European Union: Don't Let The Lights Go Out: The European Commission Provides Guidance On Capacity Mechanisms

Last Updated: 9 January 2017

On 30 November, the European Commission published its final report on its sector inquiry into capacity mechanisms. The report concludes that while these measures may not be the most effective solution to electricity supply shortages, they may be necessary in some Member States until market reforms can be implemented. The report advocates a more coherent approach to assessing the need for such mechanisms and provides guidance on their design. The Commission will also work with Member States to bring all existing capacity mechanisms into line with State aid rules.

The Clean Energy for all Europeans Package

The report forms part of the Clean Energy for All Europeans package of legislative measures, which deals with the transition of the EU to renewable energy sources. These measures have three main goals:

  • position the EU as a leader in the global transition to renewable energy
  • prioritise and improve energy efficiency
  • provide consumers with a fair deal through increased transparency and regulation.

Within this package, the report on capacity mechanisms forms part of the measures aimed at improving the functioning and integration of EU electricity markets during the transition to clean energy and is intended to create a European legal framework for capacity mechanisms.

Capacity mechanisms in the EU

Capacity mechanisms seek to ensure that sufficient generation capacity is available to meet demand by providing additional remuneration to capacity providers, on top of the income they obtain from selling electricity, in return for commitments to maintain or expand existing capacity. The Commission found 35 capacity mechanisms (past, current and planned) in the Member States1 covered by the inquiry, which fall into three main categories:

  • Market-wide capacity mechanisms: providing support to all providers that meet the required standard for participating in the scheme
  • Targeted capacity mechanisms: providing remuneration to a targeted subset of providers for maintaining or investing in additional capacity
  • Demand response schemes: providing financial support to specific demand response operators – for example, interruptibility schemes, which pay industrial customers to reduce their demand when electricity supply is low.

The Commission also identified two main pricing models:

  • Volume-based schemes: where the required capacity is determined upfront and the price established through a competitive bidding process
  • Price-based schemes: where a price is set upfront at a level calculated to generate the required investment.

Do capacity mechanisms have a role to play in the EU?

While the Commission found that electricity shortages in the EU as a whole are very rare and there is generally overcapacity, the report acknowledges that some Member States have legitimate concerns that they may not have enough generation capacity to meet electricity demand. Moreover, Europe's electricity sector is experiencing an unprecedented transition due to market liberalisation and efforts to reduce greenhouse gas emissions. Some Member States are concerned that, without the implementation of capacity mechanisms, existing capacity and expected investment in new capacity may be insufficient to maintain security of supply in the future.

The report notes, however, that Member States that are considering capacity mechanisms should make appropriate efforts to address their resource adequacy concerns through market reforms. The report identifies various market failures that deter investment in electricity generation, including lack of price responsiveness as a result of national measures to control supply and demand during peak times (such as low price caps or penalties imposed on network operators for imbalances).

Compliance with the State aid rules

Capacity mechanisms often involve financial support that may constitute State aid and as such, they have the potential to distort competition. These capacity mechanisms should therefore be notified to the Commission for approval under State Aid rules prior to implementation.

The Commission considers that many capacity mechanisms are not well-designed or based on genuine need for a capacity mechanism. The report recommends that the need for a capacity mechanism should be clearly demonstrated by a robust generation adequacy assessment. The required level of supply should be determined using a cost-benefit analysis in relation to an economic "reliability standard" that reflects consumers' willingness to pay for electricity.

The Commission notes that the potential for capacity mechanisms to distort competition may be addressed by ensuring a high degree of competition within each mechanism. The report therefore provides recommendations on their design:

  • Eligibility: schemes should involve a competitive process open to a broad category of new and existing capacity providers – any exclusions should be justifiable in the circumstances
  • Allocation tools: payments to capacity providers should be determined by a competitive process
  • Obligations: obligations on capacity providers and penalties for non-compliance should be set at an appropriate level
  • Cross-border participation: mechanisms should explicitly be open to participation by providers from other Member States to incentivise cross-border investment and investment in interconnection

The Commission also notes that it is important that the most appropriate type of mechanism is selected to address the underlying concern. For example, long-term concerns about investment in generation capacity are likely to be best addressed through volume-based market-wide schemes. Whereas a targeted measure, such as a strategic reserve that holds a certain amount of capacity outside the market for emergencies, may be appropriate for temporary concerns. The report is also clear that 'administrative' price-based capacity payments that do not allow the market to set the right price for capacity are unlikely to be regarded as appropriate measures.

What does this mean for businesses receiving support from capacity mechanisms?

Significant changes to the structure of most national electricity markets may be expected once the market reforms proposed by the Commission's Clean Energy for all Europeans package are implemented. Until then, capacity mechanisms are likely to continue to play a role but there are likely to be changes made to existing capacity mechanisms where these have not been designed appropriately. The Commission notes that it will work with Member States to bring all existing capacity mechanisms into line with State aid rules. The following changes may also be expected in relation to future schemes:

  • opportunities to participate in capacity building schemes may arise less frequently as higher adequacy assessment standards are applied
  • schemes will need to be made open to a wide group of providers using a range of technologies
  • schemes will need to be made open to providers in other Member States (facilitating cross-border investment and investment in interconnection service capacity).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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