Such mechanisms are not,however, as simple as they appear to be. They require a detailed knowledge of themarket. An erroneous estimate of the structure of the incentive can easily cause
undesired under- or overinvestment in capacity.
Greece and Ireland introduced Capacity Payments in 2006 and 2007 respectively.
Spain introduced them in 1998 but is discussing further reforms. Portugal introduced
the same Capacity Payments system as Spain in 2011.
Strategic Reserves. These are reserves triggered by extreme market or system security circumstances. The Strategic Reserve is limited to bridging the gap identified by
the competent body (transmission system operator or TSO, and/or grid regulator).
16

17
18

L. Meulman and N. Méray, Capacity Mechanisms in Northwest Europe. Between a rock and a hard place,
Clingendael International Energy Programme, Nederlands Institut voor Internationale Betrekkingen,November 2012, p. 11.
For more information, see ACER’s paper, Capacity remuneration mechanisms and the internal market forelectricity, 30 July 2013, pp. 4-8.
J. Grigorjeva, Capacity Mechanisms in the EU: Nationalizing energy security, Jacques Delors Institut Berlin,
Policy Paper 134, 21 May 2015, p. 12.

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THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

Centrally and competitively procured, it can include old power plants as well as newly
built units. But there is increasing disquiet within the industry concerning the lack oftransparency around remunerating capacity this way. Union rules on public procurement19 must be respected and help ensure that there is no overcompensation.
Belgium, for instance, introduced a Strategic Reserve in 2014 (in the wake of the‘Plan Wathelet’) to ensure a sufficient level of security of electricity supply during thewinter periods (from November to March). It is activated during such periods insituations where total Belgian consumption cannot be covered by the available
production capacity in Belgium and imports from other countries. The design,
procurement and operation of this mechanism has been assigned to the Belgian
electricity transmission system operator, ELIA, under the supervision of the CREG
(the federal regulatory authority for the energy sector), which also validates the rulesof operation.
Thanks to this mechanism, ELIA is able to activate generation units that would otherwise be unavailable, or to instruct consumers willing to participate in this mechanism
to reduce their load.
Finland, Poland and Sweden also have a Strategic Reserve mechanism, while theNetherlands developed a Strategic Reserve model in 2003 but has not yet activatedit.
(Forward) Capacity Markets. By comparison with Capacity Payments and Strategic
Reserves, Capacity Markets imply the creation of new and separate markets in addition to the existing EOM. Capacity is traded as a product on these new markets,
which are complex.
Italy, for instance, introduced Capacity Payments in 2004 to ensure capacity, but has
now chosen a market-based mechanism (auction model), with the first auction to beheld during the last quarter of 2015. The auction model was prepared by the Italiangrid operator, TERNA, on the basis of criteria developed by the Italian Regulatory
Authority for electricity (AEGW). It was approved in June 2014 by the Italian Ministryof Economic Development with the endorsement of AEGW. The auction will takeplace a few years ahead of the delivery year in which capacity is required to be madeavailable. According to this model, procurement of capacity is performed by competitive tenders where TERNA is the central counterparty that also determines the levelof capacity to be made available. Participation of power producers is made on a
voluntary basis. Specific characteristics must, however, be met by the participants(e.g., in addition, the participating power plants – planned, under construction orexisting – must have a pre-defined capacity and be located on Italian territory,

19

16

Relevant legislation includes Directive 2004/17/EC coordinating the procurement procedures of entities
operating in the water, energy, transport and postal service sectors (OJEU, L 134/1, 30.04.2004).

THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

although criteria for the participation of ‘beyond the borders’ plants are expected).
Participants cannot be intermittent power producers. The product negotiated into
each tender is the reliability option contract. Within this model, two types of auction
will be implemented (a main auction and an adjustment auction). These two auctions
also include a geographical element because they are organized by zone. In addition,a ‘secondary market’ will provide a higher degree of flexibility, allowing power
producers to trade between them the contracts they have entered during theauctions mentioned above.20
France has also decided to implement a market-based mechanism (obligation
model).21 The market will kick off on 1 January 2017. Here, the obligation to acquireenough capacity to meet the expected consumption of their customers during peak
periods is carried by electricity suppliers. To meet its obligation, the supplier will
have to acquire capacity certificates. Generating capacity operators that commit to
making their capacities available during consumption peaks are granted compensation certificates that they will be able to sell to suppliers. Capacity certificates will be
traded on the EPEX power market. It is RTE, the national grid operator, owned bystate-controlled utility EDF, which has designed this obligation model, and which will
operate the market. The mechanism is technology-neutral (e.g., nuclear, gas, wind,etc).
The United Kingdom also implements a Capacity Market mechanism (auction
model). Here the National Grid (the United Kingdom’s TSO) provides a forecast of
future peak demand and ministers decide the total amount of capacity needed toensure security of supply. Successful participants in the auctions run by National Grid
will enter into ‘capacity agreements’. Auctions will take place a few years ahead ofthe delivery year in which capacity is required to be made available. The first auction
was held in December 2014 for capacity in 2018/2019. The government wanted
commitments above 49 GW of power generation, which corresponds to the forecast
maximum demand in the United Kingdom in 2018/2019. The auction results, whichwere highly criticized,22 showed an over-subscription, with 65 GW bringing into
question the need for a capacity auction at this point in time and a clearing priceconsiderably below market consensus expectations,. This failed to attract new-build
generation and demand-response. The winners were the nuclear fleet and pumped
storage reservoirs. On the other hand, the auction outcome was considered asuccess by the government.23
20
21
22

For more information, see ‘Capacity Payment in Italy and the German case’, Clifford Chance, April 2015<http://www.cliffordchance.com/briefings/2015/04/capacity_paymentinitalyandthegermancase.html>.
See T. Veyrenc (RTE), ‘A capacity market in France – status of discussions and future steps’, WEC European
Energy Forum, 24 April 2014. See also, French Capacity Market, Report accompanying draft rules, RTE.
See the article written by C. Goodall, ‘The UK capacity auction made power companies merry thisChristmas’, in the Guardian, 24 December 2014 and the article written by M. Parr, ‘UK’s “capacity market”
is not a market – it’s state aid (£1 billion/year)’, EnergyPost.eu, 26 January 2015. See also the paper written
by Phil Baker, E. Bayer and J. Rączka, Capacity market arrangements in Great Britain, Forum for Energy
Analysis, January 2015.

17

THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

Romania has also had a Capacity Market since 2007.24 Other European countries are
discussing the topic. This is the case of Germany, where discussions are particularly
strong. It hesitates a choice between two options: an optimized EOM (Electricity
Market 2.0 option) that investors can rely on, or the introduction of a Capacity
Market mechanism. Each option has its proponents and opponents. In themeantime, several German operators have announced that they will shut down theirpeaking plants by April 2016 because according to them they can no longer supply
power to the market at profitable terms. They have even threatened to consider
legal action if the government prohibits the shutdown of plants. This situation should
not be underestimated because it could happen elsewhere in the EU.
Other types of classification are also proposed. As mentioned in Point IV of this introductory paper, the Commission has adopted Guidelines on State aid for environmental protection and energy 2014-2020 (EEAG).25 They contain for the first timerules to assess capacity mechanisms (Section 3.9). As this is a relatively new field instate aid policy, the Commission has also created a Working Group with the Member
States to help them implement the relevant provisions in the Guidelines and to shareexperience in the design of CRMs. Thematic papers are then issued by the European
Commission. In this context, the Commission has issued a discussion paper
presenting a dual description of CRMs, based on the essential distinction between
targeted and market-wide models.26 This dual description is also the one proposedin its recent capacity mechanism state aid probe, launched in April 201527 (seeFigure V, p. 19).

23
24
25
26
27

18

GOV.UK’s press release published on 2 January 2015 <https://www.gov.uk/government/news/the-firstever-capacity-market-auction-official-results-have-been-released-today>
Romania country profile, p. 79 [http://www.ebrd.com/downloads/legal/irc/countries/romania.pdf,
OJEU, C200/1, 28.06.2014.
Capacity Mechanisms Working Group, 30 June 2015 – High-level comparison of capacity mechanism
models and compatibility with state aid guidelines.
State Aid: sector inquiry into capacity mechanisms – frequently asked questions (MEMO/15/4892 of 29
April, 2015.

THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

Figure Va: Taxonomy of capacity mechanism models

Figure Vb: Different types of capacity mechanismes

19

III.

T EN CRITICISMS OF CRM S

Many criticisms are made of CRMs. The following ten counterarguments arepresented without distinguishing between the three categories of CRMs introduced.
First, capacity is encouraged on the basis of uncertain forecasts for various conditions made several years in advance.28 Deviation between forecasts and theelectricity demand – and therefore the capacity requirements – can result in distortions of the electricity price formation. More crucial in the development of the single
energy market, generation adequacy is increasingly difficult to ensure on a purely
national basis.29 Yet Member States have so far continued their own national
forecast.
Second, the cost of CRMs can be very high. Expensive CRMs could thus increase theenergy bills paid by energy consumers without facilitating improved supply
security.30 International experience shows that CRMs can cost up to 10% to 20% ofwholesale electricity (i.e., energy only) prices.31
Third, CRMs can over-reward generation that is financially viable.32 They can also be
designed in a way that benefits certain operators or technologies (even if they are
uneconomical and unsustainable) and this can discourage other types of investment.
They can also impede the development of alternative solutions such as storage or
Demand Side Response (DSR), for example.33 This is an important point considering
28

29
30

31
32
33

For instance, see the CREG Study entitled « Les mesures à prendre afin de disposer du volume adéquat demoyens de production conventionnels pour assurer la sécurité d’approvisionnement en électricité de laBelgique », 4 June 2015, p. 6.
SWD(2013) 438, p. 3.
According to the Booz 2013 Study on the benefits of an integrated European energy market, the fact that
Member States tend to ensure security of supply on a national basis costs them between €3-7 billion extra
per year.
See also A. Pototschnig and M. Godfried, Capacity mechanisms and the EU internal electricity market. The
regulators’ view: ACER’s report on capacity mechanisms, 2013, p. 1. See also B. Caldecott and J. McDaniels,
Stranded generation assets: implications for European capacity mechanisms, energy markets and climate
policy, Working Paper, January 2014, pp. ix and 11. <http://www.acer.europa.eu/The_agency/Organisation/Administrative_Board/Meetings/16th%20AB%20Meeting%20%20Background%20Documents/21-AB16-14_Pototschnig%20Godfried%20Chapter.pdf >SWD(2013) 438, p. 32.
For more information on the topic, see SWD(2013) 438, pp. 24-25.
According to the Capacity Mechanisms Working Group, Demand Response or DSR refers to ‘the ability ofelectricity consumers to supply electricity by reducing their demand at times of system scarcity.’ <http://
ec.europa.eu/competition/sectors/energy/capacity_mechanisms_working_group_4.pdf > The DSR conceptrefers to various solutions sponsored by the power grid, the most common of which involves paying companies or end-users to be on call to reduce electricity usage when the grid is stressed to capacity. The concept
is, however, broader. In fact, it can be either incentive-based, where consumers are offered payments to
reduce their power consumption at times of peak demand or when the system is under stress, or it canoperate on a time-price principle. In either case, it requires consumers to either actively respond to signals
from the operator or, hopefully with the development of ICT, to make use of automated solutions to enter
into contracts with service providers. This implies that customers voluntarily accept to deviate from normal
consumption behaviour in order to obtain lower electricity prices and to support security of supply. Consequently, Demand Response flattens the load profile and avoids more expensive investments in new power
plants. This presents the additional advantage of reducing CO2 emissions.

21THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

the comparative benefits of adapting demand rather than increasing supply. As
indicated by the Commission, DSR can offer benefits to all parties involved:‘Demand response is an asset for both the retail and the wholesale market. In
wholesale markets, equal market-entry opportunities for demand side
resources (e.g., industrial loads) alongside generation should be pursued inline with the EU energy policy. The value of demand response for the wholesale and balancing markets, at various time scales (i.e., including the dayahead, intraday and forward markets) is far from being tapped. EU industries
and businesses of all sizes need to have access to these markets and beadequately compensated. As a consumer-driven and market-based mechanism successfully implemented in many other economic sectors, demand
response is also an integral part of a consumer-centric retail market vision in
the energy sector’.34
However, a strong nexus exists between DSR and the development of smart grids,
which are presently behind schedule in Europe.35
Additionally, few countries allow DSR to participate. A frequent explanation is that it
makes the implementation of the CRM more difficult. The experience of the UnitedStates has, however, shown that a capacity mechanism that allows for adequate
participation by DSR can enable it to take off.36 This said, one of the drivers for theUnited Kingdom and France to adopt a CRM was the ambition to increase opportunities for DSR.
Fourth, a capacity market can only prove an effective solution to security of supply
problems if the capacity market itself can provide credible signals for investment. For
instance, the British mechanism with its first auction has proved unable to generate
the signals mentioned in this paper.
Fifth, various Member States have reconsidered all or part of the CRM since theirintroduction.37 This constant change in regulation can disrupt investment planningand fundraising. It also causes difficulties in managing relationships with investors.
Sixth, many CRMs involve state aid.38 Yet some countries submit their CRM for state
aid clearance to the European Commission (e.g., the United Kingdom), while others

34
35
36
37

38

22

SWD [2013] 442, p. 4.
See T. Zgajewski, Smart Grids: a very slow deployment in the EU, Egmont Paper n° 74, February 2015.
See the North European Power Perspectives’s paper, Capacity mechanisms: Revived interest in capacity
mechanisms throughout Europe in the face of high volumes of intermittent generation, September 2011.
L. Meulman and N. Méray, Capacity Mechanisms in Northwest Europe. Between a rock and a hard place,
Clingendael International Energy Programme, Nederlands Institut voor Internationale Betrekkingen,November 2012, p. 11.
L. Meulman and N. Méray, Capacity Mechanisms in Northwest Europe. Between a rock and a hard place,
Clingendael International Energy Programme, Nederlands Institut voor Internationale Betrekkingen,November 2012, p. 12.

THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

do not because they consider that their CRM do not involve state aid (e.g., France).
This constitutes an additional source of (legal) uncertainty.
Seventh, when designing CRMs, the cross-border contribution to security of supply
through market coupling and TSOs’ cooperation is often overlooked.39 Market
coupling, through an algorithm, directs electricity to flow away from low-priceregions and towards high-price ones. TSOs’ cooperation could also play an importantrole by establishing cross-border electricity balancing markets. Electricity balancing
refers to the situation after markets have closed (gate closure) in which a TSO acts toensure that electricity generation equals demand in and near real time. That is essential as it reduces the need for back-up generation and ensures security of supply at
lower costs for consumers. The approach to procuring ‘ancillary services’ is an important aspect of balancing. The latter refer to a range of functions that TSOs contract
so that they can guarantee system security.40 The rationale for developing crossborder balancing markets is thus strong. The revised version of the network code onelectricity balancing, prepared by ENTSO-E and recommended on 24 July 2015 by
ACER for adoption by the European Commission, is considered to be an important
step towards facilitating these cross-border balancing markets.
Eighth, the uncoordinated and unilateral introduction of a CRM in one Member Statecan create cross-border distortions.41
For instance, CRMs may have welfare redistribution effects between interconnectedmarkets due to ‘spill-over effects’. A March 2015 study made by DNV GL for Agora
Energiewende shows that the envisaged Capacity Market in France could benefit
German consumers by limiting the rise in power prices when electricity demand ishigh in both countries, while the cost of capacity certificates falls on French
consumers, whose electricity bills rise. German power plant operators, meanwhile,
could lose out on profits from peak power prices.42
Other examples of how design choices of CRMs can lead to cross-border distortionary effects are given by ACER.43

39
40

41

42

43

See the article by S. Farrington published in Energy Risk on 16 March 2015 entitled ‘Power capacity mechanisms worry EU electricity traders’.
Some experts consider, however, that trading an ancillary service on a capacity market creates distortions.
For more information, see the article by L. Harrison entitled ‘The trouble with capacity markets’ in Wind
Power Monthly of 1 November 2013 <http://windpowermonthly.com/article/1218191/trouble-capacitymarkets>.
L. Meulman and N. Méray, Capacity Mechanisms in Northwest Europe. Between a rock and a hard place,
Clingendael International Energy Programme, Nederlands Institut voor Internationale Betrekkingen,November 2012, p. 10.
‘Potential interactions between capacity mechanisms in France and Germany’, DNV GL, March 2015. See
also the previous study made by R. Meyer et al, ‘Analysis of capacity remunerative mechanisms (CRMs) inEurope from the internal electricity market point of view’, Elforsk rapport 14:22, March 2014.
See the previously mentioned ACER paper, Capacity remuneration mechanisms and the internal market forelectricity, 30 July 2013, p. 10.

23

THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

Ninth, CRMs might contradict the objective of phasing out environmentally harmful
subsidies, including those for fossil fuels.44
Tenth, in the literature, several simulation results show that once a CRM is implemented it becomes the main driver (as opposed to energy prices) for investments in
new electricity generation capacity.45 So remunerating generators for their capacity
may not solve problems and could even entail opportunistic speculation.

44
45

24

Communication from the European Commission on launching the public consultation process on a newenergy market design – COM(2015) 340, p. 14;
See the previously mentioned ACER paper, Capacity remuneration mechanisms and the internal market forelectricity, 30 July 2013, p. 12.

IV.

T HE E UROPEAN C OMMISSION ’ S INITIATIVES

Communication on generation adequacy in the internal electricity
marketA few years ago, the Commission was clearly considering that the single market was
the pillar of electricity security of supply (including generation adequacy). Consequently, Directive 2009/72/EC46 on the internal market in electricity affirms that ‘thesecurity of energy supply is an essential element of public security and is therefore
inherently connected to the efficient functioning of the internal market in electricity
and the integration of the isolated electricity markets of Member States’ (Recital 25).
For that reason, according to Article 3.2 of the same Directive, ‘Member States may
impose on undertakings operating in the electricity sector, in the general economic
interest, public service obligations which may relate to security, including security ofsupply,’ but such obligations have to be ‘clearly defined, transparent, non-discriminatory, verifiable and guarantee equality of access for electricity undertakings.’ They
also have to be notified to the European Commission as indicated in Article 3.15 of
the same Directive.
Reality has proved more complex, however. In a 2010 judgment, the Court of Justiceof the European Union stated that Member States have to be able to show thatpublic service obligations are necessary, proportionate and transitional in nature.47
In November 2013, the Commission also issued a Communication ‘Delivering theinternal electricity market and making the most of public intervention,’48 accompanied by a Staff Working Document entitled ‘Generation adequacy in the internal
electricity market – guidance on public interventions’.49 In this document, theCommission recalls that CRMs must not only comply with competition and state aid
rules, but should also be in line with the objectives and requirements of EU energy
policy.50 It also acknowledges that ‘if remaining market failures are identified as
precisely as possible, public intervention should be designed in a cost-effective
manner so as to ensure effectiveness and proportionality.’51

46
47

48
49
50
51

OJEU 2009, L 211/55, 14.08.2009.
C-265/08 Federutility and Others v Autorità per l’ energia elettrica e il gas. The judgment of the Court setsout ‘First, such an intervention must be limited in duration to what is strictly necessary in order to achieve
its objective… Secondly, the method of intervention used must not go beyond what is necessary to achieve
the objective which is being pursued in the general economic interest. Thirdly, the requirement of proportionality must also be assessed with regard to the scope ratione personae of the measure, and, moreparticularly, its beneficiaries.
C(2013) 7243 final.
SWD(2013) 438.
For more information, see Kai Uwe Pritzsche, ‘Capacity mechanisms: the rules on State aid in Capacity
mechanisms. Reigniting Europe’s energy markets’, Linklaters, 2014, p. 13.
Generation adequacy in the internal electricity market, SWD (2013) 438, p. 13.

25

THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

Member States can thus intervene to fill a generation adequacy gap, and this public
intervention may entail public service obligations imposed on generators, suppliers
and/or TSOs, provided a number of conditions are respected. First, as required by
Article 7 of Directive 2005/89/EC (Electricity Security of Supply Directive),52 publicauthorities must regularly undertake an assessment of the generation adequacy
situation in their Member State, also fully taking account of development at regional
and EU level. Article 4 of Directive 2009/72/EC also points in this direction:‘Member States shall ensure the monitoring of security of supply issues ... they
may delegate that task to the regulatory authorities. ... Such monitoring shall, inparticular, cover the balance of supply and demand on the national market, thelevel of expected future demand and envisaged additional capacity being
planned or under construction, and the quality and level of maintenance of the
networks, as well as measures to cover peak demand and to deal with shortfallsof one or more suppliers. The competent authorities shall publish every two
years, by 31 July, a report outlining the findings resulting from the monitoringof those issues, as well as any measures taken or envisaged to address them andshall forward that report to the Commission forthwith.’
Second, as already noted, the public service obligations must be cost-effective,
proportionate and transitional in nature. Third, ‘the intervention must be transparent and non-discriminatory. Intervention cannot undermine the effective functioning of the internal electricity market and in particular must not prevent access tonational markets by electricity undertakings established elsewhere in the internal
electricity market.’53
Interestingly, in spite of the mounting preoccupations regarding the security ofelectricity supply, the Commission has not endeavoured to elaborate some kind of
integrated security mechanism. It is somewhat paradoxical for the Member States toinvolve themselves in the creation of a continental market, while at the same timeelaborating security mechanisms at the national level.54

EU state aid rules
Many CRMs could involve state aid and have an impact on competition in the internal
electricity market. For that reason, they are subject to EU state aid rules, in particular
to the guidelines on State aid for environmental protection and energy 2014-2020,55
which contain rules to assess CRMs (Section 3.9).

52
53
54
55

26

OJEU 2006, L 33/22, 04.02.2006.
SWD(2013) 438, p. 21.
See for example M. Baritaud and D. Volk, Seamless power markets – Regional integration of electricity
markets in IEA Member Countries, 2014, p. 70.
Communication from the Commission (2014/C 200/01), OJEU C 200/01 of 28.06.2014.

THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

In these 2014 guidelines, the Commission invites Member States to establish clearly
the need for state intervention:“The nature and causes of the generation adequacy problem, and thereforeof the need for State aid to ensure generation adequacy, should be properly
analysed and quantified, for example, in terms of lack of peak-load orseasonal capacity or peak demand in case of failure of the short-term wholesale market to match demand and supply. The unit of measure for quantification should be described and its method of calculation should be provided.
(223) The Member States should clearly demonstrate the reasons why themarket cannot be expected to deliver adequate capacity in theabsence of intervention, by taking account of on-going market andtechnology developments (96).
(224) In its assessment, the Commission will take account, among others andwhen applicable, of the following elements to be provided by theMember State:(a) assessment of the impact of variable generation, including thatoriginating from neighbouring systems;(b) assessment of the impact of demand-side participation,
including a description of measures to encourage demand side
management (97);(c) assessment of the actual or potential existence of interconnectors, including a description of projects under construction andplanned;(d) assessment of any other element which might cause or exacerbate the generation adequacy problem, such as regulatory ormarket failures, including for example caps on wholesale prices.
The Member States must also establish the appropriateness andproportionality of the contemplated measures, and also the avoidanceof undue negative effects on competition and trade.
(225) The aid should remunerate solely the service of pure availability
provided by the generator, that is to say, the commitment of being
available to deliver electricity and the corresponding compensation forit, for example, in terms of remuneration per MW of capacity being
made available. The aid should not include any remuneration for thesale of electricity, that is to say, remuneration per MWh sold.
(226) The measure should be open and provide adequate incentives to both
existing and future generators and to operators using substitutable
technologies, such as demand-side response or storage solutions. The
aid should therefore be delivered through a mechanism which allows
for potentially different lead times, corresponding to the time needed27THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

to realise new investments by new generators using different technologies. The measure should also take into account to what extent interconnection capacity could remedy any possible problem of generation
adequacy.
(228) The calculation of the overall amount of aid should result in beneficiaries earning a rate of return, which can be considered reasonable.
(229) A competitive bidding process on the basis of clear, transparent andnon-discriminatory criteria, effectively targeting the defined objective,
will be considered as leading to reasonable rates of return undernormal circumstances.
(230) The measure should have built-in mechanisms to ensure that windfall
profits cannot arise.
(231) The measure should be constructed so as to ensure that the price paid
for availability automatically tends to zero when the level of capacity
supplied is expected to be adequate to meet the level of capacity
demanded.”In this framework, the Commission has recently launched an inquiry and has started
individual assessments of 11 Member States that either already have CRMs in placeor are considering them. The countries covered are: Belgium, Croatia, Denmark,France, Germany, Ireland, Italy, Poland, Portugal, Spain and Sweden.56 The United
Kingdom is excluded for now because its capacity market was cleared by DG COMP
in July 2014.57 The inquiry’s aim is to seek information in order to check that each
respective CRM does not favour particular producers or technologies, or create
obstacles to trade across national borders. Final results of the initial phase of theinquiry should be published mid-2016. This inquiry should not be underestimated as
it may provide the basis for future state aid actions and policy decisions of the European Commission (which may also include repayment of unlawful state aid).

Commission’s communication on the Energy Union
It should be noted that the EU’s approach has never been supportive of capacity
markets as drivers of security of power supply. The Commission’s communication on
the Energy Union published in February 2015 clearly stated that a functioning
internal market does not need CRMs. The EU approach instead encourages schemesof regional integration such as market coupling.58

56
57
58

28

See European Commission’s press release IP/15/4891 of 29 April 2015.
See European Commission’s press release IP/14/865 of 23 July 2014.
For more information, see Marco Giuli, ‘Capacity mechanisms – A credibility test for the Energy Union’,
Policy Brief, 11 June 2015.

THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

JRC
JRC, the European Commission’s in-house science service, has been commissioned toassess the appropriateness of existing and proposed generation adequacy assessments at national and European level, and make recommendations on improving
them.

29

V.

R ECENT M EMBER S TATES ’ COLLECTIVE
INITIATIVES

European countries have taken another step towards enhancing EU energy security
via regional cooperation.
On 8 June 2015, 12 European countries (Austria, Belgium, the Czech Republic,
Denmark, France, Germany, Luxembourg, the Netherlands, Norway, Poland, Sweden
and Switzerland) signed a ‘Declaration for regional cooperation on security ofelectricity supply in the framework of the internal energy market’. The signatories
want to start considering energy security as a European issue rather than a purely
national one, commented Sigmar Gabriel, the German Energy Minister. The declaration sets out an initial series of joint steps to be taken as part of the cooperation.
The key points of the declaration are the following:• Place greater focus on making supply and demand more flexible by making use ofstrong market signals and by using price peaks, as well as eliminating barriers thatstand in the way of greater flexibility and refraining from introducing legal pricecaps.
• Reinforce the grids and avoid restricting cross-border electricity exchange, evenin times of electricity scarcity.
• In future, place greater focus on assessing generation adequacy as a regionalgroup and develop a common approach to this end.
In addition to this first political declaration, a ‘second political declaration of thePentalateral Energy Forum’ was signed by seven European countries (Austria,
Belgium, France, Germany, Luxembourg, the Netherlands and Switzerland). In thisforum, representatives of the Member States and TSOs work together on the
coupling of their electricity markets and their power exchanges.

31

VI.

I S THE MULTIPLICATION OF CRM S THE BESTSTRATEGY ?

Currently, as we have seen, electricity prices are low on the wholesale market inEurope for many reasons. The deep economic recession after 2008, and the reduction of potential growth, have played an important role (See Figures VI, VII and VIII).
Meteorology has also led to a lower level of consumption. Furthermore, theelectricity intensity of growth has also diminished, notably because energy efficiency
has progressed. Additionally, the huge subsidies offered to wind and solar during thelast decade have brought a lot of new near-zero marginal cost capacity onto themarket. Overall, there is currently too much capacity, coinciding with economic
stagnation. Incentives for investment remain weak, and incentives for mothballing
power plants, especially gas ones, substantial.
Figure VI: EU-27 Electricity Demand

Source: A. Baker, Investing in electricity, 2014, p. 6

33

THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

Figures VII: Final consumption of electricity and derived heat, ktoe, EU-28, 1990-2013

Source: Eurostat (nrg_100a)

Figure VIII: Final consumption of electricity by sector, ktoe, EU-28, 1990-2013

Source: Eurostat (nrg_100a)

Meanwhile, the projected continuous increase in RES (much of which is variable windand solar), and its dominant part in new generation capacity additions over the forthcoming years,59 put pressure on the electricity system’s flexibility. The greater themarket share of renewables becomes, the greater the need for flexibility in the traditional fossil fuel plants will be. ‘The substantial growth of renewable energy is leading
to a slowly declining and more volatile residual load – the power demand that is not
met by fluctuating wind- and solar-electricity sources. This load needs to be followed
increasingly by fossil fuel plants seeking to avoid the negative margins associated59

34

See ENTSO-E’s latest scenario outlook and adequacy forecasts 2015 ENTSO-E, p. 26.

THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

with production costs that exceed the wholesale market price. More and more
power plants can expect to be dispatched in large and relatively rapid shifts,
depending on the respective availability of renewable sources.’60 (See Figure IX)
Figure IX

Source: F. Klose and J. Prudlo, Flexibiliszation – The new paradigm in power generation, BCG perspectives, 2013

Something has thus to be done to better guarantee the security of electricity provisioning in the future. If demand is more or less stable, conventional capacities are
slowly being retired due to the lack of economic incentives, and ENTSO-E believes
this trend could be accentuated after 2016 (see Figure X). This is not sustainable in along-term perspective. It is, however, difficult to define what needs to be done, fordifferent reasons. In such a context, it is extremely difficult to anticipate the future.
So far there is no proper method of assessment, especially for knowing how big the
problem will be. Meanwhile, security of supply has been addressed exclusively as anational issue, with decisions taken exclusively on the basis of the country’s own
welfare, while neglecting to assess the potential negative impact on the neighbouring countries or the EU as a whole. Additionally, changing the organisation ofgeneration and supply before a proper and comprehensive analysis carries risks ofexacerbating some of the sector’s ills.

60

F. Klose and J. Prudlo, ‘Flexibilization – The new paradigm in power generation’, BGC Perspectives, 2013, pp.
1-2.

35

THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

Nevertheless, If CRMs are deemed necessary in the present context, it is also essential to carefully examine other possible alternative solutions, thus far underutilised.
Here are a few. Obviously, the completion of the internal energy market and of the
Ten-Year Network Development Plan 2014 may reduce the level of insecurity. A
better use of existing capacity achievable thanks to stronger, smarter and more interconnected transmission networks (both domestic and cross-border) would also be
useful. The development of market couplings as well as the introduction of crossborder and harmonised balancing markets and ancillary services may help as well.
One essential solution should come from demand response (which also requires
stronger and smarter networks). Demand response offers the possibility to have anelectricity system where increasingly the ‘demand follows generation’ and not thereverse, in which ‘generation follows demand’. This would reduce the need for
expensive peaking plants to operate (since demand response can shift the electricity
demand from peaking moments to off-peaking moments in time), and would have apositive impact on the merit order by decreasing the marginal price.61 This said, thelowest fossil fuels’ prices will never compete with the RES in the area of variable
costs. Finally, of course, the improvement of electricity storage capabilities would be
the ideal compensation for the mounting variability of renewables. A last option,
which will probably have difficulty finding public acceptance, would be to allow peak
prices so that available capacity is remunerated by the market and not by subsidies.
Taking into consideration these measures is fundamental because, as mentioned
before, CRMs can present negative effects. In any case, CRMs need to be carefully
designed and compatible with the internal energy market. Their implementation
should not unduly increase system costs and costs to end users. Cross-border participation should be required and a clear exit strategy should be provided in case ofadverse effects on cross-border trade.62 Otherwise, the biggest danger of CRMs
could be the reduction of the efficiency of the alternative solutions.
Meanwhile, CRMs have emerged in several countries with numerous associatedproblems associated, and they could be hard to remove if they deliver unexpected
results.

61
62

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For more information, see the Insight_E study, Quantifying the merit-order effect in European electricity
markets, February 2015, p. 4.
For more information, see the study by Thema Consulting Group entitled Capacity mechanisms in individual
markets within the IEM, June 2013.

THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

Figure X: 1-ENTSO-E Fossil fuels generation capacity forecast in SO&AF 2014 and in
SO&AF 2015; all scenarios; January 7 p.mù. [GW]

Source: ENTSO-E 2015 scenario outlook & adequacy forecast, 30 June 2015, p. 22

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C ONCLUSION
One should not underestimate the huge changes undergone by the electricity system
in Europe during the last ten years. The introduction of renewables, especially solar
and wind, has made the system much more complex, since it relies now on a greaternumber of primary energy sources, quite different in technical and financial aspects.
Additionally, the capital needs of producers are extremely diverse. Some have very
high fixed costs. Others have much higher variable ones. In any case, the arrival ofmany new renewable electricity producers with very high fixed costs requires more
previsibility in a changed context that generally provides less of it. The electricity
production system has also been made, of course, more irregular with the rapid
development of renewables. As a result, the reliability challenges of the electric
system have changed and have increased. Furthermore, the development of theenergy single market has introduced an additional layer of complexity. It is not difficult to understand why such a situation has provoked a growing thirst for moresecurity, and also rising calls for public intervention.
All this does not mean that there is an immediate risk of blackout. These dangers areclear, but they are not present yet. They concern more the middle term. Energy,
however, is a very long-term sector for investments. Investment paralysis and theclosure or mothballing of power plants will inevitably lead sooner or later to difficulties.
The importance of the problem is compounded by the rising importance of electricity
in the energy system, due to the need for decarbonisation. Climate warming calls formore electricity, because it relies on renewable sources, which cannot be said about
direct use of oil, gas or coal. It can also integrate a substantial amount of increased
energy efficiency. The importance of the problem is also increased by other growing
threats of energy instability in Europe. Renewables have been supported in Europe
to fight not only climate warming, but also the EU’s growing external energy dependence.
Consequently, it is difficult to deny that, in the present context of decarbonisation,
there is a need to take measures to compensate for the growing insecurity ofelectricity provisioning. Capacity mechanisms participate in that logic and aim toprovide that compensation. However, if there were a real threat to the security ofthe electricity system, this does not automatically mean that capacity mechanisms
offer an adequate answer. In fact, the growing instability is provoked by numerous
and various factors, and not only by the growth of renewables. For instance, theinsufficiency of carbon pricing is another source of uncertainty for investment. The
insufficiency of interconnectors with other markets at the borders is yet anothersource. Cross-border trade can reduce the overall cost of the electricity system by
exploiting the complementarities between patterns of demand and differences of39

THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

costs. Maximum electricity demand and production tend to happen at different
times in neighbouring regions. A market of increased scope thus reduces proportionally the need for reserve capacity. The absence of flexibility of electricity demand isanother source of instability. If there were more demand response, there would beless need for generation capacity. Any strategy aiming to reduce electricity insecurity
thus needs to deal with many instruments.
Thus, compensating the growing insecurity of the electricity market requires a global
strategy, using different instruments to limit market distortions. The use of different
instruments is also required to minimize the negative repercussions of CRMs. They
are difficult to manage, they increase the already great complexity of the market,
they are costly, they can reduce the benefits of the single market, and last but notleast, they can reduce the efficiency of other instruments. Furthermore, it is quitedifficult to assess properly the electricity needs of an economy in a middle- and longterm perspective. In general, thus, too much attention has been concentrated on
CRMs in the EU (which have certainly been promoted too quickly), and not enoughon other potential solutions.
It is too soon to provide a valid assessment of the extent of CRMs’ efficiency andimpact as there is limited practical experience of most of them in the EU, and somehave been frequently modified since their introduction. Clearly, however, they canhave repercussions on free competition, on the single market principles and on
further integration. It is in fact paradoxical to define the guarantees of security at thenational level without taking into consideration the impact for the EU market, while
Member States frequently invite all parties involved to complete the internal market,
through, in particular, increased cooperation. As a minimum, the need for a viable
and strong EU framework clearly exists, to avert (or at least minimise) the potential
damages that could prevent a further integration of national markets. Fortunately,
the Commission has taken initiatives in that direction.
This framework’s definition, however, is fraught with difficulties. It is dependent on
a fundamental (and preliminary) question: are capacity mechanisms a temporarycomponent due to the apparition of provisional difficulties caused by RES, or a fundamental permanent component of the electricity system – also due to RES? Technically, the difference between the two analyses is essential. According to the first
analysis, the present system’s instability is something transitory, and the single
energy market, once completed, will take care of it. There is thus no need for positive
action, and the role of the EU is to limit the negative impact of capacity mechanisms
in the transitory phase. According to the second analysis, the growth of renewablesin the electricity system requires a new design. The single market will not deal withthe challenge of increased instability. The EU must thus take positive action, andpossibly define in the long term a new concept of electricity stability at its own level.

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THE RISE OF CAPACITY MECHANISMS: ARE THEY INEVITABLE IN THE EUROPEAN UNION?

Most probably, as long as RES grow and variability grows with them, the EU will haveto deal with this problem. Firstly, the internal energy market is far from completed.
It requires more action, not only in regulation, but also in interconnections. Secondly,
the persistent growth of renewables will inevitably increase the electricity system’s
fluctuations. This should continue – at least as long as very powerful means ofelectricity storage are not be available. Consequently, even if this proves difficult, ina long-term perspective a collective effort should be made by all parties involved todefine as much as possible the parameters of a global capacity framework at the EU
level.

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