28 Nov 2014 | Jakob Schlandt

Germany’s power market reform: the options on the table

The German government plans to redesign the power market to avoid shortages in power supply. In 2015, a decision will be taken on the introduction of a capacity mechanism – a system to compensate fossil power plants not only for the power they produce, but for the contribution they make to the stability of the grid by making capacity available for times of scarcity. A number of proposals put forward by industry experts and consultancies were detailed in a green paper released in October. This factsheet sums up the main contenders for Germany’s energy market reform.

Energy only market 2.0

Can today’s German power market for fossil producers survive the Energiewende? Proponents of the energy only market (EOM) say it can. In the EOM system, owners of power plants are compensated for the power they produce by selling it on free markets, such as power exchanges. As on other markets, price is determined by supply and demand.

A set of studies on reform of the EOM were commissioned by Chancellor Angela Merkel’s former coalition government of her conservative CDU-CSU and the liberal FDP and published this summer. The consultants Frontier Economics, Consentec, Formaet and R2B Energy Consulting argue that the energy market does not need capacity markets to function well and guarantee security of supply.

The EOM needs reform, however, and would be replaced by the EOM 2.0, as the proposal is called. This would involve regulation to develop flexibility of both supply and demand. Investors would need to be assured that the very high power prices to be expected at times of high demand and low supply would be politically accepted.

In short, advocates of this proposal trust that markets and investors – given the right framework – are able to predict power shortages and act accordingly. Market liberals by and large prefer this model. Criticism focuses mostly on the problem that politicians and wider society would have to accept very high power prices at times, and the considerable market power this would give power plants owners.

Additional capacity reserve

It is seen as highly likely that the EOM 2.0 would include a capacity reserve to ensure there is back-up capacity to avoid power shortages. Currently, an ad-hoc reserve for the German grid is organised by the Bundesnetzagentur (the German grid regulator). But the government proposes in the green paper that this would be complemented by a capacity reserve, even if a full-scale capacity market is introduced later on. The details of how this would function are as yet unclear. But because the power plants in this reserve would be kept on standby except in times of real scarcity and not compete against other plants, the capacity reserve would not significantly distort the energy market and is therefore not seen as controversial.

Decentralised capacity market

The two most powerful lobby groups of the German electricity sector have joined forces to support the Decentralised Capacity Market, which would mean that the Energy Only Market is complemented by a second “market” where security of supply is traded. The BDEW, where almost all owners of fossil power plants are organised, and the VKU, the German Association of Local Utilities, are both in favour of this model. Rather than doling out direct support for power stations, they propose to create a mandatory market where sellers of electricity have to acquire capacity certificates. When capacity is scarce, their price should rise, supporting investment in additional capacity, in turn balancing the market. Hans-Joachim Reck, VKU’s CEO, says that this would be the most efficient solution to the problem of dwindling capacity in Germany. “The market will decide the price of security of supply. This ensures that at times of sufficient capacity, the prices will be very low.” The government consultants have argued that it is unproven if this model would really support investment in capacity. Power plants, according to their view, are long-term investments, but the need to acquire capacity certificates is short-term.

Centralised Capacity Market

This would be a full-blown capacity market in which all providers of capacity can compete for compensation. The most prominent proposal put forward was by the Institute of Energy Economics (EWI) in 2012. The EWI’s mechanism is termed “security of supply contracts”. In essence, the government would hold auctions at which the suppliers sell generation capacity five to seven years in advance. It would be up to the state to decide on the overall capacity needed. This is identified in the green paper as one of the biggest disadvantages of the system, because mistakes could be made and politicians – fearing power shortages – are likely to be overcautious.

Also, all power plants – be they modern and relatively clean, or older, emission-heavy facilities – would be eligible for payments – which some see as doling out subsidies to exactly the kind of power generation Germany should be moving away from. The EWI model, or other centralised capacity market, is the least likely political option because it is not currently supported by any major lobbying organisation.

Focused capacity market

Finally, the WWF Germany environmental foundation sponsored a study by the Öko-Institut that proposes a more selective central capacity market that aims to support the energy transition in Germany. Two different capacity markets would be introduced: A short-term market for “incumbent power plants” would compete in auctions for payments that last between one and four years. In a second segment, power stations that are highly flexible and environmentally friendly can receive payments for 15 years. According to the authors, this would ensure that the capacity market is compatible with Germany’s long-term goal to switch to fluctuating energy sources like wind and solar. The proposal enjoys the support of some environmental organisations. Yet critics, and the green paper, point out that it could be costly.

The costs of energy market reform

What are the financial consequences of the decision? In times of sufficient power generation the reform would have little impact on energy prices, whether the German government were to decide on a fully fledged capacity market or leave the capacity supply entirely to market forces.

But the models would work very differently should power generation be tightened in the future. Centrally managed capacity markets would result in a growing surcharge being added to consumer energy bills to cover capacity payments made to power plants. With capacity expected to decline, politicians are likely to play it safe to avoid shortages, leaving them open to attack over higher energy bills. In a decentralised capacity market, where utilities would be responsible for determining how much capacity is needed, prices could also rise. But politicians would not be responsible for determining the capacity needed, leaving this to the market.

In an EOM system, utilities that buy electricity from power plants and sell it to consumers could be first in line to take the hit of skyrocketing prices at times of tightened capacity. In the long run however, year-round prices for household consumers would have to reflect this. Industrial power consumers meanwhile, would have to make the decision at what point peak prices force operations to shut down.

While the possible mechanisms for apportioning the costs of grid stability are explored in depth, as yet none of the proposals on the table have put forward figures to indicate the scale of these costs. But in a study commissioned by the Energy Ministry, the consultants of R2B estimate that a centralised capacity market that includes all power stations would cost consumers 15 billion euros in total until 2030. The price tag for the decentralised capacity market is 7 billion euros, and the focused capacity market should cost 2.5 billion euros. The EOM 2.0 plus a reserve would mean additional cost of 1.6 billion euros overall, compared to the status quo. However, these calculations are based on numerous assumptions about the electricity market – and could well turn out to be very different in reality.

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