Flexibility – The Key to Energy Transition

In the transition towards a low-carbon economy, the role of electricity is becoming increasingly important. Most decarbonization scenarios rely on a profound electrification of our economies. For example, the International Energy Agency’s (IEA) World Energy Outlook 2021 points towards a two- to fourfold increase in global electricity demand by 2050. To cater for this scenario, substantial investments in new electricity generation and transmission assets are needed. Moreover, if electricity is to facilitate the energy transition, we cannot overlook the fact that most electricity markets also need to go through a deep decarbonization process. Consequently, investments are also needed to replace current CO2-emitting power plants.

To decarbonize the rapidly growing electricity sector, variable renewable energy sources, such as wind or solar photovoltaic (solar PV) technology, have emerged as a dominant solution. There are good reasons for this, as wind and solar PV technologies are mature renewables with a successful track record and dramatically decreased costs over the last decade. In some parts of Europe (e.g. Portugal, Italy, Spain, France, or Germany) new wind or solar PV projects are today considered viable without governmental aid as Power Purchase Agreements arise to replace subsidies. Nevertheless, the weather dependency of the output from variable renewable energy sources increases the flexibility needs of electricity markets or, in other words, the capability of an electricity system to constantly rebalance its demand and supply to keep the lights on.

This means that in order to integrate a high share of variable renewables, we need to develop a better understanding of how they impact electricity markets, and what kind of threats and opportunities they present to the system. Variable renewable sources will play an important role in the energy transition, but by themselves they can only help to a certain extent. The more we invest in variable renewables, the more we need to invest in flexibility.

Most Dutch utilities advertise 100% wind or solar electricity supply. This is an artificial construction. The still relatively inflexible and variable demand pattern does not match the production cycle of renewable energy sources and utility-scale storage capacity is still limited. As energy security is important and supply must always equal demand, in the absence of already operational alternatives, utilities use other (polluting) sources of electricity when the wind is not blowing or the sun is not shining. Thus, to fully decarbonize electricity markets using renewables, there is a need for low-carbon-intensive flexibility, both for short-term (minute-to-minute or hourly) and long-term (seasonal) rebalancing.

The flexibility problem also propagates to the electricity grid, which needs to be reinforced significantly if we aim to integrate a high share of supply from wind and solar sources into the supply. Such problems are already visible on the Dutch electricity grid, as the construction of solar PV systems and wind parks outpaces grid expansion. Flexibility constraints can also appear at a lower scale. Owners of rooftop solar PVs, prosumers, sometimes face the challenge of not being able to feed their oversupply into an overloaded power grid. Grid operator Liander points out that the Dutch power system is not fully prepared for the high pace at which rooftop solar PVs are being installed in the country and calls for more attention to flexibility options such as storage solutions. We can add to these trends the expected electrification of the built environment (e.g. heat pumps) and the exponential e-mobility growth due to the rising demand for electric vehicles. As a result, we foresee a significant need for more flexibility and resilience in power networks. The need to invest in alternative flexibility-offering capacity is also recognized in the World Energy Outlook 2021, where the IEA’s conservative scenario envisions that the need for flexibility in the EU will grow by around 40% by the end of this decade. Daily demand will become more variable as we electrify economies. In their latest Renewables 2021 analysis and forecasts the IEA also recognizes that the lack of flexibility is one of the biggest hurdles in the face of a rapid deployment of renewables.

In many European markets, flexibility and grid balance are still regularly offered by conventional electricity plants, which rely on natural gas, coal, water or nuclear material as a raw material. Moreover, coal, and especially nuclear power, have limited technical capabilities to swiftly increase or decrease production in a short timeframe. While this is currently a solution, in the long term we need to replace CO2 emitting technologies, such as coal- and gas-fired electricity plants, by non-CO2 emitting assets. Where technically feasible, hydro power plants can offer flexibility, but only to a certain extent as they are also weather dependent. In addition, the locations where it makes sense to build hydro power plants are not available in all markets. As for nuclear power, there is still no consensus on its role in a low-carbon economy. Considering this picture, we must look for alternative ways to keep the future low-carbon grid in balance.

Fortunately, we already have a multitude of competing flexibility-offering solutions, all of which can have their place in future electricity markets. The most prominent ones revolve around storage (e.g. batteries, power-to-X[1]), demand response systems, and improved market interconnectivity. For flexibility-offering technologies to thrive, they must have a viable business proposition. From a very simplistic point of view, their business model is to buy low-priced electricity, sell it at a high price, and in the process help balancing the grid. However, the implementation of this business model is not as straightforward. To enhance the viability of flexibility-offering assets, we must understand how electricity prices behave in a world with a high share of supply from variable renewable sources.

What academic research teaches us, and what we also observe in practice, is that the higher the share of variable renewable sources in an electricity market, the more volatile prices become on average. Supply from variable renewable sources increases the frequency of extreme electricity prices, especially of extreme low prices. To exemplify this, in day-ahead markets it is common to see price variations of more than EUR 100/MWh in a matter of just a few hours and even close to EUR 1000/MWh in the balancing markets (see examples from the German day-ahead[2] and Dutch imbalance[3] markets). Part of this price volatility can be attributed to changes in weather conditions and thus to variations in supply from variable renewable sources.

This is good news for owners of storage or demand response applications. The more volatile electricity prices are, the greater the possibilities to profit from them. In other words, the inflexibility that wind and solar electricity bring enhances the viability of flexibility-offering solutions. The even better news is that academic research demonstrates that, at least to a certain extent, we can forecast high or low wholesale electricity prices. Academic research also shows that there are hours for which we can foresee if the average day-ahead market price will be higher or lower than the intra-day (imbalance) market price. This can be done by looking at the fundamentals of electricity markets and, in particular, at the expected demand and supply from variable renewables. As a simple example, sunny and windy hours will more likely lead to lower electricity prices than hours with unfavourable weather conditions for renewables. Based on reliable electricity price forecasts, flexibility-offering business models can be created.

[1] Power-to-X refers to options to transform oversupply of electricity into a storable source of energy (e.g. hydrogen, compressed air, synthetic fuels, etc.) and reconverting it into electricity when opportune.

[2] Day-ahead markets refer to the trading of electricity to be delivered the following day. Trading is usually structured in hourly blocks.

[3] Imbalance markets serve as a platform where discrepancies between expected and actual electricity generation or consumption can be traded away.

The integration of more variable renewable sources and flexibility-offering assets will radically transform electricity markets. From a model where prices are set based on marginal costs, we are shifting to a model that embraces the interplay between suppliers of flexibility and suppliers of variable renewable electricity.

To accommodate for this shift, we might have to rethink the way we design electricity markets. Variable renewable sources have negligible marginal costs. In electricity markets dominated by such supply sources, unless market design changes, we are more likely to see lower, sometimes even negative, electricity prices. To imagine what a market with more variable renewables could look like, we can go back to the beginning of the Covid-19 pandemic in Europe. At that time, demand in some markets fell by more than 20% and the combination of favorable weather conditions in the same period led to frequent negative electricity prices in various European countries. But negative prices can even occur under current market conditions, when electricity prices are on average high. For example, in the fall of 2021, we saw negative electricity prices on the Dutch, German and Danish day-ahead electricity markets on a few occasions.

From a consumer perspective, low or negative electricity prices are certainly appealing. However, if the business case for variable renewables is lost, investing in new wind and solar parks might become less attractive. At some point, we may need to reshape our electricity markets to prepare them for a market with only zero marginal cost producers and flexibility providers. This essentially means preparing for a shift in focus from day-to-day operating expenses (OPEX) to long-term capital expenditures (CAPEX), where marginal costs might become less relevant and prices will be increasingly linked to the upfront investment. If we are to smooth out the bumps in the energy transition road, we should do so quickly. What we have experienced during the past few months is that governments are sometimes faced with the painful decision of having to prioritize short-term energy security over longer-term climate risks. To avoid having to choose between the two, we must invest not only in renewables, but also in flexibility-offering assets as well as in grid infrastructure.