The energy crisis beyond the obvious: why DSOs matter

The European energy crisis is hunting policymakers and market players around the globe. The current energy wholesale market portrays a dystopian image of what happens when an economy, making the virtuous transition to affordable, clean, renewable power, which heavily relies on gas to keep moving forward.

By Tzeni Varfi and Maximo Miccinilli*

What’s causing the pinch? Strong recovery in demand and tighter-than-expected supply, green policy, combined with weather-related factors are the recipe for soaring energy prices, which could take several months to cool down. Europe is particularly at risk due to low stocks and its high dependence on natural gas. In recent weeks, energy prices and especially natural gas prices surged sharply (see Figure 1 below), prompting countries to reactivate coal-fired electricity generation. This has caused carbon prices to spike in turn.

Figure 1. Electricity prices for household consumers – bi-annual data (from 2007onwards)(€/kWh) -1st Semester 2021 – Band DC : 2 500 kWh < Consumption < 5 000 kWh

In our view, however, there are more fundamental reasons for high volatility and excessive price spike. The energy system is undergoing a profound and fast transformation. Investments in fossil assets are not sustainable long-term. Consequently, the energy supply-demand balance in the EU will be volatile depending on how quickly fossil fuels are phased out and green energy is phased in. Although some voices from the energy community are quick to say that this period of high prices will pass, and we will soon return to normal, we are experiencing a knife-edge situation. As the energy transition ripples across the EU, countries around the globe stumble on their transition to green energy.

Distribution System Operators (DSOs) are not to be blamed

In the discourse of energy prices, DSOs have been sidelined and to some extent ignored. This raises the legitimate question of whether the DSOs have anything to play in this equation?

The short answer would be to acknowledge that the liability of the DSOs on the increase of energy prices is to be fully exempted. DSOs are not involved in the surge in energy prices. They are only responsible for distribution of electricity while the hike is due to wholesale market.

But the story is way more complex: DSOs are on the frontlines of the energy markets and their business model is impacted by the spike energy prices. In general, they benefit from mildly higher gas and power prices as they hedge large parts of their portfolios upfront, notably the larger ones with big trading desks and strict risk policies. Nonetheless, not all DSOs have integrated business models, and some have been negatively impacted in uncompensated costs from loss procurement, by suppliers unable to pay their grid tariff, or with some declaring bankruptcy. Their business models, based on gaining new consumers through lower prices, lock clients into long contracts. The generated revenues become insufficient when wholesale power and gas prices start to climb sharply, pushing the DSOs into a price crunch situation.

What is the DSOs outlook?

DSOs rely on network tariffs which are set in advance and approved by National Regulatory Authorities (NRAs). Obviously, this tariff is affected by economic conditions and may increase as due to general inflation in prices. The Spanish government has recently unveiled a “shock plan” to slash taxes on power bills and claw back funds from DSOs to protect retail buyers. The governmental measures in Spain entail a high burden for DSOs which invoice retailers based on the electricity they purchase from the grid. Since the liquidity of the retailers is presently at risk, they pay these invoices to DSOs. DSOs themselves are not allowed by law to request collateral or guarantees or to stop invoicing the retailers.

In other EU countries, DSOs are directly responsible for their losses. The losses are counted in the distribution tariff invoiced to the final customer. The system is based on ex-ante price setting and an adjustment mechanism allowing alteration to actual costs incurred.

For instance, Germany’s market structure is based on the liberalisation of the energy sector to create choice for consumers and dismantle monopolies. As power prospects are at very high levels, some DSOs and suppliers with fragile cash positions could run into liquidity issues or even become insolvent in the coming months, particularly after the German energy regulator, confirmed it was not its role to monitor procurement strategies or pricing mechanisms.   

Renewables can’t fix it all

According to Politico, in 2020 renewables generated 38 % of the bloc’s electricity, surpassing fossil fuels to become the leading source of power in Europe for the first time ever. However, wind and solar power are yet incapable of generating enough power to account for 100% of demand year-round, even in the most favourable climate conditions.

Renewables will continue to play a remarkable role in the journey towards a lower carbon future in Europe. It is undeniable. Yet the energy transition needs much faster penetration of renewables for hard to abate sectors and vulnerable consumers, and this comes with both expected and unintended costs. Beyond the necessary social support, there is need for investment and political support for a wide range of low-carbon technologies such as Carbon Capture Utilization and Storage (CCUS) and clean hydrogen, recognizing that hanging the current EU energy model would pose risks to market predictability, competitiveness and social acceptance.

The issue is especially relevant for distribution grids as the majority of RES, as well as flexibility services, are connected to the grid. This makes the electricity distribution system the core of a future decentralized and integrated energy system that relies on renewables for electricity production. To that end, significant expansions and replacements related to integration of variable renewables such as solar and wind is needed: 70% of which will be connected at distribution level, as well as to the progressive electrification of industry, transport and buildings.

In fact, a study – “Connecting the Dots” – undertaken by E.DSO and Eurelectric with Deloitte suggests that DSOs will need 375-425 billion Euros of investment to research, innovate and deploy new technologies to guarantee a reliable network. Without such investments the electricity grid will not be able to sustain the ambitions of the energy transition which will, in turn, increase the security of supply-related risks.

Have you read?
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Transformation is inevitable – Getting it right is essential

What to expect next?

With winter approaching, the outlook doesn’t seem good for any quick recovery. The European gas market could well face further stress tests from unplanned outages and sharp cold spells. The link between electricity and gas markets are not going to vanish anytime soon since gas remains an important tool for balancing electricity markets. As clean energy transitions advance on a path towards net-zero emissions, global gas demand will start to decrease, but it will remain an important component of electricity security. This is especially the case in countries with large seasonal variations in electricity demand.

The big question is whether the current energy prices crunch is one-time show or signs of a deeper dilemma. It’s a tricky one to answer, as all the parts aren’t yet on board for a low-carbon power system. The predictions show that the energy supply-demand balance in the EU will continue to be fragile.  The European Commission has recognized that the energy prices will very likely decrease around Spring 2022. However, it is very unlikely that they will reach the pre-crisis levels.

The energy crisis arrives at a delicate moment for the EU: in July 2021, the European Commission unveiled a far-reaching set of legislative proposals to cut down the EU’s greenhouse gas emissions by at least 55% before the end of the decade. We trust, the timely approval and implementation of the ‘Fit for 55’ Package would represent a more structural solution to avoid future energy-price hikes and ensure an orderly transition from brown to green.

The hike in energy prices has inevitably brought the EU’s climate policy under new scrutiny.  We believe energy prices will continue to increase in 2022-2023, as supply tightens. Europe’s more ambitious environmental targets to penetrate more renewables cannot fully replace over the coming three years, leading to greater weather-related price volatility in the interim.

Yet high energy prices also imply increased political risks for DSOs.  This relates to the need to address the security of supply, affordability and innovation needs.

With so much happening in the energy value chain, it is vital that policy choices ensure that consumers receive reliable, affordable power when they need it most. It is also important to recognize the fundamental role that DSOs will have in putting into practice the sector integration approach unveiled by the European Commission’s strategy in 2020. We need a reality-based, fact-driven conversation around policy choices, regulatory options, potential outcomes and scenarios, and enforcement.

Reaching the -55% GHG 2030 target is only eight years away. The clock is ticking and without concrete proposals to accelerate the DSO agenda (including regulation, funding, etc), the overall outcome risks to be disappointing and very expensive.

About the authors

Máximo Miccinilli

Mr Máximo Miccinilli is the vice-President of Head of Energy and Climate at FleishmanHillard EU since March 2021. Previously he held the position of Director of Energy and Climate at the Centre on Regulation in Europe (CERRE), leading the think tank’s research and activities related to energy and climate.

He was previously leading the public affairs and communications activities of European Aluminium where he managed international campaigns on energy and climate matters.  Prior to this, he was a manager in the energy and climate practice at Burson-Marsteller Brussels (now BCW), a leading global PA and PR agency. 

He holds a MA in European Law from the College of Europe (Bruges) and an MBA in Business and Finances from the Solvay Business School (Brussels).

Tzeni Varfi

Ms Tzeni Varfi presently holds the position Policy and Legal Director at the European Distribution System Operators (E.DSO) in Brussels. She is an accomplished expert in advocacy strategy and EU decision making. She has engaged in political affairs throughout her studies and career.

She previously worked as Senior Legal Counsel in the Intellectual Property & IT law and of the Regulatory & Trade law departments at Pierstone Brussels.

She has served over 12 years in various positions in Brussels, dealing with environmental law, data protection and energy policy.

Tzeni holds a Master degree in European Legal Studies from College of Europe (Bruges) and she accomplished a Post-Master Research on International Law from the University of Bordeaux IV.

*) Disclaimer: This piece reflects only the individual opinion of the authors without engaging their respective organisations.