Will Ownership Unbundling deliver?

G LOBAL U TILITIES C ENTER D ÜSSELDORF GERMANY Will Ownership Unbundling deliver?!@#

C ONTENTS Contents Executive Summary 3 1 Introduction 4 1.1 A Brief History of Unbundling 5 1.2 The Status of Unbundling in Europe 6 2 Unbundling and its Role in Improving Competition 8 2.1 Ownership Unbundling 8 2.2 The ISO 11 2.3 The Role of Regulation 12 2.4 The Regional Independent Operator 12 2.5 The Political Alignments 14 2.6 Next Steps 14 3 Impacts on Companies 16 3.1 Overview 16 3.2 Vertically Integrated Utilities (VIUs) 16 3.3 Non-Integrated Transcos 17 3.4 Strategies Vary Across the Continent 18 3.5 Corporate Challenges of Unbundling and Separation 18 3.5.1 Designing a New Business Structure 18 3.5.2 Implementing the New Business Structure 19 3.5.3 Operating the New Business Structure 20 3.6 Compliance 20 4 Our Conclusions 22 5 Country Reports 24 Appendix: Ernst & Young Contacts 34 Table of Figures Figure 1 Critical steps in unbundling 5 Figure 2 Recent steps in unbundling 6 Figure 3 Unbundling landscape in Europe electricity 9 Figure 4 Unbundling landscape in Europe gas 9 Figure 5 The range of ISOs 11 Figure 6 Regional markets in Europe 13 Figure 7 Ownership of transmission and political opinion across Europe 15 Figure 8 Classification of major European utilities 16 Figure 9 Conflicting forces for and against disposal 17 Figure 10 Compliance issues 20 2 BALANCING E UROPEAN E NERGY M ARKETS

Executive Summary European countries may acknowledge the value of cooperation, but they tend to resist conformity. The utilities sector is a perfect example of this tension: there s a massive diversity from country to country in terms of openness, competition, regulation, and ownership across the industry. The challenge on the European Union s (EU) hands is creating a level playing field for competition in the face of such diversity. If they cannot find a way to do this, the European Commission s stated aim, to open up Europe s gas and electricity markets to competition and to create a single European energy market, 1 could very well be in jeopardy. There are clearly two camps on either side of the EU s new proposals to deliver a single European energy market. Those in favor which tend to be the countries around the edge of Europe have largely fulfilled ownership unbundling and many, with the exception of the UK, have an industry which is still driven by state-owned utilities. The other camp the opponents if you like encompasses the countries in the middle of the European continent, where the markets tend to be dominated by vertically-integrated transmission companies, in many cases privately-owned. Supporters and their utilities are likely to be seen as the winners at the end of this process. Nevertheless, vertically integrated transmission companies can take a proactive stance to the EU s proposals. They can fully evaluate the strategic implications of different unbundling scenarios; they can improve competition on the generation and supply side; they can establish regional energy markets; and they can prove their transparency and cooperation to the EU and regulatory authorities by fulfilling the current unbundling requirements and demonstrating that they have done so with independent audits. The impact of ownership unbundling is limited: ownership unbundling is just one of the steps necessary to improve competition and ultimately establish a single European energy market. To achieve the full effect, we need the right mix of unbundling, regulation and cooperation between transmission companies, as well as harmonized implementation of the EU-Directives, clear criteria for independence, common rules for privately-owned and state-owned utilities, and common rules for monitoring unbundling requirements. 1 Sector Inquiry 10 January 2007 3

I NTRODUCTION 1 Introduction The European Commission (EC) has published new plans that will force Europe s energy markets to open up to more competition. Its latest proposals 1 mean that the EU s big energy companies will have to unbundle ownership of their operations. Businesses which generate power and supply gas will not be allowed to control transmission networks. They will either have to sell them, or to allow independent third parties to operate their grids. The Commission says this will improve competition and attract new entrants to the energy sector. It also wants to create an independent EU energy agency to coordinate national energy regulators. The ownership unbundling proposal is just one of a range of measures which the Commission hopes will create a truly competitive energy market. European debates around tighter legislation to increase competition in the sector have waged back and forth for a decade now. Over the past three years, the EC has put heavy pressure on energy firms which it believed were operating uncompetitively, running an extensive investigation, and seeking to influence a number of potential takeovers. Depending on who you talk to, the proposed unbundling reforms may or may not solve the problems of conflict of interest. Opinion among EU Member States remains divided, with France and Germany strongly resistant, whilst Spain, Sweden, and the UK are in favor. What is clear is that unbundling would certainly have serious consequences for the ownership, structure, and management of the present vertically integrated utilities (VIUs), and for the utilities sector as a whole. This study explores the issues and forces at work, and aims to support your thinking about how to handle the impact of change on your business. We investigate: The development of unbundling and its current status in Europe The role of unbundling within utilities and in the wider context of energy policy How the Commission proposes to use unbundling to achieve a better integrated, more competitive European energy market How utilities can manage these changes to their advantage. We would welcome contributions to further debate about the issues discussed here. Please contact Helmut Edelmann at: Ernst & Young, Global Utilities Center, Graf-Adolf-Platz 15, 40213 Düsseldorf, Germany. Tel: +49 211 9352 11476. E-mail: helmut.edelmann@de.ey.com Unbundling goes deeper The EC gives utilities two choices on unbundling: Unbundling: critical questions and actions for utilities 1. Have you identified your preferred unbundling scenarios and do you understand the strategic implications of each? 2. What is the best option for you - disposal of the grid, share splitting, or establishing an Independent System Operator (ISO)? 3. Can your business strategy cope with the uneven status of unbundling around Europe? 4. With deeper unbundling, tighter regulation and more challenging criteria for crossborder cooperation, how will you cope with the new compliance challenges? 5. How will you demonstrate transparency and cooperation to the EU and regulatory authorities? Full ownership unbundling: the Transmission System Operator (TSO) owns the transmission assets and operates and develops the network. The TSO is independent; within any given country, supply and generation owners would not be allowed to hold significant shares in the TSO. Separate ownership of assets from operation of the system: owners of transmission systems continue to own power stations and supply companies, but would have to transfer operation and development of the system to Independent System Operators (ISOs). Supply and generation companies could not hold a significant stake in the ISO. 1 Draft Directive published 19 September 2007 4 BALANCING E UROPEAN E NERGY M ARKETS

1.1 A Brief History of Unbundling Unbundling is the separation of complex functions into several elements and it may be done for various purposes. In utilities, unbundling means separating network activities (transmission and distribution) from generation, trading, and supply. The goal is to enhance transparency, permit accurate regulation, strengthen competition, and therefore reduce prices. Unbundling a utility can be done at different, progressive levels. The simplest level is accounts unbundling, where an integrated company keeps separate accounts for its network business. The next level is information unbundling, which prevents discriminatory flows of commercially valuable information to associated businesses. Functional and management unbundling requires that the processes and procedures of the network operator are not influenced by the other businesses of the VIU. Legal unbundling requires that the network activities are conducted by a distinct legal entity 2. Full ownership unbundling means that businesses which are active in supply, generation and production of electricity and gas are not permitted to control a transmission network - they must sell it off. We summarize the progress of unbundling in the reform of the electricity and gas markets in Figure 1. There has been a progressive deepening of requirements as the reform process has developed. The 1st Directive on electricity market reform 3 was announced in December 1996; it required accounts unbundling for networks. The 1st Gas Directive 4 came a little later; it also required accounts unbundling. The Lisbon European Council in March 2000 5 asked for further liberalization of the electricity and gas industries, and this led to a second round of legislation comprising the 2nd Gas 6 and Electricity 7 Directives, which came into force on 26 June 2003. These new Directives incorporated many changes in market governance and required legal unbundling of networks. The latest round in the evolution of a common energy strategy was initiated at the end of 2005, when the European Heads of State requested the Commission to prepare a new energy policy. The Commission then conducted an inquiry into the state of competition in the electricity and gas markets. The results were published 8 on 10 January 2007. They addressed serious shortcomings in the electricity and gas markets arising from: Market concentration leading to market manipulation Vertical foreclosure, arising mainly from inadequate unbundling of functions A lack of transparency and poor availability of information to network users Regulated retail tariffs that discouraged entry and competition Poor market integration, arising from major constraints on cross-border trade Limited competition in downstream markets Discriminatory balancing markets. In the prospects paper, the Commission concluded that legal unbundling did not suppress the conflict of interest that stems from vertical integration. There is a continuing risk that networks are seen as strategic assets serving the commercial interest of the integrated entity, not the overall interest of network customers. Ownership unbundling was proposed as the most effective remedy. This paper also proposes a substantial strengthening of the powers of regulators, and enhanced European coordination. Based on this analysis, on 19 September 2007 the Commission published its first draft Energy Directive, in which the Commission has now proposed two ways of deepening unbundling. The first option is full ownership unbundling. In this case, the TSO owns the transmission assets and operates and develops the network. The TSO should be independent; supply and generation companies operating in any given country could not hold significant shares in the company. The Commission s second proposed option is the ISO which separates ownership of the assets from the operation of the system. Owners of transmission systems could continue to own power stations and supply companies, but would be obliged to transfer the operation and development of the system to an ISO. Supply and generation companies could not hold a significant stake in the ISO. The proposal treats electricity and gas in the same manner. Further key elements of the proposal are: More detailed requirements for national regulators to cooperate at the European level through a European Agency More cooperation between TSOs for a more efficient market. The 3rd Directive does not propose any legislative changes in respect to distribution system operators (DSOs). Figure 2 shows the development of political positions on unbundling in recent months. 2 This distinct legal entity is not necessarily the owner of the grid. The grid can be leased from another company of the former VIU. By this approach the fundamental idea of legal unbundling might be compassed in practice. 3 Directive 96/92/EC of the European Parliament and of the Council of 19 December 1996 concerning common rules for the internal market in electricity 4 Directive 98/30/EC of the European Parliament and of the Council of 22 June 1998 concerning common rules for the internal market in natural gas 5 Presidency Conclusions, Lisbon European Council, 23 and 24 March 2000 6 Directive 2003/55/EC of the European Parliament and of the Council of 26 June 2003 concerning common rules for the internal market in natural gas and repealing Directive 98/30/EC 7 Directive 2003/54/EC of the European Parliament and of the Council of 26 June 2003 concerning common rules for the internal market in electricity and repealing Directive 96/92/EC 8 Communication from the Commission to the European Council and the European Parliament - An Energy Policy for Europe, COM(2007) 1; DG Competition Report on Energy Sector Inquiry, SEC(2006) 1724; Prospects for the internal gas and electricity market, COM (2006) 841; An Energy Policy for Europe, COM (2007) 1; Accompanying Document to the Communication from the Commission to the Council and the European Parliament, Prospects for the Internal Gas and Electricity Market Implementation Report, COM (2006) 841, Brussels, 10 January 2007 5

I NTRODUCTION 1.2 The Status of Unbundling in Europe Implementation of the 2nd EU-Directive across Europe is uneven. In some countries, it has not yet been transposed fully into national law (e.g. Luxembourg and Spain). Some small countries have not fulfilled the unbundling requirements because the market is too small and unbundling is not deemed to have any value (Slovenia) 9. The general impact of current unbundling requirements is not clear, partly because the final implementation date of the 2nd EU-Directive for DSOs was 1 July 2007, and partly because there is no strong monitoring of the fulfillment of the current unbundling requirements across Europe. Although the EC has delivered an extensive impact assessment accompanying the proposal of the 3rd Directive, there is no clear evidence of the advantages of ownership unbundling. Figures 3 and 4 show the nature of unbundling across Europe in the gas and electricity transmission and distribution grids. There is clearly much variation in practice. This leads to incoherent interfaces at frontiers, and interferes with the establishment of a single European energy market. It seems impossible for utilities to establish a common business strategy across Europe. The wide variation in the practice of unbundling across Europe leads to incoherent interfaces at frontiers. This interferes with the establishment of a single European energy market: it seems impossible for utilities to establish a common business strategy across Europe. Figure 1 Critical steps in unbundling 19 Dec 1996 96/92/EC (1st Electricity Directive). Requirement for accounting unbundling. 22 Jun 1998 98/30/EC (1st Gas Directive). Requirement for accounting unbundling. 26 Jun 2003 2003/55/EC (2nd Gas Directive). 2003/54/EC (2nd Elec Directive). Requirement for legal, functional, and information unbundling. No obligation to separate ownership of assets. 10 Jan 2007 Energy Sector Competition Inquiry Final Report Conclusion: Level of unbundling currently inadequate to resolve systemic conflicts of interest. Ownership unbundling is viewed as the central pillar in a range of solutions. 07 Feb 2007 Preferred approach of ownership unbundling confirmed in Energy Commissioner Piebalgs speech. Realization that second option could be the ISO approach. 1996 1998 2003 2007 15 Feb 2007 Energy Council Meeting EU Energy ministers fail to back ownership unbundling proposals. EC admits that other alternatives wil also be considered (ISO). 04 Mar 2007 Pre-Council of Europe meeting statement Barroso states that opposition from Member States will not stop liberalization agenda. EC will act if Member States do not. 06 Mar 2007 Pre-Council of Europe press conference: Angela Merkel I do not think the issue of competition can be reduced to the unbundling question. Stripping the energy producers of their networks is no guarantee that there will be more competition. 08+09 Mar 2007 Council of Europe meeting It appears that ownership unbundling is off the agenda for now. The council spoke of the need to have effective separation of supply and production activities from network operations. Europe s leaders agreed the new system should be based on independently run and adequately regulated network operation systems which guarantee equal and open access to transport infrastructure and independence of decisions on investment in infrastructure. 16 Mar 2007 European Council Action Plan (2007-2009) Ensure timely and full implementation of the letter and spirit of existing Internal Market legislation relating to the opening of the gas and electricity markets. Effective separation of supply and production activities from network operations based on independently run and adequately regulated network operation systems which guarantee equal and open access to transport infrastructure and independence of decisions on investment in infrastructure. 9 Source: Commission Staff Working Document 10 January 2007 SEC (2006) 1709 6 BALANCING E UROPEAN E NERGY M ARKETS

Figure 2 Recent steps in unbundling 20 Mar 2007 Neelie Kroes, speaking to the European parliament s economic and monetary affairs committee, reaffirmed the EC s commitment to unbundling, but added that there are other options, but those require detailed and complex regulation, and that would mean a greater burden on business. 26 Mar 2007 Neelie Kroes: Legal unbundling has failed to solve the problem. That is why the Commission sees full ownership unbundling as the most effective option to solve the problems of discrimination and investment incentives. 24 May 2007 Energy Commissioner Piebalgs: The European Union wants a quick and friendly deal with utilities that will increase competition on energy markets without forcing companies to sell their power grids. Finding a solution in a nice and fast way would avoid a years-long legal battle. We want to achieve a solution in an amicable way, he said. This would guarantee that transporting energy is split off from utilities other operations. Piebalgs thinks it legally possible to make utilities sell their energy grids as part of the bloc s efforts to boost competition on closed energy markets: Reservations regarding constitutional problems can be solved. 2007 6 Jun 2007 Energy Commissioner Piebalgs admitted defeat after an exchange of views at the Energy Council in Luxembourg on 6 June on the electricity and gas market. He had been hoping for some signs that opposition was weakening to the EC s preferred option for opening up gas and electricity markets (ownership unbundling). Following the meeting, though, he spoke of not being able to hide the truth and of it being a very difficult time for the Commission to table its proposal. 1 Jul 2007 EU deadline for full market opening. 19 Sept 2007 Proposal for a Directive of the European Parliament and of the Council amending Directive 2003/54/EC and amending Directive 2003/55/EC concerning common rules for the internal market in electricity and in gas was published. Proposal for a Regulation of the EU Parliament and of the Council establishing an Agency for the Cooperation of Energy Regulators was published. 7

UNBUNDLING AND ITS ROLE IN IMPROVING COMPETITION 2 Unbundling and its Role in Improving Competition Many policy instruments are available to improve competition in the energy sector. The key ones are: The regulatory environment: An effective regulation and rigorous application of competition law should prevent the abuse of dominant positions by incumbents. Unbundling: This separates the control of transmission assets from generation and supply. It stops generators from deploying the assets strategically, either in biased operation, or through skewed investment to advance their own interests. It should also stop the supply side benefiting from distribution activities. Cooperation between network companies: If network companies can cooperate successfully to use interconnectors effectively, make capacity available on a non-discriminatory basis, and build new capacity where needed, then imports can better contest markets. Trading market maturity: As trading skills on wholesale markets develop, wholesale markets will become liquid, and non-incumbent suppliers can build cheaper and more appropriate portfolios; in many countries this learning process is at an early stage. Improving the level of consumer engagement: As consumers better Ownership unbundling, regulation and cooperation of network companies have to be treated holistically if we want to improve competition. understand their rights and options, they will start to seek and to demand information which is currently not always available to them. Unbundling, and particularly ownership unbundling, is only one instrument to improve competition, and it brings with it some substantial disadvantages 1. We therefore need to discuss its effectiveness in comparison with other measures which guarantee non-discriminatory access to the grid, improve transparency, and remove poor market integration arising from major constraints on cross-border network capacities - in other words, unbundling, regulation, and cooperation of network companies. In our view, these three instruments have to be treated holistically. The following pages present some controversial aspects of these three instruments. 2.1 Ownership Unbundling The proposals of the Commission for ownership unbundling or an ISO depend on the idea of independence. Independence is simple in concept, but hard to guarantee in practice. Four objections can be raised: 1. Independence is assessed against the criterion of control. 2. Any threshold for an acceptable level of share ownership would be arbitrary. 3. How can independence be guaranteed in the case of state-owned utilities? 4. The strategic objectives of foreign owners may run contrary to the political objectives of individual countries and the EU. Ownership unbundling does not, of itself, guarantee independence: it cannot replace independent regulatory scrutiny. First of all, the EU proposal defines independence by referring to the concept of control. But control and independence are two quite different things. To be independent means to act without influence ; but one could say that to exercise control means to be the final decision-maker. Measuring independence is a big challenge, because it is a soft fact. Excluding control over the transmission business will not necessarily lead to independence. The obvious way to ensure independence of an owner from participants in the generating and supply markets is to limit the share ownership of companies in the competitive sector in the network company a figure of 5% is sometimes suggested. What is important is that detailed criteria are established at European level and included in the Directive; if national governments are 1 For example, Vattenfall argued that alternative incremental means would achieve the same ends with less disruption. It proposed regionally independent system operators, beginning with institutionalized cooperation of the TSOs - envisaging that the present TSOs could continue to own, maintain and develop the assets. This arrangement, in their view, would stimulate market integration by harmonizing all operations and taking a regional view on grid planning and investments. ENI took a similar position. 8 BALANCING E UROPEAN E NERGY M ARKETS

Figure 3 Unbundling landscape in Europe electricity Electricity transmission grid Electricity distribution grid Accounting Legal Ownership Combination Accounting, functional, legal No unbundling in place Independent System Operator (ISO) Figure 4 Unbundling landscape in Europe gas Gas transmission grid Gas distribution grid Accounting Legal Ownership Combination Accounting, functional, legal No unbundling in place 9

UNBUNDLING AND ITS ROLE IN IMPROVING COMPETITION allowed to establish their own criteria, there could be discord and unfairness. Discrimination may not even require any common ownership: a national network, even with no ownership involvement from a generator or supplier, may act to favor national companies because of common culture, nationalism and perhaps acquaintance. Ownership unbundling will not replace independent regulatory scrutiny. State ownership poses particular problems. There is no reason to believe that a stateowned transmission company would not discriminate in favor of a state-owned generator. If either were to be privatized because of unbundling, this could be construed as a discrimination against state capital. The liberal solution would be to privatize the companies in the competitive businesses, but that cannot be enforced. Hence there is the risk that privately owned VIUs are discriminated against. Those companies have to sell their grid, while the state is allowed to have ownership of generation, transmission, and supply, only separated by the fact that responsibility lies with different ministries. The Commission explains that the proposal applies in the same way to publicly and privately owned companies. 2 It goes on to specify that two distinct public bodies could control on the one hand generation and supply and on the other transmission activities. We think that this could be viewed as organizational - perhaps even legal - unbundling, but not as ownership unbundling. The owner of the TSO and the generation and supply business is still the same: the state. Entities outside of the competitive markets may have wide strategic interests that could influence their control of networks. Countries from outside the EU could have strategic interests in managing and extending a network. Some hydrocarbon-rich countries have established sovereign funds to ensure long-term income, as revenue from hydrocarbon production falls away. A gas or electricity network with long-term prospects for stable income is a suitable target for their investment, but again the strategic interests of the country may be at variance with those of the EU. Whilst the Commission is trying to break up the major players in the EU Member States, Russia seems to have a superbundling strategy at least within the gas sector 3. Russia s superbundling strategy Whilst the Commission is trying to break up the major players in the EU Member States, Russia seems to be in pursuit of superbundling the strategy of leveraging its vast natural gas resources to expand into the transit and supply of gas in Europe. Furthermore, ownership unbundling could lead to a tremendous capital need. If the major VIUs of France and Germany have to sell their grid within a short time horizon, it might be difficult to find the necessary investors particularly because potential foreign investors like Gazprom could be excluded due to Article 8a of the draft which states that transmission systems or transmission system operators shall not be controlled by a person or persons from third countries. Because the networks will be for sale all within the same time period, this will also generate tremendous valuation issues for the networks. The harsh reaction of Russia and Gazprom to the proposal suggests that the EU has not looked outside the borders of the EU when producing this proposal. What are the effects of the proposal on other markets? What will happen to Gazprom s gas exports to Europe? China is another huge potential market for Russian gas. If Gazprom takes offence at the EU proposal, might this affect its sales strategy, and put Europe s security of supply at risk? The Commission indicates: With the view to encourage investments in new energy infrastructures by supply and production companies, the present proposal includes the possibility of a temporary derogation to ownership unbundling rules for the construction of new infrastructures. This exemption will be applied on a case-by-case basis. This implies that the EU considers the directive could actually reduce investment levels - whereas Europe urgently needs a great deal of investment in networks. Many practical questions about the Commission s proposal remain to be answered, including: If, by the end of the transition period, a VIU has not sold its network, will it be expropriated? Will it be forced to auction networks, or even sell networks in chunks? In the case of expropriation, will the country or the EU itself pay compensation when the value realized falls short of the current owner s views? How should additional operational risks be treated, if the new owner has no experience of operating a tranmission grid? What happens to long-term gas supply contracts? 2 Explanatory memorandum to the proposal for a Directive of the European Parliament and of the Council of 26 June 2003 concerning common rules for the internal market in electricity, page 6. 3 See European Energy, Breaking up is hard to do: The Economist, 15 September 2007, page 72. 10 BALANCING E UROPEAN E NERGY M ARKETS

2.2 The ISO There are many ways of delimiting the scope of an ISO, as shown in Figure 5. The activities involved in managing the system and the commercial operations, and in operating and developing a transmission network, can be outsourced to a contract manager in various combinations. Figure 5 shows three options, which penetrate progressively deeper into the business. The first option, which we have called the balancing ISO, would be to contract the system management, including dispatch and some of the commercial activities, but exclude certain strategic functions such as demand forecasting and capital planning. The second option, the operational ISO, is similar, but includes the operational planning of the system, i.e. over a longer timescale than the system management. The third option, the deep ISO, incorporates the planning and investment Figure 5 The range of ISOs System management Operational studies Procurement analysis Balancing call-off Congestion management Ancillary Services Procurement Key Real-time dispatch Billing Outsourced ISO = Contract manager Commercial management Agreements Capital plan management Long-term statement Customer contracts Demand forecasting Balancing ISO Operational ISO Deep ISO processes, including customer contracts, demand forecasting, capital planning, strategy, and development planning. The Energy Policy for Europe defines the acceptable option as a full Independent System Operator (where the vertically integrated company remains owner of the network assets and receives a regulated return on them, but is not responsible for their operation, maintenance or development). The important word in the sentence is development, because this implies that the ISO will be responsible for the investment process. The prospects paper makes the same assumption: The system operator would be solely responsible for operation and dispatch, being the primary interface with network users, and would exercise control over network maintenance and development decisions. The inquiry does not define an ISO, but it defines the problem as the process whereby: Vertical Asset operations Operational planning Maintenance strategy & asset health analysis Work scheduling Maintenance Networks operations Network development /investment Investment strategy Investment planning Procurement/contract management Building mgt, testing, etc integration also leads to a situation where operational and investment decisions are not taken in the interest of network/infrastructure operations, but on the basis of the supply interests of the integrated company (including grid connection for competing power plants). This is highly damaging to security of supply. Ensuring nondiscriminatory investment is an important part of the Commission s thinking. It may be that companies exposed to a regime of deep ISO unbundling would eventually prefer actual ownership unbundling. Companies will resist being forced into investments that they do not wish to make. If the transmission company is no longer a strategic asset, then the transmission assets simply become an immense volume of capital tied up in a low-yield, low-risk business. The company could redeploy the money elsewhere, at higher rates of return. The ISO concept is already practiced in several countries. The UK National Grid (NG) company both owns and operates the electricity transmission network in England and Wales and the gas transmission network throughout Great Britain. It operates these assets under a fully unbundled TSO model. In Scotland, NG operates the electricity system, but does not own it. Since 2005, it has acted as the System Operator (SO) under an ISO model. The ISO model was seen as inferior to ownership unbundling, but the latter was not perceived to be politically feasible. NG also has network assets in the US, operating under ISO and regional models. In the Scottish model, the SO is responsible for all operations including balancing load and managing congestion; it also allocates access rights. Responsibilities for maintenance and investment are shared. The transmission owners (TOs) prepare plans and submit them to NG, which then adjudicates. The implementation of investment is made by the TOs and, in principle, this gives scope Source: Based on Frontier Economics 11

UNBUNDLING AND ITS ROLE IN IMPROVING COMPETITION for manipulation a TO can easily delay investments that it does not wish to make. A deeper ISO, with stronger control over investment by the SO, would avoid this problem. PJM Interconnection (PJM) is a regional transmission organization (RTO) that manages the grid in fourteen contiguous states of the US. It forms the largest competitive wholesale electricity market in the world, and the largest centrallydispatched grid. The governing body is an independent, non-stakeholder board. Various member processes allow some 450 market participants to advise the board. PJM analyzes and forecasts the future electricity needs of the region, and is solely responsible for operating the regional power grid, and for investment. It conducts system planning and directs investment and maintenance, although these functions are implemented by the TOs. 2.3 The Role of Regulation It is sometimes argued that ownership unbundling is unnecessary if there is well thought out and strong regulation. Regulation and unbundling are complementary: as the competition inquiry confirms, Europe needs a substantial strengthening of the powers of regulators and enhanced European coordination 4. Again, it is clear that regulatory scrutiny is essential. An ISO or unbundled TSO is a monopoly and needs regulation. The competition inquiry recognized that there is considerable variation in national regulation in quality, nature and depth. Rules on proper market conduct and supervision differ significantly between Member States, as there is little harmonization at EU level of the transparency requirements. There is a clear need to harmonize market design, especially where it affects cross-border trade. The European Regulators Group for Electricity and Gas (ERGEG) has issued many guidelines for regulators, but these have no formal authority. The Commission proposes to introduce ERGEG+, which would be a coordinating body of existing regulators, but with some statutory authority. This is a middle way between the present uncoordinated structure and a single European regulator, and is appropriate. At a national level, many countries have put regulators in place (for example, CRE in France, OFGEM in the UK or BNetzA in Germany) but they have been set up at very different points in time, and have very different roles and powers from one country to another. 2.4 The Regional Independent Operator The Regional Independent Operator (RIO) is a different approach, starting from the premise that what is primarily deficient is the level of cooperation, not the level of 4 DG Competition Report on Energy Sector Inquiry, SEC(2006) 1724, Brussels, 10 January 2007 12 BALANCING E UROPEAN E NERGY M ARKETS

unbundling. The idea is that the management of transmission assets in contiguous areas should be transferred to a single regional operator. This idea is especially strongly canvassed by Vattenfall, which says: We are ready to commit our TSO to a regional (i.e. a supra-national) transmission structure. The appropriate model for doing so is yet to be developed. The experience we can gather with such a regional structure will be helpful for further progress. Notwithstanding our willingness to voluntarily have our TSO become part of such a regional solution, we cannot accept that national TSO or ISO structures emerge, as such national structures tend to be very long lasting and will hinder the development into regional structures. Therefore, we will not support our TSO becoming part of a national ownership unbundling or ISO solution. 5 Vattenfall cites its experience with the Nordic market and its operator Nordel, claiming that: The Nordel organization showed good results in the first stages of market integration, but has now come to a point where binding decisions are needed, for example when it comes to congestion management, balancing rules and investments; something such an organization cannot provide. This experience leads us to believe that regional ISOs combined with a proper regulatory function at community and regional level would be the most efficient way to develop the European market. 6 The alternative view is that the RIO has advantages, but does not eliminate the need for stronger unbundling and regulation. Better market integration does not remove the need to prevent discrimination on the part of vertically integrated companies. Effective unbundling and regulation would have to be a prerequisite of an RIO model. The Commission argues that: Efforts should also be made to have a gradual evolution towards regional Figure 6 Regional markets in Europe Baltic States Iberian Peninsula Scandinavia system operators. Cross-border system operators would be set up. These would be independently owned and would require additional unbundling. 7 The establishment of regional markets should not close off the option of eventually creating a single European market. Europe is already composed of regional markets, as shown in Figure 6: nevertheless, the final definition of regional markets would be a challenge. Electricity markets South East Europe Italy and neighbours Eastern Europe These regional markets are already closely working together today in respect of 8 : Capacity allocation Balancing integration Transparency. UK, Ireland Western Europe No regional market To enforce market integration, these topics have to be treated in a coherent manner in each region. In our opinion, such an approach would have the greatest potential impact on the formation of the single market. 5 Vattenfall s views on the EU Commission initiative An Energy Policy for Europe and the prioritized Action Plan, Stockholm 15 February 2007 6 ibid 7 Prospects for the internal gas and electricity market, COM (2006) 841, Brussels, 10 January 2007 8 See also ERI Convergence and Coherence Report An ERGEG Public Consultation Paper, 18 July 2007 13

UNBUNDLING AND ITS ROLE IN IMPROVING COMPETITION 2.5 The Political Alignments There is a wide range of practice and opinion across Europe that is based in fundamental social, political, and economic attitudes. The liberal economic models of Scandinavia and the UK tend to favor unbundling in some form with a specific difference: in Scandinavia, major utilities are state owned, whereas in the UK they are not. On the other hand, we find the deep involvement of the state in the economies of France and Poland. We have a classic confrontation: on one hand the concept of competitive, unbundled, pan-european companies, delivering policy objectives under market-based instruments: on the other, the concept of national champions, secure in their domestic markets, delivering policy objectives under political influence. The split reflects different concepts of European energy policy. The idea of competitive, unbundled, pan-european companies, delivering policy objectives under market-based instruments, confronts the alternative of national champions, secure in their domestic markets, delivering policy under political influence. France has suggested that the state-controlled EdF, and the new GdF-Suez merged company with a blocking state share ownership, provide the template for European energy policy. Germany lies somewhere in between: the influence of large companies is strong and German practice is more to regulate their activity than to seek structural solutions. A good indication of the division in opinion is demonstrated in the letters sent by Member States to Commissioners Piebalgs and Kroes. In June, eight countries wrote urging the Commission to maintain its position on unbundling. The letter was sent by Denmark and supported by the UK, Spain, the Netherlands, Belgium, Sweden, Finland, and Romania. The signatories alleged that, at the 6 June ministerial meeting, We have not found any of the arguments in favor of alternative models for separating production and supply from transmission convincing. 9 In July, nine countries, led by France and joined by Germany, Austria, Bulgaria, Slovakia, Cyprus, Greece, Luxembourg, and Latvia, wrote disputing the need for unbundling and claiming that: The separation of ownership between network managers and energy suppliers supported by the European Commission has not proven itself 10. The letter accepted that the market was partially dysfunctional, but claimed stronger and harmonized regulations in Europe would be a sufficient remedy. Figure 7 shows how practice maps onto opinion across Europe. 2.6 Next Steps The Commission has indicated that ownership unbundling is its preferred and superior option, but that, in the absence of adequate political support, the ISO model is acceptable. The political debate will now shift towards the details of the new regime. Clear guidance will be needed on the meaning of independence, and on the treatment of state-owned VIUs and investors from outside Europe. It will also be necessary to clarify what are the minimum criteria that are acceptable to delimit the scope of an ISO and in particular, what control it will exercise over investment and what governance procedures will be permitted that safeguard the legitimate interests of owners. The eventual outcome is uncertain; the form of the final Directive will depend on how the Commission manages the conflicting political forces. The Commission s draft, published on 19 September 2007, is a milestone for the 3rd Energy Directive but no more. The months to come will bring intensive discussion all over Europe. It is expected that the EU parliament will devote itself to Assuming the final version of the EU-Directive comes into force in mid-2008, it will have to be transposed into national law by the end of 2011. All requirements from the Directive will have to be fulfilled by this date. discussing the proposal. If it is finally agreed probably in an adopted version during 2008 countries will have a period of 12 plus 18 months to comply with the Directive. In other words, the Directive will come into force 12 months after its publication, and then EU countries will have 18 months for transposition. Article 2 explains: Member States shall bring into force the laws, regulations and administrative provisions necessary to comply with this Directive by [18 months after entry into force] at the latest. 9 FT.com, EU urged to force energy break-up, 25 June 2007 10 EU Business, Nine EU states oppose split of energy producers and distributors, 31 July 2007 14 BALANCING E UROPEAN E NERGY M ARKETS

Figure 7 Ownership of transmission and political opinion across Europe Ownership of TSO electricity Private State owns shares in TSO State owned Position about ownership unbundling (electricity) within EU-Member States State has majority in operator, but operator does not own grid assets Opponent to ownership unbundling Neutral Supporter of ownership unbundling 15

IMPACTS ON COMPANIES 3 Impacts on Companies 3.1 Overview In this Section, we examine the impact that the Commission s various competitionenhancing mechanisms will have on utilities management. In the days of large vertically integrated utilities operating within defined concessions, there was a certain uniformity in the purpose and structure of utilities. Liberalization has changed this. In the fully unbundled and competitive markets such as the UK, there are many specialist companies: generators, network operators, suppliers, power exchanges, and traders. Where liberalization has been fully implemented, it has often been followed by reconsolidation as the remaining large vertically integrated industries purchase the smaller companies in the liberalized markets. There has also been a tendency for gas and electricity companies to merge or to be acquired. The consequence of these processes is that there is now a complex structure to the industry in Europe with a disparate population of companies of different sizes, functions, and geographical scope (see Figure 8 for a classification of energy utilities). A third round of legislation will affect all these organizations differently. Specialist grid companies such as NG are likely to be interested in acquiring transmission assets or possibly in ISO management contracts. The nature of the market for the competitive businesses will also change; ownership unbundling would bring non-discriminatory access to the grid for competing generation companies with the result that sales, margins, and service standards will be challenged by new entrants. 3.2 Vertically Integrated Utilities (VIUs) Ownership unbundling presents VIUs with three critical decisions: 1) Should they dispose of the network? 2) If so, how should this be done? 3) When is the right time to do it? Essentially, there are two unbundling options: you either create two or more separate companies by splitting the shares, or you dispose of the transmission asset to Figure 8 Classification of major European utilities 1 REGULATED NON-REGULATED Regulated wires/pipes (regulated transmission & distribution with some non-regulated activities) Regulated integrated (regulated generation, wires & supply with some non-regulated activities) Integrated transmission & distribution (generation & supply non-regulated) Integrated distribution (generation & supply non-regulated) Non-regulated business Integrated electricity and gas players National Grid EnBW, E.ON, RWE Iberdrola, Essent, Nuon Centrica Electricity players Red Electrica, Terna EDP, PPC, UESR EDF, Verbund, Vattenfall Endesa, Enel, CEZ, Fortum Atel, Suez 2, Statkraft Gas players SNAM Rete Gas GDF ENI 1 This classification is done from a home country perspective, reflecting the main activities. Classifications can vary significantly between different geographies. For example, in the UK, EDF Energy is an integrated distributor in electricity, and also has a position in gas retail. 2 Only very little gas activities in Belgium 16 BALANCING E UROPEAN E NERGY M ARKETS

There are two basic unbundling options: create two or more separate companies by splitting the shares, or dispose of the transmission asset to a third party. a third party. In the case of disposal, there will be a choice over how much cash to retain in the company, and how much to distribute to shareholders. The generatingsupply rump of the VIU can use this cash for new investment. Management is likely to prefer this option. The next choice is how quickly to dispose of the network. Figure 9 shows the forces that might cause management to accelerate or delay disposal. Early disposal gives the company first mover advantages in the acquisition of new Figure 9 Conflicting forces for and against disposal VELOCITY Achieving complexity reduction Receiving cash for new investments Increasing regulatory pressure First mover advantage Decreasing market value of grids Analyst expectations VELOCITY TRANSACTION TIME & VALUE assets elsewhere. It is also likely that grids will depreciate as more become available and as their strategic value disappears, so early disposal may be advisable. There are also some disadvantages, as shown in Figure 9, but in the case of obligatory ownership unbundling these disadvantages will materialize in any case. The advantages of early disposal may therefore prevail. In the case of splitting the shares, the issue to handle is to value the different parts of the VIU. Once this is done, shareholders have to decide whether to sell their shares in the transmission company, or to sell their shares in the VIU. To guarantee independence, no person or persons are allowed to have control over the transmissions company if they have control (including through minority blocking rights on decisions of SLOWDOWN Long-term stable income source Lowering asset basis Current strategic position: Competitive advantage for having an integrated business Diversification of risk Integrated processes Existing synergies SLOWDOWN strategic importance such as investments) over a production or supply undertaking. If a shareholder has more than 25% of both companies after splitting the shares, that would be the case. He must sell the shares either in the transmission company or in the generation/supply company. In the case of an ISO, the choice is in two stages. The first choice is whether to adopt the ISO model or ownership unbundling. Assuming that disposal is the preferred option for ownership unbundling, similar considerations will govern the choice. Disposal will simplify the business, reduce regulator involvement, give first mover advantages, and relieve the company of a depreciating asset. The ISO model will diversify the business and reduce risk, but introduce contractual and regulatory complexity. From an accounting and financial communication perspective, it should also be noted that the ISO model will generate complex questions. Even if the VIU still legally owns the network, will it still be possible to consolidate the assets (under IFRS or US GAAP for example) since the VIU will actually have no control over these assets? The ISO model option could have tremendous impacts on the balance sheet and profit and loss of the VIUs. 3.3 NON-INTEGRATED TRANSCOS Unbundling of VIUs has positive and negative implications for a non-integrated transmission company. The value of existing grids is likely to fall as the supply to the capital market of assets of that nature will be substantially increased, but the grids offered for sale present an opportunity for corporate expansion by acquisition. Barriers to cross-border exchanges will be lowered and this could make for profitable opportunities, especially if contiguous grids have the same owner. 17

IMPACTS ON COMPANIES The development of regional solutions would bring more effective interconnection and possibly higher capacity interconnectors, leading to better arbitrage opportunities between contiguous markets and more extensive trading. More effective interconnection will allow generators and suppliers to connect adjacent markets with implications again for sales, margins, and standards of customer service. Incumbents will need to become more efficient, more flexible, and better adapted to customer needs. More interconnection could also lower the required capacity margin, and therefore reduce the need for investment in new capacity. 3.4 Strategies Vary Across the Continent It is very difficult to develop a generalized business strategy for Europe: the unbundling picture varies so much from country to country. Unbundling and the release of cash for acquisitions, combined with possible resistance from competition authorities to increased presence in domestic markets, may strengthen the existing trends towards globalization. A radical change in unbundling requirements will have different impacts across Europe, depending on the existing market practice. Companies will need to develop different strategies to manage that change: those who react quickly and effectively will gain advantage. In the UK and Scandinavia, there will be little change. In countries with less liberal systems, unbundling will create opportunities to expand generation and supply activities, perhaps including the acquisition of existing generators and suppliers. Cost pressures on generators and suppliers will increase. The dynamic markets and corporate activity in an unbundled regime will create continuingly changing threats and opportunities. The operating environment will be less stable than that characterized by VIUs living in long-established coexistence. To succeed in this environment will require rapid access to information, strong countryspecific analytical skills, and fast, accurate decision-making. The harmonization of legal requirements across networks in Europe will simplify business models for pan-european utilities. However, sharper regulatory monitoring of unbundling requirements means companies will need to audit their current unbundling status rigorously. 3.5 Corporate Challenges of Unbundling and Separation First and foremost, the challenges facing companies are to: Understand what is required by the EU Directives and the legislation that transposes the Directive into national law Be sure of the scope for choice within the legislation and the binding constraints Identify their options and the business consequences of each Rank these options with clear and pertinent criteria. Below we discuss the consequences of change in terms of business structure, implementation of change and moving forward on a new operational basis. 3.5.1 Designing a New Business Structure A new business structure needs to accommodate organizational, regulatory, legal, and fiscal requirements. The organizational issues largely concern the number and functions of entities in the organization; the allocation of assets to those entities; the adequacy of human resources and skills for the new functions; the protocols for communication; and the information systems that will be used to link the entities. The extent to which common services are permitted or desirable must be assessed. A new business culture will be needed to cope with the revised objectives, skills, and functions of the enterprise. The allocation of the costs of overheads, central offices, and common services must be determined, as well as the scope for outsourcing certain functions. In the case of an ISO, there are specific concerns about the relationship between the operator and the owner that must be thought through. The corporate governance model will critically affect this relationship, as well as the confidence that both sides have in the viability and fairness of the arrangements. These discussions are far from easy, although 18 BALANCING E UROPEAN E NERGY M ARKETS

it may well be that the so-called Scottish Model provides a template for use elsewhere. Unbundling will introduce substantial changes in the nature and extent of compliance with regulatory requirements. The first step is to identify the requirements in legislation, regulation, and licenses, and to determine how these requirements will be met, and what the penalties are for noncompliance. Companies then need to develop a structure for compliance reporting that is consistent with these functions. Procedures for communication with the regulator need to be established to control the level of interaction and protocols for consultation and submissions. A satisfactory model for communication with the ISO in regulatory matters must be designed. Among the main legal and fiscal priorities are the needs to determine the most tax efficient business model, and to incorporate the new legal entity. Priority issues of branding, rebranding and intellectual property rights need to be identified and settled. Legal constraints on communication between entities in the new structure need to be identified, and transformed into internal protocols. Specific issues such as the identification and settlement of cross-border leases need to be managed. 3.5.2 Implementing the New Business Structure Implementation is the process of getting the new systems to work. The important systems are IT, accounting, human resources, internal procedures and processes, finance, and risk management. IT systems are likely to need substantial revision since they are closely tailored to the functions and structures of the organization. The relationship between entities in the new structure may be quite different in terms of the information that needs to be (or can be) transferred, and the functions between which it is transferred. Constraints on data transfer may also require separation of data storage. IT systems also evolve rapidly, and a reform undertaken for the purposes of unbundling needs to be set in the wider context of how the company s information systems should evolve to match business needs and technological development. The assessment of the need for new IT architecture and new software systems should be addressed in this light. Accounting systems are also strongly influenced by company functions and structure, and will need to adjust to reflect the different scope of activities and the shift to commercial contracts as the basis for interaction between component businesses. The necessary adjustments to the internal and external accounting systems need to be identified, and procedures developed to maintain and improve controls. Any change to structure and functions will affect human resources: it will influence staff numbers, their place and nature of work, and their skills. The new structure will probably have consequences for almost all employees; new roles and responsibilities need to be specified, along with training and transition programs. New skills are likely to be needed these must be specified and where they cannot be supplied internally, recruitment must be organized. Redundant skills need to be identified and severance programs should be established. Pension and employee compliance issues inherited from the old structure must be identified and satisfied. Internal processes and protocols will need revision. Unbundled business structures are likely to depend more upon commercial contracts than do bundled structures. New procedures will probably be needed. Compliance requirements will change; reform will require that the affected processes are identified, and appropriate new processes defined and developed. The treasury function would be strongly affected by unbundling. Revenues, financial needs, credit ratings, costs of capital, capital structure, and exposure to risks will all change significantly. The key financial risks to be managed should be identified and analyzed to ensure that they are understood. New risk management systems must be developed that are appropriate to the new financial environment. The optimal financing of separated business and the initial capital structure need to be decided according to the inherent risks and the credit rating of the market. Alternative financial arrangements, in particular the scope for sale and leaseback agreements, should be developed. New financial targets and budget metrics will be required and tax implications must be assessed and managed. 19

IMPACTS ON COMPANIES 3.5.3 Operating the New Business Structure The first operational challenge is to ensure that operations are not affected by the unbundling process. This will not be easy while IT and accounting systems are changed and personnel redeployed. The second and very important challenge is to develop compliance procedures that reliably demonstrate whether a company is fully compliant with the requirements of national law and regulation. The third challenge is to develop, measure, and apply objectively verifiable performance indicators for the new businesses. Figure 10 Compliance issues 3.6 Compliance A third round of EU regulation with deeper unbundling, tighter regulation, and more challenging criteria for cross-border cooperation will increase pressures to comply and to demonstrate compliance. Even for ownership unbundling, the fulfilment of legal requirements has to be monitored by regulatory authorities. As ERGEG points out, Regulatory oversight will still be necessary for an independent network operator as it remains a monopoly. 3 The sector inquiry agreed: Guidelines, as well as monitoring and eventually adaptation of existing regulation, should serve to further enhance transparency in the gas and electricity sector. 4 The Commission therefore intends to introduce binding guidelines for transparency, and to convert ERGEG to a body with statutory authority, known as ERGEG+. Guidelines do exist. ERGEG has prepared draft guidelines for functional and informational unbundling and circulated them to companies for comments 5 ; it has also prepared guidelines for information management and transparency 6 and for unbundling of regulatory accounts 7. These guidelines have no legal authority. There are also country-specific guidelines for example, in Germany there are common guidelines of regulatory authorities of the state and the federal states to implement informational unbundling in respect of the new Energy Law. 8 Ongoing operations Challenges Compliance Questions and issues Develop ongoing compliance programs Publication of compliance reports Assessing compliance of unbundling of accounts Assessing compliance of confidentiality of economic sensible information Assessing compliance of functional unbundling Assessing legal requirements as publishing a compliance report from a risk perspective Assessing compliance of internal rules and instructions Developing a cross-border approach for multinational utilities of checking/assessing the compliance with the current country-specific unbundling requirements and with EU legislation. 3 3rd Legislative Package Input Paper 1: unbundling (C07-SER-13-06-1-PD) 4 Inquiry pursuant to Article 17 of Regulation (EC) No 1/2003 into the European gas and electricity sectors (Final Report), COM(2006) 851, Brussels, 10 January 2007 5 Draft ERGEG Guidelines of Good Practice on Functional and Informational Unbundling - An ERGEG Public Consultation Paper, ERGEG, 30 April 2007 and replies, available on ERGEG web site 6 ERGEG Guidelines for Good Practice on Information Management and Transparency in Electricity Markets, 15 March 2006 7 ERGEG Guidelines of Good Practice on Regulatory Accounts Unbundling Ref: E05-CUB-11-02, 30 April 2007 8 Gemeinsame Richtlinien der Regulierungsbehörden des Bundes und der Länder zur Umsetzung der informatorischen Entflechtung nach 9 EnWG,13 June 2007 20 BALANCING E UROPEAN E NERGY M ARKETS

To minimize compliance risk, it would be wise for utilities to demonstrate that they fulfil the current unbundling requirements in each European market. Figure 10 shows how they might tackle this task. The 2003 Electricity Directive in Article 15, sentence 2 (d) 9 specifies that: The distribution system operator shall establish a compliance program which sets out measures taken to ensure that discriminatory conduct is excluded, and ensure that observance of it is adequately monitored An annual report, setting out the measures taken, shall be submitted to the regulatory authority and published. The 2003 gas Directive 10 lays an almost identical obligation on the combined system operator. Pan-European utilities have not yet published such compliance programs for each country in which they operate. Compliance with the requirement is recommended. This might best be done via a neutral, external auditor. Such a body could bring a useful new perspective to bear on internal discussions around how to fulfill the compliance requirements. It is also likely that the assessment of an external auditor would be more credible with third parties. By engaging a neutral, external institution, the utility would demonstrate full openness and its commitment to compliance with the current unbundling legislation. An external body can achieve easier implementation from its knowledge and insight of practice and benchmarks all over Europe; it can also adopt a neutral position regarding internal conflicts. An external assessment will also minimize personal risks for the people responsible for implementing an unbundling compliance program, since they would not be forced into possible conflict with their co-workers. 9 Directive 2003/54/EC of the European Parliament and of the Council of 26 June 2003 concerning common rules for the internal market in electricity and repealing Directive 96/92/EC 10 Directive 2003/55/EC of the European Parliament and of the Council of 26 June 2003 concerning common rules for the internal market in natural gas and repealing Directive 98/30/EC 21

OUR CONCLUSIONS 4 Our Conclusions There is continuing dispute and passionate debate among countries, companies, and commentators on the merits and needs of various levels of unbundling. Much of this dispute is not based in objective analysis, but is designed to substantiate commercial or political positions. Some of the dispute is attributable to the complexity of the issues, and the difficulties of disassociating the impacts of unbundling from other contingent events that influence performance. The main controversial topics are: The actual impact of ownership unbundling on improving competition The mismatch between private and stateowned transmission network owners Legal concerns about a factual expropriation of private-owned transmission network owners The question of whether dismantling the big European utilities is the right answer in the light of Russia s superbundling strategy. Another point of the proposal that was subject to debate, and arguably is not fully resolved, is that it bundles together electricity and gas transportation. The key justification is that the two markets are vertically integrated. While this is true, it is not always possible to apply the same regulation principles to different parts of the same value chain, however convenient that may sound. There are fundamental differences in the physical structure of the electricity and gas transmission system. On the operational level, gas pipelines bear more of a resemblance to oil pipelines than to the electricity grid. There is arguably more evidence of effective unbundling of grids in electricity than in natural gas. The supply situation is also different. While new generation capacity can (at least technically) be added within the EU at relatively moderate cost, most European gas supplies are external, and the perspective of new competitors entering the supply business remains unclear. So what are the main implications of all this for the energy community? Utilities Utilities need to review their corporate strategy in the light of a third round of EU legislation on the internal market. It is likely that, one way or another, the control exercised by VIUs over network assets will be increasingly restricted. Decisions on operation, access, and investment will pass progressively out of the hands of the owner. Companies should prepare for this. An owner may decide that there is no point in retaining network assets that no longer have strategic Companies should prepare for the fact that decisions on operation, access and investment will pass progressively out of their hands. value and that are subject to the decisions of others. The critical choice for a VIU is whether to anticipate change by voluntarily adopting ownership unbundling at an early stage and, if so, how to do it. Critical factors for utilities to consider are: 1. Different unbundling scenarios need different strategic answers. 2. Disposal of the grid, share splitting, or establishing an ISO should be considered on their merits. 3. Business models should be aligned with market activities, the extent of unbundling legislation in the countries concerned, and the strategic choices identified by the company. 4. Utilities should be proactive in improving regional cooperation and in establishing RTOs. 5. They should demonstrate transparency and cooperation to the EU and regulatory authorities by fulfilling the unbundling requirements and demonstrating that they have done so. 22 BALANCING E UROPEAN E NERGY M ARKETS

Political institutions To achieve non-discriminatory, functioning networks for electricity and gas, unbundling, regulation and cooperation need to be in balance. European institutions should reassess the political support for rapid implementation of ownership unbundling. The most ambitious practical aim is to allow member states a choice of ownership unbundling or the deep ISO. The deep ISO has very similar impacts in terms of providing non-discriminatory access and may well lead in practice to ownership unbundling. After publication of the Commission s proposals, the focus of political debate will shift to the scope of the ISO. Other critical topics that still need debate are the meaning and guarantee of independence and possible prohibitions on ownership from outside the Community. By forcing ownership unbundling and, as a derogation, setting up SOs which are independent from supply and generation interests, energy markets in Europe will become more and more imbalanced. On the one hand, there will be private-owned companies which have to dispose of their grid to achieve ownership unbundling; on the other, there will be state-owned companies which are only separated on a legal and organizational level. Several factors determine the extent of competition and prices for customers: unbundling is only one of them, but to achieve non-discriminatory, functioning networks for electricity and gas requires a balance between unbundling, regulation, and cooperation. Critical next steps are: 1. Ensuring more effective cooperation between contiguous transmission systems in terms of both operation and investment 2. Applying the same rules and rights for private-owned and state-owned utilities, to establish a level playing field in a single European Energy Market 3. Harmonizing European legislation in implementing the EU-Directives, and providing legally binding Europeanlevel regulation for critical regulatory functions through ERGEG+ 4. Establishing enforceable rules to monitor the fulfillment of current unbundling legislation. Without a level playing field in Europe, we believe that extensive regulation will be needed to counterbalance different market structures. Market-based policies promoting security of supply, climate and environmental protection will be ineffective. Regulatory authorities It s vital to upgrade regulation in weaker authorities to a common community level, and develop rigorous compliance programs to ensure rules are observed. The draft of the 3rd EU Energy package contains a few proposals to strengthen the powers of national regulators, and deepen cooperation between energy regulators by setting up a European Agency. Regulatory authorities should use this strengthening of their power to continue to develop common guidelines for regulatory functions, and should develop guidelines for monitoring the unbundling requirements. The aim should be to upgrade regulation in weaker authorities to a common community level, and to ensure that the regulations are observed through the development of rigorous compliance programs. 23

COUNTRY REPORTS 5 Country Reports Austria Austria has gone further than most European countries in liberalizing its energy market. The electricity market opened fully in October 2001, and the gas market liberalized a year later in October 2002. Austria s energy market is regulated by E-Control, which was formed under the Energy Liberalization Act in 2000. The remit of the regulator is to monitor, regulate, and supervise the Austrian market. Austria has been criticized by the European Commission for the lack of power granted to E-Control. The main problem is that regulatory competencies are dispersed among a number of authorities and often lead to conflicts of interest. For example, the regional governments are responsible for ensuring unbundling of electricity distribution, but they are also major shareholders in the largest retail and distribution companies. Belgium Despite liberalization and restructuring, Suez and Electrabel still dominate the electricity and gas markets. Structural unbundling of the electricity transmission and gas transportation networks has happened, but Group Suez owns significant shares of Elia and Fluxys respectively. Energy market liberalization in Belgium has developed differently across the country s three regions. Flanders completely liberalized its gas and electricity markets in 2003, with Wallonia and Brussels waiting until January 2007 to complete the liberalization process. The agreed merger between Suez and GDF may introduce more competition into the Belgian markets. In order to win approval for the merger, GDF agreed to dispose of its 25% share of SPE (Belgium s second largest electricity company) and Suez agreed to dispose of its share in Distrigaz. Both parties also agreed to look into reducing their share of power generation capacity, and the government is said to favor a split between Electrabel (70%), SPE (15%) and another European competitor (15%). Czech Republic Liberalization and restructuring have gone further in the Czech Republic than many other Central European markets. However, some of the early decisions made by the Czech government may hinder liberalization in the medium term. In particular, the sale of Transgas to RWE in May 2002, and the decision to merge CEZ with five electricity DSOs in 2003, have effectively created two dominant players and with few new entrants. The Czech electricity market is fully liberalized, with unbundled transmission and unbundled distribution for networks with more than 90,000 connections. In the gas sector, development has been slower and full liberalization took place on 1 January 2007. Whilst Transgas has legally unbundled, ownership unbundling has not taken place. Incumbent dominance remains a problem for competition and liberalization in both the electricity and gas sectors. In the electricity sector, switching has yet to take off and CEZ controls three-quarters of customers through the customer bases of five former distribution companies (out of an original eight). In the gas market, RWE Transgas has a stranglehold on the market and has yet to unbundle fully. Its distribution companies are legally unbundled (RWE Transgas has a majority stake in six out of eight DSOs, and a minority stake in the other two). Finland In August 1996, the Finnish electricity exchange, EL-EX, was set up. This was bought by Fingrid Plc in January 1998, and in June of the same year the market was integrated with Nord Pool, the Nordic electricity market jointly owned by Norwegian and Swedish grid companies Affärsverket Svenska Kraftnät and Statnett. Nord Pool s ELSPOT price sets the market price for electricity in the Nordic countries. Around 45% of electricity trading for Nordic countries takes place on the Nord Pool exchange, with the rest accounted for by bilateral contracts which reference the Nord Pool price. Even though there are approximately 120 companies in the Finnish generation sector, the market is dominated by two large producers: the governmentcontrolled Fortum and the Pohjolan Voima (PVO) group, which is owned by large electricity consumers. Current switching rates are among the highest in Europe, with more than half of very large users having switched supplier and around 85% of commercial players having 24 BALANCING E UROPEAN E NERGY M ARKETS

done so. Residential switching penetration is lower, but still significant at around 33%. The question of whether to add to Finland s four current nuclear facilities has played a dominant role in recent Finnish political discourse. The government gave approval for a new 1,600MW capacity station at Olkiluto in 2002, due to come on line in 2009. This is potentially the most powerful nuclear facility in the world, and opposition to the project continues to be vehement. France Since 2000, mainly due to European pressure, the French electricity and gas markets have been progressively opened up to liberalization and competition, and French energy policy has changed accordingly. Major steps and achievements are: Large businesses have had a choice of supplier since 2000; medium- and smallersized businesses have been able to choose since 2004; and residential customers since 1 July 2007. Nevertheless, gas and electricity tariffs are still regulated for residential customers (and should be at least until 2010) and some specific dispositions also exist for industrial customers. A small percentage of consumers have actually decided to leave their historical supplier, regulated tariffs being lower than market prices. Since 2005, both EDF and GDF have been listed companies and GDF will soon be privatized following its upcoming merger with Suez (the French State will keep a minority stake). New investors have entered the French electricity generating market over recent years (e.g. Suez, Endesa, Poweo), and major players have managed to take a place in the French gas sector (e.g. Total). France has embraced the trading of both power and gas with Powernext in 2000 and the Points d Echange de Gaz in 2004. In order to promote competition, and at European request, EDF has put production capacities up for auction under a perennial program. In terms of unbundling and regulatory environment, France has implemented a successful system. As in many other countries, France has implemented the accounting, functional, management, and legal unbundling requested by current European Directives. But unlike numerous countries, by 2000 France had already put an independent and powerful regulator in place. This is the CRE (Commission de Régulation de l'energie), which (i) is the guarantor of the right of access to public electricity grids and to natural gas facilities and systems; (ii) ensures the smooth running and development of the electricity and natural gas facilities and systems; and (iii) is the guarantor of the independence of system operators. As explained by Philippe de Ladoucette, chairman of the CRE: CRE is the only European regulator, together with the UK, which has the power to approve the investment plan of the TSO. This is precisely a way to secure possible competition distortions from vertical integrated utilities which could advantage one investment or another to the detriment of the networks. The system put in place in France is best practice in terms of independence of the TSO. 1 It should also be noted that the CRE, in both the natural gas and electrical sectors, proposes rates for the use of public electricity grids, natural gas networks and LNG facilities to the ministers for the economy and energy, who then have a twomonth period to raise any objections. Consequences of the EU proposal Of course, both vertically integrated utilities EDF and GDF (particularly after its upcoming merger with Suez) would be affected by ownership unbundling or by an ISO system. But this is not the reason why the EU proposal faces strong opposition in France. It is the supposed advantages of further unbundling which France questions. Unbundling is supposed to be a tool to guarantee price transparency, network access, and investments. According to the EU, 1 Extract from the hearing of 1 February 2007, website of the French Senate 25

COUNTRY REPORTS Economic evidence shows that ownership unbundling is the most effective means to ensure choice for energy users and to encourage investment; this is because separate network companies are not influenced by overlapping supply/generation interests as regards investment decisions. There is certainly a theoretical risk of discrimination and abuses when companies control energy networks as well as production and supply, protecting national markets and preventing competition, since the more they increase their network capacities, the greater the competition that exists on their home market, and the lower the market price. However, as explained above, it is considered in France that price transparency, nondiscriminatory network access, and an adequate investment process have already been achieved. And concerning the level of investments, the RTOs are making, and will continue to make, the necessary investments only if the grid s access tariffs include the costs of these investments with a sufficient return rate whether there is unbundling or not. To date in France, access tariffs to electricity networks are set up in order to guarantee a 7.25% return on investments (before taxes). This is the incentive. Based on the above, it is considered in France that the excessive emphasis on ownership unbundling (or its derived ISO option), and its supposed impacts on current market shortcomings, is shifting attention away from the core requirements for fostering market integration. Before a forced unbundling or ISO, there is a more urgent need to implement the following measures, which are also included in the EU proposal: (i) Harmonize the powers and independence of European energy regulators on the basis of the highest, not the lowest, common denominator in the EU. (ii) Increase coordination between the European regulators and create a supra-national European regulator. (iii)implement common technical and security rules to European system operators and increase coordination between them. (iv) Decide a priority European interconnection plan. Given the specific French context in Europe and its energy mix (low regulated tariffs, lowest electricity production costs due to the nuclear option, and hydraulic production), unbundling (or ISO) alone will not lead to increased competition in the French market, and furthermore, more competition at European level will not lead to electricity price reductions for French consumers. Ownership unbundling raises more questions and difficulties than it resolves problems. In terms of networks it will be crucial to harmonize the powers and independence of European energy regulators on the basis of the highest, not the lowest, common denominator in the EU, increase coordination between the European regulators, and to ensure a sufficient return rate on investments to favor the development of networks and interconnections Europe urgently needs. Isabelle Triquéra, France Germany Uniquely in Europe, Germany liberalized its electricity and gas markets overnight in 1998. As there was no regulator, the industry developed through a system of self-regulation and negotiated Third Party Access (TPA). Despite notional liberalization, Germany s regional energy structure is thought to have restricted supplier switching, which has been limited within the residential sector. The new German Energy Act (EnWG), adopted in July 2005, transposed the 2nd Electricity and Gas Directives into national law. The law officially established a dedicated energy regulator, the Federal Network Agency (BNetzA), to approve tariffs for large operators, arbitrate access disputes, and oversee the development of competition. As a concession to regional governments, the federal states will oversee grid access prices for small operators. But self-regulation remains a key feature of the German market, especially in the gas sector where little unbundling has taken place and entry/exit pricing is relatively new. The original 19 pricing zones giving network access is a solution developed by the industry, and only moderated by the regulator. More than 1,400 utilities have been affected by the EnWG; they have to fulfill the current requirements of unbundling accounts, guaranteeing confidentiality of information, functional unbundling, and even legal separation of the network if more than 100,000 customers are supplied. The big four - E.ON, RWE, EnBW, and Vattenfall - dominate the German electricity market and are often accused of misusing their market position. They operate the electricity transmission grid, and have a market share of some 75% in electricity generation and 50% in retail for the most part via shareholdings in regional supply companies and Stadtwerke. E.ON and RWE are also important gas players, operating a large proportion of the German gas transmission grid. Consequences of the EU proposal German TSOs would be seriously affected by ownership unbundling. As vertically integrated utilities, the big four will either have to dispose of their grid to third parties, or split up their shares. According to the constitutional right of property, German utilities have announced strong resistance to ownership unbundling, even going to court. Because of this, it is expected to take a few years to implement ownership unbundling in Germany. As one reaction to the EU proposal, German TSOs have announced the establishment of an RTO together with France and the Benelux states 2. The aim is to accelerate investments in cross-border interconnections and cooperation in 26 BALANCING E UROPEAN E NERGY M ARKETS

operating the networks to improve competition. Germany, as the biggest European electricity market with relatively high prices, is one of the most interesting markets for all pan- European utilities to attack. Hence ownership unbundling could weaken the position of German incumbents and strengthen the market position of new entrants, like Essent, Nuon, Statkraft, or other pan-european players. Without harmonizing European legislation and trying to achieve a level playing field in Europe, German utilities could be seriously weakened by the introduction of ownership unbundling. Gerd Lützeler, Germany Greece Due to its geographic remoteness from other EU states and power grids, Greece was granted derogations from the previous Energy Directives, which resulted in the liberalization and restructuring of its energy market lagging other western EU markets. The National Electricity Law was approved in 1999 and transposed the EU 2nd Energy Directive into national legislation. Electricity liberalization happened in 2001 and effectively since July 2007, all customers can choose their supplier of electricity (so far with limited results). In the gas sector, even though Greece was granted derogations in the partial opening of the market until November 2008, it has already implemented many of the provisions of the 2nd Gas Directive. The dominance of the incumbent, PPC, remains an issue for competition and liberalization in the electricity sector. The Energy Law has sought to improve competition by gradually granting eligibility rights to all customers, but PPC s dominance currently makes choice theoretical rather than practical. Nevertheless, independent incomers have recently entered the electricity generation and supply markets, providing still limited but increasing competition to PPC. Greece has moved towards an unbundled electricity model where the transmission network assets are owned by PPC and are operated by the Hellenic Transmission System Operator (HTSO). PPC, as a VIU, is obliged to make unbundled financial statements for its electricity activities publicly available. A combined Transmission and Distribution System Operator is expected to be established in 2007 based on the same model. For gas, although the market is legally unbundled, the incumbent company, DEPA, still effectively controls the transmission network. The National Natural Gas System Operator (NGSO), which owns and operates the transmission network, is a 100% subsidiary of DEPA. Consequences of the EU proposal Under a proposed ownership unbundling approach, PPC would be required to dispose of not only its 49% participation in HTSO, but also its transmission network assets. The current Greek electricity unbundling model would best fit to the proposed ISO alternative, under which the transmission network assets may remain under (and owned by) PPC, and be operated by an Independent System Operator a solution that would require, among other things, the legal unbundling of any PPC transmission activity. For gas, under a proposed ownership unbundling approach, DEPA would have to release its controlling interest in the transmission activity carried out by the NGSO. The possibility of the establishment of a RIO within the Balkan area might be considered in the long term future, as at the moment most of the neighbor countries are not EU members. Nevertheless investments in cross-border interconnections and cooperation are taking place to increase competition and security of supply. South Eastern Europe mainly needs a Regional System Operator. This could be a big step in improving welfare and competition in the region. Vassilios Kaminaris, South East Europe Hungary In January 2003, electricity consumers with a consumption over 6.5GWh became eligible to buy from the competitive market. Two markets in Hungary were created: the public (regulated) market and the liberalized market, which allows for liberalized trading and prices. Eligibility was extended to all non-household consumers in July 2004. The remaining liberalization of the market will follow EU-Directive rules and, as such, will be opened 1 January 2008. In the new model all consumers will be eligible to choose their suppliers. Prices will no longer be regulated. Household customers can still elect to buy electricity from their respective universal suppliers. Prices applied by universal supplier license holders will have to be justified, comparable and transparent, and this will be monitored by the regulator. Network access tariffs will remain regulated. In 2006, former independent electricity system operator MAVIR reintegrated into the public utility wholesaler MVM. However, it retains its independence in system operation matters. Under the Hungarian energy model, most domestically generated energy is sold to MVM under power purchase agreements. Under pressure from the EU and market operators, the Hungarian government cemented its view that the long-standing agreements be reduced, revoked, or transformed into a format compliant with EU rules. MVM and the generators are currently negotiating to find a solution to this matter, while the recently enacted electricity law requires MVM to sell electricity obtained from these long term contracts through a publicly-held and transparent auction process. 2 See also e.g. Press release of RWE Transportnetz Strom: Federal government sets course for more intensive power trading across borders http://www.rwe.com/generator.aspx/rwe-energy/pressemitteilungen/language=en/id=67616/presse-home.html.rwetransportnetzstrom.com 27

COUNTRY REPORTS Much of Hungary s older generating capacity is becoming obsolete, and it will be increasingly necessary to develop new generating capacity, including potentially extending the lifetime of the Paks nuclear power station, in order to prevent greater import dependency and to comply with EU emissions legislation. The gas market has followed a similar development with all non-household companies free to choose their supplier since July 2004. E.ON s acquisition of MOL s gas trading and storage activities has given it a dominant position in the Hungarian gas market, although alternative supplier EMFESZ started to erode its market position recently. High pressure transmission systems remain under the ownership of MOL. The Hungarian government also decided to establish strategic gas reserves and build storage facilities in order to increase the security of natural gas supply. Italy Italy has liberalized its electricity market. The 1st Electricity Directive was implemented in Italian law in 1999 (the Bersani Decree). This created a National Transmission Grid Operator, Gestore Rete Trasmissione Nazionale 3 (GRTN) and liberalized generation, import, export, purchase and sale activities within the electricity sector. However, full liberalization has not taken place and in mid-2006 the Italian regulator, AEEG, issued several announcements criticizing electricity incumbent Enel s ability to control the market at certain times of the year. The role of gas has increased considerably in recent years, and it now accounts for 39% of primary energy demand. The Italian market has been fully opened to competition since January 2003. However, the efficacy of the unbundling of gas transmission system operators has recently been questioned by the EC. This is essentially because despite unbundling, ENI still controls more than 60% of the market. In addition, AEEG has repeatedly drawn attention to the anomalous situation of ENI, which owns Snam Rete Gas (SRG, the gas TSO monopolist) and Stogit (gas storage monopolist). In its 2006 annual report, AEEG asked the Government to separate SRG from ENI. The debate about ENI s role continues at the political level there are suggestions of a merger between Terna and SRG, to create a state-owned gas/electricity TSO. The most significant issue in recent times has been the Italian government s intervention to block the purchase of the Italian company Edison S.p.A by Italenergie Bis. The government argued that as EDF, a state-controlled company, held an 18% stake in Italenergie, and because France had not liberalized its energy sector, it should have limited voting rights. However, after having passed a Decree curtailing the voting rights of state-owned foreign companies investing in Italy, the government was forced to amend the Decree after intervention from the EU. The goal of unbundling is to give equal opportunities to all utilities players. But there will be a big challenge for the small and mediumsized utilities which form the majority of Italy s utility market: the massive and complex task of managing all the activities needed to be compliant. They ll have to take a highly structured, holistic approach if they are to achieve this. Massimo Delli Paoli, Italy The Netherlands The Dutch electricity market opened up gradually. Between 2001 and July 2004, full market liberalization was introduced three years ahead of the EU deadline. The Dutch electricity market has an unbundled TSO, TenneT, which is 100% state-owned. Before liberalization, the Dutch gas sector was dominated by Gasunie. Restructuring has produced a government-owned TSO called GTS and a trade and supply company, GasTerra, owned by Shell, Exxon, and the Dutch government. In July 2005, this process was completed with the legal unbundling of GTS and GasTerra in order to comply with the terms of the 2nd Directive. High wholesale prices have been a problem in the Dutch electricity market. Although the Netherlands imports a large proportion of its electricity, there have been problems with the pricing of import capacity. Transparency has 3 GTRN was acquired by Terna which holds more than 98% of the national electricity infrastructures, and is also responsible for transmission and dispatching and hence for the secure management 28 BALANCING E UROPEAN E NERGY M ARKETS

also been a problem in the Dutch power sector, because all players do not have equal access to information. For example, companies without generation capacity do not see what the grid operator TenneT is doing to maintain the balance of the system, and as such are unable to adjust their loads in response to TenneT s actions. Furthermore, as there is no anonymous market, companies without generation capacity have problems in closing their position intra-day. The TTF gas market has been very successful and is set to overtake Zeebrugge as Europe s second most traded gas hub. Ownership unbundling is only one step in improving competition and its effects are very limited. It alone will not create a single European market for energy. Ben van Gils, Global Utilities Leader Norway Norway is the sixth largest hydropower producer in the world, with hydropower accounting for 99% of the electricity generated. Norway is the largest producer of natural gas in Europe, yet there is no significant domestic gas market in Norway. All of the natural gas produced is sold and transported to buyers in continental Europe or the UK. Norway has the highest per capita electricity demand in the world: 22.6MWh, four times the EU average. Following the opening of the Norwegian power market in 1991 and the appointment of Statnett as TSO in 1992, Norway s first wholesale power market was established in 1993. Originally called the Statnett Market, the exchange evolved following integration with the Danish, Swedish and Finnish markets into today s Nord Pool market. Trading on a bilateral basis or via the Nord Pool exchange requires a trading license from the energy regulator. Although the Norwegian power market was fully open in 1991, the state has a strong influence in the market through its ownership of key market players. Both Statkraft, which controls around a third of power production, and the TSO Statnett are fully state-owned. The role of Statkraft is growing as it continues to purchase smaller regional companies and increase its market share. In the distribution sector there are around 30 smaller, local companies many of them owned by state or local government. Poland The main law governing the energy market is the Energy Law of 10th April 1997, which introduced a licensing requirement for all companies engaged in the generation, transmission, distribution and supply of electricity. Modifications to the Energy Law took place in 2004 when the monopoly grid operator, Polish Power Grid (PSE), unbundled its TSO unit into a separate company, PSE-Operator, in order to comply with the Power Directive. The Polish energy sector is regulated by the Energy Regulatory Office (URE) which was formed under the 1997 Energy Act. The main role of URE is to provide licenses to companies and regulate tariffs. More recently, amendments were made in 2005 to transpose the 2nd Electricity and Gas Directives into national law. Despite all of this, there are still many problems with the liberalization of the energy market, especially with regard to gas. Poland had applied for derogation with regard to the requirement to open the gas market until at least 2006, which was refused. In June 2007 the Polish Parliament decided to terminate long-term PPAs, which were one of the main obstacles to competitiveness on the electricity market. Based on the government Program for Electricity 4, vertically integrated energy companies were created. The biggest one, Polish Energy Group (PGE), has about 30% of the end consumer market share. Simultaneously, all DSOs were unbundled. The biggest problem is that all unbundling processes were run in a different way, so there is no basis for comparison between DSOs. After 10 years in operation, the President of The Polish Energy Regulatory Office was replaced by a new regulator, which imposes additional uncertainty on regulatory policy. Consequences of the EU proposal The Polish government is opposed to the EU s proposals for ownership unbundling. Piotr Wozniak, the Polish Minister of Economy, believes there is no proof that ownership unbundling will accelerate an implementation of TPA. An ownership unbundling implementation trial will probably meet very strong opposition from labor unions, which have a key position in Poland. 29

COUNTRY REPORTS Trade unions have a significant influence on the Polish electricity market, so ownership unbundling would be very difficult to achieve. In addition, for the purpose of the country s government privatizations plans, simple legal unbundling is much more convenient. Piotr Piela, Poland Romania Romania has made steady progress in liberalizing and privatizing its electricity sector. Former state incumbents RENEL and CONEL have been broken up by value chain step and some new companies have been privatized. Generation is now mainly split between three newly created companies: Hidroelectrica, Termoelectrica and Nuclearelectrica. There is an independent TSO, Transelectrirca, which is state-owned, and eight regional distribution companies. Five of the eight regional distribution companies have been privatized to date; the majority stake in the privatized distribution companies was acquired by CEZ (1 distribution company), E.ON (1 distribution company), and ENEL (3 distribution companies). Romania is the largest producer of natural gas in the Central and Eastern European region by a significant margin. Current reserves are estimated at around 172 billion cubic metres (bcm), giving a Reserve to Production (R/P) ratio of 14.71 years. Production reached a peak in 1982 and has since been declining significantly. Over the past decade, production decline has averaged 3.1% per year. Gas market liberalization has been at the same pace as power, with GDF and E.ON active in the market, each one of which holds a majority stake in either of the two major regional distribution companies, following a privatization process which was completed in 2005. One of the key new market entrants has been Italy s ENEL. In 2004 the company acquired a majority stake in Electrica Dobrogea and Electrica Banat two of the country s regional distributors and in 2006 a majority stake in another regional distributor, Electrica Muntenia Sud. Similarly E.ON and CEZ both invested in distribution companies in 2005. The Romanian government also intends to sell between 150 and 220 of the power stations owned by Hidroelectrica. A relatively sophisticated wholesale electricity market, known as OPCOM, exists in Romania. Although far from Scandinavian and certain western European markets in terms of liquidity and development, the OPCOM market represents one of Central and Eastern Europe s key wholesale energy markets. The Romanian electricity and gas sector regulators (ARNE and ANRGN respectively) required electricity and gas companies to unbundle their distribution and supply activities, with 1 July 2007 set as a deadline for the implementation of the unbundled structure. Even though electricity and gas market players are in the phase of implementing such an unbundled structure for their distribution and supply activities, only one of the market players managed to complete the unbundling implementation phase by the 1 July 2007 deadline. Consequences of the EU proposal As stated above, the Romanian Transmission System Operator (TSO), Transelectrica SA, is a state-owned joint stock company. It was listed on the Bucharest Stock Exchange after a successful IPO process in August 2006, and is also a member of UCTE (Union for Coordination of Transmission of Electricity) and ETSO (Association of European Transmission and System Operators). Similarly, the Romanian gas transportation network operator Transgaz SA is also a state-owned joint stock company and participates actively in regional gas transportation network infrastructure and interconnection projects. Neither Transelectrica SA and Transgaz SA are involved in the ownership or operation of distribution networks, nor do they perform any supply activities for electricity or gas. Therefore, provided that the privatization process for the remaining three electricity distribution companies (together with the distribution and supply activities unbundling process for all electricity and gas companies 30 BALANCING E UROPEAN E NERGY M ARKETS

in Romania) are completed successfully in the near future, the EU proposal should not have a significant effect on the Romanian electricity and gas markets. Romania has taken steps, together with neighboring EU country Bulgaria, towards the development and integration of the electricity transmission system. An implementation group was recently established focusing on a common procedure for cross-border capacity allocation and the investments required. In addition, the Romanian and Serbian electricity TSOs recently agreed the construction of a second interconnection overhead electricity line between Romania and Serbia, following the construction of the first 400 kv interconnection overhead line by the two countries. Moreover, Romania is participating in the Nabucco project for the construction of a gas transportation pipeline, passing through Turkey and other Eastern and Central European countries, linking the Russian and Iranian gas producers with Europe. Russia In the mid-1990s, the Russian privatization program led by Anatoly Chubais included the disposal of about 50% of Gazprom, the gas monopolist, and UESR, the electricity monopolist. After his appointment as CEO of UESR in 1998, Chubais took the lead in developing a reform plan for the electricity sector that would reflect international best practice. The implementation of the plan started in 2003. As of October 2007, most of the legal unbundling of the electricity sector has been implemented. Generation, transportation networks, regional distribution networks, electricity marketing, and servicing assets are now operated as separate companies. UESR has retained the majority stake in most of the companies, but the plan is to gradually privatize the competitive parts of the business, notably thermal generation and regional marketing companies. The domestic natural gas market is dominated by Gazprom and heavily regulated. Gazprom controls most of the gas production, long-distance transportation networks, and wholesale marketing. Distribution networks and retail marketing are operated by over 200 regional companies owned by Gazprom, municipalities, and private investors. Russian electricity prices are still about half of the European average, while natural gas prices are less than one-fifth. While public resistance to price liberalization remains an important factor, there is growing understanding that the current low level of tariffs is not sustainable as it does not allow for adequate investment provision. Consequences of the EU proposal Russia is not directly impacted by the new EU proposal. Nevertheless, reform in the Russian electricity sector is developing generally in parallel with Europe. It has passed the critical stage and now seems to be on track towards further ownership unbundling and price liberalization. In the gas sector, an important factor for both European and Russian unbundling discussions is access to resources and markets. European companies seek access to Russian oil and natural gas resources, while Gazprom seeks expansion in European transit and distribution channels. The new EU proposal suggests that no persons from a third country should be able to own or operate transmission systems in the EU, unless the third country obtains a special bilateral agreement with the EU. Even if Russia eventually secures such an agreement, Gazprom, as a vertically integrated company with substantial production activities, would probably not qualify as an owner of a transit system. In the domestic market, we do not expect any decisive progress in the unbundling and liberalization of the Russian natural gas sector before the early 2010s, when the profitability of selling gas in the domestic market is expected to converge with profitability of exports. We expect some progress but no breakthrough in natural gas deregulation in Russia over the next several years. In the meantime, in the electricity sector we see that the tremendous effort made by UESR management in promoting reform has begun to pay off in new investment coming to the sector. Dmitry Lobachev, Russia Spain Liberalization of the Spanish power market began in 1997 with the Spanish Electricity Act. The national regulator, CNE, was formed in 1998 under the Hydrocarbons Act 34 and by a Royal Decree passed in 1999. On 1 January 2003, Spain opened its electricity market to full competition. However, the power market is still heavily influenced by the main utilities. The government has been accused of excessive market protectionism and was taken to court in 2006 over failure to meet its obligations under the European Gas and Electricity Directives. Gas consumption in Spain has been increasing at a rapid pace, from 7% to 20% of the primary energy mix in a decade. In 2006 Spain approved a legal draft to remove regulated pricing from the gas and electricity markets and unbundle Enagas transmission and supply businesses. Spain has recently repealed legislation concerning the Cost to Transmission to Competition (CTCs) which covers so-called stranded costs. This was originally brought in to compensate utilities for investments in infrastructure that had been made but may not bring a return following liberalization. 31

COUNTRY REPORTS CTC payments have distorted the pool price and favored incumbents in the market. In 2006 the single Iberian power market, MIBEL, was launched, paving the way for Spanish providers to gain access to the Portuguese market. The Spanish utilities are currently focussing on the consolidation of the European utilities sector. Realizing Ownership Unbundling all over Europe would be a strong driver for further consolidation. Juan Maria Roman, Spain Sweden Sweden liberalized its electricity market in 1996, opening both the production and trading of electricity to competition. The Swedish wholesale market is a part of the integrated Nordic market. Since 1998, this has taken the form of participation in the Nordpool wholesale electricity market. Nordpool s ELSPOT price sets the market price for electricity in the Nordic countries. Around 45% of electricity trading for Nordic countries takes place on the Nordpool exchange, with the rest accounted for by bilateral contracts which reference the Nordpool price. More than 90% of Swedish electricity production is hydro- and nuclear power. The gas market is relatively small in Sweden and liberalization was completed in July 2007. Swedish TSO Svenska Kraftnaft is a coowner of Nordpool, the largest power exchange in Europe. Switching is well developed in the Swedish electricity market and product innovation has been high. Consumers are able to choose products such as fixed-price, fixed-term contracts or prices indexed against the Nordpool price. Price spikes on the Nordpool have caused problems for consumers over the years. In September 2005, E.ON signed an agreement with Gazprom to construct a gas pipeline in the Baltic from Viborg in Russia to Greifwald in Germany. The project is called the North European Gas Pipeline (NEGP). E.ON Sverige plans a possible branch from this pipeline to the Swedish east coast. Fortum is involved in the Swedish natural gas market via Fortum Värme. Fortum Värme plans a LNG terminal for distribution of natural gas to Stockholm s gas network. Switzerland The Swiss energy market is highly fragmented, with responsibility split between the Federal government and the regions (Cantons). Under current plans, the electricity market may be liberalized by 2012 along the lines of the EU, although there is no market regulator and limited unbundling. Switzerland imports all of its natural gas, which is secured by long-term supply agreements. Swissgas procures three-quarters of the natural gas, whilst the regional companies procure the remainder. The Swiss Federal Government is responsible for security of supply. Regional authorities (i.e. Canton level) are developing political strategies giving guidelines for the power generation mix and the use of electricity. Parliament approved the revision of the Federal Electricity Act on 23 March 2007. The Act calls for an opening of the market in two stages: in the first five years, end-consumers with an annual consumption of more than 100 MWh have free access to the market. After five years, all endconsumers can freely choose their electricity supplier. The Act and ordinances should enter into force on 1 January 2008, subject to the initiation of a referendum. The hightension transmission network (220/380 kv) has to be operated by a national network operator with Swiss majority ownership. For this purpose, transmission companies have already established the joint venture swissgrid. Ownership of the high-tension transmission networks has to be transferred to this network operator within five years after the Act is enforced. The revised Federal Electricity Supply Act also contains a package of regulations governing the promotion of renewable energy (in particular hydropower), and the introduction of measures to promote efficient electricity use. EU legislation is not applicable in Switzerland, since it is not a member of the European Union. However, because of growing integration, many areas of Swiss law follow EU law. The energy sector in Switzerland is stimulated more by financial incentives than regulated by laws. Because of this, the Swiss energy sector is also moving towards liberalization. Switzerland is a large exporter of hydro electricity. Since there is no power exchange in Switzerland, Swiss utilities are either active on the European exchanges or use the Swissix price index of the German EEX. The Swiss natural gas market is also a transit market and part of the Italy-Netherlands pipeline, which runs through Switzerland. The liberalization of the natural gas market has not been an issue yet. Turkey In Turkey, public authorities dominate the electricity market, although their share of electricity generation has fallen below 50%. However, trading, transmission and distribution are currently under state monopoly. Private sector companies are required to obtain licenses for generation, including auto production. Transmission is currently undertaken by TEIAS, which is a state company and will not be subject to privatization in the near future. Distribution is carried out by 21 companies throughout Turkey: only one company covering a mid-sized city is under private ownership. Part of the remaining companies was to be put up for sale, but the sale process has now been postponed. Turkey first initiated investment in natural 32 BALANCING E UROPEAN E NERGY M ARKETS

gas transmission in 1986, after signing a long-term purchase agreement with Russia. Currently Botas, a state-owned company, has eight purchase contracts with six different suppliers, two of which were transferred third-party companies. Natural gas accounts for 27% of Turkish primary energy consumption, and this share is expected to surge. Storage and transportation of natural gas is handled wholly by Botas. Trading is not heavily regulated, but players are required to obtain licenses to engage in importation and trading. The Turkish gas market was opened in 2002. Since November 2002, 150 licenses have been granted for activities along the natural gas market value chain. Forty-six of them are distribution licenses: the acquirers are responsible for both infrastructure development and management of distribution operations for some 30 years in certain regions. In addition to the new distribution licenses, the government also initiated the privatization of existing natural gas distribution companies. So far, two distribution companies have been privatized out of five. The privatization of the remaining distribution companies is expected to happen in the near future. United Kingdom The UK market is fully liberalized, and all gas and electricity consumers connected to licensed networks are free to choose their own supplier. The UK was the first country in the world to open its gas market to competition (although a system of regulation is in place). The UK electricity market is dominated by six vertically integrated groups of companies: Scottish Power (SP), Scottish and Southern (SSE), EDF, E.ON, RWE, and Centrica. Each of these companies owns and operates generating plant and a supply business with more than two million customers. All of them, apart from Centrica, also own electricity distribution networks. The licensing regime requires legal unbundling of generation, distribution and supply businesses. All the electricity transmission systems are owned by regulated monopolies. The electricity transmission network in England and Wales is owned and operated by National Grid (NG), and the two electricity transmission grids in Scotland are owned by SP and SSE. NG is the Scottish ISO. The UK gas market is dominated in terms of supply by Centrica (trading as British Gas). The gas transmission network is owned and operated by NG. Consequences of the EU proposal UK industry opinion is influenced by European parent companies: both full unbundling and ISO are favored. Unlike some of its European counterparts, UK TSOs will be largely unaffected by ownership unbundling requirements. SP and SSE, the owners of the two Scottish electricity transmission networks, will be required to dispose of their grids. NG is considering buying or running energy grids in other European nations as the markets open to competition. Our preference is to own assets. That way you maximize their efficiency, NG s director of network operations, Chris Train, told Bloomberg. NG may consider investing in network ownership or operating the grids on behalf of other companies, working within industry rules, Train added. The UK has largely completed unbundling, so the direct impact on UK companies will be limited. However, unbundling is still very much a hot topic given the potential impact on the UK s trading relationships with Europe and the opportunities that will arise for investments in Europe. Jon Hughes, UK 33

APPENDIX Appendix Ernst & Young contacts Irene Lorentzen Kim Richter Dmitry Lobachev Vladimir Merkushev Jon Hughes Bill Easton Ben van Gils Jan-Klaas Schoppink Piotr Piela Jaroslaw Wajer Jonas Akelis Gerd Lützeler Helmut Edelmann Isabelle Triquera Alessandro Miolo Thomas Lüthi Vincent Etienne Josef Pivonka Ludek Jirecek Istvan Havas Zoltan Tremmel Elfriede Baumann Heidemarie Kretschmer Massimo Delli Paoli Diego Massari Juan Maria Roman Gonçalves David Espana Martin Vassilios Kaminaris Yolanda Sanchez-Martin 34 BALANCING E UROPEAN E NERGY M ARKETS

Ernst & Young Contacts GLOBAL Ben van Gils Global Utilities Leader Global Utilities Center, Düsseldorf, Germany Direct tel.: +49 211 9352 21557 E-mail: ben.van.gils@nl.ey.com AUSTRIA Elfriede Baumann Vienna, Austria Direct tel.: +43 1 211 70 1141 E-mail: Elfriede.Baumann@at.ey.com Heidemarie Kretschmer Vienna, Austria Direct tel.: +43 1 211 70 1180 E-mail: Heidemarie.Kretschmer@at.ey.com BALTICS Jonas Akelis Vilnius, Lithuania Direct tel.: +370 (5) 2742-200 E-mail: Jonas.Akelis@lt.ey.com BELGIUM Vincent Etienne Belgium, Brussels Direct tel. : +32 2 774 9554 E-mail : vincent.etienne@be.ey.com CZECH REPUBLIC Josef Pivonka Prague, Czech Republic Direct tel.: +420 225 335 603 E-mail: Josef.Pivonka@cz.ey.com Ludek Jirecek Prague, Czech Republic Direct tel.: +420 225 335 480 E-mail: Ludek.Jirecek@cz.ey.com GERMANY Gerd Lützeler Düsseldorf, Germany Direct tel.: +49 211 9352 18614 E-mail: gerd.luetzeler@de.ey.com Dr. Helmut Edelmann Global Utilities Center Düsseldorf, Germany Direct tel.: +49 211 9352 11476 E-mail: helmut.edelmann@de.ey.com GREECE, ROMANIA, BULGARIA, TURKEY Vassilios Kaminaris Athens, Greece Direct tel.: +30 210 2886235 E-mail: vassilios.kaminaris@gr.ey.com Yolanda Sánchez Martín Athens, Greece Direct tel.: +30 210 2886454 E-mail: yolanda.sanchez-martin@gr.ey.com HUNGARY Istvan Havas Budapest, Hungary Direct tel.: +36 1 451 8701 E-mail: istvan.havas@hu.ey.com Zoltan Tremmel Budapest, Hungary Direct tel.: +36 1 451 8138 E-mail: zoltan.tremmel@hu.ey.com ITALY Dr. Massimo Delli Paoli Rome, Italy Direct tel.: +39 0667535752 E-mail: massimo.delli-paoli@it.ey.com NETHERLANDS Klaas - Jan Schoppink The Hague, Netherlands Direct tel.: +31 70 328 6782 E-mail: klaas-jan.schoppink@nl.ey.com NORDICS John Avaldsnes Stavanger, Norway Direct tel.: +47 51 70 67 40 E-mail: john.avaldsnes@no.ey.com Kim Richter Stavanger, Norway Direct tel.: +47 982 06 674 E-mail: kim.richter@no.ey.com POLAND Piotr Piela Warsaw, Poland Direct tel.: +48 22 557 75 80 E-mail: piotr.piela@pl.ey.com Jaroslaw Wajer Warsaw, Poland Direct tel.: +48 22 557 71 63 E-mail: Jaroslaw.Wajer@pl.ey.com SPAIN Juan María Román Gonçalves Bilbao, Spain Direct tel.: +34 944 356495 E-mail: JuanMaria.RomanGoncalves@es.ey.com David España Martín Bilbao, Spain Direct tel.: +34 944 243777 E-mail: David.EspanaMartin@es.ey.com SWITZERLAND Alessandro Miolo Zurich, Switzerland Direct tel.: + 41 58 286 46 54 E-mail: alessandro.miolo@ch.ey.com Thomas Lüthi Zurich, Switzerland Direct tel.: + 41 58 286 30 41 E-mail: thomas.luethi@ch.ey.com RUSSIA Dmitry Lobachev Moscow, Russia Direct tel: +7 495 228-3677 E-mail: Dmitry.Lobachev@ru.ey.com Vladimir Merkushev Moscow, Russia Direct tel: +7 495 755 98 81 E-mail: Vladimir.Merkushev@ru.ey.com UK Jon Hughes London, UK Direct tel: +44 7899 064320 E-mail: jhughes4@uk.ey.com Bill Easton London, UK Direct tel: +44 20 7951 5463 E-mail: beaston@uk.ey.com FRANCE Isabelle Triquéra Paris, France Direct tel.: +33 1 46 93 84 87 E-mail: isabelle.triquera@fr.ey.com Ing. Diego Massari Rome, Italy Direct tel.: +39 0667535653 E-mail: diego.massari@it.ey.com 35

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