What is the energy-only market (EOM)?
Definition
In terms of the underlying concepts, an energy-only market is the opposite of a capacity market. An energy-only market only compensates power that has been produced. A capacity market, on the other hand, compensates the mere readiness, or capacity, for power production. To ensure supply is guaranteed, the energy-only market is supplemented by various flexibility options, such as control reserve markets. Beyond that, there are usually additional reserve models similar to a capacity market aimed at guaranteeing supply.
Table of Contents
- How is an energy-only market different than a capacity market?
- France as a capacity market example
- Supply guarantees on the energy-only market
- What are the economic benefits of an energy-only market?
- Disadvantages of energy-only markets: The missing money problem
- Decentralization as a solution to the missing money problem
- Free pricing and supply guarantee on the energy-only market
- Market efficiency and merit order
- Impact of the market design on power market innovation
- Perspective: Ongoing global liberalization of the power market
How is an energy-only market different than a capacity market?
An energy-only market only compensates power that is actually produced. EOM power trading takes place either on the power exchanges or in over-the-counter (OTC) trades based on bilateral commercial agreements. Only generated megawatt hours (MWh) that go from the source to the power traders and eventually to end consumers can be bought and sold on the power exchanges.
On an energy-only market, capacity – referring strictly to a power plant’s ability to provision power – is only indirectly compensated based on implicit supply agreements, such as futures contracts. In these cases, a certain amount of power must be delivered by a certain deadline, meaning the necessary capacity to generate this power must also be available during that time.
France as a capacity market example
A capacity market has been in place in France since 1 January 2017. There, trading is conducted with certificates for capacity guarantees. These guarantees ensure that power producers will reserve capacity to generate power at a certain time – it does not mean that the producer will actually produce power at that time. It is simply an assurance that the producer has the ability to generate power during the stated period.
France's capacity market was not introduced based on market principles, but due to power shortfalls from the lack of flexibility in the country's power production, which is supplied primarily by nuclear and fossil fuel plants. Most French homes are heated electrically, meaning a temperature drop of one degree Celsius in the winter causes a 2,400 MW increase in demand. Sudden, long-lasting cold snaps led to serious supply problems in 2012, 2017, and 2018 – introducing centralized capacity control measures during the winter months was the result.
Supply guarantees on the energy-only market
In the early 2010s, experts did not believe the energy-only market was capable of guaranteeing supply. The main criticism was that market activity alone would not provide the money needed to expand reserve capacity. In practice, however, the energy-only market shows that supply can be guaranteed in a free market model, such as the one that exists in Germany.
Part of guaranteeing supply in an EOM is the control reserve market, which serves as a very short-notice capacity market for balancing network frequency. When needed, Transmission System Operators can switch capacity reserves on or off in seconds, a quick and reliable way to stabilize the network for up to an hour. Depending on the market model, it is the capacity provision and/or the delivered capacity that is compensated.
To guarantee supply in the long term, additional reserves are part of most energy-only markets. In Germany, these are the network, security, and capacity reserves. These reserves – operated partly for political reasons and partly for strategic reasons – are conceptionally similar to capacity markets. In Germany, they compensate capacity from power plants that are temporarily offline, are utilized as cold reserves, or are simply in standby mode.
Power plant strategy of the German Government (2024): The end of the energy-only market?
After the debate about the creation of a capacity market had lost momentum for years, it returned at the beginning of the 2020s. The rapidly increasing share of fluctuating renewable energies in total electricity generation, the completed nuclear phase-out, the announced coal phase-out and the switch from natural gas to hydrogen in the (distant) future made one central question more urgent: How can it be ensured that, with very high shares of solar and wind power in the system, security of supply is guaranteed even on days with little wind and sun and that the necessary secure power generation capacities can be financed? With its power plant strategy, the German government is now encouraging the construction of new gas-fired power plants, which are to be converted to run on hydrogen in the 2030s, and is announcing the creation of a capacity market at the same time. This is to supplement (or even replace?) the energy-only market from 2028.
What are the economic benefits of an energy-only market?
The energy-only market brings the economic principle of supply and demand to the power market. This makes the market more efficient, reduces overcapacity, and encourages flexibility in power production – when demand changes, power production adjusts to match power consumption.
This principle can be explained using a simple example: No baker is paid to simply have to the capacity to bake bread. Instead, a baker earns a certain price for each loaf of bread, and the price fluctuates according to supply and demand. To avoid sitting on a large supply of stale bread, the baker adjusts the number of loaves to meet the expected number of customers. There is always the option, looking ahead, to bake more bread if needed.
In a (hypothetical) capacity market in the baking industry, there would basically be the same demand for bread rolls - but bakers would have to maintain a large number of additional ovens that they do not need for their daily requirements. This would result in high maintenance costs and overcapacity would also be created.
Disadvantages of energy-only markets: The missing money problem
Critics of the energy-only market view the sufficient provision of secured capacity as problematic: It is difficult to find investors for peak-load installations that only run for a few hours a year; these few hours are also the only times when peak-load prices are realized. In addition, constructing a power plant can take ten years or more from the initial planning phase to implementation – a period that sees no returns and is subject to dramatic changes on the market.
High energy prices are also politically charged. If prices on the energy market could develop entirely on their own, the per-MWh price on the exchange would be theoretically infinite. In practice, the EPEX limit on the intraday market is 9,999 euros per MWh over short periods. These high prices, even if they were only assessed for a few fifteen-minute periods per year, would hardly stand a chance against politicians and the press. National authorities also intervene at a regulatory level in pricing: The German Bundesnetzagentur (Federal Grid Authority) set a price limit for control reserve energy of 9,999 euro per MW on 5 January 2018. But also in its reaction to the energy crisis in Germany in 2021 and 2022, in which gas and electricity prices on the free market shot up in response to the loss of Russian natural gas supplies and were cushioned on the end customer side for political reasons.
Decentralization as a solution to the missing money problem
The arguments behind the missing money problem are understandable, but they are taken in the context of the old energy market. To guarantee peak-load capacity, this market relies on large power plants that takes several years to build and require correspondingly large and long-term investments.
Investments in a decentralized infrastructure that supplies secured capacity from several smaller assets is much easier and quicker to set up. A CHP (which can also run on hydrogen) or a battery storage system can be planned and built in a few months, meaning secured capacity and also control reserve is available quickly. This would mean that capacity shortfalls from conventional power plants scheduled to be decommissioned could be compensated in a reasonable timeframe with acceptable financial impact without affecting the guarantee of supply.
Free pricing and supply guarantee on the energy-only market
On the capacity market, creating supply guarantee is simple: build more power plants. The market design guarantees that the resulting additional capacity will be accepted. In contrast to the energy-only market, it is not the supply that primarily influences the market, but the demand. This is especially attractive for large plant operators, because even plants that are waiting on standby or only used when demand spikes are compensated. Compared to peak-load prices that are allowed to develop freely, fossil-fuel power plants are given unevenly high prices for power that isn’t even needed on the market.
Switching to the broader European perspective, taking a strictly nationalistic view of the supply guarantee problem leaves the true potential of the pan-European energy market untapped. Sources of renewable energy are spread unevenly across various European countries and could balance each other out. Norwegian hydro power, solar power from Spain and Italy, and biogas or wind power from Germany would help stabilize the European power grid.
However, this would require seriously expanding the integrated European grid to reduce trade barriers, such as efforts to increase the capacity of cross-border transfer points. The fact that these are not currently adequate was made clear in a 2017 decision to separate the common German-Austrian power price zone on 1 October 2018. The close-knit network that handles the physical flow of power in Europe therefore leads to a paradoxical problem: With an increasing amount of power that does not cross national borders, the European energy market will continue to be divided against itself as long as an integrated European power market concept is lacking.
Market efficiency and merit order
On the energy-only market, establishing supply guarantee is more complex, but also more efficient. Supply and demand dictates the prices on the power exchange and, therefore, the utilization of power producers and (increasingly) consumers.
If supply shortfalls on the market are higher than usual, the price of power goes up on the exchanges. Eventually, power plants – depending on their marginal prices according to the merit order principle – will be activated to balance out the supply shortfalls. As a last resort, peak-load assets such as gas, oil, or pumped-storage plants, but also increasingly battery storage, come online to sell their urgently-needed megawatt-hours at very high prices.
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Impact of the market design on power market innovation
If a power plant operator on an oversaturated capacity market assumes that production capacity can be sold for the foreseeable future at the agreed price, there is little incentive for innovation, since revenue continues without any additional development. Shortfalls are covered by excess production, and large power plants can generate power without regard to consumption because it is the capacity that is being compensated, and not strictly the power produced. The result is a centrally-controlled system that resembles a planned economy, with high economic and environmental costs and little need for innovation.
An energy-only market, however, with its built-in market mechanisms, is capable of directly rewarding market players who contribute innovation and increased efficiency. An operator that can deliver capacity quicker can demand more money – and someone who can flexibly adjust power production according to price developments can earn more per megawatt on the power exchanges.
This market concept is attractive for representatives from the fossil-fuel sector as well, as evidenced by efforts from coal power station operators to make quicker adjustments to their installations based on power price developments. Even in large lignite-fired power plants, equipment is being installed to facilitate quicker acceleration or deceleration of the turbines –at a high technical and financial cost.
Perspective: Ongoing global liberalization of the power market
Supply guarantee, economic efficiency, environmental friendliness: These three equally important requirements are the cornerstones of a modern and sustainable power supply. Based on these three principles, the energy-only market has become viable on a European scale – although this is not without its complications between the renewable and conventional energy sources.
Developments in Germany and Europe indicate that many power markets are shifting toward an energy-only market – helped along by long-standing hopes for deeper liberalization and integration of the European power market. But, efforts to introduce capacity mechanisms that extend beyond the mere provision of control reserve also continue.
Aspects of the energy-only market, such as power exchanges, freely-traded power, and the reduction of network and market access restrictions are also being implemented in countries that have tended to be more skeptical toward a pure EOM. Proof that a market-oriented, environmentally-friendly power market does not have a negative impact on supply guarantee can be seen in a European comparison of SAIDI indicators against the percentage of power produced from renewable energies.
Disclaimer: Next Kraftwerke does not take any responsibility for the completeness, accuracy and actuality of the information provided. This article is for information purposes only and does not replace individual legal advice.
