CAPACITY MECHANISMS IN THE EU ENERGY MARKET Capacity Mechanisms in the EU Energy Market Law, Policy, and Economics Editedby LEIGH HANCHER ADRIEN DE HAUTECLOCQUE and MAŁGORZATA SADOWSKA 1 3 GreatClarendonStreet,Oxford,OX26DP, UnitedKingdom OxfordUniversityPressisadepartmentoftheUniversityofOxford. ItfurtherstheUniversity’sobjectiveofexcellenceinresearch,scholarship, andeducationbypublishingworldwide.Oxfordisaregisteredtrademarkof OxfordUniversityPressintheUKandincertainothercountries #Theseveralcontributors2015 Themoralrightsoftheauthorshavebeenasserted FirstEditionpublishedin2015 Impression:1 Allrightsreserved.Nopartofthispublicationmaybereproduced,storedin aretrievalsystem,ortransmitted,inanyformorbyanymeans,withoutthe priorpermissioninwritingofOxfordUniversityPress,orasexpresslypermitted bylaw,bylicenceorundertermsagreedwiththeappropriatereprographics rightsorganization.Enquiriesconcerningreproductionoutsidethescopeofthe aboveshouldbesenttotheRightsDepartment,OxfordUniversityPress,atthe addressabove Youmustnotcirculatethisworkinanyotherform andyoumustimposethissameconditiononanyacquirer CrowncopyrightmaterialisreproducedunderClassLicence NumberC01P0000148withthepermissionofOPSI andtheQueen’sPrinterforScotland PublishedintheUnitedStatesofAmericabyOxfordUniversityPress 198MadisonAvenue,NewYork,NY10016,UnitedStatesofAmerica BritishLibraryCataloguinginPublicationData Dataavailable LibraryofCongressControlNumber:2015944364 ISBN 978–0–19–874925–7 Printedandboundby CPIGroup(UK)Ltd,Croydon,CR04YY LinkstothirdpartywebsitesareprovidedbyOxfordingoodfaithand forinformationonly.Oxforddisclaimsanyresponsibilityforthematerials containedinanythirdpartywebsitereferencedinthiswork. ’ Editors preface How to ensure adequate levels of generation capacity in the newly liberalized energy markets? Twenty years into energy marketliberalization, Member States of theEuro- pean Union (EU) start to question the ability of the so-called ‘energy-only’ markets, where generators are paid only for the energy they produce, to provide appropriate incentivestobuildnewgeneratingcapacityintherightquantity,therightlocation,and based on the right technology. Why is there so little faith in market forces? Is not an optimal level of generation investments something that a liberalized and well- functioningmarketshouldprovide? Areplyfrequentlyheardfromeconomistsisthat,inreality,trulyfreeandcompeti- tive energy-only markets do not exist. A number of political/regulatory constraints, such as price caps, or operational barriers, keep prices for wholesale and balancing energy below their efficient levels at times when they should be high, providing insufficient revenues for gas-fired peaking units to recover their capital costs. The increasing intake of subsidized renewable energy into the system likewise depresses wholesalepricesanddriveshigher-costconventionalplantsoutofbusiness.However, assuggestedbythedivergingviewspresentedinthisbook,thereisstillnoconsensusas towhethertheseconcernsarevalidornot. Andthecommoncureenvisagedthesedays?Evenmoresubsidies.Wearewitnesstoa hasty and uncoordinated introduction of so-called capacity remuneration mechanisms (or simply, capacity mechanisms) in a number of European countries. In essence, capacitymechanismsare justanotherform ofstate-driven support whichcompensates generatorsfortheircapacity,thatis,theiravailabilitytoproduceenergyatsomepointin the future. A more certain and stable stream of revenue for capacity, in addition to revenue from the sale of energy, is supposed to mitigate generators’ investment risk, encouraging them to build new power plants, and also to keep the existing ones in operation.Capacitymechanismscanalsoremunerateconsumersfortheircommitment toreduceenergyconsumptionatsomepointinthefuture.Inthiscase,themechanism supportsinvestmentsindemandsideresponsesolutions.Capacitymechanismsarethus nothingmorethananewregulatory‘patch’inthelongtransitiontowardsacompetitive, sustainable,andsecureenergymarketthedesignofwhichstillremainstobeperfected. But is not the cure worse than the disease—assuming there indeed is a disease? Capacity mechanisms may have serious implications for the completion of the European internal electricity market, the Holy Grail pursued since the mid-1990s. In particular, they might hamper cross-border trade and distort competition in the nationalday-aheadandbalancingmarkets.Theymightalsodistortinvestmentsignals in the internal market leading to locational over- and/or under-capacity. As the economic rationale for introducing capacity mechanisms still remains uncertain, their actual impact on the performance of markets is even harder to establish. How wouldtheirintroductionaffectcompetitioninspotmarkets?Howwouldcross-border tradeevolve?Wouldcapacitymechanismsreallyboostnewinvestments,asopposedto maintainingoldandinefficientpowerplantsonafinancialdrip?Wouldtheyoptimize vi Editors’preface the generation mix? Would they incentivize demand side response and electricity storage? These are only some of the questions facing European and national policy makersandregulators. On29April2015,theEuropeanCommission(theCommission)launchedaEurope- widesectorinquiryintocapacitymechanisms,thefirstandoneofakindinquiryinto Stateaidacrossanindustrysector.1TheCommissionaimstogainbetterunderstand- ing of capacity mechanisms, and in particular whether any specific schemes would distorttheinternalenergymarket. Inthiscontext,itisimportantfirsttomaketherightdiagnosisandtotrytoidentify cheaper and less distortive alternatives to just another form of support scheme. Refiningcurrentmarketdesigns,inparticularbyfosteringdemandresponse,improv- ingtheoperationof balancingmarketsandincreasinginterconnection mightprovide moresuitablemeanstoensuresecurityofsupply,evenifthesetypesofinstrumentsall carry their own difficulties and complexities. From the perspective of the internal energy market what is required is to strike a careful balance between the efficacy of thenationalmeasureanditsdistortiveeffectsoncompetitionandcross-bordertrade. Achieving such a balance is one of the most analytically and politically challenging tasksfornationalandEuropeanregulatorsalike. If weassumethatcapacitymechanismsare indeed necessary toachieve anadequate levelofinvestment,theirdesignthenbecomesthecorequestion.Asdiscussedatlength inthisbook,thereisawidevarietyofcapacitymechanismstochoosefrom,fromsimple payments for capacityto more complex capacityauctions. Capacitymechanismdesign raisesaclassicaltrade-offbetweenacentralized,administrativedetermination of prices and/orquantities,andleavingmarketforcestoreignasfreelyaspossible.Rigiddesigns with a higher level of public intervention will probably ensure realization of the target levelofinvestment,butatwhatcost?Market-baseddesigns,althoughsuperiorintheory, mayatthesametimeleavescopeforanticompetitivebehaviour,andmaynotbringthe expectedoutcomes.Anotherimportantquestioniswhetheragivencapacitymechanism couldfitwellintotheEUTargetModelforelectricitymarkets.Onemustrememberthat capacity mechanisms add a layer of regulatory complexity onto pre-existing market dynamics when all market design elements are closely related and interdependent. A mismatch between capacity mechanisms and existing or new market elements is probably unavoidable, requiring continuous monitoring and adaptation ex post by regulators.FromtheperspectiveofEuropeanelectricitymarketintegration,thepartici- pationofcross-bordercapacityremainsakeyelementofanycapacitymechanismdesign. MemberStatesimplementcapacitymechanismsforverydifferentreasons,andtailor themtotheirnationalmarkets.Theresultingvarietyofcapacitymechanismcallsinto question the feasibility of their eventual harmonization at the EU level. However, as manyofthecontributorstothisvolumemaintain,somedegreeofharmonization(for instance,atregionallevel)wouldsignificantlymitigatetheveryrealrisksofdistortions in the internal market. It is therefore not surprising that the Commission closely 1 PressreleaseIP/15/4891of29April2015.Moreinformationonthesectorinquiryisavailableathttp:// ec.europa.eu/competition/sectors/energy/state_aid_to_secure_electricity_supply_en.html,accessed23July 2015. Editors’preface vii investigatestheissue,andhasdevelopedasetofcriteriawhichMemberStatesshould follow when designing capacity mechanisms. While the Commission cannot prevent Member States from implementing capacity mechanisms to address genuine gener- ationadequacyissues,theTreatydoesconfercertainalbeitlimitedpowerstoallowthe Commission to control these national developments. As discussed in depth in this book, the Treaty provisions on state aid, public services, competition, and the free movementofgoodsallhaveusefulandimportantrolestoplay. Overall,concernsaboutsecurityofsupplyinEurope,andplanstointroducecapacity mechanisms,raisemorequestionsthantheyanswer.Drawingonpolicy,economicand legal expertise, this book provides a comprehensive study on capacity mechanisms, theircausesandpotentialconsequencesfortheinternalelectricitymarketandfinally, andtheroleofEUlawinmitigatingtheriskofdistortionofinter-statetrade. This book project originated from a comparison of eleven in-depth case studies of national capacity mechanisms existing and/or planned in Europe. The findings extracted from thesevarious countrymodels werepresented on 11 October2013ata Florence School of Regulation (FSR) workshop in Florence, and provided a valuable researchbaseforthechaptersdealingwiththepolicy,economics,andlawofcapacity mechanisms from a broader European and international perspective, included in the firstthreepartsofthisbook.Nationalcasestudiesformthefourthpartofthisvolume. PartIdealswithEUpolicymaking.Chapter1,writtenbyFranciscoEnriqueGonzález- Díaz,providesanintroductiontothebook.Itexplainswhatcapacitymechanismsareand why they are so much discussed at the European level. The chapter guides the reader through the different types of capacity mechanisms, and discusses relevant EU legal measures, policy documents, and individual cases, placing capacity mechanisms in the broaderEUlegalandregulatoryframework.Inchapter2,AlbertoPototschnigandMartin Godfried contend that the lack of cross-border coordination of national generation adequacypoliciesistothedetrimentofthemarketintegrationprocess.Representingthe viewoftheAgencyfortheCooperationofEnergyRegulators(ACER),theauthorssuggest thatenhancedcoordinationofthesepolicieswouldminimizetheriskofmarketdistortion, inparticularbydevelopingcommoncriteriafortheassessmentofgenerationadequacy. ThisrecommendationistakenfurtherbyJean-MichelGlachantandArthurHenriotwho, inchapter3,proposeasetofconditionsforcoordinatinggenerationadequacypoliciesat EUlevel.Theauthors’analysistakesintoaccountthespecificitiesofEuropeanelectricity markets:progressiveintegrationandanincreasingshareofrenewableenergy. PartIIbringstogethervariouseconomicinsightsoncapacitymechanisms.Itbegins with chapter 4 by Christoph Riechmann and Jens Perner who get to the root of the problem: can energy-only markets with rapid expansion of renewable energy deliver adequate levels of investment? Ifnot, can we ensure investmentswithout resorting to capacity mechanisms? The authors identify different measures which may still fall within the current energy-only market design as opposed to those which may go beyond that market design. They suggest that reform of the existing market design should be exploited first before embarking on the introduction of more extensive mechanisms in the form of capacity mechanisms. However, as they acknowledge, divergent security of supply problems may require different measures. This latter issueisfurtherdevelopedinchapter5,inwhichFabienRoquesandCharlesVerhaeghe viii Editors’preface take a closer look at the specific local drivers for the implementation of capacity mechanismsinvariousMemberStates,andreturntotheissueofamorecoordinated approachtocapacitymechanismsattheEuropeanlevel,inparticularintermsofcross- borderparticipation.Thefeasibilityofcross-borderparticipationincapacitymechan- ismsisthoroughlystudiedbyDominiqueFinoninchapter6.Theauthordistinguishes twoformsofcross-borderparticipation:(a)explicit,withcross-bordertradeincapacity rights, and (b) implicit, which is simply based on the statistical contribution of generationcapacitylocatedinonecountrytothesystemreliabilityofanothercountry. He examines the social benefits of these two forms of cross-border participation in situations with and without cross-border congestion. Chapter7 looks beyond the EU debateoncapacitymechanismsanddrawsonbroaderinternationalexperience.Carlos Batlle, Paolo Mastropietro, Pablo Rodilla, and José Ignacio Pérez-Arriaga analyse variousdesignelementsof selectedAmerican long-termauctioningmechanisms,asa basisforrecommendationstosupportpolicydevelopmentscurrentlyunderwayinthe EuropeanUnioncontext.PartIIcloseswithchapter8byBertWillems,whoprovidesa more theoretical economic analysis of a capacity mechanism in a simplified perfectly competitive electricity market. The author shows how a technology-neutral capacity mechanismcanrestoreefficiencycausedbyadetrimentaleffectofapricecaponshort- termprofitabilityandlong-terminvestmentincentives. Part III focuses on the role of EU law in mitigating the risks that a patchwork of different national capacity mechanisms can pose to the successful functioning of the internalenergymarket.TheEUstateaidrulesarecurrentlytheprimaryinstrumentat the Commission’s disposal when it comes to controlling capacity mechanisms, as explained by Leigh Hancher in chapter 9. The author discusses circumstances in whichanationalcapacitymechanismcanconstitutestateaid,andconsidershowfar- reaching the criteria developed by the Commission in its recent soft-law state aid guidelines are likely to be in practice in preventing distortions of the internal energy market.Whilestateaidrulescanbeappliedtovetthedesignofcapacitymechanismex ante and therefore ideally at the implementation stage, chapter 10 turns to the EU antitrust rules, which are applied ex post. Adrien de Hauteclocque and Małgorzata Sadowskalookatthepotentialfordifferenttypesofanticompetitivebehaviourbyfirms inthecontextofcapacitymechanisms.Theyarguethatincertaincasesantitrustrules might not provide an effective response. This highlights the importance of regulation and market monitoring in mitigating the risk of market abuse. Finally, national capacity mechanisms can entail barriers to cross-border trade in energy, a result which appears to be hard to reconcile with the free movement of goods, one of the fundamental freedoms enshrined in the EU Treaties. In chapter 11, Peter Oliver discusses recent landmark cases on the compatibility of green certificate schemes in SwedenandBelgium,withtheTreatyfundamentalfreedomsandtheirsignificancefor thecapacitymechanismdebate. PartIVcontainsdetailedcasestudiesofcapacitymechanismsexistingorplannedin eleven Member States, most of which are now subject to the Commission’s sector inquiry. All chapters follow the same structure to facilitate comparison between individual country models, and each chapter is divided into three sections. The first section gives a brief description of the market context, highlighting relevant national Editors’preface ix regulation on security of supply and assessment of generation adequacy. The second section focuses on capacity mechanism design and, in case of existing mechanisms, looks at their functioning in practice. The third and last section adds a European dimensionto thediscussion, brieflyassessingthemechanisms’compatibilitywithEU law. Thisbookistoprovideafirstpointofreferenceforregulatorsandpolicymakersas well as energy firms who are either involved in the design of capacity mechanisms in Europe or are dealing with newly introduced schemes. We hope that the various contributions to this book will promote a deeper understanding of how these mech- anisms work and can stimulate wider debate on their implications both for national markets, as well as the European internal market. We hope this book will prove an invaluable resource for anyone interested in energy market design, regulation, and competitionissues. Wewouldliketotakethisopportunitytothankallthepeoplewhomadethisproject sorewardingforus.Wearedeeplygratefultoeachofthem.Thisbookwouldnothave been realizedwithout the continuous supportof the Florence School of Regulation at theEuropeanUniversityInstitute.TheFSRisauniqueorganizationintheEU,atthe crossroadsofacademiaandpolicymaking.Weoweaspecialthankstoitsdirector(and acontributortothisbook),ProfessorJean-MichelGlachantforhisencouragementand unwavering support, as well as to our sponsors who make the development of such projects possible. We would like to thank all of the contributing authors for their enthusiasm and dedication to the project, and for their patience with the demands of an extensive editorial process. Every chapter was anonymously revised and cross- reviewed by fellow contributors. We address our sincere thanks to each author for having participated in this endeavour. In addition to the contributors, we would like to thank Anne Marie Kehoe and Claire Local who provided invaluable assistance in proofreading, editing, and preparing the manuscript for publication. At Oxford University Press, Alex Flach, Natasha Flemming, Kizzy Taylor-Richelieu, and Emma Slaughterwereinspiringandpatientpartners. LeighHancher AdriendeHauteclocque MałgorzataSadowska