Competition on European electricity markets & regulation

1. Competition on European electricity markets & regulation Tor Arnt Johnsen Norwegian School of Management BI and Norwegian Water Resources and Energy Directorate, Oslo EIPM – Archamps - September 23 - 2005

2. Outline of the talk • Determinants for the degree of competition • Price formation in the electricity market(s) • Theoretical considerations • Empirical illustrations • Regulation and market design issues • Competition issues • Summary

3. Competition and market power in the electricity market depend on: • Historical background • Fundamental physical factors • Market design • Competition policy and regulation

4. Historical background • National or regional monopolies • Obligation to serve - exclusive delivery right • Bundling and little transparency • Public ownership • Social contracts (industrial and others) • Focus on supply and technical issues - not on demand • Low interest in economics and efficiency

5. Fundamental physical factors • Limited transportation and storage capacity • Physical laws govern electricity flows • Supply and demand have to balance continously • Volatile demand (day, week and season) and in many cases price-insensitive demand, in particular in the short-run

6. Market design • Unbundling, transparency and market access • System operation, transmission and reserve management • Who pays and how? • Cost socialization, averaging • Supplier switching routines • TPA (prices, cong.), Balancing, Cross-border capacity • Entry conditions, licensing, standards etc. • Regulation of network monopolies, revenue and pricing schemes

7. Competition policy and regulation • Merger control • Divestiture of production capacity, virtual power plants • Vertical integration • Market monitoring • Information and education

8. Price formation - theoretical considerations • One hour within a given geographical area: • Generation • Nuclear, wind, run-of-river hydro, combined heat and power (DH, Industrial cogeneration), electricity-only units (coal, gas, oil, bio), reservoir hydro, peaking plants • Demand • Price independent demand (time of day, temperature) • Price sensitive demand • Exchange with other regions • Transmission capacities • Relative prices

9. Price formation, cont. Day, peak demand Price Night, off-peak demand Maximum capacity Pday Supply Pnight MW

10. Nordic electricity consumption and production week 35-2005

11. Denmark’s import from Germany in week 35-2005

12. Locational marginal prices (LMP) • Limited transmission capacity within and out of the Nordic area • The TSOs declare capacities between zones • Nord Pool optimizes the use of the transmission capacities as an integrated part of the day-ahead elspot-market • Often there are more than one price within the Nordic area and price differences towards Europe

13. Electricity prices in week 35-2005

14. Implications for power purchasers • Manage your own demand and reduce withdrawal when prices are high (day-time) • The price difference between day and night indicates the current marginal value of having a more flexible electricity consumption and being capable of moving consumption from day to night

15. Regulation – the Nordic success • NORDEL, The Nordic Council of Ministers, Nord Pool and FNER made together a good platform for coordination and supervision • Full TPA and market opening long before “directives” came into force • Transmission tariffs designed largely the same way (no border tariffs) • Significant inter-connector capacity • Continuous market clearing – electricity can always be bought or sold • Successful dilution of marker power attained by integration (Nord Pool) • Strong political support also when electricity is scarce&prices high • No constraints on the development of financial markets • Regulators pro – active

16. Regional Markets is a necessary step to the Internal Energy Market • Establishment of “regional markets” is important • Various EU Market Design feasible if access and congestion management of interconnections are coupled with running of competitive energy markets • EU Market Design implies an explicit TSOs coordination mechanism + PXs coordination • EU Design can be handled at regional level under EC supervision + effective mechanism between EU regions to be found • EC “Model” removes trade barriers and trade will increase and create markets • The Scandinavian “Model”( NordPool, NORDEL and FNER) created a full regional market well before the transposition of 2003 Directives • Very slow transposition in most member countries and weak support to a regional approach • National Champion approach (political level) still important - regional and cross regional cooperation still weak • “Mini fora” did bring important issues on the agenda but progress still slow • Competition policy and regulation – reciprocity and active consumers will induce progress!

17. Market design issues • Transmission capacity allocation • The Nordic area has implicit auctions: • The Nordic power exchange, Nord Pool, collects bids for sale and purchase of electricity all over the Nordic area • The four Nordic TSOs declares transmission capacities for all international links within the Nordic area • Nord Pool derives the unconstrained and constrained market equilibriums

18. Implicit auctions – Nord Pool Unconstrained equilibrium: - One price (system-price) - Transmission constraints are not taken into account Constrained equilibrium: - More than one price if transmission capacities bind

19. Transmission capacity allocation • Nord Pool extend: • A German Elspot area at the border between Zealand and Germany (in place from Sept-05) • Implicit auction of the capacity between Norway and the Netherlands (2007/2008) • Explicit auctions (widely used elsewhere) • Bid for transmission capacity year-, month-, week-, day-ahead. Use-it or loose-it principle • Traders have to bid for transmission capacity before the two respective spot-market outcomes are known • Quite large coordination and price risk

20. Transmission capacity allocation • Implicit auctions give efficient power flow • The income for the actual link (price difference times transmitted quantity) is collected and paid to the grid owner(s). • Both implicit and explicit auctions leave the market with some area price risk!

21. Area price risk • Futures and forward contracts in the Nordic area refer to the system-price • Contracts for differences (Cfds) offer hedge between the system price and your local area-price

22. Implications for power purchasers • Be aware of reference point (price area or system price) in your contracts • If your contract refers to another area price than your own or the system price, you are left with the risk of your local area-price volatility. This may require additional hedging.

23. Competition policy • Limit concentration • The electricity market’s physical characteristics demand a larger number of competing producers than in other markets • Monitoring, transparency, information and education is important to keep the market competitive

24. Summary • The electricity market and prices are hourly. Manage your consumption – be flexible and price sensitive. Move consumption from day to night. Reduce own expenses and limit overall price volatility • Physical limitations in the transmission system are real and will generate price differentials • Be aware of area price risk • Participate and represent consumer interests when market design is decided • Participate and represent consumer interests when competition policy and regulations are decided