European matters

IFandP takes a look at the moves being made by European utilities in response to pressure to unbundle their distribution networks from the European Commission.

A final report published by the European Commission in early 2007 identified what it described as “serious shortcomings in the electricity and gas markets”. According to Neelie Kroes, the European commissioner for competition policy, the main findings were as follows:
• continuing high levels of concentration so incumbents maintain market power
• a lack of liquidity, preventing successful entry
• vertical foreclosure, as the old monopolists continue to own the energy infrastructure
• low levels of cross-border trade, due to insufficient interconnector capacity and contractual congestion since spare physical capacity is not always released
• lack of transparency about operations in the wholesale energy sector, which makes it difficult for new entrants to understand how the markets work in practice and the risks that they take on
• lack of confidence that wholesale energy prices are the result of meaningful competition.

The report also commented that the current level of unbundling between network and supply interests has negative repercussions on market functioning and investment incentives. It pointed to a sample case in 2006, when the Italian competition authority fined ENI for abandoning the expansion of the Trans-Tunisian gas pipeline, put forward by its network sector, as this would have resulted in greater competition within the Italian market. Another example cited by the commission was a case when a transmissions system operator granted transport capacity to its affiliated company, while refusing it on an almost identical route to other suppliers. With this in mind, how has the situation changed since the report was first published?

June 2008 saw the European Commission formally charge Gaz de France and E.ON with colluding to raise prices. The allegations were that these two companies had agreed “not to sell gas in the other party’s home market to any significant effect” and centred on how they managed the Megal pipeline, which they jointly owned. Both GDF and E.ON denied the charges, with GDF arguing that they were unwarranted given that they concerned activities performed under a different regulatory environment to the current regime. Ms Kroes sought to forcibly unbundle the companies and Germany’s E.ON and RWE offered to sell off their transmission networks. E.ON’s high voltage network covers 40 per cent of the country (some 32,000km). E.ON also announced plans to sell 20 per cent of its domestic generating capacity to competitors. In exchange, the commission agreed to drop two anti-trust cases against E.ON. Around the same time, RWE agreed to sell off its natural gas network. Vattenfall Europe, meanwhile, is looking to dispose of its power grid in the first half of 2009, also due to pressure from the commission. The company’s transmission unit was reported in July as being worth around €1bn and generates an annual turnover of €3bn.

As a result, German utilities have considered creating a national grid company, provided doing is feasible “from a business standpoint”. In Italy, Enel has chosen to divest its high-voltage network as well as its gas distribution business, possibly in order to raise cash after its takeover of Spain’s Endesa, which it bought in partnership with Spanish construction group Acciona, earlier this year.

Philip Lowe, the European Commission’s director general commented back in June that one motive for such offers could be the fact that these networks typically produce comparatively small returns while at the same time, requiring a great deal of capital investment. Another reason, which might have prompted E.ON’s decision is that network assets are likely to command a higher price, if sold before all the majority of utilities are forced to unbundle.

A compromise deal was eventually struck on October 10, after months of debate. As a result of opposition from France and Germany against any compulsory ownership unbundling of transmission networks, EU leaders have chosen to allow large energy utilities to retain their transmission networks but these will now be operated under independent supervision. In addition, national regulators will be able to fine utilities up to 10 per cent of their turnover if they are found to be in consistent breach of their legal obligations. The commission will also be able to exercise some of the powers possessed by national regulators if the latter are found to be non-compliant with an EU decision.

One element of the agreement that was left on the wayside was the idea of placing strongly-empowered independent trustees on the supervisory boards of network countries. Again France and Germany were the main objectors.

The deal also includes a “third-country” clause, at the behest of member states which have already achieved unbundling, in order to prevent the networks from being bought up by foreign operators, such as Russia’s Gazprom. Such deals are now only permissible, if the potential buyer’s own country has opened its networks to EU investors. The clause was however, weakened due to lobbying from Germany which was concerned that the clause could damage relations with Russia, on whom it is dependent for 40 per cent of its gas imports.

Although the deal has been heralded a step forward, it illustrates the prisoner’s dilemma that often serves for European politics. Europe, if it negotiated as a whole, would be in a much stronger position with regard to Russia and other major energy exporters but as long as individual countries (particularly Germany and Italy) stand to benefit from deals that increase the bloc’s dependence on Russia’s natural gas supplies, this is unlikely to occur. This flaw has been criticised by the International Energy Agency with Nobuo Tanaka, the agency’s executive director saying that the EU’s external energy relations are “perhaps the weakest policy area” (Platts).

In addition, the EU does suffer from the tendency of France and Germany to confuse their interests with those of the EU as a whole. As both countries were instrumental in its inception, it is easy to see how such an attitude could arise. However, the enlargement of the EU has made this mindset more problematic, given the number of new entrants to the bloc with very different economies and priorities. Small wonder then, that the recent passing of the European Presidency to France was treated with some degree of trepidation. However, France and Germany are not going it alone. They are supported by Austria, Bulgaria, Greece, Luxembourg, Latvia, Slovakia and the Czech Republic.

Other concerns include fears that states may be drifting towards protectionism in the energy sector. July saw the European Court of Justice rule that the Spanish government had broken EU law by requiring special regulatory scrutiny by its National Energy Commission for energy sector takeovers. This prevented E.ON from bidding for Spanish power utility Endesa. Another example of this trend was the merger between Suez and GDF, which was believed to have been instigated in order to prevent Suez from being acquired by Italy’s Enel. There was also a move by Hungary to prevent an Austrian takeover of one of its domestic power utilities.

In addition, there are concerns, as articulated in a recent report by the Swedish Institute for European Policy Studies (De Jong & Van Der Linde) that the tendency of EU policy makers to treat the electricity and natural gas markets in the same way, will lead to problems, given that the two markets are notably different. For example, the focus of competition within the natural gas market is not for EU customers but international with countries competing for supplies. This is partly a result of evolution of natural gas towards being a fully fledged internationally traded commodity, thanks to the rise of LNG. Although as discussed in “Joining forces for greater power” (IFandP November), there are plans afoot to increase the international trade in electricity, it is clear that these are less progressed than with natural gas, particularly as transmission losses mean that the main role of electricity imports will remain chiefly that of load balancing for some time to come. Another difference is that as the EU becomes more and more dependent on natural gas imports, the upstream gas sector becomes less subject to EU regulation.

Steady progress

Aside from the issue of unbundling, there have been some welcome developments over the past few months which should help to boost either competition or the functioning of the electricity markets. A small but welcome example is news that French supermarket chain Carrefour has entered the retail electricity market. The European Commission has urged more retailers to follow its example.

Furthermore, the Commission gave its approval in September, to a joint venture proposed by Energinet, E.ON Netz, Vattenfall Transmission, together with the EEX and Nord Pool exchanges, which will provide coupling services between the Danish and German electricity markets.

A similar joint venture won approval in August. The Capacity Allocation Service Company for Central Western Europe (CASC) will act as “a single auction office to implement and operate monthly services for the yearly and monthly allocation of power transmission capacity on the common borders between the five countries based on standardised systems and rules” (press release). The five countries mentioned are: Belgium, France, Germany, Luxembourg and The Netherlands. The venture is expected to “optimise the cross-border flows of electricity by enabling buyers and sellers on a power exchange to get automatic access to cross-border energy trade without having to acquire the corresponding transmission capacity,” according to the EC.

Are demergers desirable?

There is some evidence that the virtues of an integrated approach to electricity or natural gas retailing and distribution have been oversold, even if one discounts the political pressure on utilities from the European Commission. Take the break-up of British Gas as an example. This created Centrica (retail and some gas production), BG Group (E&P) and eventually, Lattice Group (pipeline networks), which was demergered from BG in 2000. The break-up allowed the different management teams to concentrate on their own areas and unlocked considerable value. Indeed, Centrica’s share price almost doubled in the first 12 months of trading and the demerger in 2000 paved the way for the subsequent merger between Lattice and the National Grid. All three companies have gone on to outperform the FTSE 100 index for the majority of the past five years.

Another issue is that, while in the past bundled utilities were seen as more resilient, compared to their less diversified peers, the potential for cross-subsidising and the ability of such operations to act as a natural “hedge” against losses in any particular area has been substantially constrained by regulation. In addition, it can create a false sense of security, thus reducing the speed at which upper management might move to limit any losses.

Where next for Europe?

It is clear that there has been considerable progress towards the EU commission’s goal of a more open and competitive energy sector in Europe. That said, there are some storm clouds looming on the horizon. In the longer term, the increasing scarcity of fossil fuel resources and the growing spending power of China and India, will put increasing pressure on individual states, in response to rising energy prices. This, coupled with the near-impossibility of producing a coherent energy policy due to the wide variation in terms of national energy mix, priorities, affluence and economic strength, could well put a great strain on collaborative efforts in the future. On the other hand, the tough and much-publicised goals of reducing carbon emissions and simultaneously upping the proportion of renewables in the Bloc’s energy mix could well work in the opposite direction. For instance, the latter would reduce the supply pressures associated with fossil fuels. In addition, the problem of intermittency associated with wind power will create an incentive for closer integration of the EU’s power networks. However, such targets threaten to create winners and losers within the bloc. For example, despite the UK’s recently-acquired position as the world’s leader in offshore wind farms, Germany and Denmark dominate the wind turbine manufacturing business in Europe, while Iberdrola and Vattenfall are planning to develop 6000MW of installed wind capacity in Britain. Although such industry is to be applauded, it is hardly an ideal situation for the UK’s balance of payments, even if it will provide some protection if the natural gas market tightens further in the years to come.

Regardless of such tensions, it is likely that Russia’s dominance over the natural gas sector will remain the largest sticking point for EU energy policy, especially as the Baltic states, Poland, Ukraine and Georgia are opposed to further energy dependence on Russia due to their security concerns.

For more information on this topic, consider visiting the following websites:
http://ec.europa.eu/comm/competition/sectors/energy/inquiry/index.html
http://www.euractiv.com/en/energy
www.capgemini.com/m/en/doc/Energy_Transmission_Networks_Unbundling.pdf