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28 | 4th - 10th April 2014 | UtilitY WEEK Markets & Trading Market view O n 4 February 2014, market coupling in northwest Europe went live. On the same day, Bloomberg carried a story about concerns over supply security in Europe as the proportion of green genera- tion increases across the continent. On the face of it, the two are not necessarily con- nected. However, dig a little deeper and it soon becomes apparent that they are indeed related, via concerns raised by numerous commentators about the implementation of capacity markets across Europe. So what is market coupling? One of the founding principles of the European Union is the creation of a single market, and the energy sector is seen as particularly impor- tant in this regard. As a result, there is a process at EU level to achieve the internal energy market. One of the impediments to the creation of the internal electricity mar- ket has been the historically poor level of interconnection between member states, so the Commission has issued guidelines and a network code to deal with capacity allo- cation and congestion management, and a target model has been developed as a means of addressing the practical issues around facilitating border-free electricity trading. One of the limbs of the target model requires the development of a day-ahead single-price market coupling model, hence the term mar- ket coupling. Ultimately there will be a single model that will simultaneously determine volumes and prices across all Europe, thus linking regional markets into a virtual market, and the northwest market coupling announced in February is an important part of that process. Market players bid into a single exchange that uses an implicit auction of cross-border transmission rights (based on physical avail- ability) to minimise price differentials across the coupled markets and establish a single clearing price. The process is based on a sin- gle algorithm, which has been developed by various power exchanges across Europe. The process requires transmission system opera- tors and power exchanges to work together at all stages of the process, both pre and post-coupling. Alongside market coupling, the wider target model requires the establishment of energy-only regional markets and it is this issue that has provoked debate as to whether the target model for the internal energy market is fit for purpose. The issue revolves around decarbonisation of electricity genera- tion. The policy of encouraging renewable generation leads to increased levels of inter- mittent capacity on each national system. This has potentially significant effects on sys- tem stability and capacity margins and raises concerns that energy-only markets cannot deliver sufficient investment in conventional generation to ensure system reliability in the future. Hence across Europe, governments and policymakers are looking at introducing capacity mechanisms to address reliability and capacity margin concerns. What does this have to do with the inter- nal energy market and market coupling? One of the issues that has long required the European Commission to perform a tightrope walk is how to create a functioning internal market without having common rules across the whole of Europe. Clearly the easiest route to a single market is to have the same rules across the whole area, but politically this is nigh on impossible to achieve, so alternative solutions are needed. One of the advantages of the target model is that it uses economic tools to effectively manage interconnector capacity and produce a single day-ahead price without the need for market rules in the coupled markets being the same. When it was developed, it was perfectly reasonable to consider only energy markets. Generators would receive revenue based on the marginal cost of energy supplied, which works perfectly well for conventional plant, and cross-border trading could be achieved relatively easily because like was being traded with like across all markets. However, the world has changed. As the market penetration of renewable generation increases, marginal cost decreases dramati- cally and so ceases to provide reliable cost signals. In addition, policy-driven market interventions affect the merit order in many countries, thus further skewing the price signals to future investors. To address these problems, many, but by no means all, the EU member states are actively pursuing the implementation of capacity mechanisms. These mechanisms vary significantly from state to state, with the result that the propor- tion of the wholesale electricity price that comprises capacity is likely to vary, too. Uneven implementation and different capacity market rules across the EU are likely to lead to market distortions and price vari- ations across Europe under a coupled mar- ket. It is not difficult to imagine a situation where, for example, a generator in a market with explicit capacity payments could receive double payments as a result of market cou- pling. Or that generators in an energy-only market may successfully bid into a coupled market with capacity payments, thus reduc- ing the amount of physical capacity available to the system operator in its host country. This has implications not only for cross-bor- der electricity trading, but also for the system stability of the individual member states, at a time when domestic energy supply has never been higher on the political agenda. Market coupling is undoubtedly an important step towards the creation of the internal energy market. However, it seems it will need to go a step further if the introduc- tion of capacity mechanisms at a national level across the EU is not to pose potential problems. There are also concerns that the capacity mechanisms themselves will need to change as the current proposals largely focus on capacity adequacy (that is, the amount of capacity installed) as opposed to capacity flexibility, which is likely to become increasingly valuable in a world with ever more amounts of intermittent generation. Full market coupling across Europe is due to be in place by the end of 2014. Capac- ity mechanisms will follow over the ensuing years. It seems likely that EU member states may well have to be persuaded that harmo- nisation of capacity mechanisms is going to be a key part of ensuring the internal energy market and system stability aer all. Elisabeth Blunsdon, of counsel, Hogan Lovells Stability key to single market Market coupling is the first step towards an internal energy market in the EU. But growth in renewable generation calls for harmonised capacity mechanisms to ensure stability, says Elisabeth Blunsdon.