European electricity market reform Principles, outcomes and issues

1
European electricity market reformPrinciples,
outcomes and issues

• Lars Bergman
• Stockholm School of Economics
• Presentation at
• CCER, Beijing University, April 9, 2007

2
Plan and background literature

• Plan of the presentation
• Economics of created markets
• The EU electricity market directives
• Security of supply, market power and efficiency
  The case of the Nordic electricity market
• Literature
• N-H von der Fehr, E.S. Amundsen and L. Bergman
  (2005), The Nordic Market Signs of Stress. The
  Energy Journal, 71-98. Special Issue European
  Electricity Liberalisation.
• E.S. Amundsen and L. Bergman (2006), Why has the
  Nordic electricity market worked so well?.
  Utilities Policy 14, 148-157.

3
The development of a market

• As an organic process
• Agents realise that there are potential gains
  from trade
• Market institutions (trading rules, meeting
  places etc) that reduce transaction costs are
  established
• By discretionary decision
• Barriers to trade are reduced or abolished
• Market institutions are created through
  legislation, decision by regulator etc

4
Different dynamics of change

• Markets created by organic development
• Market institutions are contestable
• Thus market institutions survive only until
  better alternatives become available (Example
  trading floors vs. computers)
• Markets created by discretionary decision
• Market institutions are not (fully) contestable
• Thus market institutions may survive even if
  better alternatives become available

5
Economics of market design

• In recent years several markets in Europe have
  been created by discretionary decision
• Markets for allocation of spectrum, 3G licenses,
  emission permits, green certificates, etc.
• New markets for electricity, railway services
  etc.
• The EU Commission has, through its Directives,
  played an active role in the creation of these
  markets
• The design of created markets has become a
  vibrant field of economics research

6
The structure of the power industry

• The electric power industry is a network industry
  consisting of four segments
• Generation (G)
• Transmission (T)
• Distribution (D)
• Retailing (supply) (R)
• Traditionally the European power industry has
  been
• Vertically integrated, in general GT DR
• Dominated by publicly owned companies
• And electricity has been a Non-traded good

7
The EU directives

• The EU Commission has issued two directives about
  the structure of the electricity market
• The first became effective in 1999
• The second will become effective in 2007
• The key elements of the directives are
• Vertical separation of G, T, D and R
• Third party access to transmission (T) and
  distribution (D) networks
• Competition in generation (G) and retailing (R)
• Full market access for all customers (from 2007)
• In addition cross-border trade is encouraged
• But there are no EU rules about transmission
  pricing and several other market design features

8
The European power industry

• Four islands
• United Kingdom
• Scandinavia and Finland (the Nordic countries)
• The Iberian peninsula (Spain, Portugal)
• Central Europe (Germany, France, Belgium,
  Netherlands, Italy etc.)
• Dominated by a few giants
• EDF, France (460 TWh)
• RWE, Germany (215 TWh)
• E.ON, Germany (230 TWh)
• ENEL, Italy (226 TWh)

9
The Nordic electricity market

• A well integrated regional market
• Institutionally integrated A common power
  exchange (Nord Pool) and similar transmission
  pricing models
• Significant interconnector capacity and no border
  tariffs
• Consumption and production
• Annual consumption around 390 TWh
• Around 50 hydro power and 20 nuclear power
• A few major and many small generators
• Vattenfall, Sweden (70 TWh, 18)
• Fortum, Finland (47 TWh, 12)
• Statkraft, Norway (40 TWh, 11)
• E.ON, Sweden (29 TWh, 7)

10
What should a well-functioning competitive market
deliver?

• Market clearing
• Supply should be equal to demand at all times
  (supply security), and there should be a market
  price at which electricity can be bought or sold
• Efficiency
• The cost of supplying electricity should be
  minimized
• The price should be equal to (the relevant)
  marginal cost
• Least-cost new capacity should be added as demand
  grows
• Price level
• Whether the consumer price is high or low depends
  on
• the degree of competition
• the marginal cost of generation, transmission and
  distribution
• the level of charges and taxes

11
Electricity market reform Major issues

• Will security of supply be maintained when
  central dispatch and planning is replaced by
  market based production and investment decisions?
• Will the degree of competition be sufficient, or
  will market power prevent the potential benefits
  of competition to be realized?
• Will competition bring about efficiency increases
  to the benefit of consumers?

12
Market power A threat to workable competition

• Definition
• The power to profitably raise the market price
  above the competitive level
• Observations on market power
• Potential market power may or may not be
  exercised
• The Lerner index (price-marginal cost)/price is
  a common measure of (exercised) market power
• Concentration, measured by HHI or CRX, is a
  common measure of potential market power
• In electricity markets concentration is not an
  ideal measure of potential market power

13
Market power in wholesale markets

• As generation and load have to balance in real
  time pivotal generators have very significant
  potential market power
• Pivotal generators need not be big (in terms of
  annual production or market share)
• But big generators are pivotal more often than
  small generators
• Thus there is a positive relation between
  concentration and potential market power in
  wholesale electricity markets

14
Impact of the 2002-03 supply shock

• Background
• The extremely dry autumn 2002 lead to the lowest
  water reservoir level in several decades
• Result
• The price of electricity reached unprecedented
  levels, but supply-demand balance was maintained
• Question
• Was the price increase just a result of increased
  scarcity of hydropower, or did the major
  generators exercise market power?

15
Analytical tools

• Numerical Cournot model of the Nordic market
• Presented in Will Cross-Ownership Re-Establish
  Market Power in the Nordic Power market?, The
  Energy Journal, Vol. 23, No 2, 2002 (with Eirik
  Amundsen)
• The PoMo model
• Developed by K.A. Edin and EME Analys but not
  published
• Dynamic optimization model, designed to simulate
  weekly spot market pricing on the assumption that
  the market is competitive and agents are risk
  neutral (i.e. act on the basis of expected values
  of stochastic variables such as water inflow and
  nuclear power output)

16
An experiment with PoMo

• Generators exercising market power would produce
  less than under perfect competition, and prices
  would thus be higher than under perfect
  competition
• It follows that if market power is exercised
  actual spot market prices would systematically
  exceed the (simulated) PoMo prices
• If real world generators are risk-averse actual
  spot market prices would rise earlier, but also
  fall earlier, than (simulated) PoMo prices in a
  dry year

17
Comparison of actual and simulated prices
2002-2003
18
Competition works!

• The PoMo analysis suggests that the 2002-2003
  price increase essentially was a result of
  increased scarcity of hydro power
• Thus high prices do not to any significant degree
  seem to depend on insufficient electricity market
  competition
• Yet high electricity prices is a real economic
  problem for electricity intensive industries and
  households with electric heating

19
Views on the electricity market

• 2001 A role model for Europe
• Low prices, healthy power industry
• Competition works, to the benefit of consumers
• 2006 Somebody has to do something!
• High prices, high power industry profits
• Competition does not work, and the lack of
  competition benefits the producers
• 2007 OK, but something must be wrong
• Prices much lower in January than in August
  (2006)
• After all competition seems to work, or

20
Factors affecting electricity prices in a
competitive market

• Nature
• Hydropower supply varies significantly between
  years
• Political decisions affecting capacity and costs
• Rules and regulations about licensing and siting
  of new capacity
• Rules about the use of existing nuclear power
  capacity
• Producer taxes
• Climate policy
• Cap on CO2 emissions and the design and
  functioning of the market for CO2 emission permits

21
Computed impact of a uniform 25 CO2 per tonne
charge 2010Source Bergman-Radetzki, Global
klimatpolitik. Konsekvenser för Sveriges ekonomi
och energisektor. Stockholm SNS Förlag
2003Electricity TWh CO2 Tonnes Price /MWh
22
Why has the market worked well?

• Simple but sound market design
• To a large extent made possible by the large
  share of hydro power in the Nordic system
• No price regulations or regulations that increase
  transaction costs (such as nTPA)
• Successful dilution of market power
• Far-reaching integration of the national markets,
  made possible by significant inter-connector
  capacities and distance-independent transmission
  prices
• Well developed forward markets
• Strong political support for a market-based
  electricity supply system
• And possibly an informal commitment to public
  service by the power industry

23
Problems and solutions

• Due to environmental concerns and policies the
  marginal cost of electricity has increased and is
  likely to remain high
• This is a real problem.
• The transition from low to high electricity
  prices has not been widely anticipated, is
  painful and will include structural change
• This is also a real problem
• The electricity market is signaling that
  electricity is becoming more costly
• This is not a problem
• Redesigning the rules and regulations of
  electricity market can only change the signal,
  not the underlying reality (dont shoot the
  pianist)

24
Conclusions about the Nordic market

• The Nordic electricity market basically works
  well
• Supply security has been maintained, prices are
  close to relevant marginal costs, and
  productivity has increased
• Political intervention has increased the end-user
  prices of electricity by
• raising the marginal cost of supplying
  electricity
• adding new taxes/charges on electricity
  consumption
• Entry barriers, due to environmental and other
  political constraints, may limit investments and
  competition