Our energy destinies rest in the hands of governments – and this is particularly true in power markets. More than 70% of future investments in global energy supply will be made by state-directed entities or respond to regulatory incentives. If we narrow this view to the power sector, more than 95% of global investment will be made in sectors that are fully regulated or affected by mechanisms to manage the risk associated with variable prices on competitive wholesale markets.
Traditionally, electricity markets developed and operated within strictly regulated frameworks, in which vertically integrated utilities handled all or most activities from generation to transmission to retail. Over the past 35 years, however, many parts of the world have gradually moved towards competitive markets as a means to generate and procure electricity alongside many of the support services required to operate a power system.
Today, countries that rely on competitive markets to maintain efficient operations in the short term, either through bilateral physical contracts, power exchanges, or co-ordinated spot markets, account for 54% of the world’s electricity consumption. Once China completes implementation of its power sector reform, this share will increase to almost 80%.
Despite their imperfections, markets have largely succeeded in the goal of providing reliable electricity at least cost to consumers. Nonetheless, some regional markets have come under strain. Without policy measures to address this shortfall, there is a risk to future security of supply. This is a topic that is examined in much greater detail in the electricity focus of the World Energy Outlook-2018.
Since 2010, some electricity markets have experienced a decline in wholesale energy prices brought about by stagnant demand, low natural gas prices and higher output of generation with low marginal costs. This situation is not unique to Europe, for example, our analysis points to similar outcomes emerging in regions such as the United States and Australia.
The decline in market revenues experienced in many markets raises some questions about the ability of competitive markets to provide adequate returns to sustain the existing fleet and to provide adequate signals for timely and efficient investment. The problem arises from the low wholesale market prices that have occurred in many markets, as a result of rapid deployment of variable renewables, the requirement for high levels of reliability (through healthy capacity margins), and, in some cases, low natural gas prices.
While periods of reduced profitability are a natural part of competitive markets, declining revenue in lean systems where investment is needed – which we see in some markets today – may signal a need to re-evaluate market design and its ability to deliver investment and electricity security, especially since the main conditions that have depressed wholesale prices are likely to continue at least in the near term. With new sources of capacity and flexibility in power systems becoming more widely available and cost-competitive, future regulatory frameworks or market reforms should strive to ensure a level playing field for all system resources, including power plants, energy storage systems and demand-side response.
Furthermore, wholesale markets are responsible for non-energy revenues that come from providing a variety of products commonly referred to as system or ancillary services. These products safeguard against unforeseen changes in demand or available supply (primary and secondary reserves), as well as products that support the quality of power (reactive power, frequency regulation and inertia). They provide revenues to sources that, even if not essential for the adequacy of the system, support the reliability of supply and quality of power delivered.
Recent trends suggest that some markets may be unable to deliver investment signals that guarantee resource adequacy. For example, in markets in the European Union, the share of total production costs covered by electricity sales fell from 77% in 2010 to about 60% in 2017, and looks set to continue declining. Such unsatisfactory market signals led many European utilities to broaden their exposure to global markets by means of deep business restructuring and reorganisation, in addition to giving large space for capex optimisation and high investments in operational efficiency, renewables and digitalization. In fact, even if in 2017 the missing money gap narrowed, as wholesale electricity prices and total electricity sales increased by about 20%. This relief was temporal, however, mainly a result of a rebound in natural gas prices, lower contribution than usual of hydropower to the generation mix and extended nuclear plants outages. Unfortunately none of these underlying causes of partial remuneration recovery is likely to continue.
In the United States, the share of total generation costs covered by wholesale electricity sales is also declining. Stagnant demand and the rising share of variable renewables, led by wind power, have added to the downward pressure on wholesale electricity prices in several US electricity markets. Electricity sales may continue to recoup less than the total cost of generation, owing to an expected growth from solar PV and wind generation and a persistence of low gas prices, despite the possibility of a return to growth for electricity demand spurred by space cooling and the electrification of heat and transport.
In Australia, the recent experiences have been quite different; mostly due to scarcity pricing – which also constitutes a key signal for new investment required - that has more than offset an increasing share of renewables during the last seven years and has covered a rising portion of total costs in generation.
The experience of established competitive markets provide useful examples of potential concerns and solutions for countries looking to transition to competitive markets. For example, Japan is pursuing electricity market reforms that establish a set of markets for baseload, transmission usage, capacity, balancing and zero emission credits, which will provide a basket of complementary revenue streams. Mexico is also pursuing market reforms that aim to transition away from regulated to competitive markets and that take account of the experience of other countries.
These points lead to the obvious question: how will the electricity market of the future work? It is very likely that over the medium to long term, many markets will continue to experience further downward pressure on wholesale energy prices as more zero-cost power generation enters the market alongside new energy service providers and innovative technological solutions. Policy makers, regulators and energy sector stakeholders need to understand the changes underway and seek new solutions and market designs that can support the transition towards low-carbon electricity markets while at the same time ensuring the security and adequacy of power systems.
Correction 22 March 2019: The figure "Gap between wholesale electricity market revenues and total generation costs, 2010-17" was updated to correct a mismatch between legend and series colours and an incorrect y-axis scale for Australia.