How to Reinvent the Electricity Market for a Low Carbon World

The world must reinvent the way it generates, purchases and distributes electricity if it is to win the fight against climate change, according to a major new report published in February 2016 by the International Energy Agency (IEA).

The paper suggests that while the technology of electricity generation has undergone a massive revolution in recent years, the regulatory regime and market design of most electricity markets have not kept up with the pace of technological change.

"For a century, a centralized high-carbon power system kept the lights on," IEA Executive Director Fatih Birol said in the report. "If regulatory regimes, market design and system operation end up lagging behind technology deployment, the result may undermine electricity security and, ultimately, the low-carbon transition itself."

Although countries such as France and Brazil have managed to build large-scale renewable energy capacity into their existing energy system, this is largely due to a stroke of geographical good fortune that means they are well-suited for technologies such as hydroelectric power. For most other countries, the answer to the renewables conundrum lies largely in wind and solar - intermittent renewables which will require a wholesale redesign of energy markets to implement at scale, Birol said.

"Rapid improvements in low-carbon, demand-response and storage technologies can lead to a smarter, more efficient and more secure system, but achieving their full potential requires new approaches to policy and regulation," he says in the report.

Consequently, the electricity markets of the future will require a new framework to encourage low-carbon investments while maintaining security of supply, the IEA said. Changes to network investments, regulations, capacity markets, and integration processes are all required, although it admits there is no definitive answer to what the "perfect market design" will be in a low-carbon world. Instead, improvements to market design are likely to be evolutionary and reflect interactions between different technologies and market rules.

The challenge is stark: the average CO2 intensity of electricity needs to fall from 411g per kWh in 2015 to 15g per kWh by 2050 if the world is to stand any chance of honoring the emission reduction commitments made in the international Paris Agreement.

However, the IEA reckons five key recommendations could lay the foundations for low carbon energy markets:

1. Long-term support is crucial

Long-term arrangements to incentivize investment in low-carbon power generation are still "crucial" to achieving decarbonization of the power system in time to prevent dangerous levels of global warming, the IEA says. This is because 2030 decarbonization objectives require the deployment of low-carbon technologies faster than older, dirtier generation sources are expected to retire - meaning that market signals on their own will not be enough to drive the transition.

The IEA recommends that these government-backed support structures should be designed so that risks are shared between investors, consumers and governments, for example by modulating the level of support through market prices. It also suggests that energy market auctions are a good way "introduce competitive forces to determine the level of support needed" as they tend to bring forth the most competitive low-carbon technologies while allowing for greater control over the capacity deployed.

2. Design responsive pricing

Short term markets and flexible price signals will be key to ensuring energy security as the share of renewables in the electricity system increases. The IEA recommends that a market design with a high "temporal and geographical resolution" is needed, to allow the price of electricity to fluctuate according to different market - and weather - conditions throughout a country. It calls for more analysis into what kind of structures would work best in different national markets.

3. Modernize tariffs

New technologies such as battery storage and decentralized generation are introducing a new era of price elasticity into the consumer energy market. The IEA suggests electricity market systems should be adjusted to more easily capitalize on price response, to allow smaller electricity customers to respond to fluctuations in the wholesale electricity price.

More effort should be made by retailers to alert consumers of the varying prices for energy, allowing them to adjust their behavior and send accurate market signals back up the chain to induce efficient investment choices, the IEA says.

4. Put a cost on carbon

"Electricity prices in most countries today are too low to recoup the investment costs of any low-carbon technology, including renewables and nuclear," the report notes. To incentivize investment in low-carbon generation, it suggests a "high and robust" carbon price is needed, although it admits this is likely to be a time-consuming and contentious process to deliver.

5. Overhaul energy distribution

Wind and solar could be rolled out much more quickly if more work was done to improve transmission networks in many countries, the IEA says. To drive development, it suggests governments explore cross-border transmission lines and the introduction of transmission auctions to introduce innovation and competition to market incumbents.

Likewise, regulation of distribution networks need to be overhauled to better provide for the introduction of new "distributed energy sources" such as heat pumps, micro turbines, solar arrays, energy storage and demand-response systems. The IEA recommends that regulation becomes "output-based" to allow distribution firms to find the most efficient investment level for their specific energy mix.

A low carbon energy market is entirely feasible, but as the IEA report stresses, policymakers and regulators need to realize it will look very different to the kind of market that delivered the carbon-intensive, centralized, and environmentally unsustainable energy markets we rely on currently.

For more information on carbon management, please refer to the following links: 
COP21 Summit: Highlights and Key Takeaways 
Collaborating to Meet Global Sustainability Needs 
Carbon Pricing: Public-Private Cooperation towards Global Sustainability