After a 16 month wide-ranging inquiry into the energy sector, the European Commission has presented its final conclusions in a detailed report which identifies serious shortcomings in respect of the operation of competition in EU energy markets and proposes measures to address these issues. Some of these remedies will need to be implemented by further legislative measures requiring agreement by EU Member States, not all of whom are likely to agree to the proposals. Other remedies proposed by the Commission rely on full implementation of existing legislation and more active application of existing powers under EC Treaty competition rules in relation to anticompetitive agreements (Article 81), abuse of market power (Articles 82 and 86), merger control (Regulation 139/2004) and state aid (Articles 87 and 88). The Commission has also proposed several general objectives which can be criticised as lacking any detail.

The final report concludes that the key areas calling for urgent action are:

  • Achieving effective unbundling of network and supply activities.
  • Removing the gaps in the regulatory regime, in particular for cross border issues.
  • Addressing market concentration and barriers to market entry.
  • Increasing transparency in market operations.

The main findings of the Commission’s report in this respect and its proposals to achieve these objectives are explained below. The briefing concludes with some commentary on the implications of the report.

Unbundling of network and supply activities

Despite current rules on non-discriminatory third party access (TPA) to energy infrastructure, vertically integrated companies are suspected of favouring their affiliates. There is also a concern that they often take decisions that are not in the interest of the network/infrastructure but rather on the basis of the supply interest of the company. Vertical integration between generation and supply is also seen as reducing the necessity for companies to trade on wholesale markets and potentially hindering the development of liquidity, resulting in non-transparent prices which can create distrust among both customers and potential competitors. Notably, the report states that the inquiry has not revealed any significant synergy effects linked to vertical integration and concludes that both the network business and the supply business of a vertically integrated player would continue to thrive after separation.

Proposals

  • Most controversially, the Commission has proposed as the best solution proceeding with complete ownership unbundling of network companies and the supply and generation companies. The Commission considers that this to be the most effective means to ensure choice for energy users and to encourage investments. This type of proposal has to date been politically unacceptable to some Member States and now has already met with strong opposition in some quarters on the basis that it would amount to expropriation of shareholders' assets and would endanger security of supply. Currently only 11 Member States have implemented full ownership unbundling for gas networks or electricity networks.
  • Alternatively the Commission supports the creation of an independent system operators (ISO) in which vertically integrated companies would remain owners of their network (and receive a regulated return on them) but would not be responsible for their operation, maintenance or development. This solution will require detailed, prescriptive and costly regulation and will not deal with the key issue of disincentives to invest in networks. Such a system is currently applied in the UK. This proposal is a compromise solution in the event that the opposition to ownership separation is insurmountable.

Market concentration

The Commission has concluded that incumbents remain dominant by largely controlling upstream gas imports/domestic production and electricity generation in combination with infrastructure ownership. This restricts competition at the wholesale and retail level, as new entrants are dependent on a vertically integrated incumbent for services through the supply chain. At the wholesale level, gas and electricity markets remain national in scope and generally maintain the level of concentration of the pre-liberalisation period.

Proposals

  • The Commission intends to use its current competition/antitrust powers to remove obstacles to market entry. For example, in the context of merger control, it uses structural remedies such as divestiture requirements to prevent further market concentration.  Structural remedies may also be used in Article 82 cases where the structure of the undertaking means that there is a substantial risk of repeated abuse of market power. The Commission is currently investigating several cases in the energy sector on this basis. Any attempt to break up dominant companies is likely to raise legal issues under Article 82.
  • The Commission has identified that energy release programmes would be used to develop market liquidity and reduce the effect of concentration. This includes electricity virtual power plant auctions and gas release programmes which require incumbent companies to sell defined volumes of energy, usually on large scales, combined with the release of network capacity.
  • The Commission recommends that national energy regulators should analyse conditions in their respective markets in co-operation with competition authorities in order to develop further measures to increase liquidity in the market. Some Member States have already introduced ceilings on ownership of electricity generation and long-term contracts to reduce market power by divestiture of production, asset swaps and contract releases.

Lack of market integration

The Commission has concluded that inadequate investment (and lack of investment incentives) in cross-border infrastructure, long-term legacy contracts entered into prior to the liberalisation Directives and under-utilisation of existing capacity, especially through ineffective congestion management, restrict cross-border sales which are essential to create a single market.

Proposals

  • The Commission will strictly monitor compliance with use-it-or-lose-it rules under existing legislation and develop these rules through guidelines. Regulatory decisions relating to these contracts should also be scrutinised by the Commission.
  • The legal position of pre-liberalisation long term gas supply contracts under the Gas Directive should be clarified following the recent ruling by the European Court of Justice requiring electricity contracts to be notified to the Commission for approval under the Electricity Directive.
  • A regulatory framework to ensure adequate TPA to gas storage facilities should be established, including (i) legal unbundling, (ii) binding guidelines on TPA, and (iii) increased powers of the national regulators.
  • The Commission will establish a working group to monitor investments in generation, production and network capacity, particularly cross border capacity, and develop a clear framework for investment in infrastructure as part of the EU energy plan.
  • The Commission is considering producing new guidelines on exemptions from TPA to new infrastructure to clarify when exemptions can be considered not detrimental to the development of competition and to provide greater certainty to investors. It is not clear whether this will restrict the terms of exemptions in terms of length of exemption or restrict 100 per cent exemption of infrastructure from TPA.
  • Coordination between transmission system operators (TSOs) should be enhanced through a new legislative framework based on existing associations of TSOs which requires information exchange, technical co-operation, development of standards and monitoring with a view to the development of a regional system of operators.

Price formation

The report concludes that pricing in gas contracts does not react properly to supply and demand because it is linked to oil price indexes. Although electricity price formation is more complex (taking into account factors such as prices in primary fuel and EU CO2 emissions trading) the Commission considers that prices on electricity spot and forward wholesale markets are not the result of fair competition. Proposal No specific price measures are proposed here. However, the Commission considers that ensuing liquidity in the gas market will be crucial to improving confidence in price formation which can allow relaxation of the linkage to oil prices. It is hoped that this will be achieved by the various measures described above. In addition, the Commission proposes establishing a monitoring system for trading on wholesale markets to increase confidence in the market and limit risk of market manipulation. It supports regulators being empowered to collect and exchange information in this respect.

Long term transmission and supply agreements

The Commission has found that new entrants often lack effective access to networks and wholesale markets as a result of long-term transmission contracts and resulting capacity hoarding and long-term supply contracts between gas producers and incumbent importers. It considers that, although these contracts have an important role in Europe’s security of supply, they have the effect of locking up a significant proportion of the energy coming into the market and consequently exclude potential new entrants in the market. In addition, it finds that competition at the retail level is restricted by the length of contracts for industrial users and by the use of clauses restricting customers’ use of gas as well as restrictive practices regarding delivery points.

Proposals

  • The Commission is considering how to ensure that existing and future gas import contracts do not remain in the hands of only a few companies.
  • The Commission will, as a priority, review under Article 81 and 82 competition effects of long term transmission and supply contracts (including pre-liberalisation contracts), weighing the potential limitation of competition against the need to secure those types of large investments with long-term contracts. In particular, where contracts are concluded by dominant firms, they are likely to be seen as foreclosing the market unless there are clear countervailing benefits.
  • The Commission will continue to use competition/antitrust rules to prohibit restrictive clauses in contracts. It was hoped that the Commission would issue further guidelines on this issue but there is currently no clear understanding of the limits of what is acceptable or how the Commission will deal with, for example, the recent Gazprom long-term agreements.

Collusion between incumbent operators

The Commission finds that incumbent companies rarely enter other national markets and there is a tendency to co-ordinate rather than to compete against one another. It states this was confirmed by the inspection it carried out at the four electricity generators/suppliers in Germany in December 2006, alleging that the companies colluded to keep electricity prices artificially high by restricting output.

Proposal

  • The Commission will vigorously apply its powers under competition/antitrust rules to prevent collusion between companies in the energy sector. This is likely to mean further dawn raids on energy companies in 2007.

Balancing markets

The Commission's criticisms in this area, are as follows. The small size of current balancing zones and the divergent rules in each zone increases the complexity and cost of shipping gas in Europe. This makes it difficult for new entrants to the market and give little incentive for major incumbents to move. Balancing charges, clearing costs and penalties are also not transparent and often contain unjustified penalty charged favouring incumbents. The electricity markets for balancing and reserve energy are highly concentrated giving scope for exercise of market power and deterring new entrants. The structural relationship between TSOs and their affiliated generation provides an incentive for TSOs to buy excessive reserve capacity and pay high prices to favoured affiliate.

Proposals

  • Ownership unbundling as described above would appear to help to address these issues.
  • The Commission also supports the introduction of more open and flexible tendering procedures for balancing energy by new guidelines/legislation.
  • It also suggests increasing the geographical size of electricity balancing control areas to reduce concentration.

Transparency

The Commission has concluded that there is a lack of reliable and timely information on the markets relating to network availability (particularly electricity interconnections and gas transit), operation of generation capacity and gas storage. It considers that, if information was more widely available on an equal footing and in a timely manner, this would increase market transparency and reduce market entry barriers. Proposal The Commission intends to publish binding guidelines on transparency to ensure that all relevant market information is published on a rolling basis in a timely manner.

LNG

The final report contains a fairly detailed review of the current LNG market. It concludes that LNG contributes to the objective of security supply by allowing the EU to import gas from regions otherwise not reachable via pipeline and thus to diversify its supplier base. LNG has also significant potential for enhancing the flexibility of gas markets as production and transport facilities are less regionally constrained than pipelines, allowing redirection of supply if necessary. The LNG spot trade practice has also emerged alongside long-term trade in the last ten years and in 2005 accounted for 11 per cent of the global LNG trade. Furthermore, it is recognised that there is now a trend for LNG import by new entrants as well as by national incumbent companies that also own LNG terminals, and this is seen as having a positive effect on downstream competition.

Proposal

The Commission notes that it is important that the following factors which are responsible for the development of a flexible short term LNG market are maintained: (i) the presence of uncommitted liquefaction capacity, (ii) the presence of excess capacity on receiving terminals, (iii) the availability of tankers not committed under long-term contracts, (iii) use-it-or-lose-it measures imposed on capacity holders in terminals, (v) and development of liquefaction facilities.

Regulatory environment

The Commission believes that Europe needs a substantial strengthening of the powers of independent energy regulators and enhanced European coordination between energy regulators to provide a strong Community overview particularly as regards cross-border issues. It considers that there is also a need for harmonisation of market design, especially regarding methods having an effect on cross-border trade.

Proposals

  • The Commission wants the powers of the independent national regulators to be enhanced through legislation to ensure that they have strong up front powers over (i) all aspects of TPA to the network, (ii) access to gas storage, (iii) balancing mechanisms, (iv) market surveillance, for example, power exchanges, (v) compliance with accounts unbundling of distribution system operators, (vi) all cross border issues, (vii) end user price controls, (viii) information gathering, and (ix) sanctions for non-compliance.
  • It wants to reinforce co-ordination between national energy regulators by ensuring that their decisions concerning cross border issues need to be notified to the Commission (similar to the structure used for exemptions for TPA to new infrastructure).
  • To enhance the consistency of regulation in cross-border issues, it wishes either to formalise the role of the European Network of Independent Regulators or to establish a single EU body responsible for adopting decisions relating to regulatory and technical issues relevant to cross border trade. This creation of a “European Regulator” is opposed by many Member States.