By Stephanie Conaghan

The European electricity market opened in  theory to competition on February 19, but  the reality is more complicated. 

European countries were required by February  19 to implement national legislation adopting  common rules for their internal markets in electricity. The rules are found in  a European Union directive, 96/92/EC. The directive has already prompted  some movement among  developers active in the  EU, and should offer significant investment opportunities to energy companies seeking to enter the  market. On paper, some 60% of EU power markets  are now open to competition. However, a few  important facts should be borne in mind as one  analyzes the situation. 

First, the nature of EU directives is to set principles and goals but allow member states freedom,  albeit limited, as regards the manner in which  targets should be reached. The purpose of the  directive is for the various electricity systems to share the same principles regarding competition  and market access. Different competitive models  and ways of ensuring access to the grids can be  chosen. This means that, though there are significant similarities across countries, individual countries have different structures. Second, several  issues remain unsettled, including open access to  the transmission grid, transmission pricing and the  question of recovery of stranded costs. Finally, the  directive allows individual countries to restrict  competition under certain conditions. This article,  after a short description of the directive’s effect so  far, briefly discusses these issues. 

Background 

Directive 96/92/EC, adopted by the Council of  Ministers in 1996, provides for phased competition  in the European electricity sector. As a first step,  member states must permit large industrial and  commercial customers using more than 40 gWh on  an annual basis to select their electricity suppliers.  Such customers account for approximately 26% of  the EU electricity demand. By 2003, countries must  have opened at least a third of their electricity  market to competition, with the consumption  threshold being lowered to 9 gWh. Although  Ireland, Belgium, and Greece were granted extensions to comply with the directive, they have  opted to open their markets now. 

The majority of European countries have  chosen to open their markets beyond what is  demanded in the directive. In the UK, for example,  freedom to select a power supplier will be extended  to all retail customers later this year. The German  market also will be 100% open at the outset, with  all consumers being able to select a power supplier.  Spain intends to open 40% of its market by October 1999, starting with 30% in February.  France has not yet transposed the directive into  national law.

France is reluctant to liberalize its  electricity sector and will likely implement a  restricted version of the directive. A bill imple menting the EU directive is under discussion in the  Assemblée Nationale, but probably will not  become law until October 1999. Along with  France, Italy has not passed enabling legislation,  but it is expected that competition will be introduced in stages over the next five years. The first  stage has been approved by the cabinet, meaning  that 30% of the market will be subject to market  forces this year. 

Structure of Directive 

For the construction of new capacity, member  states are allowed to choose between two different  competitive models or a mix of the two models: 1)  the authorization procedure and 2) the tendering  procedure. 

Under the authorization procedure, applications that conform with certain objective criteria  determined by the member state for granting  authorization would be authorized. Such criteria  may relate to the security of the electricity system,  the protection of the environment, and energy efficiency. The need for new capacity would not be  taken into account. 

In contrast, the tendering procedure envisages  central planning, but no generation monopoly for  the incumbent utility. The incumbent utility could  elect to participate in the competitive tendering of  the new capacity. 

The overwhelming majority of member states  will use an authorization procedure to introduce  competition. Even when the need for capacity is  centrally planned, the directive requires that it  must be possible for self-producers and independent power companies satisfying the objective  criteria defined by the member states to obtain  authorization outside of a tendering procedure. 

The directive requires the incumbent utilities to  separate their wires business from generation,  through separate management and separate  accounts. They also must offer non-discriminatory,  open access transmission service to third parties  based on negotiated or regulated third party access,  or the single buyer model. The latter involves the  supply of power through a central purchaser,  which is in charge of the  grid. The single buyer  would be obliged either to  carry out contracts  between producers and  consumers or to give such producers and  consumers access to the system. Ten EU states out  of the 15 have opted for regulated third party  access, whereby a generation provider and  consumer contract directly with each for power  supplies, but access to the grid is governed by  published and regulated tariffs. Only Germany and  Greece have opted for negotiated third party  access, in which the supplier and consumer engage  in a bilateral transaction for the supplies and negotiate access to the network with its operator. Italy  and Portugal have opted to use a system that  combines negotiated third party access and the  single buyer model. Importantly, the directive  authorizes the operator of the transmission or  distribution network to refuse access to the grid if  there is insufficient capacity on the grid. 

Impact 

The directive already has prompted a rise in crossborder acquisitions, mergers, joint ventures and  strategic positionings, with companies seeking to  break into neighboring markets. Electricité de  France has bought London Electricity owned by  U.S.-based Entergy in a deal worth $3.2 billion.  IVO, a Finnish power group, has bought Stockholm Energi, for $1.95 billion. Also, Vattenfall of  Sweden, RWE of Germany, Tractebel of Belgium,  National Power and PowerGen of the UK and  Endesa and Iberdrola of Spain have bought or are seeking acquisitions and joint ventures in other EU  countries. In addition, utilities are looking to diversify their businesses: in the U.K., British Gas and  Eastern Energy are offering customers dual fuel,  electricity and gas contracts. ScottishPower offers  gas, electricity, water and telecommunications to  its customers. Utilities in other member states are  following a similar approach. 

Power trading markets, offering spot and  futures contracts, are being developed to meet the  increasingly sophisticated demands of European  customers. The Amsterdam Power Exchange,  which is modeled on NordPool, is being prepared  to start trading electricity this quarter. NordPool,  the Scandinavian electricity market, which has  been in operation for some time, consists of a  highly liquid spot market for physical trading and  a futures market for trading. A power exchange is  expected to be up and running in Germany by the  end of the year. The UK is exploring new trading  arrangements for its power pool in light of  “gaming” of the system by large generators. 

Open Issues 

While competition is set to be implemented, a  number of issues remain, including the award of  stranded costs to the incumbent utilities, precise  terms and conditions of access to the transmission  grid by third parties, pricing for transmission  service, and the right of member states to deviate  from the directive under certain circumstances.  Energy companies seeking to enter the European  market should keep the following in mind: 

Non-discriminatory Third Party Access to Transmission Grid: Germany has proven the early testing  ground for the effectiveness of the open access  requirement in the directive. The German energy  law implementing the directive requires regional  transmission companies to provide non-discriminatory access to grids. However, no regulations  were passed to ensure such access. Prior to the  directive coming into force, Enron filed a complaint with Germany’s competition authorities, the Federal Cartel Office, alleging that it had  been denied access unfairly to Hagen-based  regional supplier Elektromark’s transmission grid  in violation of Germany’s energy law. Enron was  attempting to supply a municipal utility when  access was denied by Electromark, the regional grid  operator, on the grounds that a network constraint  would hinder the transmission of the Enron power  supplies to the municipal utility. The FCO dropped  the proceedings after Elektromark and Enron were  able to agree to a negotiated transmission tariff. It  is worth noting that Germany, as an interim  measure, is also allowing its hundreds of municipally-controlled distributors to adopt single buyer  status and maintain control of the distribution  grid, which may limit the ability of competitors to  penetrate local markets. 

Pricing for Transmission Service: Transmission  pricing requires an overhaul in Europe. The directive fails to provide for a uniform system of transport fees, which complicates the creation of a panEuropean competitive power market. Under the  present regime, pancaked rates, or a series of rates,  are being charged for transmission service, which  will stifle competition. A working party of grid  operators is attempting to establish a uniform  cross-border electricity tariff, which should ensure  transparency of prices for transmission, as well as  transparency and uniformity in the rules relating  to access to the grid and grid management. The  recent German proceeding, together with disparate  national treatment of transmission service, may  highlight the need for a European-wide regulator,  with certain similar powers to those exercised by  the Federal Energy Regulatory Commission in the  US. Individual member states are exploring the  creation of commissions for electricity regulation  to handle issues in connection with liberalization. 

Stranded Costs: The EU commission is not  expected to rule on country plans for stranded cost  recovery until later this year. The UK, Greece and  Sweden are the only countries that have not  requested compensation  for stranded assets. The  compensation determination will affect pricing for  supply in the competitive market, which could  result in a market barrier to new entrants and  thwart competition. Plans by Spain to deal with  stranded costs have already led to complaints of  unfair competition from companies seeking to  break into the Spanish market. The government  has proposed to authorize utilities to securitize  approximately $8.0 billion of stranded costs resulting from the move to competition. The national  commission for the electricity sector, appointed by  the previous socialist government, argued that the  compensation paid via the securitization package  was overly generous to the utilities and prevented  increased savings for consumers. The government  dismissed the commission’s criticisms. The EU  competition commissioner has warned the Spanish  government not to grant stranded asset relief prior  to full commission scrutiny, as this is an EU-wide  issue. 

Public Service Obligations: Under the directive,  member states are allowed to restrict competition  due to “public service” obligations, which are  defined by the member states and relate to issues  of security of supply, regularity, quality and price  of supplies, or environmental protection. For  example, Spain and Germany have authorized  transitional arrangements designed to protect  German and Spanish coal markets. The UK also has  imposed curbs on building gas-fired power stations  to protect its coal market. In addition, the European nations are allowed to impose a reciprocity  Off To The Races In Europe requirement, which can last no longer than nine  years, if there is unequal implementation of the  directive in different member states. If State A  supports reciprocity, such as Spain for example, it  can exclude generators from State B from gaining  access to the customers of State A because the  generators of State A are not allowed to supply  equivalent customers in State B. Test cases on reciprocity are anticipated in future. In accordance  with the directive, the EU commission will monitor the development of the markets in light of the  reciprocity provision and may recommend to the  EU council and parliament a further opening of  the markets, based on experience gained. 

Future of European Power Market 

It is important to note that the purpose of the  directive is for the various electricity systems to  share the same principles regarding competition  and market access, even though they may be  different in structure. The impact of the directive  will depend greatly on the level of support of individual governments and the effectiveness of the  regulatory regimes in enforcing competitive principles. Opening of the electricity market to date in  Europe has given rise to increasing investment by  independent power companies, such as Enron, and  the trend is likely to continue. In the UK, for  example, where privatization of the electricity  sector was initiated in 1990, US companies have  invested billions of dollars. Smaller investments by  US utilities and independent power companies  have been made in Spain, Italy, the Netherlands,  Germany and elsewhere. Further investment by  independent power companies is likely to be  encouraged by industrial customers seeking an  alternative to their current monopoly supplier. In  the Netherlands, for example, Enron has begun  supplying power to several large Dutch companies.  In future, the ability to trade in spot and  futures markets and take advantage of pricing  differentials will contribute to making an invest ment in the deregulated European power market  successful. Also, control of gas facilities will be a  significant factor, as gas-fired generation capacity is  expected to grow in the European nations because  of its low cost, efficiency and cleaner environmental characteristics than other fuel sources. This is  particularly relevant as phased competition in gas  starts in 2000 pursuant to another EU directive,  which will create convergence and arbitrage opportunities for investors involved in the electricity and  gas markets. As in the US, competition in the European power market will likely gain a momentum of  its own. The competitive European electricity  sector is likely to experience the normal growing  pains we are witnessing in the US, but there is no  putting the genie back into the bottle. ■    ➥