Electricity market reform: will the Commission hit a brick wall with conflict between member states?

Energy - March 15, 2023

In the context of Europe’s energy security crisis, the European Union is elaborating a legislative proposal to reform the EU’s integrated electricity market. As Commission President von der Leyen stated in June, the EU’s electricity market “does not work anymore” and needs to be adapted to the “new realities of dominant renewables”, arguing that short-term crisis measures are necessary but not sufficient to tackle the record high energy and electricity prices, and instead advocating longer-term structural reforms of the electricity market. In fact, for the past year, Southern European states, predominantly Spain and France, have been spearheading calls for “structural solutions” to mitigate high energy prices, primarily reforming the current ‘merit order’ marginal pricing system to decouple electricity prices from natural gas.

After a period of public consultations, the European Commission is expected to publish its reform proposals in mid-March 2023. The overarching objective is to protect consumers and mitigate the unprecedented volatility in electricity prices that has afflicted Europe for the past 2 years. However, energy is a sensitive and polarising issue that generates intergovernmental conflict between alliances of member states. There are various dimensions of conflict that are already playing out in informal Council of Ministers meetings and national leaders’ declarations, and they will certainly also frame the legislative process once the Commission formally presents its proposals.

The fundamental dimension of conflict concerns the nature of the electricity market reform. Energy is one of the main areas of conflict that cross-cuts the ailing Franco-German axis. Furthermore, this division partly aligns with the traditional north-south cleavage, though on some aspects of energy, some Central and Eastern European states like Poland have sided with the Southern states. On the one hand, the former group of member states, led by Spain and France, advocate a deep transformation of the electricity market to decouple electricity prices from natural gas prices, as they blame this system for price spikes. Spain and France have large renewable energy mixes, so they oppose the current marginal pricing system whereby wholesale electricity prices are determined by the most expensive energy source used to meet demand, meaning expensive natural gas usually dictates all other electricity market prices. France has dubbed this system “absurd”.

On the other hand, ordoliberal Germany and other fiscally prudent Northern states like Denmark and the Netherlands, are apprehensive about far-reaching reforms that could distort market mechanisms. These countries are concerned about the repercussions a radical market reform could have on energy security and supply. Germany, for instance, is concerned about the incentives generated by the market to invest in renewables, and flexibility in power generation capacity as backup for intermittent renewables. Therefore, these countries support preserving the current market architecture and instead favour a more cautious and “targeted” reform consisting of measures like long-term contractual arrangements to give certainty to investors and lower the cost of renewables investment. Germany is apprehensive about a far-reaching reform. Therefore, the ultimate package proposed by the Commission in March will likely be more watered down than the ambitions of the Mediterranean states and focus on measures like long-term power contracts to mitigate price volatility, e.g. power purchase agreements, and contracts for difference. Whether the proposals are ambitious or not, they will inevitably generate friction between the competing interests and visions of the two main blocs of member states, as the Southern states will likely be able to assemble a coalition of 15 member states to outvote Germany and its coalition of 7 states.

Secondly, conflict extends to other aspects related to electricity market reform, such as the desirability of a gas price cap or a windfall tax on energy companies. The EU finally approved an emergency gas price cap in December, euphemistically dubbed the ‘market correction mechanism’, but not without significant conflict. Spain, for instance, had been defending the extension of its ‘Iberian exception’ mechanism to other EU member states – the ‘Iberian exception’, approved by the EU in April, allowed Spain and Portugal to temporarily decouple electricity prices from gas prices through a price cap. Germany had resisted proposals for a price cap for months, fearing that it would limit German companies’ ability to find alternative supplies on the global gas market in the context of losing access to Russian gas.

However, Germany ultimately, albeit reluctantly, caved into pressure and agreed to the price cap to not compromise EU unity, in what seems to be another manifestation of the loss of Berlin’s muscle in the EU since the Scholz chancellorship. Germany did receive some minor concessions like accelerating the deployment of renewables and a revision of EU emergency permitting rules. Nevertheless, other northern states like Austria and the Netherlands persevered in their opposition to the price cap and their concerns about its potential impact on security of supply. This coalition of Northern states remains sceptical about policies that impose “revenue limitations”, like price caps or windfall taxes. Therefore, these conflicts will continue to frame EU energy policy if extending the current one-year price cap is eventually put on the table, all the more relevant considering that countries like France consider the current price cap mechanism insufficiently ambitious.

Indeed, conflict over electricity market reform spills over into deeper related questions that are pertinent to the debate on electricity market reform, such as the future of Europe’s energy mix and the role of sources like fossil fuels and nuclear power in this energy mix. Over the two years, the high price and primary role of natural gas as the primary energy source used in peaking power plants in many countries to provide marginal production capacity when demand is high has been a key driver of soaring electricity prices. Furthermore, as the recent report on ‘The Future of European Energy and Transformation Challenges for Latvia’ shows, natural gas generates a significant amount of power plant baseload capacity in many countries like Italy, the Netherlands and Germany. Therefore, discussions about the future of the EU’s electricity market will necessarily have to contend with the question of what sources will be the basis of Europe’s future energy mix, and indeed this generates significant conflict between member states.  For instance, Central and Eastern European countries like Poland and the Czech Republic clash with Western countries over the future role of fossil fuels like coal. Similarly, France clashes with anti-nuclear states like Germany and the Nordic states due to its desire for nuclear energy to be included in the EU strategy for achieving carbon neutrality, as well as the role of nuclear-derived ‘red hydrogen’ in the EU’s green energy targets.

In a nutshell, the upcoming proposals for electricity market reform will generate significant conflict and are already further straining the ailing Franco-German Axis. Even at the most fundamental level, they are clashing over the timetable of the reform, with Paris calling for the reform to be completed in the next few months, but Berlin favouring delaying it until after the 2024 European Parliament elections.