Application of price caps and other imperfections in European market arrangements may lead to undesirable consequences. These may include dampening the market value of flexible resources to address scarcity, impeding the reflection in electricity prices of the value of scarce supplies during demand peak, suppressing the incentive to engage in long-term contracts and contributing to ‘missing money’ — an impediment to full cost recovery of energy resources, thereby jeopardising secure supplies. In practice, such imperfections have contributed to the introduction of out-of-energy-only market interventions — notably capacity markets and strategic reserves — which in turn are susceptible to a host of flaws.
The most immediate concern is to address price caps and other impediments to allow the value of supplies (pricing above marginal cost) to be expressed during scarcity. Accompanying programmes to support the removal of barriers to demand-side flexibility assist in the proper functioning of scarcity pricing.
The following focuses on reforms to allow the value consumers assign to scarce supplies to be reflected in imbalance and balancing prices and thereby in wholesale markets, such as in spot, intraday and day-ahead prices. The annex presents an overview of interactions with factsheets considering other elements supporting efficient energy price formation.
The EU’s Electricity Regulation states it is ‘critical to ensure that administrative and implicit price caps are removed in order to allow for scarcity pricing.’ Article 20 of the Regulation requires when addressing resource adequacy concerns that Member States consider removing price caps and introducing a shortage pricing function for balancing energy. This links to Article 44(3) of Regulation (EU) 2017/2195 of 23 November 2017, establishing a guideline on electricity balancing, which provides that each ‘TSO may develop a proposal for an additional settlement mechanism separate from the imbalance settlement, to settle the procurement costs of balancing capacity’ …, which ‘should be preferably achieved with the introduction of a shortage pricing function.‘ Provisions therefore allow for price formation free of caps and for scarcity pricing but do not ensure it.
Justifications for the removal of price caps include that they impede efficient short-term price formation and undermine the confidence of the market that fixed costs of investments can be recovered (and thus contribute to missing money). Price caps do this by directly impeding efficient price formation. Other market issues may exacerbate inefficiencies such as through use of capacity payments to procure availability of reserves, with the effect of impeding the efficient reflection of the value of reserves in imbalance price formation.
Direct solutions build on the removal of limits in price formation. This entails removing explicit price caps. To address the risk that decision-makers subject to short-term political pressures will interfere in price formation, reforms should ensure empowered and independent regulation, helping to depoliticise wholesale price formation by removing it away from the political sphere. Regulatory monitoring of the abuse of market power should be properly resourced to provide confidence that abuse of market power is not in fact driving observed scarcity prices.
Additionally, introduction of reserve scarcity pricing functions (also called reserve shortage pricing, or RSP), which allow the value of reserve capacity to be reflected in price formation, will help to lift price caps as well as assuage policymaker concerns regarding market power. This may be accompanied by other reforms to back-propagate the effect of the RSP into the day-ahead reserve market. This can be achieved by providing for participation of reserve capacity in a real-time market and requiring the capacity provider to buy back the amount of reserve capacity that it has sold to the system operator in the day-ahead market at the real-time price of reserve. Finally, measures that unlock demand-side resource flexibility — including those assisted by smart metersmart meter Smart meters provide electricity customers and their suppliers with accurate, near real-time information on consumption and/or generation that allows for managing their consumeption better and engaging in demand-side flexibility. It allows DSOs to have better visibility of their networks. rollout — further support an efficient outcome.
If not addressed directly, these issues may ostensibly justify out-of-energy-only market interventions — typically capacity markets and strategic reserves — to ensure capacity adequacy, which themselves are typically susceptible to a number of flaws. These include heightened risk of procurement of a volume of capacity beyond that which is economic; the allocation of risk of uneconomic, long-lived investments to the consumer rather than the shareholder; and technology non-neutrality and splintering of European electricity markets — the latter two reflecting challenges in incorporating technologies and foreign resources on a level playing field. Addressing these issues directly may preclude such out-of-market interventions or at least limit the scale and accompanying risks of such interventions.
Incorporation of a circuit breaker, which turns off the reserve scarcity pricing function, may help ensure that scarcity pricing does not provide economic rents vastly beyond what is needed to support an efficient level of reliability (for, say, a one in 20-year event) and address concerns that may otherwise impede RSP introduction. Analysis of the February 2021 event in Texas, ERCOT (which relies solely on scarcity pricing) suggests a circuit breaker would have been merited. A price shock absorber to tackle the European gas price crisis could work in a similar vein.
Energy Price Formation
The scope of this factsheet is scarcity prices, with reform enacted in imbalance price formation and in balancing markets. These reforms sit alongside other important design elements in supporting efficient formation of energy prices, notably marginal cost and single pricing and locational pricing in imbalance price formation and in balancing markets (see Efficient Price Formation factsheet) and locational pricing (see Locational Marginal Pricing factsheet), as presented in the figure below.
More broadly, marginal pricing (also known as pay-as-clear), which is currently a feature of wholesale markets in Europe, incentivises the party with the cheapest additional offering to balance demand and supply for electricity. A clearing price that is linked to marginal cost thus drives minimisation of total long-run cost and maximises societal welfare.
- Supports locational investment signals for generators and consumers and addresses network bottlenecks, without costly redispatch
- Focus of reform: wholesale prices
- Allows efficient valuation of reserves that enable the least cost penetration of renewables, and limits need for costly interventions
- Focus of reform: Imbalance pricing and balancing energy prices
Energy Price Formation
No Data Found
- Supports an efficient allocation of effort between markets
- Focus of reform: imbalance pricing and balancing energy prices
- Provides efficient signals to guide balancing behaviours and removes unhelpful signals to integrate vertically
- Focus of reform: imbalance pricing and balancing energy prices
Source: RAP graphic
References and Further Reading
- Agency for the Cooperation of Energy Regulators. (2015.) ACER/CEER annual report on the results of monitoring the internal electricity and natural gas markets in 2014. Council of European Energy Regulators.
- Agency for the Cooperation of Energy Regulators. (2021.) ACER Guidance on the application of Regulation (EU) No 1227/2011 on wholesale energy market integrity and transparency.
- European Commission. (2016.) Report from the Commission: Final report of the sector inquiry on capacity mechanisms.
- European Commission. (2017.) Commission regulation (EU) 2017/2195 of 23 November 2017 establishing a guideline on electricity balancing.
- European Commission. (2019.) Regulation (EU) 2019/943 of them European Parliament and of the council of 5 June 2019 on the internal market for electricity.
- Office of Gas and Electricity Markets. (2014). Electricity Balancing Significant Code Review — Final policy decision.
- Hogan, M. (2016). Hitting the mark on missing money: How to ensure reliability at least cost to consumers. Regulatory Assistance Project.
- Hogan, M., Claeys, B., Pató, Z., Scott, D., Yule-Bennett, S. & Morawiecka, M. (2022). Price shock absorber: Temporary electricity price relief during times of gas market crisis. Regulatory Assistance Project.
- Hogan, M. (2021). Real-life drama: Lessons for Europe from a Texas tragedy. Euractiv.
- Papasaviliou, A. (2020). Scarcity pricing and the missing European market for real-time reserve capacity. Energy Journal, 33(10).
- Phipott, A., Read, G., Batstone, S., & Miller, A. (2019). The New Zealand electricity market: Challenges of a renewable energy system. IEEE Power and Energy Magazine, 17(1).