COMMISSION STAFF WORKING DOCUMENT Investment perspectives in electricity markets Accompanying the document COMMUNICATION FROM THE COMMISSION TOT HE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN ECONOMIC AND SOCIAL COMMITTEE AND THE COMMITTEE OF THE REGIONS Launching the public consultation process on a new energy market design
Date: 2015-07-15
Institutions: Directorate-General for Energy, European Commission
Subjects: EU investment, climate change, electrical energy, energy policy, innovation, reduction of gas emissions, renewable energy

EN 

   EN 

   EUROPEAN COMMISSION  Brussels, 15.7.2015  SWD(2015) 142 final   COMMISSION STAFF WORKING DOCUMENT Investment perspectives in electricity markets Accompanying the document COMMUNICATION FROM THE COMMISSION TOT HE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN ECONOMIC AND SOCIAL COMMITTEE AND THE COMMITTEE OF THE REGIONS Launching the public consultation process on a new energy market design {COM(2015) 340 final}  
 
 
ABBREVIATIONS AND SYMBOLS USED 

COUNTRIES 

Austria 
AT  
Belgium  
BE  
Bulgaria  
BG  
Cyprus  
CY  
Czech Republic 
CZ  
Germany  
DE  
Denmark  
DK  
Estonia  
EE  
Greece  
EL  
Spain  
ES  
Finland  
FI  
France  
FR  
Croatia 
HR 
Hungary 
HU  
Ireland  
IE  
Italy 
IT  
Lithuania 
LT  
Luxembourg 
LU  
Latvia 
LV  
MT   Malta 
NL  
NO  
PL  
PT  
RO  
SE  
SI  
SK  
UK  
US  

Netherlands 
Norway 
Poland 
Portugal 
Romania 
Sweden 
Slovenia 
Slovakia 
United Kingdom 
United States 

UNITS 

GWh 
kWh 
Mtoe 
MWh 
tCO2 
TWh 

OTHERS 

CAPEX  
ECM 
EEX 
EIA 
ENTSO   
ETS 
EU  

ii 

Gigawatt hour 
Kilowatt hour 
Million tonnes of oil equivalent 
Megawatt-hour 
Tons of carbon dioxide emissions 
Terawatt-hour 

Capital Expenditure 
Error correction model 
European Energy Exchange 
Energy Information Administration  
European network of transmission system operator 
Emissions trading scheme 
European Union 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
EUA 
EUR 
FiT 
GDP 
GHG 
HHI 
HICP 
IEA 
LCOE 
LRMC 
MS 
OCGT 
OECD 
OPEX 
RES 
VOLL 

European Union allowances 
Euro 
Feed-in tariff 
Gross Domestic product 
Greenhouse gas 
Herfindahl-Hirschman index 
Harmonized index of consumer prices 
International Energy Agency 
Levelised Cost of Electricity 
Long run marginal cost 
Member State 
Open-Cycle Gas Turbine 
Organization for Economic Cooperation and Development 
Operating expenditure 
Renewable energy sources 
Value of Lost Load 

iii 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
ACKNOWLEDGEMENTS 

iv 

 
 
CONTENTS 

Executive Summary 

Part I: 

Investments in electricity markets: evolution and drivers 

Introduction 
1. 

Public support 

Investment trends in electricity generation 

Price evolution: electricity, carbon and commodity prices 

Investments in electricity generation: recent trends 
1.1. 
1.2. 
1.3. 
1.4.  Concluding remarks 
Investment in electricity: assessing the drivers in renewables and 
conventional technologies 
2.1.  public support and investment 
2.2.  Market driven Investments 
2.3.  Concluding remarks 

2. 

Part II: 

Investment needs and price signal: perspectives 

Introduction 
1.  Price signal in electricity markets and market framework in member 

Price signal to investors 

States 
1.1. 
1.2.  Market Frameworks in Member States 
1.3.  Concluding remarks 
The transition to low carbon economies and investment needs 
2.1. 
2.2. 
2.3.  Concluding remarks 

The ongoing transformation of European electricity markets 

The case for investments in electricity markets 

2. 

Part III: 

Reconciling markets with investment signal: which market 
arrangements? 

Introduction 
1. 

The economics of the transition to low carbon economies 
1.1. 
1.2. 

The economics of low carbon technologies 

Investment criterion in low carbon technologies in a changing electricity 

system 

1.3.  Concluding remarks 

2.  Market arrangements through the energy transition 

2.1.  Current trends 
2.2.  Challenges for investments and options in power systems under 

decarbonisation (transition phase) 

2.3.  Challenges for investments and options under decarbonised power systems 

(decarbonised phase) 

1 

5 

7 
8 
8 
9 
10 
17 

18 
18 
19 
27 

29 

31 

32 
32 
37 
39 
41 
41 
42 
46 

47 

49 
50 
50 

58 
61 
62 
62 

62 

69 

v 

 
2.4.  Concluding remarks 

References 

Glossary 

Annexes 

A.1. Investment drivers: variables description 
A.2. Power price drivers methodology and data description 

A2.1.  Methdology 
A2.2.  Data description 

A.3. The transition to low carbon technologies: impact on the merit 

order curve 

A.4. Methodology to calculate the annualized capital expenditure 

LIST OF TABLES 

I.2.1. 
II.1.1. 
II.1.2. 
II.2.1. 
III.2.1. 
A1.1. 
A2.1. 
A2.2. 
A2.3. 
A2.4. 
A2.5. 
A2.6. 

Results of the electricity investments drivers 

Electricity Regional Initiatives 

Electricity market characteristics at Member State-level 

Electricity cost structure 

Dispersion* in the EU electricity sector: price and market support 

Investment model 

Panel unit root test results 

Pedroni and Kao residual co-integration test results 

Panel FMOLS and DOLS long-run estimates (in logs) 

Short run causality (Variables in first differences) 

Long run causality (Variables in levels) 

Data description – Power price drivers 

LIST OF GRAPHS 

I.1.1. 
I.1.2. 
I.1.3. 
I.1.4. 
I.1.5. 
I.1.6. 
I.1.7. 

I.1.8. 
I.1.9. 
I.1.10. 
I.2.1. 
I.2.2. 
I.2.3. 

Evolution of installed generation capacity 

Installed generation capacity - EU28 

Net change in installed generation capacity 2004-2008 

Net change in installed generation capacity 2009-2013 

Total support to the energy sector 

Components of total support 

Average domestic and industrial retail electricity price, wholesale price and 

crude oil price evolution 2007-2013 

EU: retail price change and the contribution of the price components 2009-2013 

Electricity wholesale price 

Energy commodities and CO2 prices 

Support per electricity produced 

RES share and support evolution 

Investment decision 

73 

74 

80 

83 

84 
85 
85 
89 

91 
95 

27 
37 
38 
42 
65 
84 
86 
87 
88 
89 
89 
90 

8 
8 
9 
9 
10 
10 

13 
14 
14 
15 
19 
19 
20 

vi 

 
 
 
 
II.1.1. 

II.1.2. 
II.2.1. 

A generic merit-order curve and the effect of increased low marginal cost 

technologies 

Taxonomy of capacity mechanisms 

Ranges for EU28 - Net Power Capacity Investment (in GWe - aggregate 2011-

2030) 

EU28 - Electricity consumption (in TWh) - Final electricity demand in TWh* 

Annual Investment Expenditures in billion of euro - 2010 (2011-2030) 

II.2.2. 
II.2.3. 
II.2.4. 
Levelised costs of fossil fuel and low carbon technologies 
III.1.1.  Generic merit order curve under no capacity constraints 
III.1.2.  Generic merit order curve under scarce capacity 
III.1.3. 
III.1.4. 
III.1.5. 
III.1.6. 

Impact of demand response on the load duration curve 

Cost development of an entrant and an incumbent technology 

Estimated mark-ups for low carbon technologies with Open gas Cycle Turbine 

Short-run impact of demand response on the sudden changes of power outputs 

III.2.1. 

III.2.2. 
III.2.3. 
III.2.4. 
A3.1. 
A3.2. 

A3.3. 

A3.4. 

as a marginal producer 

Estimated mark-ups in EUR/tCO2 for low carbon technologies under a marginal 

price regime 

Degree of harmonisation of national market intervention 

Cost structure of the technology mix under conventional power system 

Cost structure of the technology mix under the decarbonised phase 

Merit-order curves under the conventional phase (stage 1) 

Merit-order curves under the transition phase (stage 2) when technologies 0 are 

operating 

Merit-order curves under the transition phase (stage 2) when technologies 0 are 

not operating 

Merit-order curves under the decarbonised phases (stage 3) 

LIST OF BOXES 

I.1.1. 

I.1.2. 

I.2.1. 

I.2.2. 

II.1.1. 

III.1.1. 

Electricity Markets and Policy Context 

Electricity wholesale price drivers 

Investment drivers: relevant literature 

Methodology and data 

Wholesale electricity markets 

Price developments and market adjustment through the energy transition 

III.1.2.  Quantifying the investment criterion 

III.2.1. 

III.2.2. 

Reforms in the Emission Trading Scheme 

Low carbon technologies and market designs: the experience in South and 

Central America 

36 
37 

41 
41 
42 
43 
50 
51 
56 
57 
57 

61 

64 
66 
70 
70 
91 

92 

93 
94 

11 

16 

22 

25 

33 

53 

59 

67 

71 

vii 

 
 
 
 
 
 
 
EXECUTIVE SUMMARY 

The EU has confirmed 
its intention to 
decarbonise its 
economies 

The decarbonisation of EU economies is at the core of the EU’s agenda for 
climate change and energy. The Climate and Energy Package adopted in late 
2008  targets  require  the  EU’s  Member  States  to  cut  their  greenhouse  gas 
emissions by 20 %, to produce 20 % of their energy from renewable sources, 
and to reduce their gross primary energy consumption by 20 %. In 2009, this 
agenda  was  complemented  by  the  aspirational  goal  of  reducing  greenhouse 
gas  emissions  by  80-95 %  by  2050.  These  ambitions  were  reaffirmed  in 
October 2014, when Member States agreed to set targets for 2030 of 40 % for 
domestic greenhouse gas emissions reduction, at least 27 % for the share of 
renewable energy  and at least -27 % for energy consumption. 

The substantial investment in low-carbon technologies that will be needed to 
achieve  these  goals  will  have  to  be  supported  by  an  economic  and 
institutional  framework  capable  of  facilitating  this  transition.  The  power 
sector is likely to play a central role in the energy transition. First, it has been 
the  main  sector  experiencing  decarbonisation  since  the  last  decade  and  its 
challenges  still  remain  high.  Second,  in  the  near  future,  the  power  sector  is 
expected to support the economy in reducing its dependence on fossil fuels, 
notably in the transport and heating and cooling sectors. For this reason, the 
cost effective promotion of private and public investments in this sector will 
be crucial so that consumers can reap the benefits of this strategy. This report 
provides  analysis  of  the  key  challenges  for  investments  in  the  electricity 
generation  sector  and  reviews  how 
the  current  market 
arrangements or to introduce possible new ones that that could improve the 
current and future investment framework. 

improve 

to 

Investment in new 
generation capacity is 
increasing… 

Investment in the EU’s electricity generation sector has not been affected by 
the economic crisis and has even been accelerating since 2009. Between 2004 
and 2012, capacity increased by 30 % in the EU, in comparison to just 10 % 
in the US. As a result the share of renewable energy in the EU’s electricity 
mix has continued to rise since 2008. 

… in a context of 
increasing public 
support 

… and a weakening 
investment price 
signal 

As  with  investments  in  other  sectors  of  the  economy,  investments  in 
electricity  generation  are  in  general  driven  by  market  conditions.  They  can, 
however, benefit from various forms of public support, provided these are in 
line  with  EU  state  aid  rules.  Public  support  may  have  different  objectives, 
such as security of supply, environmental concerns or social inclusion. With 
the  increasing  production  of  renewable  electricity,  the  support  to  these  new 
technologies rose to € 40 bn in 2012, financed mostly by end-user consumers 
through  levies  on  retail  electricity  prices.  As  a  result,  retail  prices  have 
increased for households and, to a certain extent, industries. 

By contrast, the opposite trend was observed on wholesale  markets. Market 
prices for fossil fuels have decreased since oil prices peaked in 2008. Despite 
a  rebound  in  2009-2010,  oil  prices  have  been  declining  since  2011. 
Wholesale  power  prices  have  followed  the  same  evolution,  lowering  the 
expected profits of investors. Moreover, due to the sharp decline in the price 
of  CO2  emission  allowances,  the  use  of  high  carbon  emitting  power  plants 
and the investment in them has only been discouraged to a certain extent. An 
empirical  analysis  of  the  drivers  of  wholesale  electricity  prices  shows  the 
importance  of  electricity  demand,  as  the  main  determinant  of  prices.  This 
confirms that the economic crisis, by lowering electricity demand, has played 
a major role in depressing wholesale electricity prices. However, the results 

1 

 
Executive Summary 

… wholesale 
electricity prices still 
matter for competitive 
technologies 

… but the rising 
penetration of low-
carbon technologies is 
changing investment 
conditions 

also  suggest  that  renewable  energy  production  had  a  downward  impact  on 
wholesale  prices  as  their  market  penetration  has  grown,  which  could  be 
interpreted as an indication of structural changes on the market. 

The investment framework has also undergone considerable changes. On the 
one  hand,  investments  in  maturing,  clean  technologies  have  taken  place 
thanks  to public  support, which  reduced  the  capital  and operating  costs and 
the  risks  for  investors.  On  the  other  hand,  investment  in  conventional 
technologies  has  been  influenced  by  fundamental  factors  that  matter  for 
investors. The report includes an empirical analysis of investment drivers in 
conventional  technologies.  The  results  confirm  the  importance  of  the  price 
signal  as  a  trigger  for  investments  in  mature  energy  technologies,  but  also 
points  to  the  influence  of  macroeconomic  factors  such  as  interest  rates, 
competition and a favourable business environment. 

Today, in wholesale electricity markets, power prices are set by the bid of the 
marginal unit. This is achieved mostly within day-ahead markets as currently 
other markets such as intra-day markets are not sufficiently developed. Under 
the  assumption  of  perfect  competition,  bids  represent  the  marginal  costs  of 
the  plant  to  supply  energy.  But  the  role  of  the  market  price  signal  varies 
across market frameworks. In energy-only markets, the stability of the system 
in  terms  of  new  investments  in  capacity  is  achieved  through  price  signals. 
When  electricity  demand  is  higher,  prices  increase  to  signal  scarcity.  This 
increases the profits of generators and gives them the incentive to invest. In 
other  market  frameworks,  the  energy  market  can  be  complemented  by  a 
capacity  mechanism.  In  such  markets,  generators  get  revenues  from 
electricity  trading  (energy  market),  but  also  get  remunerated  for  their 
available capacity in the market. 

The rising penetration of low-carbon technologies represents a challenge for 
the electricity sector under the current market arrangements. As their share of 
production  increases,  electricity  markets  will  increasingly  be  dominated  by 
units  with  low  operating  costs  but  high  initial  capital  costs.  The  risk  is  that 
under  current  market  arrangements  and  without  further  integrating  existing 
markets, wholesale market price may prove too low to trigger the necessary 
investments  in  generation  capacity.  In  such  a  situation,  it  needs  to  be 
evaluated if generators would require some additional forms of remuneration, 
which would have to be borne by consumers or tax payers and would need to 
stand in proportion to the benefits provided. 

According to Commission estimates, the power sector will require up to EUR 
90  billion  of  investment  a  year  until  2030,  of  which  EUR  50  billion  are 
needed in energy generation and EUR 40 billion are needed in power grids. 
The  high  investments  needs  and  the  changing  investment  environment  call 
for a reflection on the effectiveness of current market arrangements to drive 
investments.  

The transition to a low-
carbon economy 
impacts both 
capacity and prices 

This report contributes to the current debate on market design by discussing 
the  consequences  of  decarbonisation  in  a  competitive  market  environment 
and  by  providing  an  analytical  framework  to  understand  the  transition  to  a 
low-carbon  economy.  The  analysis  aims  to  describe  the  consequences  of 
decarbonisation  on  the  investment  environment  under  current  market 
arrangements.  On  this  basis,  the  analysis  identifies  possible  challenges  that 

2 

 
 
Executive Summary 

the  EU  could  face  during  and  after  its  transition  to  a  low-carbon  economy. 
Today,  the  transition  is  still  ongoing,  but  markets  will  soon  face  a  larger 
share  of  low  carbon  technologies.  Investments  in  electricity  generation  are 
long-term  by  nature  and  investors  need  to  assess  their  future  profitability 
before  deciding  to  invest  today.  The  challenges  of  the  transition  phase  will 
differ during its different stages of completion and therefore need to be well 
understood in order to be successfully addressed. 

Under  current  market  arrangements,  the  rising  penetration  of  low-carbon 
technologies  is  likely  to  put  pressure  on  wholesale  market  revenues  during 
the  transition  phase.  This  may  make  it  difficult  to  achieve  the  necessary 
levels of investment, and non-competitive low carbon technologies may still 
require some form of support. At the same time, the market is likely to face 
overcapacity, which will need to be addressed in order to reduce the costs of 
the  transition.  Once  decarbonisation  has  be  achieved,  the  issue  of  market 
revenues  may  become  even  more  salient,  as  the  cost  structure  of  the 
technology  mix  based  on  low  variable  costs  and  high  fixed  costs  could 
challenge  the  ability  of  market  prices,  formed  today  mostly  on  day-ahead 
markets, to allow investor to recoup their costs. As a result there could be a 
risk that investors may not be able recoup their investments under the current 
forms  of  market  arrangements  (especially  in  view  of  the  existence  of  price 
caps, market fragmentation and imperfect competition). 

The  report  explores  further  possible  avenues  to  tackle  the  investment 
challenges identified in the analysis and brought about by the transition. The 
central  objective  of  any  market  arrangement  should  be  to  minimise  public 
support  in  order  to  make  the  penetration  of  low-carbon  technologies  cost 
effective  for  end-consumers  and  society  at  large.  Therefore,  the  report 
reviews  how  the  existing  market  arrangements  can  be  improved  and  which 
ones  could  be  deployed  for  the  transition  phase.  The  aim  of  such 
arrangements  would be  to  deepen  market  integration,  make  effective  use  of 
the  carbon  price  signal,  ensure  the  phasing  out  of  high  CO2  emitting 
technologies in the short run and reinforce the spot price signal. 

… as a result, market 
arrangements may 
need to evolve 

intervention.  Given 

In the long run, the challenge will be to put in place market arrangements that 
provide sufficient revenues for investments to take place without any form of 
State 
that  successful 
decarbonisation  may  create,  there  is  a  need  to  start  reflecting  on  the  most 
suitable  market  arrangements  for  the  transition  phase  and  on  the  type  of 
market  arrangements  that  Europe  will  need  once  it  has  reached  its 
decarbonisation goals. 

investment  challenges 

the 

3 

 
 
Part I 
Investments in electricity markets: evolution and 
drivers 

 
 
INTRODUCTION 

This  part  describes  the  changing  pattern  of  electricity  investments  over  the  past  decade.  EU  electricity 
markets  have  been  reshaped  by  regulatory  reforms  starting  in  the  1990s,  and  by  the  decarbonisation 
agenda  and  the  adoption  of  targets  to  reduce  greenhouse  gas  emissions  and  increase  the  share  of 
renewables in energy consumption.  

Chapter one describes the recent evolutions of investments in electricity markets. Investment in electricity 
generation in the EU has been steadily increasing over the last fifteen years. This trend has been driven by 
the  energy  and  climate  change  policy  agenda  and  has  led  to  a  significant  increase  in  the  proportion  of 
electricity generated from renewables. Such an evolution would not have been possible without any forms 
of public support at production, demand or investment level. The last section highlights the divergent path 
of  retail  and  wholesale  electricity  prices.  Retail  prices  for  both  households  and  industries  have  risen 
largely. Wholesale  prices, by  contrast,  have  fallen  in  recent  years  due  to  a  number  of  factors  including 
lower commodity prices, the economic slowdown and higher production from renewables.  

Chapter  two  discusses  and  analyses  the  investment  drivers  in  electricity  markets.  First  the  analysis 
focuses on renewable technologies as investments in these new technologies were mostly driven by the 
policy  agenda  and  the  resulting  public  support.  By  contrast,  investments  in  conventional  technologies 
were mostly driven by macro-economic and energy specific factors. The econometric analysis carried out 
in  this  chapter  shows  that  the  price  signal  matters  for  these  mature  technologies  along  with  other 
economy-wide factors such as demand, competition and financial conditions. 

7 

 
 
 
 
 
 
 
 
 
 
1. 

INVESTMENTS IN ELECTRICITY GENERATION: RECENT 

TRENDS 

and 

energy 

The electricity generation sector is experiencing 
a  transformation  driven  by  the  EU  policy 
climate 
agenda.  Generation 
technologies  are  changing  in  response  to  climate 
change  policy  as  well  as  to  security  of  supply 
concerns.  At  the  same  time,  the  reform  of  the 
sector 
is  putting 
competitive  pressure  on  utilities  to  improve  the 
efficiency of their operations.  

through  market  opening 

This  chapter  focuses  on  the  electricity  sector  and 
describes  the  recent  evolution  of  investment  in 
electricity  markets.  Section  1  analyses 
the 
evolution  of  installed  capacity  over  the  period 
2004  –  2013  in  the  Member  States.  Section  2 
describes 
to 
electricity  over  the  period.  Section  3  looks  at  the 
electricity  price  evolution  in  relation  to  coal,  oil 
and CO2 prices. Section 4 concludes.  

in  public  support 

increase 

the 

1.1. 

INVESTMENT 
GENERATION 

TRENDS 

IN  ELECTRICITY 

Investments in power generation in the EU have 
continued to expand over the last 15 years. The 
evolution of capacity in the EU followed a steady 
increasing  trend.  Compared  to  the  US,  where  the 
increasing  trend  was  interrupted  by  a  break 
between 1998 and 2000, growth of capacity in the 
EU  followed  a  more  stable  and  faster  increasing 
trend,  which  accelerated  starting  in  2009  (Graph 
I.1.1). 

Graph I.1.1:  Evolution of installed generation capacity 

In the OECD database capacity is defined as capacity at 
31st December including electrical capacity of both 
electricity (only) and CHP plants 
Source: OECD and Eurostat 

in  the  EU 

Generation  capacity 
increased 
sharply from 2009 onwards due to the addition 
of  new  renewables  technologies  on  the  already 
existing capacity. The composition of the capacity 
mix  progressively  changed:  nuclear  capacity 
started  declining  in  recent  years  (2010-2013)  due 
to  phasing  out  decisions  in  some  Member  States. 
Conventional  capacity  showed  a  decline  in  2012-
2013 (Graph I.1.2). 

Graph I.1.2: 

Installed generation capacity - EU28 

Other renewables includes wind, solar, geothermal and 
tidal. 
Conventional includes combustible fuels 
Source: Eurostat 

Investment  in  electricity  generation  capacity  in 
the post-crisis period was of greater magnitude 
than  pre-crisis.  During  the  period  2004-2008, 
generation  capacity  modestly  increased  in  some 
Member States (Graph I.1.3). For example, 25 GW 

8 

408012016020019901991199219931994199519961997199819992000200120022003200420052006200720082009201020112012IndexUnited StatesEU280200000400000600000800000100000012000002004200520062007200820092010201120122013MwConventionalNuclearHydroOther renewables 
 
 
Investments in electricity markets: evolution and drivers 

Part I 

Graph I.1.3:  Net change in installed generation capacity 

2004-2008 

Conventional includes fossil fuels and other sources. 
Renewables includes hydro, solar, wind, tidal, geothermal. 
Source: Eurostat, Energy Statistics 

Graph I.1.4:  Net change in installed generation capacity 

2009-2013 

Conventional includes fossil fuels and other sources. 
Renewables includes hydro, solar, wind, tidal, geothermal. 
For Sweden due to lack of data, it is assumed that the 
hydro capacity in 2013 is the same as in 2012. 
Source: Eurostat, Energy Statistics 

1.2. 

PUBLIC SUPPORT 

were  added  in  Spain  and  17  GW  in  Germany. 
Between  2008  and  2012,  instead,  a  period  which 
coincided  with  the  development  of  renewables, 
capacity  additions  were  much  more  significant, 
with 35 GW of additional capacity in Spain and 51 
GW  in  Germany.  The  same  evolution  can  be 
observed  in  other  Member  States,  like  Italy, 
Portugal,  Greece,  Romania,  the  United-Kingdom, 
France,  Netherlands,  Czech  Republic,  Poland, 
Sweden,  and  Denmark.  This  phenomenon  was 
mainly  driven  by  the  increase  in  renewable 
installed capacity, accompanied by a more modest 
increase of conventional technologies.  

in 

increased 

At  the  same  time,  Member  States  are  not 
following  the  same  investment  trends.  Between 
2009  and  2013,  a  majority  of  Member  States 
(Germany, Italy, France, Romania, Spain, Greece, 
the  United  Kingdom,  Belgium,  Austria,  Poland, 
Czech  Republic,  Bulgaria,  Portugal,  Slovakia  and 
their  overall  generation 
Ireland) 
capacity, while for the rest there was little change 
in  generation  capacity  and  for  some  even  a 
decrease  (notably  Sweden)(1).  With  respect  to 
in 
low  carbon 
investment 
Germany,  Italy,  France,  Romania,  Spain  and  the 
United  Kingdom,  renewable  capacity  increased 
quite  substantially,  whereas  in  the  Netherlands 
additions in conventional capacity were larger than 
in  renewables.  France  stands  out  as  a  country 
where  conventional  capacity  decreased  in  the 
period 2004-2008 whereas there were additions in 
In 
conventional  generation 
Germany,  instead,  where  renewables  increased 
significantly 
additional 
conventional  capacity  was  built  also  due  to  the 
phasing-out of nuclear power plants (Graph I.1.4). 

in  2009-2013. 

technologies, 

2009-2013, 

during 

tax 

allowances 

The  expansion  of  capacity  of  the  period  2008-
2012  was  accompanied  by  policy  efforts,  in  the 
form  of  increased  public  support  to  the  sector. 
Public  support  is  a  type  of  state  intervention, 
which can take the form of direct transfer of funds, 
targeted 
exemptions, 
investment  tax  deductions,  loan  guarantees,  price 
support,  price  caps,  and  price  guarantees. 
Arguably,  public  support  to  energy  has  always 
been used to reach some policy objectives such as 
inclusion, 
energy 
environmental  goals,  or  competitiveness  exposure 
of  energy  intensive  industries.  More  recently,  the 

independence, 

social 

and 

(1)  It  needs  to  be  noted  that  the  calculations  in  Graphs  I.1.3 
and I.1.4 show the net change in capacity, and not the total 
size of investment that took place in the different Member 
States. Hence, decommissioning of one type of generation 
can  in principle  mask  the  actual  size  of investment  in  one 
category  or  the  other.  For  instance,  decommissioning  of 
large hydro installations makes the resulting net change in 
renewable capacity smaller.  

9 

-1000001000020000300004000050000ESITDEROUKPTNLHRATELIEBEFRPLMTSECYCZFIHUSILUDKEELVSKLTBGMwNuclearConventionalRenewables (except biomass)-1000001000020000300004000050000DEITFRROESNLELUKBEATPLCZBGPTSKIELVCYSIFIHREEDKLUMTLTHUSEMwNuclearConventionalRenewables (except biomass) 
                                                           
 
 
 
Investments in electricity markets: evolution and drivers 

Part I 

development  of  the  new  low  carbon  technologies 
and the need to secure a new investment path has 
triggered new forms of support to deployment.  

The  total  amount  of  public  support  to  the 
electricity  sector  increased  over  the  period 
2008-2012  from  EUR36  to  EUR63  billion (2). 
Public  support  increased  both  for  fossil  fuel  and 
renewable  technologies,  even  though  the  latter 
accounted  for  most  of  the  increment:  support  to 
renewables  grew  by  93%  compared  to  39%  for 
fossil fuels (Graph I.1.5). 

Graph I.1.5:  Total support to the energy sector 

rather than to generators and is mainly constituted 
by  energy  and  VAT 
tax  exemptions,  price 
guarantees  (in  the  form  of  social  tariffs  for 
electricity  set  below  a  reference  price  or  the 
provision  of  fossil  fuel  below  costs  as  inputs  to 
electricity  generation),  and 
load 
schemes,  by  which  payments  are  provided  to 
electricity consumers that agree to be switched off 
remotely where the system requires it.  

interruptible 

In comparison, the other forms of support were 
smaller. Support to investment follows support to 
demand  with  a  share  of  approximately  14%; 
support  to  energy  savings  has  a  share  of  8%. 
Support  to  R&D  was  very  low  compared  to  the 
support  granted  to  all  other  sectors  (support  to 
production, to investment, to energy saving and to 
energy  demand)  up  until  2012,  when  it  hit  6%  of 
the total (4). 

Graph I.1.6:  Components of total support 

Total support is the sum of five categories: support to 
energy demand, support to investment, support to 
production, support to energy efficiency and support to 
R&D. 
Notice: the graph figures do not include external costs. 
Source: Own calculations based on ECOFYS, 2014 

tradable  certificates 
support 

Support  to  production  constitutes  the  main 
share of total support (around 45%). It includes, 
among others, exemptions from fuel taxes, feed-in 
for 
tariffs  and  premia, 
renewable  energy  quotas,  and 
to 
decommissioning.  The  increase  in  support  to 
production  can  be  explained  by  the  increase  of 
renewable  technologies  in  the  fuel  mix.  This  new 
renewable  capacity  was  mainly  installed  with  the 
support  of  feed-in  schemes.  In  the  majority  of 
Member  States,  most  of  this  support  has  been 
financed  by  consumers 
levies  or 
surcharges,  while  in  a  few  cases  it  has  been 
financed through general taxation (3). 

through 

Support to energy demand accounts for 30% of 
total  support.  It  is  granted  to  the  demand  side 

(2)  These  figures  refer  to  the  value  in  EUR2012  of  support 
provided 
fuel  and  nuclear 
technologies  in  the  form  of  production  and  investment 
support and do not include other costs of electricity. 

renewables, 

fossil 

to 

(3)  European Commission (2014a). 

Source: ECOFYS, 2014 

1.3. 

PRICE EVOLUTION: ELECTRICITY, CARBON 
AND COMMODITY PRICES 

Trends  in  electricity  should  be  interpreted  in  the 
wider  context  of  the  macro  economic  framework 
in the energy sector, which have an impact both in 
the retail and wholesale market.  

(4)  R&D  support  reported  in  the  study  might  be  under-
estimated. The Strategic Energy Technologies Information 
System (SETIS) reported that public R&D spending on low 
carbon  energy  technologies  in  the  EU  (both  at  EU  and 
Member  States  level)  amounted  to  about  EUR  1.5  bn  per 
year  in  2007  and  EUR  3  bn  per  year  in  2011.  Data 
available at https://setis.ec.europa.eu 

10 

01000020000300004000050000600007000020082009201020112012Million EUR2012RES excluding hydroNuclearFossil FuelsHydro02040608010020082009201020112012Support to R&DSupport to energy savingsSupport to demandSupport to productionSupport to investment% 
 
                                                           
 
                                                           
Investments in electricity markets: evolution and drivers 

Part I 

11 

(Continued on the next page) 

 
 
 
 
 
 
 
Investments in electricity markets: evolution and drivers 

Part I 

Box (continued) 

(Continued on the next page) 

12 

 
 
 
 
 
Investments in electricity markets: evolution and drivers 

Part I 

Graph I.1.7:  Average domestic and industrial retail 

electricity price, wholesale price and crude 
oil price evolution 2007-2013 

Note: The graph presents a weighted average of the retail 
prices. Prices are weighed by the share of electricity 
consumption. 
The Consumption bands used were DC for Households 
(2500 kWh < Consumption < 5000 kWh) and IC for Industry 
(500 MWh < Consumption < 2000 MWh), wholesale prices 
are average spot prices from different European power 
exchanges and pools 
Source: Eurostat 

Box (continued) 

1.3.1.  Electricity retail price evolution  

In  the  recent  period,  electricity  retail  prices 
have  experienced  an  increase (5)  compared  to 
wholesale  prices.  This  divergence  is  the  result  of 
the  increase  of  renewable  capacity  and  of  public 
support,  which  has  been  mostly  financed  by 
consumers  through  levies  on  electricity  retail 
prices.  The  increasing  trend  can  be  observed  for 
both household and industry retail price throughout 
the whole EU, even though there are considerable 
differences in the price level between the two types 
of consumers across groups of Member States.  

In  countries  with  regulated  retail  prices,  the 
retail  tariffs  are  higher  than  in  countries 
without  regulated  prices.    Whereas  the  two 
groups  of  countries  showed  different  levels  of 
retail  prices  already  in  2007,  through  2012  the 
increase  in  countries  with  regulated  prices  was 
regulated 
higher 
than 
prices(6).  In  addition, 
the 
household  and  industry retail  price  level  is higher 
for the former than for the latter. 

in  countries  without 

the  gap  between 

increase 

levies (7)  have  been  the  main 
Taxes  and 
contributor 
for 
to  retail  price 
households  and  industrial  consumers.  Indeed, 
the increase of the taxes and levies component has 
been  particularly  pronounced  and  on  average  it 
contributed  by  more  than  2%  to  the  annual 
increases  of  retail  prices 
the  2009-2013 
period (8). During the same period, a similar trend, 
but relatively lower, was observed for the network 
component. For both categories of consumers, the 
average  annual  contribution  of  this  component  to 
the  retail  prices  increases  was  around  0.6%.  In 
contrast, the contribution of the energy component 
to the retail price evolution, presented a diverging 
pattern  between  the  two  consumer  categories  for 
the period. In particular, the energy component put  

in 

(5)  European Commission (2014b). 
(6)  Countries  with  regulated  prices  are  Belgium,  Bulgaria, 
Cyprus, Denmark, Estonia, Greece, Spain, France, Croatia, 
Hungary, Italy, Lithuania, Latvia, Malta, Poland, Portugal, 
Romania,  Slovenia,  United  Kingdom.  Countries  without 
regulated  prices  are  Austria,  Germany,  Finland,  Ireland, 
Luxembourg, The Netherlands, Sweden, Slovakia. 

(7)  Eurostat energy price data distinguish between energy and 
supply costs, network costs and taxes and levies. Hence, it 
is  not  possible  to  separate  the  impact  on  prices  of  levies 
and  taxes  respectively.  Taxes  generally  refer  to  tax 
instruments such as VAT and excise duties, while specific 
levies  support  targeted  energy  or  climate  policies  (eg 
renewable energy).  

(8)  Anecdotal evidence suggests that  most of the increase has 
been driven by levies and to a lesser extent by taxes. . 

13 

010203040506070809010005010015020025020072008200920102011201220132007200820092010201120122013Countries with regulated retail pricesCountries without regulated retail pricesEUR/bbl]EUR/MwhPr_Retail H-HPr_Retail IndustryPr_WholesalePr_Crude oil 
                                                           
 
                                                           
 
 
 
 
to  upward  pressure.  For 

downward pressure on retail prices for households 
in  first  two  years  of  the  analysis,  which  then 
shifted 
industrial 
consumers,  in  contrast,  it  contributed  to  lowering 
retail  price  increases  throughout  the  period.  On 
average,  this  component  decreased  annually  by 
1.1% 
for 
households it increased by 0.9%. 

industrial  consumers,  while 

for 

Graph I.1.8:  EU: retail price change and the contribution 

of  the price components 2009-2013 

The graph presents the EU 24 weighted average 
compounded annual growth rate of the electricity price 
components of households (consumption band DC) and 
industrial consumers (consumption band IC). Prices are 
weighed by the share of electricity consumption. 
Source: Eurostat and own calculations 

1.3.2.   Wholesale  electricity  and  energy 

commodity prices evolution 

Electricity wholesale prices have been declining 
after  2011.  After  the  price  spike  in  2008,  due  to 
the  influence  of  oil  prices,  wholesale  electricity 
price on the German  market  (EEX) experienced a 

Investments in electricity markets: evolution and drivers 

Part I 

drop  of  10%  between  2009  and  2014.  On  the 
French market (Powernext) and the Nordic market 
(Nord  Pool),  prices  decreased  by  5%  and  15% 
respectively,  in  the  same  period.  The  drop  in 
wholesale  prices  is  the  result  of  many  different 
factors,  among  which  the  evolution  of  energy 
commodity prices such as coal, gas and oil prices. 
They are, among other things, drivers of wholesale 
prices  because  they  are  the  inputs  for  most  of  the 
conventional electricity production (see box I.1.2). 

Graph I.1.9:  Electricity wholesale price 

Source: Bloomberg, Platts 

Coal,  gas  and  oil  prices  followed  similar 
decreasing  paths  starting  from  2011.  After  a 
rebound  in  2010,  oil  price  started  to  decline  from 
2011, and experienced a sharp drop in 2014-2015. 
Gas and coal follow a trajectory which is similar in 
shape, even though the peak point for coal is 2011 
while for gas  it is 2013. In  the period  2011-2015, 
gas  prices  dropped  by  10%,  while  coal  by  17% 
(Graph I.1.10).  

By  contrast,  since  2009  the  carbon  price  has 
decreased  sharply.  Carbon  price  plays  a  role  on 
the  wholesale  electricity  market  in  that  it  adjusts 
the  relative  costs  of  conventional  and  low  carbon 
technologies and may incentivise investment in the 
latter.  CO2  price  followed  a  rapid  and  overall 
decreasing  path:  between  2008  and  2015,  it 
dropped  by  68% 
to 
7.0EUR/tCO2.  Such  low  levels  have  very  little  if 
not  negligible  effects  on  the  relative  costs  of 
technologies and therefore can be assumed to have 
had  a  limited  effect  on  short-term  production 
choices.  Fuel  switching  decisions  for  existing 
plants  are  mainly  influenced  by  the  relative  costs 
of energy inputs (gas and coal). In the longer term, 
though,  CO2  pricing  is  expected  to  play  a  strong 
role in the investment decision (see Box III.2.1). 

from  22.3EUR/tCO2 

14 

-8-4048091011121309-13Industries%-40481216091011121309-13HouseholdsTaxes and LeviesEnergy and SupplyNetwork costsRetail price%02040608010012014020082009201020112012201320142015IndexEEXPowenextNord Pool 
 
 
Investments in electricity markets: evolution and drivers 

Part I 

Graph I.1.10:  Energy commodities and CO2 prices 

Source: Bloomberg, Platts 

generation 

Other  important  factors  contributing  to  lower 
for 
wholesale  prices  are  weak  demand 
electricity  due  to  the  economic  crisis  and  the 
renewable 
increasing 
share. 
Investments 
in  renewable  generation,  mostly 
driven  by  public  support,  and  made  in  a  situation 
of lower demand, contributed to lowering prices on 
the wholesale market. An econometric analysis of 
the  drivers  of  wholesale  prices  confirms  the 
upward  impact  of  demand  and  commodity  prices 
on  prices,  while  an  increasing  share  of  renewable 
tend to lower prices (see box I.2.2). 

15 

02040608010012014020082009201020112012201320142015IndexPCO2PCOALNBPoilEEXPowenextNord Pool 
 
 
Investments in electricity markets: evolution and drivers 

Part I 

(Continued on the next page) 

16 

 
 
 
 
 
 
Investments in electricity markets: evolution and drivers 

Part I 

Box (continued) 

1.4.  CONCLUDING REMARKS 

Investment  in  electricity  generation  has  been 
resilient  to  the  crisis  but  its  composition  has 
changed. The expansion of renewable sources was 
much  more  pronounced  than  for  conventional 
ones,  a  development  which  became  more  evident 
after 2009.  

even 

renewable 

Public support has increased both for fossil fuel 
and 
though 
technologies, 
renewables  accounted  for  most  of  the  increment. 
Its  composition  across  types  of  support  remained 
relatively  stable,  with  the  major  share  going  to 
support  for  electricity  production,  followed  by 
support  to  demand,  to  investment,  and  to  energy 
efficiency. 

While  electricity  retail  prices  have  risen  in  the 
recent  period,  wholesale  price  have  decreased. 
The main factor contributing to rising retail prices 
are  taxes  and  levies,  but  network  costs  have  also 
increased.  Rising  levies  reflect,  among  other 
things,  the  need  for  financing  support  schemes  to 
renewable  production.  Wholesale  prices  have,  in 
contrast, fallen due to lower demand for electricity 
as well as lower prices on fossil fuels and carbon.  
The increasing share of renewable generation in a 
situation  of  lower  demand  has  also  contributed  to 
lower prices. 

17 

 
 
 
 
 
2. 

INVESTMENT IN ELECTRICITY: ASSESSING THE DRIVERS IN 

RENEWABLES AND CONVENTIONAL TECHNOLOGIES 

respond 

economic 

environment 

Electricity  is  a  sector  in  which  investments  are 
determined  by  macroeconomic  conditions,  but 
influenced  by  policies. 
are  also  highly 
Investments 
to  macroeconomic 
conditions:  general  economic  growth,  demand 
evolution  and  financial  conditions  determine  the 
general 
in  which 
investment decisions are taken. Investments in the 
electricity sector are subject to a group of energy- 
specific  factors  which  influence  the  decision  to 
invest  and  the  magnitude  of  the  investment:  the 
generation  mix  of  the  country,  the  wholesale 
prices, (9)  as  well  as  indicators  about  the  supply 
side of the market such as the reserve margin and 
the  capacity  factor  of  the  electricity  system.  In 
addition to this, policies can have a sizeable impact 
on  investment  decisions  for  example  when  they 
support  some  technology  groups  in  order  to 
achieve specific objectives.  

This  chapter  explores  both  sets  of  investment 
drivers.  Section  1 describes  the  different forms  of 
support  granted  to  renewable  technologies  and 
compares them to what is received by conventional 
ones. Section 2 develops an econometric model to 
understand 
in 
the  drivers  of 
conventional technologies. Section 3 concludes. 

investment 

2.1. 

PUBLIC SUPPORT AND INVESTMENT 

Public  support 
for  renewables  has  been 
justified  by  the  need  to  promote  low  carbon 
technologies  at  early  stages  of  development. 
These technologies would otherwise not be able to 
compete  on  the  market  due  to  higher  costs.  New 
renewable  electricity  production  in  Europe  has 
been  deployed  mainly  thanks  to  subsidies  and 
priority  of  dispatch.  Most  renewable  technologies 
remain too expensive and uncompetitive in relation 
to the market prices of today, even though certain 
are gradually becoming more mature: according to 
the  IEA (10),  increased  investment  in  research, 
in 
development  and  demonstration 
emerging  technologies,  particularly  ocean  and 

(RD&D) 

(9)  The profit streams of power plants do not depend only on 
day ahead markets (wholesale prices), but also on ancillary 
services  and  intraday  and  balancing  markets.  In  general, 
day  ahead  markets  are  considered  as  the  most  important 
source of revenues of power plants. 

(10)  IEA (2014) 

enhanced  geothermal, 
competitiveness.  

is  needed 

to  enhance 

For  this  reason,  renewable  technologies  have 
received the highest level of support per MWh. 
In the EU28, the average support per MWh for the 
2008-2012  period  was  around  64  EUR/MWh, 
starting  at  54  EUR/MWh  in  2008  reaching  62 
in  2012 (11)  with  a  peak  of  70 
EUR/MWh 
EUR/MWh  in  2010.  The  support  level  increased 
by  27%  between  2008  and  2010,  reflecting  the 
implementation of the EU renewable energy policy 
as  agreed  in  2009  (Graph  I.2.1).  By  contrast, 
support  to  conventional  technologies  has  been 
much  more  limited,  which  can  be  explained  by 
their  level  of  maturity.  Public  support  to  these 
technologies  has  slightly  increased  between  2008 
and 2012 (12).  

to  be  very  effective 

In  most  Member  States,  support  schemes  and 
instruments  have  limited  the  risk  exposure  of 
producers, hence of investors. In 2012, seventeen 
Member  States  applied  feed-in  tariffs.  This  is  an 
instrument  which  drastically  reduces  the  risk  for 
the  producer  as  it  provides  a  fixed  remuneration 
for  the  renewable  electricity  produced.  Feed-in-
in 
tariffs  have  proved 
promoting  renewable  electricity  deployment,  but 
this type of support also runs the risk of being very 
costly. Feed-in-premiums is another variant, which 
is  a  more  market-based  instrument  that  was  used 
by  nine  Member  States  in  2012.  It  provides  a 
premium  in  addition  to  the  wholesale  electricity 
price so that the producer is at least partly exposed 
to  the  price  risk.  Quota  obligation  systems  were 
used  in  eight  Member  States.  This  implies  the 
creation  of  a  market  for  green  certificates,  which 
provides 
the  generators  with  an  additional 
remuneration  source  on  top  of  the  price  received 
the  electricity  produced  from  renewable 
for 

(11)  Estimates  are  potentially  downward  biased  because  of 

missing data. 

(12)  It  is  important  to  notice  that  the  levels  of  support  to 
renewables  and  to  conventional  technologies  presented  in 
Graph  I.2.1  are  not  directly  comparable.  As  explained 
earlier, renewables are considered to be on an early stage of 
development 
conventional 
technologies.  This  means  that  it  should  be  taken  into 
consideration  that  the  present  conventional  technologies 
were  developed  in  another  market  framework,  where  they 
also  received  some  potentially  comparable  forms  of 
support. 

to  mature 

compared 

18 

 
                                                           
                                                           
Investments in electricity markets: evolution and drivers 

Part I 

contain  these  costs and  make  them  more  market-
oriented (14).  In  some  cases  (i.e.  Spain,  Portugal, 
Greece  etc.) 
imposed 
retroactively, which  impacted  the  remuneration of 
past investments. 

reforms  were 

these 

Reforms  to  support  schemes  have  not  yet 
translated  into  a  slowdown  of  investment  in 
renewables, (expressed as share in total capacity) 
according to current data.. The share of renewables 
in  the  EU  has  been  on  an  increasing  trend  since 
2008,  whereas  production  support  started 
its 
decrease in 2010. This apparently counter-intuitive 
fact  can  be  explained  by  considering  that,  despite 
having been revised, support schemes appear to be 
still enough to sustain investment, probably thanks 
to the reduction in their costs through learning. An 
additional  aspect  is  that  investment  responds  with 
a lag to the change in support schemes, hence the 
effect  the  reduced  support  is  not  visible  in  2012 
data. Finally, it is important to stress that, whereas 
the  data  presented  are  European  averages,  the 
specific  situation  in  Member  States  might  differ 
substantially.  

Graph I.2.2:  RES share and support evolution 

Source: Eurostat and ECOFYS 2014 

2.2.  MARKET DRIVEN INVESTMENTS 

While  renewables  were  developed  heavily 
relying  on  public  support,  conventional (15) 
generation  was  affected  by  energy  policy 
through 
changing  market 
conditions. EU policies are affecting the shape of 

induced 

the 

(14)  For  this  reason,  more  market  oriented  and  cost-efficient 
support  schemes  were  advocated.  European  Commission 
(2013). 

(15)  In  this  chapter,  the  term  conventional  refers  to  nuclear, 
hydro and combustible fuels generation technologies.  

sources. Here, the producer is exposed to both the 
electricity  and  the  certificate  price  risk.  Finally, 
both  investment  grants  and  fiscal  incentives  were 
used by ten Member States respectively in 2012. 

Graph I.2.1:  Support per electricity produced 

Hydro power was excluded from the analysis because it 
was mainly developed using support arrangements dating 
from before 2008. Its inclusion would underestimate the 
support level.  
Source: Own calculations based on Eurostat, Energy 
Statistics and ECOFYS 2014 

Support  given  to  renewables  decreased  from 
2010, due to the slowdown in economic activity 
caused  by  the  economic  crisis  but  also  due  to 
reforms  of  support  systems  aimed  at  reducing 
their  costs.  The  crisis  has  reduced  demand  and 
deteriorated  the  general  investment  climate.  The 
high cost of the renewable support system induced 
Member States to undertake reforms to make them 
more  cost-efficient.  This  development  was 
underpinned by the economic crisis, which forced 
Member States to enact reforms aiming to improve 
the  efficiency  of  spending.  The  rising  cost  of 
support  to  renewables  has  been  one  contributing 
factor  behind  the  emergence  of  tariff  deficits  in 
several EU Member States (13). A tariff deficit can 
be  defined  as  a  shortfall  of  revenues  in  the 
electricity system, which arises when the tariffs for 
the  regulated  component  of  the  retail  electricity 
price is set below the corresponding costs borne by 
the energy companies. Costs related to the support 
to  renewables  have  been  contributing  to  the  tariff 
deficits in Spain, Portugal, France and Greece, and 
for 
in 
Germany  and  Italy.  All  these  countries  have 
undertaken  reforms  since  2012  to  reduce  and 

the  system 

imbalances 

temporary 

in 

(13)  European Commission (2014a). 

19 

010203040506070809020082009201020112012EUR2012/MwhRES (excuding hydro)NuclearFF - Total0408012016020082009201020112012IndexRES share in total capacitySupport per Mwh 
 
                                                           
 
                                                           
in 

introduced  competition 

the  electricity  market  in  different  ways.  Market 
liberalization 
the 
generation  segment  of  the  value  chain;  renewable 
obligations  are  reducing  the  residual  demand  that 
conventional  technologies  face;  the  EU  emission 
trading  scheme  (ETS)  is  increasing  the  costs  of 
production  of  conventional  technologies  in  line 
with their carbon intensity.  

2.2.1.  The 

investment 
conventional technologies 

framework 

for 

The  factors  that  determine  the  investment 
decision in the power sector can be grouped into 
three  main  categories,  i.e.  macro-economic, 
competition  and  energy-specific.  In  order  to 
understand  their  role,  it  is  useful  to  provide  a 
discussion of the assumptions to their contribution, 
which will be used to construct a model to analyse 
market driven investment in the recent past. 

influence 

Macroeconomic 
the 
conditions 
decision to invest in electricity generation. They 
refer  to  economy-wide  factors  that  influence  the 
the  financing  of 
financial  risk  arising  from 
investment  as  well  as  the  policy  objectives  and 
institutional  factors  under  the  control  of  policy-
makers  (IEA,  2003).  As  such, 
the  business 
environment,  the  cost  of  capital  and  access  to 
finance  are  likely  to  impact  the  profitability  of 
projects  and  ultimately  the  decision  to  invest. 
Moreover,  given  the  role  of  electricity  in  the 
economy, economic growth is an important driver 
of electricity investments as it stimulates electricity 
consumption,  hence  the  need  to  build  additional 
generation capacity (16).  

Another  important  factor  which  influences  the 
attractiveness  of  the  market  is  the  competition 
intensity  and  potential  barriers  to  entry.  By 
nature,  the  electricity  sector  displays  high  sunk 
costs  and  needs  large  capital  investments,  which 
may  provide  an  advantage  to  incumbents.  In 
general,  electricity  markets  are  concentrated, 
which is a consequence of the characteristics of the 
sector, but may also give the opportunity to adopt a 
strategic  behaviour  to  limit  new  entries  in  the 

(16)  The  long  term  causality  with  economic  growth  is  bi-
directional.  This  means  that  GDP  growth  has  a  positive 
effect  on  electricity  investment  and  vice  versa.  See 
European Commission (2014c).  

Investments in electricity markets: evolution and drivers 

Part I 

market 
strategies). 

(e.g. 

excess 

capacity 

and  pricing 

Finally  energy-specific  conditions  are  likely  to 
attract investors if profit prospects are high and 
uncertainty is low (17). Energy-specific conditions 
refer  to  those  factors  characterising  the  electricity 
system such as the wholesale price, (18) the reserve 
margin, the capacity factor and the generation mix. 
But  they  also  include  the  economic  conditions 
under  which  generators  operate, 
the 
remuneration  of  their  capacity  or  the  price  signal. 
Finally,  the  policy  framework  and  the  extent  to 
which  clean  technologies  are  supported,  influence 
the decision to invest in conventional technologies.  

i.e. 

Graph  I.2.3  summarises  the  main  factors (19) 
influencing  the  investment  decision  in  electricity 
markets. 

Graph I.2.3: 

Investment decision 

Source: European Commission 

2.2.2.  Hypotheses 

The following macroeconomic factors are assumed 
to play a role in investment decision: 

Macroeconomic factors 

(17)  This section focuses on new investments and does not take 
account  of  replacement  of  capacities  (see  box  1.2.2).  As 
mentioned  by  Ründiger  and  al  (2014),  a  large  amount  of 
coal power fleet (130-170 GW) will reach the end of their 
production life.   

(18)  The wholesale electricity price is considered as a reference 
price  to  signal  investment  (IEA,  2003).  It  is  the  basis  for 
pricing  electricity  long  and  short-term  contracts,  even  in 
the  case  where these  contracts  are traded  over the  counter 
(OTC) than in Spot markets. 

(19)  Factors  such  as  the  public  acceptance  and  availability  of 
sites,  which  are  important  for  nuclear  and  hydro  plants, 
respectively, are not taken into account in the analysis due 
to data availability issues..  

20 

Macroeconomic factors-Economic growth-Financial conditions-Business environmentCompetition factors-Concentration of the market-Barriers to entryEnergy-specific factor-Market price-Capacity in the market-Market Framework-Policysupport to new technologyInvestment decision 
                                                           
 
                                                           
Investments in electricity markets: evolution and drivers 

Part I 

  Higher  electricity  demand  leads  to  higher 

investment in power generation 

Economic  growth  is  normally  accompanied  by 
higher  investments. (20)  In  electricity  markets, 
demand  is  strongly  correlated  with  economic 
growth, mainly because increased business activity 
implies  higher  electricity  consumption (21).  Hence 
it  can  be  seen  as  a  sign  of  an  expanding  market 
that  businesses  will  want  to  exploit  by  increasing 
their 
installed  capacity.  This 
indicates that demand is positively correlated with 
investment.  In  the  future  electricity  demand  is 
expected  to  be  decoupled  from  economic  growth, 
as  a  result  of  energy  efficiency  policies,  so  far  it 
appears that it parallels economic growth. 

investments 

in 

  Investments  are  negatively  associated  with 

interest rates 

Power plants are capital-intensive investments, for 
which the cost of financing plays a substantial part. 
Interest rates are used in the economic literature as 
an  indication  of  the  cost  of  capital:  it  is  expected 
that higher interest rates have a negative effect on 
investments  as 
investments  more 
expensive. 

they  make 

  A stable and transparent policy environment 
reduces  investment  risk  and  contributes 
positively to new investments 

Quality  of  regulation  is  an  important  factor  in 
determining  the  investment  environment.  Good 
regulation that removes barriers to entry generally 
induces  new  entry  and 
investment.  Better 
regulation also induces investments when it is able 
to reduce the level of economic rents in a specific 
sector  (see  Box  I.2.2).  Because  of  the  long  time 
horizon,  economies  of  scale  and  scope  and  the 
regulatory  and  political  risks,  investment  will  be 
especially  sensitive  to  a  country's  institutional 
environment.  It  is  expected  that  the  better  the 
policy  environment  in  terms  of  commitment  and 
transparency,  the  better  the  business  environment 
and the more attractive the investment.  

(20)  European Commission (2014c). 
(21)  Demand  could  as  well  be  interpreted  as  a  technical  factor 
when  considering  the  load  profiles  it  generates  for  the 
electricity  system.  Here,  though,  demand  is  interpreted  as 
reflecting  the  general  economic  conditions  of  the  country 
(economic  growth  vs.  contraction)  and  this  is  why  the 
variable is accounted for in the macroeconomic factors. 

21 

 
                                                           
 
 
Investments in electricity markets: evolution and drivers 

Part I 

(Continued on the next page) 

22 

 
 
 
 
 
 
Investments in electricity markets: evolution and drivers 

Part I 

at  which  that  demand  occurs (23).  It  can  be 
interpreted  as  an  indicator  of  overcapacity  in  the 
sense that a high value implies that there is a large 
amount  of  available  generation  to  meet  peak 
demand. On the other hand, if the indicator is low, 
it means that available capacity is small compared 
to  maximum  demand.  Hence,  it  is  expected  that 
incentives  to  invest  in  market-oriented  power 
plants are higher the lower the reserve margin.  

  Penetration  of 

technologies 
induce lower incentives for new investments 
in conventional power plants 

renewable 

the 

reduces 

residual 
Renewable  penetration 
demand  for  conventional  generation,  therefore 
reducing  the  size  of  the  market  they  can  bid  on. 
Penetration  of  renewable  was  incentivised  by 
support  schemes,  which  are  assumed  to  make 
investment in such technologies more attractive to 
investors (for example, because of more stable and 
higher returns) and hence to divert resources from 
is 
low-carbon 
conventional 
expected  that  a  higher  renewable  share  decreases 
the 
in  conventional 
investment 
technologies  because  they  increase  their  risk 
profile. In fact, the presence of renewables makes 
the  revenue  stream  for  conventional  power  plants 
very  uncertain,  whereas 
their  absence, 
conventional  power  plants  will  be  operating  a 
more predictable number of hours over the year.  

investment.  It 

scope 

for 

to 

in 

  Additional 

revenues 

capacity 
mechanisms  increase  the  incentives  for  new 
investments 

from 

In  energy  only  markets  price  caps  may  not  allow 
power  producers  to  receive  the  full  amount  of 
scarcity  rents  and  to  be  able  to  recoup  the  fixed 
cost of their investment. The presence of capacity 

(23)  Royal academy of engineering (2013). The reserve margin 
can  be  determined  either  for  total  available  generation 
firmed) 
technologies  or 
generation 
latter 
calculation is used, as it is considered as a better indicator 
for  identifying  lack  of  key  investments  for  ensuring 
security of supply. 

for 
technologies.  In 

total  non-volatile 

this  analysis, 

(i.e. 

the 

Box (continued) 

Competition and Energy-specific factors 

The  following  competition  and  energy-specific 
factors are analysed: 

 

 Electricity  wholesale  price  as  a  signalling 
device for investment 

In a market, where the only commodity  is energy 
(energy-only market) and there is no extra trade in 
capacity  or  other  products,  the  primary  income 
source  for  recovery  of  capital  costs  is  the  infra-
marginal rent generated by the difference between 
the  clearing  price  and  the  generators'  marginal 
costs. According to the theory of spot pricing, the 
optimal  capacity  stock  is  such  that  the  price 
resulting from scarcity is high enough to repay the 
capital  costs  of  the  marginal  generators  when 
demand  exceeds  supply (22).  Therefore,  when 
prices  are  high,  the  system  signals  the  need  for 
new  investment;  hence,  it  is  expected  that  higher 
prices are positively correlated with investment. 

  Highly 

create 
concentrated  markets 
significant  barriers  to  entry  that  may 
impede  new  investment  or  expansion  in 
electricity generation  

Concentrated  markets  are  likely  to  suffer  from 
abuse  of  market  dominance,  by  which 
the 
incumbent  firms  enjoy  the  ability  to  unilaterally 
raise  prices  by  providing  a  less-than-optimal 
capacity.  It  is  therefore  expected  that  the  market 
concentration,  as  captured  by  HHI,  CR3,  etc. 
indexes, has a negative impact on investments. 

  Overcapacity  reduces  the  motive  for  new 

investments 

The reserve margin indicator is defined as the ratio 
between 
the 
maximum  level  of  electricity  demand,  at  the  time 

total  available  generation  and 

(22)  Not  all  trade  is  performed  through  the  spot  market.  For  a 
discussion of the relationship among the different forms by 
which electricity is traded, refer to Box II.1.1. 

23 

 
                                                           
                                                           
 
 
 
 
Investments in electricity markets: evolution and drivers 

Part I 

mechanisms,  which  act  as  complementary  source 
of revenues, helps to mitigate price uncertainty and 
volatility  caused  by  weather  conditions  and 
intermittent  generation  by  providing  additional 
sources  of  revenues  to  producers  than  the  energy 
only market (24). Capacity mechanisms can be seen 
as  a  factor  that  competes  with  spot  prices  for  the 
role  as  a  signal  for  investment  needs;  this  is 
because  if  all  the  capacity  is  procured  though 
capacity mechanisms, scarcity prices that reflect a 
structural lack of capacity will never appear on the 
spot market. For this reason, the analysis includes 
a  dummy  variable  for  the  presence  of  capacity 
mechanisms to capture the effect on investment. 

(24)  For  a  discussion  on  energy-only  markets  and  capacity 

mechanism, see section 2.2.4 in chapter II.2. 

24 

 
 
                                                           
Investments in electricity markets: evolution and drivers 

Part I 

25 

(Continued on the next page) 

 
 
 
 
 
 
Box (continued) 

2.2.3.  Results 

Table  I.2.1  presents  the  estimation  results  of  four 
distinct Tobit models based on the EU-28 Member 
States  for  the  period  2005-2012.  The  difference 
between the four specification models is the choice 
of  the  variables  included  in  the  analysis.  The 
consistency  of 
terms  of 
the  coefficients 
statistical  significance  and  their  size  between  the 
various  specifications,  indicate  that  the  results  are 
robust (25). In addition, in order to reflect the time 
effect on investment, the model includes lags. (26) 

in 

Electricity  wholesale  prices  are  a  key  driver  of 
investment  in  power  generation.  The  positive 
and  statistically  significant  sign  of  the  electricity 
the 
wholesale  price  changes 
that 
observation  of 
stimulates 
investment 
the  near  future.  This  finding 
confirms  that  investors  in  power  plants  react  to 
high prices as a signal for higher expected returns, 
compared to other investment opportunities.  

indicates 
increasing  prices 

in 

Increasing  demand  for  electricity  creates  the 
need for new generating capacity. What matters 
for  new  investment  in  power  generation  is  the 
growth in electricity demand in the course of time, 
rather  than  its  level  in  comparison  to  other 
countries.  Under  an  increasing  demand  pattern, 
investors  are  faced  with  less  uncertainty  on  load 
factors  for  their  plants,  when  and  how  often  they 
will  run,  and  the  prices  that  could  be  achieved 
when they do run, as higher demand is associated 
with higher wholesale prices. Thus, it increases the 
the 
expectations 

for  higher  profitability  of 

(25)  The  results  of  the  Lagrange  Multiplier  test  indicate  that 
to  any 
is  not  any  case  of  heteroskedasticity 

there 
specifications. 

(26)  The  statistical  significance  of  some  variables  with  a  lag, 
suggests  that  the  current  level  of  investment  in  installed 
capacity is influenced by past evolution of the explanatory 
variables  or,  in  other  words,  that  investment  responds  to 
changes  of  the  explanatory  variables  with  a  lag.  This  is  a 
sign of significant time effects on investments. The overall 
impact  of  a  variable  with  more  than  one  lag  is  calculated 
based on the sum of all the coefficients that are statistically 
significant. 

Investments in electricity markets: evolution and drivers 

Part I 

investment as the anticipation for the growth of the 
electricity demand is optimistic.  

the  statistical  significance  and 

The  cost  of  financing 
is  of  considerable 
importance  to  investments  in  power  plants.  As 
expected, 
the 
negative sign of the coefficient of the interest rates 
imply  that  a  rise  in  interest  rates  has  a  sizable 
negative  effect  on  capital  expenditures  in  power 
plants.  In  particular,  the  market  interest  rate  is 
considered to be a key building block in the firm’s 
user  cost  of  capital,  which,  combined  with  the 
resulting stream of expected cash flows, constitute 
the  primary  determinants  of  whether  and  how 
much to invest. 

Tight  reserve  margins  trigger  investment  in 
power  plants.  The  negative  correlation  between 
the  reserve  margin  and  the  new  additions  in 
electricity  installed  capacity  implies  that,  under 
conditions of high reserve margins investments are 
not  attractive.  The  reason  is  that  a  high  reserve 
margin  is  an  indication  of  excess  capacity,  which 
means that the probability for a new investment to 
recover its capital plus a fair return on the assets is 
relatively limited.  

and 

create 

incentives 

Competitive  markets  reflect  a  good  business 
environment 
for 
investment  in  power  generation.  A  competitive 
environment  provides  a  steady  and 
reliable 
business  environment  for  new  investments  in 
electricity  markets.  The  coefficient  of 
the 
accumulated  shares  of  the  three  larger  electricity 
producers that was used as proxy of the degree of 
competition 
in 
installed  capacity  are  negatively  correlated  with 
concentrated market structures.  

that  new  additions 

indicates 

However,  in  order  for  competition  to  deliver  its 
anticipated  benefits,  the  market  also  requires 
governments  to  commit  to  policy  and  regulatory 
authorities  to  ensure  transparency  and  optimal 
monitoring  of  the  functioning  of  the  electricity 
markets.  Although  in  all  specifications  the  proxy 

26 

 
                                                           
 
 
 
 
Investments in electricity markets: evolution and drivers 

Part I 

Table I.2.1: 

Results of the electricity investments drivers 

*, **, *** indicates significance at 10%, 5%, and 1% confidence level. 
(1) Installed capacity of power plant: nuclear, combustible fuels, biomass and hydro plants 
Source: Commission Services 

that  was  used  in  order  to  capture  the  quality  of 
regulation  had  the  expected  sign,  it  was  not 
statistically significant. (27) 

is  associated  with 
conventional 

in  total 
Higher  penetration  of  renewables 
lower 
installed  capacity 
generation 
investments 
in 
technologies.  The  negative  and 
statistically 
significant coefficient of the share of renewables in 
the total installed capacity implies that renewables 
replace over the years larger and larger part of the 
electricity supply curve. 

The  coefficient  of  the  dummy  variable  for  the 
presence  of  capacity  markets  was  statistically 
insignificant though it presented the expected sign, 
The  insignificance  of  this  coefficient  may  be 
explained  by  the  fact  that  most  of  the  capacity 
mechanism  incentives  were  introduced  mainly 
over  the  recent  years.  This  implies  that  other 
factors  played  a  crucial  role  in  the  period  of  the 
analysis. 

2.3.  CONCLUDING REMARKS 

Investment in renewables was driven by public 
support, which was much higher than the support 
granted  to  nuclear  and  fossil  fuels. Public support 
started  decreasing  in  2010  as  a  response  to  fiscal 
consolidation and to the increasingly heavy burden 
on public finances. 

Market  fundamentals  were  important  drivers 
of  investments  in  conventional  technologies, 
mainly  represented  by  the  wholesale  electricity 
price, financial conditions, demand and the level of 
competition  on  the  market.  The  relevance  of 
the 
wholesale  price 
the 
remuneration 
market.  Similarly, 
financial 
conditions  and  demand  captures  the  effects  of  the 
economic  slowdown  brought  about  by  the  recent 
economic  crisis.  Finally,  the  level  of  competition 
on the market explains the influence of the market 
structure. 

investment  signals 
investors  can  expect  from 

impact  of 

the 

for 

In the future, in a world of competitive electricity 
technologies, the price signal as well as the macro-
economic  framework  will  matter  for  investors, 
hence  the  importance  of  market  functioning  and 
price formation. 

(27)  This  effect  might  have  been  captured  by  the  fixed  effects 
and  that  is  why  the  variable  of  quality  of  regulation  is 
statistically insignificant. 

27 

Variables(1)(2)(3)(4)Electricity DemandΔ(eldem)1.29***1.29***1.29***1.29***Interest RatesΔ(iln)1.17**1.21**1.19**1.22**Interest RatesΔ(iln(-1))-2.00***-2.00***-2.04***-2.00***Quality of Regulation 0.730.87Concentration Ratio of main GeneratorsΔ(cumshare)-0.13***-0.13***-0.13***-0.13***Electricity Wholesale Price (Spot)Δ(spot)-0.08-0.08-0.08-0.08Electricity Wholesale Price (Spot)Δ(spot(-1))0.09**0.09**0.09**0.09**RES share (% in total installed capacity)Δ(ShRES)-0.41*-0.42*-0.43*-0.42*Reserve MarginΔ(resmargin)11.72**11.75**11.85**11.75**Reserve MarginΔ(resmargin(-1))-12.85***-12.97***-13.01***-13.04***Dummy of Capacity Mechanisms0.380.14Constant6.28***5.156.32***4.94Country Fixed effectsYESYESYESYESPeriod Fixed effectsYESYESYESYESLog likelihood-113-113-113-113Left-censored observations20202020Uncensored observations50505050Dependent Variable: New Additions in Installed Capacity (1)Competition FactorsMacroeconomic FactorsEnergy-Specific Factors 
                                                           
 
 
 
Part II 
Investment needs and price signal: perspectives 

 
 
INTRODUCTION 

Both  the  macro-economic  framework  and  the  energy  market  design  play  an  important  role  in  driving 
investments in electricity generation. This part looks at price formation in electricity wholesale markets 
and presents the main characteristics of the sector. It also assesses the challenges posed by the increasing 
penetration of low carbon technologies.  

Chapter  one  describes  the  marginal  pricing  principle  of  wholesale  electricity  markets  and  discusses  the 
different  types  of  market  design  to  keep  the  system  reliable,  i.e.  energy-only  market  or  capacity 
mechanism.  It  also  presents  the  different  market  frameworks  in  place  in  Member  States.  Efforts  to 
integrate energy markets in the EU are relatively recent but are showing signs of progress. Still the design 
of electricity markets varies considerably across the EU.  

Chapter  two  discusses  the  investment  needs  to  meet  the  decarbonisation  policy  agenda.  Substantial 
investment  will  be  required  in  the  electricity  sector  both  because  of  the  sector's  own  need  to  reduce 
emissions,  but  also  because  demand  is  expected  to  rise  from  other  sectors  of  the  economy  seeking  to 
lower  their  emissions.  The  chapter  also  analyses  the  ongoing  transformation  of  electricity  markets 
induced by low carbon technologies. It discusses how the ongoing transformation contributes to changing 
the framework for investors, which points to the need to have the right market framework.  

31 

 
 
 
 
 
 
 
 
1. 

PRICE SIGNAL IN ELECTRICITY MARKETS AND MARKET 

FRAMEWORK IN MEMBER STATES 

Prices are a key drivers of investment decisions 
as  they  influence  potential  remuneration  to 
investors. 
competitive 
In  well-functioning 
markets,  high  prices  are  expected  to  signal  the 
need for additional investment. For investors, it is 
important  that  prices  are  above  the  long  run 
marginal costs so that producers can recover their 
fixed costs. 

This  chapter  describes  the  main  characteristics  of 
electricity  markets. Section 1 focuses on the price 
formation  mechanism 
today's  electricity 
markets.  Section  2  looks  at  market  features  in 
Member States. Section 3 concludes. 

in 

1.1. 

PRICE SIGNAL TO INVESTORS 

1.1.1.  Remuneration in the electricity market 

it 

because 

represents 

Expected  remuneration  is  the  key  signal  for 
investment 
the 
profitability  of  the  undertaking.  For  electricity 
producers,  remuneration  can  come  from  different 
sources, which also differ according to the market 
design 
(section  1.1.2).  Generators  can  be 
remunerated  for  the  energy  they  deliver  from 
bilateral  contracts  and/or  from  the  wholesale 
market;  they  can  be  remunerated  from  balancing 
services  they  provide;  or,  if  such  markets  exist, 
they  can  get  remuneration  for  the  availability  of 
production  capacity  that  they  offer  (refer  to  Box 
II.1.1  for  a  more  detailed  description).  All  such 
products  contribute  to  the  final  remuneration  of 
generators. 

In  general,  the  spot  price  on  the  wholesale 
market corresponds to the price set on the day-
ahead  market.  Generators  bid  on  the  day-ahead 
market  and  then  refine  their  positions  during 
intraday  trade.  Both  markets  are  linked  and 
participants  get  revenues  from  both  intraday  and 
day-ahead markets (see box II.1.1). 

1.1.2.  Marginal cost pricing 

Electricity prices on the spot market are based 
on  the  bid  of  the  marginal  unit (28).  The  typical 
electricity  supply  curve  is  a  piecewise  linear 
function. Each step represents a type of generation 
source, with the quantity of electricity that can be 
supplied at the quoted price. Cheaper generation is 
dispatched  first  in  the  market,  so  that  the  supply 
function  is  upward  sloping:  demand  is  first  met 
with lower cost energy, and higher cost generation 
is  called  in  progressively  with  increased  quantity. 
The equilibrium price (the 'spot price') is the price 
of  the  marginal  generation  source  needed  to  meet 
demand. Simplifying, it can be said that this is the 
price that all generators receive. The supply curve 
obtained  by  aggregation  of  the  different  bids  is 
also  known  as  merit-order  curve.  All  bids  below 
the clearing price are in the merit whereas all bids 
above the clearing price are out of merit. 

. 

The spot price on the wholesale market is used 
as a reference price for all other markets where 
energy  is  traded,  forward  markets  or  bilateral 
agreements.  In a  market  which  is not distorted by 
external  interventions,  the  variability  of  the  spot 
price  plays  a  role  in  signalling  the  need  of 
investment  in  new  resources.  Where  interventions 
are in place which protect some technologies from 
exposure to prices (for example remuneration from 
pre-determined  schemes  rather  than  from  the 
market  price),  distortions  might  appear 
that 
weaken the price signal.  

(28)  This  is  achieved  mostly  within  day-ahead  markets  as 
currently  other  markets  such  as  intra-day  markets  are  not 
sufficiently developed.  

32 

 
 
 
 
 
 
 
 
 
                                                           
Investment needs and price signal: perspectives 

Part II 

33 

(Continued on the next page) 

 
 
 
 
 
 
 
Investment needs and price signal: perspectives 

Part II 

Box (continued) 

(Continued on the next page) 

34 

 
 
 
 
 
Investment needs and price signal: perspectives 

Part II 

Box (continued) 

Graph  II.1.1  shows  a  generic  merit-order  curve 
technologies:  renewables, 
with  six  generation 
nuclear,  lignite,  hard  coal,  natural  gas  and  oil. 
They are ordered left to right on the basis of their 
marginal  costs  from  the  cheapest  to  the  most 
the  merit-order 
expensive.  Demand 
curve at a point in the supply served by hard coal 
plants.  The price  is set by  the  bid of  the  last hard 
coal  plant  in  the  merit.  This  means  that  all  other 

intersects 

generation  units  with  lower  bids  earn  an  infra-
marginal rent equal to the difference between their 
bid  and  the  bid  of  the  hard  coal  plant  (that  is  the 
spot  price).  Under  the  assumption  of  perfect 
competition  in  the  market,  bids  represent  the 
marginal costs of the plant to supply energy. 

35 

 
 
 
 
 
Investment needs and price signal: perspectives 

Part II 

Graph II.1.1:  A generic merit-order curve and the effect of 

increased low marginal cost technologies 

Different  market  designs  exist,  which  can  be 
classified under two main categories based on the 
products traded: in an energy only market, the only 
product  is  the  power  produced,  whereas  in  the 
presence  of  a  capacity  market,  the  availability  of 
power plants is an additional product. 

the  signal 

for 
In  an  energy-only  market, 
investment relies on high prices that materialise in 
moments  of  excess  demand  (these  are  called 
scarcity prices and moments of excess demand are 
scarcity  scenarios):  whenever  there  is  a  scarcity 
scenario,  prices  are  allowed  to  rise  so  that 
generators start earning 'scarcity rents' that are high 
enough  to  cover  their  fixed  costs  of  capital  and 
induce  new  investment/new  entry  in  the  market. 
The problem with this approach is that it may lead 
to  high  price  volatility,  which  increases  the 
investment risk associated to the electricity market 
and the uncertainty – especially for peaking plants, 
but  also  for  variables  renewable  plants(29)  –  to 
recuperate  their  investments;  the  possibility  for 
prices  to  reach  very high  levels  may  also  be  used 
strategically  by  market  players  to  abuse  market 
power.  For  these  and  other  reasons,  wholesale 
electricity  prices  are  usually  capped.  Finally, 
potentially  variable  and  high  prices  might  not  be 
desirable 
they  expose  consumers,  both 
households  and  industry,  to  unsustainable  high 
prices;  nonetheless,  long  term  contracts  could  be 
devised for customers not willing to be exposed to 
price volatility. 

if 

Alternatively,  the  market  can  be  designed  as  an 
energy  market  complemented  by  a  capacity 
mechanism. Markets designed in this way involve 
the  trade  of  two  products:  scheduled  energy  (and 
services)  and  the  ability  to  deliver  power  at  some 
point  in  time  (that  is:  "generation  capacity").  For 
the trade of electricity, these markets make use of 
the  same  wholesale  market  design  as  energy-only 
markets. The difference is that they complement it 
with a capacity mechanism. Capacity mechanisms 
are tools to remunerate capacity for the simple fact 
of  being  available  if  needed.  They  can  be  price-
for  capacity 
based,  hence  setting  a  price 
availability;  or  they  can  be  quantity  based,  in 
which  case  the  required  volume  is  determined  at 
the  outset  and  it  is  left  to  the  market  to  set  the 
appropriate  price.  All  the  relative  costs  associated 

Source: AGORA Energiewende 

With such a mechanism, a well-functioning and 
competitive  power  market  produces  electricity 
at the lowest cost for each hour of the day. The 
equilibrium  price  reflects  both:  (i)  the  cost  of 
producing  one  kWh  of  electricity  from  the  most 
expensive source needed to meet the demand; and 
(ii) the price that consumers are willing to pay for 
the final kWh required to meet the demand.  

1.1.3.  Economic  approach  to  the  equilibrium 

of the electricity system 

The  characteristics  of  electricity  production 
make the reality of electricity markets complex. 
First,  storability  of  electricity  is  currently  limited, 
which  means  that  the  electricity  produced  is 
consumed  instantaneously.  Any  oversupply  of 
electricity  would  be  lost  at  the  moment  it  is 
produced.  Second,  demand  is  still  rather  inelastic 
(although  important  improvements  in  demand 
response  are  foreseen  in  the  near  future),  and 
prices  can  reach  very  high  levels  within  a  short 
period  if  demand  is  not  met.  By  contrast,  when 
demand  is  low,  a  large  part  of  capacity  remains 
idle,  hence  not  remunerated  by  the  market.  The 
task of ensuring a sufficient level of supply to meet 
demand  at  all  moments  is  a  challenging  one,  not 
only  for  the  daily  dispatching,  but  also  in  a  long 
term  perspective.  The  electricity  system  needs  to 
be  able  to  invest  in  capacity  ahead  of  demand 
developments  in  order  to  make  sure  that  enough 
production capacity is available when needed. 

For this reason, an important aspect of market 
design  is  the  need  to  keep  the  system  reliable. 

(29)  As  high  prices  will  tend  to  appear  when  generation  from 

variable renewable is low. 

36 

 
 
                                                           
Investment needs and price signal: perspectives 

Part II 

Table II.1.1: 

Electricity Regional Initiatives 

Source: European Commission 

with  capacity  mechanisms  should  be  borne  by 
consumers.  

the  architecture  of  the  different  energy  systems 
towards an integrated design.  

The  Commission  distinguishes  six  categories  of 
capacity mechanisms (30) which are split between 
targeted  and  market-wide  mechanisms.  Targeted 
mechanisms  focus  on  the  additional  capacity 
expected  on  top  of  what  the  market  will  provide. 
Market-wide  mechanisms  provide  support  to  the 
majority of capacity providers in the market. Both 
targeted  and  market  wide  mechanisms  can  be 
further  split  between  volume-based  and  price-
based 
intervention.  Volume-based  mechanisms 
are:  tender,  reserve,  central  buyer,  de-centralised 
obligation;  while  price  based  mechanisms  are: 
capacity payment and targeted capacity payment.  

Graph II.1.2:  Taxonomy of capacity mechanisms 

Source: European Commission 

1.2.  MARKET 

FRAMEWORKS 

IN  MEMBER 

STATES 

Historically  energy  policy  in  the  Member  States 
was  managed  at  national  level,  whereas  only 
relatively recently efforts have been made to steer 

(30)  For  further  information,  refer  to  the  State  Aid  sector 
and  European 
capacity  mechanisms 

into 

inquiry 
Commission (2013c) 

1.2.1.  EU integration 

Market  integration  has  improved  thanks  to  the 
Electricity  Regional  Initiatives  (ERI),  launched  in 
2006,  aimed  to  create  seven  regional  electricity 
markets  in  Europe,  as  an  interim  step  towards  the 
Internal  Electricity  Market.  Each  region  brings 
together regulators, companies, Member States, the 
European Commission and other interested parties 
to focus on developing and implementing solutions 
to  improve  the  way  in  which  regional  energy 
markets develop. An overall monitoring process at 
EU level ensures that progress towards a single EU 
market 
is 
there 
convergence and coherence across the regions.  

is  not  hampered,  and 

that 

A  similar  harmonisation  effort  started  in  2014 
with  respect  to  support  schemes.  Investment  in 
renewables  was  achieved  mainly  through  support 
schemes  that  were  national  in  scope  (chapter  I.2). 
In  2014  the  new  Guidelines  for  state  aid  for 
environmental  protection  and  energy (31)  set  the 
path  towards  harmonisation  of  support  schemes 
across Europe.  

Market  coupling  has  also  improved.  On  24 
February 2015, for the first time, day-ahead power 
markets were linked from Finland to Portugal and 
Slovenia,  accounting  for  about  2,800  TWh  of 
yearly  consumption  and  encompassing  nineteen 
power systems. The EU has also agreed to achieve 
an  interconnection  level  of  at  least  10  %  of  their 
installed  electricity  production  capacity  for  all 
Member  States  by  2020.  This  target  has  been 
proposed  to  be  extended  to  15%  by  2030. (32)  In 
addition, regional cooperation is being pursued, for 

(31)  European Commission (2014d) 
(32)  European Commission (2014e) 

37 

RegionCountries in the regionNorthern regionDenmark, Finland, Germany, Poland, Sweden, NorwayBaltic regionEstonia, Latvia, LithuaniaCentral Eastern regionAustria, Czech Republic, Germany, Hungary, Poland, Slovakia, SloveniaCentral South regionAustria, France, Germany, Greece, Italy, SloveniaCentral West regionBelgium, France, Germany, Luxembourg, NetherlandsSouth West regionFrance, Portugal, SpainFrance, United Kingdom and Ireland regionFrance, Ireland, United Kingdom 
 
                                                           
                                                           
 
 
 
Investment needs and price signal: perspectives 

Part II 

Table II.1.2: 

Electricity market characteristics at Member State-level 

A Member State is reported as having a capacity mechanism or a strategic reserve whether they are "active", "proposed" or 
"under consideration".  
Source: ACER 2013 

to 

instance, 
reinforce  cross-border  network 
infrastructures  such  as  in  the  North  Sea  area 
(through  the  North  Seas  Countries'  Offshore  Grid 
Initiative), in the Baltic region (through the Baltic 
Energy Market Interconnection Plan - BEMIP) and 
the  Pentalateral  Energy  Forum  between 
in 
Germany,  Belgium,  France,  Luxembourg, 
the 
Netherlands and Austria. 

1.2.2.  Member States 

In terms of market design, most Member States 
employ  a  power  exchange (33),  where  trade 
through the market is optional (see table III.1.2). 
Greece, Ireland, Portugal and Spain have adopted a 
power pool, where all transactions must go through 
the  market.  In  Bulgaria,  Cyprus,  and  Luxemburg 
there  is  no  wholesale  market  and  transactions  are 

(33)  For  more  information  on  the  architecture  of  spot  markets, 
including  the  difference  between  power  exchange  and 
power pool refer to Box II.1.1 

either agreed on a bilateral basis (over the counter) 
or are managed by the central authority. 

Member  States  differ  also  in  the  choice  of 
reliance  on  an  energy-only  or  a  capacity 
market.  Currently,  most  of  the  active  capacity 
mechanisms  aim  to  ensure  the  firmness  and 
adequacy  of  the  overall  capacity  of  the  market  to 
meet demand. Some Member States purely rely on 
an  energy-only  market  (Austria,  Bulgaria,  Czech 
Republic,  Estonia,  Latvia,  Lithuania,  Netherlands, 
Romania,  Slovakia  and  Slovenia)  whereas  others 
made  the  choice  to  accompany  the  energy-only 
market by some form of capacity mechanism (see 
section 1.1.3). 

implemented 

Different  forms  of  capacity  mechanisms  have 
several  European 
in 
been 
countries  while  others  are  discussing  their 
implementation.  Belgium,  Sweden,  Finland,  and 

38 

CountryPower ExchangePower PoolEnergy only MarketCapacity MechanismStrategic ReserveAustriaxxBelgiumxxBulgariaxCroatianananaCyprusnananaCzech RepublicxxDenmarkxxEstoniaxxFinlandxxFrancexxGermanyxxGreecexxHungaryxxIrelandxxItalyxxLatviaxxLithuaniaxxLuxembourgnananaMaltanananaNetherlandsxxPolandxxPortugalxxRomaniaxxSlovakiaxxSloveniaxxSpainxxSwedenxxUnited Kingdomxx 
                                                           
 
 
 
Investment needs and price signal: perspectives 

Part II 

revenues  collected  from 
the  market  are  not 
sufficient  to  cover  their  costs  plus  a  fair  return, 
then a subsidy will be given in €/MW on a yearly 
basis  in  order  to  ensure  that  the  predetermined 
level of profitability (38) will be achieved. 

exchange 

The  presence  or  not  of  a  price-cap  on  the 
wholesale  market  is  one  additional  source  of 
heterogeneity  across  Member  States.  For 
instance,  price  caps  have  been  set  in  the  French 
and  German  power 
at  +/-3000 
EUR/MWh,  which  means  that  the  price  cannot 
exceed these limits. Nord Pool Spot has a range of 
-200  EUR/MWh  to  +2,000  EUR/MWh (39), (40). 
The Irish power exchange SEM has a price cap of 
1  000  EUR/MWh.  In  the  Iberian  power  market 
OMEL  bids  are  allowed  between  0  and  180 
EUR/MWh (41).  Possibly,  also  other  Member 
States implement price caps. 

1.3.  CONCLUDING REMARKS 

Power price formation is based on the bid of the 
marginal unit required to meet demand, which 
in  a  competitive  market  will  correspond  to  its 
marginal cost. For each technology, the difference 
between  the  market  price  and  its  costs,  i.e.  the 
inframarginal-rent,  allows  investors  to  breakeven. 
Some  additional  revenue  can  also  be  realised  on 
the balancing market.  

The role of the price is different across market 
frameworks. In energy only markets, the stability 
of the system in terms of investments in capacity is 
achieved through electricity prices. When demand 
is  in  excess,  prices  increase  to  signal  scarcity  on 
the  market.  The  high  scarcity  price  enables  the 
generators  to  cover  their  fixed  capital  costs  and 
provide an incentive to invest so that the capacity 
will  be  able  to  meet  market  demand.  In  other 
is 
the  energy  market 
market 
complemented  by  a  capacity  mechanism 
to 
incentivise 
the  capacity 
available  to  meet  the  demand  (often  targeting  a 
long term reliability standards). 

frameworks, 

investment 

to  make 

(38)  Set  at  7.3%  pre-tax.  The  level  of  profitability  is  set  based 
on  the  yield  of  the  Spanish  ten  year  bond  plus  300  basis 
points and it is revised every six years 

(39)  EMCC (2009) 
(40)  ECF (2012) 
(41)  European Commission (2013a) 

Germany  operate  strategic  reserves (34).  Ireland, 
Italy,  Portugal  and  Spain  practice  capacity 
payments.  France  plans  to  implement  a  capacity 
obligation  scheme  supported  by  certification  of 
capacity.  Denmark  plans  to  implement  a  strategic 
reserve. Greece has a capacity obligations scheme 
since 2005 (35). The United Kingdom has opted for 
a centralized, market wide capacity auction. Other 
Member  States  are  supporting  new  investments 
through tenders for new capacity. Various Member 
States  are  considering  new  capacity  mechanisms. 
(36).  

to 

the  Energy  Act  2013 

Support  schemes  are  evolving.  Even  though  a 
big  part  of  investment  in  renewables  is  driven 
by support schemes, evolution towards market-
based  allocations  and/or  pricing  can  be 
observed  in  some  Member  States.  To  tackle  the 
problem  of  revenue  uncertainty  in  electricity 
generation  and  a  consequent  difficulty  in  getting 
private  sector  investment,  the  United  Kingdom 
implement 
passed 
(EMR)  which 
Electricity  Market  Reform 
implements 
for 
Contracts 
legally-binding 
Difference. Through a Contract for Difference the 
electricity generator is paid the difference between 
the  price  reflecting  the  cost  of  investing  in  a 
particular 
the 
‘reference price’– a measure of the average market 
price  for  electricity  in  the  British  market.  In 
addition,  the  scope  of  the  schemes  is  changing 
from renewable-targeted (a type of action which is 
(a 
more 
requirement  which  is  instead  emission  reduction- 
specific).  In  Spain,  feed-in  tariffs  and  feed-in 
premia  were  replaced  by 
investment  support 
schemes (37)  based  on  which  renewable  producers 
must  submit  offers  to  the  market  operator.  If  the 

technology-specific) 

technology  –  and 

low  carbon 

low-carbon 

to 

(34)  See  the  classification  of  capacity  mechanisms  in  section 
II.1.1.3.  The  impact  of  these  various  forms  of  capacity 
mechanisms is different whether they are targeted or wide 
market-based.. 

(35)  In  parallel,  a  transitory  capacity  payment  scheme  was  put 
in  place  from  2006 
to  facilitate  market 
till  2014, 
participants  conclude  capacity  available  contracts  due  to 
the significant market share of the incumbent. 

(36)  The  Commission  has  launched  a  state  aid  sector  inquiry 
into  capacity  mechanisms  in  2015  to  provide  a  clearer 
picture of the different initiatives in this area. The  inquiry 
will  identify  design  features  that  may  distort  competition 
between  capacity  providers  and  distort  cross-border  trade; 
and 
in  particular  will  examine  whether  capacity 
mechanisms  ensure  sufficient  electricity  supply  without 
distorting competition or trade in the EU's Single Market. 

(37)  Real Decreto-ley 9/2013 

39 

 
                                                           
                                                           
Investment needs and price signal: perspectives 

Part II 

Although  EU  wholesale  markets  have  been 
progressively  harmonised,  market  framework 
still  differ  across  Member  States  in  terms  of 
electricity  traded  via  various  markets  (day-ahead, 
intra-day,  balancing  markets),  implementation  of 
capacity  mechanisms  and  other  forms  of  price 
regulation, e.g. price caps. 

40 

 
2. 

THE TRANSITION TO LOW CARBON ECONOMIES AND 

INVESTMENT NEEDS 

The  decarbonisation  agenda  of  the  European 
Union  requires  large  investments  to  take  place 
in  the  next  future.  At  the  same  time,  the 
liberalisation  of 
the  electricity  market  has 
enhanced the role of spot markets in providing the 
signal for investment. However, the penetration of 
low  carbon 
the 
functioning  of  the  market  and  changing  the 
investment landscape.  

is  challenging 

technologies 

The  objective  of  this  chapter  is  to  reflect  on  the 
evolution  of  key  features  for 
in 
electricity  markets.  Section  1  assesses  investment 
needs in electricity generation; Section 2 describes 
the  ongoing  transformation  of  electricity  markets 
and the potential impact on power prices. Section 3 
concludes. 

investment 

2.1. 

THE  CASE 
ELECTRICITY MARKETS  

FOR 

INVESTMENTS 

IN 

targets  and 

The  transition  to  a  low-carbon  and  energy-
secure  economy  requires  mobilisation  of 
significant  investments  in  Europe.  The  Impact 
Assessment of the energy efficiency review and its 
contribution  to  energy  security  and  the  2030 
Framework 
for  climate  and  energy  policy 
estimated the investment needs related both to the 
achievement  of 
the 
the  2030 
modernization  and  transformation  of  the  energy 
system  in  the  EU  Member  States (42).  These 
projections  show 
that  EUR  90  billion  of 
investments are needed annually up to 2030 in the 
power sector, of which EUR 50 billion for energy 
generation  and  EUR  40  billion  related  to  power 
grids. This is driven by the need to modernise the 
EU's  ageing  energy  infrastructure  (for  generation 
as  well  as  transmission  and  distribution),  as  a 
response  to  security  of  supply  issues,  and  due  to 
energy and climate policy ambitions.  

Significant  investments  in  renewable  power 
capacity  will  be  needed  up  to  2030  under 
decarbonisation. Graph II.2.1 presents the ranges 
of net capacity investment in the period 2011-2030 
for 
Impact 
Assessment of the energy efficiency review and its 
contribution  to  energy  security  and  the  2030 

the  different  scenarios  of 

the 

(42)  European Commission (2014f) 

41 

Framework  for  climate  and  energy  policy.  These 
investment numbers include lifetime extensions of 
existing  plants,  refurbishments  and  replacement 
investments on existing sites. 

Graph II.2.1:  Ranges for EU28 - Net Power Capacity 

Investment (in GWe - aggregate 2011-2030) 

Source: European Commission (2014 f) 

In  addition  to  the  investment  needs  for  the 
power  sector,  substantial  investments  are  also 
required  in  other  sectors  of  the  economy,  i.e. 
electrification), 
transport 
efficiency, 
(energy 
innovation)  and 
buildings  (energy  efficiency, 
industry  (energy  efficiency,  innovation).  Total 
investment needs are estimated at EUR 850 billion 
annually up to 2030. 

Graph II.2.2:  Annual Investment Expenditures in billion of 

euro - 2010 (2011-2030) 

Source: European Commission (2014 f) 

sector. 

electricity 

Decarbonisation  of  the  rest  of  the  economy  is 
expected  to  lead  to  higher  demand  for  the 
Electricity 
generation 
consumption is still largely driven by GDP growth 
although  energy  efficiency  improvements  have 
contributed  to  decouple  energy  performance  from 
consumption 
economic 
decreased starting in 2008 due to the impact of the 
the  subsequent  sluggish 
economic  crisis  and 

growth.  Electricity 

020040060080010001200Nuclear energy Renewable energy - Hydro(pumping excluded) & Otherrenewables (tidal etc.) Renewable energy - Wind power& SolarThermal power - Fossil FuelsFired (Solids, Oil, Gas)Thermal power - Geothermal heat& Biomass-waste firedRanges - Gwe2945206634053IndustryResidentialTertiarytransportGridGeneration and boilers 
                                                           
 
 
Investment needs and price signal: perspectives 

Part II 

Table II.2.1: 

Electricity cost structure 

* refers to scenario 2 of the Impact Assessment; ** refers to scenario 5 of the Impact Assessment. 
Source: Own calculations based on Impact Assessment accompanying the document Energy Roadmap 2050, part 2, Table 
31. 

to  energy 

recovery,  as  well  as 
intensity 
improvements. At the end of 2012, total electricity 
consumption  was  still  2.3%  lower  than  in  2008, 
whereas analysts were expecting an average annual 
growth  rate  of  about  2% (43)  at  the  time.  In  the 
future,  the  energy  efficiency  improvement  in  the 
rest  of  the  economy  is  expected  to  increase  the 
demand  for  electricity.  According  to  the  Energy 
Roadmap  2050 (44),  the  electricity  share  in  the 
final  energy  consumption  is  expected  to  double 
compared 
the  decarbonisation 
in 
scenarios (45) reaching 36% - 39% of final energy 
demand  in  2050.  This  reflects  the  increasing  role 
played by electricity in decarbonising final demand 
sectors  such  as  heating  and  services  and  in 
particular transport. 

to  2005 

Graph II.2.3:  EU28 - Electricity consumption (in TWh) - Final 

electricity demand in TWh* 

*European Commission (2014)  
Source: European Commission 

increases  by  almost  a 

Electricity  demand  in  the  transport  sector  in 
2050 
factor  eight 
compared to 2005 under the different scenarios of 
the  Impact  Assessment  of  the  energy  efficiency 
review and its contribution to energy security and 
the  2030  Framework  for  climate  and  energy 

(43)  IEA (2008) 
(44)  European Commission (2011a) 
(45)  Scenario 1bis: Current Policy Initiatives ; Scenario 2: High 
energy  efficiency 
;  Scenario  3:  Diversified  supply 
technologies scenario ; Scenario 4: High RES ; Scenario 5: 
Delayed CCS ; Scenario 6: Low nuclear 

policy. This is mainly due to the electrification of 
road  transport,  in  particular  private  cars.  About 
80%  of  private  passenger  transport  activity  is 
foreseen to be carried out with electrified (plug-in 
or  pure  electric)  vehicles  by  2050.  Compared  to 
transport, the electricity demand of households and 
the  tertiary  sector  is  expanding  more  modestly  by 
the 
2050,  yet  markedly,  mainly  driven  by 
electrification  of  heating  and  cooling.  This  new 
usage  of  electricity  overcomes  the  improvements 
in  energy  efficiency  of 
achieved  by  2050 
thermal 
increased 
appliances  as  well  as 
integrity  in  the  residential  and  service  sectors  and 
more  rational  use  of  energy  in  all  sectors.  By 
contrast,  industrial  electricity  demand  remains 
quite stable by 2050 compared to 2005. 

the 

2.2. 

THE  ONGOING  TRANSFORMATION  OF 
EUROPEAN ELECTRICITY MARKETS 

2.2.1.  Changing  cost  structure:  high  capital 

costs technologies  

From  an  economic  perspective,  low-carbon 
technologies can be considered as low-marginal 
cost technologies. Low carbon technologies share 
the  same  cost-structure:  high  fixed  (investment) 
low  marginal  (operating)  costs;  whereas 
and 
conventional fossil fuel-based power sources have 
lower  capital  costs  and  higher  operating  costs 
(Graph II.2.4). This has an important effect on the 
market  outcome  because  as  the  share  of  low-
carbon technologies increases, average spot market 
prices may tend to decrease (46) and price volatility 
to increase. 

(46)  Obviously  this  trend  is  difficult  to  predict.  Theoretical 
arguments can be can be used to support the claim that with 
variable  renewables  the  frequency  of  low  prices  may  well 
increase,  but  the  price  level  where  prices  are  high  might 
also  increase,  possibly  resulting  in  a  neutral  or  even 
positive effect on average wholesale prices (see Box I.1.2). 
As  concerns  the  analytical  evidence,  the  literature  review 
carried out in Pöyry 2010 arrives at the general conclusion 

42 

02004006008001,0001,2001,400REF2013EE27GHG40EEMRES30GHG4020052050205020502050IndustryHouseholdsTertiaryTransport(EUR 2008 per MWh)2030205058%53%42%47%scenario 4scenario5Reference ScenarioHigh RES penetration*High nuclear penetration **203020502030205067%Variable and fuel costs31%20%35%33%Fixed and Capital costs69%80%65% 
 
 
                                                           
                                                           
 
 
 
Investment needs and price signal: perspectives 

Part II 

Graph II.2.4:  Levelised costs of fossil fuel and low carbon 

2.2.2.  The 

penetration 

of 

variable 

technologies 

technologies 

solar  are  variable 

Beyond the common cost structure, low carbon 
technologies  differ  in  the  type  of  capacity  they 
provide:  nuclear  and  hydro  plants  provide  firm 
capacity (meaning that they can reliably predict the 
amount  of  energy  they  will  be  able  to  deliver), 
(or 
whereas  wind  and 
technologies  which  depend  on 
intermittent) 
uncertain  and  difficult 
to  predict  weather 
conditions  (at  least  over  a  lead  time  of  more  than 
technical 
hours). 
24 
on 
characteristic  with 
the 
requirements  of 
infrastructure, 
where ancillary services are likely to play a bigger 
role  than  what  they  historically  did.  In  addition, 
intermittency  translates  into  an  economic  impact 
because the unpredictable amount of cheap energy 
on the market increases the price risk.  

Intermittency 
great 
the  electricity 

a 
is 
impact 

The  day-by-day  market  activities  are  impacted 
by  the  intermittent  nature  of  wind  and  solar 
power.  Increased  penetration  of  this  type  of 
technology  creates  challenges  to  the  reliability  of 
the  electricity  system:  it  is  not  just  a  matter  of 
having enough installed capacity to meet demand; 
the  issue  is  rather  ensuring  that  the  system  is 
flexible enough to supply electricity when the high 
share of variable  renewables  is not able  to  supply 
power due to weather conditions.  

2.2.3.  Changing  conditions  for  investors:  lower 

price and intermittency 

and 

energy 

sources)  are 

characteristic) 

the 
streams 

Both the electricity price (which depends on the 
increased 
cost 
to 
(due 
uncertainty  of  revenue 
intermittent 
crucial 
elements  of  the  investment  decision.  If  the 
average  electricity  price  on  wholesale  markets  is 
too  low  to  cover  the  fixed  costs  together  with  the 
marginal cost of electricity production, investment 
is not profitable in expectation, and rational market 
actors  will  not  undertake  it.  On  the  other  hand, 
intermittency  in  the  availability  of  cheap  energy 
sources increases the variance of price: this means 
that  the  price  can  be  low,  but  also  very  high  in 
periods  when  low  carbon  technologies  are  not 
available.  This  translates  into  higher  investment 

Calculations are based on the year 2011 and do not 
include carbon costs. 
Source: SETIS 

low  carbon 

technologies.  The 

Studies  have  estimated  the  role  that  fixed  and 
marginal costs will play in a system dominated 
Impact 
by 
Assessment  accompanying  the  Communication 
from the European Commission "Energy Roadmap 
2050 (47)"  analyses  policy  scenarios  with  high 
penetration  of  low  marginal  cost  technologies 
(renewables  and  nuclear).  The  study  models  the 
evolution  of  electricity  prices,  and 
includes 
projections  on  fixed  and  variable  costs  of  the 
generation  mix  induced  by  the  policy.  The  fixed 
costs  can  be  identified  as  the  capital  costs;  while 
variable  costs  can  be  identified  with  the  marginal 
costs  on  which  the  wholesale  electricity  price  is 
determined.  The  figures  provided  in  the  Impact 
Assessment  clearly  show  that,  under  the  current 
policy scenario, with relatively low penetration of 
renewables,  variable  and  fixed  costs  represent 
approximately  50%  of  the  costs  each.  Under  the 
High  renewable  penetration  scenario,  fixed  costs 
constitute more than 2/3 of the overall costs, while 
variable  costs  decrease  to  1/3.  Similar  figures  are 
obtained  for  the  high  nuclear  penetration  scenario 
(see Table II.2.1). 

that  there  is  a  downward  movement  of  wholesale/spot 
prices due to increased wind power penetration. 

(47)  European Commission (2011a) 

43 

04080120160200LCOE (€/MWh)Other variable OM expenditure [€/MWhel]Fuel expenditure [€/MWhel]Fixed OM expenditure [€/MWhel]Capital expenditure [€/MWhel] 
 
 
                                                                                   
risk (48)  negatively  affecting 
decision. 

the 

investment 

For the electricity system to be reliable, most of 
low marginal cost units cannot serve the system 
alone:  nuclear  plants  are,  in  general,  independent 
from weather conditions (49), but they require long 
booting  periods,  while  wind  and  solar  power 
(variable  renewable  sources)  are,  by  definition, 
dependent  on  weather  conditions  which  are  not 
easily  predictable.  This  means  that  large  scale 
deployment  of  low  marginal  cost  units,  and  in 
the 
particular  variable  renewables,  challenges 
reliability  of  the  electricity  system.  For  reliability 
to  be  maintained,  they  need  to  be  complemented 
with  other 
like  demand 
types  of  resources, 
for 
response,  storage,  and  generation  units 
moments of unfavourable weather or to cope with 
sudden  demand  spikes  requiring  fast-responding 
generators (50).  Fast  responding  generation  units 
(mainly  secondary  reserves)  can  be  procured  by 
transmission  system  operators  (TSOs)  through 
balancing  and  ancillary  service  markets  It  is 
important to notice, though, that balancing services 
are  not  designed  for,  and  hence  not  likely  to   
substitute  other  forms  of  generation  for  a  long 
duration  of  high  demand  and  low  output  from 
intermittent  renewables;  to  solve  this  adequacy 
problem, more resources would be needed.  

This means that the introduction of low carbon 
technologies  requires  flexibility  resources  to 
stay in the market (fast responding firm capacity, 

(48)  The market structure and technology generation mix play a 
crucial  role  in  determining  the  actual  risk  for  individual 
cases. 

(49)  However, nuclear power plants are sensitive to heat waves 

due to their cooling requirements. 

(50)  Traditionally,  nuclear  power  plants  have  been  considered 
as  baseload  sources  of  electricity  as  they  rely  on  a 
technology  with  high  fixed  costs  and  low  variable  costs. 
This  is  the  most  economical  and  technically  simple  mode 
of  operation.  In  this  mode,  power  changes  are  limited  to 
stability  and  safety  purposes,  and  they  do  not  adjust 
production to changes in the load. Developments in nuclear 
technology  are  increasing  the  flexibility  of  nuclear  power 
plants within a limited scope, and in countries like France 
and  Germany  they  have  partly  become  load  following 
technologies (again). Their applicability in this area is still 
limited in  most other countries though, and nuclear power 
plants need to be paired with peaking plants to ensure that 
demand  is  constantly  met.  Hydro  power  can  be  of  three 
types: run-of-river plants, which are not flexible enough to 
be  load-following,  and  reservoir/pumped  storage  plants, 
both of which are a very flexible source of electricity. The 
main limitation of the latter type of plants is that the scope 
for capacity expansion is rather limited. 

Investment needs and price signal: perspectives 

Part II 

currently represented by conventional peaking and 
mid-range plants, demand response, storage, better 
use  of  interconnections  and  more  efficient  use  of 
existing  plants).  With  small  shares  of  variable 
renewables  in  the  system,  their  intermittency  can 
be  smoothed  out  with  existing  conventional 
capacity.  But  when  the  variable  renewable  share 
reaches  higher  levels  (some  estimates  put  the 
threshold at 20-25% (51) back-up capacity runs for 
very limited amounts of time, with a consequential 
decrease in profitability that may force them to exit 
the market and/or discourages new investment. 

Reliability  of 
the  system  and  generation 
capacity  adequacy  are  interlinked  problems.  If 
low  carbon  technologies  depress  wholesale  prices 
and  cause  a  lack  of  conventional  capacity  in  the 
overall  generation  mix,  the  provision  of  back  up 
capacity  in  the  form  of  ancillary  services  and 
balancing power might become more burdensome, 
if flexibility is not appropriately rewarded. Hence, 
the  fact  that  there  might  be  a  capacity  problem 
overall,  and  in  particularly  for  gas  and  coal,  risks 
increasing the size of the reliability problem. 

2.2.4.  Marginal  cost  pricing  and  investment 

signal 

Whereas  the  marginal  cost  based  pricing 
mechanism is widely considered as the best way 
to achieve  efficient  use  of  resource in  the  short 
term,  its  role  in  guiding  investment  is  being 
challenged by the changing environment imposed 
by  low  carbon  technologies,  (intermittency,  fewer 
hours  run  for  peaking  units  and  lower  market 
prices).  Depending  on 
techno-economical 
characteristics  of 
the  generation  mix,  price 
formation  in  a  short-run,  competitive  market  may 
not  turn  out  to  be  functional  to  send  long  term 
price signals to induce investment, (de Castro et al 
2010) (52).  

the 

There  is  a  broad  consensus  on  the  need  to 
promote market-based investments without any 

(51)  CIEP 2014 
(52)  Competition  amongst 

renewable, 

fossil  and  nuclear 
electricity  may  not  only  be 
influenced  by  national 
subsidies,  tax  policies,  political  objectives  and  decisions 
but  also  by  technical  aspects.  In  particular,  technical 
aspects  can  constitute  serious  constrains  for  investment  in 
nuclear  capacity  such  as  the  minimum  size  required,  the 
adequacy of the grid to the size of the generation, the need 
to have adequate cold source (sea or river). These technical 
constraints also impose additional costs for new entrants.  

44 

 
                                                           
                                                           
Investment needs and price signal: perspectives 

Part II 

However,  capacity  mechanism  may  have  adverse 
effects linked to the ability to forecast demand and 
predict  the  right  capacity  adequacy.  In  addition, 
capacity  mechanisms  implemented  without  taking 
into  account  cross-border  trade  is  likely  to  cause 
over-capacity and distort allocation of investments. 
(Tennbakk  2013;  Grigorjeva,  2015). Moreover, as 
most of systems remunerate incumbents, the risk is 
that  the  existence  of  remuneration  for  capacity 
freezes  the  market  and  hampers  innovation  by 
delaying investments in new facilities (Grigorieva, 
2015).  Finally,  it  needs  to  be  noted  that  model 
based  analyses  show  that  there  is  no  urgent  need 
for  capacity  mechanisms 
in  most  European 
countries in the first few years to come (Tennbakk, 
2013).  

Recently,  the  investment  challenge  has  been 
aggravated  by  the  penetration  of  low  carbon 
technologies,  as  these  technologies  tend  to  lower 
the  remuneration  of 
wholesale  prices,  hence 
investors while increasing volatility. Castro and al 
(2010)  show  that  a  system  dominated  by  low 
carbon technologies leads to reduced market prices 
independent  of  production  costs  and  does  not 
guarantee the financial viability of existent firms., 
Cramton  et  al.  (2013)  argue  that  renewables 
aggravate  the  adequacy  problem  because  their 
to 
production 
marginal  costs  close  to  zero).  Because  of  this 
characteristic, 
demand 
fluctuations,  and  thereby  price  fluctuations.  The 
authors  add  that  with  rising  renewable  in-feed, 
generation  adequacy 
is  challenged  because, 
conventional investments get less attractive due to 
lower load factors.  

is  entirely  price-inelastic  (due 

renewables 

intensify 

On the issue of increased volatility and its effect 
on  investments,  Blyth  et  al.  (2015)  analyse  the 
effects of an increasing share of renewables on the 
price formation mechanism. They demonstrate that 
over  time  the  wholesale  market  will  present  an 
increasingly less attractive risk/return profile, with 
lower  average  prices  and  higher  volatility,  which 
will 
larger 
induce  market  concentration  as 
companies  can  more  easily  bear  these  risks.  They 
also  show  that  inadequate  near-term  investment 
signals  emerge  when  market  participants  are 
confronted with behavioural considerations of risk, 
limited  foresights  and  excessive  discounting. 
Similarly,  Pikk  and  Viiding  (2013)  analyse  the 
potential  impact  of  more  renewable  electricity 
production  on  wholesale  prices  in  the  NordPool 

form  of  support.  However,  the  views  diverge  on 
the  way  to  achieve  this  end.  The  main  debate  is 
between. energy-only markets where prices would 
be  allowed  to  reach  high  levels  during  scarcity 
hours;  or  by  capacity  remuneration  mechanisms, 
remunerating some capacities for their availability. 

Energy-only  markets  are  potentially  able  to 
deliver  an  investment  equilibrium,  by  pushing 
out  of  the  market  unneeded  peak  plants  when  in 
excess,  as  well  as  being  able  to  attract  new 
investment  through  high  prices.  Oren  (2005)  and 
Hogan  (2005)  explain  that  generators  should  be 
able to balance their expenditures through bidding 
higher  than  marginal  costs  in  hours  of  supply 
shortage. For this to happen, markets need to allow 
prices  to  reach  high  levels  during  scarcity  events, 
which means that price cap, where existent, should 
be removed (Giuli 2015; Grigorjeva, 2015).  

Some  authors  (Cramton  and  al,  2013)  discuss  the 
ability  of  scarcity  price  to  fix  the  investment 
equilibrium.  In  reality,  markets  are  imperfect  and 
prices  are  usually  capped  to  avoid  the  abuse  of 
market  power. One of  the difficulties  is to  set  the 
"value  of  lost  load  (VoLL)  which  corresponds  to 
what  consumers  would  pay 
to  avoid  power 
interruption. For this reason, the authors argue that 
the scarcity price approach relies on the quality of 
the regulator's estimate. Finally, the existence and 
frequency  of  high  prices  question  the  political 
acceptability  of 
an 
equilibrium based on scarcity prices (ACER, 2013; 
OECD et al., 2015).  

consequences  of 

the 

are  necessary 

For  all  these  reasons,  some  authors  claim  that 
capacity  mechanisms 
to 
compensate  for  market  imperfections.  Cramton 
and  Stoft  (2005),  and  Joskow  and  Tirole  (2007) 
emphasize that there will always be imperfections 
in  the  energy-only  market  leading  to,  e.g.,  price 
spikes and market power, because the demand side 
does  not  actively  participate  in  the  market.  They 
conclude that there is a need for a different market 
scheme  that  would  ensure  generation  adequacy, 
e.g.,  a  capacity  market.  Originally,  capacity 
mechanisms  were  created  to  make  up  for  the  lost 
profits due to the existence of stringent price caps 
(Giuli,  2015).  Capacity  mechanisms  can  take 
different  forms  (see  chapter  II.1),  but  they  are  all 
based  on  the  idea  of  remunerating  the  capacity  to 
produce  electricity,  rather  than  the  electricity 
actually delivered.  

45 

 
Investment needs and price signal: perspectives 

Part II 

explained  by  the  price  formation  (i.e.  assuming 
generators  bid  according  to  their  marginal  costs) 
and  the  cost  structure  of  these  technologies  with 
high fixed costs and low operating costs. In such a 
system, there is a risk that a market price based on 
the operating cost of the marginal unit may not be 
sufficient  for 
to  generate  sufficient 
revenue to cover their fixed costs. This is under the 
assumption  that  technologies  with  low  variable 
costs  will  dominate  the  market  and  therefore 
regularly act as the marginal producer. 

investors 

This  translates  into  a  risk  that  the  current 
arrangements  of  wholesale  markets  will  not 
provide  the  proper  incentives  for  long-term 
investment  in  the  power  generation  sector. 
Markets  are  supposed  to  serve  two  functions: 
optimisation  of  resources  already  in  place,  and 
driving  investment  for  the  future.  Whereas  the 
electricity  market  serves  the  first  function  well,  it 
is  not  clear  whether  the  current  electricity  market 
design  will  be  sufficient  to  convey  the  right  long 
term investment signals in a system dominated by 
low-carbon technologies with low operating costs. 
However, a proper market framework is important 
to make these investments happen. 

spot market, in the context of significant help from 
government  support  schemes  for  investment  in 
renewable production capacity. Their results are in 
line with the findings of Blyth et al. (2015) as they 
show that, ceteris paribus, NordPool Spot is likely 
to have very high price volatility in the future and 
alternative  revenue  sources  are  required  for  new 
investment. 

to 

leads 

reflection 

transition.  The 

This  dynamic 
is  the  starting  point  for  a 
reflection by OECD et al. (2015), which observe 
that the design  of  wholesale  electricity markets 
is not strategically aligned with the transition to 
low  carbon.  The  current  market  design  is  failing 
to provide the visibility of future electricity prices 
that  would  help  secure  investment  in  the  low-
carbon,  high-capital  cost  technologies  needed  for 
the 
the 
conclusion  that,  despite  the  fact  that  wholesale 
electricity markets will remain useful for the least-
cost  dispatching  of  existing  capacity,  left  on  their 
own,  they  would  require  repeated  periods  of  very 
high prices, with a high price on CO2, and scarcity 
periods  and  risks  of  rolling  brown-outs,  before 
these 
investors  would  unlock 
technologies. The OECD et al. claim, instead, that 
the right investments could be achieved more cost-
effectively  if  new  forms  of  market  arrangements 
were  agreed.  Similarly,  IEA  (2015)  questions  the 
ability of the current model of liberalised markets 
with a carbon price to deliver investment at a scale 
and  pace  needed  to  achieve  decarbonisation.  It 
concludes  that  additional  instruments  to  secure 
investments  for  decarbonisation  might  be  needed 
on  top  of  a  carbon  price  and  well-designed  short 
term markets. 

financing  of 

2.3.  CONCLUDING REMARKS 

in 

Investments 
the  power  generation  are 
expected to play a central role in the transition 
to  low  carbon  economy.  Not  only  the  electricity 
sector  has  a  large  decarbonisation  potential;  it  is 
also  expected  to  contribute  to  the  decarbonisation 
of other sectors of the economy by supplying low 
carbon electricity.  

The increasing share of low carbon technologies 
in the electricity mix is likely to lower the prices 
on  the  spot  market.  Under  current  market 
arrangements,  this  corresponds  to  the  day  ahead 
market.  These  price  developments  can  be 

46 

 
Part III 
Reconciling markets with investment signal: 
which market arrangements? 

 
 
INTRODUCTION 

The increasing penetration of low carbon technologies is changing the market reality and poses several 
challenges for both investors and public authorities. From a dynamic perspective, the transition to a low 
carbon economy influences both prices and capacities and leads to new equilibriums for each stage of the 
transition. This part aims to provide an economic framework for the transition to a low carbon economy 
and discusses possible market arrangements. 

Chapter  one  analyses  the  impact  of  the  decarbonisation  using  different  sequences  –  yesterday,  a  world 
dominated by conventional fuels; today with a transition phase led by the penetration of new technologies 
and,  tomorrow  with  a  decarbonised  world  where  electricity  is  mostly  produced  by  low  carbon 
technologies.  

Chapter  two  reviews  the  challenges  for  each  sequence  –  today  and  tomorrow  –  and  identifies  possible 
market-based arrangements that would incentive investments while minimising the cost for society.  

49 

 
 
 
 
 
 
 
 
1. 

THE ECONOMICS OF THE TRANSITION TO LOW CARBON 

ECONOMIES 

increasing  penetration  of 

The 
low  carbon 
technologies  is  affecting  the  cost  structure  and 
composition of the technology mix (see part I and 
II). This impacts the price formation on the market 
and  hence  the  way  investors  recoup  the  costs  for 
their investments.  

The  objective  of  this  chapter  is  to  understand  the 
evolution  of  the  investment  conditions  in  power 
the  decarbonisation  process. 
markets  during 
Section  1  analyses  the  impacts  of  low  carbon 
technologies  on  prices  and  quantities.  Section  2 
looks  at  the  cost  developments  and  learning 
potential  of  low  carbon  technologies.  Section  3 
concludes. 

1.1. 

THE  ECONOMICS  OF  LOW  CARBON 
TECHNOLOGIES 

1.1.1.  Impact  of  low  carbon  technologies  on 

prices and capacities  

The transition to a low carbon economy leads to 
a shift to technologies with high fixed costs and 
low  operating  costs  (see  part  II).  This  evolution 
changes  the  cost  structure  as  well  as  the  total 
capacity  of  the  electricity  system  in  the  short  and 
medium  run.  From  an  investor's  perspective,  the 
overall conditions to invest will change due to the 
impact  on  the  price  of  the  energy  transition, 
thereby  changing  the  incentive  to  invest  or  not. 
From public authorities' perspective, it is important 
that the impact on the capacity and prices induced 
by  the  changing  structure  of  the  electricity  mix 
remains  compatible  with  an  efficient  and  cost-
effective electricity market.  

long 

need 

decisions 

Investment 
term 
predictability,  which  makes  it  important  to 
understand  the  consequences  of  the  transition 
to low carbon technologies in both the short and 
medium  term.  The  market  transition  can  be 
summarised  by  three  chronological  stages  with 
their  own  characteristics  in  terms  of  price  and 
production  conditions.  In  order  to  understand  the 
impact  of  this  development,  three  power  systems 
are  constructed  that  represent  each  stage  of  the 
energy  transition,  from  yesterday  (conventional 
phase – stage 1) to today (transition phase – stage 

2)  and  tomorrow  (decarbonised  phase  –  stage 
3) (53).  During  the  transition  phase,  most  of  low 
carbon  technologies  are  not  yet  competitive  and 
would not enter in the market without any form of 
support.    During  the  decarbonised  phase,  it  is 
assumed  that  low  carbon  technologies  dominate 
the  technology  mixes  of  the  European  power 
systems  and  compete  on  the  market.  Each  stage 
corresponds  to  a  changing  electricity  mix  induced 
low  carbon 
by 
technologies and leads to different equilibriums in 
terms of price and quantity. The magnitude of the 
quantity (or capacity) and the price (cost structure) 
effect differs across the stages of the transition. 

increased  penetration  of 

the 

Remuneration  for  producers  relies  mainly  on 
the price fixed by the marginal unit (see chapter 
II.1). Each technology available on the market will 
face a remuneration which is composed of the sum 
of infra-marginal rents gained during the different 
periods  of  time  as  well  as  scarcity  rents  when 
demand is scarce (see graph III.1.1 and III.1.2 and 
annex 3). These rents allow for the recovery of the 
fixed cost of the peaking units, and also contribute 
to the cost recovery of the other technologies. 

Graph III.1.1:  Generic merit order curve under no capacity 

constraints 

Source: European Commission 

(53)  For example, under the different scenarios53 of the Energy 
Roadmap  2050,  low  carbon  technologies  start  producing 
around  65%  to  70%  of  the  gross  electricity  generation  by 
2025-2030. See European Commission (2011a). 

50 

 
 
 
                                                           
Reconciling markets with investment signal: which market arrangements? 

Part III 

Graph III.1.2:  Generic merit order curve under scarce 

capacity 

The  first  effect  is  a  capacity  adjustment  effect, 
which  corresponds  to  a  change  in  supply  and 
demand that requires the production to be adjusted 
to  the  new  conditions.  Depending  on  the  stage  of 
the  transition,  this  adjustment  can  be  positive  or 
negative.  The  second  effect  is  a  revenue  effect 
which  is  due  to  the  entry  of  technologies  with 
lower  variable  costs  than  the  existing  technology 
mix. In both stages, this revenue effect is negative 
for producers (see Box III.1.1) (55). 

Source: European Commission 

The  penetration  of  low  carbon  technologies 
changes  the  merit  order  curve.  Under  the 
transition  phase,  it  is assumed  that current market 
arrangements  remain  and  electricity  demand  is 
constant (54).  The  introduction  of  low  carbon 
technologies  changes  dynamically  the  merit  order 
curve  by  pushing  the  supply  to  the  right  for  a 
certain period of time proportional to their capacity 
factors.  By  contrast,  when  these  technologies  are 
not operating, the power system uses conventional 
technologies  (see  graph  A3.3  of  annex  3).  In  the 
decarbonised phase, merit order curves are getting 
flatter  with  steeper  ends  that  reflect  a  technology 
mix  dominated  by  low  carbon  technologies  with 
low  variable  costs  and  conventional  capacity  to 
ensure that demand is met at any time. Indeed, low 
carbon  technologies  are  able  to  operate  during 
most of the year due to a high degree of European 
market  integration  that  allows  drawing  on  their 
spatial  and 
in 
particular,  changes 
the  operating  conditions 
(reduction  of  number  of  hours)  of  peaking 
technologies.  

time  complementarities.  This, 

As  a  result,  and  under  current  market 
arrangements,  two  main  effects  would  be  at 
play during the energy transition that affect the 
level of installed capacity and market revenues. 

(54)  Holding  electricity  demand  constant  is  a  conservative 
assumption  as  electricity  is  expected  to  grow  through  its 
deployment in the transport and heating and cooling sector. 
However  this  is  also  expected  to  be  compensated  by 
improved  energy  efficiency.  Considering  the  uncertainties 
on  the  electricity  growth  in  the  future  and  for  the  sake  of 
the clarity of the analysis, demand remains constant. 

51 

to 

the 

low 

The  transition  phase  under  current  market 
the 
arrangements,  which  corresponds 
situation of today, is likely to benefit from lower 
equilibrium  prices (56),  but  would  display 
transitory  over-capacity  of  installed  capacity. 
carbon 
transition  phase, 
During 
technologies  are  continuously  introduced  in  order 
to  meet  the  EU  climate  and  energy  targets  during 
the  transition  phase.  This  may  create  temporary 
corrected  by 
that  would  be 
overcapacity 
adjustment of the total generating capacity to reach 
through 
a  new 
equilibrium, 
decommissioning  of  plants  with 
the  highest 
operating  costs.  As  the  marginal  cost  of  total 
supply would decrease as low carbon technologies 
enter  into  the  market,  this  would  result  in  a  new 
equilibrium  price  that  is  lower  than  the  previous 
equilibrium  price,  triggering  a  revenue  reduction 
for the producers (see Box III.1.1).  

instance 

for 

to 

which 

phase, 

decarbonised 

The 
is 
representative  of  the  market  of  tomorrow,  is 
likely  to  be  dominated  by  a  much  lower 
equilibrium price for most part of the year and by 
the need for strong price spikes (and its associated 
uncertainty) 
fixed  cost  of 
investments.  Under  the  decarbonised  phase,  the 
energy  transition  is  achieved,  i.e.  low  carbon 
technologies are dominating the technology mixes 
of  the  European  power  systems.  Due  to  the  high 
carbon 
low  marginal 
penetration  of 
technologies,  the  supply  curve  becomes  flatter 
with  steeper  end  compared  to  the  transition  phase 

recoup 

cost 

the 

(55)  The analysis  considers the revenues  induced by wholesale 
price  evolution.  In  reality,  generators  get  other  forms  of 
revenues  such  as  for  balancing  services.  Other  sources  of 
revenues,  for  instance,  through  more  developed  balancing 
or intraday markets or unconstrained scarcity pricing could 
counter this decrease in revenues. 

(56)  The extent of the price decrease depends on several factors 
such  as  a  change  of  the  carbon  price  during  the  transition 
phase. Quantifying it precisely goes beyond of the scope of 
this report. 

 
 
 
                                                           
                                                           
Reconciling markets with investment signal: which market arrangements? 

Part III 

resulting in lower price equilibrium in most part of 
the year and high prices when demand is high and 
capacity  is  scarce.  The  feasibility  of  frequent  and 
intense  price  spikes  is  uncertain  in  the  future, 
notably  due  to  factors  such  as  public  acceptance, 
regulatory  intervention  to  prevent  market  power, 
low  price  caps  set  in  power  markets.  Due  to  this 
uncertainty,  a  revenue  decrease  for  the  producers 
can  overall  be  expected.  As  prices  are  lower, 
demand  increases  (as  a  result  of  the  elasticity  of 
demand),  which  requires  increasing  the  quantity 
produced. The example presented in box III.1.1 is 
neutral on the way to achieve this new equilibrium. 
For  example,  the  increase  in  quantity  can  be 
achieved  through  the  addition  of  new  capacity 
(investments). An alternative would be to maintain 
some capacity  from the transition phase, provided 
they  have  the  right  flexibility  and  CO2  emissions 
characteristics  and  the  (stranded)  cost  of  keeping 
them is not too high (57). 

(57)  It  is  noted  that  the  extent  of  capacity  adjustments  will 
depend  also  on  the  evolution  of  the  future  electricity 
demand. 

52 

 
 
                                                           
Reconciling markets with investment signal: which market arrangements? 

Part III 

53 

(Continued on the next page) 

 
 
 
 
 
 
Reconciling markets with investment signal: which market arrangements? 

Part III 

Box (continued) 

(Continued on the next page) 

54 

 
 
 
 
 
Reconciling markets with investment signal: which market arrangements? 

Part III 

Box (continued) 

55 

(Continued on the next page) 

 
 
 
 
 
Reconciling markets with investment signal: which market arrangements? 

Part III 

Box (continued) 

1.1.2.  Impact of Demand Response  

their  consumption  pattern 

Demand response enables consumers to change 
voluntarily 
in 
response  to  market  signals.  Consumers  can  also 
themselves (or through aggregators) place bids on 
power  exchanges (58)  and  thereby agree  to  change 
their  demand  for  electricity  at  a  given  point  in 
time (59). In practice, consumers would be asked to 
decrease 
the  power 
their  consumption  when 
system  is  facing  a  stress  or  peak  and  incentivised 
to  consume  in  periods  of  low  demand  or  over-
capacity. Demand response allows also consumers 
to reveal their willingness to pay during periods of 
scarcity, which would provide reliable information 
to investors with respect to investments in peaking 
capacities. 

With the development of demand response, the 
revenue  streams  for  the  different  technologies 
can  be  expected  to  slightly  decrease  or  remain 
equivalent (60)  to  the  previous  situation  with 
inelastic  demand,  while  revenue  needs 
in 
peaking technologies would decrease. This effect 
is shown in Graph III.1.1, where demand response 
tends  to  increase  consumption  during  semi-base 

(58)  in particular, in the intraday or balancing markets, as these 
prices  are  more  likely  to  reflect  the  price  differential 
required to incentivise consumers to reduce their load. 

(59)  European Commission (2013 b) 
(60)  Due to the fact that an increase in demand in base or semi 
base  load  periods  will  increase  their  relative  prices 
compared to the scenarios without demand response.  

load and base-load periods where prices are lower 
at the detriment of the peak period. 

Graph III.1.3:  Impact of demand response on the load 

duration curve 

Source: European Commission 

Demand  response  would  also  mitigate  the 
impact  of  the  variability  of  wind  and  PV 
generation  on  market  revenues.  In  the  case  of 
sudden  and  unforeseen  increase  in  wind  or  PV 
generation  (supply  curve  with  sudden  surge  in 
output  in  Graph  III.1.2)  that  normally  would  tend 
to  depress  prices,  the  effect  of  demand  response 
would be to consume more during this period (shift 
demand  from  Q1  to  Q2),  which  is  effectively  a 
transfer of consumption from a higher price period 
to  this  low  price  period.  The  resulting  impact  on 
the  different  technologies  would  be  overall  less 

56 

 
                                                           
 
 
 
 
 
Reconciling markets with investment signal: which market arrangements? 

Part III 

revenue  for  power  producers  (61).  The  opposite 
would happen in case of a sudden decrease of wind 
or  PV  power  generation  that  could  trigger  high 
prices; the effect of demand response would be to 
absorb  this  decrease  in  production  by  shifting  the 
consumption  to  other  periods  (from  Q1  to  Q3), 
hence  preventing  periods  of  scarcity  pricing. 
Assuming  schematically  an  equal  probability  of 
sudden positive or negative output of wind and PV 
production,  the  development  of  demand  response 
would  tend  to  mitigate  their  effect  on  market 
revenues. 

Graph III.1.4:  Short-run impact of demand response on the 

sudden changes of power outputs 

represents  the  observation  that  the  cost  of  a 
technology  decreases  by  a  certain  amount  with 
every doubling of installed capacity (62). Each time 
a  unit  of  technology  is  manufactured,  some 
knowledge  and  learning  accumulates  that  makes 
the  future  technology  units  cheaper  to  produce. 
This  concept  is  also  used  to  extrapolate  cost 
reductions  to  future  cumulative  production  levels 
and  assess 
investment"  which 
corresponds to the difference between the costs of 
the  entrant  technology  and  the  cost  of  incumbent 
technologies (63)  (Graph  III.1.3).  Without  learning 
effects to compensate for the revenue decrease, no 
investments  would  take  place  or  public  support 
would be needed. 

the  "learning 

Graph III.1.5:  Cost development of an entrant and an 

incumbent technology 

Source: European Commission 

1.1.3.  The  dynamic 

transition: 
of 
addressing  the  competitiveness  of  new 
technologies 

the 

Most  low  carbon  technologies  in  the  transition 
phase  are  entrant  technologies,  which  are  not 
yet  fully  competitive  in  the  market  (e.g.  off-
shore  wind,  advanced  bio-power,  carbon  capture 
and storage). Therefore, the level of fixed costs is 
influenced  by  the  degree  of  maturity  of  these 
technologies  and  also  their  capacity  of  further 
decreasing  costs.  This  means  that,  as  regards  the 
dynamic  of  the  transition,  the  investments  in  the 
different 
the 
transition  phase  and  decarbonised  phase  will 
depend  on  the  capacity  of  these  technologies  to 
reduce their costs proportionally to the decrease in 
revenues that occurs during this transition through 
the different stages.  

technology  mixes 

composing 

This  cost  reduction  should  take  place  notably 
learning  effects.  Learning  effects 
through 

(61)  The  extent  of  this  expected  decrease  will  depend  on  the 
level  of  demand  elasticity  as  lower  prices  can  lead  to 
higher consumption. 

57 

Source: JRC, European Commission 

Learning  effects  are  realised  through  research 
and  innovation,  but  can  also  be  incentivised  by 
support  to  deployment (64).  The  rationale  is  that 
deployment  of  these  new  technologies  increases 
further 
the  cost 
deployment 
as 
mentioned by Stern (2006), reversing the causation 
may  lead  to  disappointing  results,  hence  the  need 
to 
these  new 
technologies to minimise the costs of development. 

the  potential  of 

costs.  However, 

reflect  on 

suggesting 

reduction, 

decreases 

that 

(62)  Wene, C.-O. (2000). 
(63)  JRC (2012). 
(64)  This  has  been 

the  approach 

to  support  renewable 
development  in  the  EU.  The  revised  State  aid  Guidelines 
take  account  the  different  level  of  maturity  of  renewable 
technologies and acknowledge the need to expose the most 
mature ones to market signals. 

 
 
                                                           
 
                                                           
Reconciling markets with investment signal: which market arrangements? 

Part III 

1.2. 

INVESTMENT CRITERION IN LOW CARBON 
TECHNOLOGIES 
IN  A  CHANGING 
ELECTRICITY SYSTEM 

rents during the different periods of time of a year 
and over the entire project life time shall cover its 
fixed costs. 

1.2.1.  The decision to invest 

The  investment  decision  is  based,  and  will 
remain based, on the expected profits. To invest 
in any technological projects, investors require that 
revenues recoup at minima the total costs incurred 
during  the  project  life  time  (e.g.  technical  or 
economic  life)  of  the  project.  This  investment 
criterion  can  be  reformulated  into  the  following 
revenue/cost expenditure balance as follows: 

or  

∑   

      (∑   

    )

∑

    ∑

∑ ∑

  ∑

   :  infra-marginal  rent  for  technology  i 

With    
during period t and in year y 

1.2.2.  Quantification 
criterion 

of 

the 

investment 

Investing in low carbon technologies (for which 
the  fixed  costs  account  for  about  70%  of  their 
total  costs)  under  market  conditions  and 
without any support will depend on the relative 
cost levels of these technologies compared to the 
other  technologies  of  the  system.  An  important 
aspect  will  be  their  learning  potential  over  time, 
i.e.  the  ability  to  accommodate  for  the  decreasing 
rate  of  revenues  through  cost  reduction    as  the 
energy  transition  progresses  (from  the  convention 
phase to the decarbonised phase). 

       ∑

 > 0 

with 

      {∑   

  (∑    

)} 

With: 

  : Annual profit for technology i, in EUR/yr in 

year y 

PLT : project life time (in year) 

d: discount rate 

t:  index  of  a  demand  period  of  a  year,  e.g.  base, 
medium and peak 

     :  Revenue  for  technology  i  during  demand 
     can  be  written  as 
period  t  and  in  year  y.    
   is  the  equilibrium  price  for 
    is the energy quantity 
  and   

   ,  where,    
demand t (in     
generated  by  technology  i  during  the  demand 
period t in  Wh   and in year y. 

:  Annual  total  costs  for  technology  i  in 

∑    
year  y,  in  EUR/yr.  This  is  equal  to∑   

   :  Variable  cost  of  technology  i,  in 
   Annual  fixed  cost  of  technology  , 

E  

 ,  with    
  and     
in EUR/yr, in year y. 

This  investment  criterion  implies  that  revenues 
acquired  by  technology  i  through  infra-marginal 

58 

 
  
 
      
   
   
  
   
 
   
   
 
   
  
  
  
   
     
   
 
   
 
 
   
  
     
    
     
 
 
   
  
 
 
   
  
        
   
   
   
 
        
   
   
 
  
   
        
 
   
   
   
   
 
        
   
   
 
Reconciling markets with investment signal: which market arrangements? 

Part III 

59 

(Continued on the next page) 

 
 
 
 
 
 
Reconciling markets with investment signal: which market arrangements? 

Part III 

Box (continued) 

(Continued on the next page) 

60 

 
 
 
 
 
Reconciling markets with investment signal: which market arrangements? 

Part III 

Box (continued) 

of 

low 

cost  performance 

carbon 
The 
technologies  is  improving  over  time,  which 
means  that  they  would  be  able  to  cover  an 
increasing  part  of  their  costs  through  the 
market  in  the  future.  This  is  explained  by 
research  and  innovation  efforts  that  decrease  the 
cost  of  technologies  over  time  as  well  as  the 
expectation  of  increasing  fuel  prices  and  CO2 
prices  in  the  long  run.  For  mature  technologies 
such  as  onshore  wind,  market  revenues  as 
modelled  with 
assumptions 
presented  in  Box  III.1.2  would  be  sufficient  to 
cover investment costs by 2020 and 2030.  

the  optimistic 

the 

low 

Nonetheless,  most 
carbon 
of 
technologies  will  not  be  competitive  during  the 
transition phase. A price gap is likely to remain 
for  less  mature  low  carbon  technologies  until 
2030,  which  will  prevent  them  to  cover  their 
total cost with market revenues. This means that 
investors  would  not  have  incentives  to  invest  in 
these  market 
technologies  under 
low  carbon 
conditions,  unless  the  price  gap  is  expected  to  be 
covered over time. 

Graph III.1.6:  Estimated mark-ups for low carbon 

technologies with Open gas Cycle Turbine as 
a marginal producer 

Source: European Commission 

61 

1.3.  CONCLUDING REMARKS 

The  success  of  the  transition  depends  on  the 
capacity  of  the  low  carbon  technologies  to 
reduce  their  costs  and  to 
improve  their 
integration  into  the  power  system.  The  cost 
performance  of 
is 
low  carbon 
improving  over  time  due  notably  to  learning 
effects.  Nonetheless,  most  of 
low  carbon 
technologies  will  not  be  competitive  during  the 
transition phase which means that investors would 
not  have  incentives  to  invest  in  low  carbon 
technologies under these market conditions, unless 
the price gap is expected to be covered over time. 

technologies 

low  carbon  technologies 

Under the current market arrangements which 
include  institutional  barriers,  the  increasing 
penetration  of 
is 
changing  the  way  the  market  is  functioning.  In 
the  short  to  medium  term,  further  investments  in 
low carbon technologies are likely to result in price 
decreases.  Without  parallel  exit  of  sufficient 
conventional  capacity,  this  would  also  result  in 
over-capacities that would further decrease prices. 
Both effects would contribute to the emergence of 
specific investment challenges to be addressed.  

the 

energy 

transition 

As 
approaches 
completion,  the  cost  structure  effect  of  low 
carbon  technologies  is  setting  prices  for  most 
part  of  the  year,  putting  a  strong  emphasis  on 
very  high  (and/or  frequent)  price  spikes  to 
allow  recoup  investment  costs.  Considering  the 
uncertainty  of  these  price  spikes,  notably  due  to 
factors  such  as  public  acceptance,  regulatory 
intervention  to  prevent  market  power,  low  price 
caps set in power markets, the cost structure effect 
of low carbon technologies risks being dominating 
which  could  induce  a  lower  equilibrium  price  on 
the wholesale market, challenging further the way 
investment  costs  are  recouped.  This  development 
would be influenced by the carbon price.  

020406080100120140Off-shore WindturbineNuclearHydropowerCoal with CCSOnshore wind€/Mwhel201120202030 
 
 
 
 
 
 
2.  MARKET ARRANGEMENTS THROUGH THE ENERGY 

TRANSITION 

The investment conditions for new technologies 
will  be  evolving  significantly  as  the  energy 
transition  progresses 
III.1). 
Investment  decisions  are  system  dependent. 
Therefore,  for  investments  to  happen,  it  requires 
market  frameworks  that  match  over  time  the 
economics of power systems with higher levels of 
decarbonisation.  

chapter 

(see 

This chapter analyses the investment conditions in 
two  power  systems  representatives  of  the  middle 
point and end point of the energy transition: power 
systems  under  decarbonisation  and  decarbonised 
power  systems.  This  corresponds  to  the  transition 
phase  and  decarbonised  phase  of  section  III  1.1 
respectively.  Section  1  summarises  investment 
challenges for the transition phase and investigates 
possible  market  arrangements  to  strengthen  the 
market  framework.  Section  2  performs  a  similar 
analysis  for  the  decarbonised  phase.  Section  3 
concludes.  

2.1.  CURRENT TRENDS 

A  well-integrated  internal  energy  market  with 
increasing  demand  response  and  decarbonisation 
of  energy  supply  is  the  cornerstone  of  the  EU 
strategy  to  achieve  a  low  carbon  economy  by 
2050.  

in 

The starting point of this analysis is, therefore, 
the  current  market  model  pursued 
the 
European  Electricity  Target  Model (65)  and 
characterised by an increased integration of power 
markets  at  EU  level  with  more  cross-border 
interconnections 
regional 
cooperation.  Under  this  market  framework,  prices 
are  determined  under  the  marginal  cost  pricing 
principle,  although  wholesale  prices  are  currently 
capped  either  by  regulations  or  through  rules 
imposed by power exchanges. Demand response is 

enhanced 

and 

progressively  deployed  pushed  notably  by  the 
regulatory framework (66). 

The  current  market  framework  also  includes 
CO2  pricing  through  the  European  Emission 
Trading  System  (ETS).  The  European  Council 
has  agreed  to  strengthen  the  ETS  through  the 
introduction  of  a  market  stability  reserve  and  a 
faster reduction of the number of allowances as of 
2021,  by  increasing  the  annual  linear  reduction 
factor which determines the EU ETS cap.  

The  market  framework  is  also  complemented 
by  various  interventions  on  the  market.  For 
instance,  national  market  support  schemes  aim  at 
fostering  investments  in  low  carbon  technologies. 
Capacity mechanisms in some Member States aim 
at  incentivising  investments  to  ensure  that  a 
sufficient  amount  of  capacity  will  be  available. 
Rules  for  both  types  of  support  schemes  are 
included  in  the  guidelines  on  State  aid  for 
environmental  protection  and  energy  2014-2020 
and  a  number  of  Communications  from  the 
Commission (67). 

2.2.  CHALLENGES  FOR 

INVESTMENTS  AND 
OPTIONS 
IN  POWER  SYSTEMS  UNDER 
DECARBONISATION (TRANSITION PHASE) 

2.2.1.  Challenges  

A  key  challenge  for 
investors  under  the 
transition  phase  might  be  the  decrease  of 
market revenues triggered by the penetration of 
low carbon technologies. This phenomenon is due 
to  the  capacity  adjustment  and  revenue  reduction 
effects  identified  in  section  III  1.1.  This  expected 
decrease  in  market  revenues  might  risk  stifling 
investments  and/or  increasing  their  cost  through 
higher  market  premiums,  while  deteriorating  the 
financial positions of existing power plants. At the 
same time, the risk of "non-investments" due to the 
decrease of market revenues might place a risk of 

(65)  Network codes are the main vehicles for implementing the 
Target Model. There are ten network codes currently under 
development,  grouped 
three  main  categories: 
into 
Connection  Codes,  Operational  codes  and  Market  codes. 
https://www.entsoe.eu/major-projects/network-code-
development/Pages/default.aspx 

(66)  This  includes  the  Electricity  Directive  (2009/72/EC),  the 
Energy  Efficiency  Directive 
the 
development  of  network  codes  for  the  internal  electricity 
market  (particularly  those  on  demand  connection,  system 
operation and balancing) 

(2012/27/EU),  and 

(67)  European  Commission  (2013  b),  European  Commission 

(2013 c), European Commission (2013 d) 

62 

 
                                                           
                                                           
Reconciling markets with investment signal: which market arrangements? 

Part III 

issue 

intervention  and 

level  of 
degree  of  public 
to 
competition.  An  additional 
strengthen  price 
signals  based  on  market 
arrangements  to  cover  the  price  gap  that  remains 
for  some  low  carbon  technologies  in  the  most 
effective  way,  while  incentivising  investments  in 
flexible solutions to ensure security of supply.  

is  how 

By  definition, 
the  objective  of  market 
arrangements  should  be  to  minimise  public 
support in order to make the penetration of low 
carbon technologies cost effective for consumers 
and society at large. Market integration and price 
signal  are  obvious  solutions  as 
they  would 
incentivise  investments  when  necessary  while 
increasing  competition.  More  challenging  is  to 
address  the  competitiveness  gap  of  most  of  new 
low  carbon  technologies.  The  carbon  price  is 
expected  to  orient  investments  towards  clean 
technologies. However, its low level might not be 
sufficient  to  trigger  these  investments.  Any  other 
form of interventions would need to be designed in 
a way that would not weaken the wholesale market 
price signal.  

In  this  context,  i.e.  during  the  transition  to  a 
decarbonised  system,  three  strands  of  market 
arrangements could be explored: 

  Reinforcing  the  price  signal  through  scarcity 

pricing 

  Reinforcing 

the  price 

to  orient 
investments  in  clean  technologies  through  the 
carbon price 

signal 

security  of  supply  and  of  increasing  need  for 
market support with impact on consumer bills and 
potentially also on public finances. 

the 

revenues  during 

Less  mature 
low  carbon  technologies  will 
continue  to  suffer  from  a  price  gap  that  will 
prevent  them  to  cover  their  total  costs  from 
transition 
market 
phase (68).  Investments  in  these  technologies  will 
therefore  not  take  place  under  market  conditions. 
This  poses  a  challenge  to  public  authorities  to 
improve the cost-effectiveness of support schemes 
to 
and  make 
integrate  low  carbon  technologies  in  the  market. 
This  effect  will  be  enhanced  by  the  revenue 
compression  occurring  when  the  share  of  low 
carbon technologies is increased.  

them  more  market-based,  and 

through 

investments 

Under the transition phase, there will also be a 
need to manage an over-capacity in generation. 
As  the  energy  transition  is  pushed  by  the  policy 
objective  of  decarbonisation,  this  will  mean  that 
there  will  be  an  overcapacity  in  fossil  fuel 
generation  to  manage,  while  maintaining  security 
in  flexibility 
of  supply 
solutions  such  as  demand  response,  flexible 
generation, 
expansion. 
Disinvestments  are  currently  taking  place  limited 
to some extent by existing exit barriers and mostly 
in  gas-fired  power  plants  as  a  result  of  low 
wholesale  and  CO2  prices  together  with  low  coal 
and  higher  gas  prices.  This  may  pose  a  challenge 
in  terms  of  security  of  supply  as  these  gas  plants 
are the most flexible generation units, which play a 
key role in maintaining the reliability of the power 
system (69). 

storage 

grid 

and 

2.2.2.  Different forms of market arrangements 

investment  challenges 

The 
identified  above 
would  intensify  without  adjustments  to  the 
the 
current  market 
decarbonisation  of  the  European  power  systems 
progresses through the transition phase in line with 
the EU Energy and Climate Agenda. 

framework 

as 

The  effectiveness  of  the  market framework  can 
be  analysed  through  the  following  dimensions:  
level  of  price  and  market  risks  for  an  investor, 

(68)  Mature 

technologies  such  as  onshore  wind  become 

competitive on the market under the transition phase. 

(69)  Ben Caldecott (2014) 

63 

  Continuing  European  Market  Integration  to 
reduce  market  fragmentation  and  benefit  from 
economies of scale and scope 

Reinforcing  the  price  signal  through  Scarcity 
pricing 

Market  prices,  if  not  restricted,  signal  the 
market  value  of  investments  according  to  the 
need of the system. When investments are needed 
in  order  to  cope  with  sudden  demand  or  supply 
variations,  prices  will  be  allowed  to  increase 
during  these  times  thereby  indicating  to  potential 
investors  the  need,  through  scarcity  prices,  for 
solutions with the right characteristics (e.g. flexible 
power plants, demand response, storage).  

 
                                                           
Limiting  the  price  signal (70)  undermines  the 
capability  of  the  market  to  generate  scarcity 
prices,  thereby  limiting  the  rents  that  are 
required to cover the total costs of investments. 
This leads to a shortfall of revenues to finance new 
generation  investment.  Higher  price  variability  is 
also important for demand response, as it acts as an 
incentive  for  consumers  to  become  active  during 
critical periods, while also incentivising the use of 
storage. 

Wholesale  prices  could  therefore  be  allowed  to 
reflect  consumers’  willingness  to  pay  and  to 
value investments according to the needs of the 
system in order to ensure welfare maximisation. 
An  indicator  for  this  willingness  to  pay  is  the 
Accurately 
Value-of-Lost-Load 
estimating  VOLL  is  challenging  as  it  depends  on 
multiple  factors  such  as  the  type  of  customer 
affected, 
regional  economic  conditions  and 
demographics,  time  and  duration  of  outage,  and 
the structure of economic activities etc. (71) 

(VOLL). 

the  price 

Reinforcing 
to  orient 
investments  in  clean  technologies  through  the 
carbon price 

signal 

Investment  in  electricity  is  expected  to  play  a 
fundamental  role  in  the  decarbonisation  of  the 
economy.  The  external  costs  of  low  carbon 
technologies  is  lower  than  that  of  fossil  fuels  and 
the  market  price  should  be  able  to  reflect  the 
overall  different  social  costs  of  the  technologies. 
The  carbon  price  changes  the  relative  costs 
between  technologies  (see  Chapter  II.2)  and  it 
helps  to reduce  emissions  in  a  cost effective way. 
Hence,  a  sufficiently  high  carbon  price  would 
induce  a  switch  to  cleaner  energy  sources  (i.e. 
switch from coal to gas and/or renewables).  

Achieving  high  levels  of  decarbonisation  in  the 
power sector requires a portfolio of low carbon 
technologies.  Several  of  these  key  technologies 
will  not  yet  have  reached  a  sufficient  cost 
performance  during 
to 
the 
generate enough revenues to cover their total costs. 
The CO2 price in the ETS will increase the cost of 
thereby 
fossil 

technologies,  and 

transition  phase 

fuel  based 

(70)  It  is  noted  that  it  is  not  only  a  question  of  technically 
limiting  the  price  signal.  Fear  of  investors  of  future 
regulatory intervention may prevent also high prices. 

(71)  LEI (2013) 

Reconciling markets with investment signal: which market arrangements? 

Part III 

contribute to cover the relative price differential of 
less  mature  low  carbon  technologies.  It  improves 
the  competitiveness  of  low  carbon  technologies, 
and  thus  supports  the  energy  transition.  The 
recently agreed reforms of the ETS as of 2020 are 
expected to strengthen the carbon price signal (see 
Box III.2.1). 

The  need  for  additional  price  mark-up  will 
diminish over time as the competitiveness of low 
carbon technologies is improved. A higher CO2 
price in the ETS, which is likely in the long run, 
would  also  contribute  (graph  III.2.1).  Mature 
technologies  such  as  wind  on-shore  will  not 
require  additional  support  towards  2020.  For  less 
mature  technologies,  the  additional  CO2  price 
required by 2020 would range from 50 to 150 EUR 
per tonne of CO2 on top of the 20 EUR/tCO2. By 
2030,  the  mark-up  is reduced  for  most of  the  low 
carbon  technologies  due  to  learning  effects.  The 
price differential ranges from 20 to a bit more than 
50 EUR/tCO2 on top of the CO2 price assumed in 
the  reference  case.  These  estimates  are  only 
indicative  and  should  be  read  as  an  order  of 
magnitude. 

Graph III.2.1:  Estimated mark-ups in EUR/tCO2 for low 

carbon technologies under a marginal price 
regime 

Source: SETIS (2015), Own calculation 

Continuing European Market Integration  

Market  integration  is  fundamental  to  ensure 
optimised and cost-effective investments for the 
energy transition. The interconnections contribute 
to  a  better  utilization  of  existing  transmission 
infrastructure and help to reduce the intermittency 
of supply induced by variable technologies, hence 
reduce price  volatility.  The  increase  in  the size  of 
the  energy  market  also  reduces  the  need  for 
investment  in  back  up  generating  capacity  and 

64 

050100150200250Off-shore WindturbineNuclearHydropowerCoal with CCSOnshore windMark-up in €/tCO2201120202030 
                                                           
 
Reconciling markets with investment signal: which market arrangements? 

Part III 

Table III.2.1:  Dispersion* in the EU electricity sector: price and market support 

CWE region is composed of Austria, Belgium, France, Germany and the Netherlands. Nordic region is composed of 
Denmark, Finland; Norway and Sweden. SWE region is made of Portugal and Spain 
¨Note: Dispersion is measured by the coefficient of variation. The higher the coefficient, the higher the dispersion across 
Member States.  
Source: Platts, Ecofys, Eurostat 

provides  greater  liquidity  of  wholesale  markets. 
Finally, 
among 
generators (72). 

competition 

increases 

it 

The  expected  benefits  of  market  integration 
translate  into  cost  and  price  reduction  for 
consumers.  Increased  competition  is  expected  to 
decrease  mark-ups,  which  translates  into  lower 
prices.  Empirical  analysis  shows  that  market 
opening and competition appear to have significant 
downward  effects  on  consumer  prices  (both 
households  and  industry) (73).  In  addition  market 
integration 
costs. 
According  to  some  estimates,  the  net  economic 
benefits from the completion of the internal market 
mainly  refers  to  cost  savings (74)  and  ranges  from 
13  to  40  billion  Euros  per  year  by  2030. (75)  The 
basis for these estimates is a higher level of market 
integration  than  today  through  market  coupling, 
that  remains  based  on  national  self-sufficiency 
with only short term arbitrage.  

contributes 

lowering 

to 

Price convergence is another expected outcome 
of  market  integration  as  domestic  and  foreign 
prices  should  progressively  equalise  according  to 
the  most  efficient  supplier (76).  Hence,  the  degree 
of price convergence is used as a good indicator of 
market  integration.  However,  in  the  case  of 

electricity, national factors such as the energy mix 
play  an  important  role  and  will  influence  the 
resilience  of  economies  to  external  price  shocks. 
Despite 
in  well-functioning 
markets,  the  convergence  of  retail  price  should 
mirror the convergence of wholesale prices. 

limitations, 

these 

in 

Electricity  wholesale  market  exhibits  low  price 
dispersion.  The  dispersion  of 
the  day-ahead 
wholesale  price 
thirteen  European  power 
exchanges (77)  was  about  20%  in  the  2008-2014 
period.  The  day-ahead  price  convergence  is  even 
higher within the seven regional markets launched 
in  2006  by  the  European  regulators,  with  price 
dispersion levels below 10% (78) (Table III.2.1). 

Retail  price  dispersion  has  increased  between 
2008  and  2014  for  industrial  customers  and 
households. It is also higher than for the wholesale 
market,  which  can  be  explained  by  the  fact  that 
taxes  and  levies  are  managed  at  national  level. 
Nevertheless, price dispersion remains higher even 
when taxes and levies are excluded, indicating that 
the relative higher dispersion of retail prices can be 
attributed to other factors than the fragmentation of 
the wholesale market (Table III.2.1). 

(72)  ECF (2012) 
(73)  European Commission (2014 b). 
(74)  E.g.  fuel  costs,  annualised  generator  capital  costs,  and 

annualised transmission capacity capital cost 

(75)  Study  commissioned  for 

the  Commission.  Booz  & 

Company (2013) 

(76)  European  Commission  (2007),  Kalantzis  and  Milonas 

(2010) 

(77)  APX,  BPX,  EPEX,  EXAA,  ELEXON,  NordPool,  OTE, 

PolPX, DESMIE, GME, OMEL, OPCOM, OTE 

(78)  Seven regional markets defined as Central-West, Northern, 
the  United  Kingdom  and  Ireland,  Central-South,  South-
West, Central East and Baltic. Further price convergence is 
expected due to the Multi-Regional Coupling initiative that 
started  in  2014  and  covers  19  countries  in  March  2015. 
http://www.epexspot.com/en/market-coupling 

65 

2008200920102011201220132014Market support Renewable (excl. Hydropower)99%83%84%96%82%--Electricity retailIndustry (excl. Taxes) - consumption 500-2000 MWh27%24%27%29%33%30%30%Industry (excl. VAT)  - consumption 500-2000 MWh26%23%25%27%31%28%29%Households (excl taxes)  - consumption 2500-5000 kWh25%24%22%23%27%26%27%Households (excl. VAT)  - consumption 2500-5000 kWh31%29%27%29%30%28%31%Electricity Wholesale Spot prices19%16%15%11%21%17%20%CWE Region3%5%3%2%5%12%9%Nordic region11%5%4%3%11%4%11%SWE region6%1%0%2%1%1%2%* Price dispersion is measured by the coefficient of variation (standard deviation divided by the mean). 
                                                           
                                                           
 
 
 
Reconciling markets with investment signal: which market arrangements? 

Part III 

requirements to ensure beneficiaries are integrated 
into the market. 

Graph III.2.2:  Degree of harmonisation of national market 

intervention 

By  contrast,  the  high  dispersion  of  public 
support  reflects  the  fragmentation  of  the 
market  (Table  III.2.1).  A  large  part  of  the 
incentives  for  investments  in  security  of  supply 
and  decarbonisation  are  promoted  through  public 
support  within  national  borders.  The  dispersion 
shows  consistent  high  levels  from  2008  to  2012, 
reflecting  the  management  of  these  schemes  at 
national level. 

2.2.2.1.  Instruments 

Source: European Commission 

R&I support and market pull measures need to 
be  synchronised  to  effectively  unlock  the  cost 
reduction  potential  of  less  mature  low  carbon 
technologies,  flexible  solutions  and  demand 
services.  Relying  on  market  based  instruments  is 
critical  in  this  period  of  transition  in  order  to 
ensure that investments are guided by the specific 
needs  of  the  system  through  the  indication  of  the 
price  signals.  This  will  give  benefits  from 
competition  to  keep  cost  in  check.    Other  gains 
include  promotion  of  innovation  in  technologies, 
services and business models. 

long 

for  when 

life  time  of  energy 
Considering  the 
investments,  the  long  term  evolution  of  the 
economics  of  the  power  system  should  be 
accounted 
selecting  market 
arrangements  in  the  short  to  medium  term.  In 
particular, the decrease in market prices due to the 
increased  penetration  of  low  carbon  technologies, 
as  described  under  section  III  1.1,  is  expected  to 
intensify  as  European  power  systems  complete 
their decarbonisation process. This can be foreseen 
to have a strong impact on market revenues. 

implemented 

the  Europeanisation 

Reinforcing price signal and market integration 
are a way to drive further the energy transition 
in  a  cost  effective  way.  The  different  strands  of 
market  arrangements  can  be 
in 
different  ways.  Scarcity  pricing  could  be 
implemented, for instance, by setting price caps at 
VoLL  or  implementing  scarcity  pricing  through 
Operating  Reserves (79).  Similarly,  different 
degrees  of  harmonisation  could  be  considered 
regarding 
of  market 
interventions  (Graph  III.2.2).  For  instance,  under 
the  full  harmonisation  option,  design  elements  of 
low carbon technology market support or capacity 
eligible 
remunerations 
technologies,  capacity  cap,  support  and  duration 
levels,  operating  rules  would  be  decided  and 
implemented  at  EU 
level.  The  minimum 
harmonisation  option  is  similar  to  the  approach 
currently  undertaken 
the  State  Aid 
guidelines  for  environment  and  energy.  In  this 
case, all the design elements and operating rules of 
the  schemes  remain  determined  at  national  level. 
However, they could follow guidelines at EU level 
that  also  impose  minimum  requirements  such  as 
cross-border  participation,  competitive  allocation 
of support, competition between technologies, and 

schemes 

through 

such 

as 

(79)  William W. Hogan (2013) 

66 

00.511.522.53Support schemeDecision of designelementsDecision on supportlevelFull (EU-wide)medium (MS with EU requirement)Soft (MS) 
                                                           
 
Reconciling markets with investment signal: which market arrangements? 

Part III 

67 

(Continued on the next page) 

 
 
 
 
 
 
Reconciling markets with investment signal: which market arrangements? 

Part III 

Box (continued) 

(Continued on the next page) 

68 

 
 
 
 
 
Reconciling markets with investment signal: which market arrangements? 

Part III 

Box (continued) 

discussed  under  Part  III.1.1  and  shown  under 
graph III.2.4 is that the marginal cost never crosses 
the  average  cost,  hence  pricing  at  marginal  cost 
would  lead  to  an  economic  loss  for  generators. 
This is a noticeable difference with a conventional 
power  system  as  shown  in  Graph  III.2.3,  which 
exhibit increasing average costs that allows for an 
equilibrium to be found between the marginal cost, 
average  cost  and  demand.  This  revenue  shortfall 
will  be  strongly  dependent  on  the  frequency  and 
intensity of price spikes in the future. However, in 
the  decarbonised  phase,  it  is  uncertain  if  these 
price spikes will be feasible and enough or allowed 
to be high enough to recoup the fixed costs. 

Under  the  decarbonised  phase,  the  decreasing 
level  of  CO2  emissions  of  the  technology  mix 
will reduce the social cost of the power system.  . 
In  a  decarbonised  system  which  mainly  applies 
clean technologies on the margin, the carbon price 
will  have  less  influence  on  wholesale  market 
prices. As  a  result,  the  role  of  the  carbon  price  to 
low-carbon 
generate 
technologies can be expected to be reduced. 

infra-marginal 

rents 

for 

2.3.  CHALLENGES  FOR 

INVESTMENTS  AND 
OPTIONS  UNDER  DECARBONISED  POWER 
SYSTEMS (DECARBONISED PHASE) 

2.3.1.  Challenges  

In  a  future  decarbonised  system,  the  effectiveness 
of  the  market  framework  can  also  be  assessed 
through  the  incentives  investors  get  from  market 
signal,  the  degree  of  public  intervention  and  the 
level of competition. Compared to stage 2, most of 
technologies  are  expected 
to  have  become 
competitive.  

The  cost  structure  of  the  technology  mix  of 
decarbonised  power 
systems  will  exhibit 
decreasing average cost trend due to fact that low 
carbon  technologies  have  low  variable  costs  and 
fixed costs constitute more than 2/3 of the overall 
costs (see chapter II.2). Nonetheless, conventional 
capacity will be needed to meet high demand and 
account  for  resource  availability  and  the  lack  of 
firmness  of  some  low  carbon  technologies.  This 
will result in merit order curves with steep ends.  

When  technologies  display  decreasing  average 
costs  and  positive  fixed  costs,  assuming  perfect 
competition,  marginal  pricing  may  default  to 
produce  sufficient  revenues  to  cover  the  fixed 
costs of the technologies (80). The main reason as 

(80)  Varian  R.  Hal  (1996),  Baritaud,  M.  (2012),  Finon  D. 

(2013) 

69 

 
                                                           
 
 
 
 
Graph III.2.3:  Cost structure of the technology mix under 
conventional power system 

Source: European Commission 

Graph III.2.4:  Cost structure of the technology mix under 

the decarbonised phase 

Source: European Commission 

2.3.2.  Different forms of market arrangements 

As  in  the  previous  phases,  the  effectiveness  of 
the market framework needs to take account of 
the  price  signal  for  an  investor,  the  degree  of 
public  intervention  and  level  of  competition, 
while  maximising  the  overall  social  welfare.  In 
the  decarbonised  phase,  low  carbon  technologies 
are  expected  to  be  competing  on  the  market.  
Investments in a market environment characterised 
by  technologies  with  high  fixed  costs  and  low 
variable costs will depend on the price signals and 
their  ability  provide  remuneration  to  compensate 
for the structural revenue gap induced by this cost 
structure and uncertainty related to price spikes. 

In this phase, the transition is assumed to have 
been  successfully  completed,  and  the  objective 

Reconciling markets with investment signal: which market arrangements? 

Part III 

of  market  arrangements  would  be  to  ensure 
security  of  supply  in  the  short  and  long  run. 
There  are  currently  few  markets  in  the  world 
which  are  dominated  by  low  carbon  technologies, 
but 
that  ensuring 
investment in the long term is a crucial issue (see 
box  III  2.2).  Any  market  arrangements  should  be 
able  to  deliver  long  term  investments  without 
relying on state interventions or guarantees. 

their  experience 

shows 

70 

-100102030405060701234567891011121314151617181920212223242526€/MWhqMCAVCACDP*Q*-200204060801001234567891011121314151617181920212223242526€/MWhqMCAVCACDP*Q*Revenue Shortfall 
 
 
 
 
Reconciling markets with investment signal: which market arrangements? 

Part III 

71 

(Continued on the next page) 

 
 
 
 
 
 
Reconciling markets with investment signal: which market arrangements? 

Part III 

Box (continued) 

Three  separate  strands  of  market  arrangements 
could be further explored in view of a future fully 
decarbonised power system: 

  Reinforcing  the  price  signal  through  scarcity 

pricing  

  A  wholesale  market  complemented  by  an  EU 

wide capacity market  

  An  EU  wide  market  for  long  term  contracts 

based on average cost pricing  

Reinforcing  the  price  signal  through  scarcity 
pricing 

Reinforcing  the  price  signal  through  scarcity 
pricing  will  become  essential  in  decarbonised 
power  systems  as  the  high  share  of  low  carbon 
technologies  coupled  with  high  demand  response 
will  tend  to  result  in  very  low  prices  during  most 
part  of  the  time.  Prices  should  then  be  allowed  to 
indicate  accurately  and  visibly  through  scarcity 
prices the specific needs for the proper functioning 
of the power system in the short run for periods of 
scarcity  (e.g.  to  trigger  demand  response,  storage 
and  other  forms  of  flexible  solutions)  and  in  the 
long run (e.g. to foster investments). 

A  wholesale  market  complemented  by  an  EU 
wide capacity market  

feature  of 

The  main 
such  a  market 
arrangement  would  be  to  develop,  besides  the 
wholesale market, a market for capacity where 
producers would contract out and be able to get 
a  return  on  the  availability  of  their  capacity. 
Under  this  configuration,  the  wholesale  market  is 
kept to ensure efficient short-term dispatching and 
as  an  indicator  of  the  real  time  value  of  each 
energy  assets  for  signalling  specific  investment 
gaps (e.g. in peak or base load, flexible etc.).  

An  EU  wide  market  for  long  term  contracts 
based on average cost pricing  

The  main  feature  of  this  market  arrangement 
would  be  to  shift  competition  from  the  spot 
market  -  competition  in  the  market  -  to  a  long 
term  contract  market  -  competition  for  the 
market.  Under  this  configuration,  suppliers  are 
required to cover their forecasted demand through 
long-term  contracts  with  low  carbon  generators 
and  flexible  solution  providers.  In  exchange, 
term  contracts  with 
generators  receive 
conditions and terms allowing them to recover the 
total  costs  of  their  investments.  The  short-term 

long 

72 

 
 
 
 
 
Reconciling markets with investment signal: which market arrangements? 

Part III 

In  the  long  term,  it  is  uncertain  whether 
wholesale  prices  based  on  existing  market 
arrangements  will  be  able  to  provide  the 
revenues  necessary  to  cover  the  total  costs  of 
investments and thereby incentivise investments 
in  low-carbon  generation.  In  this  context,  the 
market  design  might  need  to  evolve,  which  could 
entail,  for  example,  scarcity  pricing,  European 
efficient  and 
integrated  markets,  and,  when 
needed,  an  increasing  reliance  on  long  term 
contracts  or  some  form  of  capacity  markets.    On 
the latter option, it remains unclear to which extent 
the  market  itself,  under  current  arrangements,  can 
cater  for 
the 
development  of  new  forms  of  contracts.  These 
changes of the market frameworks can be expected 
to be needed in the next decades. Considering the 
inertia of the energy system and life time of energy 
assets,  this  calls  for  starting  a  reflection  already 
now  on  these  long  term  issues  related  to  the 
electricity market design at the EU level. 

this  development  e.g. 

through 

market in this context acts as a balancing market to 
settle 
contractual 
arising 
differences between generators and suppliers.  

imbalances 

from 

low 

carbon 

technologies, 

Some  regions  of  the  world  such  as  Latin 
America,  where  power  systems  are  dominated 
by 
namely 
hydropower,  have  adopted  markets  for  long 
term  contracts.  One  of  the  main  reasons  often 
cited for this change in market structure is related 
to  the  effect  of  hydropower  plants (81)  on  price 
signals.  Under  power  systems  dominated  by 
hydropower,  it  was  observed  that  prices  mask 
structural  supply  problems.  As  a  result,  price 
increases only when the power system  is about to 
fail, for instance due to a drought that reduces the 
outputs  of  hydropower  plants,  which  does  not 
allow enough time to make investments. (See box 
III.2.2).  Such  market  form  shows  noticeable 
difference  with 
in 
particular,  it  replaces  the  wholesale  market  and 
there is no carbon market. 

today's  EU  markets  as, 

2.4.  CONCLUDING REMARKS 

EU  power  systems  have  entered  an  era  of 
profound  changes.  The  cost  structure  of  low 
carbon technologies is increasingly influencing the 
price  formation  on  the  wholesale  market,  and 
thereby  the  incentives  to  invest  in  energy  assets. 
Therefore,  there  is  a  need  to  ensure  that  market 
designs are not carved in stone but evolve with the 
energy transition.  

In  the  short  to  medium  term,  the  critical 
challenges  are  (i)  to  trigger  investments  in  low 
carbon  technologies  while  making  public  support 
more  focused  and  market-based,  (ii)  to  avoid 
(structural) over/under capacity, while investing in 
flexibility  solutions  and 
the 
competitiveness  of  low-carbon  technologies.  For 
this,  scarcity  pricing,  reinforcing  CO2  prices,  and 
continuing  the  market  integration  are  options  to 
strengthen  price  signals  to  drive  investment  and 
improve  the  efficiency  of  the  current  market 
framework. Hence, these options are solutions that 
can  improve  the  market  functioning  both  in  the 
shorter and longer term. 

foster 

(iii) 

to 

(81)  Hydropower is the dominant supply source in the region. It 
represented  in  2011  52%  of  the  total  installed  capacity  or 
68% of the energy produced in 2011. [1] 

73 

 
                                                           
 
REFERENCES 

ACER (2013), Capacity Remuneration Mechanisms and the Internal Market for Electricity, ACER Report 

Alesina, A., S. Ardagna, G. Nicoletti and F. Schiantarelli (2005), "Regulation and investment", Journal of 
the European Economic Association 3(4): 791-825 

Baritaud, M. (2012), "Securing Power during the Transition: Generation Investment and Operation Issues 
in Electricity Markets with Low Carbon Policies", IEA Energy Papers, No. 2012/13, OECD Publishing.  

Blyth,  W.,  D.  Bunn,  M.  Chronopulos  and  J.  Munos  (2014),  "Systematic  Analysis  of  the  Evolution  of 
Electricity  and  Carbon  Markets  under  Deep  Decarbonisation".  Norwegian  School  of  Economics, 
Department of Business and Management Science Research Paper Series, n° 2014/39 

Boot,  P.A.  and  B.  van  Bree  (2010),  "A  zero-carbon  European  power  system  in  2050:  proposals  for  a 
policy package", ECN-E-10-041, April 2010 

Booz & Company (2013) "Benefits of an Integrated European Energy Market", 20 July 2013. 

Brett,  M.  F.  and  CH.  Hogendorn  (2015),  "The  Marginal  Cost  Controversy",  Journal  of  Economic 
Perspectives — Volume 29, Number 1 — Winter 2015 — Pages 193–206. 

Caldecott, B. and J. McDaniels (2014), "Stranded Generation Assets: Implications for European Capacity 
Mechanisms", Energy Markets and Climate Policy Working Paper. University of Oxford’s Smith School 
of Enterprise and the Environment - January 2014 

Castalia Strategic Advisor (2013), "International Experience with Single Buyer Models for Electricity" - 
Report to Contact Energy - August 2013 

Cochran,  J.,  M.  Miller,  M.  Milligan,  E.  Ela,  D.  Arent  and  M.  Fuctch  (2013),  "Market  Evolution: 
Wholesale Electricity Market Design for 21st Century Power Systems". 

Commissariat  Général  à  la  stratégie  et  à  la  prospective  CGSP  (2014),  "The  Crisis  of  the  European 
Electricity System - Diagnosis and possible ways forward" - January 2014 

Crampton, P., A. Ockenfels and S. Stoft (2013), "Capacity Market Fundamentals", Economics of Energy 
& Environmental Policy, 2:2. 

De  Castro,  J.N.,  R.  Brandão,  S.  Marcu  and  G.  Dantas  (2010),  Market  Design  in  Electric  Systems  with 
High  Renewables  Penetration".  Grupo  de  Estudos  do  Setor  Eletrco,  working  paper  presented  at 
International Conference on Applied Business & Economics. 

DECC  (2011),  "Electricity  Market  Reform  –  Options  for  Ensuring  Electricity  Security  of  Supply  and 
Promoting Investment in Low-carbon Generation" - 12 July 2011 

ECF  (2012),  "From  Roadmaps  to  Reality"  process,  Briefing  note  for  discussion  -  Theme  3:  wholesale 
power markets, 2012. 

ECOFYS, S. A. (2014), "Subsidies and costs of EU energy". ECOFYS. 

EMCC  (2009),  Results  of  the  first  25  days  of  Nordic-German  tight  volume  market  coupling",  Press 
Release Hamburg, 4 December 2009. 

ENTSO-E (2014), "Market Design Policy Paper". Brussels. 

74 

 
References 

Eurelectric (2011), "Integrating Intermittent Renewable Sources into the EU Electricity System by 2020: 
Challenges and Solutions". Brussels: Eurelectric documents. 

Eurelectric  (2014),  "Renewable  Energy  and  Security  of  Supply:  finding  Market  Solutions".  Eurelectric 
Report. 

Eurelectric (2015), "A reference model for European capacity markets", March 2015. 

European Commission (2008), Commission Staff Working Document, "Second Strategic Energy Review 
- an EU Energy Security and Solidarity Action Plan, Energy Sources, Production Costs and Performance 
of Technologies for Power Generation, Heating and Transport". SEC(2008) 2872 

European Commission. (2011). "Impact Assessment accompanying the Communication Energy Roadmap 
2050", SEC(2011) 1565/2 and SEC(2011) 1565. 

European Commission (2012), "The state of the European carbon market in 2012", COM(2012)652. 

European  Commission  (2013a),  Staff  Working  Document  "Generation  Adequacy  in  the  internal 
electricity market - guidance on public interventions", SWD(2013) 438 

European  Commission  (2013b),  Commission  Staff  Working  Document,  "Incorporating  Demand  Side 
Flexibility, in particular Demand Response, in Electricity Markets". SWD(2013) 442 

European Commission (2013 c), Communication Delivering the Internal Energy Market in Electricity and 
making the most of Public Intervention, COM(2013) 7243. 

European  Commission  (2013  d),  Staff  Working  Document  "Guidance  on  the  use  of  renewable  energy 
cooperation mechanism", SWD(2013) 440 

European Commission (2014a). "Electricity Tariff Deficit: Temporary or Permanent Problem in the EU?" 
European Economy, Economic Papers 543. 

European  Commission  (2014b).  "Energy  Economic  Development  in  Europe",  European  Economy 
1/2014. 

European  Commission  (2014c).  "Infrastructure  in  the  EU:  Developments  and  Impacts  on  Growth", 
European Economy, Occasional Papers 203 | December 2014. 

European  Commission  (2014d)  –  "Guidelines  on  State  aid  for  Environmental  Protection  and  Energy 
2014-2020" (2014/C 200/01) 

European  Commission  (2014e),  Communication  "Progress  Towards  Completing  the  Internal  Energy 
Market", COM(2014) 634 final 

European Commission (2014f)  - IMPACT ASSESSMENT – "Energy Efficiency and its contribution to 
Energy Security and the 2030 Framework for Climate and Energy Policy", SWD(2014) 255 

European  Environmental  Agency  (2014),  Trends  and  projections  in  Europe  2014;  "Tracking  progress 
towards Europe's climate and energy targets for 2020", EEA Report, No 6/2014. 

EUROSTAT (2015), Newsrelease 10 February 2015. 

75 

 
 
Eyraud,  L.,  A.  Wan,  C.  Zhang  and  B.  Clements  (2011),  "Who's  going  Green  and  Why?  Trends  and 
Determinants of Green Investments", WP/11/296, IMF. 

Finon D. (2013), “The Transition of the Electricity System Towards Decarbonisation: the need for change 
in the market regime”, Climate Policy, Vol. 12(2012), pp. 1-16. 

Finon,  D.,  &  Roques,  F.  (2013),  European  Electricity  Markets  Reforms:  the  "Visible  Hand"  of  Public 
Coordination. Chaire European electricity Markets CEEM Working Paper. 

Genoese,  F.  and  C.  Egenhofer  (2015),  "Reforming  the  Market  Design  of  EU  Electricity  Markets: 
Proposals to address the Challenges of a Low-Carbon Power Sector", CEPS Task Force Report. 

Giuli,  M.  (2015),  "Capacity  mechanismes  –  A  credibility  test  for  the  Energy  Union",  Policy  Brief, 
European Policy Centre (EPC). 

Green, R. (2004), "Did English Generators Play Cournot? Capacity withholding in the Electricity Pool," 
Working  Papers  0410,  Massachusetts  Institute  of  Technology,  Center  for  Energy  and  Environmental 
Policy Research. 

Green,  R.  and  N.  Vasilakos  (2011),  "The  Long-term  Impact  of  Wind  Power  on  Electricity  Prices  and 
Generating Capacity", University of Birmingham - Discussion Papers, (11)09. 

Griffith, R. (IFS and CEPR) and R. Harrison (IFS) (2004), "The link between product market reform and 
macro-economic  performance" European Economy n°209. 

Grigorjeva, J. (2015), "Capacity mechanisms in the EU: Nationalizing Energy Security", Policy Paper N° 
134, Jacques Delors Institut. 

Haavelmo, T (1960), "A study in the Theory of Investment", The University of Chicago Press. 

Hammons,  T.  J.  (2011),  "Market  Mechanisms  and  Supply  Adequacy  in  the  Power  Sector  in  Latin 
America,  Electricity  Infrastructures  in  the  Global  Marketplace",  (Ed.),  ISBN:  978-953-307-155-8, 
from:  http://www.intechopen.com/books/electricity-infrastructures-in-the-global-
InTech,  Available 
marketplace/market-mechanismsand-supply-adequacy-in-the-power-sector-in-latin-america 

Hartley, P. and A. Moran (2000), "Marginal Costs and Prices in the Electricity Industry", IPA June 2000 

Hauge,  J.  and  D.  Sappington  (2010),  "Pricing  in  Network  Industries",  The  Oxford  Handbook  of 
Regulation. 

Henisz,  W.J.  (2002),  "The  institutional  environment  for  infrastructure  investment,"  Industrial  and 
Corporate Change, Oxford University Press, vol. 11(2), pages 355-389. 

Henisz,  W.J.  and  A.Z.  Bennet  (2001),  "The  Institutional  Environment  for  Telecommunications 
Investment," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 10(1), pages 123-147, 
03. 

Hope,  E.  (2005),  "Market  Dominance  and  Market  Power  -  A  Competition  Policy  Perspective", 
Konkurrensverkets uppdragsforskningsserie. 

IDB  FACT  SHEET  (2013),  "Central  American  Electrical  Interconnection  System  (SIEPAC)  and 
Regional Electricity Market (MER)" 

References 

76 

 
 
References 

IEA (2003), "Power Generation Investment in Electricity Markets", OECD/IEA, Energy Market Reform. 

IEA (2007), "Tackling Investments in Power Generation". 

IEA (2008), "Global Energy Trends", Energy Outlook, Chapter 2, Table 2.3, page 84. 

IEA (2014), "Energy Technology Perspectives 2014", Chapter 2, page 68. 

IEA (2015), "Energy Technology Perspectives 2015". 

Ishii  J.  and  J.  Yan  (2004),  "Investment  under  Regulatory  Uncertainty:  US  Electricity  Generation 
Investment since 1996". CSEM WP 127. 

Jakubiak,  J.  (2004),  "Marginal  Cost  Pricing  Has  Little  Place  in  Electricity  Regulation",    24th  Annual 
North American Meeting of the USAEE/IAEE 

Joint Research Centre. (2013), Technology Map of the European Strategic Energy Technology Plan 2013. 
JRC Science and Policy Reports. 

Jorgenson,  D.W.  (1967),  "Capital  Theory  and  Investment  Behaviour"  in  Determinants  of  Investment 
Behaviour by Robert Ferber, NBER p.129-175 , 1967 

Kalantzis  (2010),  Market  integration  and  price  dispersion  in  the  European  electricity  market,  Energy 
Market (EEM), 2010 7th International Conference on the European 

Keay,  M.  (2013),  "The  EU  "Target  Model"  for  Electricity  Markets:  fit  for  purpose?"  Oxford  Energy 
Comment. The Oxford Institute for Energy Studies. 

Keay, M., J. Rhys and D. Robinson (2012), "De-carbonization of the Electricity Industry: Is there still a 
Place for Markets?" The Oxford Institute for Energy Studies. 

Léautier,  T.  (2013),  "The  Visible  Hand:  Ensuring  Optimal  Investment  in  Electric  Power  Generation", 
IDEI Working Paper Series. 

LEI  (2013),  "Estimating  the  Value  of  Lost  Load"  -  Briefing  paper  prepared  for  the  Electric  Reliability 
Council of Texas, Inc. by London Economics International LLC, June 17th, 20138 

Levy,  B.  and  P.T.  Spiller  (1994),  "The  Institutional  Foundations  of  Regulatory  Commitment:  A 
Comparative  Analysis  of  Telecommunications  Regulation,"  Journal  of  Law,  Economics  and 
Organization, Oxford University Press, vol. 10(2), pages 201-46, October. 

Linklaters (2014), "Capacity Mechanisms. Reigniting Europe's Energy Markets" 

Maurer, L. T. A. and L. A. Barroso (2011), "Electricity Auctions: An Overview of Efficient Practices", 
World Bank 2011 

Malik,  A.  and  S.  Al-Zubeidi  (2006),  "Electricity  Tariffs  based  on  long-run  Marginal  Costs  for  Central 
Grid System of Oman", Energy, 31 (12), 1703-1714 

Mastropietro, P., C. Batlle, L.A. Barroso and P. Rodilla (2013), "Electricity Auctions in South America: 
Towards Convergence of System Adequacy and RES-E Support", IIT Working Paper. September 2013 

77 

 
 
Neuhoff  K,  (2004),  "Large  Scale  Deployment  of  Renewables  for  Electricity  Generation",  OCDE, 
SG/SD/RT(2004)4. 

Neuhoff  K.  and  L.  de  Vries  (2004),  "Insufficient  Incentives  for  Investment  in  Electricity  Generation", 
Cambridge Working Papers in Economics CWPE 0428. 

Neves  Ferreira,  P.  (2013),  "The  Re-regulation  Debate:  Average  vs.  Marginal  Pricing",  Evanston, 
"Wholesale Electricity Markets - Hurdles to overcome" Northwestern University Workshop. 

OECD/NEA.  (2012),  "Nuclear  Energy  and  Renewables:  System  Effects  in  Low  Carbon  Electricity 
Systems". 

OECD  (2014),  "The  Patterns  of  Entry  in  the  Generation  Segment  of  the  Electricity  Supply  Sectors  of 
OECD Countries", WPIEEP (2014)8 final. 

OECD (2015) (forthcoming), "Aligning Policies for the Transition to a Low Carbon Economy", SG/APT 
(2015)1. 

Pikk P. and M. Viiding (2013), "The Dangers of Marginal Cost Based Electricity Pricing", Baltic Journal 
of Economics, 13:1, 49-62. 

Pöyry for the European Wind Energy Association. (2010), "Wind Energy and Electricity Prices". 

Ragwitz, M., J. Winkler, C., M.G. Klessmann and, G. Resch (2012), "Recent Developments of Feed-in 
Systems  in  the  EU"  –  A  research  Paper  for  the  International  Feed-In  Cooperation,  A  report 
commissioned  by  the  Ministry  for  the  Environment,  Nature  Conservation  and  Nuclear  Safety  (BMU)  - 
January 2012 

Rathmann, M. (2007), "Do support systems for RES-E reduce EU-ETS driven prices?",  Energy Policy, 
(35)342-349. 

Roques,  F.,  D.  Newbery  and  W.  Nuttall  (2005),  "Investment  Incentives  and  Electricity  Market  Design: 
the British Experience", Review of Network Economics, Vol. 4, Issue 2. 

Rudinger A., T. Spencer, O. Sartor, M. Mathieu, M. Colomber and T. Ribera (2014), "Getting out of the 
Perfect  Storm:  Towards  Coherence  between  Electricity  Market  Policies  and  EU  Climate  and  Energy 
Goals", IDDRI Working Paper, n° 12/14. 

SETIS (2015) available at https://setis.ec.europa.eu/EnergyCalculator/ 

Staffell,  I.  and  R.  Green  (2012),  "Is  there  still  a  Merit  in  the  Merit  Order  Stack?",  Imperial  College 
Business School. 

Stern, N., (2007). "The Economics of Climate Change: The Stern Review",  Cambridge and New York: 
Cambridge University Press. 

Spiller,  P.T.  and  I.  Vogelsang  (1993),  "Regulation  without  Commitment"  Boston  University  -  Industry 
Studies Programme. 

Stoft, S. (2002), "Power System Economics: Designing Markets for Electricity", IEEE Press. 

Tennbakk, B., J-B. Lafitte, P. Capros, C. Delkis, N. Tasios and M. Zabara (2013), "Capacity Mechanisms 
in Individual Markets witin the IEM", Cowi, E3M-Lab, THEMA. 

References 

78 

 
 
References 

The  Economist,  "How  to  lose  half  a  trillion  euros  -  Europe's  Electricity  Providers  face  an  Existential 
threat", (2013, October 13). 

Tobin,  J.  (1958a),  "Estimation  of  Relationships  for  Limited  Dependent  Variables". Econometrica (The 
Econometric Society) 26 (1): 24–36. doi: 10.2307/1907382. JSTOR 1907382. 

Traber,  T.  and  C.  Kemfert  (2011),  "Gone  with  the  wind?  -  Electricity  Market  Prices  and  Incentives  to 
Invest in Power Plants under Increasing Wind Energy Supply". Energy Economics, (33) 249-256. 

Vagliasindi, M. (2012), "Key Drivers of PPPS in Electricity Generation in Developing Countries", Policy 
Research Working Paper 6118, The World Bank. 

Vassilopoulos, P. (2007), "Les Prix des Marchés de Gros de l'Electricité Donnent-ils les Bons Signaux et 
les Bonnes Incitations pour l'Investissement en Capacité de Production Electrique?", Thèse de doctorat; 
Université Paris Dauphine. 

Varian, H.R. (1996),  "Differential  Pricing and Efficiency",  First  Monday  peer-reviewed  Journal  on the 
Internet, Volume 1, Number 2 - 5 August 1996 

Vyre, C. V. (2014), "Financial Investors and the Unbundling Provisions for TSOs", European Energy and 
Environmental Law Review. 

Weron, R. (2006), Modeling and Forecasting Electricity Loads and Prices. Wiley Finance. 

Hogan,  W.W.  (2013),  "Electricity  Scarcity  Pricing  Through  Operating  Reserves"  Working  paper  in 
Economics of Energy and Environmental Policy, Volume 2 – Number 2 

Wilde,  D.  (2011),  "How  Reliable  is  the  Price  Forming  Mechanism  on  the  European  Energy  Exchange 
(EEX) for the German Wholesale Electricity Market?", University of Dundee. 

79 

 
 
 
GLOSSARY 

Adequacy: power generation (or supply) adequacy can be defined as the ability of the system to meet the 
aggregate power and energy requirement of all consumers at virtually all times.  

Ancillary Services: are those services necessary to support the transmission of capacity and energy from 
resources to loads while maintaining reliable operation of the transmission service provider in accordance 
with  good  utility  practice.  They  refer  to  a  range  of  functions  which  TSOs  contract  so  that  they  can 
guarantee  system  security.  These  include  black  start  capability  (the  ability  to  restart  a  grid  following  a 
blackout); frequency response (to maintain system frequency with automatic and very fast responses); fast 
reserve (which can provide additional energy when needed); the provision of reactive power and various 
other  services.  Some  are  serviced  through  markets,  simultaneously  cleared  with  energy  markets;  others 
are serviced through cost-based mechanisms and do not have markets.  

Balancing refers to the situation after markets have closed (gate closure) in which a TSO acts to ensure 
that demand is equal to supply, in and near real time. 

Base load plants: they are those plants that run continuously all year round with a steady load. In the EU 
they  are  the  lignite  fired  conventional  plants,  gas  fired  combined  cycle  generation,  and,  wherever 
possible, nuclear plants.  

Baseload: it is the minimum basic amount of electricity needed to meet demand.  

Capacity factor: the ratio of the total energy generated by a generating unit for a specified period to the 
maximum possible energy it could have generated if operated at its maximum capacity rating for the same 
period (NERC). 

Conventional plants: the term refers to the non-low carbon technologies, based on fossil fuels (lignite, 
hard coal, natural gas, oil). They usually constitute the mid-range and peaking plants. 

Capacity  mechanism:  capacity  mechanisms  in  general  reward  capacity  providers  for  their  ability  to 
deliver electricity when needed, rather than the actual delivery of electricity, even though various models 
exist.  A capacity market does not need price spikes to induce investments. 

Demand response: refers to a mechanism that enables consumers to change voluntary their consumption 
pattern in response to market signals.  

Dispatchable generation: is electricity produced by those generating plants that can be turned on or off, 
or can adjust their output at the request of the power grid operators. This is not the case, for example, with 
some  types  of  base  load  generation  like  nuclear  power,  which  can't  easily  adjust  its  generation  on 
demand;  or  some  renewable  sources  like  wind  power,  which  can't  be  controlled  by  operators. 
Dispatachable generation is used in order to (but is not limited to) meet peak demand. 

Firm  capacity  is  the  amount  of  energy  available  for  production  or  transmission  which  can  be  (and  in 
many cases must be) guaranteed to be available at a given time. Of the firm capacity available, the actual 
energy guaranteed to be available is referred to as firm energy. Nonfirm energy, in contrast, refers to all 
available energy above and beyond firm energy. 

Flexibility  is  the  ability  to  reconcile  volatile  consumption  and  volatile  generation.  This  implies  a 
capability (e. g. ramping), coupled with a high level of controllability and reliability / availability of the 
power system. 

Gate closure: the moment when contracts are frozen. After gate closure, no trading is allowed anymore 
for  the  day-ahead.    At  this  point,  parties  are  expected  to  adhere  to  the  physical  data  submitted  to  the 
System Operator and to the contracted volumes submitted before Gate Closure. 

80 

 
Part %ChapterNumber% 

%ChapterTitle% 

Imbalances: an imbalance occurs whenever there is a mismatch between the quantity of electricity traded 
on the spot (day ahead) market and the actual generation/consumption when contracts are executed. For 
example,  generators  may  physically  produce  more  or  less  energy  that  they  have  sold  and  suppliers 
(through their customer demand) may physically consume more or less energy than they have purchased. 
These surpluses and deficits are referred to as imbalances.  

Inframarginal rent: inframarginal rent refers to the rent earned by all generation sources utilized to serve 
demand that have lower marginal costs than the marginal generation source. The final price for electricity 
will be, in fact, the marginal cost of the last generator needed to meet demand, and all other generators in 
the merit will be able to earn the difference between their marginal costs and the final electricity price. 

Load  factor:  it  can  be  defined  as  either:  (i)  the  number  of  hours  of  electricity  generated  over  the  year 
divided  by  the  total  number  of  hours  in  the  year;  or  (ii)  the  amount  of  generation  (in  MWh)  produced 
during the year divided by the theoretical maximum production during the year. 

Load: is the total electricity demand. 

Mega  Watt  (MW):  is  the  most  common  unit  of  measure  of  electricity.  It  corresponds  to  the  power 
needed to light approximately 750-1000 homes.  

Peaking plants: plants that are characterised by low fixed costs and high marginal costs. They also have 
rather long booting periods.  

Ramp up: in electricity jargon it means "increase output". 

Scarcity rent: it is the rent earned by electricity generators during scarcity periods, that is: periods when 
demand  cannot  be  met  by  increased  supply.  The  electricity  price  during  scarcity  periods  can  increase 
dramatically. 

Spin: is the increase in output that a generator can provide/back down in a very short period (usually 10 
minutes). 

81 

 
Annexes 

 
 
 
ANNEX 1 

Investment drivers: variables description 

Table A1.1: 

Investment model 

* The data concern 13 MS (Austria, Belgium, Germany, Denmark, Greece, Spain, Finland, France, Italy, The Netherlands, 
Portugal, Sweden, United Kingdom) and their period varies based on the year of each market establishment 
Source: European Commission 

84 

VariablesAcronymsDescriptionUnitSourceSampleNew Additions in Installed CapacityChange of installed capacity of nuclear, combustible fuels, biomass and hydro power plantsMWEurostatEU28, 2005-2012Electricity Wholesale Price (Spot)spotBaseload electricity pricesEURO/MWhPlatts, BloombergEU*, 2005-2012Concentration Ratio of main GeneratorscumshareCumulative market share of main generators(%)EurostatEU28, 2005-2012RES shareShRESShare of the installed capacity of Solar, Photovoltaic and Wind in the total electricity installed capacity of the system(%)EurostatEU28, 2005-2012Reserve MarginresmarginFirmed capacity over peak load(%)Eurostat, ENTSO-EEU28, 2005-2012Dummy for Capacity MechanismsBinary variable that takes the value of 1 when there is a support mechanism for generators(0-1)Commission ServicesEU28, 2005-2012Electricity DemandeldemElectricity demandTWhEurostatEU28, 2005-2012Interest RatesilnInterest Rates in nominal terms(%)AMECOEU28, 2005-2012Dummy for Quality of Regulation Binary variable that takes the value of 1 when the score of the quality of regulation is above the mean of all the MS(0-1)World BankEU28, 2005-2012Energy-Specific FactorsMacroeconomic Factors 
 
 
 
ANNEX 2 

Power price drivers methodology and data description 

The  relationship  between  electricity  wholesale  prices,  electricity  demand,  imports,  exports,  renewables 
and other external factors (Brent oil, Coal-ARA, Natural Gas-TTF and carbon prices) on a monthly basis 
over the period September 2007- July 2014 is examined for 13 EU day-ahead electricity markets (Austria, 
Belgium, Germany, Denmark, Greece, Spain, Finland, France, Italy, The Netherlands, Portugal, Sweden, 
United Kingdom). The objective is to see whether there is a long term relationship between some of these 
variables and how they relate to each other. For this purpose, a panel analysis is employed, consisting of 
three main steps: First, the order of integration of all variables is tested. Second, after having determined 
the  order  of  integration  in  the  series,  heterogeneous  panel  co-integration  tests  were  used  to  investigate 
whether a long term relationship between the variables in question exists. Third, in case of a long term 
relationship, a panel based error correction model is developed in order to identify the short and long-run 
causal relationship between the variables examined. 

A2.1.  METHDOLOGY 

Panel Unit Root Tests 

A number of unit root tests have been developed for establishing the order of integration of series in a 
panel context. The most common of them are Levin, Lin and Chu (2002), Breitung (2000), Im, Pesaran 
and  Shin  (2003),  Fisher-type  tests  using  ADF  and  PP  tests-Maddala  and  Wu  (1999),  Choi  (2001),  and 
Hadri (2000). These tests present many similarities with the unit root tests used on single series. 

The basis of panel unit root test is to identify if there are restrictions on the autoregressive process across 
cross-sections or series. This can be tested based on the following AR(1) process for panel data:  

(1) 

where i stands for cross-section units or series, that are observed over periods t.  

The Xit represent the exogenous variables in the model, including any fixed effects or individual trends, 
ρi are the autoregressive coefficients, and the errors are assumed to be mutually independent idiosyncratic 
disturbance.  If  |  |    ,    is  said  to  be  weakly  (trend-)  stationary.  On  the  other  hand,  if  |ρi|=1  then  Yi 
contains a unit root.  

For  purposes  of  testing,  two  additional  assumptions  can  be  made.  First,  one  can  assume  that  the 
persistence  parameters  are  common  across cross-sections so  that ρi=ρ  for  all.  The  Levin,  Lin,  and  Chu 
(LLC),  Breitung,  and  Hadri  tests  all  employ  this  assumption.  Alternatively,  one  can  allow  ρi  to  vary 
freely across cross-sections. The Im, Pesaran, and Shin (IPS), and Fisher-ADF and Fisher-PP tests are of 
this form. 

The  results  of  the  LLC,  IPS,  Fisher-ADF,  and  Fisher-PP,  Breitung  and  Hadri  panel  unit  root  tests,  for 
each  of  the  variable,  are  presented  in  Table  A2.1.  The  test  is  performed  both  for  the  level  and  first 
difference  of  electricity  wholesale  prices  (PSPOT),  electricity  demand  (ELDEM),  electricity  imports 
(IMP) and exports (EXP), the share of RES in total electricity production (SHRES), the Brent crude oil 
(POIL), the Coal ARA (PCOAL), the natural gas-TTF (PNG) and the carbon prices (PCO2). 

85 

 
                         
         
 
 
 
 
 
 
 
 
Power price drivers methodology and data description 

Annexes 

Table A2.1:  Panel unit root test results 

The optimal lag length was selected based on the SIC criterion. The null hypothesis is that the variable follows a unit root 
process, except for the Hadri Z-stat and the Heteroscedastic Consistent Z-stat. Probabilities for the Fisher-type tests are 
computed using an asymptotic Chi-square distribution. All other tests assume asymptotic normality. *, **, *** indicate 
significance at 10%, 5% and 1% confidence level. 
Source: Commission Services 

The tests are rather inclusive in levels regarding stationarity. The null hypothesis of a unit root cannot be 
rejected for Hadri tests for all variables and for the LLC and Breitung tests for some variables, including 
the wholesale electricity prices, electricity demand and imports, share of renewable and the carbon prices. 
Only  the  exports  of  electricity  can  be  considered  as  stationary  variable  in  levels.  After  taking  the  first 
difference  of  the  first  set  of  variables  that  found  to  be  non-stationary,  the  tests  indicate  that  the  series 
become  stationary  at  1%  confidence  level.  Thus,  the  results  are  fairly  conclusive  on  regards  first 
differences and indicate that these variables are non-stationary in levels, and become  stationary only in 
first differences, which mean that they are integrated of order one or I(1). 

Panel Co-integration Tests 

After  taking  into  account  the  results  of  the  panel  unit  root  tests,  the  next  step  involves  the  test  for  co-
integration  of  the  variables  in  question  based  on  the  heterogeneous  panel  co-integration  techniques 
developed  by  Pedroni  (1999)  and  Kao  (1999),  which  allow  for  cross-sectional  interdependence  with 
different individual effects. Both have extended the Engle-Granger framework on co-integration analysis 
by adjusting the analysis in panel data. These tests are considered as improvements of conventional tests 
due to the increasing power of the panel co-integration tests (Rapach and Whohar, 2004). Pedroni (1999) 
proposes two types of residual-based tests for panel co-integration. The first type tests, including panel v-
statistic,  panel  ρ-statistic,  panel  PP-statistic  and  panel  ADF-statistic,  provide  within  estimations  and 
follow  a  standard  normal  asymptotically  distribution.  The  second  type  tests,  including  the  group  r-
statistic,  the  group  PP-statistic  and  the  group  ADF-statistic,  are  also  asymptotically  normal  distributed 
tests. Compared to the first type test, they provide between estimations as they pool the residuals for the 
between-group. 

According to Pedroni (1999) the following general specification can be used to test for co-integration. It 
allows for heterogeneous intercepts and trend coefficients across cross-sections: 

(2) 

86 

Levin, Lin & Chu t*Breitung t-statIPS W-stat ADF - FisherPP - FisherHadri Z-statHeteroscedastic Consistent Z-statLevel PSPOT-0.161-5.44***-6.33***90.414***108.24***3.87***3.43***ELDEM57.24-891-0.11741.77**182.13***-0.784.10***IMP-1.91**-0.29-8.375***141.31***172.13***5.78***4.301***EXP-3.00***9.84***173.59***186.37***7.90***5.19***SHRES-9.12***2.56-9.75***178.31***251.76***4.40***7.81***BRENT-2.06**-6.89***-5.08***65.84***26.363.28***3.28***co20.52-1.82**PCOAL1.20-6.94***1.69**1.69**PNG3.171.595.89***5.89***First DifferencesSpot-21.97***-12.03***-26.34***-353.15***-626.66***-1.18-1.15ELDEM166.46***-12.83***194.54***315.61***-3.27-1.62IMPORTS35.88***-14.30***251.17***272.22***-2.030.03EXPORTS-2.07-1.51SHRES2.46***-17.75***292.90***557.56***-1.740.49BRENTco212.57***-2.38-2.38PCOAL-17.13***-2.50-2.50PNG-38.89***-25.58***-0.47-0.47H0: Non-stationarityH0: StationarityCommon processIndividual process 
 
 
                    
          
 
 
 
 
 
 
 
Power price drivers methodology and data description 

Annexes 

where  i  stands  for  cross-sections,  t  for  time  periods  and  αi  and  δi  are  individual  and  trend  effects, 
respectively, Yit is the electricity wholesale price and Git is a vector of the other explanatory variables. 
Under  the  null  hypothesis  of  no  co-integration,  the  residuals  eit  will  be  I(1).  The  Kao  test  follows  the 
same basic approach as the Pedroni tests, but specifies cross-section specific intercepts and homogeneous 
coefficients  on  the  first-stage  regressors.  In  addition,  Maddala  and  Wu  (1999)  used  Fisher’s  result  to 
propose  an  alternative  approach  to  testing  for  co-integration  in  panel  data  by  combining  tests  from 
individual cross-sections to obtain at test statistic for the full panel. 

Overall, it can be concluded that there is a panel long-run equilibrium relationship between the variables 
examined  each  time.  Taking  into  account  the  non-stationarity  property  of  all  the  variables  and  the 
aforementioned  residual  panel  co-integration  tests,  the  Pedroni’s  (2004),  the  Kao’s  (1999)  and  the 
combined Johanshen and Fisher tests were used to establish whether a long-run relationship exists. 

Table A2.2 reports the within and between dimensions of the panel co-integration tests, the Kao's test and 
the Johanshen- Fisher panel co-integration test. The results of heterogeneous panel tests indicate that the 
null of no co-integration between variables in Model 1 and these of Model 2 can be rejected at the 1% 
significance levels in all tests. In fact, the combined Johansen and Fisher tests imply that there might be 
up to two co-integrating relationships among the variables of the two models. For both cases it seems that 
individual  coefficients  can  be  estimated  when  estimating  the  long-run  relationship.  Electricity  exports 
were  excluded  from  both  models  as  they  were  not  statistically  significant,  as  well  as  the  coal  prices 
because there was indication of severe case of multicolinearity based on the variance inflation indicator 
and the coefficient of variance decomposition. Along the same lines, the variables of the Brent oil prices 
and the natural gas prices was decided not to be included in the same regression and this was the main 
reason for estimating two separate models. 

Table A2.2:  Pedroni and Kao residual co-integration test results 

The null hypothesis for all the tests, except for the Johanshen-Fisher test, is that the variables are not cointegrated. Under the 
null hypothesis, all the statistics are distributed as standard normal distribution. *, **, *** indicate significance at 10%, 5% and 
1% confidence level.  
Source: Commission Services 

Given  these  findings,  two  main  estimators  are  used  for  estimating  the  cointegrating  vector  in  a  panel 
context, the Fully Modified Ordinary Least Square (FMOLS) estimators and the Dynamic Ordinary Least 
Square (DOLS) estimators. (82) The FMOLS estimator, proposed by Phillips and Hansen (1990), employs 
a  semi-parametric  correction  to  eliminate  the  problems  caused  by  the  long  run  correlation  between  the 
cointegrating  equation  and  stochastic  regressors  innovations.  The  DOLS  estimator,  advocated  by 
Saikkonen (1992) and Stock and Watson (1993), is a parametric approach that eliminates the feedback in 
the cointegrating system. 

(82)  The FMOLS and DOLS are necessary because of the correlation between the error term and the lagged dependent variables in 

the panel VECM specification. 

87 

SPOT, IMP, SHRES, CO2, ELDEM, PNGSPOT, IMP, SHRES, CO2, ELDEM, POILStatisticStatisticPanel v-Statistic 0.13-0.27Panel rho-Statistic-4.59***-3.39***Panel PP-Statistic-6.52***-4.64***Panel ADF-Statistic-7.17***-4.66Kao's test (ADF)-3.35***-5.17***Johanshen Fisher-Trace TestAt most 2 - 74.03****At most 2 - 59.71***Johanshen Fisher-Max Eigen.At most 2 - 54.29****At most 1 - 85.36***Group rho-Statistic-4.17***-2.31**Group PP-Statistic-7.07***-4.01***Group ADF-Statistic-7.65***-3.59***Alternative hypothesis: common AR coefs. (within-dimension)Alternative hypothesis: individual AR coefs. (between-dimension) 
 
 
 
                                                           
Power price drivers methodology and data description 

Annexes 

The  long-run  equilibrium  is  then  estimated  using  the  FMOLS  and  DOLS  technique (83)  (Table  A2.3). 
Results  of  panel  FMOLS  and  DOLS  indicate  that  electricity  wholesale  prices  are  positively  correlated 
with all the variables in both models, except for the share of renewables in the total electricity production. 
Almost all of the estimated coefficients are statistically significant at the 1% levels, implying that there is 
a strong long-run relationship between the variables included in the analysis based on both approaches: 
FMOLS and DOLS. 

Table A2.3:  Panel FMOLS and DOLS long-run estimates (in logs) 

Note: *, **, *** indicate significance at 10%, 5% and 1% confidence level. 
FMOL: Fully Modified Ordinary Least Squares 
DOLS: Dynamic Ordinary Least Squares 
Source: Commission Services 

Panel Granger Causality Tests 

Once a long-run relationship between the variables examined has been identified, this relationship is used 
to estimate a panel error correction model, with the same specifications as in the co-integration tests. This 
will  indicate  the  direction  of  the  causal  relationship  of  the  variables  in  question,  both  in  the  long  and 
short-run. Thus, the residuals of the lon-run model (equation 2) are included as regressor in the dynamic 
error correction model, which is specified as follows: 

                        ∑

  ∑

(3) 

Where Δ represents the difference operator, EC is the lagged error correction term derived from the long-
run model (equation 2), αi,λi and βi are the coefficients, u is the error of the equations, Y represents the 
dependent variable each time, G is the set of the explanatory variables and k is the number of lags based 
on Schwarz information criterion. 

The  direction  of  the  causal  relationship  will  be  determined  by  the  results  of  the  Granger  causality  test, 
after treating the panel data as one large stacked set of data. The only exception of the test is not letting 
the data from one cross-section enter the lagged values of data from the next cross-section. This method 
assumes that all coefficients are same across all cross-sections. 

Taking into consideration of the residuals of the long-term equilibrium, a panel VECM model is used to 
estimate  the  direction  of  causality  in  the  short  and  the  long  run.  The  results  of  the  VECM  with  six 
simultaneous equations for the analysis of the causal (84) relationships for Model 1 and 2 are presented in 
Tables A2.4 and A2.5 below. The optimal  lag structure of 13 and 11 months, respectively  for Model 1 

(83)  It  is  important  to  note  again  that  the  DOLS  method  has  the  drawback  of  reducing  the  number  of  degrees  of  freedom  by 
including leads and lags in the variables studied, leading to less robust estimates. Hence, the DOLS estimation method is used 
to confirm the general trend and direction of the causality obtained by the FMOLS method. 

(84)  The significance of  causality tests  are  determined  by the Wald  F-test. 

88 

VariableDay-ahead pricesDay-ahead pricesDay-ahead pricesDay-ahead pricesCarbon price0.22***0.22***0.19***0.19***Natural gas price0.42***0.42***Share of renewables-0.09***-0.11***-0.10***-0.12***Import0.16***0.16***0.15***0.18***Electricity demand0.23***0.24**0.44***0.54***Oil price0.33***0.39***R265%68%51%64%Country Fixed EffectsYESYESYESYESEstimation MethodFMOLSDOLSFMOLSDOLSMODEL 1MODEL 2 
 
 
 
           
 
   
           
 
   
          
 
 
                                                           
Power price drivers methodology and data description 

Annexes 

and 2, for the two relationships is chosen based on the Schwarz Information Criterion, in order to remove 
autocorrelation in the residuals. 

Table A2.4: 

Short run causality (Variables in first differences) 

Note: *, **, *** indicate significance at 10%, 5% and 1% confidence level. 
Source: Commission Services 

Table  A2.4 presents  the results  of  the  short  run Granger  causality  tests for both  models.  Their  findings 
appear to converge regarding the direction of the causality of most of the variables, except for the change 
of the electricity imports in the electricity wholesale prices equation and for the change in the electricity 
imports equation and the renewables equation. In general the tests suggest that for most of the variables 
there is a bi-directional causality. In particular, in the short run the findings indicate that the electricity 
wholesale prices are influenced by changes in the carbon prices, the electricity demand and imports, the 
share of renewables in the total electricity production and the natural gas prices. In the same context, the 
carbon prices are driven by the wholesale electricity prices, the electricity demand, and the share of the 
renewables  production  and  the  development  of  fossil  fuel  prices  (Brent,  Natural  gas).  Along  the  same 
lines, electricity demand is affected by the electricity wholesale prices and carbon prices, the share of the 
renewables  and  the  changes  in  fossil  fuel  prices  that  influence  the  production  cost.  The  share  of 
renewables is influenced mainly by the electricity demand evolution and the carbon and fossil fuel prices. 
The  fossil  fuel  prices  are  affected  by  almost  of  all  explanatory  variables  through  the  impact  that  these 
variables have on the demand for the fossil fuel commodities. In contrast to the rest of the variables, the 
tests indicate that the electricity imports are driven only by the electricity demand evolution. 

Table A2.5: 

Long run causality (Variables in levels) 

Note: *, **, *** indicate significance at 10%, 5% and 1% confidence level. 
Source: Commission Services 

Turning now to the long-run causality among the variables (Table A2.5), the tests suggest that almost for 
all variables a bi-directional causality exists. Only the electricity imports can be considered as a weakly 
exogenous variable. The findings indicate that the electricity imports are not influenced in the long run by 
any of the variables included in the analysis, while they influence only the share of renewables production 
over the total electricity production. 

A2.2.  DATA DESCRIPTION 

89 

TO: PSPOTPCO2ELDEMIMPSHRESPNGPSPOTPCO2ELDEMIMPSHRESPOILPSPOT31.66***28.67***10.912.9578.04***47.77***49.27***13.7914.7445.98***PCO226.76***76.29***3.7468.30***109.51***47.36***67.92***2.6935.6***433.9***ELDEM31.13***46.76***26.79***32.74***48.20***25.51***59.6***25.71***29.12***124.96***IMP16.1416.878.3415.2819.19*20.41*14.8310.2321.12**13.57SHRES13.3241.09***19.48*9.1124.84**1656.1***18.477.2550.8***POIL36.56***229.5***57.46***7.1438.32***PNG35.75***230.37***100.29***3.677.80***MODEL 1MODEL 2FROM:TO:PSPOTPCO2ELDEMIMPSHRESPOILPNGPSPOT5.35***4.33***0.781.56*7.82***11.01***PCO22.74***5.49***0.543.84***12.8***8.55***ELDEM3.69***6.12***0.994.07***3.92***7.70***IMP1.050.440.451.7*0.30.74SHRES1.63*5.42***2.93***0.857.23***3.17***POIL6.06***31.13***3.20***1.311.69*PNG6.02***41.66***9.74***0.944.64***FROM: 
 
 
 
 
 
 
 
Power price drivers methodology and data description 

Annexes 

Table A2.6:  Data description – Power price drivers 

Note: the data concern the following EU countries: Austria, Belgium, Germany, Denmark, Greece, Spain, Finland, France, 
Italy, The Netherlands, Portugal, Sweden, United Kingdom 
Source: European Commission 

90 

VariableDescriptionUnitSourceSampleCarbon PriceFutures Carbon Prices€/tCO2EcowinJanuary 2008- July 2014Electricity Spot PricesMonthly electricity baseload prices €/MWhPlatts, Power ExchangesSeptember 2007- July 2014RES-E Monthly gross electricity generated fromHydro, Solar Thermal, Solar Photovoltaic, and WindGWhIEASeptember 2007- July 2014Price of CoalCoal  (ARA) prices in €/tonne€/tonneEcowinSeptember 2007- July 2014Total electricity productionMonthly gross electricity generatedGWhIEASeptember 2007- July 2014Total electricity demandMonthly electricity demandGWhEurostatSeptember 2007- July 2014Imports and Exports of ElectricityMonthly imports and exports of electricityGWhEurostatSeptember 2007- July 2014Brent pricesMonthly Brent Prices €/bblBloombergSeptember 2007- July 2014 
 
 
ANNEX 3 

The transition to low carbon technologies: impact on the merit 
order curve 

To understand the impact on the investment framework of a shift to a technology mix dominated by low 
carbon  energy  technologies  with  high  fixed  costs  and  low  operating  costs,  three  power  systems  are 
constructed that represent each stage of the energy transition. 

-  Stage  1,  the  conventional  phase,  represents  power  systems  that  existed  15  to  20  years  ago  before  the 
deployment of low carbon technologies such as wind and PV 

- Stage 2, the transition phase, is representative of current power systems with an increasing penetration 
of low carbon technologies such as wind and photovoltaic  

-  Stage  3,  the  decarbonised  phase)  represents  a  future  power  system  dominated  by  low  carbon 
technologies as can be expected in a medium to long term timeframe. 

The demand level to be met is assumed to be the same in each scenario. It is composed of three distinct 
periods: a base load period where the  average power demanded is D1; a semi-base load period with an 
average demanded power D2 and a peak period with an average demanded power D3. In order to factor in 
policy  developments,  the  demand  is  considered  increasingly  price-responsive,  i.e.  more  elastic,  as  the 
energy  transition  progresses.  This  is  due  to  a  wider  deployment  of  demand  response  over  time  in 
industrial and services sector as well as in households, notably through the use of aggregators. Therefore, 
the slope of the demand curve changes from stage 1 to stage 3. 

Under stage 1, the demand can be met by two technology classes. One technology class is composed of 
two technologies (tech 1 and tech 2) with low operating costs (OPEX) and high capital costs (CAPEX) 
such as nuclear or hydro technologies. The other technology class is made of two technologies with high 
OPEX  and  low  CAPEX  such  as  coal  or  gas-fired  power  plants  (tech  3  and  tech  4).  The  revenues 
(R_(i,t) (85) gained by each technology  in this market framework are sketched in graph A3.1. 

Graph A3.1:  Merit-order curves under the conventional phase (stage 1) 

Source: European Commission 

(85)  i refers to technology and t to demand period 

91 

 
 
 
                                                           
The transition to low carbon technologies: impact on the merit order curve 

Annexes 

Revenues  for  each  technology  are  the  difference  between  the  variable  cost  of  the  technology  and  the 
revenue acquired at the market price when selling the quantity demanded (so-called infra-marginal rents). 
Accordingly, revenues for technology 1 are the sum of the revenues acquired during demand D1 (R1, 1) 
when  the  price  is  set  by  technology  2  which  is  the  marginal  technology  in  this  case;  and  the  revenues 
during demand D2 (R1, 2) when technology 3 is the marginal producer; and the revenues during demand 
D3 (R1, 3) when prices reach P3 that can go up to the value of loss load (VoLL). Indeed, a number of 
hours  of  unmet  demand  are  considered  to  allow  for  the  recovery  of  the  fixed  cost  of  the  peaking 
technology  4,  and  also  to  contribute  to  the  cost  recovery  of  the  other  technologies.  The  investment 
criterion for technology 1 is met when these revenue streams equal the fixed cost of technology 1. The 
same logic applies for all technologies.  

Stage 2 differs from stage 1 as the penetration of low carbon technologies is higher. This is achieved with 
the introduction of a new technology class, represented by tech 0 that has the lowest variable costs (e.g. 
wind farms, photovoltaics). The demand levels are assumed to remain constant compared to stage 1, but 
with  an  increasing  price  responsiveness  of  demand  which  translates  into  a  flatter  curve.  This  power 
system  could  be  representative  of  the  current  European  power  systems.  The  effect  on  the  merit-order 
curves of the entry of this technology class is portrayed under graph A.3.2. Given that the technologies 
composing  technology  class  0  have  limited  capacity  factors  due  to  the  intermittency  of  their  primary 
energy sources, the different demand segments D'1, D'2, D'3 are met alternatively as shown under graph 
A.3.2  when  technologies  0  are  operating  or  as  shown  under  graph  A.3.3  when  technologies  0  are  not 
operating. 

Graph A3.2:  Merit-order curves under the transition phase  (stage 2) when technologies 0 are operating 

Source: European Commission 

92 

 
 
 
The transition to low carbon technologies: impact on the merit order curve 

Annexes 

Graph A3.3:  Merit-order curves under the transition phase (stage 2) when technologies 0 are not operating 

Source: European Commission 

The  introduction of  technology class  0 pushes  the  merit  order  curve  to the  right  for  a  certain  period of 
time  proportional  to  their  capacity factors, while  the  increased  responsiveness  of  the  demand  decreases 
the scarcity rent gained by the different technologies. By contrast, when the technology 0 is not operating, 
the power system is operating with the technology mix as under stage 1. It is noted that under constant 
demand levels, the financial position of technology 4 deteriorates under stage 2 compared to stage 1 due 
to an overcapacity effect which limits the number of hours where the price goes above its marginal costs 
and  due  to  the  increasing  demand responsiveness which  limits the  height of price  spikes. The  resulting 
impact of the introduction of technology 0 is an overall price, hence revenue, decrease. 

Stage  3  represents  a  power  system  that  would  be  dominated  by  low  carbon  technologies (86),  with  a 
demand  (D''1,  D''2,  D''3)  exhibiting  higher  levels  of  price-responsiveness  and  with  a  high  degree  of 
European market integration. In this context, the system can be managed so that low carbon technologies 
(class 0) are able to operate during most of the year. This is feasible through drawing on spatial and time 
complementarities, which can be utilised due to high market integration and regional coordination. The 
increased penetration of low carbon technologies has resulted in a change in the technology mix, with for 
instance, no tech 3 and a quantity of technology 4 (as a representative of flexible systems) to meet period 
of high demand and to account for the resource availability. This results in merit order curves which are 
flatter and steeper at the end as shown under Graph A.3.4.  

(86)  Stage 3 could be expected to start in about 10 years. For example, under the different scenarios86 of the Energy Roadmap 2050, 
low carbon technologies start producing around 65% to 70%  of the gross electricity generation by 2025-2030. See European 
Commission (2011). 

93 

 
 
 
                                                           
The transition to low carbon technologies: impact on the merit order curve 

Annexes 

Graph A3.4:  Merit-order curves under the decarbonised phases (stage 3) 

Source: European Commission 

The effect on revenues of this almost complete decarbonisation of power systems is an overall decrease in 
prices,  hence  revenues  compared  to  stage  2  for  most  part  of  the  year.  The  financial  position  of  all 
technologies  will  depend  extensively  on  the  frequency  and  ability  of  prices  to  reach  high  levels.  The 
feasibility of such price spikes is uncertain. 

94 

 
 
ANNEX 4 

Methodology to calculate the annualized capital expenditure 

The  annualized  capital  expenditure  of  technology  i  CAPEXi  is  calculated  using  the  methodology 
described in (87), as follows: 

With: 

SCI: the specific overnight capital investment of the power generation facility, in €/MW 

IDC: the interest during construction 

CRF: the capital recovery factor 

Load Factor: the annual load factor of the facility 

Values for future SCIs are calculated on the assumption that current prices will decrease due to learning 
effects. Hence, based on the technology learning theory, the future specific cost of a technology, SCIF, is 
calculated using the global installed capacity as a proxy, based on the formula: 

              (

)

⁄

Where: 

SCIP or F: the current and future specific capital investment cost 

CP: the current global installed capacity 

CF: the installed capacity of the technology in a future time 

LR: the learning rate of the technology. 

The IDC is calculated considering the construction time for each plant and a capital expenditure profile 
during construction: 

        ∑                      

Where: 

CT: is the construction time, 

Wk: is the fraction of total capital used in year k, 

R: is the interest rate. 

For all technologies an interest rate of 10% is assumed for the calculation of IDC. The capital recovery 
factor (CRF)  is  calculated  from  the  formula,  with d  is the  real discount rate and  n  is the  economic  life 
time. 

(87)  European Commission (2008) 

95