The opening of European electricity markets

The opening of European electricity markets

Jean-Baptiste LesourdUniversité de la Méditerranée

EIPM Conference "Managing Electricity Contracts", 23.9.2005

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For almost 50 years…

• …(1945-1990), especially in Europe electricity production and distribution were considered as a so-called natural monopoly with, in many cases, vertical integration.

• This justified in principle either regulation of electricity companies, especially in terms of pricing, or public ownership of such companies.


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At that time…

• …electricity companies in local monopoly situations in Europe mainly proposed posted tariffs, even to comparatively large industries, except perhaps for a few very large corporate consumers that usually were net puchasers but had their own production facilities (heavy industries such as steel or aluminum makers…).


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Nowadays (2005)…

• In many areas of the world (especially North America, and EU Europe) production and distribution of electricity have been opened to competition.

• The EU model considers production and supply as competitive with no vertical integration as previously. The network (transport and low-voltage distribution) is still in a monopoly situation.


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The EU policy…

• …aims at effective competition with:• Removal of statutory barriers to entry and of legal

monopolies; enough sellers initially;• Separation (unbundling) of monopoly sector

(transmission and distribution networks) and of competitive sectors (production and supply, whether wholesale or retail);

• Competitive network management regulated published network access charges under non-discriminatory conditions.


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In the UK (1)

• …for almost 50 years, since 1947 (nationalization of the British electricity industry under the Atlee labour administration) and until the 1990’s the Central Electricity Generating Board (CEGB) was in a monopoly situation and a 100% public ownership.


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In the UK (2)

• In the early 1990’s, CEGB was broken down into several entities including:

• Separate transmission company with access duty for easier competition;

• Three production companies (including one nuclear);

• New entry was strongly encouraged, but this was not enough towards effective competition.


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In the UK (3)

• Further policy steps lead to a competitive situation from the initial 3 main producers to 40 producers now.

• In 2004, the market share of the largest company, initially 48%, went down to 21%. (S. Littlechild).


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In France (1)

• …the situation was close to the pre-1990 British situation : EDF (Electricité de France) was 100% public ownership and almost in a monopoly situation (at least for distribution) until the early 2000’s. Both the CEGB and EDF were run by engineers (still the case for EDF), theoretically in the public interest, using sophisticated mathematical management techniques.


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In France (2)

• The only sizable companies other than EDF were in Alsace and Moselle departments. These were German between 1871 and 1918; they have kept some German legislation, and the German tradition of Stadtwerke (municipal utilities). One of them is Electricité de Strasbourg, listed at the Paris Bourse (EDF being its main stockholder), a local monopoly until the end of the 1990’s.


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In France (3)

• A law of 2000 led to competition in supply for large corporate consumers;

• July 1, 2004: competition in supply extend to all corporate consumers (retail is still a monopoly activity for other consumers);

• An electricity exchange (Powernext, spot and futures) was set up;

• EDF is still the dominant producer and supplier. Electrabel-Suez, and others, account for about 10% of market.


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Germany (1)

• Before the total opening of the market in 1998, roughly speaking, a tradition of some 900 municipal electricity companies (Stadtwerke) prevailed, all in a local monopoly situation.

• But the picture has dramatically changed since 1998.


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Germany (2)

• The German market is not unbundled, so that access to network is a problem;

• There are four "majors" (including EON and RWE…) involved in production, transport and distribution;

• 34 regional companies and 700 stadtwerke are mostly involved in local distribution.


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The Nordic market

• Norway’s Energy Act (1990) aims at competitive electricity markets (unbundling, regulatory system);

• A Norwegian-Swedish market was set up in 1996, and a Nordic market (Denmark, Finland, Norway, Sweden) in 2001;

• There is a centralized Nordic power exchange (Nordpool, spot and futures markets).


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Markets: centralized or not?

• There are various types of markets in terms of organization :

• Centralized markets, with intermediaries (brokers, auctioneers…) centralizing supply and demand.

• There are also decentralized markets, on which there are no intermediaries.


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(More or less) centralized markets

• Auction markets: buyers go up in price, or sellers go down in price, until a suitable price is reached) are centralized by an auctioneer (UK);

• Power exchanges: all orders for buying (with maximum prices) and selling (with minimum prices) are taken by brokers, who find a suitable market price that satisfies all orders (Powernext, EEX).


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Decentralized markets

• There are also decentralized markets, including:

• Markets with posted prices;

• And over-the-counter markets, on which commercial contracts are freely negotiated between sellers and buyers (these are the most important case for industrial purchasing).


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Commodity markets…

• …are usually :

• Over-the-counter with contracts freely negotiated between buyers and sellers;

• Or markets with posted prices (mostly in the case of retail markets);

• Or centralized markets, which can be either spot or futures (most commodities).


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Markets features : electricity vs. other commodity markets

Commodity Over-the counter-

Posted prices Spot markets Futures markets

Nonferrous metals

Large industrialconsumers

None Important (reference prices, LME…)

LME

Crude oil and oil products

Refiners and traders

Retail markets, subject to taxation

Important (reference prices, Rotterdam)

London Petroleum Exchange

Electricity Large and medium-sized consumers

Retail markets, posted tariffs

Local (country)markets

Powernext, EEX.de, Nordpool


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Large corporate electricity consumers…

• …are mainly involved in OTC markets with taylored-made freely negotiation of contracts (80-85% of market);

• They are also active on organised electricity exchanges (for about 15-20% of markets);

• Smaller consumers still rely on posted tariffs.


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Electricity purchasing, and market actors

• Electricity purchasers can deal with :

• Electricity companies involved in production and distribution;

• Electricity traders;

• Electricity exchanges (for marginal quantities, about 15% only);

• Their own electricity production.


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Electricity : a complex product

• Electricity is a product with rather complex quality attributes (time of the day, season, with so-called peak load times, wholesale and retail prices).

• This is a distinctive feature if we compare electricity with other commodities, which have much simpler quality attributes.


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Due to technical constraints …

… electricity is not traded on global world markets such as the oil market; it is rather traded on local (country…) markets and exchanges, within larger regions such as North America and Europe.


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Electricity…

…differs from all other energy sources.

All other energies (coal, oil products, gas…) are tangible materials, with some volume, some weight, and are storable: they represents capital assets, in the form of inventories, or commodities.


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Elements of total electricity price

• The price of the basic commodity (quoted exchange price, or over-the-counter price as published by data vendors, essentially Platt’s) (Typically 30-40 €/MWh in 2005).

• The price of transport (can be regulated as network is in a monopoly situation);

• Taxes, including VAT (when applicable), and other specific taxes.


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Electricity supply contracts : main features

• Quantities;• Qualities (a quite complex bundle of quality

attributes in the case of electricity);• Prices (specified fixed for contract duration,

revisable, indexed on spot prices, on producers' prices or on some other reference ?)

• Date(s) and miscellaneous conditions for delivery.


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In terms of pricing, electricity contracts…

• Are very technical; • With a relatively complicated set of price

charges;• All of which are now negotiable.


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Negotiable pricing (charge) items in electricity contracts

• Fixed charges; • Service/capacity charges; • Maximum demand penalties; • Power-station fuel cost adjustments to

price; • High voltage tariffs (cheaper than

ordinary "mains" voltage supply).


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Technical adjustments…

• …are possible, for instance, with respect to Power factor adjustments : approximatively 1% of monthly demand charge is added for each 0.01 by which the power factor falls below 0.9 (power factor losses in electromagnetic coils can be minimized by correct matching of equipment to duty loading).


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Risks and electricity contracts

• Various risks must be taken into account :

• Risk of supply disruption ? • Risk of adverse price variations ?

• Quality risks ?

• Other miscellaneous risks ?


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Risk of supply disruption

• A power purchaser has to tradeoff between the costs of supply disruption, and the investment costs necessary to ensure supply security;

• This is true of many industries, in which power supply disruption can damage heavily the facilities, in addition to production losses; also think of services, such as financial services: electricity supply disruption in the market room of a bank can have enormous costs;

• Usually, firms develop their own electricity prodution to avoid such problems.


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However, flexibility can be an asset...

. A competitive purchasing manager should always try to ensure flexibility in his or her supplies or more generally to his/her own production facilities;

• This can even imply voluntary disruption of company production, to be able to sell back at a high price some power to an electricity supplier at overload times.


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Risks of adverse price variation…

• …(upward variation in the case of a purchaser) are encountered for all commodities, including electricity;

• The purchaser will check carefully for delivery dates, and for the reference price used in the contract (Platt’s, electricity exchanges). Is it a spot price, or a forward or futures price on some exchange ? Furthermore, it is important for a purchaser to try to forecast whether prices will increase or decrease.


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Quality risks (1)

• These are the risks that the quality features of the commodity purchased do not comply with consumer’s specifications;

• Electricity has a complex bundle of quality attributes; for instance, accidental overvoltage can lead to heavy accidental damages.


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Quality risks (2)

• Quality risks, however, are treated in the network accessing contract, not in the supply contract itself.


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Other miscellaneous risks

• Conflicts and disputes (arbitrage, legal possibilities...);

• Natural disasters such as earthquakes, hurricanes, and more generally extreme climatic conditions;

• As shown by Arthur Hailey’s "Overload" , the risk of electricity theft is not mere fiction…


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Conclusions (1)

• Electricity purchasing implies:

• Technical skills (electrical engineering) : electricity is a very technical and complex product;

• OTC contract negotiation (large corporations), or optimal use of tariffs (smaller companies);

• Activity on organized markets (to cope with price volatility risks);


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Conclusions (2)

• Electricity purchasing also implies:

• Good knowledge of markets (at stake: economics), for both OTC negotiations and activity on organized markets;

• Managing facilities and equipment (a very technical activity);

• In many cases: managing one’s own production facilities.


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Systems thinking

• All this has to be integrated into a whole corporate policy (systems thinking): one wants adequate profit margins, a smaller electricity bill is not and end in itself;

• For instance, capital investment, suitable maintenance of facilities, optimal use of flexibility can be highly effective in improving overall competitiveness, as well as reducing electricity costs alone.


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This seminar will deal with all these aspects of corporate

electricity purchasing


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Thanks for your attention

The opening of European electricity markets

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