In 1996, the EU embarked upon the liberalization of the electricity market. In 2003 and 2009, two waves of legislation followed, and 2014 was declared the year of completion of the internal energy market. …[] a process of spontaneous convergence has led all Member States to adopt a pool market model for wholesale trading.

In the pool, producers and importers sell their output through a bidding process to suppliers, traders, and large industrial customers. Bids are arranged in ascending order, according to the marginal costs of generating units (the so-called ‘merit order’), and the price is set at the level of the marginal cost of the most expensive unit dispatched in order to meet demand. However, this model—which is often described as the ‘energy only’ market - suffers from a notable failure: demand and supply do not necessarily meet at times of extreme scarcity, ie there is no guarantee of the market clearing. Two factors commonly explain this failure.

First, demand is inflexible. In other commodities markets, if supply is scarce, the price would rise and demand would shrink until the market clears. By contrast, in electricity markets, customers are often unable to reduce demand. As a consequence, there may be situations where, even if all available generators produce as much electricity as they can, they are still unable to meet demand. This leads to energy rationing (rolling blackouts). Because supply and demand do not meet, the market does not send any meaningful price signal at times of extreme scarcity.

Second, prices may be capped. Assuming there is enough capacity to meet demand even at peak times, the energy price will rise to reflect the marginal operating cost of the most expensive unit dispatched. When the margin between available capacity and peak demand tightens, electricity prices will rise to the point of reflecting a scarcity premium. Prices may then reach extremely high values, potentially up to the value of lost load (VOLL), when consumers prefer not to consume energy. For reasons of socio-political acceptability and functioning of the energy-only market, prices may be capped. In these cases, supply will meet demand (in the short term), but the capped price might not be enough to cover the fixed costs of the producing power plants, which in turn may deprive the market of the necessary investment in new or replacement capacity.

Thus, the energy-only market may not provide the price signal which would guarantee an adequate level of generation. This situation is commonly described as the missing money problem, because of the failure to provide high enough returns to maintain the level of capacity adequate to meet demand. Capacity mechanisms address this failure by providing the payments deemed necessary to support an appropriate level of generation adequacy, in addition to the revenues from the energy-only market. Against this background, the integration of large stocks of capacity from renewable generation sources (RES) contributes to the generation adequacy problem in two ways. First, RES capacity exacerbates the traditional missing money problem. Second, RES capacity contributes to another market failure. These two points are discussed in the two following paragraphs.

First of all, RES production is characterized by very low marginal costs and when it sets the price in the energy-only market, the price level may reach zero or a level close to zero. As a result, all other generators are unable to cover their costs. When demand is met by RES capacity acting together with other technologies, the result is that the supply curve moves to the right (see Figure 1.1). Some conventional plants are therefore pushed out of the merit order and all suffer from low utilization rates. As a result, there is a strong incentive for them to exit the market.