ANNEX: The Czech Republic´s comments on the Discussion Paper of the Federal Ministry for Economic Affairs and Energy (Green Paper)

February 2015

The Czech Republic appreciates the German Green Paper´s effort to provide all the relevant stakeholders with a first insight into the future reform of German electricity market. We support the market-based approach of the Green Paper and would welcome preservation of this approach in the upcoming White Paper as well.

Following the Green Paper call, we would like to present our views and suggestions in 6 areas: Design of the electricity market, Capacity remuneration mechanisms, Flexibility, No-regret measures, European Cooperation and Issue of a single price zone (not in order of priority).

I. Future design of the electricity market

The Czech Republic agrees with the Green Paper´s (GP) statement, that the undistorted Energy Only Market (EoM) can provide sufficient price signals for future investment through existence of balancing groups and related imbalance settlement. We agree the proper EoM functioning has to enable scarcity pricing, which provides incentives for capital-intensive investments in order to secure sufficient capacity to cover peak demand. External studies also confirmed that an optimised electricity market, which allows undistorted price signals to reach all market participants, is sufficient to ensure security of supply without creating additional capacity market.

We would like to point out some causes of EoM failures as we think they are not properly addressed in the GP. In the Czech Republic´s view, following market distortions deserve closer attention (not in order of priority):

o fragmented and distorted national subsidy policies and distortive national capacity remuneration mechanisms o state regulated electricity prices for some customer groups o missing cross-border allocation mechanisms at some borders o state determined bidding zones o differentiated grid access o uneven participation on balancing services provision o inadequate pricing of system imbalances (including extensive use of system services instead of market signals based on non-discriminative balancing responsibility) o price caps and missing scarcity pricing, including future pricing of electricity storage in a way that will inhibit demand side response

An important element of the EoM is the existence of scarcity pricing. The Czech Republic completely agrees with the Green Paper that price spikes at the wholesale electricity market, leading to higher price volatility and thus providing sufficient investment incentives even for peak power plants as well as investment in load management measures on customer side, have to be fully accepted. All relevant markets including intraday and balancing market should allow bids without any limitation. At the same time, the enforcement of transparency at wholesale markets should not be misused for price regulation under specific circumstances. In this respect, clear and detailed rules under the

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REMIT are necessary in order to provide long-term guarantees for investors that regulatory bodies will accept scarcity pricing as standard market phenomenon and not unduly penalize it.

Furthermore, we think that the effects of renewable energy sources´ subsidies that are causing substantial market distortions are not properly addressed. In addition to direct feed-in tariffs subsidies which deform wholesale market price, RES cause further market distortions by having priority network access, priority dispatch and because they currently do not assume responsibility for imbalances. We appreciate that the reform of the EEG suggests more market-friendly price guarantees for new RES installations combined with the tendering procedure and not their automatic dispatch. Price volatility is naturally exacerbated by increased intermittent RES generation. Yet, only market-based price formation will lead to rational and efficient electricity pricing (including pricing of intermittent sources; with these sources we must take into account the need to back them up with flexible conventional sources or other technologies or sufficient flexible demand has to be found in the market). High price volatility enables effective use of flexible sources, which gain profit from price differential on both the production and demand side of the market. Price of flexibility on the electricity market without participation of any support schemes or regulated activities should be the only driver for building future energy storages. This will also give the right price signals for demand response and support energy savings and management.

In this connection, we welcome the 2014 amendment of the Renewable Energy Sources Act, which aims for greater RES inclusion in the market.

Since there is deep investors´ mistrust in the market rules and long-term legislation stability, the proposed set of measures intended to support Energy Only Market “restart” should be designed as a long-termed and very clearly guaranteed at the top political level.

II. Capacity remuneration mechanisms

As already stated above, we think that reformed Energy Only Market provides a good basis for securing short and mid-term system safety and long-term generation adequacy. From our perspective, capacity remuneration mechanisms represent unnecessary market intervention, cause further market distortion and might pose a significant risk to the security of supply if there are errors in the system setting. As stated in the r2b report, they could even lead to increase in CO2 emissions and thus might be contradictory with the binding European climate goals. Germany currently possesses sufficient amount of capacity available (the GP even states overcapacities); the grid reserve regulation will maintain critical capacity needed in locations where nuclear power plants are scheduled phase-out and even gives TSOs the power to instruct direct construction of new power plants if needed. Public opinion on further regulatory intervention presented by introduction of capacity remuneration mechanisms should also be taken into account. If capacity remuneration mechanisms will be adopted and price volatility at the electricity market further decreased, it would also be more difficult to induce any demand side response. Due to its inherent characteristics, demand response is always less “firm” than generation or storage capacity, and capacity remuneration mechanisms could have a difficulty to properly take this into account.

Capacity markets, if being introduced, must be coordinated at the European level. An uncoordinated approach in different Member States would inevitably further hamper integration of electricity markets in Europe. It should be guaranteed that the foreign capacity is factored into national

2 mechanisms and can participate in them from the very beginning. Such a market should be market- based and non-discriminatory. The Czech Republic is of an opinion that in case the capacity remuneration mechanism is introduced in Germany, it should not be the centralised one as it disadvantages capacity based on the criteria of availability. It would also be in breach with the Guidelines on State aid for environmental protection and energy 2014-2020.

III. Flexibility

Flexibility, in the Green Paper´s understanding, is the feasibility to balance power generation and power consumption. Germany´s goal is to create efficient power system where flexible producers, flexible consumers and storage systems respond to the intermittent supply of wind and solar power. The Czech Republic would like to express support for this approach; we think that if the measures are introduced wisely, they may bring significant benefits such as lowering peaks and efficient use of all the available capacities. For cost-efficiency reasons, it is necessary to enable technology-neutral competition among all the flexibility options. In each case, the financial perspective of a transmission grid transformation1 towards more flexibility could be more elaborated upon.

We agree that nowadays there is no special need to specifically support and promote individual technologies beyond the parameters of research funding. Market must provide incentives from both static and dynamic perspective to develop and deploy flexibility options. The Czech Republic fully agrees that the level and volatility of the wholesale prices, prices on the balancing markets and opportunity costs in the heating and transport sectors provide sufficient incentives for the future investment. We would like to stress that market-based approach should be applied in all the sectors of the electricity market.

In connection to the renewable energy sources, according to the EEG reform, Germany plans to ensure that new renewable energy facilities will need to accept the same responsibility for the overall system balance as conventional power plants. The Czech Republic welcomes this proposal and suggests gradually extending this measure to already built renewable power plants (i.e. for those exceeding certain generation capacity threshold). This could significantly increase the overall system flexibility. Another possibility would be to remotely control wind and PV installations and thus use their balancing capacity when needed in a cost-efficient manner.

The other technology mentioned in the Green Paper is pumped-hydroelectric storage plants. This is by all means a climate-friendly technology and its potential should be fully utilized, yet on purely market-based terms; avoiding socialisation of the costs in the system services payments, as this would further distort the market price signals and de-motivate DSR. We would like to ask whether there is any prognosis available on the future potential of these power stations in Germany.

The Green Paper accentuates accumulation possibilities on many occasions. Besides already mentioned pumped storage power stations, we would like to ask about expected future use of other technologies for this purpose. In our opinion, lithium batteries will not provide sufficient capacity to balance RES generation in the near future, not mentioning high costs of such a technology. Other

1 p. 14: We are transitioning from a power system in which controllable power stations follow electricity demand to an efficient power system overall where flexible producers, flexible consumers and storage systems respond increasingly to the intermittent supply of wind and solar power. This transition will take place over the coming years. 3 possibilities are to generate hydrogen or methane, stow it and consequently burn it in case of need; to accumulate energy through compressed air etc. We find it important to always look on the efficiency of the whole accumulation cycle of different technologies.

Demand-side response is another flexibility measure elaborated in the GP. According to the Paper´s assumptions2, consumers will adjust their demand in times of need (when there is low or on the contrary high RES generation, especially from wind or solar power plants). We would like to ask for further explanation on anticipated materialisation of this measure.

Finally, the GP suggests improving the structure of network charges to allow for more flexibility and fairly distribute the burden of financing the grid infrastructure. In this connection, network charges and state-imposed price components could be levied more on the basis of capacity (kW) instead of energy (kWh) wherever possible and reasonable, because this will properly reflect cost structure of transmission and distribution, where fixed costs clearly dominate. This would allow more flexible use of available capacity without imposing further network charges and reflect better real demand for the grid capacity and further grid development. We would be interested in elaborating these measures in more detail. Is there any analysis of economic impact of such measures available?

IV. No regret measures for strengthening the market price signals in order to ensure system safety

The Czech Republic agrees with the no-regret measures stated in the Green Paper, as they could reform the EoM and thus solve the possible future problem of generation adequacy without introduction of capacity remuneration mechanisms.

One of the means currently used to ensure system safety is redispatch. The Green Paper states that it could be extensively used in the future to overcome a transitional phase at the market (besides the capacity reserve). In this connection, we see two issues. Redispatch is a rather expensive method to balance consumption and generation and should not be considered a substitute for grid expansion. Second aspect is connected to the cost-effectiveness and cost reflectivity as well. Current practice very often leads to the situation, where by redispatch, conventional power plants are first instructed to lower their production even though from the economical point of view it would make more sense to adjust renewable sources generation at first. As redispatch costs are expected to significantly increase in the following years, it is necessary to find a way to allocate these costs straightforwardly and avoid extensive socialisation as it would further undermine locational signals as an important incentive for investors in new generation capacity.

According to the GP, Ordinance on Reserve Power Plants (network reserve) should be extended until 2022 and can become a part of a capacity reserve. This is due to a growing need for redispatch in the winters ahead fuelled by growing RES generation. In our point of view, ancillary services market should be used in a more efficient way so that redispatch remains last-resort option in case of extraordinary circumstances rather than becoming standard part of transmission system daily

2 p.16: …In such situations, the opportunities for exporting electricity to neighbouring markets will no longer suffice. It is therefore important that domestic conventional thermal power generators reduce their production capacity as much as possible (see 2.3) and flexible electricity consumers increase their demand at such times. In the future, these flexible consumers are also expected to come from other sectors such as the heat and transport sectors (sector coupling, see Chapter 3). 4 operation. It could depend on alternative technologies and renewables as this could lower minimum generation and help avoiding negative prices in times of low residual load (lowering conventional power plants basis). Also, emergency back-up power systems could participate in the market; this could relieve the network reserve. Still, a thorough analysis of reliability of alternative technologies, such as the biomass or back-up power systems, is needed. Reserve power plants (those, who are part of the network reserve) should in our opinion be available for redispatch only and should not intervene into the wholesale market (with respect to the proper allocation of redispatch costs, where “polluter pays” principle should replace currently used “requester pays” principle).

We fully support German decision to implement no regret measures which aim to strengthen incentives to uphold balancing group commitments. In this regards, we think that renewable energy sources should also be responsible for system imbalances and should carry costs of possible imbalance settlement.

One of the proposed no-regret measures is the Capacity Reserve introduction. If this should really be the case, the Czech Republic calls for these elements to be respected:

o Generation fleet used in Capacity Reserve should be excluded from the electricity wholesale market at all times. o Capacity Reserve should be introduced only for a limited time-span under predefined quantitative and pricing conditions. It should be procured by the TSOs in a competitive process and also dispatched exclusively by the TSOs. o It should be used only to solve potential crisis situation in the grid and should be applied only after the closure of trading at the intraday electricity market provided that scarcity pricing will be effectively placed. o Conditions for access of other Member States in the market should be created and thus on a market-based approach respecting technological neutrality of such sources. The European Commission stressed recently that national systems for ensuring generation adequacy should be opened for other Member States participation as well.

We fully agree that Capacity Reserve must be designed in such a way that it neither acts like a price ceiling in the market nor gives market players a comfortable alternative to fulfilling their delivery commitments. V. European Cooperation

We consider the creation of the European Internal Energy Market as a common priority for both the Czech Republic and Germany. In our opinion, Internal Electricity Market should comprise of following components:

o Integrated Energy-Only-Market (including Balancing Market) o Ancillary Services Market o Functioning EU Emission Trading System

o Strictly neutral low-CO2 premium (potentially)

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The Czech Republic fully supports further development and cross-border integration of spot and balancing markets and also ancillary services market. Enhanced cooperation between respective countries and market coupling could be extended to quarter-hour products as well.

Concerning functioning of the EU Emission Trading System, the Czech Republic supports introduction of the Market Stability Reserve.

The Green Paper states, that “in coupled markets, electricity is traded simultaneously, taking into account the transmission capacities available. As a result, production capacities and grids can be better utilised.” (p. 13) The Czech Republic welcomes this attempt to reduce the overcapacities in the European energy market. However, some level of capacities will be needed in order to ensure security of supplies to end consumers. The Green Paper accentuates this and also reflects ENTSO-E forecasts, which stipulate that in 2020 Germany will still have lack of sufficient generation capacity in the southern states. The Czech Republic would like to offer a solution in this matter – by coupling German and Czech electricity markets, southern German states such as Bavaria or Baden- Württemberg would be able to use generation capacities in the Czech Republic without the need for the further regulatory interventions such as capacity remuneration mechanisms. This could secure German security of supply in a cost-efficient manner.

GP further states that the interregional exchange of electricity balances out fluctuations in wind, solar irradiation and demand. We definitely agree with this, however, we would like to stress that above mentioned market coupling is necessary to be able to use these benefits. Also, costs for grid expansion are lower with cross-regional electricity transition.

VI. Maintaining of a single price zone

The Green Paper states that uniform wholesale prices are possible in a single price zone, when there is a sufficient capacity; i.e. it assumes the existence of a grid without congestion. It recognizes, that “if bottlenecks reach a certain level of intensity, i.e. their extent and frequency exceeds a certain level, redispatch measures can no longer effectively relieve the congestion in a way that guarantees security of supply. This is because every interference with system operation increases the risk of errors, particularly if a high number of simultaneous redispatch measures is performed.” (p. 32)

At the same time, the Paper implicitly expects the single DE-AT bidding zone to be preserved. The biggest problem, as seen from Prague, is the fact, that the DE-AT bidding zone does not respect congestions inside the zone and thus does not fulfil conditions for the overall market efficiency. For the Czech Republic, the unscheduled loop flows issue is still very relevant. The Czech transmission grid was severely overloaded in December 2014 and January 2015 due to the trade exchange between Germany and Austria. This trade exchange was in the amount of 7800 MW, transit through the Czech Republic´s transmission grid reached values of 3200 MW. In order to ensure safety of the transmission system, the Czech TSO ČEPS a.s. had to activate redispatch measures. Costs of these measures are covered by the Czech end consumers and only between December 2014 and January 2015 valued 2,5 times the total sum for redispatch measures in 2012 and 2013.

Furthermore, the trade between Germany and Austria is de facto given a preferential treatment to other traders, which naturally leads to discrimination of producers and customers in the neighbouring zones, mainly in the Czech Republic. The Czech Republic is in the phase of implementing technical measures to deal with unscheduled flows which overload the system (phase-

6 shifters), but non-discriminatory system solution based on market principles and in accordance with the EU rules would be much preferable to use of technical tools. In this respect, the first measure should be an inclusion of DE-AT border into coordinated cross-border allocation capacity calculation mechanism. In the meantime, the Czech Republic would appreciate an explanation of compensation payments mechanism in DE-AT bidding zone3 and quick adoption of the “polluter pays” principle for redispatch cost allocation.

Neighbouring transmission systems are also jeopardized due to the lacking development of domestic German transmission grid in the North-South direction. According to Bundesnetzagentur, in order to secure supplies after the RES generation increase, 1855 km of new power lines have to be built. Only 268 km has been built so far; this represents only 15 % share of planned lines. The Green Paper considers regional grid bottlenecks to be an interim problem. It stresses the need for grid expansion in order to allow the flow of electricity from North to South; on the other hand it also states that investment in controllability of local network stations is less capital-intensive and that if grid load peaks are shaved by generation management, required grid expansion is reduced.

We think that the follow-up of the Green Paper, the White Paper, should reconfirm concrete time frames for grid expansion as stated in the Energy Lines Expansion Act and Federal Requirements Plan Act to regain the confidence of neighbouring states and investors. BCGs analysis4 notes that the longer the country delays in completing the necessary grid extension, the greater the need for mechanisms that spur the construction of new power plants in certain regions would be. The European Commission at the last Florence Forum in November 2014 also stated that the grid expansion is necessary to complete the IEM. The Czech Republic would also like to know more about possible alternatives in case that Germany will not manage to build these lines in reasonable time schedule.

3 p. 29: Compensation for generation management prevents grid congestion having negative effects on the electricity market. The operators of the curtailed conventional and RES plants as well as the operators of conventional plants that are ramped up receive financial compensation from the grid operators. The costs are distributed to electricity customers via the network charges. This is of central importance in a single price zone in order to prevent distortion of electricity trading. 4 The Boston Consulting Group´s analysis “Germany´s Energiewende. The End of Power Market Liberalization?”. Accessible on https://www.bcgperspectives.com/content/articles/sustainability_energy_environment_germany_energiewen de_end_power_market_liberalization/#chapter1 7