By Igor Muszynski

Poland put new rules for electricity supply into effect in May.

The new rules reinforce opportunities for project developers to pick off industrial customers from the incumbent utilities by building inside-the-fence projects and also make the country a more hospitable place to generate electricity from wind and other forms of renewable energy.

However, their main purpose is to bring Polish electricity laws into line with a European Union directive on operation of the internal electricity market. Poland joined the European Union in May 2004. The new rules address, among other things, the trading of renewable energy, the right to choose an energy supplier, the calculation of energy tariffs and the tender process for constructing new generating capacity.

Inside-the-Fence Projects?

Household gas and electricity customers will have the right to choose their utility suppliers from July 1, 2007. This is the deadline under the EU directive for when all residents of the European Union must have retail choice.

Industrial customers in Poland already have the right to choose their suppliers, opening the door to development of inside-the-fence power projects.

All major power generating projects financed in Poland over the last decade were done on the basis of long-term power purchase agreements with the transmission system operator. Since the European Commission views long-term PPAs entered into in the 1990’s as a form of unauthorized state aid and has been pressuring Poland to terminate the existing PPAs, utilities are likely to refrain from executing new long-term contracts.

However, the right to sell directly to the final customers creates a new means of financing independent power projects. The European Union directive requires incumbent utilities in all EU member states to give access to the grid to both power producers and power customers. This right enables sponsors to choose the best location for their projects since they ought to have access to the grid from any location within the European Union.

Project developers who want to pick off industrial customers from the incumbent utilities by building inside-the-fence plants would sign direct long-term power purchase agreements with the industrial customers. The expanding free market means that such customers are unlikely to enter into a “classic” long-term PPA with clauses passing most of the offtake risk to the electricity offtaker. Power contracts will have to be related to the actual electricity prices available in the market and provide certain safeguards to the power producer in the case of market disruptions. Industrials are unlikely to enter into PPAs that do not provide them with visible benefits compared to what they can get by buying electricity directly from power marketers.

Setting up an inside-the-fence project is still not easy for several reasons. First, technical requirements imposed by the transmission and distribution grid operators for metering devices and related data transmission, which must be met by both the generator and the customer, impose high additional costs on independent power projects. Second, a number of additional contracts must be signed to facilitate direct sales from the generator to the final customer, including with special trading operators to secure access to the grid and balancing. These can be time consuming and expensive to negotiate. Third, the fact that many large industrial customers in Poland are not companies with investment-grade ratings poses an additional risk of payment defaults. Just to give an example, the biggest Polish electricity customer, the Polish railroad, has struggled for years with its lack of financial liquidity, causing permanent problems to its electricity providers.

Existing PPAs

The Polish government submitted a draft law to parliament in the spring that would terminate all existing long-term power purchase agreements.

All major power generating projects to date were financed on the basis of such long-term PPAs. The PPAs were identified during negotiations over Poland’s application to join the European Union as an obstacle to full liberalization of the electricity market since they cover around 60% of total generating capacity in Poland. After two years of discussions among the European Commission, the Polish government, the domestic power industry and banks that financed power projects, the Polish government prepared a draft law that offers a voluntary termination of PPAs in exchange for compensation due within 14 days from the date of termination of the PPA. The compensation is subject to later adjustment over the next 10 years based on actual performance of the electricity market after termination, but there is a cap on how much of an adjustment can be made. Compensation will be paid from monies raised through a bond offering made by a special company to be established under the draft law.

The draft law is controversial. There is still an ongoing debate in the power and financial communities, and the measure proposed by the government is by no means certain to be enacted. However, one thing is clear: there will not be any more long-term PPAs with utilities, so new means must be found to finance independent power projects. A turn in the market toward inside-the-fence structures is just one of the possibilities.

Renewable Energy

The new rules Poland implemented in May are expected to stimulate demand for renewable energy.

Poland already has had on its statute books a law requiring utilities and traders selling electricity directly to end users to supply a percentage of their total sales from renewable energy sources. In December 2004, the Ministry of Economy set this threshold at 3.1% for 2005, to be increased annually up to 9% in 2010. However, a shortage of renewable energy sources and vague wording in the applicable laws allowed many to circumvent this requirement. For example, many distributors and traders buy renewable energy and then resell it to other suppliers, thereby enabling a number of suppliers to meet the required thresholds with the same renewable energy.

To end this practice, Poland introduced the concept in May of “green certificates,” which are certificates of origin for renewable energy. The certificates will be issued by the Energy Regulatory Authority to renewable energy generators. Each certificate will constitute a legal right and evidence the production of a specified quantity of renewable energy. The rights incorporated in the certificates will be traded on the Polish Power Exchange, called the “PolPx,” and electricity suppliers will be able to buy certificates on the PolPx in order to meet the renewable energy thresholds.

The “green value” of electricity will therefore be separated from physical energy flows, and the trading of green certificates will provide renewable energy generators with a mechanism for selling electricity on the market at competitive prices.

Electricity suppliers who do not meet the renewable energy threshold will be required to pay a fine equal to PLN 240 (€60) for each mWh of shortfall in renewable energy.

This fee is seen as a major drawback of the new system, as it has the effect of setting a ceiling for the “green value” of electricity in advance since suppliers are unlikely to spend more on green certificates than the fine they would otherwise have to pay. The need for mandatory sales of certificates through the power exchange has also been widely criticized. Critics charge there is no need to require trades to occur through the power exchange, since any fear the government has about skyrocketing prices will be addressed by the effective cap set on prices for the certificates by the market.

The new rules also remove one of the biggest obstacles for windpower projects by exempting renewable power from the general “balancing rules.” These rules impose painful financial consequences on generators who declare a day in advance different production than they actually deliver. Wind projects are exposed to weather risk, and the prospect of extremely high balancing costs has been commonly viewed as a key risk in such projects to date. The exemption is available until the end of 2010 and has been welcomed by project developers.

Another incentive introduced under the new rules in May is a 50% mandatory discount in the interconnection fee for renewable energy suppliers with projects that are smaller than five megawatts.

Cogeneration Projects

The Polish government is expected to propose other changes in Polish law soon to support construction of cogeneration projects.

A cogeneration project is a power plant that produces two useful forms of energy from a single fuel. An example is a power plant that burns coal under a boiler to produce steam, some of which is used to heat an adjacent factory and the rest is run through a steam turbine to generate electricity.

EU Directive 2004/8/EC makes support of high-efficiency cogeneration a priority within the European Union. Member states are supposed identify all their existing cogenerators. This is the first step, to be followed by new incentives for development of additional projects.

Another directive permits privileges in dispatch of cogeneration units, provided the privileges do not cover more than 15% of total electricity consumption in a given member state. For the past several years, Poland has required utilities in the country to supply at least 40% of their electricity from cogeneration units. The introduction of green certificates has led to discussion about whether to provide an analogous system for cogenerated power. The EU will probably end up authorizing a menu of possible incentives from which member countries will be permitted to choose.

Electricity Tariffs

The new rules allow utilities in Poland to set their electricity tariffs at levels that will earn them a “justified return” on invested capital. This has been viewed in Poland as a victory for the utilities. Tariffs must be approved by the Energy Regulatory Authority.

However, a drawback of the legislation may be its vagueness: the new rules do not specify a minimum capital return ratio. Instead, this ratio is to be set in a future ordinance by the Minister of Economy, making it relatively easy to amend. A draft ordinance has already been circulated that defines “justified return” as a rate calculated by multiplying the sum of a base return plus a premium that reflects risk times the net account value of the assets used in the licensed activity. Such an approach seems correct in general terms, but it may be difficult to apply since reaching agreement on the figures to fill in for the variables in the formula may prove elusive.

Tenders for New Capacity

The new rules introduce a tender procedure for construction of new generating capacity, intended to facilitate government planning. Tenders will be organized by the Energy Regulatory Authority whenever the Minister of Economy foresees a potential long-term shortage of electricity.

Each tender will explain the types of incentives to be offered by the government to potential investors and will be published in the official bulletin of the Energy Regulatory Authority and in the official journal of the European Union at least six months before the closing of the tender procedure.

In selecting the winning bidder, the Energy Regulatory Authority will be obliged to take into account consistency with Polish energy policy, the safety and security of the electricity grid, how much additional work will be required on the grid to accommodate the new project, the potential environmental effects of the project, a preference for local investment, and the types of fuels to be used, among other factors. The winner of the tender will conclude an agreement with the Energy Regulatory Authority establishing the investor’s obligations and the financial incentives for constructing the plant.

Depending on the type of incentives offered, which have not yet been announced, the new system could have the effect of pushing developers to build projects that rely on more environmentally-friendly technologies. On the other hand, it may forestall investment in new projects that do not qualify for state aid, as investors may abandon their investment plans until the government organizes a tender and offers special financial incentives. By holding a tender to create new capacity, the government would be admitting that the market is too risky for investment without special incentives.