EU power market reform: the devil is in the detail

Under the current power market setup, all generators receive the same price for their output at a given point in time, regardless of how the power was generated.

This price is usually determined by the cost of the most expensive unit dispatched to meet power demand – in 2022 these were typically gas-fired units. Many renewable generators were therefore paid high prices for their output while their operating costs remained unaffected, so boosting profitability.

Conscious decoupling

Consequently, temporary windfall taxes and price caps were introduced last year to address the perception of excessive profits. Now, policymakers are focusing on designing a long-term solution that will aim to decouple prices paid to renewable generators from volatile fossil fuel prices.

The key tool the EU intends to use for achieving this decoupling is Contracts for Difference (CfDs) – a tool already used in many EU countries. Under the CfD mechanism, renewable generators sell their output at a fixed (often inflation-linked) price over a long period – usually 15 years.

Developers bid to build renewable capacity, with bids reflecting the prices generating assets will likely receive per unit of output produced. Auctions are generally run so that the required amount of capacity is built at the lowest possible cost. In essence, the EU is looking to expand, and potentially standardise, the existing auction framework.

Are CfD auctions the answer?

In principle, this could be a good idea. Historically, CfDs have a good track record of delivering large amounts of renewable capacity at relatively low prices in certain markets.

For example, in the latest UK CfD auction, held in 2021-22, developers entered into contracts to deliver almost 11 gigawatts of renewable capacity in 2026 at prices as low as £37 per megawatt hour in 2012 terms, equivalent to around £47 in 2022 terms. This is well below the power prices in the wholesale market, which averaged more than £200 per megawatt hour during 2022.¹

That said, while switching renewable generators to CfDs could therefore be an effective solution and take Europe a long way towards solving the energy crisis, the devil will be in the detail.  

The problem with price caps

In many EU member states, governments have come to expect – or even demand – low prices for new renewable capacity in CfD auctions and have duly imposed caps on the prices at which developers can bid in future bidding rounds. For example, the maximum price at which offshore wind developers can bid in the next auction round in the UK is £44 per megawatt hour – a 19% increase on the previous round. Meanwhile, the cost of equipment has risen by more than 40%², while the cost of financing has risen too.  

Some warning signs started emerging late last year, with the governments of Spain, Poland, Germany and Italy aiming to secure several gigawatts of renewable capacity in 2022. The auctions were largely unsuccessful, with Spain acquiring just 46 megawatts out of the 3,916 megawatts sought.

Developers often highlight that bid price caps are the main reason for auction failure.³ They point out that the caps are set too low and don’t fully reflect the recent increases in project costs.

But despite current shortcomings, EU power market reform can be made to work, in our view. The key will be ensuring that CfD auctions deliver prices which ensure an appropriate return on capital. From the perspective of long-term investors, it is encouraging that the policy has moved beyond firefighting, in the wake of the Ukraine war and subsequent EU energy crisis, to long-term structural reform to deliver energy security and climate change goals.

1. Source: BNEF as at 22 February 2023.

2. Source: Aurora Energy Research data as at January 2023.

3. Source: BNF as at December 2022.