Price setting in the electricity markets within the EU single market

PricesettingintheelectricitymarketswithintheEUsingle market AreportbyEASACtotheCommitteeonIndustry,ResearchandEnergyoftheEuropean Parliament February2006 Forfurtherinformation: FionaSteiger EASACSecretariat TheRoyalSociety 6-9CarltonHouseTerrace London SW1Y5AG tel:+44(0)2074512697 fax:+44(0)2079252620 email:fiona.steiger@royalsoc.ac.uk

EASAC EASAC theeuropeanacademiesscienceadvisorycouncil isformedbythenationalscienceacademiesofthe EUMemberStatestoenablethemtocollaboratewitheachotherinprovidingadvicetoEuropeanpolicy-makers. ItthusprovidesameansforthecollectivevoiceofEuropeansciencetobeheard. Itsmissionreflectstheviewofacademiesthatscienceiscentraltomanyaspectsofmodernlifeandthatan appreciationofthescientificdimensionisapre-requisitetowisepolicy-making.thisviewalreadyunderpinsthe workofmanyacademiesatnationallevel.withthegrowingimportanceoftheeuropeanunionasanarenafor policy,academiesrecognisethatthescopeoftheiradvisoryfunctionsneedstoextendbeyondthenationalto coveralsotheeuropeanlevel.hereitisoftenthecasethatatrans-europeangroupingcanbemoreeffective thanabodyfromasinglecountry.theacademiesofeuropehavethereforeformedeasacsothattheycan speakwithacommonvoicewiththegoalofbuildingscienceintopolicyateulevel. ThroughEASAC,theacademiesworktogethertoprovideindependent,expert,evidence-basedadviceaboutthe scientificaspectsofpublicpolicytothosewhomakeorinfluencepolicywithintheeuropeaninstitutions. Drawingonthemembershipsandnetworksoftheacademies,EASACaccessesthebestofEuropeansciencein carryingoutitswork.itsviewsarevigorouslyindependentofcommercialorpoliticalbias,anditisopenand transparentinitsprocesses.easacaimstodeliveradvicethatiscomprehensible,relevantandtimely. EASACcoversallscientificandtechnicaldisciplines,anditsexpertsaredrawnfromallthecountriesofthe EuropeanUnion.Itisfundedbythememberacademiesandbycontractswithinterestedbodies.Theexpert membersofprojectgroupsgivetheirtimefreeofcharge.easachasnocommercialorbusinesssponsors. EASAC'sactivitiesincludesubstantivestudiesofthescientificaspectsofpolicyissues,reviewsandadviceabout policydocuments,workshopsaimedatidentifyingcurrentscientificthinkingaboutmajorpolicyissuesorat briefingpolicy-makers,andshort,timelystatementsontopicalsubjects. TheEASACCouncilhas24individualmembers highlyexperiencedscientistsnominatedoneeachbythe nationalscienceacademiesofeveryeumemberstatethathasone,theacademiaeuropaeaandallea.itis supportedbyaprofessionalsecretariatbasedattheroyalsocietyinlondon.thecouncilagreestheinitiationof projects,appointsmembersofprojectgroups,reviewsdraftsandapprovesreportsforpublication. TofindoutmoreaboutEASAC,visitthewebsite www.easac.org-orcontactfionasteiger,easacsecretariat [e-mail:fiona.steiger@royalsoc.ac.uk;tel+44(0)2074512697]. 2

Contents Introduction Summary 1 Characteristicsofthemainelectricitymarkets 1.1 Mainelectricitymarkets 1.2 Internationalinterdependence 1.3 Competition 1.4 Networkunbundling 1.5 Publicvsprivatesectors 1.6 Regulation 1.7 Conclusions 2 Europeanpricestructuresandtrends 2.1 Pricestructures 2.2 Pricetrends 2.3 Conclusions 3 Impactonelectricitypricesofemissionstrading 3.1 Background 3.2 ElectricitypriceeffectsoftheEU-ETS:theory 3.3 ElectricitypriceeffectsoftheEU-ETS:evidence 3.4 EfficiencyofpricerisesduetoEU-ETS 3.5 Conclusions 4 Long-termcontracts 4.1 Background 4.2 Benefitsoflong-termcontracts 4.3 Risksoflong-termcontracts 4.4 Otherfactors 4.5 Conclusions 5 Conclusions Bibliography Tables 1 KeycharacteristicsofEUelectricitymarkets 2 Internationalinterdependence 3 Competitioninretailandgenerationmarkets 4 Levelofcustomersswitchingsupplier 5 Networkunbundling 6 Marketopening 7 Regulatoryrole 8 Electricityforhouseholds averagepricebycountryofonekwh 9 Coefficientsofvariationforregionalelectricitymarkets 10 Estimatesofpriceimpactsofemissionstrading Figures 1 Regulatoryindependence 2 DevelopmentoftheaveragepriceofonekWhfordomesticelectricityconsumption 3 DevelopmentoftheaveragepriceofonekWhforindustrialelectricityconsumption 4 Priceconvergence coefficientofvariation 5 Estimatedbreakdownofexpectedelectricityprices2004 6 EvolutionofthepriceofanEUemissionsallowance 7 Differencesbetweenmarginalcostsandwholesalepowerprices 8 SparkspreadsofUK,DE,andNLbeforeandafterEU-ETS 3

Introduction ThisreportwascommissionedfromEASACbytheEuropeanParliamentCommitteeonIndustry,Researchand Energyaspartofitsover-archingframeworkcontract. TheEuropeanCommissionrecentlyputforwardadetailedreportdescribingprogressinthecreationofthe internalelectricity(andgas)market 1 andisplanninganotheroneoncompetitiveness in gas and electricity to comeinthefirsthalfof2006.inpreparationforthis,atleastwhereitreferstotheelectricitymarket,the EuropeanParliamenthasrequestedananalysisofsomeimportantissues,namely: 1 thecharacteristicsofthemainelectricitymarketswithintheeusinglemarket 2 anassessmentofthepricingstructuresandcomparisonbetweenmarkets,showingpricetrends 3 theimpactonpricestoend-usersofemissionstradingcertificates/allowances 4 theimpactoflong-termcontractsontheefficiencyofelectricitymarkets Ourreportisbasedonthecontributionsandinputofthefollowingexperts,workingonavolunteerbasis: ProfessorJohnFitzGerald,EconomicandSocialResearchInstitute,Dublin,Ireland ProfessorJean-MichelGlachant,UniversityParisSud,France ProfessorFerdinandGubina,UniversityofLjubljana,Slovenia ProfessorDavidNewbery,UniversityofCambridge,UK ProfessorWolfgangPfaffenberger,BremenEnergyInstitute,InternationalUniversity,Germany ProfessorPekkaPirilä,HelsinkiUniversityofTechnology,Finland TheexpertsweresupportedbyasecretariatconsistingofChrisDoyle,StephenHansenandFionaSteiger.The reporthasbeenreviewedbytheeasaccouncil. 1 COM(2005)568final,CommunicationfromtheCommissiontotheCouncilandtheEuropeanParliament,Reporton Progressincreatingtheinternalgasandelectricitymarket,{SEC(2005)1448} 4

Summary ThroughthelegislationbeingimplementedatEuropeanUnionleveltheEUwillhavethemostintegratedenergy marketintheworld:from1july2007boththedomesticandindustrialmarketswillbefullyopen.additionally, thelegislationseekstheunbundlingofproductionandsupplyactivitiesintheenergymarkets. ThisreporthasbeencommissionedtofacilitatefurtherconsiderationoftheelectricitymarketswithintheEUby themembersoftheindustry,researchandenergycommitteeoftheeuropeanparliament.itconsidersfour areas:themaincharacteristicsoftheeuelectricitymarkets,theirpricestructures,howtherecentlyimplemented emissionstradingallowancesschemewillimpactonthepriceschargedtoend-users,andhowlong-term contractswillimpactontheefficiencyoftheelectricitymarkets. ElectricitymarketswithintheEUarehighlydiverse.However,ingeneralitisclearthatinterconnectivityislow andthatpricingiscomplexanddependentontheregulatoryframework,capacityandglobalenergyprices. EmissionTradingAllowancesarealsocomplexandhavethecapacitytoaffectpricesandgeneratingmix,though itistooearlyforanysucheffectstobeclear.long-termcontractsarenecessaryforimprovedstability,efficiency andcompetitiveness. Characteristics of the electricity markets TheelectricitymarketsoftheEUaregenerallydividedintosixregions,someofwhich,suchastheBalticregion orthenordicregion,arerelativelyhomogenousentitieswithanoperatingregionalmarket,whileothers,suchas thewesterneuropeanregion,arenotyetveryintegratedbutsharesimilarcharacteristics.cross-bordertrade currentlyaccountsforonlyabout8%ofeuelectricityconsumption,afigurethatcanbeattributedtoalowlevel ofinterconnectingcapacitybetweenmemberstatesandtherelativeisolationofnationalmarkets. Thecharacteristicsofthemarketsconsideredinourstudyare Internationalinterdependence Competition Networkunbundling Publicvsprivatesectors Regulation ItisnotpossibletomakebroadgeneralisationsabouttheEUelectricitymarketsacrossanyofthese characteristics,andevenataregionallevelthemarketsareoftenmoreconceptualthanactualfunctioning entities.however,oneparameterwheremoreofadistinctiveregionalsimilaritycanbeseenisintheopeningup ofthemarkets,withthenewaccessioncountriesgenerallyshowinglowerdegreesofmarketopeningthanthe EU-15states.Buteventhatdistinctionisnotaclearone.ThoughtheultimateaimofEuropeanelectricitypolicy istocreateaneu-widemarketforelectricity,thereiscommonagreementthatthisisstillsomewayoffandthat atthisstageitwouldbeprematuretotalkofan EUmarket forelectricity. Pricing structures ExaminingpricestructuresintheEUelectricitymarketsisnotsimplebecauseofthemarketliberalisationthathas alreadytakenplace,whichhasledtomanymorecompetingtariffsandcompaniesnotbeingeagertoshare commerciallysensitiveinformation.however,theeuelectricitymarketssharemanysimilarpricingstructures, includingmoreflexibletariffsforindustrialusers. 5

6 Whilethepricestructuresarelargelysimilar,areasofdifferencedoexist,includinganumberofMemberStates offeringsocialtariffstodomesticcustomers,usuallythepoorordisadvantaged.valueaddedtaxischargedon electricityinallthememberstates,thoughtheaccessionmemberstendnottohaveanyextrataxesonelectricity whiletheeu-15largelydo.notsurprisingly,unregulatedmarketsoffermoretariffs,structuresandservicesto customers. Themediantrendforprices,exclusiveoftaxes,wasdownwardbetween1995and2000forbothdomesticand industrialusersofelectricity.priceswerethenstableforfiveyearsbeforebeginningtorisein2005.theprice decreasesafter1995wereconsistentwiththepredictedeffectsofmarketliberalisation,butitshouldalsobe appreciatedthatenergypricesfellandproductivityrose,bothofwhichwouldcontributetofallingelectricity prices.itisnotjustmarketliberalisationthatcancauselowerprices.conversely,thestabilityinpricesandthen therecentrisesdonotmeanthatliberalisationhasceasedtobeeffective;risesinthepriceofgasandoilhave impactedonelectricitypricesinthepastyear.moreover,whenliberalisationbegantheeuropeanelectricity markethadexcesscapacity;thishasnowdwindled,leadingtoanupwardpressureonprices. Interconnectionofelectricitysupplyandprovisionwouldlogicallyseemtoleadtoaconvergenceofprices.The evidenceseemstosupportthisastheregionsacrosstheeuhavemoreconvergenceinpricesthantheeu-25as awhole.however,thesamepricecanhaveadifferentimpactindifferentcountrieswhenenergypricesare convertedtoapercentageofthecostofliving. Insummary,theformatofelectricitypricesiscommontomostEUcountries,withindustrialconsumershavinga widerchoiceoftariffsthandomesticcustomers.priceshavedroppedsinceliberalisationbegan,butdidincrease in2005,foranumberofreasons.sincethemarketsbegantoopenpriceshavebeguntoconvergeatregional level,thoughnotacrosstheeuasawhole. Emission trading allowances AnewimpactonpricesistheEmissionsTradingSchemewhichstartedin2005aspartoftheEU scommitment tomeetingitskyototargets.underthescheme,businessesthatemitcarbondioxidemustholdallowancesat theendofeachyearequaltothevolumeofco 2 emitted.iftheydonothavesufficienttocovertheiremissions theymustbuyextraallowancesontheopenmarket,butconverselytheyarealsoabletosellunusedallowances ontheopenmarket.thepriceoftheallowancesisnotfixedbutwillrespondtothedemandsofthemarket place.inthesecondhalfof2005thepriceofanallowancestabilisedaftershootingupinthesummer.the factorsbehindthesuddenrisewouldseemtobetherapidincreaseingasprices,thedroughtsinsouth-west Europeandextremeweatherinspringandearlysummerleadingtounexpectedlyhighdemandforenergy. OnlyayearintotheschemeithasbeendifficulttoquantifytheeffectthatEmissionsTradingAllowances(ETAs) havehadonthepriceofelectricity,buttheirimpactseemstobedifferentonwholesalepricesthanonend-user prices.theorysuggeststhatcostswillbepassedontoconsumers,unlessasignificantproportionofenergy comesfromzero-emissionssources.buttherearealsoscenariosthatsuggestthatnosignificantrisechangeswill result.thereiscertainlythepotentialfortheschemetoalterthegeneratingmix,however,ifcostsforcheapbut environmentallyintensivesourcesriseabovethoseformoreexpensivebutcleanertechnologies. AnalysisbyDavidNewberyhasledtotheconclusionthatmostoftheallowancecosthasbeenpassedthrough intothewholesaleprice.theimpactonend-userpricesseemstobelessthanonthewholesaleprice,because mosteuropeanhouseholdsareonregulatedtariffswhichareprotectedfromcostsarisingfromtheetas. Industrialcustomers,althoughgenerallyoperatinginfreemarkets,can,insomecountries,switchbackto regulatedtariffs.thelong-termcontractsthatsomeindustrialusersareonareonlypartiallylinkedtothe wholesalemarkets;sofar,thishaslessenedtheimpactofetasonindustrialend-userprices.atthisstage, though,wewouldemphasisethatitisstilltooearlyinthelifetimeoftheetastoconductmeaningfulanalysis.

Long-term contracts Althoughlong-termcontractsareusedintheEUitisdifficulttosayexactlyhowmuchofthemarketiscovered bythem.long-termcontractsarethemeansforindustrialelectricityuserstoshieldthemselvesfromthevolatility ofthemarket.thisstabilitypersuadesplayersinthemarkettotaketheriskofparticipating.thelackoflongtermcontractsisconsideredtobethesolereasonbehindthecaliforniaelectricitycrisisin2000-01. Themainadvantageoflong-termcontractsisthattheyencourageinvestmentinaverycapital-intensive,slowreturnindustrybyallowinginvestorstomanagetheirinvestmentrisk.Ifcustomersarenotpreparedtosign contractsformorethanacoupleofyearsthennewentrantswillnotbeencouragedtoenterthemarket.by beingabletolockinasecurerevenuefromlong-termcontractsnewfirmsarelikelytobepreparedtoenterthe market,whichpromotesfurthercompetitiveness. Aswellasgivingnewproviderstheincentivetoentertheelectricitymarket,long-termcontractsservetoaid efficienttimingofessentialmaintenanceworktoelectricityplantsasgeneratorsscheduletheirworkforthe cheapesttimesinthemarket,whichiswhenthereareplentyofothersourcesofelectricityavailablefor customers. Contracttradingwouldbefundamentaltotheefficiencyimpactoflong-termcontractsontheelectricity markets:withaliquidandfunctioningmarketforlong-termcontractsitislikelythattheriskreducingand efficiencyenhancingconsequencesofthecontractswoulddominate.however,inasmall,staticmarketitwill haveanegativeeffect. Anotherargumentinfavouroflong-termcontractsisthattheycoulddiscouragecollusionashighrewardsgive theprovideranincentiveto cheat onacartel.astheshort-term, spot,marketbecomeslessofasourceof incomeforproviders,thequantityofincomegainedthroughcollusiondeclinesandsocollusiveactivitybecomes lessattractive. Theconclusionamongcommentatorsisthatlong-termcontractswouldimproveefficiencyintheelectricity industryduetothreemainbenefits:stabilityofprices,encouraginginvestmentandunderminingexploitationof marketpower.however,long-termcontractswillnotsolvemismatchesbetweenmarketdemandandsupply. 7

1 Characteristics of the main electricity markets ThissectionofthereportwillfirstlistthekeycharacteristicsofthemainEUelectricitymarkets.Afterconsidering whatwemeanby maineuelectricitymarkets,wethenexaminethemarketsbyarangeofindicators includinginternationaldependence,competitivenessandnetworkunbundling. 1.1 Main electricity markets InitsMarch2004strategypaperMedium-term vision for the internal electricity market,theeuropean Commissionsetoutitscurrentpolicywhichisbasedonaregionalstepping-stoneapproachtowardselectricity integration.themedium-termaimissuccessfulintegrationofcountriesintolocalregionalmarkets;withthis thenultimatelybeingfollowedbyfurtherintegrationintoafully-fledgedeuropeanmarket. Currently,cross-bordertradeisrelativelylowatabout8%ofEUelectricityconsumption.Thiscanbeattributed tothepreviousrelativeisolationofnationalmarkets.therehasalsobeenanhistoricallackofinterconnecting capacitybetweencountries,withcriticalbottlenecksinsomeareas,thoughtheeuropeancouncilmeetingin Barcelona2002attemptedtotacklethisbyinsistingthatcountriespossessinterconnectingcapacityequaltoat least10%oftheirgeneratingcapacity. ThoughtheultimateaimofEuropeanelectricitypolicyistocreateanEU-widemarketforelectricity,thereis commonagreementthatthisisstillsomewayoffandthatatthisstageitwouldbeprematuretotalkofan EU market forelectricity. Itmakessensetotalkof regionalmarkets ontwolevels.first,thereareexamplesofregionswherecountries do,tosomeextentatleast,haveanoperatingregionalmarket suchasthenordicmarketandtoalesser extenttheiberianmarket.secondandmorebroadly, regionalmarkets tendtogroupcountriestogetheronthe basisofsimilarmarkets,commonregionalcharacteristicsandculturalandphysicallinkswhereitisimagined that,intime,thesecountriescouldlikelyformthebasisoftrueregionalmarkets. Thus,itisimportanttonotethelimitationofdiscussingregionalmarkets-thatnotall regionalmarkets actually functionastruemarketsatthistime(easterneuropeforexample).itremainsnecessarytoexaminecountries individuallyaswellascollectively,asformostcountriestheelectricitymarketwouldmostcorrectlybedefinedon anationalratherthanaregionalbasis. Thereexistsroughlybroadagreementonregionalmarketdefinitions,thoughthereisnotunanimityonthe classifications.herewediscusssixareasandthedegreetowhichtheyarefunctionalasaregionalmarket: (i) (ii) Western Europe: Austria, Belgium, France, Germany, Luxembourg, Netherlands, Thisrepresentsthemajor(nascent)regionalmarketforelectricitywithintheEU.Thoughitdoesnotyet representatrueintegratedmarket,therearealreadysignsofitdeveloping forexampleinaustriaand somepartsoffranceandgermanyacommonwholesalepriceareahasdevelopedbecauseofthehigh leveloflocalinterconnection. Iberia: Spain and Portugal MovestowardsasingleIberianelectricitymarketstartedin1998.November2001sawthesigningofa CollaborationProtocolinwhichitwasstatedthattheaimwastocreateasingleIberianmarketfor electricity.thefirststageoftheprocesswillbetheestablishmentofacommonwholesaleelectricity market,withconvergenceoftheretailmarketstofollowlater.althoughitwasinitiallyintendedforthe 8

(iii) (iv) (v) (vi) Iberianmarkettobeginoperatingon1January2003,thishasbeendelayedbecauseofchangesinthe politicalsituation thoughfurtheragreementshavebeensignedsincethen. UK and Ireland Thoughtherearelinkagesbetweenthem,anddiscussionsofextendingtheseinthefuture,theUKand Irelanddonottrulyformasinglemarket,buttheydostandtogetherasisolatedislandsinNorthwest EuropewithlimitedscopeforconnectiontotherestofEuropeintheimmediatefuture.Therehasalso beensignificantprogressinachievingintegrationwithinthisregion,ieimprovinginterconnection betweentherepublicofirelandandnorthernireland,andbetweenengland,walesandscotland. Nordic: Denmark, Finland and Sweden (and also Norway) TheNordicmarketrepresentsthegreatestdegreeofintegrationofanyoftheregionalEUmarkets.This integrationhasbeendevelopingoveranumberofyears,andtheregionnowboaststheremovalof separatebordertariffsandacommonwholesalemarketforelectricitysharedbetweendenmark, Finland,SwedenandNorway the NordPool.TheshareoftradingthroughtheNordPoolhasrisento 40%oftotalelectricityconsumptionin2004,withtherestthroughbilateraltradesdirectlyorusing over-the-counterservices.thelevelofpricesettinginthepoolisgenerallydominatedbyhydropower producersbecauseoftheirlowmarginalcostsandtypicalstatusasmarginalproducers;thoughthis dependsuponhydrologicalconditionswhich,whenpoor,candrivepricessignificantlyhigher. UndernormalloadconditionstheinterconnectionsbetweendifferentareasoftheNordicpowersystem aresufficienttofulfillalltransmissionneeds,butundervariouscircumstancesbottleneckslimit transmission.therefore,bynomeansarethesecountriesfullyintegrated;infactforabouthalfofthe hoursoftheyearthemarketareaissplitintoseveralpriceareasasthetransmissionnetworkcannot cope.whenthissortofsplittingoccurs,pricesaredeterminedseparatelyforeachpriceareaassuming thattheinterconnectionsbetweeneachareaareusedfully.thereareplanstoreinforcethenetworkat severalkeypoints,asthesesplitssignificantlycompromiseoperationofthemarket;inaddition,thefact thatthisproblemissoacuteinsuchastronglyinterconnectedareathrowsdoubtuponplanstoextend themarkettoareaswithmuchweakerconnectionsanytimesoon. Baltic: Estonia, Latvia, Lithuania InFebruary2000,Estonia,LatviaandLithuaniadecidedtocreateacommonBalticelectricitymarketand establishtransmissionlinksbetweenthethreecountries;thethreecountriesnowhaveajointpower poolknownas BalticIPS.OneofthemajorobjectivesoftheBalticIPSsystemistheenhancementof regionalcooperationanditsintegrationintothewesterneuropeanelectricitymarket.thereareplans forimprovementstothetransmissiongrid,throughinterconnectingitwiththepolishelectricitysystem. Ithasbeennotedthatthiscross-bordertransmissionprojectbetweenLithuaniaandPolandisofgreat importanceforthedevelopmentofanintegratedeuelectricitymarketandfortheimprovementofthe reliabilityofsupply. Eastern Europe: Czech Republic, Hungary, Poland, Slovakia and Slovenia TheEasternEuropeancountriesareintheearlystagesofelectricitymarketreformandhavesomeway togobeforetheyformatrueregionalmarket.however,havingelectricitymarketsinsimilarstatesof evolutiontheycanconceptuallybeusefullygroupedtogether. AdaptationoflawswithinthereformsandtheirinterpretationindifferentEasternEuropeanmarkets varies,leadingtodifferentmarketdevelopments.asanexample,coordinatedexplicittransmission capacityauctionsbetweenthepolish,czech,slovakandgermantransmissionsystemoperatorsare 9

takingplace.similarly,sloveniawithitsadoptionoftheeuropeanmarketmodelinfluencesthebalkan powerregion. ThecentralEuropeannetworkgetscongestedbecauseoftheprioritygiventorenewables.With20GW ofelectricityingermanyrequiredtobesourcedfromwindenergy,atcertaintimes(windpeak,low electricitydemandandwindnotbehavingasprojected)plannedtransactionshavetoberescheduled andtheeffectsarefeltoutsidethegermanborders.thisisanobstacletotradeinthenetwork.experts agreethatfluctuatingwindenergyhastobeintegratedintothesystemmanagement.atpresentthat wouldbeillegal. Inaddition,thereareseveralcountriesthatdonotfitintoanyoftheseregionalmarketsneatly:Malta,Greece andcyprusfallintothiscategorybecauseoftheirisolatedgeographiclocations.herewealsoincludeitaly, whichdoesnotfitwellintoanyonemarket somecommentatorsplaceitintheiberian( SouthernEurope ) market,somethewesterneuropean,whileothersargueitisaspecialcaseforvariousreasonssuchasits locationanditsrelativelaginestablishingacompetitivegenerationmarketandnationalelectricitypool. Weusethesedefinitionsofregionalmarketswhereitmakessensetodoso,butfocusuponnationalmarkets wherethisprovidesamoreaccuratescopeofanalysis.therefore,whereitappearstherearemeaningfulregional trends,weprovideregionalfigures. Table1givessomekeyfiguresonelectricityproductionandconsumptionfortheEUonacountrybycountry basis.whatisimmediatelystrikingisthevariation,particularlybyfuelmix.notealsothatthisvariationshowsno regionalpattern:thereisasmuchvariationwithinregionsasbetweenregions. ForexampleintheNordiccountries,Swedenusesverylittlecoal,whileFinlandandDenmarkaresignificantusers ofitasafuelsource.ineasterneurope,polandisalmostentirelyreliantuponcoal,whilstothercountriesinthe regionuseitfarless:slovakiaandsloveniaaremuchlargerusersofnuclearenergy,whilsthungaryisalso significantlydependentupongas.nuclearenergyhasavarieduseacrosstheeu:franceandlithuania,for example,useover77%and79%respectivelyastheirsourceofelectricityproduction,while12countries, includingaustria,cyprusandpolanddonotuseanynuclearenergy.twoofthenewestandsmallesteu countries,maltaandcyprusareentirelydependentonoilfortheirenergyproductionbutafewcountries, includingtheczechrepublicandestoniauselessthan1%oil. Onusage,againthereisnoconsistencyacrosstheEU-25countries,withsomecountries,suchastheUK, HungaryandFrancehavingtheirhighestusageamongresidentialcustomerswhileinotherssuchasGermany, FinlandandPolandindustryusesmostelectricity. 10

Table 1 Key characteristics of EU electricity markets Total electricity production* (GWh) Totalfinal consumption* (GWh) Coal % Oil % Gas % Electricityproductionfuelmix Biomass % Waste % Nuclear % 11 Hydro % Other % Industry % Transport % Consumptionusage Agriculture % Commercial andpublic services% Residential % Austria 63,173 60,848 14.9% 2.8% 17.8% 2.6% 0.6% 0.0% 60.7% 0.6% 40.3% 5.4% 2.0% 25.0% 27.2% 0.0% Belgium 84,630 79,732 13.7% 1.2% 25.5% 0.7% 1.3% 56.0% 1.6% 0.1% 50.2% 1.9% 0.4% 14.9% 32.6% 0.0% Cyprus 4,044 3,637 0.0% 100.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 13.9% 0.8% 3.1% 44.9% 35.6% 1.6% CzechRepublic 83,227 52,407 62.0% 0.4% 3.7% 0.6% 0.0% 31.1% 2.2% 0.0% 39.2% 4.2% 2.1% 24.0% 27.7% 2.8% Denmark 46,264 32,434 54.7% 5.1% 21.2% 3.6% 3.2% 0.0% 0.0% 12.2% 30.1% 1.1% 5.9% 31.3% 31.7% 0.0% Estonia 10,159 5,573 92.2% 0.4% 6.9% 0.3% 0.0% 0.0% 0.1% 0.1% 36.4% 1.7% 3.7% 29.5% 28.6% 0.0% Finland 84,228 80,843 31.8% 1.1% 16.6% 11.2% 0.9% 27.0% 11.4% 0.1% 54.8% 0.8% 1.1% 18.1% 25.2% 0.0% France 566,902 408,433 5.2% 1.5% 3.0% 0.3% 0.6% 77.8% 11.3% 0.2% 32.5% 2.9% 0.8% 27.5% 34.5% 1.7% Germany 599,470 509,265 52.4% 0.8% 9.8% 0.7% 1.5% 27.5% 4.1% 3.2% 45.5% 3.2% 1.5% 22.4% 27.4% 0.0% Greece 58,478 48,595 60.1% 14.9% 13.7% 0.2% 0.2% 0.0% 9.1% 1.7% 29.1% 0.5% 5.7% 30.8% 33.8% 0.0% Hungary 34,145 31,396 27.1% 4.8% 34.8% 0.4% 0.2% 32.3% 0.5% 0.0% 30.5% 3.3% 3.4% 27.5% 35.2% 0.0% Ireland 25,235 22,531 32.6% 9.7% 51.7% 0.3% 0.0% 0.0% 3.8% 1.8% 31.5% 0.1% 0.0% 34.8% 33.6% 0.0% Italy 293,865 291,436 15.0% 25.9% 39.9% 0.5% 1.1% 0.0% 15.1% 2.6% 49.5% 3.2% 1.8% 23.1% 22.3% 0.0% Latvia 3,979 5,201 0.6% 2.1% 38.5% 0.6% 0.0% 0.0% 57.0% 1.2% 30.9% 2.6% 3.1% 35.9% 27.3% 0.2% Lithuania 19,488 7,179 0.0% 1.7% 12.9% 0.0% 0.0% 79.5% 5.1% 0.9% 36.6% 1.3% 2.3% 33.4% 26.4% 0.0% Luxembourg 3,620 6,015 0.0% 0.0% 72.1% 0.5% 1.3% 0.0% 25.3% 0.7% 66.1% 1.7% 1.3% 18.4% 12.5% 0.0% Malta 2,236 1,806 0.0% 100.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 30.8% 0.0% 0.0% 34.8% 34.4% 0.0% Netherlands 96,775 100,520 28.4% 3.0% 58.8% 1.3% 2.7% 4.2% 0.1% 1.6% 40.5% 1.6% 4.0% 30.8% 23.2% 0.0% Poland 151,631 98,712 94.0% 1.6% 1.6% 0.3% 0.2% 0.0% 2.2% 0.1% 40.7% 4.8% 4.3% 27.8% 22.3% 0.0% Portugal 46,852 43,164 31.0% 13.2% 16.5% 2.6% 1.2% 0.0% 34.3% 1.3% 39.0% 1.0% 2.1% 30.5% 27.4% 0.0% Slovakia 31,178 22,952 20.5% 2.3% 7.7% 0.3% 0.1% 57.3% 11.8% 0.1% 49.4% 3.2% 4.0% 21.5% 22.0% 0.0% Slovenia 14,019 12,521 36.4% 0.4% 2.6% 0.9% 0.0% 37.1% 22.5% 0.0% 52.6% 1.4% 1.1% 13.2% 24.0% 7.6% Spain 260,727 217,898 29.1% 9.2% 15.1% 1.1% 0.3% 23.7% 16.8% 4.6% 44.2% 2.4% 2.3% 26.3% 24.9% 0.0% Sweden 135,615 129,773 3.1% 2.9% 0.4% 3.9% 0.3% 49.7% 39.3% 0.5% 42.9% 2.2% 1.5% 21.8% 31.6% 0.0% UK 398,620 337,443 35.2% 1.8% 37.3% 1.3% 0.4% 22.2% 1.5% 0.3% 33.8% 2.5% 1.2% 28.2% 34.3% 0.0% EU25 3,118,560 2,610,314 31.8% 5.2% 17.7% 1.2% 0.8% 31.2% 10.4% 1.7% 41.1% 2.7% 1.8% 25.2% 28.8% 0.4% Source: IEA Energy Statistics - 2003 data * Production and consumption differ because of imports and exports, transformation (ie electricity used by heat pumps and electricity used by electric boilers), the energy sector (ie own use by plant and electricity used for pumped storage), and distributional losses. ** This is against total domestic production. The EU figure is weighted by electricity production for fuel mix, and electricity consumption for use. Other %

1.2 International interdependence ByinternationalinterdependencewemeanthedegreetowhichEUcountriesdependuponeachotherfor electricitythroughinternationaltrade;wealsodiscussthecurrentlimitationsontradeimposedbyscarce interconnectioncapacities.thereisanotherdimensiontothisissuethatwedonotdiscusshere,whichisthe degreetowhichcountriesdependupononeanotherforfuelresourcesthattheythenusetogenerateelectricity withintheirownborders. TheImportsandExportscolumnsofTable2showfiguresforactualcross-bordertradeinelectricity,normalised againstdomesticproductionintherelevantcountry.theregionalandeufiguresintable2donotrepresentthe Table 2 International interdependence Imports % Exports % ImportCapacityas a%ofinstalled Capacity* Austria 30% 21% 24% Belgium 17% 10% 29% Cyprus 0% 0% 0% CzechRepublic 12% 32% 23% Denmark 15% 34% 50% Estonia 1% 20% 66% Finland 14% 8% 14% France 1% 13% 13% Germany 8% 8% 11% Greece 7% 4% 12% Hungary 41% 21% 38% Ireland 5% 0% 6% Italy 18% 0% 8% Latvia 67% 1% 100% Lithuania 21% 60% 50% Luxembourg 179% 77% 90% Malta 0% 0% 0% Netherlands 21% 4% 17% Poland 3% 10% 10% Portugal 13% 7% 8% Slovakia 28% 35% 37% Slovenia 43% 41% 68% Spain 4% 3% 4% Sweden 18% 8% 29% UK 1% 1% 3% WesternEurope 9% 10% 15% Iberia 5% 4% 5% UK&Ireland 1% 1% 3% Nordic 16% 12% 27% Baltic 28% 30% 69% EasternEurope 16% 21% 23% EU 10% 8% 13% Source: Report from the Commission on the Implementation of the Gas and Electricity Internal Market (2005) - Technical Annexes UCTE July 2003 forecast, Nordel winter 2003-4 forecast, NGC and ESBNG 7 year statement, ETSO Winter 2004-05 NTC data, includes capacity from Switzerland and South East Europe, excludes Morocco Ukraine and Russia; IEA Energy Statistics - 2003 data. Averages for regional blocks and for the EU are weighted by electricity consumption in each country 13

14 blockasawhole,buttheaveragesofallthecountriesinthatblock.so,forexample,thebalticfiguresrepresent theaverageimportandexportsofallthecountriesinthebalticarea(includingwitheachother),nottheimports andexportsofthebalticareawithotherareas. TheimportcapacitycolumnshowsdatafortheNetTransferCapacities(NTC)ofallcountriesprovidedbyETSO (EuropeanTransmissionSystemOperators).Thisfiguregivesanindicationofthemaximumlevelofexchange betweenagivencountryandallofitsneighboursthatispossibleatonetime.thesentcfiguresarerelatedto installedcapacity,whichistypicallymuchhigherthanpeakload relatingittothiswouldgivehigherfigures. ThefigureforNetherlands,therefore,representsthemaximumthecountrycouldexchangewithBelgiumand Germany-adjacentcountriestowhichitisconnected.Thisindicatesthesizeofphysicalconnections,andhas nothingtodowitheconomicfactorssuchashowmuchpoweritactuallydoesimport,orwhetherlocal countrieswouldbewillingtotradethismuch. TheImportcapacityfigurethereforeillustrateshowinterconnectedacountryiswiththerestofEurope,andto whatdegreeitcouldrelyonimportingelectricityinsteadofgeneratingitlocally.weseeawidevariation.some countriessuchasluxembourgandlatviaaresowellconnectedtheyhavethecapabilitytoimportalmostall theirpower,whilemoregeographicallyperipheralcountriessuchasirelandanditalyhavemuchlowerfigures. Attheregionallevel,theNordicandparticularlytheBalticcountriesonaverageshowrelativelyhighlevelsof internationalinterdependence,whilstukandirelandshowverylittle.theeasterneuropeancountriesshow higherinternationalinterdependencethanwesterneuropeancountries. 1.3 Competition ThekeyaimofelectricityregulationandofrecentDirectiveshasbeentoprovideacompetitiveandsustainable electricitymarket.itisincreasinglywidelyagreedthatthebestwaytoachievethisisthroughanopen, competitivemarket,withentrybyanumberofprivatefirms.thedegreetowhichthishasbeenachievedvaries widelyacrosstheeu;insomecountriessuchastheukthemovetoacompetitiveindustryhasbeenbroadly completed,whileinmanyeasternstatestheprocessisjustbeginning. Forafullycompetitiveelectricitymarket,boththegenerationandretailmarketsneedtobecompetitive.Afirm withadominantpositioninthegenerationmarketcouldperhapsforeclosetheretailmarket,projectingits dominancefromonesectortotheother. Table3giveskeyindicatorsofcompetitivenessinbothgenerationandretailmarkets.Inthegenerationmarket weseethemarketshareofthelargestproducerandlargestthreeproducerscombined;andintheretailmarket weexaminethecombinedshareofthelargestthreeproducersandthenumberofsignificantsuppliers. Itishardtodiscernnotabletrendsamongstthesefigures forexampletheczechrepublicappearstohavea highlycompetitivemarket,butslovakialessso;franceappearstohavearelativelyuncompetitivemarket,while Austriaappearstobetheopposite.Inassessingthecompetitivenessofamarket,however,itisnotonlythe concentrationfiguresthatareimportant:theextentofnetworkunbundling,whichweexamineinthenext section,iscrucialindetermininghoweasilyrivalscanentertheindustrytotackleanyexcessivelevelsofprofit. ItisalsonotablethatelectricitycompaniesintheEUhaveengagedinsignificantmergerandacquisitionactivity inrecentyears,drivinghigherconcentrationlevels.althoughmovestowardslargerregionalmarketsoraneuwidemarketcouldcountertheserisingconcentrationlevelsinthelongerterm,intheshortertermthistrend couldbeacauseofconcernasitcouldgivecompaniesmarketpowertoraiseprices. However,notallintegrationhasbeenhorizontalinnature.Recentyearshavealsoseenatrendinvertical integration,withgeneratorsandretailerscombining.thishasalogicaleconomicreasonbehindit,inthatit allowsfirmssignificantlytoreduceriskasreturnsatonelevelareinverselyrelatedtoreturnsattheother:higher

electricitypricesimplygreaterreturnforgenerators,butlowerreturnsforretailers.therefore,combiningthe twocanclearlyeliminatemuchofthisvariationandrisk,providingagoodargumentforallowingthesetypesof mergers. Infact,asJamasbandPollittnote,inpre-liberalisationdaysthemarketwasorganisedonthebasisofvertically integratedorganisations,withrestructuringoftenattemptingtoreducethis,onlytoseeprivatisedutilities attemptingtoreversethisandre-integrate.thereasonforlesserefficiencyofthehorizontalstructuremayliein theinadequatemarketdesignwithnumerousflawsandcrosssubsidies,leadingtofrequentchangesofthe marketmodel. Table 3 Competition in retail and generation markets Numberofsuppliers withmarketshare >5% Retailmarket Top3suppliers'share (allconsumers)* 15 Generationmarket Largestproducerby capacity** Top3producersby capacity** Austria 4 67% 45% 75% Belgium 2 ~90% 85% 95% Cyprus 1 100%(1) 100% 100% CzechRepublic 8 46% 65% 75% Estonia 1 n/a 90% 100% France 1 88% 85% 95% Germany 3 50% 30% 70% Greece 1 100% 100% 100% Hungary 7 56% 30% 65% Ireland 4 88% 85% 90% Italy 6 35% 55% 75% Latvia 1 99% 95% 100% Lithuania 1 100%(1) 50% 80% Luxembourg 2 100%(2) n.a. n.a. Malta 1 100%(1) 100% 100% Netherlands 3 88% 25% 80% Poland 3 32% 15% 35% Portugal 3 99% 65% 80% Slovakia 4 84% 75% 85% Slovenia 6 71% 70% 95% Spain 5 85% 40% 80% UK 6 60% 20% 40% Nordicmarket- Denmark 5 67% Finland 6 30% 15% 40% Sweden 4 70% Source: Report from the Commission on the Implementation of the Gas and Electricity Internal Market (2005) - Technical Annexes. The figures for the generation market for Denmark, Finland and Sweden include Norway. *Includes both eligible and non-eligible markets **Rounded to nearest 5% For household customers Consolidation is currently occurring in Poland Anotherimportantstatisticrelatedtocompetitioniscustomerswitching,whichdemonstratesthetendencyof customerstomovebetweenrivalsuppliers.highlevelsofswitchingdrivecompetitionbetweencompetitors,as firmsknowtheywillrapidlylosemarketshareiftheypriceuncompetitively,sotheymustconstantlystriveto delivervaluetocustomersandestimatetheirdegreeofsatisfactionwithservices.

Table4showsthedegreeofconsumerswitchingforbothlargeindustrialandsmallercommercialordomestic usersoverarangeoftimeframes.aclearregionaltrendisinitiallyvisiblehere allthecountriesinthenordic anduk&irelandregionshaveseenover50%ofindustrialswitchingsincemarketopening howeverthismost probablyreflectsthefactthatthesemarketshavebeenopenlongerthanthoseofsomeotherregions.during 2003,thehighestswitchingcountriesincludedtheNordiccountriesofDenmarkandFinland,butalsothe EasternEuropeancountriesofHungaryandLithuania:inotherwordsitisdifficulttoidentifymeaningfulregional trendsinthesefigures. Table 4 Level of customers switching supplier Largeeligibleindustrialusers* Smallcommercial/domestic Sincemarket opening During2003 16 Sincemarket opening During2003 Austria 22%** 7% 3% 1% Belgium 35% 8% 19% 19% Cyprus 0% 0% CzechRepublic Denmark >50% 22% 5% 5% Estonia 0% 0% Finland >50% 16% 4% France 22% Germany 35% 6% Greece 0% 0% Hungary 24% 19% Ireland >50% 6% 1% 1% Italy ~15% Latvia 0% 0% Lithuania 17% 17% Luxembourg 10% Malta 0% 0% Netherlands 30% 35% n.k. Poland 10% 7% Portugal 9% 7% 1% 1% Slovakia 10% 3% 4% Slovenia 10% 10% Spain 18% 5% 0% 0% Sweden >50% 5% n.k. 10% UK >50% >50% 22% Source: Report from the Commission on the Implementation of the Gas and Electricity Internal Market (2005) - Technical Annexes; Regulators. * In general this refers to clients consuming more than 1GWh/year ** 100% have renegotiated with their existing supplier Flanders region only The remaining approximately 65% have renegotiated with their existing supplier A further approximately 25-50% have renegotiated with their existing supplier Corresponds to 19% of high voltage customers consumption Approximately 18% have renegotiated with their existing supplier Consumerswitchinghaslimitationsasanindicatorofthestateofcompetitioninamarket.Inmanymarketswe observelowratesofconsumerswitchingbecauseofhighlevelsofcompetition,whichensuresallproducers pricelowsothatthereisnoneedforconsumerstoswitchtoanotherproducer.thereforewewouldtypically expecthighlevelsofswitchinginthebeginningofamarketopeningprocess,andhighratesforlargeconsumers becausesmallpricedifferencescanbefinanciallyimportant.intheoftenregulatedresidentialmarket,regulation itselfcankeepswitchingrateslowbecauseitleadstopriceconvergence.

1.4 Network unbundling Networkunbundling theprovisionofopenthird-partyaccesstothegridincludinglegalseparationofmarketorientedactivitiesandtransmission/distributionnetworkownershipandoperation isgenerallyrecognisedasan essentialstepincreatingefficientandcompetitiveelectricitymarkets.transmissionanddistributionnetworks are,bytheirverynature,naturalmonopolieswherethereislittlescopeforcompetition.itisthereforeimportant thatthesefunctionsareverticallyseparatedfromthepotentiallycompetitivegenerationandretailsupplysectors, andthataccesstothesenetworksisnon-discriminatoryandcost-reflective.thisfacilitatescompetitionandthe entryofrivalfirms,whichneedtousethesenetworkstocompete,andalsopreventscross-subsidyofgeneration bytransmission.theevidencetodateisthatverticalseparationofnetworkscanyieldsignificantbenefits. Itisimportanttodistinguishbetweentheverticalseparationofthenetworkfunctionsfromothersectorsinthe verticalchain,andseparationofgenerationandretailingfunctionsfromeachother.verticalintegrationofthe latterkindhasajustifiedeconomicreason,inthatitallowsfirmstoreduceriskexposure,whichiswhyitisa commonlyseenphenomenon:generatorsandretailersareexposedtooppositepricerisks whenelectricity pricesrisegeneratorsgainandretailerslose(iftheyhavesoldtofinalconsumersatanagreedprice),andvice- Table 5 Network unbundling Ownershipunbundling Transmission system operator Distribution systemoperator 17 Unbundlingindex(5max) Transmission systemoperator Distributionsystem operator Austria Legal Legal 4 3 Belgium Legal Legal 4 3.5* Cyprus Management None 2 1 CzechRepublic Legal Accounting 3 2 Denmark Legal Legal 4 3 Estonia Legal Legal 3 3 Finland Ownership Accounting 5 1.5 France Legal Management 4 1 Germany Legal Accounting 4 1.5 Greece Legal None 1 0 Hungary Legal Accounting 3 1 Ireland Legal Management 3 3 Italy Ownership Legal 5 3 Latvia Accounting Accounting 3 3 Lithuania Legal Legal 4 4 Luxembourg Management Management 1 1 Malta ** - 1 Netherlands Ownership Legal 5 3 Poland Legal Accounting 3 0 Portugal Ownership Accounting 5 3 Slovakia Legal Management 3 1 Slovenia Legal Accounting 3 1 Spain Ownership Legal 5 4 Sweden Ownership Legal 5 4 UK Ownership Legal 5 4.5 Source: Report from the Commission on the Implementation of the Gas and Electricity Internal Market (2005) - Technical Annexes *Brussels region not yet legally unbundled and no compliance officer in Flanders region ** Single buyer model

versa.byintegrating,thesetworiskswilllargelyoffseteachother;themergershouldnotraiseanti-trustissues providedthatbothgenerationandretailmarketsaresufficientlycompetitive. Table5showstheextentofownershipunbundling thatiswhetherthenetworkoperatorshaveaseparate ownershiporlegaltreatment,whethertheyaresimplyunderseparatemanagementormerelyhaveadistinct accountingtreatment.theunbundlingindexfollowsjamasb&pollittinassessingarangeoffactorstocreatea scorereflectingthedegreeofunbundlinginacountry. 2 Thislooksatwhetherthesystemoperatorshave publishedaccounts,acomplianceofficer,separatecorporateidentities,separatelocations,andwhether transmissionsystemoperators(tsos)areownershipunbundledanddistributionsystemoperators(dsos)are legallyunbundled.ascoreofzeroindicatesaverylowlevelofunbundling,whileascoreof5demonstratesthat unbundlingisataveryadvancedstage. Noteagainthelowlevelsofregionalcorrelation,andthatWesternEuropeancountriesbynomeansalwayshave moreunbundledmarketsthanmorerecentmembersoftheeu. 1.5 Public vs private sectors AllEUelectricitymarketsaremovingtowardsfullmarketopening,andtheendingofstatemonopolies,though theydifferinhowfaralongthisprocesstheyhavegone.table6demonstrateshowthisvariesacrosstheeu, andillustrateshowthisvariesfromcompletemarketopeningtonoopeningwhatsoever.insomemarkets,such astheuk,thisprocessofmarketopeninghasbeencompletedforsometime.however,inothers particularly therecentmembers theprocessofliberalisationstillhassomewaytogo. ThisisillustratedinTable6,whichshowstheachievedextentofmarketopening.Thisstatisticdoesshowclear variationbyregionalmarket.themarketscontainingtheaccessioncountries,thatisthebalticandeastern Europeanmarkets,showmuchlowerdegreesofmarketopeningthantheothermarkets,wherethisismainlyor entirelycomplete. Table 6 Market opening Marketopening Marketopening Austria 100% Malta 0% Belgium ~90% Netherlands 100% Cyprus 35% Poland 52% CzechRepublic 47% Portugal 100% Denmark 100% Slovakia 66% Estonia 10% Slovenia 75% Finland 100% Spain 100% France 70% Sweden 100% Germany 100% UK* 100% Greece 62% WesternEurope 89% Hungary 67% Iberia 100% Ireland 56% UK&Ireland 97% Italy 79% Nordic 100% Latvia 76% Baltic 42% Lithuania EasternEurope 56% Luxembourg 57% EU 85% Source: Report from the Commission on the Implementation of the Gas and Electricity Internal Market (2005) - Technical Annexes * In Northern Ireland, the electricity market is open to non-households 2 Jamasb,Tooraj,andMichaelPollitt.2005.Electricity market reform in the European Union: review of progress toward liberalisation and integration.theenergyjournalspecialissue,11-41 18

Fullmarketopeningandstateownershiparenotmutuallyexclusive.Forexample,theNordicregionboasts completemarketopeningyetitisincreasinglymovingtowardsanoligopolyofthefour nationalchampions Vattenfall,Fortum,StatkraftandElsam. Infact,asJamasbandPollittpointout,theEUelectricityDirectivessaynothingabouttheneedforprivate ownership.ukandportugalhaveseenthegreatestinstancesofprivatisation,whileitalyhasseenprivatisationto alesserextent. 1.6 Regulation Regulationiskeyinanindustrynaturallycharacterisedbyextremelyinelasticdemandanddifficultentry,where firmscaneasilygainmarketpower.table7describesthekeyrolethatregulationplaysacrosstheeu,withthe roleoftheregulatorinlawandtheidentityoftheagencyresponsibleforoversightofthewholesaleand balancingmarket.inthetable, advisory meansthattheregulatorwillbeconsultedbuthasnolegalpowersof enforcement. Table 7 Regulatory role Roleofregulatorincompetition law Monitoringofwholesale& balancingmarket Austria Advisory Regulator Belgium Advisory Regulatorstudies Cyprus CzechRepublic Limitedornoformalrole None Denmark Limitedornoformalrole TSO(NordPool)&competition authority Estonia Limitedornoformalrole None Finland Limitedornoformalrole TSO France Concurrentpowers/regulator Regulator withincompetitionauthority Germany Limitedornoformalrole CompetitionAuthority(BKA) Greece Limitedornoformalrole None Hungary Ireland Advisory Regulator Italy Advisory Regulator Latvia Concurrentpowers/regulator None withincompetitionauthority Lithuania None Luxembourg Malta Netherlands Concurrentpowers/regulator Regulator withincompetitionauthority Poland Advisory Regulator Portugal Advisory Regulator Slovakia Slovenia Spain Advisory Regulator Sweden Advisory TSO UK Concurrentpowers/regulator Regulator withincompetitionauthority Source: Report from the Commission on the Implementation of the Gas and Electricity Internal Market (2005) - Technical Annexes 19

Pricecapsforend-usersarecommoninmostMemberStatesasameansofregulationwherecompetitionisnot yetdevelopedenoughtoguaranteelowprices. GilardistudiestheindependenceofregulatorsinseveralindustriesacrossarangeofEuropeancountries,scoring theagenciesbyasystemhehasdeveloped.itisinspiredbysimilarindicesoftenseenforcentralbanksand consistsoftwenty-oneindicatorsgroupedunderfiveequallyweighteddimensions,namelythestatusofthe agencyhead,statusofthemembersofthemanagementboard,relationshipwithgovernmentandparliament, financialandorganisationalautonomy,andregulatorypowers. HisresultsarepresentedbelowinFigure1.8.UnfortunatelyhisanalysisdoesnotincludeBalticorEastern Europeancountriessowearenotabletogetafullpan-Europeanpicture,howeverthefindingsarestill instructive.notonlydoweseehowindependencevariesacrosstheeu,wealsoseethatcountrieswith regulatorsofsimilarindependenceachievetheirscorefordifferentreasons,suchasfranceanddenmark. Figure 1 Regulatory independence Source: Gilardi, Fabrizio, Delegation to Independent Regulatory Agencies in Western Europe: A Cross Sectional Comparison, Paper prepared for the workshop Delegation in Contemporary Democracies, ECPR Joint Sessions of Workshops, Edinburgh (UK), 29 March - 2 April 2003 1.7 Conclusions ItisnotsimpletogeneraliseaboutthecharacteristicsofEUelectricitymarkets,andinattemptingtodosoitis likelyonewouldmissmuchimportantlocalvariation.so,despiteourdesiretoconceptualisetheeuasconsisting ofahandfulofregionalmarkets,itiskeythatwekeepanationalfocusuntiltalkofregionalmarketsismore reflectedbytherealitiesinpractice. NorcanwemakethebroadassumptionthatWesternEuropeancountrieshavemoredevelopedelectricity industriesthantheireasterncounterparts.infactonanumberofindicestheoppositeappearstobetrue:the 20

BalticcountrieshavemadestrongeradvancementsthanFranceandGermanyinformingatrueregionalmarket andinnetworkunbundling,thoughtheydolaginmarketopeningandincreatingcompetitivemarkets. Forthisveryreason,anyanalysisofEUelectricitymarketscannotbesimple,andthereisnotalwaysaclear unambiguousanswertopolicyquestions.however,thisdoesnotmeanthatnolightcanbeshedonthesubject: inthefollowingsectionswelookatpricingandpricingstructuresandtheeffectsofemissionstradingandlongtermcontractsupontheindustry. 2 European price structures and trends ThissectionofthereportoutlinesfirstelectricitypricestructureswithintheEUandthenpricetrends.Manyof theintendedbenefitsofelectricityliberalisationderivefromlowerprices,sounderstandingtheircurrentstateis importantwhenassessingprogresstowardaneucommonmarket.inturn,long-termtrendsofpricesreflect functioningofthemarket,whichshouldprimarilyincreasetheeffectivenessandproductivityofthepower systems,withlowerelectricitypricesasawelcomeby-product. 2.1 Price structures 2.1.1 Data source and description TheEurostatpublicationElectricity price systems 2004describeselectricitypricestructuresforeachofthe twenty-fivememberstates,andthefollowingdrawsheavilyonthisdocument.itwaswritteninaccordwith CouncilDirective90/377/EECforimprovingpricetransparency,andisthemostthoroughandrecentofficial sourcedealingwithpricestructures. Marketliberalisationhasmadethetaskofsummarizingpricestructuresmoredifficult.Intheeraofstate electricitymonopolies,dataonpricingplanswasmostlystraightforwardandeasilyobtainablebythepublicat large.withmarketopeningneitherisnecessarilytrue(bower).first,liberalreformshavebroughtmanymore competingtariffsintothemarket.second,whereasbeforederegulation,priceinformationforelectricitywas quicklyandreliablypassedbypublicproviderstoeurostat,privatecompaniesnowhaveanincentivetowithhold thesameinformationfromcompetitors(bower). Electricity price systems 2004thereforesuffersfromsomelimitations.Itdetailsthepricingstructureforregulated markets,andinunregulatedmarketsitdescribessuchcontractconventionsashavearisenbetweensuppliers andconsumers.insomeunregulatedmarketsnopricestructureinformationisgiveneitherbecausesuppliers havewithheldinformation,orbecausecontractsaretooidiosyncratic. 2.1.2 Summary of common elements of price structures ThefollowingfeaturescapturethebasicstructureofEuropeanelectricityprices. Tariffsforindustrialusersaremoreflexibleandvariedthantariffsfordomesticusers. Industrialusersareoffereddifferenttariffsaccordingtothevoltageoftheirconnectiontothegrid. Industrialuserspayatariffwiththreedistinctelements:astandingcharge(measuredintimeunits),acharge basedonmaximumcontracteddemand(measuredinkw),andaconsumptioncharge(measuredinkwh). Industrialtariffsreflectthecostofprovidingelectricityservice,sothathigher-voltagecustomerspayahigher standingchargeandlowerper-unitconsumptionchargethanlower-voltagecustomers. Industrialtariffsarenotsectorspecific. Domesticusershaveatariffwithtwocomponents:astandingchargeandaconsumptioncharge. 21

TheconsumptionchargeforbothindustrialanddomesticuserscaneitherbethesameforeachkWh consumed,orvaryaccordingtonightandday,summerandwinter,andpeakandoff-peaktimes. Suppliersimposehigherstandingchargesinexchangeforofferingdiscountsonconsumptionduringcertain timeperiods. Justbecausecountriessharethesamegeneralpricestructureinnowayimplieshoweverthatcountriessharethe sameprices. 2.1.3 Differences in price structure across countries WhilepricestructuresinEuropearebroadlysimilar,somedifferencesdoexist.First,somecountries(including Belgium,France,Greece,Lithuania,andPortugal)offersocialtariffstocertaingroupsofcaptiveconsumers, usuallythepoorordisadvantaged;however,thispracticeisnotwidespread.second,whileallcountriescharge valueaddedtax(vat)onelectricity,theeasterneuropeandbalticregionsdonothaveanyextrataxeson electricityforthemostpart,whereastheeu-15countrieslargelydo.anotherinterestingaspectoftaxationis thatmanyeu-15countriesactuallyexemptenergy-intensivecompaniesfrompayingnon-vattaxesifthey improvetheirenergyefficiency;thusthetaxforcertainindustrialuserscreatesinvestmentincentives.by contrast,domesticconsumerscandolittletoavoidpayingtax. Finally,ofmostrelevanceforthisreportaredifferencesinpricestructurebetweenunregulatedandregulated markets.althoughsection2.1.2abovepointsoutfeaturescommontobothmarkets,unregulatedmarketsstand outforvariousreasons.liberalreformshavebroughtintothemarketmultiplecompanies,eachofwhichoffers tariffsthatarepotentiallymorenuancedthanthoseofstatemonopolies.forexample,inmostcountrieslarge industrialoperationsobtaintheirelectricitythroughbilateralcontractingwithserviceproviders,meaningthat eachcustomercouldintheorynegotiateadifferentpriceplan.also,inmostunregulatedmarkets,companies offerlong-termfixed-pricecontractsthatinsureconsumersagainstpricevolatility,alongwithflexiblebillingand energymanagementservices.moreover,infreemarketscustomerscanobtainnetworkandretailservicesfrom twoseparatecompanies,andpayadifferenttarifftoeach(althoughtheprinciplesofsection2.1.2applytoboth tariffs).aselectricitymarketreformscontinue,onewouldexpectmoreinnovativepricestructurestoemergeas companiesviefornewcustomers. 2.2 Price trends Themainimpactsonpricesthataliberalisedelectricitymarketissupposedtobringarereductionsand convergence;indeed,thesepriceeffectsare'thesinglemostimportantperformanceindicator'ofsuccessful liberalisation(jamasbandpollitt2005).accordingly,thissectionwilldeterminetowhatextentthetwo phenomenaareapparentinthedata. 2.2.1 Evidence of price reductions TheprimarysourceforthissectionistheEurostatpublicationGas and electricity market statistics Data 1990-2005.Figures2and3chartEU-15real(adjustedforinflation)priceswithandwithouttaxesfordomesticand industrialusersovertheelevenyearperiodendingin2005.similareu-25chartsarenotavailablesincedataon theaccessioncountriesismissingbefore2004.theaveragepricewithouttaxesforonekwhofdomestic electricityconsumptionfell6%between1995and2000,atwhichpointitstabilisedbeforecreepingupin2005. Evenmorestrikingisthe12%dropintheaverageindustrialpriceoverthesametimeperiod,althoughmuchof thefallwaswipedoutby2005.moreover,between1997and2003,thepriceforsmallindustrialconsumersfell 20%whilethepriceforlargeconsumersfell9.5%(JamasbandPollitt2005).Whentaxesareincluded,both industrialanddomesticconsumershaveseenpricesrisefrom1995to2005owingtoswedish,german,and Dutchtaxincreasesin2000;however,priceswithouttaxesarethemostrelevantfordiscussingmarket liberalisationsincetaxescauseend-userpricestoriseandfallregardlessofreforms. 22

Figure 2 Development of the average price of one kwh for domestic electricity consumption, EU-15 (1995=100) based on price in Figure 3 Development of the average price of one kwh for industrial electricity consumption, EU-15 (1995=100) based on price in Table8displaysdomesticpricedataatacountrylevelinordertoillustratethattheEUaggregate-pricemasks considerableindividualcountryheterogeneity:denmark,ireland,hungary,thenetherlands,andslovenia experiencedpriceincreasesduring1995-2000and2000-2005,whilebelgium,france,italy,andtheukallsaw pricesfallforbothperiods.furthermore,swedenandirelandbothhadlargepriceincreasesfrom2000-2005. 2.2.2 Interpreting the evidence on price decreases Whilepricedecreasesfrom1995through2000arecertainlyconsistentwiththepredictedeffectsofliberal markets,otherhypothesesarealsoworthconsidering.first,energypricesfellgentlyoverthisperiod(jamasband Pollitt2005).Second,labourproductivitygrowthinthegas,electricityandwatersectorsgrew5.7%ayearfrom 1995-2001(ECCommissionReport2004).Inotherwords,fallingcostsofproductionmightexplainfalling prices.thesepointsdonotdiscredittheimpactofliberalisation,butdoshowthatmanydifferentfactorscan potentiallydriveelectricityprices. Alongthesamelines,theflatpricesafter2000andthepricerisesfrom2004-2005donotinthemselves establishthatprogressinelectricitymarketshasstalledorreversed,thefearofwhichpromptedtheeuropean CommissiontolaunchaninquiryinJune2005intorestrictedordistortedcompetitionwithintheEU(EC CommissionReport2005).Forexample,gasandoilpriceshaveincreasedevenmorethanelectricitypricesinthe recentpast.sincegasplaysamajorroleineuropeanelectricitygenerationonecouldreasonably 23

Table 8 Electricity for households - average price by country of one kwh, without taxes - in cent 1995 2000 2001 2002 2003 2004 2005 Change 1995-2000 (%) Change 2000-2005 (%) EU-25 10.0 10.46 EU-15 11.02 10.31 10.27 10.33 10.34 10.3 10.74-6 4 Austria 9.49 9.45 9.32 9.26 9.81 9.64 2 Belgium 12.31 11.71 11.84 11.37 11.2 11.45 11.16-2 -5 Cyprus 8.45 9.9 8.45 9.15 9.28 9.15 9 CzechRepublic 4.75 5.38 6.42 6.54 6.6 7.29 29 Denmark 6.08 7.18 7.81 8.65 9.47 9.15 9.27 17 29 Estonia 4.57 5.5 5.5 5.76 Finland 7.03 6.45 6.37 6.97 7.38 8.1 7.92-7 23 France 10.06 9.28 9.14 9.23 8.9 9.05 9.05-8 -3 Germany 12.98 11.91 12.2 12.61 12.67 12.59 13.34-6 12 Greece 6.47 5.64 5.64 5.8 6.06 6.21 6.37-2 15 Hungary 4.55 6.22 6.34 7.23 7.33 7.94 8.51 152 32 Ireland 7.34 7.95 7.95 8.83 10.06 10.55 11.97 7 51 Italy 15.09 15.0 15.67 13.9 14.49 14.34 14.4-4 -4 Latvia 4.87 7.02 Lithuania 5.35 6.09 Luxembourg 10.67 10.56 11.2 11.48 11.91 12.15 12.88 2 22 Malta 4.84 6.09 6.17 6.31 6.03 5.88 5.85 16 0 Netherlands 8.46 9.38 9.78 9.23 9.7 10.31 11.02 15 17 Poland 7.1 7.61 7.21 6.13 5.83 Portugal 12.57 11.94 12.0 12.23 12.57 12.83 13.13-3 10 Slovakia 10.24 11.23 Slovenia 6.71 8.3 8.37 8.58 8.33 8.41 8.61 59 24 Spain 10.56 8.95 8.59 8.59 8.72 8.85 9.0-14 1 Sweden 6.37 6.29 7.01 8.38 8.98 8.46 40 UK 9.46 10.56 9.96 10.31 9.59 8.37 10.15-12 -11 Note: Based on standard consumer Dc ( 3 500 kwh/year) on 1 January of each calendar year. Source: Eurostat conjecturethatproducersarepassingontheirincreasedcoststoconsumers.taxincreasesaswellasthe introductionofemissionstradingmightalsohelpexplaintherecentpricerises. Anotherimportantmechanismbehindthepricetrendsiselectricitysupply.WhentheEUreformsbegan,the Europeanelectricitymarkethadexcesscapacity,meaningtherewasroomforcompetitiontopushpricesdown. Thisexcesscapacityhassincedwindled,leadingtoupwardpressureonprices.Onewouldexpectfirmsto respondtohigherpriceswithincreasedinvestmentincapacity,butnewinstallationstakeseveralyearsto becomeoperational,sopricesareslowtoadjusteveninfreemarkets. Onefinalpointtonoteisthatinmanycountries(especiallyScandinavia)electricitypricesaredeterminedinlarge partbyhydrologicalconditions,sopricetrendscanalsodependonweatherpatterns. 2.2.3 Evidence of price convergence SomeevidenceexistsofpriceconvergenceinEUmarkets.JamasbandPollitt(2005)computethecoefficientof variation(thestandarddeviationdividedbythemeanorcv[coefficientofvariation])forthreedifferentgroups overaneightyearperiod;theresultsareshowninfigure4.ahighercvmeanspricesaremoredivergent.as 24

seeninthefigure,small-scaleusershaveseenmoderatelyconvergingprices,whilelargeindustrialusershave not. Figure 4 Price convergence coefficient of variation (CV) Intheorypriceconvergenceshouldoccurinanopenelectricitymarketbecauseofastraightforwardmechanism thatthefollowingsimplifiedexampleillustrates.ifaconsumerinfranceisbuyingelectricityfromagreek supplier,andasloveniancompanyoffersalowerprice,thentheconsumerwillpresumablyswitchsupplier.the GreekcompanywilleitherhavetomatchtheSlovenianprice,orelsegooutofbusiness;eitherway,theprice gapwilldisappear.ofcourse,thisargumentrestsontheassumptionthatelectricitycanactuallyflowtofrance fromsloveniaandgreece.inotherwords,theelectricitysystemsofeuropeneedtobeinterconnectedforeuwidepriceconvergencetooccur.section1.2showsthatseriousgapsarepresentininterconnectedness,andso forthisreasonaloneonewouldnotexpecttoseepriceconvergence.toexaminefurthertheargumentthat interconnectionisthekeytoachievingpriceconvergence,onecantaketherawpricedatafromtable8, computethecvforregionalblocks,andexaminewhethertheresultingstatisticsarelowerthantheeu-widecv computedwiththesamedata.table9givestheresults. Table 9 Coefficients of variation for regional electricity markets 1995 2000 2001 2002 2003 2004 2005 EU-25 34.5 29.6 29.6 26.8 25.9 28.5 27.4 Western 16.6 11.5 12.4 14.0 14.5 12.8 15.2 Europe Iberia 12.3 20.2 23.4 24.7 25.6 26.0 26.4 UKandIreland 17.8 20.0 15.9 10.9 3.3 16.3 11.6 Nordic 10.2 6.7 12.5 12.7 12.4 6.4 7.9 Baltic 6.3 10.4 EasternEurope 27.1 27.8 18.6 12.0 10.0 20.7 24 Source: Author s calculations ThemostinterestingfeatureofTable9isthateachregiontakenseparatelyshowssubstantiallymoreprice convergencethantheeuasawhole,meaningthatinterconnectedness(combinedwithotherformsof integration)doesindeedleadtopriceconvergence.everyregionineveryyearhaslessvariationinpricesthanthe EU-25asawhole.ThelargeanderraticfluctuationsintheactualCVfiguresfromyeartoyearderivefromspot pricedatawhichisitselfwidelyvariable.also,someoftheregionshaverelativelyfewmembers,soprice 25

changesinonecountrycanaffectsignificantlythetotalregion svariability.still,thepatternisclear:regions demonstratemorepriceconvergencethantheeuropeanaverage. Onecaveattothediscussionisthatthesamepriceintwocountriescanhavedifferentimplications.Forexample, ifthepriceofelectricityinluxembourgisthesameasthepriceofelectricityinpoland,thenpoles,whose incomesaresignificantlylower,areactuallypayingmuchmoreforelectricityinrealterms.inotherwords,one cancheckforpriceconvergencecontrollingforincomedifferences.spaceconstraintspreventsuchananalysisin thisreport. Thefinalobstacletoachievingpriceconvergenceliesinnetworkcosts,whicharenotsubjecttocompetitive pressure.figure5,takenfromjamasbandpollitt(2005),showsthevarioussourcesthatcontributetofinal electricityprices.networkchargesarebothalargepartofpricesandhighlyvariable.onemechanismthatmight bringaboutmoreuniformnetworkchargesiscontinuednetworkunbundlingcombinedwithindependent incentiveregulationofnetworks.theformerpreventsanti-competitivenetworkpricingbyverticallyintegrated firms,andthelatterbringsefficiencyimprovementsthroughmethodssuchaspricecaps(jamasbandpollitt 2005). Figure 5 Estimated breakdown of expected electricity prices 2004 (50 mwh /year customer) ( /mwh before taxes) 2.3 Conclusions ThestructureofelectricitytariffsiscommontonearlyeveryEuropeanuserandcountry.Onemaindifferenceis thatindustrialusershavealargerarrayoftariffsthandomesticconsumers.also,electricityserviceprovidersin openmarketshavemoreflexibilityinadjustingtariffsthanthoseinregulatedmarkets. Priceshavedecreasedsincethestartofliberalisation,althoughmostofthefallsoccurredbefore2000.AtanEU levelpriceshaveslowlyconvergedforsomegroupssincetheopeningofmarkets,whileataregionallevelprice differencearemuchless.severalfactorsotherthanfailureofmarketreformsmightbedrivingrecentpricerises aswellaslackofconvergence. 26

3 Impact on electricity prices of emissions trading ThissectionfirstdiscussesthecreationandoperationoftheEuropeanUnion semissionstradingsystem(eu- ETS).ItthenstudiestheimpactoftheEU-ETSonpricesatatheoreticallevelbeforepresentingpreliminary empiricalevidence. 3.1 Background information 3.1.1 The Kyoto Protocol and the EU Recognisingtheimportanceoflimitinggreenhousegas(GHG)emissionsinthestruggleagainstglobalwarming, negotiatorsfromaroundtheworldfinalisedthekyotoprotocolin1997.forty-oneindustrialcountriesagreedto reduceghgemissionsbyanaverageof5%from1990levelsovertheperiod2008-2012.theeusignedupto theagreementasabloc,andagreedtoreduceghgemissionsby8%over2008-2012(levy2005). 3.1.2 The structure of the EU emission trading scheme (ETS) SeveraloptionsexisttomeetGHGreductiontargets,includingcarbontaxes,regulation,legislationand emissionstrading.foravarietyofreasons,theeudecidedin2002toadoptthelatteroption.aninitialtrial phasebeganinjanuary2005andwillrunthroughtotheendof2007,beforeasecondtradingperiodrunsfrom 2008-2012,theKyotocommitmentperiod(Levy2005). TheEU-ETSisa'cap-and-trade'mechanism:governmentsdistributeafixednumberofpollutionallowances (whereoneallowancecorrespondstoonetonofemissions),therebycappingemissions;afterreceiving allowances,companiesarefreetotradethem.allowancesacquireamarketpricethatequatessupplyand demand.attheendofeachyear,everycompanymustholdallowancesequaltototalemissionsorelsefacea fine whichdoesnotbuythemoutofemissioncompliance,astheyhavetopresentthemissingallowancesin thenextyear.thus,companiesthatcannotkeepemissionsbelowtheleveloftheirinitialallowanceallocation mustpurchaseadditionalallowancesontheopenmarketfromcompaniesthatcan(royalsociety2002). TheinitialphaseoftheEU-ETScoversonlycarbondioxide(CO 2 ),theprimarycomponentinghgemissions. 11,400installationscurrentlyparticipate,whichtogetheraccountfor55%oftotalEUCO 2 emissionsand45%of totalghgemissions.governmentsdistributetotalallowancesof2182mega-tonnesayear;theelectricitysector receives55%ofthem,reflectingitsimportanceintotalemissions(levy2005).animportantpointisthat pollutersareallocatedtheirinitialallowancefreeofcharge,anallocationmethodcalledgrandfathering(royal Society2002). 3.1.3 Trading on the allowance market Afterspendingthefirstfewmonthsoftradingnearteneuros,thepriceofanallowanceshotuptothirtyeuros byjuly,beforestabilisingbetweentwentyandtwenty-fiveeurosinthelasthalfoftheyear.severalfactorsmight havecausedthepricerise.first,gaspricesgrewfasterthancoalpricesover2005,increasingthecompetitiveness ofcoal(whichgeneratesmoreemissions)relativetogasgeneration.second,waterpoweralsosufferedrelative todirtierfuelsduring2005becauseofthedroughtsinsouth-westeurope.finally,extremeweatherled,in MarchandJune,tounexpectedlyhighdemandthatwassuppliedbyheavilypollutingoilfacilities.Allthese factorsincreaseddemandforallowances,pushingupprices(levy2005).figure6showshowtheprice(ineuros) ofanallowancehasdevelopedsincethestartoftradinginjanuary2005. 27

Figure 6 Evolution of the price of an EU emissions allowance (in ) 3.2 Electricity price effects of the EU-ETS: theory 3.2.1 Links between carbon costs and prices Standardeconomictheorypredictsthatthemarketpriceofagoodispositivelyrelatedtothemarginalcostof thefinalunitsupplied,iethecostofproducingthelastunitsoldtomeetdemand.inlightofthisrelationship, theintroductionoftheeu-etshasonedefiniteandonepotentialeffect.first,whoeversuppliesthefinalunit willcertainlyhaveanadditionalelementinmarginalcost:thepriceoftheallowanceusedupinproduction.even ifthesupplierreceivesthisallowanceforfree,inproducingthefinalunititisgivinguptheopportunitytosellits allowanceonthemarket,andsoitincursarealcost.theonlyexceptionwouldbeifthemarginalsupplier creatednoemissions,likeanuclearorwindfacility.however,thissituationwillnotlikelyapplytoanyeuropean countryasawholeforalongtime.basedonthisanalysis,onewouldexpectthemarginalsuppliertopass through100%oftheco 2 costsintothewholesaleelectricityprice(reinaud2003). Thepotentialeffectofcarbontradingistochangetheidentityofthemarginalsupplier.Accordingtoeconomic theory,thelowestcostproducersuppliesthemarketuntilitscapacityisexhausted,atwhichpointthenext lowestcostproducerstepsintosupplythemarketuntilitssupplyisexhausted,andsoonuntilsomeproducer succeedsinsatisfyingdemand.asexplainedinthelastparagraph,thisproducersuppliesthemarginalunitand sodeterminesmarketprice.now,whencarboncostsareintroducedintothepowermarket,thecost-rankingof facilitiespotentiallychanges(nera2005).forexample,withoutconsideringemissionscosts,coalischeaperthan gas.however,gasiscleanerthancoal,sowhenemissioncostsareincluded,thereissomethresholdallowance pricebeyondwhichgasischeaperthancoal.so,inamarketwhere,beforeeu-etsbegan,acoalfacilitywasthe marginalsupplier,onecouldseeagasfacilitybecomethemarginalsupplier.ifthecoalfacilityremainedthe marginalsupplier,thentheimpactonelectricitypricesofemissionstradingwouldbemuchlargerthanifagas facilitybecamethemarginalsupplier:sincegasdoesnotcreateasmuchpollution,fewercostsgetpassedonto themarket. 28

3.2.2 Countervailing forces Ontheotherhand,JuliaRenaud sinternationalenergyagency(iea)reportpublishedjustbeforethestartofthe EU-ETSidentifiessomescenariosunderwhichallowancetradingwouldnotleadtosubstantialpricechanges. Thefirstiswhencarbon-intensivetechnologiesarethemarginalproducersinamarketwheresupplycompetition isintense.inthiscase,ifoneofthecompaniestreateditsallowancesasrealcostsandraiseditsprice,itmight losemarketsharetoacompetitor.companieswouldhaveanincentivenottotreatgrandfatheredallowancesas realcostsinordertogivethemselvesmoreflexibility.pricecompetitionamongthemarginalproducersinorder tomaintainmarketsharecouldbethemostsalienteconomicforce,limitingtheimpactonelectricityprices.a similarargumentwouldapplyiftherateofcustomerswitchingwerehigh(renaud2003). Anotherpointisthatifaproducerhasalargemarketshare,itmightdecidenottopassonallowancecoststo consumersinordertokeepthepriceaslowaspossible,limitingnewentrants.onefinalsituationinwhichprices mightnotincreaseisiftheallowanceallocationformulaforeachyeardependsoneitherpastproductionorco 2 emissions.ineithercaseproducershaveanincentivetomaximisemarketshareduringtheyearinorderto receivealargeallocationofallowancesinthenextyear(nera2005). 3.2.3 Impact on end-user prices Sofarthemainpriceunderconsiderationhasbeenthewholesaleprice,sincethewholesalemarketistheone ontowhichgeneratorsinacompetitivemarketselltheirpowerandpassoncosts.however,consumersof electricitydonotbuyatthewholesaleprice;theybuyfromretailers,whointurnpurchaseelectricityatthe wholesaleprice. Thereareseveralreasonstobelievethattheimpactofemissionstradingontheretailpriceislessthanonthe wholesaleprice.mosteuropeanhouseholdsarestillonregulatedtariffs,andregulatorsarenotlikelytoagreeto passoncostsarisingfromgrandfatheredpermits.moreover,eventhoughindustrialusersoperateingenerally freemarkets,theycanswitchbacktoregulatedtariffsinsomecountries,andsohaveprotectionagainstlarge priceincreases(levy2005). Referringbacktofigure5,end-userelectricitypricesdependonmuchmorethangenerationcosts,soarisein thelatterwillcausealessthanproportionalriseintheformer.furthermore,manyindustrialusersnegotiate long-termcontractswithsuppliersthatstipulatepricesonlypartiallylinkedtowholesalemarkets,althoughthis maychangeasthenascentfreemarketdevelops.eveninthefreestmarkets,however,industrialusershave scopetobargainwithretailersoverhowpricesareset(levy2005). 3.2.4 Summary of effects Inshort,manydifferentforcescombinetotranslateallowancecostsintowholesaleelectricityandend-userprice changes.table10summarisestheanalysisoffourdifferentstudiesthathaveattemptedtodisentanglethem. Table 10 Estimates of price impacts of emissions trading Allowanceprice Effectsonelectricityprice McKinsey 25 (modellingresult) +30%onwholesale,+15%on end-use ICFConsulting 5 (2005-2007), 10(2008-2012) (assumptions) Reinaud(2005) 20 (assumption) 29 +19%onwholesale +21%onwholesale Levy(2005) +(30%-60%ofallowancecosts) onwholesale Reinaud (2005) provides the information on the McKinsey and ICF studies.

3.3 Electricity price effects of the EU-ETS: evidence Sincethereisonlyayear sworthoftradinginformationsincetheeu-etsbegan,anyattempttoquantifyhow pricesandwholesalepricesrelatecanonlybeindicativeandisboundtobeincomplete. Levy(2005)findsthatinthefirstquarterof2005,CO 2 andelectricitypricesdidnotmovetogetherinspain, France,theUK,GermanyorItaly,butthatinthesecondquartertheydid.Inaddition,inthesecondhalfof2005 wholesalepowerpricesgrewmoreincorrelationwithpricesofemissionallowances.thiscouldimplythat companiesbeganpassingonallowancecoststhreemonthsafterthesystembegan,orsimplythatsomethird variablechangedinthesecondquarterthatwasrelatedtobothco 2 andelectricityprices.toexploretheissue further,levyproceedstoconstructmeasuresofthemarginalcostofelectricityinthesamefivemarkets.she thencomparesthefivedifferencesinwholesalepriceandmarginalcosttoexaminewhethertheresultinggaps relatetotheco 2 price evidencethatallcarboncostsarefactoredintoprices.figure7showsherresults.the scaleonthelefthandsideofthefiguremeasuresthedifferenceinthelistedcountries,whiletherighthand scalemeasuresthepriceofco 2. Figure 7 Differences between marginal costs and wholesale power prices ThetwomonthsforwhichthegapissignificantinthefivecountriesareMarchandJune,andtheseareprecisely themonthsinwhichpricessuddenlyincreasedowingtoweather-relateddemandshocks.otherwise,thegap betweenmarginalcostandpricedoesnotappearlargeinanycountry.moreover,fromapriltomaytheco 2 pricerosewhiletheprice-costgapshrunk.ontheotherhand,aslevynotes,ingermanythegapincreasedon averageduringthefirstsixmonths,whileintheukthegapincreasedeverymonth.furthermore,preliminary evidenceindicatesthatinfrance,germanyandtheukthegapcontinuedtogrowthroughthesummer.inthe end,levy sanalysisprovidesonlylimitedevidenceofanypriceimpactofemissiontrading,althoughgivensucha shorttimescaleitisdifficulttoknowhowmuchweighttoputontheresults. DavidNewberyhasrecentlycompletedhisowninvestigationintocarbonandelectricitypricelinksusingasimilar methodology,butwithanexpandeddatasetcontainingmoremonths.heconsidersthedifferencebetween electricitypricesandfuelcostsforgasfacilities(astatisticknownasthesparkspread)ingermany,the NetherlandsandtheUKthroughAugust2005.Thesparkspreadmeasuresprofitability.Toexaminepriceeffects ofemissionstrading,hetakesthesparkspreadfortheeu-etsperiodandsubtractsthecostofanallowance.if 30

thegas-firedpowersectordoesnotpassonanyofitsemissioncoststoconsumers,thesparkspreadnetof allowancecostsduringeu-etsshoulddroprelativetosparkspreadsbeforejanuary2005.ifthesectorpasseson itsentirecosts,thenthesparkspreadnetofallowancesshouldbeequalbeforeandafterjanuary2005 (Newbery2005).Figure8showsthedata. Figure 8 Spark spreads of UK, DE, and NL before and after EU-ETS Afteraninitialfluctuationperiod,profitsinclusiveofallowancecostshavereturnedtoroughlytheirlevelbefore thecommencementoftrading.newberythusconcludesthat'mostifnotallofthe[allowance]opportunitycost hasbeenpassedthroughintothewholesaleprice,'thoughagainmuchmoredataisneededfullytoestablish thisclaim. Newbery sresultsareclearlymuchstrongerthanlevy s,aswellasmoreinlinewiththeory.aslevynotes, however,itmightsimplytakecompaniestimetolearnhowtooperateunderthenewsystem,andherdataset endsinjune2005.shecitesinterviewsinsummer2005withgermanandfrenchpowerexecutivesinwhich theysaytheircompaniesincreasinglyfactorco 2 pricesintothewholesaleprice.ascanbeseeninfigure8,it wasnotuntilthesummerthatgas-firedplantsfullyinternalisedco 2 costs. OnefurtherpieceofevidencecomesfromPekkaPirilä,fromtheHelsinkiUniversityofTechnology.Having controlledforchanginghydrologicalconditionsinscandinaviaduringthetradingperiod,hefindsthatemissions tradinghasledtoa10 /MWhincreaseinelectricityprices,whichisaroundfiftypercentoftheincreasein marginalcostofcoalfiredcondensingpowerbroughtaboutbytheeu-ets. InthepresentEU-ETSthecostcompensationprovidedbyfreeallowancesisalwaysgiventothepower producers,eveninsituationswhereincreasedpriceseliminateeconomiclosses.atthesametimehigher electricitypricesinducelossestoelectricityconsumers,includingindustriesthatcannottransferadditionalcosts totheirproductpricesbecauseofinternationalcompetition.thuslossescausedbypoliticaldecisionsare 'compensated'toalargeextenttocompaniesthathavenotsufferedanylossesbutcannotbecompensatedto therealloser. 31

3.4 Efficiency of price rises due to EU-ETS Priceincreasesfromtradingallowanceschemesmayormaynotbeefficientforsociety.Ontheonehand, producersmightsimplybepassingontothemarketthecostsofrealemissionreductionefforts;ontheother somecompaniesmightbeenjoyingwindfallprofitsresultingfromthegoodluckofgettingmoreallowances thantheyneed.especiallyinschemeswhereproducersaregivenallowancesforfree(suchaseu-ets),theriskof thelatterisalwayspresent.companieshaveapowerfulincentivetohideplannedemissionsreduction investmentsfromtheauthoritiesinordertomaximizetheamountofallowancestheyreceive(royalsociety). Oncethetradingschemebeginstheycangothroughwithemissionsreductionandhaveleftoverallowancesto sellonthemarket,ineffectgettingsomethingfornothing. Auctioningisaneconomicallymorerationalmeansofallocatinglicenses.Whencompanieshavetobidfor allowances,theywouldpayonlywhattheybelievetheallowancesareworth,andcompanieswouldnotlikely obtainsuperfluouscredits.theallowanceallocationswouldmoretrulyreflectactualmarketconditions,andthe priceincreasesthatconsumersexperiencewouldprobablybefinancingco 2 emissionsreductions.themain obstacletoauctionsisthattheyconstituteatransferofwealthfrompolluterstogovernment,whilethefree distributionschemetransferswealthintheoppositedirection.politically,then,freedistributionisoftenthe easiestwaytobeginanemissionstradingsystem. Basiceconomics,however,suggeststhattheEUshouldmovetoanauctioningsystemsoonerratherthanlater, orelseriskunderminingitsgoalofreducingemissionsasefficientlyaspossible.asinmanyothersituations, marketforcesaremorelikelytoallocategoodsefficientlythangovernmentauthorities.infuturetradingperiods oftheemissiontradingscheme,theallowancesareboundtobecomerealcoststotheproducerssincetheir amountwillsteadilydecline. 3.5 Conclusions EconomistsandconsultantsagreethatthereshouldbeanimpactonelectricitypricesderivingfromtheEU-ETS, buttheydonotagreeonthesizeoftheimpact.thefirstlinkisbetween1)increasedproductioncostscoming fromtheintroductionofpollutioncostsand2)thewholesaleprice.increasedwholesalepricesshouldalsolead toincreasedend-userpricesinopenmarkets.bothlinksarecomplicatedbyamyriadoffactors,themost importantonesofwhichdealwithmarketstructure.asthisreporthasestablished,manydifferentmarketscoexistwithintheeu,andthestructureofeachonecontributestohowemissionscostsaffectprices. ThelittleavailableempiricalevidenceconfirmsarelationshipbetweenEU-ETSandwholesaleelectricityprices. Muchmoreworkinthisdirectionisneededoncethesystemhasbeeninplaceforlonger. 4 Long-term contracts Inthissectionofthereportweanalysethepossibleeffectsthatlong-termcontractscouldhaveupontheEU electricitymarkets.wereviewexistingcontractualarrangementsandthenassessarangeofpossibleadvantages anddisadvantagesofthemarketmovingtowardslonger-termcontracting. 4.1 Background Long-termcontractsareseenbetweengeneratorsandelectricityretailers,thoughitispossiblethatintime otherssuchasbrokersmayincreasinglybecomecontractingparties,especiallyasthesystemdevelops.longtermcontractscouldbesignedforanytermthepartieswish,withcontractsstretchingfarintothefuturea 32

possibility.itisnotpreciselyknownhowmuchoftheelectricitymarketslong-termcontractscurrentlyaccount for,thoughweknowthatinseveralmarketstheyplayanimportantrole.forexample,intheuk5-year contractswereintroducedbackin1993,andinfinlandlong-termcontractsboundtoownershipforman essentialcomponentofthenuclearpowerplantbeingconstructed suchownershipsolutionshavebeenused therefordecadesandremainanimportantfactorinsecuringelectricityforlargeindustrialconsumers. Efficiencyinthiscontextmeansthatelectricityisproducedatthelowestcostthatissustainableinthelongrun, thatproducerscannotexploitmarketpowertoraisepricesabovecompetitivelevelsandthatfirmshavean incentivetoinvestuptotheamountthatthemarketiswillingtopayforthebenefits.inotherwords,social welfareismaximisedinsuchaperfectlycompetitivemarketmodel. Long-termcontractswouldcoverthequantityofpowersuppliedandfixaprice,andwouldincludeclauses coveringavarietyofcircumstancessuchaslegislativeandproductioncostchanges.thetradingoflong-term contractscantakevariousforms;itcanbebilateral(perhapsmediatedbyabroker),orwithanindependently operatedcontractsexchange,whichcouldfeaturesecondarytradingofcontracts. 4.2 Benefits of long-term contracts 4.2.1 Stability Thefundamentaltroublewithelectricitymarketsisthatdemandisalmostcompletelyunresponsivetoprice fluctuations,supplyfacesbindingconstraintsatpeaktimes,andstorageisnoteasy.thesecharacteristics necessarilyimplythatshort-termpricesforelectricityaregoingtobeextremelyvolatile.thisinherentinstability posesriskstoeveryoneinvolvedinthesystem generators,distributorsandfinalconsumers. Long-termcontractscanprovideawayofmarketparticipantsinsulatingthemselvesfromtheseinherentrisks: afterhavingsignedalong-termcontractapartyisrelativelyunaffectedbyanysuddenchangesinthemarket suchasrapidpricefluctuationsorsupplyshortages.usinglong-termcontractsinthiswayisnotanewidea,or onethatisonlyconsideredwithintheareaofelectricity.infact,itiscommontoseelong-termcontractsinother industriesthatfeatureagreatdealofspotpricevolatilityinordertosmoothtransactionprices. 4.2.2 Case study: California Astrongexampleillustrationoftheintrinsicinstabilityoftheelectricitymarket,andtherolethatlong-term contractscan(orcannot)playinmitigatingcrises,isprovidedbythecaliforniapowercrisisof2000-2001.this wasintheheadlinesasthestatewashitbyawaveofblackoutsduetochronicshortagesofelectricity,causing pricestospikeatseveralthousandpercentoftheirnormallevels,sendingcompaniestothevergeofbankruptcy andcostingthestatebillionsofdollars. Lookingatthiscrisis,JamesBushnell(researchdirectoroftheUniversityofCaliforniaEnergyInstitute,Berkeley) citesthelackoflong-termcontractsbetweentheutilitiesandwholesaleelectricitysuppliersastheuniquesource ofcalifornia scrisis. If one considers these three elements concentration of ownership, lack of price-responsive demand, and lack of long-term contracts, only one element differentiates California from other regions: the lack of longterm contracts. 3 3 Bushnell,James, California selectricitycrisis:amarketapart?,csemworkingpaper119,november2003 33

Forvariousreasons,utilitiesdidnotengagesignificantlyinlong-termcontractingofelectricity(thoughthese werenotstrictlybanned).jamessweeney,professorofmanagementscienceandengineeringatstanford University,speakingataseminarontheissueargued: So there was no long-term protection for the investor-owned utilities If you are selling to retail customers who do not want price fluctuations, the way to operate is through long-term contracts to have that security. 4 Thesecommentatorsarenotaloneincitinglong-termcontractsasbeingofprimeimportanceincreatingmarket stability.severinborenstein,auniversityofcalifornia,berkeley,economicsprofessoranddirectorofthe UniversityofCaliforniaEnergyInstitute,agreesthatalthoughpricecapswereacontributortothecrisis,thelack oflong-termcontractswasthemostimportantcause. The difference between California and what happened in every other state is not retail price caps they all had retail price caps it was the lack of long-term contracts and long-term procurement. 5 Summarising,Bushnellremarks Many factors contributed to the California crisis: market power of producers, a flawed market design that included a freeze on retail rates, inflexible regulatory policies at both the state and federal level, but most uniquely, the lack of contracts or other long-term arrangements and the concentration of transactions in short-term, daily markets. 6 4.2.3 Encouraging investment Adefiningcharacteristicoftheelectricitymarketisthatitisextremelycapitalintensive,withmajorinvestments beingmadeupfront,andreturnsmadeoveralongperiodoftime.long-termcontractsprovideameansfor investorsinnewcapacitytomanagetheirinvestmentrisks,andcanthusservetoencourageinvestment-this willincrease,andpromoteamoreefficientlevelof,investment.currentlyinvestmentwherethereturnis forecasttobegreaterthanthecost(andisthus efficient inaneconomicsense)maybedeterredbytherisks involved.bybeingabletoreducealargepartofthisriskthroughlong-termcontracts,amore efficient levelof investmentisencouraged. JohnFitzGeralddiscussesthisargumentinthecaseoftheIrishelectricityindustry.Henotesthat: Probably the most serious problem with the current market is that new customers are not prepared to sign contracts for power supply with new entrants for periods longer than two or three years. This means that new entrants can not guarantee themselves a market in advance of investing. As the capital costs in building generating stations are very large, this makes investment very risky, increasing the cost of capital. The normal way to finance a new power plant is to borrow, with long-term contracts for sales of electricity providing security. This is not possible in the Irish case because of the impossibility of obtaining matching long-term contracts for sales. The result of these uncertainties is to greatly increase the cost of capital for new plant and to reduce the incentive to invest. This is a common problem to all electricity systems. 7 Notethatheretheinvestmentthatisencouragedisnotnecessarilyjustbyincumbentfirms,butcouldbeby potentialentrants.bybeingabletolockinasecurerevenuestreamfromtheirinvestmentthroughlong-term 4 Murray,Bruce, RewindingtheCaliforniaElectricityCrisis,FACSNET. 5 Murray,Bruce, RewindingtheCaliforniaElectricityCrisis,FACSNET. 6 Murray,Bruce, RewindingtheCaliforniaElectricityCrisis,FACSNET. 7 FitzGerald,John, TheIrishEnergyMarket PuttingtheConsumerFirst,ESRIWorkingPaper145,August2002. 34

contracts,firmsconsideringentrywillbegreatlyencouragedandthusthiscouldfurtherenhancethedegreeof competitivenessinthemarket,andservetodrivepricesdown.incumbentfirmscouldperhapsanticipatethis entry,andmaythenstrivetokeeppriceslowerinordernottoattractit.thustherecouldbeapro-competitive effectevenifentrydoesnotactuallyoccur.long-termcontractsareparticularlyvaluablewhenthemarket environmentissubjecttonon-commercialrisks,notablyfrompoliticalorregulatoryopportunismor indecisiveness Notethatthestrengthofthiseffectdependsuponthelengthofthelong-termcontractsavailable:ifacontract isavailableforthewholelifeofageneratingplant,anentrantislikelytobemoreencouragedthanifhewas onlyabletosecureacontractcoveringpartofitslifespan.thefinnishnuclearplanmentionedaboveprovidesa clearexampleofthisargument,thecontractsitisbaseduponareeffectivelyalmostlife-of-plantandclearlythis hasfacilitatedthisinvestmentgoingahead. 4.2.4 Undermining producer market power Severalauthorshavearguedthatthenatureoftheelectricityindustry withitshighlyinelasticdemandinthe shortrun,andhighcostsofentry necessarilyputssuppliersinapositiontoexploitmarketpower. Long-termcontractscanhelpunderminecollusionbetweengenerators,aslong-termcontractsprovideanother marketmechanismforfirmstocheatonothersinacollusiveagreement.theycanalsoprovideagreater incentiveforparticipantsto cheat ontheagreement:itmaynotbeworthcheatingonthecartelforasmall short-termcontractastherewardsarenotlargeenough.however,withalargelong-termcontractforseveral yearsinthefuturethegainsofunderminingthecartelaremuchlarger. Ithasalsobeenarguedthatasgeneratorstradeanincreasingamountoftheirpowerthroughlong-term contracts,andtherelativeimportanceofthespotmarketasasourceofsalesdeclines,theincentivetoexploit marketpowerinthespotmarketwillalsofall.asfirmstradelessthroughthespotmarket,thequantityon whichtheystandtogainacollusivemark-upfallsalso,sohencetheirincentivetoengageincollusiveactivity. Ofcoursethesebenefitsdependuponone sinterpretationofhowmuchofaproblemmarketpowerand collusionis(andwillbeinthefuture)inthevariouseuelectricitymarkets. 4.2.5 Aiding efficient timing of maintenance work Long-termcontractingcanservetofacilitateleast-cost(henceefficient)timingandcoordinationofmajor maintenancework,wheregeneratingcapacityistakenoutofservice.theownerofgeneratingcapacitywill haveanincentivetotradeoutofthecontracts(tosupplyelectricity)forthemaintenanceperiodandwill scheduletheworkforwhenthiscanbedonecheapest iewhenthepriceofelectricityislowest.thisisefficient asthiswillbewhenthereisplentyofelectricityandotherscanmakeupforthereducedcapacity. Thishasthefurtherefficienteffectofsignallingamaintenancedecisiontoothers,viatheriseinpriceof electricityintheforwardmarket,whichwilldiscouragethemfromschedulingworkatthesametime. 4.3 Risks of long-term contracts 4.3.1 Lack of flexibility Fromabuyer sperspectivethereisofcourseariskoflockinginahigherpricethancouldhavebeenobtainedin thespotmarket itisquitepossiblethatthecontractedpricewillnotequalthecontemporaneousspotprice (thoughofcoursethereverseisalsopossible). 35

Contractscanbeflexible,withclausescoveringallmannerofcircumstances howevertheyarenotinfinitely flexible.whileitmaybetheoreticallypossibletocontractoveravastnumberofvariablesandcontingencies,in practicethismaybedifficultandtimeconsuming.davidnewberynotesthatintheuk: Risks could have been hedged by long-term contracts between generation and supply companies, but the transaction costs of writing long-term contracts to cover all contingencies (such as the ending of the Pool, the Emissions Trading System, Climate Change Levy, Renewables Obligation Certificates) might make vertical integration more attractive. 8 Ifadistributorbuysaproportionofitsforecastelectricityneedsthroughlong-termcontracts,andthenthespot pricefallsalot,iteitherhastosellataloss,orriskthatconsumerscouldswitchawaytootherprovidersthatcan offercheaperelectricityboughtthroughthespotmarket.thedistributorwiththelong-termcontractcouldthen finditselfhavingexcesselectricity.forthisreasonitseemswisethatdistributorsdonotbuytoomuchoftheir electricityneedsthroughlong-termcontracts,asthissituationcouldprovefatal.inabsenceoftheelectricity derivativemarket,asolutiontothisproblemusedbydistributorsisshort-termandmedium-termcontracts, whichovertheshortertimespanexposethemtoasmallervariationinpricechanges.usuallyalong-term contractrepresentsahigherrisktoadistributorfromlossesduetolowerprices. 4.4 Other factors 4.4.1 Contract trading Aquestionoffundamentalimportanceiswhetherthecontractsaretradable,andhowliquidthemarketfor contractsis.withaliquidandfullyfunctioningmarketforlong-termcontracts,itislikelythattherisk-reducing andefficiency-enhancingconsequencesofthecontractswilldominate.however,withlittleornoscopetotrade contracts,theirimpactcouldbemorenegative. Thesuitabilityofthecontractsforsecondarytradingwilldependonthenatureofthecontract itislikelythat somecontractsmaybemoretradablethanothers,suchasstandardisedfixedquantitycontracts.however, contractingpartiesarelikelytotakeaccountofthispoint,andthegeneraldevelopmentofsecondarymarkets, whentheydrawuptheircontracts. 4.4.2 Electricity derivatives Essentially,thekeyroleoflong-termcontractsistoreducethepricerisktowhichmarketparticipantsare exposed.thisrolecanbe,andhasbeen,playedbyelectricityderivatives,whichcanalsobeusedtomanage marketrisks.theeffectivenessofderivativesinfulfillingthisrolepartlydependsonhowwelldevelopedand liquidthederivativesmarketisinaparticularcountry. IntheNordicmarket,forexample,financialderivativesextending3-4yearsintothefutureareusedextensively bymarketparticipantstohedgetheirriskexposuretopricefluctuations,andtheseformanefficientalternative tolong-termcontractswhichareusedaswell.forperiodsofmorethan4years,long-termcontractsaremore importantthanderivatives.incontrast,inthebalticmarketderivativesarelessfrequentlyusedandfuturesand forwardcontractshavenotstartedtoflourishyet,mainlyowingtoaweakpricesignalandlowliquidity. Thusonecouldarguethatderivativeandlong-termcontractsaresubstitutes,andthatcountrieswithwellfunctioningderivativesmarkethavelessofaneedforlong-termcontracts.However,mostobserverstalkabout 8 Newbery,David, ElectricityLiberalisationinBritain:TheQuestforasatisfactoryWholesaleMarketDesign,TheEnergy JournalSpecialIssueonEuropeanElectricityLiberalisation. 36

derivativesandlong-termcontractsbeingcomplementary,andthatallowingparticipantsthefulluseofboth allowsthemtobestmanagetheirriskandprovidesuccessfulmarketoutcomes. 4.5 Conclusions Manycommentatorsstronglyadvocatelong-termcontractsasameansofimprovingefficiencyintheelectricity industry,andofpreventingcriseslikethatincaliforniaoccurringagain.overall,itisgenerallyarguedthat greateruseofthesecontractswouldincreaseefficiencyandbesociallybeneficialowingtotheirthreemain benefits: stabilityofprices; encouraginginvestment(andperhapsentrybynewplayers); underminingexploitationofmarketpower. Whatevertheimpactsoflong-termcontracting eveniftheyarestronglybeneficial theydonotdirectlysolve thefundamentalunderlyingdriverofmarketvolatility,whichisthemismatchesbetweenmarketdemandand supply.theysimplyservetomitigatetheeffectsofthisproblemandpreventlargefluctuationsinelectricitybills theystillfailtobringinthedemandsideofthemarketwithincreaseddemandresponsivenessandsome degreeofreal-timepricingwhichsomecommentatorshavearguediscrucialandultimatelyamoreeffective approach. However,evencommentatorswhoargueforalternativeandperhapsmoreradicalpolicymeasuresstilladmit thatlong-termcontractshaveanimportantroletoplay. 5 Conclusions TherequirementsofthisstudyweretoanalysetheEuropeanelectricitymarketandreportonvariousaspectsof it,ratherthantomakepolicyrecommendations.ouranalysisdoes,however,suggestsomedirectionsinwhich policymightusefullydevelop. Clearly,theEUelectricitymarketisverycomplex,anditisdifficulttomakegeneralisationsaboutit.Twothings thatcouldclearlybedesirable,however,aregreatercross-borderconnectivityandanincreaseinlong-term contracts. Whilsttheconceptofemissionstradingisclearlyapositiveoneforcontrollingemissions,itistooearlytosee howitwilleffecttheelectricitymarketsandconsumerandwholesaleprices.themarketshouldbemonitored forsucheffectsoverthecomingyears. Likewise,ithasbeendifficulttogeneralisefrompricingtrendsinthemarketsincerecentyearshaveseen deregulation,marketliberalisation,fluctuationsinglobalfuelcostsaswellasagradualdecreaseinovercapacity inthemarket.sincewearenowatapointwherethemarketseemsstable(withrespecttosupplybalancing demandandgeneralliberalisation),itwillbeimportanttomonitorpricesoverthenextfiveyears. 37

Bibliography Auer,Hans,NenadKeserie,ReinhardHaas,GustavResch,ClausHuber,ThomasFaber.Medium- and long-term effects of EU-electricity enlargement,berlinsessaconference EnsuringSustainableEUElectricity-Enlargement (WP5) Borenstein,Severin.January2001.The trouble with electricity markets (and some solutions),programmeon WorkableEnergyRegulation(POWER)WorkingPaper081 Bower,John.A review of European eectricity statistics.oxfordinstituteforenergystudies. http://www.oxfordenergy.org/pdfs/jelsample.pdf Bushnell,James.November2003.California s electricity crisis: a market apart?,csemworkingpaper119 CommissionoftheEuropeanCommunities.2004.Report from the Commission: annual report on the implementation of the gas and electricity internal market.brussels CommissionoftheEuropeanCommunities.2005.Communication from the Commission to the Council and the European Parliament: report on progress in creating the internal gas and electricity market.brussels ERGEG.June2005.The creation of regional electricity markets,discussionpaper EuropeanCommission.January2005.Report from the Commission on the implementation of the gas and electricity internal market Eurostat.Electricity prices - price systems 2004 http://epp.eurostat.cec.eu.int/portal/page?_pageid=1073,46587259&_dad=portal&_schema=portal&p_produc t_code=ks-ec-05-004 Eurostat.Gas and electricity market statistics data 1990-2005 http://epp.eurostat.cec.eu.int/portal/page?_pageid=1073,46587259&_dad=portal&_schema=portal&p_produc t_code=ks-71-05-392 FitzGerald,John. August2002.The Irish energy market putting the consumer first,esriworkingpaper145 FitzGerald,John.June2003.Energy policy in Ireland,ESRIWorkingPaper160 Gilardi,Fabrizio.29March-2April2003.Delegation to independent regulatory agencies in Western Europe: a cross-sectional comparison,paperpreparedfortheworkshop DelegationinContemporaryDemocracies,ECPR JointSessionsofWorkshops,Edinburgh(UK) Glachant,Jean-MichelandFrancoisLeveque.August2005.Electricity internal market in the European Union: What to do next? 20 priorities derived from SESSA research programme,draftversion Green,Richard.March1999.The electricity contract market in England and Wales,TheJournalofIndustrial Economics Green,Richard.December2003.Retail competition and electricity contracts,cmiworkingpaper33 Jamasb,Tooraj,andMichaelPollitt.2005.Electricity market reform in the European Union: review of progress toward liberalisation and integration.theenergyjournalspecialissue,11-41 LCGConsulting.September1995.Long-term trading Levy,Camille.2005.Impact of emission trading on power prices: a case study from the European Emissions Trading Scheme.Mimeo,UniversitéParisDauphine,DEAd EconomieIndustrielle Murray,Bruce.Rewinding the California electricity crisis,facsnet NERA.2005.Methodology for measuring CO2 pass-through: a report for EnergieNed.London,NERAEconomic Consulting 38

Newbery,David,Electricity liberalisation in Britain: the quest for a satisfactory wholesale market design,the EnergyJournalSpecialIssueonEuropeanElectricityLiberalisation Newberry,David.2005.Emissions trading and the impact on electricity prices.mimeo,cambridgeuniversity Reinaud,Julia.2003.Emissionstrading and its possible impacts on investment decisions in the power sector. Paris,InternationalEnergyAgency. TheRoyalSociety.2002.Economicinstruments for the reduction of carbon dioxide emissions.london,theroyal Society Speck,StefanandMachielMulder.July2003.Competition on European energy markets: Between Policy Ambitions and Practical Restrictions Thomas,Steve.September2005.The European Union gas and electricity directives 39