Electricity & Natural Gas Industries

1. Electricity & Natural Gas Industries Lecture on Regulation Theory Date: December 2011 Prepared by: Petr Brynda

2. Structure of businesses electricity natural gas production production/structure balancing TRADE structure/storage transportation transportation distribution distribution customer customer

3. Electricity product specification • Homogenous product • Unstorable commodity • Demand and Supply must be balanced immediately • Capacity problems: • Day consumption cycles • Seasonal consumption cycles

4. Industry structure and Competition considerations • Power-Generation • Competition between power-plants – deregulation; • Access to transmission and distribution network as a prerequisite. • Transmission-networks: 400 and 220 kV (trunk network) • Network monopoly; • Need for regulation; • How profitable should the industry be: only reproduction or even profit? • Systemic services. • Distribution – 110 kV • “Last-mile” – owned by distributors; • If there is a competition in sales under the current network regime, the regulation could be reduced. • Trade • Competition allowed. • The necessity for regulation of each segment is interlinked.

5. Vertical integration • Almost in all countries: • Strong oligopolists in power-generation • Indirectly competitive regional monopolies in distribution • Step-by-step direct competition • Impact of various energy sources: • Nuclear • Thermal • Water • „Green“ – not able to compete unless tax allowances and subsidies

6. Price comparison • Average price – cannot be determined objectively because of: • Costs on particular segments of industry structure may be shifted to other segments (depending on policy). • Complexity – Proper benchmarking requires comparison of all price-components. • Price components: • Wholesale; • Transmission and networks; • Distribution; • Trade; • Systemic services – 17% of total costs in the Czech Rep. • Primary – “second” balancing; • Secondary – “minute” balancing (up to 30 minutes) • Back-up – unexpected events; • Reactive energy (“Jalová energie”) – need for compensation • Remote control of electricity consumption.

7. Natural Gas

8. Structure of Gas Industry (Europe) • Source, exploitation • Pipeline system, transportation, distribution • Storages Business (limited) Sources • Russia • Gazprom • North Sea • Norway (StatoilHydro) • Netherlands (Shell) • Great Britain (British Petrol) • Algeria • Sonatrach

9. Gas import to EU25 (bcm) Source: BP Statistical Review 2005

10. Regulatory aspects

11. What to regulate?(Relevant markets) Production – competition (E) / oligopoly (G) Transportation – monopoly Distribution – monopoly system services (E) / storage (G) – competition/monopoly ??? Trade - competition capacity business

12. Regulator‘s tasks • Protect consumers against energy utilities' efforts to increase prices • Emphasise the quality and reliability of energy supplies to consumers • Support competition, i.e. support the development of well-working rules of the electricity and gas markets conducive to decreasing prices to end customers • Promote the effectiveness of energy utilities' business (analysing the impacts of regulation, motivating energy utilities to reduce costs of energy supplies…) • Price stability, i.e. regulation of reasonable profit derived from business, and high-quality, reliable and safe energy supplies to end customers.

13. Competition of substitutes (heating vs technology) Brown coal Light heating oil Heavy heating oil Electricity District heating Ecological Taxes market distortion – different VAT on district heating Is regulation really needed?(natural gas example)

14. European Experience

15. Legal Regulatory Framework European Level (3rd energy package, June 2009 + 18 months) • Directive 2009/72/EC repealing 2003/54/EC repealing 96/92/EC (E) • Directive 2009/73/EC repealing 2003/55/ECrepealing 98/30/EC (G) • Regulation on on conditions for access to the network for cross-border exchanges in electricity 714/2009 repealing 1228/2003 • Regulation on conditions for access to the natural gas transmission networks 715/2009 repealing 1775/2005 • Guidelines for Good Practise (TSO, SSO, congestion management) • Regulation establishing an Agency for the Cooperation of Energy Regulators713/2009 Problem • directives had to comply with very heterogenous energy structures • UK: liberalization, open market • France: vertically-integrated monopoly (EdF/GdF))

16. to separate production and supply from transmission networks to facilitate cross-border trade in energy more effective national regulators to promote cross-border collaboration and investment greater market transparency on network operation and supply increased solidarity among the EU countries 3rd legislative package (goals)

17. opening July 1, 2004 – nonhouseholds July 1, 2007 – all legal unbundling July 1, 2004 – TSO (transmission systém operator) July 1, 2007 – DSO (distribution systém operator) Milestones of market opening &unbundling Directive 2003/54/EC (E) Directive 2003/55/EC (G) • opening • July 1, 2004 – nonhouseholds • July 1, 2007 – all • legal unbundling • July 1, 2004 – TSO (transmission systém operator) • July 1, 2007 – DSO (distribution systém operator)

18. Existing Barries – Electricity • Market concentration - Most wholesale markets remain national in scope with high levels of concentration ingeneration, which gives scope for exercising market power. Sales on spot marketsgenerally reflect the level of concentration in generation, unlike those for trading in forwardmarkets which show less concentration. However, caution is needed in assessing marketpower in electricity markets only on the basis of market shares. Analysis of trading in powerexchanges shows that, in a number of them, generators have the scope to raise prices, aconcern also expressed in the inquiry by many customers. Analysis of generation portfoliosalso shows that the main generators have the ability to withdraw capacities to raise prices.Further assessment will be needed in order to determine whether operators have unduly usedthese possibilities to raise prices. • Vertical foreclosure - Vertical integration of generation, supply and network activities has remained adominant feature in many electricity markets. Vertical integration of generation and retailreduces the incentives to trade on wholesale markets. Low levels of liquidity are an entrybarrier. The strong links between supply and network companies reduces the economicincentives for the network operators to grant access to third parties. Many respondents arehighly critical of the efficiency of existing unbundling obligations, believing thatdiscrimination in favour of affiliates continues, and calling for stricter measures. • Market integration - The low level of cross-border trade is insufficient to exert pressure on (dominant)generators in national markets. Integration is hampered by insufficientinterconnectorcapacity and long-term capacity reservations predating the liberalisation. Improving access tointerconnectors requires better methods of congestion management. There is also a lack ofadequate incentives to invest in additional capacity to eliminate long-established bottlenecks.Different market designs hamper market integration. • Transparency - There is a serious lack of transparency in the electricity wholesale markets that is widelyrecognised by the sector. Improved transparency would minimise risks for market playersand so reduce entry barriers to generation and supply markets, provide a level playing field,and improve trust in the wholesale markets and confidence in its price signals. More than 80percent of market participants are not content with the current levels of transparency. Usersrequest more information on technical availability of inter-connectors and transmissionnetworks, on generation, on balancing and reserve power, and on load. Rules on propermarket conduct and supervision differ significantly between Member States, as there is littleharmonisation at EU level of the transparency requirements in electricity markets. • Price formation - Price formation is complex, and many users have limited trust in the price formationmechanisms. Fuel price increases in marginal plants certainly play a role in recent electricityprice developments. Gas prices have significantly increased but coal prices have remainedrelatively stable. Analysts cannot yet agree on the extent to which the EU emissions tradingscheme has affected electricity prices. The co-existence of regulated and free market prices onseveral national markets has an adverse effect on the development of competitive markets. Ina number of Member States, special measures to reduce electricity costs for large energyintensive users have also been considered, although compatibility with antitrust and state aidrules provides limits to lowering prices by such schemes.

19. Existing Barries – Natural Gas • Market concentration - At the wholesale level, markets generally maintain the high level of concentration of thepre-liberalisation period. Wholesale trade has been slow to develop, and the incumbentsremain dominant on their traditional markets, by largely controlling up-stream gas importsand/or gas production. Incumbents trade only a small proportion of their gas on hubs. Withlittle new entry in retail markets, customer choice is limited and competitive pressure reduced.The overall picture for potential new entrants is one of dependency on vertically integratedincumbents for services throughout the supply chain. • Vertical foreclosure - Lack of liquidity and limited access to infrastructure prevent new entrant suppliersfrom offering their services to the consumer. The network of long term supply contractsbetween gas producers and incumbent importers, makes it very difficult for new entrants toaccess gas on the upstream markets. Additionally, certain features of these contracts limitincentives for incumbents to provide liquidity on traded markets. Considering the highlyconcentrated upstream markets, it is particularly important to avoid that these structurespropagate into market foreclosure downstream. Gasinfrastructure (networks and storage) is toa large extent owned by the incumbent gas importers, and the insufficient separation of thisinfrastructure from supply functions results in insufficient market opening. Despite EU ruleson third party access and legal/functional unbundling, new entrants often lack effective accessto networks, the operators of which are alleged to favour their own affiliates. • Market integration - Cross-border sales do not presently exert any significant competitive pressure.Incumbents rarely enter other national markets as competitors and available capacity on cross-border import pipelines is limited. New entrants are unable to secure transit capacity on keyroutes. The primary capacity on transit pipelines is controlled by incumbents based on legacycontracts that derogate from normal third party access rules. This is reinforced by ineffectivecongestion management mechanisms, which can make it hard to secure even small volumesof short-term, interruptible capacity on the secondary market. In most cases, new entrantshave not even secured capacity when there have been expansions of transit pipeline capacity. • Transparency -There is a lack of reliable and timely information on the markets - normally thelifeblood of healthy competition. Network users request more transparency on access tonetworks, transit capacity and storage, going beyond the current minimum requirements setby EU legislation. To ensure a level playing field, users require information to be madeavailable on an equal footing. Confidentiality rules also undermine effective transparencywhen given too wide an interpretation. • Price formation - More effective and transparent price formation is needed in order to deliver the fulladvantages of market opening to consumers. Gas import contracts use price indices that arelinked to oil products and recent price increases have, therefore, closely followeddevelopments in oil markets. This results in wholesale prices that fail to react to changes inthe supply and demand for gas. No clear trend towards more market based pricingmechanisms can be observed in long-term import contracts. Gas prices on existing gas hubshave also been rising recently, and ensuring liquidity is crucial to improving confidence inprice formation on gas hubs. Even when different producers are selling from the same field,the contracts generally contain the same price index and often even the same actual price.

20. Data 2005

22. Accounts separated accountings Management separated managements Legal separated legal entities Ownership separated ownership Unbundling – from accounts to ownership

25. Concentration in electricity & gas (production, wholesale) Data 2008

26. GdF => Suez EON => Endesa (no) Gazprom => Centrica (no) Concentration in energy industryTurnover of energy companies

27. Customer Choice (cumulative since market opening) Data 2004

28. Customer choice in E and G – switch rate Electricity Gas

29. Natural gas Limited number of producers (oligopoly) Limited (geologically) number of back-ups/structure Long transportation routes/long term contracts Electricity Competition in production Mobility of production Permanent balancing Final Comparison

30. DG TREN, Report on progress in creating the internal gas and electricity market http://ec.europa.eu/energy/gas_electricity/legislation/benchmarking_reports_en.htm DG COMPETITION, Energy Sector Inquiry http://ec.europa.eu/competition/sectors/energy/inquiry/index.html 3rd legislative package http://ec.europa.eu/energy/gas_electricity/legislation/third_legislative_package_en.htm Further readings