Summary

The EU's January 2008 energy package is an ambitious attempt to combine three different policies in one. The simplicity of calling it "the EU energy package" belies legal, technical and economic complexity. It would be rash to assume that lawmakers, whether in the EU or in individual Member States, can achieve what they want merely by legislative act. In dealing with multiple market failures, the EU has challenged itself to resolve many "known unknowns", and it will need the help of EU business - the traditional and the renewable energy industries and their advisers - to work together to do so.

Background

In January1 this year we published an analysis of the EU's January 2008 energy package, an abridged version of which appeared in the March1 edition of this Alert. We noted that it was important to see the proposals, which span energy policy, internal market and environmental policy, as a coherent whole. We also contended that together these reforms would substantially change how we do business, and how we live our lives.

In brief, the proposals are:-

  • 20/20/20 by 2020 - 20% reduction in greenhouse gases (GHGs), 20% greater energy efficiency, 20% share of renewables2 (up from 8.5% today)
  • Carbon Capture and Storage - 12 demonstration-scale plants in the EU by 2015
  • New Emissions Trading Scheme, broadening scope of industries3 included, GHGs covered and shifting from allocations to auctions.
  • Completing the energy market with a third liberalisation package.

In June 2008, the European Council's meeting discussed the proposals, but no firm conclusions have been reached, and fundamental aspects of the reform programme are still being debated. Meanwhile, oil prices surged and fuel prices have risen (although at the time of writing, both oil and fuel prices have ebbed slightly).

Market failure

The EU recognises that it needs to correct at least two market failures in the energy sector. First, energy markets are not sufficiently open and liberalised to achieve an efficient allocation of resources, leading to higher prices and sub-optimal patterns of supply in the EU (the "principal market failure"). Second, the social cost of emitting GHGs does not form an adequate part of the cost of production and supply (the "climate change market failure").

These two market failures relate to each other in complex ways. If the EU corrects the principal market failure through "liberalisation" of energy markets, but no more, it does not necessarily follow that society will itself correct the climate change market failure. That may be because liberalisation should lead to lower prices for electricity as currently generated, of which over 90% is from non-renewable sources, making it harder for renewable-based electricity to compete. On the other hand, if the EU corrects only the climate change market failure, but does not succeed in reforming the energy markets, it may be legally, technically or economically difficult for renewable-based generation to access and use existing transmission systems, and may in fact worsen supply.4

Will it work?

It is to be hoped that the proposed measures to correct these market failures, once finally agreed, will work. However, we cannot assume this. The desired outcomes may not be achieved, or not fully achieved; or undesirable consequences instead ensue (e.g. worsening of supply, increase in prices). Since the outcome (and the speed of getting to it) is far from certain, business may face direct and unpalatable consequences and, of course, uncertainty. Long-term investment in major technology depends, amongst other things, on a long-term and internally-consistent legal framework, and that is precisely what is so difficult to achieve.

There are many reasons why the measures might be slow to work. We examine two of these below.

The slow pace of energy liberalisation in Europe

First, liberalisation of energy markets has proceeded very slowly. What does "liberalisation" mean? On its website5, DG Competition (the antitrust policy and enforcement branch of the European Commission) states that

"[s]ervices such as ... energy ... have not always been as open to competition as they are today. The European Commission has been instrumental in opening up these markets to competition (also known as liberalisation)...services like these have previously been provided [in the EU] by national organisations with exclusive rights to provide a given service. By opening up these markets to international competition, consumers can now choose from a number of alternative service providers and products."

On this reasoning, new suppliers of energy should be able to get to the marketplace and compete with the incumbent suppliers. Other benefits claimed are lower prices and new and more efficient services, which together contribute to a more competitive economy. This therefore concerns the principal market failure. 

As regards EU energy market liberalisation, two principal points stand out. First, there is no such thing as an EU energy market. Although the first EU Directives6 were enacted a decade ago, the Commission found in its 2005-2007 market enquiry that energy was bought and sold in the EU in largely un-integrated national markets.7

Secondly, liberalisation proceeds at different speeds, from different starting points, across the 27 EU Member States. Each has its own mixture of energy generation sources, and its own transmission and distribution infrastructure, levels of market concentration, and balancing mechanisms. Furthermore, since liberalisation is effected by EU Directive rather than EU Regulation, the scope for national variation persists.8

Bearing these two points in mind, progress may be genuine, but it will be slow. The proposed Electricity and Gas Directives are to be transposed into national law within 18 months of the new renewables Directive coming into force. As matters stand, even assuming such timely transposition across Europe (not at all guaranteed), that takes until 2011, or maybe later.

The technical and legal challenges of access and use of system

Energy policy already sets incentives for promoting renewable-source electricity generation. The principle was established at EU level by Directive 2001/77/EC on the Promotion of Electricity from Renewable Sources (the "Renewables Directive"). The intention was that the EU would together achieve 22% of gross electricity consumption from renewable sources by 2010, but it did not intend to create a harmonised system of support for renewable technologies across the EU - this was left to Member States to determine.

The technical challenge was expressed in Article 7 of the Renewables Directive, blandly termed "Grid system issues". Article 7(1) begins:-

"Without prejudice to the maintenance of the reliability and safety of the grid, Member States shall take the necessary measures to ensure that transmission system operators and distribution system operators in their territory guarantee the transmission and distribution of electricity produced from renewable energy sources."

Article 7(1) then distinguishes between priority access to the grid which Member States may permit (but they are not required to do so) and dispatch of generating installations (allocation of plant to meet demand) where Member States are required to give priority to renewables plants, but only insofar as the operation of the national electricity system permits.

The legal terminology indicates the enormous practical difficulty of effecting change. First, the principal objective is to maintain the reliability and safety of the grid, and renewables objectives are secondary to that. The two objectives should not conflict, but in practice they might, for example:-

  • New generating installations add capacity to the network. Capital investment is needed not only to effect connection to the network, but to ensure that it is sufficiently robust to handle that capacity.
  • Where the transmission system is vertically integrated e.g. with generating installations based on non-renewable sources, there is significant potential for the system operator, if unimpeded by regulation9 or competition law, to protect its own generating plant from competition by renewable-sourced generation.
  • The transmission system operator may have a significant role in the design and operation of the rules for access to and use of its system, and regulation combined with enforcement action is needed to ensure that this role is not abused to the detriment of renewable-sourced generation.

Moreover, the Renewables Directive does not mandate priority access, so the position of each renewable-sourced generation operator may differ in each Member State. By contrast, the priority dispatch of such stations is mandated, but the caveat, "insofar as the operation of the national electricity system permits" leaves very broad scope for renewable-sourced generators to be legally excluded - simply because the matrix of system operation and trading rules does not prevent it.

The situation is summarised in recital 32 to the Commission's proposed new Directive on renewables:-

"[T]here has been significant variation between Member States in the degree of integration actually achieved. For this reason it is necessary to strengthen the framework and review its application periodically at national level."

Nevertheless, in Article 14(1) of the proposed new Directive on renewables ("Access to the Electricity Grid"), the only change from the existing Article 7(1) is that priority access shall be mandated rather than may be mandated. If enacted, this change will reduce some of the uncertainty of the old Article 7, but arguably not enough. There is much more to the Renewables Directive and its proposed successor than this, but this one example demonstrates the difficulties of effecting such wide-scale changes to the grid systems of Member States.

To give another example of the problems that arise in practice, on 16 July 2008, the UK energy regulator OFGEM published an "impact assessment" on "CAP 148", a proposal by Wind Energy (Forse) Ltd in April 2007. The proposal was that, for the purpose of the UK Connection and Use of System Code ("Code") (the document established by the UK transmission system operator, National Grid, to which all market participants in the UK must be signatory), all "new" renewable generation should have their connection and dispatch prioritised over all other generation including both conventional and existing renewable generation.10

The Code notes that in the UK, under current rules, applications for connection to and use of the transmission network are processed on a "first come, first served" basis. It also notes that connection of new generation and allocation of transmission rights is contingent on technical works being completed to reinforce the system, so that it can accommodate both existing connections as well as new. However, OFGEM declined to accept the proposal (as it is permitted to do), on the basis that "there are much better ways of unlocking the benefits, primarily lower carbon emissions, of allowing faster connection of renewables that CAP 148 is seeking to achieve, without prioritising any particular technology."

Concluding thoughts

The analysis above by no means exhausts the difficulties of achieving both a liberalised and single European energy market on the one hand, and an increased share of renewables on the other. The shape of the EU Emissions Trading Scheme after 2012 may radically alter the incentives applicable to electricity generation, with a shift from allocated emission rights to auctioned rights. The proposed new Renewables Directive will require Member States in effect to remove disproportionate planning and other barriers to new renewable-sourced plant.

However, since the shape of a post-Kyoto agreement after 2012 is not known, and since the EU's own commitments to renewables in part depends on that agreement, there remain plenty of "unknowns" in the sector.

That said, it is very plain that the European Commission will continue to be ruthless in its pursuit of anti-competitive practices that impede the liberalisation of the European energy markets (and their integration), and which in consequence, impede the growth of renewable-sourced generation.11

What is also clear is that the legal and technical complexity of the energy sector across the EU's 27 Member States must be closely scrutinised to minimise risks and uncertainty and to maximise the future business opportunities in the sector.