Network activities -i.e. transmission and distribution- remain de-facto natural monopolies and need to be operated under regulated conditions to control costs, profits and access to all market participants on non-discriminatory terms. The European Council recently agreed on a legal unbundling of the transmission and distribution from the upstream and downstream activities. IFIEC Europe, representing the industrial energy users, is in favour of a stricter regulation as it “is convinced that ownership unbundling is the only effective way to ensure that transmission and distribution are clearly separated from other generation and supply/trading activities open to competition and to avoid conflicts of interest. Availability of grid services at lowest cost and adequate quality is of central importance to the smooth-functioning of the whole electricity market”.
But the European deregulation policy does not only affect the electricity sector on the country level. Before the liberalisation, the electricity market in Europe was nationally organised and the incumbent companies were not subject to the threat of entry. At these days, the Electricity Directive of the Commission is creating a single European electricity market, in which electricity can be traded across borders. Electricity consuming companies are now entitled to freely choose their power supplier. A good example of a company, which immediately made use of the free choice of supplier, is BASF Belgium, located in the harbour of Antwerp. BASF used to buy power from Electrabel, the main Belgian electricity supplier, but entered recently into long term contracts with the German supplier RWE.
Hence, incumbent national electricity producers have to accept the entry of European competitors in their market, again to the benefit of electricity consumers. A working paper of the commission (2001) shows us “that electricity prices for industrial consumers and small enterprises have gone down in almost all member states since the Electricity Directive was implemented. In general, the most significant price reduction can be found in the member states that have opened 100%.” The price developments for industrial consumers and small enterprises are resumed in the table on the next page.
From the same table the European Commission concludes “liberalisation reduced the difference in electricity prices between member states. Significant price reductions can be found in Germany, Portugal, Spain and Austria, where the pre-competitive prices were amongst the highest in Europe.” The European deregulation policy leads to harmonisation of the electricity prices among the member states.
Table: Price developments for industrial consumers and small enterprises
Source: Working paper European Commission, March 2001. Figures from Eurostat.
A trans-European electricity market can even be more attractive for multinational companies with plants located in different European countries. In the traditional national electricity market structure, each plant had to discuss a contract with the local (national) electricity supplier. In the liberalised electricity market, multinationals can obtain a better negotiation position when they discuss huge contracts for the supply to several plants. Further, one single market will increase the transparency in the electricity market and will facilitate the cost calculations for investments by multinational or foreign firms.
The introduction of competitive pressures has been seen to lead to technical innovations and improvements in energy efficiency. Today the European Commission estimates that a large economical potential for further improvement still remains in the EU, over 18% of the present energy consumption. Further, also the restructuring of the monopolistic companies will result in a reduction of the X-inefficiency and in higher standards of services. Power producers or suppliers will try to create a competitive advantage by improving their service to consumers and by offering energy saving solutions.
2.2. Disadvantages
Although the deregulation in the electricity market results in many advantages for European companies, it cannot avoid some disadvantages.
The most important disadvantage is electricity supply instability and price instability, which has happened to California electricity. In nearly all electricity markets, demand and supply are both inelastic to price. Such characteristic results in inherent electricity volatility. So even small changes can lead to a price boom or bust. This kind of price volatility can cause non-electricity companies’ production cost and price to change constantly, especially for the companies using large amount of electricity. In addition, in nearly all currently restructured markets, the demand response on high prices is primarily limited to actions by the independent system operators, which can exercise contract rights to interrupt power supply to certain customers. Thirdly, when the demand exceeds the supply, electricity producers may find it profitable to exercise market power by restricting their output. Fortunately, real-time pricing and long-term contracting can help to control the above problems under the deregulation.
A second disadvantage is that deregulation stimulates electricity companies to choose for cheaper raw materials to reduce their cost. Thus European companies active in the primary industry (mining) which are in fact inefficient, will experience problems as they loose an important client. In Germany, Spain and the United Kingdom, the electricity industry has been the major consumer of high-cost, locally produced coal. The result of liberalisation has been the reduction of prices paid to domestic coal producers and the increase of the amount of coal imported from low priced producer countries such as Australia and Poland. In the United Kingdom, the amount of domestically produced deep-mined coal has fallen from 73 million tonnes to around 30 million tones between 1990 and 1998. Over the same period, the number of mineworkers in the formerly state-owned mines has fallen from 59,000 to less than 7,000.
Traditionally, the four stages in electricity industry -generation, transmission, distribution and retailing- were integrated and governed by one company. The ongoing liberalisation separates these stages vertically to introduce competition in the electricity industry, but at the same time decreases the economies of scope, what can result in higher costs for power supply. Moreover, although the deregulation policy includes specific measures to prevent problems such as price discrimination or denial of access, it still can produce a problem on cooperation between the different sectors of the electricity supply chain. An emerging problem in some deregulating countries is that the private sector appears to be in the process of reintegrating business that the government initially kept separate. In England and Wales, both the major fossil fuel generators, National Power and PowerGen, have sought to acquire a distribution and supply business in order to increase access to final customers. The fact above indicates that vertical integration among electricity sectors can serve customers more efficiently.
The aim of deregulation is to introduce competition by separating state-owned electricity companies vertically and horizontally. But the result could be the opposite, as liberalisation leads to pressure for mergers and the threat of takeover. Property rights theory indicates that the threat and reality of mergers are some of the most important drivers towards efficiency within a liberalised market. Economies of scale have motivated horizontal mergers between distribution and supply companies. Within the United Kingdom, Scottish power merged with Manweb. In Sweden, Birka Energi, the result of a merger between Stockholm Energi and Gullspang, generates around 20% of domestic electricity consumption and has now been bought by Finland’s Fortum. Economies of scope seem to have been the motivation for number of multi-utility mergers. Some water companies merged with electricity distribution and supply companies in England. Even state-owned companies have joined the takeover market: EDF acquired London Electricity in 1998 and owns a minority share in Sweden’s Graninge. As a result, there is the risk that in the long term the electricity market will be controlled by a few large (multinational) companies instead of by governments as before. This possible oligopolistic market can reduce again the impact of competitive forces to the detriment of the European electricity consuming companies.
We may conclude that almost all the electricity consuming companies welcome the liberalisation in the electricity market to create a competitive environment, resulting in efficiency increase and lower prices. On the other hand, they insist on non-discriminatory and transparent mechanisms under regulatory scrutiny to limit the natural monopoly power of the transmission and distribution and they are in favour of continuously adjusted regulations to steer the liberalised electricity market in the right direction.
3. Lessons from the California electricity crisis and crucial elements in the European deregulation policy
As already pointed out above, European companies represent the major consumption of electricity in Europe. Given that electricity represents a key -or at least an important- variable cost for a company, the price of electricity is of the utmost importance as it directly influences its competitiveness into a more and more global market place. Today -probably more than ever- European companies try to reduce their operating costs in order to achieve the optimal efficiency. According to the economic theory, “perfect competition” remains the most efficient way to produce a good and to maximise the welfare of the society.
Although this economic rule theoretically also makes sense for network industries, the common governments’ opinion was that the electricity industry needed to be well regulated or even public owned to achieve the maximisation of the society’s welfare. The underlying hypothesis was that the electricity industry had and still has some characteristics which prevent the “invisible hand” to do its job efficiently. As a result, the electricity industry was until recently organised in national, vertically integrated and often public owned monopolistic structures, in general inefficient.
Without blaming the past, the environment of today has changed and imposes the reorganisation of the electricity industry in Europe. Also the creation of the European Union and its ambition to create a single market, as well as the objective of Lisbon to make the European Union the most competitive economy in the world by 2010, contributed to the need for liberalisation of the European electricity industry.
As the European companies want to defend their competitive position in a more global market place, their requirements can be formulated as follows: European companies need an electricity market where electricity prices tend to be as cheap as in the rest of the world. Moreover, they need a reliable network, integrated through Europe, accessible and adequate to the demand in the sense that it can provide enough grid capacity and prevent shortages.
3.1. Lessons from the California crisis
During the year 2000, two major elements prevented Californian companies to be competitive or, even worse, to exert correctly their activities: the severe energy shortages and the resulting extreme price inflation (prices were around 200% above the level of the previous year).
Consulting the literature, we have to conclude that numerous reasons can be quoted to explain this electricity crisis and that the explanations differ widely according to the position and opinion of the author. In this discussion we do not focus on the changes of external elements (like the weather), but we want to understand why the “deregulated” market failed to respond efficiently to these changes. In fact, one of the main reasons explaining the crisis was that the Californian electricity market was not completely and imperfectly deregulated. Indeed, wholesale prices were deregulated, whereas retail prices were fixed (by the state of California) to an artificially low level. Moreover, regulators were limiting the construction of new plants what consequently resulted in low electricity supply. This situation gave market power to wholesale generators (with the resulting possible manipulations) and enabled them to increase the prices well ahead the cost of production at a moment when retail prices were fixed. As a consequence, demand exceeded supply (both inelastic, thus creation of shortages) and retail companies were obliged to sell electricity at a lower price than their purchase price on the spot market, which inevitably conducted them to bankrupt.
The lessons of this dramatic situation conduct us to the crucial elements according to European companies for the establishment of a good European liberalised electricity market.
3.2. Crucial elements in the European deregulation policy
1. Creation of an effective competitive market.
Given that the transmission and the distribution in the electricity supply chain represent natural monopolies, the generation and the supply of electricity have to be really opened to competition. More concretely, it means that the incumbent players in each national market needs to be well controlled in order to ensure that they do not abuse their “previous” dominant position. Moreover, we observe that in the recently liberalised markets in Europe, a trend towards concentration of generators and suppliers occurs, as well as a horizontal integration of electricity and gas industries. According to the International Federation of Industrial Energy Consumers (IFIEC-Europe), the problem is that “the speed at which concentrations are occurring at both national and trans-national levels is unfortunately proving to be faster than the development of competition via the growth of cross-border-trade.” To reduce this kind of anti-competitive behaviours and to favour a real price decrease, regulators should develop incentives to increase the number and type of suppliers (for instance by reducing the costs of developing new power plants, by limiting the number of market shares or, more generally, by reducing the several entry barriers occurring in the industry).
2. Access to the transmission and distribution network needs to be guaranteed at low cost, with a sufficient quality and in a non-discriminatory way.
This implies the vertical separation and ownership unbundling whereby transmission and distribution are clearly separated from generation and supply activities open to competition. Moreover, to establish a transparent system concerning the pricing of monopolistic activities, the regulator should inform the consumer about the real costs and revenues of these activities.
3. Creation of a real single, integrated European electricity market
Business globalisation is a trend for European companies. Indeed, more and more companies establish their branches or subsidiaries in other countries. To achieve profit maximisation, European companies need to minimise the cost of input; they require an integrated and single electricity market allowing competitive and reliable prices of electricity. To this end, supply competition through cross-border exchanges should be developed. This highlights the need for interoperability between the different national networks and a better management of the supply across Europe.
Moreover, a single and integrated market can provide the electricity industry with economies of scale and scope. Electricity producers can increase their supply of electricity because the demand increases when it faces an integrated European market instead of a national market.
4. The Regulator cannot have its cake and eat it!
Sometimes, it seems that Europe would like to achieve opposite objectives at the same time: the absolute competitiveness of its economy against too heavy taxes on its liberalised market. Indeed, the IFIEC notes “increasing surcharges and taxes are borne by electricity consumers to finance not only public policies relating directly to electricity, but also policies concerning other sectors. (…).” According to the same federation, “the cost-efficiency of public policies should be increased”. Moreover, “energy, environmental and other public policy initiatives should not be financed through surcharges and taxes on electricity”.
As we discussed above, liberalisation is far from being a simple process. Just opening the market without any intervention will not lead automatically to perfect competition. On one hand, from the lessons of the Californian crisis (where price control and scarce resources were the main mistakes) we know that a partial liberalised market can be worse than a “stable” regulated market. On the other hand, by studying the strategy of the European Union which implements deregulation “step-by-step”, we observe that it can also cause some competitive disadvantage for consumers who don’t have as much choice of supplier as planned, because of the concentration and the vertical integration preventing real competition and efficient allocation of resources.
Finally, when we analyse the nature of the problems appearing in this phase of partial deregulation (phase two in the deregulation process) as well as the consequences of the interventions of the regulator, we can conclude that currently the best deregulation policy is a policy that will correct (or “re-regulate”) the imperfection of the market in order to constantly stimulate the competition and to achieve the objective of Lisbon. The final objective may remain a perfect competition with very few interventions of the regulator. However, the future structure of the liberalised electricity market in Europe is likely to be an oligopoly structure, including again some risks, which affect competition and efficiency (Cournot equilibrium, Cartels, etc.).
4. Differences and similarities between deregulation in the European electricity sector and other European sectors
The electricity industry belongs to a group of Network industries, which are characterised as “industries involved in delivery of products and services to final customers via network infrastructure”. The network industries include postal services, telecommunications, energy (electricity and gas), water distribution and sewerage, railways, maritime and air transport industries. They all have had traditionally a very concentrated market structure with only one monopoly company, operating in each network sector. Over the last decade the network industries faced a significant pressure to implement market elements with the objective to transform the monopolists markets into liberalised and competitive environments.
Although all these network industries have many features in common, such as public goods dimension, high sunk costs, long-term return on investment or extreme political and economic importance, each of them has different nature and its own industry-specific elements. It goes without saying that every deregulation policy in any network industry is especially developed and adopted to the specific characteristics of the sector. In this question we would like to discuss the differences and similarities between deregulation in the electricity sector and other network industries sectors.
4.1. Similarities
1. The common OBJECTIVE of the deregulation
The liberalisation process in each network industry, including the electricity industry, has one common objective: the implementation of market elements (such as market opening for the competition, introducing of cost based prices, reducing employment in these sectors etc.) in the traditionally monopolistic sectors and the transformation into efficient and competitive sectors. The goal behind the liberalisation is to create a common European market in each industry, benefiting from synergies, economies of scale and shared resources throughout the EU.
In general, European industrial or commercial companies welcome the liberalisation of network industries. As the outputs of many network industries represent important inputs to other industries, the increased efficiency of network industries together with lower prices of their product and services is expected to have positive impact on the efficiency of European companies and on increased positive performance of the EU in the global aspect.
2. Common PRINCIPLES of deregulation
The deregulation of the electricity market as well as of other network sectors has to rely on the same general principles: transparency, non-discrimination, verifiability and objectivity. Identical access to information, conditions for entering and using the infrastructure, independency and objectivity of the regulatory and monitoring authority have to be secured for all companies.
3. Deregulation reflecting GRADUAL APPROACH in liberalisation
The liberalisation in electricity as well as other network industries is a gradual process that can be phased in three basic steps – monopoly (1), monopoly and competition (2) and competition (3). The 3-phased liberalisation process therefore determines the character and intensity of deregulation. While in the first phase regulation focuses on preventing monopoly abuses by incumbents (incumbent’s cost-allocation procedure, price-setting behaviour and unbundling of incumbent’s operation), later on the emphasis is put on regulation and monitoring of competition policy. Although in long-term the diminished degree of regulation corresponds with the intensified liberalisation in network industries, the introduction of competition in network industries requires parallel increase in regulatory activity in short term.
The non-electricity European companies appreciate this gradual approach, while it can secure gradual and smooth adaptation of all market components and economic actors and lead to better synchronization of liberalisation of all network industries.
4. Deregulation reflecting VERTICAL SEPARATION of network industries
Electricity, like other network industries, is a vertically integrated industry consisting of 3 vertical components: upstream production (power generation), infrastructure (transmission and distribution) and downstream service provision (retailing). The deregulation policy in network industries applies different approach towards the monopoly elements of vertical structure such as infrastructure -where it allows preservation of right to exclusive ownership-, and potentially competitive elements of downstream and upstream vertical components -where it favours liberalization and opening of the markets. To serve the requirements of transparency and non-discrimination within the vertical structure, the regulation policy makes use of the unbundling instrument; internal separation of accounting and ownership of vertically integrated electricity undertakings. The regulation is also concerned to prevent the monopoly abuse by monitoring incumbent’s price setting mechanism and discrimination of other access conditions.
5. AMENDMENT of initial DEREGULATION framework
The unique nature of the network industries liberalisation requires permanent monitoring and verification of the functioning of the adopted legal framework. In the electricity sector as well as in all network industries the directives and regulations, that initiated the liberalisation procedure of these industries, are subject to continuous amendments reflecting the specific effects on the market.
The non electricity companies closely cooperate in the preparation of further legislation amendments and try to incorporate proposals based on its observations and experiences in the renewed legislation.
6. Same BARRIERS against EFFECTIVE DEREGUATION
Network industries share the same barriers against effective deregulation such as access, interconnection and legacy of monopoly. Also the liberalised market is not a perfect competitive market.
7. Same REGULATORY AGENCY for various sectors
In some network industries, especially where the “closeness” of the markets is significant, very strong convergence of the deregulation policies can be observed. Therefore broader regulatory agencies within two or more “complementary” (rail and air) or “substitute” (electricity and gas) sectors arise, with broader horizontal scope of regulatory. This helps to further deepening of the synchronization of the liberalization of all the network sectors.
4.2. Differences
One of the most crucial differences between network industries has to do with the different level of deregulation process on each sector. The electricity market for instance, in most of the European countries has just entered phase two, while the telecommunication sector is just one step beyond full liberalisation. That can show us that actually the deregulation process evolution in a network industry sector can be either a slow or a fast one. The different rate of the step-by-step deregulation has to do with many reasons, such as, the disposable investment funds that are available and the possibility of implementing the new technologies.
The different stage of liberalisation of network industries is associated with the different driving forces to this direction. The following table gives an overview of the main driving forces towards deregulation for the different network industries:
Source: Jeremy Alouche. Internal meeting – European Commission (2003).
Especially for the electricity sector, the driving forces for liberalisation of the market were the failure of the public management, the impact of potential competitors (investments) and the growing need for an internal European market. As we have already mentioned, the technological development and changes in demand are a key factor in the network industry sectors. This element however did not have a direct impact on the electricity sector because of the high cost of investment in the electric-power-producing industry.
The legislators and the legal procedures of deregulation of the network industries are also different compared to other network industries. In the electricity sector, the European Commission is responsible for the transmission stage but the distribution process at the national level has been retained at the state regulations. On the other hand in telecommunications and air transportations the Commission is the sole legislator. In telecommunications and electricity, deregulation is a proceeding via Directives for implementation by the member states while in other sectors, i.e. air transportation, the process is done by specific regulations.
One of the main features of network industries is the vertical separation. The thing that makes electricity sector unique and very interesting, from a deregulatory point of view, is its horizontal separation in power generation. Electricity can be produced with many different ways. Across the Europe electricity is generated by nuclear power, coal, natural gas, oil-fired plants, hydro plants and other renewable source of powers, with the last one being favoured by the Commission as an alternative source of power. The opening up of the markets will introduce competition in this field and will definitely turn to be very beneficial, and cost reductive since most national markets are not familiarised with all generation sources.
Analysing the electricity sector market from a macro-economic spectrum, we can argue that it has inelastic demand and inelastic supply too. In the first case, that is a fact because of the luck of direct subsidies, so the increases/decreases of the prices don’t have direct impact on the demand on the product. On the other hand the high cost of power production and the storage impossibility, makes the increase of production very difficult. The deregulation policy therefore has to take into consideration these characteristics that make this product different from other sectors.
Based on our research we can conclude that non-electricity companies are in favour of further liberalisation of all network industries. The outputs from network industries represent often a very important source input for other European companies. The earlier implementation of liberalisation policy together with intensive regulatory elements in the electricity but also other network sectors lead to significant costs savings (electricity industry - up to 10 percent) in production elsewhere in the economy and helped to increase the overall performance of European non-electricity companies in the global framework.
5. After deregulation, time for privatisation?
In general, we will consider that privatisation is a good solution for the future, if it can contribute to achieve a better competitiveness of the European companies in the global market place. In other words, if privatisation is a middle to improve competitiveness into the electricity industry, then it represents a solution we will favour and defend.
However, to know what we are speaking about, let us first consider quickly what privatisation is about. Liberalisation attempts to enable new entrants to enter the market in order to move progressively from a monopolistic market to a competitive market: it actually concerns the number of players in the industry. On the contrary, privatisation directly concerns the ownership. It is important to note that it is possible to have a non-liberalised market with a private ownership as well as a liberalised market with a public ownership. In this way, liberalisation is not especially associated with “privatisation” and inversely. Moreover, note that in the context of the electricity liberalisation, the question of the ownership mainly concerns the monopolistic elements of the electricity supply chain (i.e. transmission and distribution), whereas the other elements should have been regulated by the rules of competition and a complete private ownership.
First of all, the European Union policy does not favour any specific type of ownership. This opinion reflects certainly another very important point “Economic theory and empirical evidence suggest that competition is a more important determinant of efficiency than ownership per se.” However, given that “public ownership of firms in the network industry is extensive in Europe” it represents probably more the fact that this neutral position concerning the ownership is the result of the pressures coming from the different governments of each European country. Indeed, we can learn from a dynamic perspective of the economic theory that “the threat of takeover and the role of capital markets under private ownership can provide very powerful efficiency incentives for management. It is very difficult to find surrogates for these features under public ownership and therefore private ownership is generally superior in efficiency terms to public ownership. From a cost (productive) efficiency view, empirical studies have tended to favour private ownership in some of the network industries. (…) In analysing a variety of networks industries, Galal et al. (1994) found that privatisation is associated with greater efficiency and welfare gains.”
Another argument in favour of the privatisation is that it enables the creation of an active market for property rights in electricity firms.
Nevertheless, these optimistic findings are largely contrasted by other studies:
“UK electricity privatisation did produce some cost 'savings', which were almost entirely caused by job losses. These included job losses in the electricity industry itself, and job losses in the coal industry, which lost a lot of business as a result of privatisation. But the benefits were not seen by consumers. A detailed analysis found that all the cost savings were more than offset by increases in dividends, and so the only beneficiaries were the new shareholders - prices to consumers actually rose sharply.
The World Bank has published a paper, which concludes that UK consumers have lost billions of pounds as a result of electricity privatisation. The authors calculated the net savings (mainly due to reductions in labour costs in the electricity companies and in the coal industry, at a big cost in lost jobs and income) to be between £6bn and £11.9bn - equivalent to a reduction of about 3.2 to 7.5 percent of prices.
They then examined the actual distribution of benefits - and found that the price reductions did not happen. Prices did not fall as fast as costs, and so: "Power purchasers seem to be paying higher prices than they would have under continued public ownership". The reason for this, say the authors, was that "higher company profit margins offset lower costs". This happened to such an extent, that "the shareholders benefit by more than the total net benefit". So none of the savings ever reached the consumers (let alone the employees). In fact, consumers lost between £1.3bn and £4.4bn as a result.
UK Electricity privatisation - who won, who lost
Source: World Bank PPPS Note 124
A more recent study of the components of electricity prices has reached similar conclusions. The reduction in distribution costs has only happened since the regulator imposed tougher formulae, not because of privatisation; that the reduction in prices is much less than the fall in fuel costs, because of the three- and four- fold increase in the profit margins of the distributors; and that the element of supply costs is too small to make meaningful competition possible for small consumers. ”
Moreover, this same study, which clearly demonstrates the inefficiency of privatisation, also highlights the undesirable consequences on employment due to privatisation as well as (between many other arguments based on statistics) the performance problems arising after privatisation in major cities like Rio de Janeiro, Auckland and Buenos Aires.
Given that the literature is mixed and that even the European commission is neutral about the question, it seems difficult to have a final sharply contrasted point of view. However, taking into account the liberalisation occurring in Europe, privatisation of the monopolistic elements can be considered as desirable. Indeed, as explained in the paper of Bergman et al. (op.cit), “the legacy of monopoly in network industries and the scale of public ownership in Europe’s network industries can present problems when competition is introduced”. These “problems” actually concern conflicting priorities for public owned companies and the fact that they could suffer from disadvantageous positions, the other companies in the sector beneficiating from state aids that they can not receive for evident reasons of fairness on the competition. In this way, it seems favourable to clearly separate state as owner and state as regulator.
However, we are still convinced that the state as regulator has still its important role to play to make privatisations successful in Europe (i.e. respecting the European companies’ objectives). Indeed, regulators should not only ensure that the equity is respected when the sector is privatised (with for instance a tax and benefit system), but they should also take the necessary measures in order to ensure the transparency (different systems are possible: sector specific-agency, independent legal entities, ownership unbundling) of the cost and return structure of the grid structure as well as its reliability. The final objective is to benefit from the advantages of privatisation as well as to protect the interests of European consumers.
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Note that these typical characteristics of network industries are developed further in this paper (part 4)
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