A solution to current high power prices

while preserving market mechanisms

Germany has announced a package of measures to fight high energy prices, including a price cap for non-gas producers like renewables. While the logic of not paying the currently sky-high gas-driven prices for generation that largely has fixed costs is not absurd, the way it is done is not very smart and is confiscatory.

The original error was not to impose fixed prices on fixed-cost generation in the first place. The German tariffs for renewable energy take the form of a floor, rather than an actual fixed price, and lets renewables projects take advantage of high spot prices, when they happen. While this seems attractive to support renewables, it has led to a race to the bottom for the minimum tariffs, which now reach zero for offshore wind (ie projects only rely on volatile spor markets for revenues) which is very inefficient - and provides no protection to consumers - or even an implicit subsidy to the GAFAMs.

The right way to design tariffs is already used in the UK and France: real two-way “contracts for differences” where the generators get money from the public entity when prices are low, and pay back the difference between spot prices and their agreed price, when spot prices are high, like today. In France and the UK, this is providing a natural hedge to power prices and helps keep retail prices down. Since this was not done from the start in Germany, this needs to be implemented in a way that protects both consumers and investors in existing and future generation capacity. In the UK this could be applied to old projects that are still under the semi-merchant ROC regime.

This should not be done as an administrative decision, for the price (like the proposed cap in Germany) but via a market mechanism.

The proposal should be to impose that all renewables project switch to fixed contracts, but in order to make that faire, these should be long term contracts - irrespective of the duration of existing underlying mechanisms for older assets. I would suggest to offer 25 year contracts. Such long duration would allow these projects to have visibility over cashflows even as they abandon the short term high revenues they could get under current spot prices (or have to deal with existing forward sales or revenue hedges they may have put in place).

The price for such contracts should reflect long term generation costs but be a bit higher than currently available strike prices under CfDs - the most recent auction results should be used as a floor, rather than a cap.

In order to establish a market price that makes sense, the auction should apply to all existing generation capacity not under two-way CfDs, and incentives them to bid the lowest price possible. To ensure a realistic price, there needs to be competitive pressure. My suggestion would be to set the price on that offered by the median generator in the auction, and impose that all bidders below that level get the offered price, plus a premium (say 5 EUR/MWh), while those above it get the offered price minus a penalty (also 5 EUR/MWh). This would ensure that most bidders will offer a realistic price, or at most one inflated by 10 EUR/MWh, which would be an acceptable distorsion in the current market.

(I'm sure auction specialists can come up with a better design but you get the idea - we want people to bid genuine prices that will keep them profitable under these contracts, but not absurdly so).

The counterpart to these contracts will make the low priced electricity (or the cash difference) available to distribution companies to pass on to retail consumers.

This will allow to (i) not disturb the spot market as these projects will still have to offer their volumes on the daily market to help balance the grid (something which is needed to keep on having incentives to reduce demand in a supply-constrained environment, (ii) provide a significant volume of fixed price generation that can be used to protect retail prices, and (iii) provide a good framework for long term investment in renewables.