On 10 January 2007, the European Commission published its final report on the energy sector competition inquiry with Competition Commissioner Neelie Kroes announcing that it "will make uncomfortable reading for many energy companies". It also made uncomfortable reading for the EU's Council of Energy Ministers who were presented with the report by the Commission on 15 February 2007 and considered its proposals at the EU summit on 8 and 9 March 2007.

The clear message from the Commission is that the current system is not delivering and that consumers and businesses are losing out because of inefficient and unnecessarily expensive gas and electricity markets. The Commission proposes a number of solutions which will require tough decisions from the Member States in this most sensitive of areas.

The Commission's report must be seen against a backdrop of recent intensive regulatory activity at the European level in the energy sector. In May and December 2006, the Commission "dawn-raided" a number of energy companies for potentially anti-competitive behaviour.

The May investigation, targeted at gas companies in five Member States, relates mainly to the possible exclusion by incumbents of potential customers from wholesale markets and infrastructures as well as possible unlawful market sharing between incumbents.

The December investigation targeting the four "incumbent" electricity generators and suppliers in Germany, concerns the withholding of production capacity on electricity markets with the view to raising prices and possible abuses on electricity balancing markets.

The Commission has also indicated, that it has received "a number of very interesting complaints." Commission updates on the status of its investigations are expected this year.

Meanwhile, the Commission continues to threaten at least 16 Member States with court action for violation and non-transposition of the 2003 Acceleration Directives. This includes the UK, which was accused of continuing to grant preferential access to incumbents of transmission capacities at interconnectors in violation of the Directives and European Court jurisprudence on the subject.

On the State Aid front, the Commission has recently opened a formal enquiry into Spain's regulated electricity tariffs considering that they may have "provided significant amounts of operating aid to these industries and, to a certain extent, to the electricity incumbents…who could have made an abnormal profit on the arrangements." State aid also featured, albeit as an aside, in the Commission's merger clearance of Iberdrola's acquisition of ScottishPower, an area in turn where the Commission has required in certain instances far reaching remedies to ensure effective competition on national energy markets (for instance in its clearance of the merger of Gaz de France and Suez).

The use of its competition law powers to secure in individual cases what it was hoped that liberalisation would secure across the board, is clearly frustrating the Commission. As Neelie Kroes remarked when publishing the Commission's energy report, "more than a decade after having launched the drive for liberalisation, we are still far from having a single, competitive and well-functioning European energy market."

The report's key finding is that for new market players to be able to provide real competition, they need access to energy supplies, the network and customers. According to the Commission, this is simply not happening in the majority of Member States, principally because of:

#  high levels of market concentration;

#  substantial vertical integration, resulting in unequal access to infrastructure and facilitating strategic behaviour that disadvantages rivals;

# nadequate market integration, caused by insufficient interconnection capacity, possible collusion between incumbent operators to share markets and insufficient investment in new infrastructure;

#  a lack of third party access to infrastructure, particularly cross-border interconnectors; and

#  deficiencies in national regulatory regimes, which fail to prevent anti-competitive behaviour or prevent market entry.

The Commission proposes several solutions to deal with the perceived lack of competition on national energy markets. These range from a substantial strengthening of the powers of national regulators, to changes in the method for allocating limited interconnector capacity. However, it is the Commission's views on unbundling and vertically integrated energy companies that have to date caused the biggest controversy.

Since 1 July 2004, vertically integrated undertakings have been required to separate legally their transmission activities from their production and supply activities and convert them into separate legal entities that are independent in terms of management and decision-making. With certain limited exceptions, legal unbundling of distribution activities will become mandatory from 1 July 2007.

Legal unbundling does not prevent companies with downstream transportation activities having common ownership with producers or suppliers. In addition to unbundling requirements, energy companies are broadly prohibited from discriminating between their system users and communicating any commercially sensitive information they obtain when carrying out their activities to any third party. They must also provide access to their transportation systems on objective, transparent and non-discriminatory terms.

The Commission's view is that the legal unbundling is not sufficient to ensure that a real competitive European market for electricity and gas can develop. In particular, the Commission considers that legal unbundling does not suppress, in its view, the inherent conflict of interest that stems from vertical integration. The Commission considers that there is a real and present danger that networks are seen as strategic assets serving the commercial interest of the integrated entity, not the overall interest of network customers.

The Commission doubts that information barriers put in place under the current unbundling rules provide sufficient guarantees that Transmission System Operators (TSO) will not release market sensitive information to their integrated companies. Nor that the current system removes the incentives for discrimination with respect to third party access (e.g. not making available unused capacities). The Commission also states there is considerable evidence that investment decisions of vertically integrated companies are biased to the needs of supply affiliates, and considers they have no real incentive to develop the network in the overall interest of the market, with the consequence of facilitating new entry at generation or supply levels.

The Commission considers two possible solutions to the issue:

#  Fully (ownership) unbundled TSOs

Under this option the TSO would independently own both the transmission assets and operate the network; supply/generation companies could no longer hold a significant stake in the TSO.

#  The ISO model - separate system operators without ownership unbundling

This option would require separation of system operation (to be performed by an independent system operator (ISO) from ownership of assets. Supply/generation companies would still be allowed to own transmission networks but access to the networks would be controlled by the ISO.

The Commission considers that ownership unbundling is the most effective means to ensure choice for energy users and to encourage investment. The ISO model would improve the current position but would require more detailed, prescriptive and costly regulation and would be less effective in addressing the disincentives to invest in networks. In short, the Commission doubts whether the ISO model would ensure the new investment in capacity necessary for new competitors to enter a market, nor prevent the disclosure of confidential information.

Ownership unbundling faces one rather obvious impediment- the French. Francis Loos, France's energy minister, has proposed a model based on the French system of "regulated unbundling." This is where large energy companies are left intact but prices for access to energy grids are set by an independent regulator.

The other obvious objector is Germany, who has adopted a more conciliatory stance no doubt motivated in part by the fact Germany currently holds the EU's six-month presidency. Michael Glos, Germany's economics minister, considers the first step is to ensure that the Acceleration Directives are fully implemented by all the Member States.

Secondly an independent operator could take over management of the distribution networks of integrated energy companies. If that fails to ensure competition, then ownership unbundling should be considered.

From the legal perspective, the German government has also suggested that forced property unbundling might breach the country's constitutional property rights, with a major German energy company further signalling that it would amount to an "expropriation" of shareholder' assets.

The possibility of legal challenges to ownership unbundling is not an area that has, to date, been considered in any depth. The Commission does appear conscious that any action it proposes must satisfy the EC principle of "proportionality," noting in the report that "disincentives to adequately invest in networks without ownership unbundling cannot in any event be fully addressed by regulators".

There is nothing in principle which would prevent "expropriation" per se, provided the principles of legality and proportionality were duly respected. Article 1 of the First Protocol to the European Convention on Human Rights provides for the protection of property and state expropriation of private assets has had a judicial airing on a number of occasions. Under the ECHR an interference with a property right must be authorised by law (which any unbundling measures would be) and demonstrate a reasonable degree of proportionality between the means selected and the ends sought to be achieved. Were ownership unbundling to be challenged on the basis of Article 1 Protocol 1, therefore, the case would ultimately come down to an assessment of "proportionality" and whether the European Commission has sufficiently robust arguments to justify both the choice ownership unbundling over other measures (e.g. the ISO model) and also the mechanics for ownership unbundling (likely to be left to the Member States to decide), e.g., in terms of ensuring adequate compensation for former owners.

However, the possibility that national property rights in combination with Article 295 EC (which provides that the EC Treaty shall in no way prejudice the rules in the Member States governing the system of property ownership) could trump any European legislative requirement to ownership unbundling is potentially a more significant legal obstacle to the Commission's plans. Article 295 is unlikely to prevent ownership unbundling per se, but it may well prevent the forced privatisation of state owned electricity assets which full ownership unbundling would involve in certain Member States. To that extent, attempts by the Commission to promote ownership unbundling in other Member States (where electricity assets are already in private hands) could well be viewed as discriminatory and unlawful. In other words, were the Commission to be blocked by Article 295 from forcing the privatisation of state-owned electricity assets in certain Member States, then ownership unbundling could well lead to a distinctly uneven playing field for competing public and private sector operators. Those placed at a competitive disadvantage in this way would not be slow to tackle the Commission on this point.

That said, the greater hurdle facing the Commission is ensuring sufficient consensus amongst the Member States to take forward its suggestions. Unsurprisingly, France and Germany joined forces to block the ownership unbundling proposal at the EU Summit, though the wording of the Summit's conclusions were surprisingly robust speaking of the need to have the "effective separation of supply and production activities from network operations". Indeed, it appears that the Member States agree that the new system should be based on "independently run and adequately regulated network operation systems which guarantee equal and open access to transport infrastructure and independence of decisions on investment in infrastructure."

The Commission has taken the summit's conclusions as giving it the approval necessary to bring forward legislation later this year. While it appears that the Commission will not be proposing full ownership unbundling, the draft legislative package is expected to push for the adoption of the ISO model i.e. energy companies will be able to continue to own their power grids but its management will be the hands of a genuinely independent operator. The ISO model may in turn prove to be an interim step for more radical proposals in the future.