Navigating European power market reform: what traders need to know

Why reform is on the table

The post-crisis environment raised two urgent questions: how to safeguard consumers from severe price increases, and how to preserve incentives for renewable energy investments. As wholesale prices reached historic highs, governments stepped in with measures like price caps, windfall taxes, and emergency revenue limits - short-term solutions that highlighted the conflict between market efficiency and affordability.

Reform is now aimed at making the system more resilient. The EU’s Electricity Market Design package and the UK’s Review of Electricity Market Arrangements (REMA) both aim to balance short-term price signals with long-term stability. Policymakers want markets that promote investment in clean generation and flexibility, while also protecting households and industry from volatility.

For traders, this involves adapting to a system where more price formation occurs outside the traditional day-ahead market. The direction of reform will determine how much liquidity remains in short-term products and how much shifts to longer-term or capacity-based contracts.

Key proposals and their impact on trading

A prominent trend in reform debates is the increasing use of long-term contracts like Contracts for Difference (CfDs) and Power Purchase Agreements (PPAs). These instruments offer price stability for generators and investors by fixing a strike price, thereby minimising their exposure to wholesale market fluctuations. For traders, this shift may gradually decrease the amount of merchant power subject to spot prices, channelling liquidity into fewer, shorter-term contracts.

Capacity remuneration mechanisms are increasingly popular alongside long-term price guarantees. These markets compensate generators, and more often storage or demand response providers, solely for their availability, not for actual electricity generation. This shift changes the risk-reward landscape by turning part of the generation business into a financial product based on availability. Traders are adapting by modelling capacity revenues in conjunction with energy margins, frequently employing hybrid valuation methods derived from structured products practices.

Another key element of reform involves flexibility products. As the share of renewables in generation increases, system operators are implementing local and temporal flexibility auctions to manage intermittency. These mechanisms may develop into comprehensive flexibility markets, rewarding participants for rapid ramping or demand-side engagement. For trading teams, they offer both a new hedging tool and a new source of volatility: short-term but potentially profitable price signals linked to system constraints.

Finally, market integration continues to be a key concern. The EU remains committed to cross-border connections and unified pricing zones, whereas the UK might diverge due to REMA enforcement. Traders active in both regions should watch how clearing procedures and transmission rights evolve, as changes in interconnector access or bidding zones can directly influence spreads, liquidity, and correlation patterns.

Marginal pricing vs. pay-as-bid: what changes

Central to Europe’s market reform discussion is the use of marginal pricing. Under the existing uniform-price system, all generators receive the market-clearing price, which is determined by the marginal plant, typically a gas plant. Critics argue that this system exposes consumers to unpredictable gas-related prices, even when renewable energy production is substantial. Conversely, supporters contend that marginal pricing promotes efficient dispatch and clear price signals.

Some policymakers have suggested pay-as-bid models, where each generator receives payment based on its offer rather than the clearing price. While politically attractive, such systems can diminish transparency and liquidity. For traders, the main concern is how any change to the clearing mechanism might impact forward curves and volatility patterns. Marginal pricing enables spreads to mirror actual generation costs and merit order dynamics; replacing it could conceal these relationships, making fundamental modelling and risk management more complex.

In practice, most reform proposals fall short of completely abandoning marginal pricing. Instead, they concentrate on adjusting its effects, that is, employing CfDs or capacity mechanisms to shield consumers from spikes while maintaining market efficiency. Traders, therefore, need to understand not just the main reforms but also how they interact with the existing market structure. Even slight adjustments to settlement periods or balancing rules can influence liquidity across day-ahead, intraday, and forward markets.

Hedging implications are already emerging. As more renewable output is sold through long-term CfDs, the residual merchant volume will become a smaller but more volatile part of the system. That concentration of risk may widen spreads and increase price sensitivity to weather, outages, or interconnector flows. Advanced hedging - combining forward, options, and cross-commodity strategies - will be essential to manage this concentrated volatility.

Capacity and flexibility markets

Reform is also broadening the scope of capacity and flexibility mechanisms, introducing new product categories and arbitrage opportunities. Traders are observing how these systems develop from simple availability payments into dynamic, tradable instruments.

• Capacity markets offer predictable income streams but introduce new valuation factors, including penalty risk, derating elements, and volatility in clearing prices. As these products develop, they may draw speculative interest beyond just generators, from hedge funds or utilities seeking non-correlated returns.

• Flexibility markets, meanwhile, are still in their early stages. Pilot auctions in the UK and several EU countries are testing local flexibility services, often at distribution level. For traders, this creates the potential for short-term locational price signals that could affect intraday spreads and congestion management.

• Storage and demand response are essential enablers in both frameworks. Batteries and flexible loads are increasingly regarded as dispatchable assets, capable of deriving value from both energy and capacity products. Understanding their participation is vital for forecasting imbalance risk and intraday volatility.

As these market layers deepen, they create a more complex yet diverse landscape of price formation. Each mechanism, whether energy, capacity or flexibility, contributes its own liquidity pool, correlation structure, and hedging behaviour.

Strategic adaptation for trading desks

For trading organisations, reform is not just a regulatory concern but also a strategic one. Desks must adjust risk systems, data feeds, and modelling tools to accommodate new product ranges and market structures. Scenario planning becomes essential: traders need to run sensitivities for different reform outcomes. For example, how a shift towards pay-as-bid or regional flexibility zones might influence volatility or the shape of the forward curve.

Regulatory monitoring remains equally crucial. New reporting obligations under REMIT and national equivalents will evolve alongside market reforms. Compliance teams must stay vigilant to potential shifts in the definitions of inside information, market abuse, or cross-border reporting as products change.

In parallel, trading strategies will need to become more cross-functional. The boundaries between power, gas, carbon and flexibility products are blurring. Firms with integrated modelling across these commodities will be best placed to interpret price signals as the reform agenda unfolds.

Ultimately, those who view reform as a trading variable and not just a policy backdrop, will have an advantage. By anticipating how rule changes influence risk transfer and market behaviour, traders can position themselves ahead of structural shifts instead of reacting afterwards.

Conclusion

European power market reform presents both challenges and opportunities. As policymakers seek greater stability and consumer protection, traders face a landscape where liquidity shifts, volatility adjusts, and new product layers develop. Marginal pricing may persist, but its dominance will be moderated by long-term contracts, capacity revenues, and flexibility markets.

For trading desks, the message is clear: structural change is imminent, and it will reshape how risk and value are allocated across different timeframes and regions. Those who adapt their analytics, hedging, and product coverage early will not only survive the transition, but they will define the next competitive advantage.