Policy News, BB200603
Sector Inquiry reveals electricity market retains monopolistic tendencies
The Green Paper on a "Common Energy Policy for Europe" released on Wednesday 8 th March identified as its first priority area “the development of fully competitive internal energy markets in Europe.” Andris Piebalgs in a speech to a conference on EU Energy Policy and Law the next day said that “it is clear that today there remains too many barriers to competition.” Indeed that is the conclusion of the Commission’s extensive sector inquiry, led by DG Competition and launched in June 2005. It unequivocally found, out of a survey of 3,000 industry participants, that the market is still in the grip of former incumbents.
The issue is one of widespread concern as attested by the more than 600 people that came to Competition Commissioner Neelie Kroes’ presentation of the preliminary results in Brussels on February 16th.
The Inquiry set out to assess the competition conditions on European gas and electricity markets, with the overall objective to address the barriers currently impeding the development of a fully functioning open and competitive EU-wide energy market by 1 st July 2007. Prompted by energy users frustrated at the high prices, and allegations of price manipulation, the Inquiry is one of the most thorough investigations in the Commission’s history. Findings in the power sector of the preliminary report range from discontent at what is suspected as market abuse stemming from the dominant position of large generators on the power markets, to the linked problem of vertical integration, and difficulty in obtaining access to networks.
Struggling against a lack of transparency and a greatly superior market size make it very difficult for new entrants to break through, and prevent real competition from taking root.
Seemingly insurmountable barriers to establishing new inroads into the power sector are a bad situation for wind energy; a new competitor in the field of electricity generation, that has the technical and economic attributes for mainstream integration, but faces the challenge of pushing into a system seized by dominant control.
The Commission’s Sector Inquiry release has come at a highly relevant time to the sector as new developments mount in the mega merger sagas of Endesa, E.ON, Gas Natural, and Gaz de France, Enel and Suez. Competition law is what the current indications of market malfunctioning are checked against. The preliminary report identifies market concentration as the major problem “and this makes the Community’s action under the merger regulation essential” it says.
To see how competition became so cornered, it is necessary to examine the Directives on Electricity Liberalisation that were established to create competition in the sector.
Impact of the Directives
The Directives 96/92/EC followed by the more stringent 2003/54/EC attempted to bring about through legislation a fully competitive market in the gas and electricity sectors. This analysis is focused on the electricity sector. The Liberalisation Directives have impelled a new face of the power sector, one in which markets and liberalization play a vigorous role. But the entrenched anti-competitive behaviour affiliated with a captive market and built-in network, core elements of the power business, continues to lie at the foundation of the sector and exert a damaging influence on competition. In some essential respects, it is because the Directives failed to force the following:
Concentration in market share
Full market opening aimed at by the second Directive on Electricity Liberalisation does not in itself instruct a break up of market share. As the Sector Inquiry puts it, market opening by legislation “does not automatically lead to the introduction of competition in supply markets previously dominated by incumbent players.” Concentration in market share and all the cross benefits implicit in that has thus had fairly free rein.
Vertical integration and access to grid
Generation companies have still been allowed to own grids because the 2 nd Electricity Directive did not stipulate full ownership unbundling – only legal unbundling. Separate accounting was made legally necessary. Some Member States have separated transmission but many have not and in those cases, new entrants face a particularly onerous challenge. Just as bad is on the distribution side. Distribution companies have managed to stay out of the legal unbundling clause until July 2007, and those that serve less than 100,000 customers, are exempted altogether. In Germany, a large number of respondents provided detailed information on a very substantial number of German distribution network companies that are said to cross-subsidise supply activities with revenues from (monopoly) network charges.
An even more damaging gap in legislation formation has been not unbundling generation and retail, allowing companies to overstep the market and supply directly to customers. Vertical integration of generation, supply and network activities has been noted in a very concentrated fashion and is discussed in more detail later.
The Inquiry reports that “there is a serious lack of transparency in the electricity wholesale markets that is widely recognized by the sector.” More than 80% of market participants are not content with the current levels of transparency.
The growing of an internal European electricity market is paralyzed by cross-border capacity remaining entrapped in the hands of incumbents and legacy contracts that do not possess any competitive features.
The report rounded up views received on the functioning of spot and forward markets as such:
"There is an oligopoly on the supply side (…) accounting for 80% of generation output."
"French and Belgian markets are dominated by single players – thus distortions can easily occur there."
"Forward and futures prices at EEX do not react to supply and demand. A very dry summer such as 2003 drives up prices, the end of the dry period should thus result in a price decrease. However a downward trend after a price peak is not observable. Obviously the few players at the power exchange are able to prevent price decreases by limiting the offer."
Effects of market dominance
Forward markets tend to take their cue from the spot market. If volatility is sparked off by unforeseen outages, raising the expectation of uncertainty, buyers will pay more of a premium for certainty. In the influence it can have over prices in the over-the-counter (OTC) and power exchange markets, both through the abstaining of capacity and through the size of bid or offer it can make, large generators have the upper hand. A large number of participants and a healthy liquidity on the markets would serve to reduce the effects of any such play. However this result has not been obtained. Even in the spot market where the number of participants is much larger, a relatively small number of market participants accounts for a large part of the overall spot volume traded on both the selling and buying side, according to the Commission.
The deterrents to entering the market again come down to market power. Generators with large capacity can hold back on supplying the grid because the financial loss from turning off some units of generation would be outweighed by the financial gain of higher prices yielded from the rest of the capacity, says the sector Inquiry.. Table 1 shows the share of available capacity and effective generation of the main operators in France and Spain.
The table also shows how generators with less capacity are needed in times of peak generation. Whilst large baseload generators can profit from withholding capacity, smaller generators with peak capacity (oil or hydro) can profit from charging high prices in times of high demand and short supply, and this is seen to be often the case.
Lack of liquidity is also related to vertical integration. The use of power exchanges has risen over the years and differs according to country but compared to national electricity consumption, Table 2 shows how power exchanges and OTC trading, with the exception of Spain, is minimal. The bulk of business is secured outside of the market, through power purchase agreements.
The Inquiry analysis uncovered that in certain markets the main generators have been able to take much larger net positions (between sales and purchases) in the forward market than all other participants. The weight of how this may tip the prices on the market introduces a substantial element of risk which new entrants may feel unequipped to be exposed to. It has been seen that these net positions are often brought to the power exchanges, determining prices and undesirable levels of concentration there.
Interestingly the participants alongside the large European generators, who obviously do feel equipped to be exposed to the risk in the market, are large financial players, who have no generation or supply business but trade for financial gain. Financial players are among the top five players in all markets apart from Belgium, which shows on the one hand a degree of confidence in the market. On the other though it shows how smaller players; generators, suppliers or users, without the trading expertise and financial backing, are more excluded from the market.
Price-setting on the power exchanges was investigated. That is, if only one operator’s selling bid becomes the clearing price, it points to a distinct lack of alternative offers, or shows the residual demand is supplied by a few or just one operator. The EEX, APX and Powernext (German, Dutch and French) exchanges showed variation, and the existence of smaller generators with marginal plants, though some of the price-setters are traders who arbitrage. On the other hand only one operator set the clearing price in all macro-zones of GME, in West Denmark, East Denmark, and Finland. “All in all,” the report concludes, “the price setting frequencies indicate a substantial scope for influencing the prices on certain power exchanges.”
The Commission’s investigation also discovered that the same price-setters on the markets where high market concentration is displayed were placing bids around the clearing price, so influencing market prices. The EEX is beginning to show similar characteristics to the Spanish OMEL of peak plants being optimized through power exchanges.
In order to analyse the occurrence of withdrawing plant to shore up market prices, the Commission looked at load factors to identify plants which are not run at their maximum capacity. Load factors of German plants were studied in the years 2000, 2004 and 2005. The results primarily showed a higher correlation between marginal costs and load factors over the years, and also that many plants were switched to low load when the marginal costs fell below the spot market level.
The conclusions remain after the analysis that the high levels of concentration in generation give generators scope for market power. Markets do however have a greater share of participation than what would be derived from pure market generation share, though that is not generally from smaller physical competitors.
Vertical foreclosure has highly detrimental effects on liberalization by screening out new entrants and in bypassing the wholesale market, liquidity becomes thinner and volatility a more common feature. The Commission says in its executive summary that the Inquiry has confirmed that foreclosure of the market by tying in long-term downstream contracts is an immediate priority for review of case situations under competition law.
Vertical integration also holds up the development of a cross border market as it is much easier to enter as a supply or generation company but not as both.
In terms of the market, if market concentration is on the side of generators, the dominance of long positions will be intrinsically anti-competitive. The situation can be remedied to some extent by innovative instruments such as the VPP capacity auctions in France.
Unbundling helps to remedy the practices of vertical integration, but as the report points out, does not “eliminate the incentives for vertically integrated companies to engage in such conduct.”
Network operators can only refuse access to their networks if no or insufficient capacity exists, yet outright refusals of network access are commonly made with no clear proof. Additionally “a lack of transparency as regards network constraints combined with the obligation on applicants to contribute to network reinforcement creates considerable leeway for vertically integrated companies to raise their rival’s costs for bringing new capacity online.”
The report also acknowledges that a vertically integrated network operator has no incentive to make attractive offers for building network extensions and reinforcements that will serve its competitors.
The Inquiry received a strong note of dissatisfaction regarding the administrative barriers to switching supplier, and discriminatory conduct in favour of affiliated supply companies.
The last part of the report deals with insufficient interconnector infrastructure and capacity and methods of allocation hindering European market integration. The Green Paper published on the 8th March urged for action to free up capacity reserved for former incumbents under electricity and gas long term contracts.
It says “For timely and sustainable investments, a properly functioning market is needed, giving the necessary price signals, incentives, regulatory stability and access to finance.”
Much is needed to be done to create a level playing field for the electricity system to progress and grow. Shutting out new entrants and throttling growth as has been extensively found in the Commission’s sector Inquiry is not the way to reach the goals of a thriving and sustainable electricity market.