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1. Executive SUMMARY

1.1 Introduction

This report was commissioned by Electricity Market Group (EMG), a working group under the Nordic Council of Ministers. The objective is to support Nordic governments in designing effective and efficient Capacity Remuneration Mechanisms (CRM) (also referred to as Capacity Mechanisms), and/or Non-Fossil Flexibility Support Schemes (NFFSS) to ensure security of supply within a rapidly changing electricity market landscape. Addressing increasing concerns about maintaining adequate firm capacity and flexibility amid the green transition, the report evaluates various designs, both existing and new, assessing their effectiveness, cost-efficiency, and compatibility with existing market structures.

The report presents suitable market mechanisms tailored to various future scenarios in the Nordic region, offering a flexible toolbox rather than endorsing a single solution. It assesses each of the designs and evaluates their effectiveness in addressing different scenario combinations, including cold winters, interconnection failures, major supply disruptions, and extended periods of low renewable energy generation (‘dunkelflaute’). Furthermore, it examines cross-border participation and the harmonisation of markets across the Nordic region.

While this report evaluates various designs for maintaining adequate firm capacity and flexibility, Nordic decision-makers should also prioritise assessing the alternative: supporting the functioning of the energy-only market to alleviate the need to intervene. They should examine existing recommendations for electricity market reform to optimise market efficiency and ensure security of supply. Market intervention should be considered only as a last resort, given the substantial financial implications of capacity mechanisms. According to ACER, annual capacity payments for market-wide CRMs in Europe range from approximately €20,000 to €60,000 per MW. Applying this to the Nordic region as a rough estimate, covering the 2023 peak demand of ~65 GW would require annual payments of €1.3–3.9 billion. Irrespective of any decision on support mechanisms for capacity and/or flexibility; enhancing the functioning of the energy market to deal with scarcity would likely be a ‘no-regret’ option.

1.2 Main design recommendations

1.2.1 Dispatchable flexible reserve

Recommended implementation: The dispatchable flexible reserve mechanism is particularly suited to addressing low-probability, high-impact events that require relatively rapid, yet planned responses. This design incentivises new investments in assets that can offer flexibility on an intraday and multi-day basis, while providing seasonal reliability. To mitigate the risk of a crowding-out effect, capacity is restricted from normal wholesale market operations and activated exclusively during periods of critically high market prices, indicating potential capacity shortfalls. Within-day flexibility is achieved through asset activation within the intraday market, necessitating specific adjustments to eligibility criteria. Market-based activation enhances operational efficiency by reducing the need for explicit dispatch instructions from Transmission System Operators (TSOs).

Main design features: Dispatchable flexible reserve represents a new yet recognisable concept, functioning similarly to a strategic reserve by providing dedicated, restricted capacity, but with enhanced flexibility. These reserves are activated exclusively during critically high-price periods within the Single Intraday Coupling (SIDC), the preferred variant, or alternatively within the Single Day-Ahead Coupling (SDAC), contingent upon acceptable merit order distortion levels – to be determined by decision makers. Delaying activation until closer to delivery through SIDC provides the market with opportunities to respond to price signals and resolve capacity issues independently, thereby minimising market distortion.

The design explicitly aligns with the NFFSS regulation, aiming specifically at incentivising new investments in non-fossil flexible capacity. Compared to traditional strategic reserves, typically used to prolong the operational life of existing ageing assets, dispatchable flexible reserve is likely to incur higher per-MW costs due to their requirement for new or refurbished capacities. However, these reserves offer superior flexibility in terms of eligible asset classes and activation approaches. Unlike conventional strategic reserves that necessitate operationally complex, last-resort dispatch instructions by TSOs, a dispatchable flexible reserve enables direct activation within existing market mechanisms. This capability ensures robust within-day and multi-day flexibility and reduces operational complexity for TSOs.

Potential risk: The primary risk associated with this design is merit order distortion. Ringfencing or restricting assets may, in some instances, lead to situations where these assets are more cost-effective for dispatch than those dispatched through the wholesale market. This could result in inefficiencies if the mechanism unintentionally displaces otherwise economically optimal market-based dispatch decisions. Furthermore, by providing a backstop capacity in the market, this mechanism may depress electricity prices and discourage new investments in peaking capacity or Demand-Side Response (DSR). Policymakers must carefully balance the extent of ringfencing or restrictions to mitigate this risk while ensuring system reliability and investment incentives remain intact.

1.2.2 FRR availability obligation

Recommended implementation: The FRR availability obligation is specifically recommended to mitigate risks associated with interconnection outages, particularly in scenarios of low renewable output. It aims to address local flexibility shortfalls and enhance system reliability in regions heavily dependent on interconnections with other markets.

The integration of common aFRR and mFRR Energy Activation Markets (EAM) platforms, PICASSO and MARI, across Europe strengthen reliability by facilitating cross-border balancing service sharing. Additionally, the Nordic dimensioning methodology forecasts future imbalances and procurement needs for aFRR and mFRR, generating price signals to incentivise investment. However, the missing money problem may require additional mechanisms to close potential investment gaps in FRR.

Main design features: This mechanism builds on the existing FRR Capacity Market (CM) but introduces longer lead-times and contracts specifically targeting new investments in non-fossil flexible capacity. Providers must at least meet FRR eligibility criteria.

Given the regulatory limitations of balancing markets, this design is proposed under the NFFSS regulation to accommodate longer lead-times. Like the FRR CM, the FRR availability obligation requires contracted assets to bid into either the mFRR or aFRR EAM, depending on system needs.

Potential risk: Market distortion risk, potentially affecting EAM prices, locally and in neighbouring markets, causing a crowding-out effect.

1.2.3 Strategic reserve 2.0

Recommended implementation: Addressing rare but critical adequacy gaps such as extreme weather events combined with large, unexpected outages. The contracted generation or demand-side capacity is kept outside the market and activated only when needed to prevent market distortion. It ensures availability of additional capacity during multi-day or seasonal shortages. It does not provide real-time or within-day flexibility unless combined with other products. Within-day flexibility is possible to achieve with warming contract and/or products designed to attract more flexible units, complementing slower-reacting, potentially legacy, assets. Real-time flexibility can be ensured through combination with FRR availability obligation.

Main design features: Strategic reserves is a targeted mechanism in which a central body procures capacity that is ringfenced from the market, activated only in severe critical events. If activated, the imbalance price is settled at VoLL or the price cap in the intraday market, whichever is highest. The 2.0 version of the strategic reserve is designed to address the limitations of traditional strategic reserve schemes, namely:

A lack of eligible MW for reservation.
Inflexibility due to long ramp-up times.
Complex TSO last resort dispatching rules.

Key improvements include:

Lowering entry barriers by expanding eligibility to new asset types, such as extending the ability of complementing heat pumps and electric boilers with biomass/thermal boilers. The scheme should also facilitate DSR participation and, in certain cases, support new investments in flexible assets.

Enhancing dispatch speed through:
- Warming contracts, which initiate asset start-up, reducing the time needed for ramping up unit.
- Introducing a two-product approach if faster ramping is required, one product for fast activation and another following traditional eligibility criteria.
- Alternatively, this design can be integrated with an FRR availability obligation to meet faster ramping needs.

Optimising ramping speed and reducing complexity by reviewing TSO dispatching rules related to dispatch instructions. Additionally, warming contracts may be linked to market prices, for instance, automatic activation of warming contract when the SDAC max price threshold is reached.

This approach ensures strategic reserves remain both effective and adaptable, improving system reliability while integrating a broader range of flexible assets.

Potential risk: By ringfencing specific assets, strategic reserve 2.0 may lead to inefficient dispatch if these assets are more cost-effective than market-based alternatives, potentially undermining economic efficiency. Policymakers must strike a careful balance between mitigating this risk and maintaining both system reliability and investment incentives to ensure a well-functioning electricity market.

1.2.4 Market-wide CRM

While the report does not explicitly recommend market-wide CRMs, it acknowledges their potential benefits. Under ideal implementation, they may incentivise new investments with minimal market distortion. With appropriately designed contracts and products, they can also attract the right type of flexible assets to address specific needs. Moreover, eligibility criteria could be structured to limit capacity payments to non-fossil assets.

The report refrains from recommending market-wide CRMs due to two key factors: (1) the substantial financial commitments associated with broad capacity payments, which pose significant risks of failing to achieve intended outcomes due to their sensitivity to unpredictable market developments; and (2) the specific conditions of the Nordic region, which generally benefits from ample capacity and flexibility under normal circumstances, rarely necessitating additional resources. The report assume only relatively small volumes would be needed in the end.

Furthermore, market-wide CRMs are particularly vulnerable to inaccuracies in derating factors, potentially misallocating support to unsuitable assets. Setting derating factors for hydropower with reservoir is especially challenging due to the complexities of water value calculations.

As a result, targeted and, to some extent, ringfenced mechanisms are considered more suitable for addressing any identified capacity or flexibility gaps in the Nordics.

1.3 Additional key takeaways

1.3.1 Cost recovery

In principle, the cost of the scheme should be recovered from those who cause the requirement for the scheme. Generally, this can be linked to peak demand, suggesting that the associated levy should be targeted at peak consumption. Such an approach would not only ensure a fair allocation of costs, but also serve as an additional price signal, encouraging greater deployment of demand-side response (DSR) and thereby helping to reduce both the size and overall cost of the mechanism. Consequently, the needs assessment, which underpins the determination of volume requirements, should reflect this, ensuring that the impact is incorporated into the capacity or flexibility volumes ultimately procured.

Strategic Reserves 2.0, however, may be considered a justified exception to this principle. As a last-resort instrument, activated only under extreme system stress and after all market-based solutions have been exhausted, it serves a broader system integrity function rather than addressing regular peak demand. In this context, targeted cost recovery would be inappropriate

1.3.2 Cross-border participation

As a general principle, cross-border participation is recommended to prevent distortions in neighbouring markets and enhance overall welfare. However, this report acknowledges both the opportunities and challenges associated with cross-border participation.

For market-wide CRMs, it is recommended enabling cross-border participation while recognising its complexities.

For targeted mechanisms, the recommendation depends on the specific design and purpose. Targeted mechanisms are typically introduced to address market failures in a specific country when decoupled from neighbouring areas. Allowing foreign capacity participation could dilute their intended effect. Based on this, strategic reserve 2.0 and the FRR availability obligation are recommended as national schemes without cross-border participation.

For dispatchable flexible reserve, the case for cross-border participation is stronger if multiple countries have a need for and implement this mechanism. In such cases, the likelihood of transmission constraints during scarcity events should be accounted for by applying appropriate derating factors.

1.3.3 Regional harmonisation

To mitigate future challenges and reduce potential negative cross-border impacts, it is recommended that Nordic decision-makers establish an early consensus on the following key areas:

Needs assessment: Harmonise adequacy and flexibility assessments across the Nordic countries to ensure a consistent approach. Aligned timing is also key, to prevent freeriding.
Value of Lost Load (VoLL): Where relevant, use a common methodology for defining VoLL, in line with ACER’s recommendations in their Security of Supply 2024 report at the European level.
Regulatory harmonisation: Where applicable, adopt a coordinated approach to CRM or NFFSS regulations to enhance market efficiency.
Platform cooperation: For markets introducing new mechanisms, explore shared procurement systems. Even if mechanisms differ, certain features can be standardised. A common system provider can help reduce costs and improve interoperability.