Ask the Experts

Redesigning electricity markets for successful decarbonisation

To meet the low-carbon pledges many countries have made to limit climate change will require more than simply installing more renewables: electricity markets must be reinvented so that they stimulate the right investments and efficiently price electricity for consumers, without compromising energy security. The IEA publication Re-powering Markets: Market design and regulation during the transition to low-carbon power systems details best practices to guide this evolution. The report’s lead author, Manuel Baritaud, explains its insights for the improvement of the market framework critical to decarbonisation worldwide. 

Senior Energy Analyst (Electricity) in the IEA Gas, Coal and Power Markets Division

How can electricity markets attract the huge investment necessary for the transition to a low-carbon power system?

Adequate investment in decarbonisation requires that we redesign electricity markets comprehensively. Pricing in CO2 remains a key objective, increasing revenues for capital-intensive low-carbon technologies and overcoming the lock-in of existing high-carbon generation – all while ensuring a secure electricity supply and operational efficiency. Drawing on the experiences of member countries, particularly in Europe and the United States, the IEA has found that a successful transition requires a new balance between regulation and competitive markets to create an environment that results in low-carbon investment.

Theoretically, with a sufficiently high carbon price, electricity markets would automatically shift to decarbonised generation, but in realitywe are missing some essential conditions. First, wholesale prices for power currently are too low to stimulate investment – and given cheap gas and coal, they are likely to stay depressed for years. Plus, power markets base electricity prices on the short-term marginal costs for fossil power plants, which are uncertain, and that complicates the recovery of high upfront fixed investment costs for the likes of utility-scale renewables, nuclear, and carbon capture and storage.

Even if those market forces could be addressed, a final important point is that governments often want to control the deployment of specific technologies, to reduce reliance on imported fuels as well as for other reasons, and that deployment can differ from the mix markets might obtain.

The risk of a large-scale blackout and capacity shortage makes electricity security an issue for regulators rather than just for markets.

What does the IEA mean by a new balance between regulation and competitive markets?

There are several areas where Re-powering Markets sees the need for continuing supplementary regulation to help competitive electricity markets navigate the vast transformation to a low-carbon electricity sector.

A critical example is reliability. The risk of a large-scale blackout and capacity shortage makes electricity security an issue for regulators rather than just for markets. So the redesign of electricity markets has to take into account how governments regulate reliability. For instance, most consumers are not exposed to dynamic electricity prices, so they cannot respond when there is scarcity and prices surge. Governments must carefully define market rules that rein in scarcity prices. Given the uncertainty at stake and the scale of the transformation needed, one option to deal with reliability, besides scarcity prices in short-term markets, is to rely on capacity mechanisms that serve as safety nets.

What are these capacity mechanisms, and what role does the IEA see for them?

Capacity mechanisms are increasingly used to ensure adequate generation capacity and maintain security of supply. Re-powering Markets looks at two forms of capacity mechanisms currently used in a number of IEA countries.

The first, targeted volume-based capacity mechanisms, are essentially strategic reserves. This can involve power sources like plants that otherwise might be decommissioned or mothballed but that are instead kept on standby. In some cases, low-carbon sources are built to serve and also kept on standby. These backups enter the markets only when scarcity lifts prices above a pre-determined level.

The other form examined in Re-powering Markets is market-wide capacity mechanisms, also known as capacity markets. Under such mechanisms, extra payment is promised to any technology, provided that it is available during expected tight system conditions: this can include power plants both traditional and low-carbon, but also demand response programmes. In theory, the openness to any solution leads to a least-cost portfolio of technologies. But these markets are complex and so must be designed carefully.

The goal for capacity mechanisms, of whichever form, is in principle to ensure a secure electricity supply – and not to provide subsidies or maintain unnecessary capacity. Another source of controversy is whether old, polluting resources are kept available because of capacity markets and therefore could continue to emit carbon dioxide.

Regardless, governments must bear in mind that capacity mechanisms do not substitute for getting wholesale market design right in the first place. 

Browse related IEA topics: