When a bunch of thermal power plants shut down simultaneously, around 4.6 GW on 30 June 2020, one would normally expect to hear concerns about emerging blackouts. But not in Spain. The recent closure of half of the remaining coal fleet has hardly raised an eyebrow, and rightly so.

The country is suffering from an acute overcapacity problem that has persisted for over the past decade, a result of large additions of new generating plants, declining demand due to the financial crises and a failure to retire the plants rendered uneconomic as a result. The latter has been enabled by capacity remuneration mechanisms claimed to be needed to “keep the lights on” (in some instances, the Spanish government directly blocked retirements too). These mechanisms reward generators for being available, though not necessarily when they are most needed, and they have cost consumers dearly — more than a dozen billion Euros from 2007 to 2017 — with no measurable added value in return.

The recent retirement of coal plants should therefore be welcomed. More power plant closures will be necessary to establish a healthy and economically sustainable power market, especially as the share of renewables increases. Our own analysis shows that even if all coal and nuclear generation shuts down by 2025 and, at the same time, peak demand increases significantly from current levels, Spain would still retain resources well in excess of commonly established, economic reliability standards.

Flexibility will be key

There is general recognition that a system with considerable shares of variable renewables will need to be significantly more flexible. The International Energy Agency (IEA) has determined power system flexibility as a global priority for our transitioning power systems. Power system flexibility will need to manifest across different timeframes, from milliseconds to seasonal. There is a number of levers one could use to address the flexibility challenge, including traditional thermal generation, updated market designs, demand side response, and storage.

Demand side flexibility is a highly cost-efficient solution

Spain’s National Energy and Climate Plan correctly identifies the active participation of demand as one of the ways to strengthen security of supply. A new paradigm for demand will be necessary in the future. Traditionally, system operators have forecasted demand and scheduled supply to meet it. In the future, the opposite should increasingly be the case, meaning system operators forecasting generation and “scheduling” demand to follow available generation (or relying on demand “scheduling” itself in response to market prices). Demand side flexibility is one of the cheapest sources of flexibility in the power system. With nearly a complete roll-out of smart meters, Spain is well-positioned to take advantage of this resource. The further deployment of new, smart and flexible technologies, such as automated controls and electric vehicles, will only make its development easier. To achieve this new role for demand, however, Spain will need to reform its market appropriately.

Policies to fast-track demand side flexibility

Wholesale energy pricing will be key to developing the necessary flexibility in the market, on the demand and supply side as well. The value of investment in more flexible resources can be seen most clearly and only properly compensated when prices correctly reflect the real-time value of energy.

The best way to reveal the true value of energy in the market is through the introduction of administrative shortage pricing in the balancing market (and certainly not by capping wholesale prices at 180 €/MWh, or even at 300 €/MWh, as is the case in Spain at the moment). Essentially, this means that when the system is nearing or experiencing a supply shortfall, the prices should be significantly higher than the short-run cost of the marginal resource in the merit order and could be as high as the Value of Lost Load (or otherwise the value that consumers place on an uninterrupted service). Such a construct incentivises suppliers to hedge their risk of being short by exploring the potential for cost-effective demand response, amongst other solutions.

As an example, the implementation of administrative shortage pricing in Texas has incentivised an active demand-side market. In summer 2019, demand participation in the system operator and commercial programmes (e.g. time-varying tariffs) helped to shave around 10% of peak demand at times of system stress and contributed significantly to avoiding any involuntary load curtailments. These levels of demand response developed from near negligible levels a few years ago. Average wholesale prices in Texas are among the lowest of any market in North America, despite — or in part due to — these high scarcity prices.

The Spanish regulator would be wise to closely monitor the implementation of dynamic tariffs in the free market.

The correct formation of wholesale prices can deliver maximum benefits when complemented by retail tariffs that closely resemble them, or simply, dynamic retail prices. Currently, the Spanish state offers regulated, dynamic tariffs, while their availability in the free market is rather limited. This should be a reason for concern, alongside the fact that the available profit margins appear to be supressed by the regulated tariffs. The Spanish regulator would be wise to closely monitor the implementation of dynamic tariffs in the free market, their effectiveness and ensure that the regulated offers are replaced by a competitive and active free market. The availability of dynamic tariffs for consumers with smart meters is a requirement on suppliers, established by the European Electricity Directive.

Spain should also enable the participation of the demand side in all markets, either directly or through aggregation. The regulator plans to open the market for balancing services to the demand side. In doing so, policymakers could learn important lessons from across the globe and develop rules that facilitate the development of demand response by making use of best practices, such as establishing a minimum bid size of 100 kW, as has been the case in the majority of the US markets for many years.

Staying the course

The current overcapacity in the Spanish market is unsustainable. Importantly it suppresses energy prices while driving up costs, and it masks the need for flexibility in the market, which will become all the greater as the power system transitions. Further plant closures are inevitable and necessary.

As renewables replace thermal generation, a new portfolio of more flexible resources will be needed and a new role for the demand side can offer significant benefits and strengthen security of supply in a cost-efficient manner. To realise this potential, a set of policy reforms are needed in the wholesale and retail market.

Will Spain grab the opportunity that lies right on its feet?