Capacity Markets in Europe

European context

With the increase in electricity production from renewable sources in Europe, capacity markets are becoming essential for the smooth operation of electricity networks. The intermittent nature of renewable sources creates challenges in managing electricity supply and demand. Effective management is therefore crucial to ensure the reliability of the networks.

The concept of generation adequacy is central, referring to the ability of the electricity system to continuously meet demand, even in the event of planned or unplanned interruptions. This adequacy is assessed in terms of capacity and reliability, influenced by various factors such as energy demand, generation capacity, cross-border interconnections, and system flexibility.

EU Member States are required to monitor this adequacy via the ERAA (European Energy Resources Adequacy Assessment) and may supplement it with national assessments. If they have concerns, they must first identify and correct any regulatory or market distortions. If these concerns persist, they may resort to temporary capacity mechanisms, first assessing the viability of a strategic reserve before considering other types of mechanism.

Capacity mechanism definitons

The capacity market is a market mechanism set up in the European electricity systems. Its function is to guarantee that electricity production will be sufficient to meet peaks in demand. These peaks in demand occur at certain times each year when the electricity network is under great strain. This mechanism therefore complements the energy market, where electricity is bought and sold, by ensuring that adequate investment is made to increase or maintain generation capacity.

There are two main types of capacity market. The first is the centralized capacity market; it is based on auctions where producers are paid to maintain available capacity and is managed by a central entity such as the grid operator. The second is the decentralized capacity market, which allows for bilateral contracts or dedicated markets, offering flexibility and adaptation to the specific needs of market players. In Germany, Sweden and Finland, this type of mechanism is called “strategic reserves”, which, as the name suggests, are reserves of capacity ready to be used when needed. In Spain and Portugal, the “targeted capacity payment” allows direct payments to producers selected based on their capacity and speed. 

All the mechanisms on the map have been approved by the European Commission. Some additional member states are considering implementing a capacity mechanism in the future, while France is considering revamping its existing capacity mechanism.

A few figures on European capacity mechanisms

Member States’ capacity mechanisms are financed by users of the electricity system (e.g. by end-users via network tariffs or levies, or by suppliers or balance responsible parties). Costs are analyzed by year of delivery, both aggregated across the EU and by Member State. In absolute terms, the total costs of capacity mechanisms increased in 2022 and 2023. Total payments for the provision of capacity in 2022 amounted to more than €5.2 billion per year, compared with €4.8 billion in 2021. In 2023, costs are forecast to increase by 40% year-on-year, reaching €7.4 billion. This is mainly due to higher costs in 2023 for the French and Italian capacity mechanisms. In France, the nuclear unavailability experienced in 2022 has increased capacity auction prices and therefore the projected unit costs of the capacity mechanism in 2023.

The graph above shows this increase, representing the costs incurred or expected to be incurred to finance the capacity mechanisms per unit of demand (2020-2024), and expressed as a percentage of the average annual day-ahead price in the respective Member States. From the point of view of the electricity consumer, the costs of the strategic reserves (in place in Finland, Germany and Sweden) are significantly lower than the costs of the four market-wide capacity mechanisms. However, the three strategic reserve schemes differ significantly in terms of the average payment to beneficiaries, with the German scheme having much higher levels of remuneration per MW of allocated capacity.

In terms of the distribution of technologies remunerated through capacity mechanisms in the EU, of the 174 GW of capacity remunerated in 2022, only 5 GW was procured from demand-side response and battery storage. The share of capacity procured from these non-traditional capacity providers is small compared to established technologies, but the share is rising steadily.

The future of capacity mechanisms in Europe :

Although they are essential to the smooth operation of a grid that is increasingly reliant on intermittent power generation, capacity markets in Europe have come in for criticism and additional regulation for a few reasons. The first and most important is that the European Union does not want these mechanisms to distort competition and to be compatible with the internal energy market, i.e., not to hinder cross-border electricity exchanges. 

These mechanisms must also comply with the objectives of reducing greenhouse gas emissions and encouraging the transition to renewable energy sources. Often regarded as state aid, they must be approved by the European Commission. To do this, the regulatory body in each country must prove that the mechanism it wishes to put in place, whether centralized, decentralized or both, does not create excessive distortions in the energy market. 

The various major European players have recently agreed that the procedures for approving capacity mechanisms need to be simplified. Previously very difficult to put in place, given the strict conditions explained above, the Council has proposed changes aimed at streamlining the procedure within the current framework of the capacity mechanism. It also asked the European Commission to present a detailed report assessing other possibilities for simplifying the process of implementing capacity mechanisms. 

Following on from these simplifications for the major European players, a great deal of change is to be expected in the European capacity markets. We already have major examples in Poland, Portugal, Spain, and Germany. These countries are already in the process of replacing their interruptibility schemes with demand response mechanisms, which will play a crucial role in the stability of the European networks.

Tanguy Deseine |  Energy Consultant at Magnus Commodities