European Commission’s First State Aid Sector Inquiry Identifies Preliminary Concerns with Capacity Mechanisms

The European Commission’s Interim Report is critical of price-based mechanisms and calls for harmonized methods to determine generation adequacy levels and reliability standards.

The European Commission (Commission) published its Interim Report and Staff Working Document (SWD) on capacity mechanisms on 13 April 2016. As part of the sector inquiry (the first into State aid), the Commission reviewed responses from 124 organizations, including public bodies, energy regulators, network operators and market participants commercially active in the 11 Member States covered. The report and SWD describe capacity mechanisms across Member States and come to a number of tentative conclusions as to how the Commission considers the mechanisms could be improved to create a better functioning and competitive electricity market in Europe. The report is now open for consultation until 6 July 2016.

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Latham & Watkins Antitrust & Competition Practice April 13, 2016 | Number 1951
European Commission’s First State Aid Sector Inquiry
Identifies Preliminary Concerns with Capacity Mechanisms
Today’s Interim Report is critical of price-based mechanisms and calls for harmonized
methods to determine generation adequacy levels and reliability standards.
The European Commission (Commission) today published its Interim Report and Staff Working Document
(SWD) on capacity mechanisms.1 As part of the sector inquiry (the first into State aid), the Commission
reviewed responses from 124 organizations, including public bodies, energy regulators, network
operators and market participants commercially active in the 11 Member States covered. The report and
SWD describe capacity mechanisms across Member States and come to a number of tentative
conclusions as to how the Commission considers the mechanisms could be improved to create a better
functioning and competitive electricity market in Europe. The report is now open for consultation until 6
July 2016.
Background to the sector inquiry
The electricity sector in the European Union is experiencing radical change. Market liberalization and the
increasing share of renewables in the energy mix are giving rise to concerns that today’s electricity
markets fail to provide the investment signals required to ensure generation adequacy.
Against this background, Member States have introduced capacity mechanisms in order to maintain
security of supply. On 29 April 2015, the Commission launched the sector inquiry because of concerns
that capacity mechanisms risk distorting competition and undermining the EU internal energy market
(ultimately) leading to higher prices for consumers.
Preliminary factual findings on capacity mechanisms
Types of capacity mechanisms: The SWD identifies six types of capacity mechanisms: (i) tenders for
new capacity; (ii) strategic reserves; (iii) targeted capacity payments; (iv) central buyer models; (v)
decentralized obligations; and (vi) market-wide capacity payments. Strategic reserves are the most
common form of capacity mechanism and include capacities that are not participating in the wholesale
market, but that are kept apart to maintain security of supply. The following chart illustrates a further
taxonomy of capacity mechanisms:
Latham & Watkins April 13, 2016 | Number 1951 | Page 2

Source: based on the European Commission’s SWD accompanying the Interim Report, page 37.
Adequacy assessment and reliability standards: One of the problems the Interim Report identifies, is
the mismatch between the methodologies Member States apply in relation to the adequacy and reliability
of existing capacities. The Commission believes that there is (at best) a weak relationship between the
level of capacity procured and the level of reliability desired. The lack of common methodologies
reinforces the national focus of most mechanisms and does not allow for cross-border action at EU or
regional level. The Interim Report proposes an alignment of methodologies used to define generation
adequacy and reliability standards and notes that this will likely be a key element in the Commission’s
market design initiative.
Design features of capacity mechanisms: The three main choices that Member States make when
determining the design of a capacity mechanism relate to eligibility, allocation and design.
As regards eligibility, the Commission is concerned that the restricted number of participants entitled to
participate in the scheme may lead to overcompensation due to the lack of competitive pressure and the
need for additional capacity mechanisms to compensate capacity providers which were not included in
the original capacity mechanism. However, the Interim Report does acknowledge that an increasing
number of capacity mechanisms allow the participation of capacity providers from other Member States.
For example, as part of the Commission’s investigation into State aid for the UK capacity mechanisms,
the UK authorities committed to opening the participation to interconnectors as of 2015 and this became a
reality in the 2015 capacity auction.2
The report identifies two different approaches to allocation of capacity remuneration, namely
administrative and competitive allocation processes. The Interim Report is critical of administrative
allocation processes in that they do not normally determine the true value of capacity. As a result, they
are unlikely to be cost-effective and are also unlikely to send the proper signals for investors.
Targeted
Volume based
Tender for new
capacity
Reserve
Price-based
Targeted
capacity
payment
Market-wide
Volume-based
Central buyer
De-central
obligation
Price-based
Market-wide
capacity
payment
Latham & Watkins April 13, 2016 | Number 1951 | Page 3
The design of the allocation process may also impact competition in the electricity market. According to
the Interim Report, where obligations imposed on capacity providers and penalties for non-compliance
are limited, capacity providers have insufficient reliability incentives. The Interim Report calls on Member
States to ensure that price signals are not replaced by capacity mechanisms.
Interim Report preliminary conclusions
The Commission draws four main preliminary conclusions. First, it is necessary to establish a common
methodology to determine generation adequacy and to define reliability standards that allow public
authorities to assess the need for public intervention in an objective manner and improve cross-border
comparability.
Second, the report is critical of price-based capacity mechanisms (i.e. price-based mechanisms offering
market-wide or targeted capacity payments) compared to volume-based capacity mechanisms due to the
higher risk of overcompensation stemming from price-based capacity mechanisms.
Third, the Interim Report distinguishes between short-term and long-term responses to potential capacity
problems. The Commission considers that strategic reserves and tenders for new capacity can be used to
tackle transitional capacity problems but are not capable of resolving underlying market failures. On the
other hand, the report considers that de-central obligation mechanisms and central buyer mechanisms
are adequate to address longer-term capacity problems. These capacity mechanisms also tend to
increase competition for capacity remuneration by allowing the participation of different capacity providers
from both the supply and the demand sides and attracting new capacity.
Fourth, whatever the public authority’s final choice, the Interim Report encourages Member States to
introduce carefully designed capacity mechanisms that do not undermine the functioning of the electricity
market. In this regard, capacity mechanisms must be established according to transparent and open rules
of participation.
Next steps and implications for the energy sector
The Interim Report sets out the Commission’s possible future directions in its actions in the energy sector.
From a legislative perspective, the sector inquiry will support and complement future policy and legislative
work in the area of security of electricity supply in the context of the Energy Union strategy. The
consultation launched in July 2015 on energy market design, as part of the energy summer package,
explicitly refers to the sector inquiry as a source of information that can feed into new legislative initiatives
addressing security of supply in Europe.3 In this sense, the sector inquiry is also intended to complement
the public consultation on risk preparedness in the area of security of electricity supply, which aims to
review Directive 2005/89 on security of electricity supply and infrastructure investment.4
From an enforcement perspective, the sector inquiry will enable the Commission to better understand
existing or planned Member States’ capacity mechanisms. Based on the findings of the final report, the
Commission could be inclined to investigate those capacity mechanisms which are considered more
distortive of competition and cross-border electricity trade in order to assess their compliance with the
Guidelines on State aid for environmental protection and energy 2014-2020 (EEAG 2014-2020).5 For
example, the Commission has already initiated two in-depth investigations on capacity mechanisms in
France6 and the results of the sector inquiry may encourage the Commission to open further such probes.
Alternatively, the Commission may informally engage with Member States in order to address potential
shortcomings in the design of capacity mechanisms. An open question is whether the Commission will
Latham & Watkins April 13, 2016 | Number 1951 | Page 4
assess the links between the EEAG, services of general economic interest (SGEI) and the Altmark
judgment in the final report of its sector inquiry.7
The Commission has invited Member States, relevant stakeholders and the general public to submit
comments within the next 12 weeks with the objective of preparing the final report, which the Commission
intends to publish later this year. Since this is the last stage of the process in which stakeholders can
participate before the Commission adopts a firm position on the design and operation of capacity
mechanisms, interested parties should take advantage of the opportunity to contribute to the formation of
future European energy policies.

If you have questions about this Client Alert, please contact one of the authors listed below or the Latham
lawyer with whom you normally consult:
Elisabetta Righini
elisabetta.righini@lw.com
+32.2.788.6238
+32.478.32.47.57
Brussels

Lars Kjølbye
lars.kjolbye@lw.com
+32.2.788.6252
Brussels

Javier Ruiz Calzado
javier.ruiz.calzado@lw.com
+32.2.788.6206
Brussels

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Endnotes

1 Available at: http://ec.europa.eu/competition/sectors/energy/state_aid_to_secure_electricity_supply_en.html
2 Commission decision C (2014) 5083 final of 23.7.2014 in Case SA.35980 (2014/N-2) – United Kingdom –Electricity market
reform – Capacity market.
3 Section 4 of Communication from the Commission, “Launching the public consultation process on a new energy market design”
{SWD(2015) 142 final} , 15 July 2015, COM(2015) 142 final.
4 Consultation on risk preparedness in the area of security of electricity supply.
https://ec.europa.eu/energy/sites/ener/files/documents/DG%20ENER_ConsultationPaperSoSelectricity14July.pdf
5 Guidelines on State aid for environmental protection and energy 2014-2020 [2014] OJ C 200/1.
6 The first relates to a country-wide capacity mechanism in France and the second to a tender for a new gas-fired power plant in
Brittany.
7 Altmark Trans and Regierungspräsidium Magdeburg, C-280/00, ECLI:EU:C:2003:415.

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