British philosopher and mathematician Alfred North Whitehead once wrote “fundamental progress has to do with the reinterpretation of basic ideas.”

If recent trends are any indication, such a re-evaluation is imminent if not already underway in many electricity markets around the world, a process that could have wide ranging implications for the world’s most capital intensive sector.

Two related processes are driving these changes: first, the move toward more competitive electricity markets; and second, the growth of renewable energy sources, namely wind and solar.

While these two processes have unfolded in parallel over the past few decades, there are signs that a deeper convergence may be underway. From capacity markets to energy storage, smart grids to demand response, electricity systems are already beginning to show signs of change; however, the most fundamental changes may be required in the basic design of electricity markets themselves.

Theory Due to the fact that renewable energy technologies like solar and wind power have little to no marginal cost, they represent a significant departure from fossil-based power plants. As a result, when wind farms and solar plants are located in liberalized markets, they typically bid into the spot market at zero (sometimes less); this strategy helps ensure that their electricity gets purchased whenever the wind blows, or the sun shines. One of the consequences of this is that as the share of renewable electricity with zero marginal cost in the overall mix grows, renewable energy sources actually push spot market prices down since power plants with higher short-term marginal costs are no longer needed to meet demand. In the absence of clear power purchase agreements (PPAs), bilateral contracts, or feed-in tariffs, this entails significant risks for investors. To date, most RE capacity in the world has been financed with one of these three mechanisms and has therefore remained largely sheltered from spot market fluctuations. And yet, a moment’s thought will quickly reveal that in a liberalized market, as soon as RE technologies start to represent a sizeable share of the market, RE producers quickly begin to undermine their own revenues. This is a point often only dimly appreciated by economists and regulators, who are inclined to focus on how electricity markets should work in theory, rather than how they work in practice.

Practice To draw on an example, consider Germany. Due to feed-in tariffs that guarantee a minimum price (in what amounts to a de facto PPA), Germany has seen a surge of renewable energy development since the early 2000s. The consequences of this surge in zero marginal cost power have been clear: electricity prices during the summer on Germany’s spot market are often lower during the day than they are during the evening, as the large influx of solar power (approximately 32 GW as of Q4:2012) enters the grid. (The same has occurred with wind power in the north of the country). Figure 1: Profile of Electricity Supply in Germany, May 21st – 27th 2012. Source: Fraunhofer ISE, EEX