Potential impacts of Brexit on power markets
Great Britain’s electricity markets are currently integrated into those of the EU, with common rules governing their operations. Significant cross-border flows of electricity take place between continental Europe, Great Britain (GB) and the island of Ireland.
Before market integration was in place, electricity and capacity had to be traded separately forcing Traders to commit to cross-border trading volumes based on anticipated market prices. As a result, interconnector capacity was often underused. Furthermore, power sometimes flowed in a counterintuitive way from high- to low-price areas [UK government 2018]. Without financial support, a harmonized framework for investment in interconnectors and clear price signals pointing out the benefits of additional capacity, investors were reluctant to invest in additional interconnection capacity.
Implicit market coupling improves the efficiency of capacity allocation, creates clear signals for increased interconnector capacity and allows traders to easily trade across borders. If the United Kingdom[i] leaves the EU, current and future benefits of the European Internal Energy Market could be reversed depending on the terms of Brexit.
The aim of this study is to assess the potential impacts of the “Brelecxit” (Brexit and its effect on the electricity market). The paper starts with a brief explanation on the rationale behind the European Internal Energy market. The subsequent sections treat interconnectors and the EU market model with a focus on their importance for GB. Finally, the cost impacts of the Brelecxit is modeled for a Norwegian and Swiss style bilateral deal with the EU.
The rationale behind the European Internal Energy Market
Historically, electricity grids and markets were developed on a national level. Coupling national electricity grids and markets has however significant benefits:
- From an economic point of view, trade between countries leads to a more efficient allocation of resources increasing liquidity and overall welfare;
- From a system perspective, a larger grid allows to absorb the inherent volatility of renewable energy sources.
The EU commission therefore created a legislative framework that promotes electricity market integration. It plays a crucial role in (i) creating the right framework for investment in interconnectors - the physical backbone of market coupling and (ii) establishing a suitable market model that allows for efficient trade between different countries over these interconnectors.
The right framework for interconnector investment
The European Commission called for all EU countries to achieve interconnection of at least 10% of their installed electricity production capacity by 2020. Seventeen countries are on track to reach that target by 2020, or have already reached the target.
GB is connected to France, the Netherlands, Ireland and recently Belgium with a total capacity of +-5GW. This corresponds to roughly 5% of the installed capacity in GB. In comparison with the other EU countries, this ratio is on the low end (Figure 1). GB is catching up however with 10 interconnections scheduled for commissioning in the next 4 years (Figure 1 and Annex A).
Figure 1: Current interconnection level as a % of installed interconnection capacity for EU countries and GB interconnectors [Sia Partners, ELECLINK 2016 and EC 2019]
Investing in interconnection capacity is tricky as the capital investment is substantial while the revenues are strongly correlated to the congestion rent. Congestion revenue originates from a situation where transmission capacity between markets is not sufficient to fulfill the demand. When this is the case, the interconnector owner generates a revenue given by the price difference multiplied by the cross-border flow. Revenues are thus highly dependent on market dynamics which are unpredictable on the long term.
In order to provide a sustainable price signal for investors, the British regulator (Ofgem) has a support mechanism in place for interconnector projects - the so-called cap and floor regime. This framework caps the maximum revenue of an interconnector but also guarantees a minimum revenue in case the price differential between the markets on both sides of the cable becomes too small. On the other hand, national regulators in EU member states are also involved in negotiating arrangements for their side of the interconnectors. This situation could trigger a need for potential bilateral arrangements between GB and EU member states.
The EU also plays a crucial role in promoting interconnector investment via the so-called projects of common interest (PCI) with loans and funding for studies. Such loans are for example provided by the European Investment Bank (EIB) - a non-profit EU lending institution with the European countries as shareholders. The aim of this institution is to support the EU’s long term strategic objectives such as interconnector projects. The EIB is supporting a large part of the new interconnection projects in Europe as evidenced by the fact that all recent interconnection projects between GB and Europe have received loans from the EIB (apart from the ELECLINK cable). Brexit puts this type of support at risk for all 7 interconnector projects with a completion date between 2020 and 2023 (see Annex A).
In conclusion, investors in interconnectors linking GB to other markets and vice versa could find access to cheap loans from the EIB restricted and face a more complex regulatory environment. The revenue model guaranteed by Ofgem via the cap and floor regime on the other hand will likely not be impacted by the Brelecxit.
An efficient market model maximizing social welfare
Interconnectors are a necessary condition for market integration but they are not sufficient by themselves. The EU Commission defined target models for the main electricity markets (forward, day-ahead, intraday and balancing) with the aim of achieving a smoothly functioning electricity market that enables efficient usage of interconnectors. A description of each target model is provided in Annex B.
This section focuses on implicit allocation of cross border capacity - a key aspect of the target models for the day ahead and intraday markets that is directly at risk with Brexit. Implicit capacity allocation allows traders to buy or sell power and capacity products through a single trade. In other words, it allows the market participants to buy simultaneously cross-border energy and capacity through a centralized platform. The alternative to implicit allocation is explicit capacity auctioning. In this case, a market participant needs to procure the energy and capacity trade separately leading to inefficient trading due to the information asymmetry. It encourages reverse flows (cross border flows that go against the price differential) and capacity hoarding (acquisition of available transmission capacity without using it or without using it effectively) – two phenomena that are detrimental for welfare creation.
Implicit capacity allocation is essential for the efficient usage of an interconnector and the liquidity on the market via two concrete examples. Firstly, the GB-Ireland border is selected as a case study for interconnector usage since implicit allocation of capacity was very recently[ii] introduced on this border. Secondly, the Swiss continuous market serves as an example to demonstrate the importance of implicit capacity allocation for creating and maintaining liquidity on the market.
Case study on the GB-IR border
The efficiency of interconnector usage is quantitatively assessed by looking at the correlation between commercial flows on interconnectors and the price difference between the 2 bidding zones they are connecting. For an efficient market, it is expected that the flows go from the bidding zone with the low price to the bidding zone with the high price.
Sia Partners’ analysis shows clearly how market coupling has led to a strongly increased efficiency in the use of the Moyle and EWIC cables connecting Ireland with GB. Before Ireland was coupled to GB, commercial exchanges on the GB Ireland border flowed 40% of the time against the natural direction, i.e. from the higher to the lower price market. Figure 2 shows the hourly flows in February and March 2018 with reverse flows outlined in the yellow areas.
Figure 2: Commercial exchanges on the GB-Ireland border before Ireland joined MRC (February-March 2018) [source: ENTSO-E]
As a concrete example, on February 12th 2018, 980MWh (the maximum allowed flow) was exported from GB to Ireland while the price in GB was actually 38,8 €/MWh higher in GB. In this case, more expensive Producers in GB were activated to supply Irish Consumers at the expense of cheaper Producers in Ireland. Obviously, this does not make sense from an economical point of view. After the I-SEM go live, the picture changed drastically with commercial flows 96% of the time following the price differential (Figure 3).
Figure 3: Commercial flows on the GB-Ireland border after Ireland joined MRC (November-December 2018) [source: ENTSO-E]
Quantifying the loss of welfare due to the absence of market coupling is a complicated exercise. The direct loss of welfare needs to be calculated by simulating the impact of suboptimal flows on supply and demand curves on both sides of the border. Secondary effects include decreased trade due to risk aversion of Traders as evidenced in the second case study below. In 2014, ACER has estimated the lost welfare of not having market coupling with implicit capacity allocation on the GB-Ireland border (1GW) at €110M annually [ACER 2014] and a more recent study based on a model for rational trade on decoupled markets puts the total welfare losses of not having market coupling on the GB-France border (3GW) at €617M annually [Geske 2018]. On a per GW basis, the welfare destruction linked to “market uncoupling” can therefore be estimated in the range of €100M-200M annually. GB would carry 60% of this efficiency loss while the remaining 40% would be borne by the countries connected to GB and to a lesser extent the whole EU market. The estimations for welfare destruction in case of market uncoupling are summarized for the main impacted countries in Table 1. It should be noted that in relative terms, the losses for Ireland are 5 times higher than for France due to its lower population.
Table 1: Summary of welfare destruction per country in case of market uncoupling
Case study on the Swiss continuous market
Access to implicit cross border capacity can also have an important impact on the liquidity of a market. This is demonstrated through an analysis of the volumes on the Swiss intraday continuous market before and after XBID go live in June 2018. Before XBID, the Swiss market was benefiting from implicit capacity allocation with the French and German market on the Intraday Capacity Services (ICS) platform. Due to worsening relationship with the EU, Switzerland could not join XBID and as the EU commission decided that XBID should be the sole platform for implicit capacity allocation on the continuous market, no more implicit allocation was possible on the Swiss market [RTE 2018]. The effects of this exclusion are shown in Figure 4 with volumes dropping to up to 90%. The continuous intraday trading in Switzerland moved largely to the nontransparent and inefficient over the counter market.
Figure 4: Evolution of liquidity on the Swiss continuous market from February 2017 to January 2019 [EPEX SPOT 2019]
This case shows how implicit allocation of capacity is a key factor for traders to participate in a market. Furthermore, the Swiss case provides an example of how GB would struggle to put in place any type of market coupling (via XBID or a bilateral arrangement) with another EU member state on the continuous market in case of a hard Brexit.
Different flavours of Brelecxit
Even at three weeks of the Brexit deadline, there is still significant uncertainty about the form Brexit will take. For our impact analysis, we therefore consider two scenarios based on the current bilateral agreements in Switzerland and Norway.
Norway managed to strike a deal with far stretching integration with the EU internal energy market. It adopts the energy policies set out by the EU (without having decision power) and remains in all market coupling initiatives.
Switzerland has a more complicated relationship with the European Commission and has therefore not yet managed to negotiate an energy deal with the European Union. This has led to an exclusion from the market coupling initiatives on the day ahead (MRC) and continuous (XBID) market. It has lost all access to implicit capacity allocation with any other EU member state. Extrapolating this example to the GB would mean that no implicit capacity would be made available anymore on the cables between GB and its neighbouring countries. Due to its geography, the island of Ireland would also be de facto decoupled from the EU continental market at least until the Celtic link with France goes live.
The impact of each scenario on market coupling in GB is summarized in Table 2. For a Norwegian deal, the consequences of Brexit for market coupling is limited to potential delays in implementation of pan European projects such as XBID. No major cost impact is expected in the mid-term. A Swiss deal on the other hand has important cost implications with literature estimates ranging from €500M to €1000M annually for the day ahead market and between €13 and €100M of foregone benefits on the balancing market (see Table 2 and Annex C).
Table 2: Overview of Brelecxit impact on market coupling initiatives
The Norwegian and Swiss deal model what could be the outcome in case of a soft or a hard Brexit. There is no guarantee however that the Brelecxit will be an exact copy of either type deal: it might also take a hybrid form, combining elements from the Swiss and Norwegian agreements with the EU.
The EU has created a framework that promotes electricity market integration. In this study, we show that this framework creates substantial benefits for its member states which are at risk with the Brexit - the UK’s decision to leave the EU.
Most importantly, the cross-border market on the day-ahead and intraday timeframe benefits from implicit allocation of capacity which significantly improves the efficiency of interconnector usage and the overall functioning of the market. A first case study on the GB-Ireland border showed that the incidence of reverse flows dropped from 40 to 4% as implicit allocation of capacity was introduced on this border. A second case study showed that the 90% drop of volumes on the Swiss continuous intraday market also demonstrates the importance of access to implicit capacity for creating a liquid market. These benefits will be reversed if the Brelecxit leads to a Swiss deal where GB’s electricity borders are uncoupled from its neighbouring countries. The associated welfare destruction was estimated between €500M-1000M annually. An expected 60% of this loss is to be borne by GB, 16% by France and 8% by Belgium, the isle of Ireland and the Netherlands.
On the balancing market, several initiatives are on-going to promote harmonization of products and pooling of reserves with neighbouring countries. In case of a Swiss deal, it is uncertain whether GB will be able to access the European balancing markets. The foregone benefits from not being able to do so are estimated between €13M for the optimistic scenario and up to €100M for the pessimistic scenario.
The EU also encourages investment in interconnectors directly via the European Investment Bank and a harmonized regulatory framework. Given the current concerns over GB’s security of supply, interconnection plays a key role in the supply strategy. This is evidenced by the 7 interconnection projects that are scheduled for completion before 2022. A Swiss deal could delay these projects or even lead to a cancellation.
In case a Norwegian style deal is struck, the UK will lose its decision power related to EU energy policy but it would allow to keep the benefits linked to the internal energy market not only for itself but also for Ireland and continental Europe.
To download the complete study, click here
Références & sources
[i] The United Kingdom leaves the EU but from an electricity market point of view, the focus is on Great Britain. Northern Ireland has its own electricity market and regulator and is fully integrated with the electricity market in the Republic of Ireland via the integrated single electricity market (I-SEM). The general assumption is that I-SEM will remain coupled regardless of the terms of the Brexit.
[ii] Ireland became part of the pan-European Day Ahead market with the I-SEM go live on October 1st 2018
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