Source - VTT-R-04621-16 Electricity Market Designs and Flexibility (2016)

Electricity market designs and flexibility. VTT Technical Research Centre of Finland, Research Report VTT-R-04621-16, October 2016. Authors: Juha Forsström, Göran Koreneff, Lassi Similä. Produced under the FLEXe programme (Tekes). 47 pages.

Bibliographic details

Full title: Electricity market designs and flexibility
Report code: VTT-R-04621-16
Publisher: VTT Technical Research Centre of Finland
Programme: FLEXe (Flexible Energy Systems), funded by Tekes
Date: October 2016
Authors: Juha Forsström, Göran Koreneff, Lassi Similä
Length: 47 pages + Appendix Q&A

Summary

This report examines electricity market design shortcomings in the context of high variable renewable energy (VRE) penetration, evaluates proposed solutions including capacity mechanisms and two-market designs, and proposes a practical implementation of a separate renewables market for the Nordic NordPool environment. The analytical focus is theoretical and forward-looking from a 2016 Nordic perspective, but the market design questions it raises have become more acute in the years since.

The report is structured in five parts: (1) shortcomings of current market design, (2) Nordic-specific capacity mechanism analysis, (3) short-term market design options, (4) the Keay (2016) two-market model with VTT simulation, and (5) a NordPool-specific proposal for a Wind System Operator.

Four diagnosed shortcomings of current electricity markets

The report identifies four structural failures in liberalized electricity markets under high VRE penetration:

Missing money problem: Spot market prices collapse toward zero as VRE with zero marginal cost dominates supply during VRE-rich periods. Conventional dispatchable generators cannot cover their capital costs at average market prices. This drives capacity exit, eventually creating adequacy problems.
Unsustainable VRE economics without subsidy: The same mechanism that destroys conventional generator economics also prevents VRE from operating without feed-in tariffs or other support. Zero marginal cost + zero price = zero revenue during high-VRE hours. Subsidies “solve” this by decoupling VRE revenue from market prices, but do so at the cost of distorting the market further.
Market power in peak hours: During tight supply hours (low VRE, high demand), the few remaining dispatchable generators face near-inelastic demand and can exercise market power, driving prices far above efficient levels. Inflexible demand amplifies this: if demand cannot respond to high prices, prices can spike to levels unjustified by cost.
Inadequate flexibility signals: Existing market structures do not adequately reward the flexibility that DER and demand response can provide. Short-term markets may not be short enough (hourly resolution misses intra-hour flexibility value); product designs may not accommodate DER response times; and the market structure does not separate the value of “energy available now” from “energy available on demand.”

The Appendix Q&A (pp. 42–47) provides a structured debate format: each claim, arguments for, counter-arguments, and proposed solutions — providing a useful map of where expert disagreement concentrates.

Nordic capacity mechanism analysis

The Nordic electricity system presents specific challenges for capacity mechanisms:

Low-price era (2014–2016): Nordics experienced prolonged low prices due to combination of surplus hydro, wind expansion, and VRE support in Germany/Denmark affecting NordPool.
Condensing power: Nordic thermal backup plants (“kondensproduktion”) were squeezed most — too inflexible for balancing, too expensive for baseload, increasingly uncompetitive against low-carbon alternatives.
Anti-capacity mechanism tradition: Nordic countries have historically resisted capacity mechanisms on grounds that the energy-only market should be allowed to clear efficiently with adequate scarcity pricing.

The report evaluates both strategic reserves and market-wide capacity obligations, noting that the EU framework being developed (ERAA methodology, now in Regulation 2024/1747) requires systematic adequacy assessment before any mechanism can be approved. The Nordic tradition is compatible with this approach as long as scarcity pricing is effective — but the authors note that political resistance to very high scarcity prices weakens this in practice.

Short-term market design options

The report reviews design parameters that affect flexibility value capture in short-term markets:

Sub-hourly markets: Moving from hourly to 15-minute or even 5-minute market intervals allows faster-responding resources (batteries, demand response) to provide value that is invisible in hourly clearing. Sweden implemented 15-minute electricity pricing in October 2025 — consistent with this recommendation.
Scarcity pricing: Administratively-set price caps limit the scarcity rent available to incentivize flexible capacity. If the price cap is too low, flexible generators and demand response get insufficient compensation during tight supply hours.
Pool vs bilateral trading: Centralized pool markets with security-constrained dispatch can optimize flexibility more efficiently than bilateral markets, but require stronger coordination infrastructure.

The Keay (2016) two-market design

The core theoretical contribution of this report is an application and simulation of the two-market design proposed by Malcolm Keay (OIES Paper EL17, 2016). This design directly addresses the missing money and VRE sustainability problems by separating electricity markets into two distinct products:

Firm market

Product: electricity that is available on demand — dispatchable, schedulable, firm
Participants: conventional generators (coal, gas, nuclear, hydro, biomass); VRE generators can participate by contracting with a flexible generator to create a “hybrid” firm unit
Price: higher than non-firm market; covers capital costs of flexible generation; equivalent to the current spot market functioning as designed
Consumer proposition: “on-demand electricity” — higher price, guaranteed availability

Non-firm market

Product: electricity that is available when generation conditions allow — inherently intermittent
Participants: primarily VRE generators (wind, solar); any generator with zero or near-zero marginal cost
Price: lower than firm market; reflects the cost advantage of zero-marginal-cost generation; price set by regulator initially, transitioning to market auction as costs fall
Consumer proposition: “as-available electricity” — lower price, no delivery guarantee; consumer must either manage their own flexibility or absorb imbalance costs

Market interaction

The two markets share one physical grid and one system operator. Dispatch is managed together by the SO. Non-firm power is dispatched automatically when available; curtailment rules apply only when system cannot absorb further injection.

The crucial mechanism: consumers who opt into the non-firm market have a strong financial incentive to flex their demand to follow variable supply. If they over- or under-consume relative to their contracted non-firm allocation, they pay imbalance penalties (settled at non-firm balance market prices, set to be less favorable than if they had matched their allocation). This turns price-responsiveness from a passive byproduct into the core mechanism of the product.

Why this matters for demand response

The two-market design is not primarily a supply-side proposal — it is a demand response incentive mechanism. By creating a low-cost, as-available electricity product, it creates a strong and ongoing financial reason for consumers to invest in flexibility infrastructure (smart controls, thermal storage, EV scheduling). Under the current single-market design, the case for consumer flexibility investment is weak: the price signal is real but infrequent, and the spread between peak and off-peak prices is insufficient to justify hardware investment in most cases.

Under the two-market design, consumers in the non-firm market face a permanent, structural incentive to follow supply variability. This shifts DR from an occasional emergency response to everyday operation — which is exactly what is needed as VRE penetration grows.

The two-market design is conceptually consistent with how EU policy has evolved: the LFM-h/p/e products approved in Sweden by Ei in December 2025 create availability-based products where DSO procurement of flexibility has an ongoing character, not purely emergency activation.

VTT simulation results

VTT built a simplified 24-hour simulation model to test the two-market design. Findings:

Case 1 — Spot market without VRE: Market functions as designed. Only marginal (oil-fired) plants show negative economics, consistent with their role as infrequent scarcity plants inadequately represented in a representative-day model.

Case 2 — Spot market with high VRE share: Plant economics deteriorate across the board. Even nuclear shows barely positive results. VRE brings prices down so low that dispatchable capacity is unsustainable. This is the “missing money problem” visualized.

Case 3a — Two-market design with static customer flexibility: Consumer flexibility is modeled as a uniform demand reduction (simplified). The firm market price stabilizes. Plant economics recover to approximately the single-market pre-VRE baseline. The non-firm product clears at consistently low price, incentivizing non-firm market participation.

Case 3b — Two-market design with refined flexibility: Consumer flexibility is concentrated at peak periods (reducing the two-peak shape of daily demand toward a flatter profile). The firm market supply profile becomes substantially easier to operate. The simplified simulation model cannot fully capture the dynamic value (start/stop costs, ramp rates), but the qualitative improvement is clear.

Caveat: The simulation model is acknowledged as too simplified to quantify the full dynamic benefits. The authors explicitly flag the need for more sophisticated models that include unit commitment costs, ramp constraints, and longer time horizons.

The Wind System Operator (WSO) — NordPool implementation proposal

Chapter 5 is a thought experiment: how could a separate renewables market be implemented within existing Nordic market infrastructure?

The proposal:

Wind System Operator (WSO): A new market entity holding balance responsibility for wind power generators and end-users who opt into the wind market. The WSO manages:

Procuring wind production from generators at a fixed tariff (initially regulated, auction-based later)
Selling pro-rata wind allocations to participating end-users at a price lower than the normal spot market
Managing imbalances between forecast wind production and actual end-user consumption

End-user mechanics:

Each WSO consumer contracts a baseline portfolio: e.g., 30% normal market + 70% WSO market
The WSO calculates each consumer’s pro-rata share of actual wind production hourly
If the consumer uses exactly their allocated share: pays only WSO base price (lower than spot)
If the consumer uses more than their share: buys the excess at unfavorable up-regulation prices from the WSO balance market
If the consumer uses less than their share: sells the surplus at unfavorable down-regulation prices

This pricing structure is explicitly designed to penalize deviation from one’s wind allocation, creating a direct financial incentive to flex consumption to match wind output. The penalty structure (Table 4 in report) shows that deviating from allocation is always more expensive than matching it.

Why this is implementable without major infrastructure changes: The report’s key practical claim is that this design can operate within existing metering, settlement, and market infrastructure. The only new element is the WSO as a balance responsibility holder with its own imbalance settlement rules. Smart meters with hourly readings (available in Sweden since the 2009–2011 AMI rollout) are sufficient to settle WSO imbalances.

Integration with normal system operator: The normal SO manages the overall balance market. WSO interacts with the SO via defined settlement rules (four cases based on whether WSO is over/under-producing and whether the normal system is in up/down regulation). Excess WSO revenues from favorable settlement interactions can be directed to capacity cost recovery funds.

Swedish relevance

Sweden completed its first-generation AMI rollout by 2009 and is now implementing second-generation smart metering with sub-hourly resolution. The WSO proposal would be technically feasible in the Swedish metering environment. The FLEXe programme was Finnish-focused, but NordPool operates across all Nordic countries and any major market design change would require Nordic coordination.

The WSO design has not been pursued as policy. However, the incentive structure it proposes — lower prices for flexibility-committed consumers — is now appearing in Swedish policy discourse through effekttariffer design and the LFM-e real-time dispatch product.

Key claims and caveats

The two-market model simulation confirms qualitative benefits but acknowledges the model is too simple for rigorous quantification
Nordic opposition to capacity mechanisms remains strong; the missing money problem is real but politically contentious
The WSO proposal is a thought experiment; no financial modeling was completed within the project
The authors note FLEXe-specific questions throughout: do proposed solutions consider small-scale DER opportunities? Do solutions incentivize prosumers?

Relevance to wiki

Demand Response — two-market design as structural DR incentive; explicit vs implicit DSM in VRE context
Balancing Markets — missing money problem; Nordic capacity mechanism debate; scarcity pricing
Flexibility Market — non-firm market concept as precursor to current explicit DSM design
Flexibility Need Assessment — adequacy assessment prerequisite for capacity mechanisms
Distribution Network Development Plan — DNDP/FNA three-way architecture as demand-side complement to supply-side capacity questions
SWITCH — LFM-h/p/e as availability-based product consistent with non-firm market incentive logic
Elmarknadshubb — WSO settlement infrastructure requirements parallel to FIS requirements
Demand Response — consumer flexibility incentive mechanism; rebound effects; synchronisation risk