The European Electricity Market: Real Reform Depends on Long-Term Contracts

The energy crisis of 2022 showed how exposed the European electricity market was to gas prices. But the real turning point was the discovery that volatility is not a hiccup. It is the new equilibrium of a system dominated by renewable sources. In fact, when sunlight and wind are abundant, prices plummet to zero or even become negative. When production drops, they rise rapidly. This is no longer a cyclical anomaly: it is the new normal in a decarbonized electricity system.

This electricity market structure is the subject of a new study by Francesco Decarolis (Department of Economics and BAFFI Centre, Bocconi University), “Reforming EU Electricity Market Design: PPAs, CfDs, and Long-Term Signals for a Renewable-Dominated System,” published in the BAFFI Centre Working Paper Series. Francesco Decarolis also holds the ENEL Foundation Chair in Competitiveness & Transition.

“Volatility in high-renewable systems is not an anomaly but a structural feature, one that must be managed through institutional innovation rather than suppressed through ad hoc interventions.”

According to Francesco Decarolis, it makes no sense to address volatility with emergency measures; it must be governed. In other words, we cannot “calm” the market every time prices fluctuate; we need to design rules that absorb that volatility.

The spot market is no longer enough

The traditional electricity market is based on hourly prices determined by the interaction between supply and demand. This mechanism remains fundamental:

“Short-run price formation, however, remains indispensable for efficient dispatch and consumption.”

Short-term prices are used to efficiently allocate production, storage, and consumption. The problem lies elsewhere: these increasingly unstable prices are not sufficient to finance investments in renewable energy plants, which require substantial capital and 20- or 30-year horizons. Greater uncertainty means higher capital costs, and therefore more expensive energy in the long term.

PPAs and CfDs: two instruments, a delicate balance

Decarolis' study analyzes the complementary role of:

• Power Purchase Agreements (PPAs): long-term bilateral contracts between producers and buyers (often energy-intensive companies), which set prices and quantities.
• Contracts for Difference (CfDs): generally public financial contracts that guarantee a “strike” price, compensating the producer if the market price falls and recovering the extra if it rises.

CfDs are therefore centralized instruments that stabilize revenues and reduce financing costs in projects awarded through auctions, while PPAs are decentralized agreements that allow the market to express the actual value of renewable energy in the system. In simple terms, CfDs offer public stability, while PPAs reveal market value. They are not alternatives, but complementary. The real challenge of the Electricity Market Design (EMD) reform, the European reform of the electricity market design, is to make them coexist without one stifling the other.

Italy’s case: high volatility, high opportunities

Italy is a natural laboratory. It has some of the most volatile prices in Europe, a congested grid, and an industrial fabric dominated by small and medium-sized enterprises with limited access to credit. Instruments such as the FER-X mechanism (the Italian auction system with Contracts for Difference for mature renewable energy plants) and the PPA Market can therefore strengthen the stability of the system, especially if accompanied by targeted public guarantees and greater mobilization of public demand.

The crux of the matter is clear: the problem is not 'too much market', but rather an incomplete market, unable to fully cover price, volume, and credit risks.

More complete markets, not more regulation

Francesco Decarolis summarizes the philosophy behind the necessary reform as follows:

“Long-term market reforms should not aim to replace market dynamics with regulation, but to make markets complete enough to deliver Europe’s clean energy objectives.”

If volatility is structural, the answer cannot be to leave it to the market or replace it with permanent subsidies. Decarolis suggests something different: keeping hourly markets intact to ensure efficiency in production and consumption, but complementing them with a stable architecture of long-term contracts.

In practice, this means three things. First: use public Contracts for Difference for a share of new renewable capacity, so as to lower the cost of capital and ensure sufficient investment. Second: leave room for private Power Purchase Agreements, which allow companies to hedge against price risk and the system to bring out the real value of energy at different times and in different areas. Third: coordinating public auctions and the private market, preventing CfDs from covering the entire production and stifling market contracts.

Decarolis therefore argues that four actions are needed in Europe: reduce information asymmetries and valuation problems that increase PPA transaction costs; strengthen and target public guarantees to overcome credit constraints, especially for SMEs; use public sector demand as an 'anchor' to activate long-term contracts; refine the design of CfD auctions so that public support and private PPAs reinforce each other, rather than replacing or compressing each other.

The goal is no longer regulation, but a clear division of roles: the spot market for short-term efficiency, long-term contracts for financial stability.