Insights Blog

EU energy Ministers agreed on 9 September 2022 on short-term measures to decrease high energy prices, reiterated in the State of the Union Address. They invited the Commission to swiftly develop proposals in the areas of: (1) capping revenues of inframarginal electricity producers, (2) imposing price caps on gas, (3) incentivising electricity demand reduction, and (4) supporting liquidity by ensuring that market participants have sufficient collateral to meet margin calls.

Capping Revenues of Producers

Electricity markets based on economic dispatch are structured around an economic merit order – generation is scheduled to be brought on the grid starting with producers bidding the lowest prices, followed by incrementally more expensive bids, until demand is met. The cost of the last unit of electricity needed to meet demand – the marginal cost unit – sets the market clearing price. In the EU, gas-fired generation may set the marginal price for several reasons, in which case wholesale market prices are driven up as gas prices are reflected in bids.

The inframarginal price cap under development at EU level seeks to limit the higher revenues attributed to other forms of generation (such as coal, wind, solar, nuclear) as a result of this. Preparatory papers described the proposal as “temporarily skimming the revenues earned by inframarginal generators and using these to relieve the pressure of high energy prices on customers, while leaving wholesale price unchanged”.

In Ireland, it is important to bear in mind some of the nuance around how electricity is traded and subsidised.

The vast majority of renewable electricity producers in Ireland are supported through subsidy schemes, mainly REFIT (which ran for projects that were being developed from around 2006 to 2015) and now increasingly RESS.

Under the RESS scheme, renewable electricity producers are required to enter into a power purchase agreement (PPA) with an electricity supply company. The RESS rules require that the price the producer gets paid under the PPA is the price they bid into the RESS auction – this is the strike price. Average auction prices in RESS 1 and RESS 2 were lower than wholesale prices today. When the Market Reference Price is lower than the strike price (in other words, the supply company could have purchased the power cheaper in the wholesale markets) the supply company gets topped up from the PSO pot to the level of the strike price (unless the Market Reference Price is below 0). When the Market Reference Price is above the strike price (as now is likely the case) the supply company pays back to the PSO pot.

Notable for Ireland is that new legislation puts in place a legal basis for supply companies to pay money back out of the PSO pot to customers – so there is now a mechanism for channelling the difference in the cost of producing renewable electricity and the (higher) wholesale price of electricity back to customers.

Previously, under REFIT, renewable electricity producers also entered into a PPA with an electricity supply company (and these contracts are still ongoing). Under the REFIT scheme, the supply company under the REFIT PPA is entitled to a top-up from the PSO pot when the market price is below the applicable REFIT reference rate. The PPA price had to be equal to at least the applicable REFIT reference rate (effectively a price floor). It is important to remember, however, that REFIT PPAs – including the PPA price – are privately negotiated. It is not therefore known the extent to which, in any specific case, electricity producers or electricity suppliers are receiving the upside under their REFIT PPA.

Similarly, existing Corporate PPAs in Ireland are predominately structured as contracts-for-difference (CfDs) with electricity producers being paid a strike price by reference to the SEM market price. Questions also arise in respect of other forms of generation intended to be the subject of the price cap. They may have entered into a variety of commercial and hedging arrangements and a one size approach will unlikely fit all.

Ensuring that market rules support the functioning of an efficient market is an ongoing process. Even before the war in Ukraine, rules were undergoing significant reform to support a decarbonised energy mix. As it becomes more urgent to protect customers from the impact of the war, it is important to recall key legal principles and the intent underpinning current market and contractual mechanisms, to help avoid any unintended outcomes arising from well-meaning interventions.

Incentivising Demand Reduction 

Further detail is awaited on the proposal to coordinate demand reduction across the EU. The non-paper on emergency electricity interventions of 1 September 2022 states that the main objective is to reduce overall & peak hours’ consumption, to lower clearing prices in electricity markets, and to preserve security of supply.

The non-paper continues that the “main instruments to be used to achieve this demand reduction could be similar to the demand reduction tenders implemented by some Member States in the gas sector: Member States would request particular consumer categories (e.g., industrial, or aggregated retail consumers) to submit bids on the amount of financial compensation they would need to cut consumption in pre-established circumstances. …. Regarding final consumers (e.g. households), the demand reduction could be incentivised by remunerating consumers for decreasing their consumption …”.

The non-paper suggests that while this comes at a cost for public budgets, that might not necessarily be higher than the cost of price intervention on the supply side and would align with the EU’s policy goal of incentivising demand side response.

Under EU law, demand side response is configured as a change of electricity load by final customers from their normal consumption patterns in response to market signals, including in response to time-variable electricity prices or incentive payments, or the acceptance of a customer’s bid to sell demand reduction or increase at a price in an organised market as defined in certain provisions in EU law.

This is an entirely different proposition from setting about demand reduction through use of system tariffs (as proposed in Ireland), as we have highlighted previously here.