Could better designed electricity markets help drive decarbonization?

Electricity markets around the world have lately been the center of attention because of persistent high prices. It is easy to forget in the current turmoil that a competitive wholesale market for electricity generation can be an effective tool to help reduce carbon emissions . UK, Germany, Australia, and parts of the USA have seen such markets, supported by air pollution standards, along with renewable and carbon policies to drive coal out of the mix. Phasing coal out through competitive markets is a process that started with the ‘dash for gas’ in the UK in the 1990s. However, given the unprecedented pace at which all fossil fuels are required to disappear, even the staunchest devotee of market probably wonders if carbon markets require some tweaks, or do they need to change drastically (e.g., place far greater reliance on 20–30-year long contracts)?

Can markets in their current form be an ally to decarbonization?

These questions are important not just for the developed world, but also developing countries. Although so far only one in five developing countries has introduced a wholesale electricity market, many of them are in the process of introducing or planning one. Over the course of the next three, four of five decades – the success of meeting decarbonization goals will depend a fair bit on wholesale markets delivering the clean energy investments and pushing fossil fuels out of the mix . The sheer scale and pace of it does not let us dwell on experiences in a handful of countries. Planning studies galore suggest trillions of dollars (including nine trillion in China alone) will be needed over the next three decades to decarbonize energy systems. Those impressive decarbonization plans would largely need to be realized through some form of a “market” – maybe the ones set up in China, India, Turkey, Southern Africa, Mexico etc. will do the job, maybe they will need minor or major fixes. We don’t know.

Obscure link between decarbonization and markets

A new Policy Research Working Paper is our attempt to bring together the limited body of research and try to decipher the messages therein about the level of changes needed to the existing markets. As is typical of economists, they say all answers are possible. Some say that the current market design is adequate, others assert that relatively minor adjustments will do the job, and there are those who call for sweeping changes in an effort to replace markets with organized long-term contracts. Their opinions diverge primarily because of the sheer volume of investment needed in clean energy (mainly variable renewables). In particular, significant uncertainties in electricity prices that variable renewables entail in spot markets may render the current design untenable for such a rapid and massive transition. Also surprising was the fact that there seems to be very little empirical evidence to support any of these hypotheses. As far as we can see – there are not adequate market simulation studies for any of the major geographies proving that the current designs can do the job. The empirical support of an organized long-term market is also conspicuous by its absence.

More empirical evidence needed to determine the way forward

The volume and depth of the qualitative arguments, as well as observations around some of the markets that have decarbonized, led us to a conclusion that there is no reason yet to think about a complete overhaul of the market design. They have worked in the last three decades, albeit at a different scale and speed of transition, and they are, by and large, working well in some countries that have already seen a fair share of renewables. There needs to be more evidence that the current systems are not working and empirical evidence in support of a new mechanism.

There is an urgent need for more analytical work to rigorously test alternative market design proposals. The building blocks for such modeling work, including game theoretic models of electricity generator behavior and market clearing engines, have been well established for at least 25 years. What is needed is a “market design laboratory” to bring these emerging proposals together to test the efficacy of alternative designs on investment needs, the behavior of spot prices, and level of carbon emissions . It is critical for development institutions like the World Bank to develop an evidence base for key fossil-fuel heavy markets to offer the best advice and guide the process of market-led decarbonization.