The changing dynamics of European electricity markets

The recently adopted electricity market reform sees the state becoming a major financial intermediary in the European electricity sector, with implications for its approach to recovering costs. 

Conall Heussaff is a Research analyst at Bruegel

States are taking a more active role in the energy transition through direct investments in clean tech R&D and manufacturing, as well as support for clean electricity. EU countries have strict targets for wind and solar deployment that will require hundreds of billions of euros in annual investments, most of which will receive state guarantees.

Despite this clarity on the supply side, there is significant uncertainty about the future consumption of electricity, as it depends on how fast heating and transport is electrified, and on the growth of data centres. Electricity supply-demand mismatches are a significant concern and could result in costly inefficiencies, ultimately affecting final consumer energy costs.

The central role of the state is reinforced by the recently reformed EU electricity market design rules that entered into force this week, in which long-term state-backed contracts (often referred to as contracts-for-difference) have been designated as the main instrument for financing clean electricity generation investments.

Such contracts provide a state guarantee for a fixed price for electricity generation, with the state providing a top-up to producers to when wholesale market prices fall below a certain level (conversely, producers pay back money to the state if market price exceed that level).

These contracts are promoted in the electricity market design for two reasons. First, as a means to both protect consumers from price spikes such as occurred during the 2022 energy crises by hedging generators at fixed, stable prices.

Second, to create suitable conditions for investment by providing price certainty.

The majority of new investments in wind and solar plants across Europe are supported by such contracts, helping to deliver the much-needed decarbonisation of electricity. Yet there is an underappreciated implication of their widespread uptake: the state will assume much of the clean electricity supply investment risk

At present, most financial flows between electricity producers and electricity suppliers occurs through trades on wholesale market exchanges. Electricity suppliers then recover their costs from final consumers.

However, with the use of long-term state-backed contracts, the state is becoming a major financial intermediary between electricity producers and electricity consumers.

According to our estimates in a recent policy brief, in a future scenario with lower electricity demand than anticipated (say, if electric vehicle and heat pump deployment slow down), tens of billions of euros annually could flow from the state to electricity generators, instead of through market exchanges.

Why does it matter if money flows through the state rather than through markets? Energy policy must evolve as the state takes on more risk associated with clean electricity supply investments.

Unlike typical market participants, the state can implement broader risk management strategies. It can put in place incentives for efficient, flexible electricity systems that can shift around surplus supply in both space and time. The state can also manage its supply side risk by stimulating demand, if needed.

Critically, how the state recovers the costs of state-backed contracts from final consumers becomes an important energy policy question. The standard approach recovers the costs from retail electricity consumers – meaning households and businesses – with many industrial consumers, especially energy intensive consumers, exempted.

Given that these contracts could become a central part of the electricity market system, a more balanced approach is needed. Households and businesses should not be burdened with a disproportionate share of the total costs and should retain the incentive to electrify.

State-backed contracts have successfully supported renewable deployment and are rightfully promoted as an instrument to accelerate decarbonisation, but their broader implications must be addressed.

Electricity policy must account for the growing role of the state, mitigating the risk of supply-demand mismatches and ensuring that all consumers pay their fair share of the electricity system.