The EU's electricity and gas industries: why are we in this mess and what can be done? Part 1

June 6, 2013 | 00:00

The EU's electricity and gas industries: why are we in this mess and what can be done? Part 1

People are complaining more and more about 'information overload'.  Sometimes, indeed, it appears to be 'misinformation (or disinformation) overload'.  And the processes governing daily life are becoming more complex and being developed and applied increasingly remotely from the vast majority of citizens.  Nowhere is this increasing complexity and remoteness of decision-making more obvious than in the long drawn-out efforts to complete the EU's internal markets in electricity and gas. 

"Electricity's increasing complexity" (c) Thinkstock

Reasserting the "four freedoms"

The increasing complexity and remoteness of decision-making is imposing unnecessary, excessive and unjustified costs on final consumers and on the EU economy.  It makes sense on occasion to return, as it were, to 'first principles'. The page on the web-site of the European Commission (EC) that deals with the single market sets out some basic governing principles:

"The cornerstones of the single market are often said to be the "four freedoms" - the free movement of people, goods, services and capital.  These freedoms are enshrined in the EC Treaty and form the basis of the single market framework.  But what do they mean in practice for everyone in the EU?
Individuals: the right to live, work, study or retire in another EU country
Consumers: increased competition leading to lower prices, a wider choice of things to buy and higher levels of protection
Businesses: much easier and cheaper to do business across borders"

Those of us who are more advanced in years remember the earlier manifestation of the EU as the European Economic Community. The focus then was on defining, developing, applying and enforcing these "four freedoms". And this focus was grounded on solid foundations in both the theory and practice of economics and political economy. A broad consensus existed that a mixed economy with genuinely competitive markets generated outcomes that were economically and socially superior to any alternatives that might be available or could be considered. This did not mean that the nature of the political economy that was built on these foundations went uncontested. There has always been, and continues to be, fundamental conflict in the political sphere - that, fortunately, more often than not is mediated by the democratic process - about the role of the state relative to the private sector and the location of the boundaries between the state and the market. And this conflict is often accentuated when 27 nation states are required, increasingly, to pool elements of their national sovereignty to achieve policy objectives agreed by all in their common interests.

With the passage of time it appears that the focus on these "four freedoms" has become blurred. But the continuing baleful impact of the Great Recession is encouraging a sharper focus on these 'first principles'.

With the passage of time it appears that the focus on these "four freedoms" has become blurred
Following an earlier initiative, in October 2012 the Commission issued a second (Act II) initiative on the Single Market. It includes a table of 12 key actions1.  For the energy sector lever, the objective is to "further integrate the EU energy market to reduce prices, promote renewable energy and improve security of supply"; the means is to "improve the application of the third energy package"; and the key action is to "implement [an] action plan to enhance the implementation and enforcement of the third energy package and make cross-border markets that benefit consumers a reality"2.

The absence of genuine democratic legitimacy

Describing the objective in terms of reducing prices, promoting renewable energy and improving security of supply is a demotic use of language presumably intended to render the argot of the Commission more 'citizen-friendly' and persuasive. It is possible, and, perhaps, it is the hope, that presenting the 'three pillars' of competitiveness, sustainability and security of supply (on which EU energy policy rests) in this manner may encourage increased and sustained popular acceptance and support.

The problem is that it won't; and it can't. The EU's energy and climate change project has never secured the extent of genuine democratic legitimacy that it requires. Nevertheless, the Commission has played the very weak hand of cards it was dealt initially to pursue, slowly, steadily and determinedly, over a period of more than 20 years, its objective of completing the internal market in electricity and gas. DG ENER (morphing from its previous manifestations as DG XVII and DG TREN) has taken the lead, but it has been supported at crucial points by DG COMP and, more recently, by DG SANCO (the DG for Health and Consumers) on consumer issues.

Completing the internal market in electricity and gas was 'unfinished business' in the wake of the Single European Act (SEA) in 1987, but it took the Commission nine years from then to secure the enactment of the 1st Electricity Directive in 1996 (followed by the 1st Gas Directive in 1998). And these directives were very tentative steps towards market liberalisation. Not surprisingly, most national incumbent, integrated

The EU's energy and climate change project has never secured the extent of genuine democratic legitimacy that it requires
transmission and supply businesses were strongly opposed. Many national governments were unenthusiastic. The UK Government was not entirely alone, but its pioneering efforts in terms of the privatisation of its electricity and gas supply industries and the subsequent combination of regulation and market liberalisation attracted limited political or policy support in many other Member States. Britain's then self-sufficiency in natural gas contrasted forcefully with the increasing reliance of continental Europe on gas supplies from the Norwegian GFU, Gazprom and SONATRACH based on long-term, 'take-or-pay' contracts with oil-linked prices.

The difficulties posed by the exercise of market power and political meddling

The challenge confronting the Commission (and which continues to confront it) may best be expressed in the context of the acquisition, retention and exercise of political and economic (or market) power and the roles played by powerful and influential sectional economic interests. On energy policy and regulation, the Commission had very limited powers to pursue its objective. It relied almost totally on national governments, collectively, in the Council to provide it with the appropriate policy direction and then to persuade the Council - and increasingly the European Parliament - to consent to the legislation and regulations it drafted - and to transpose these into national law. Most national governments were very happy to 'talk the talk' of electricity and gas market liberalisation, but, when required to agree on precise primary legislative provisions and then to transpose these in to national legislation, they found it very difficult to 'walk the walk'.

Prior to market liberalisation, the existing incumbent electricity and gas suppliers enjoyed cosy, vertically integrated monopoly arrangements. Their staff and suppliers shared in this enjoyment. And the external gas suppliers enjoyed lucrative, if occasionally prickly, but broadly secure contractual arrangements with the national incumbents. The only party losing out was final consumers who ultimately paid for every aspect of

The only party losing out was final consumers who ultimately paid for every aspect of these commercial and contractual arrangements
these commercial and contractual arrangements. There was no doubt that significant economic rents - in terms of prices being much high than the economic costs of supply - were being captured along the electricity and gas supply chains. But there were many influential and powerful players with their snouts in the trough. Over time, most Member States had developed broadly stable arrangements to ensure the allocation of this largesse in a way that minimised conflict among the various players. Even if final consumers were paying much more than they should have being paying, secure and reliable supplies of electricity and gas were being provided.

Starting with good intentions and some success

However, the Commission was well aware that the extraction of this largesse was damaging the EU's international competitiveness in terms of higher business and living costs and, particularly, in terms of a high cost of energy to industry competing in an increasingly globalised market. The Commission's initial steps, in the 1st Electricity and Gas Directives, were limited. This was perfectly understandable. Its powers were limited; it had to rely on persuasion. And the opposition to any change was formidable. This was just one example of the continuous battle that the Commission is fated to fight - the promotion of 'more Europe' against the desires of national governments to maintain maximum discretion - and to retain the ability to pander to the narrow, sectional economic interests that exercise varying degrees of power and influence over them. The opponents of change sought to apply the principle of 'subsidiarity' (in theory allowing decisions to be taken at the appropriate level of governance, but in practice permitting national obstructionist tactics), to maintain a requirement to preserve Public Service Obligations and to highlight the obvious differences in institutional and structural arrangements among Member States so as to impede the implementation of the relatively limited changes sought by the Commission.

In addition to a growing body of economic theory demonstrating not only that the introduction of competition and choice was desirable in the electricity and gas industries, but that it was also possible, the Commission had two 'models' of how competition and choice could be introduced. The first was the process of gas industry de-regulation pursued in the US from 1978 and which was largely complete by the late 1990s. The second was the process of privatisation, competition and regulation initiated in Britain for the gas industry in 1986 and for the electricity industry in 1990. For a variety of reasons, many perfectly understandable, some downright abstruse, the Commission favoured key elements of the British approach which was based on full unbundling of network and supply activities, wholesale markets in electricity and gas and full retail competition for all final consumers from 1998.3

The Commission could not be that ambitious - at least initially. But the first directives of 1996 and 1998 established two key principles. First, a minimum share of the electricity and gas markets - mainly serving large volume consumers defined by a volume threshold - was opened to competitive supply in almost all Member States. Secondly, electricity and gas networks were required to provide access (third party access) on non-discriminatory terms to network users other than the incumbent supplier. In addition, while the option of negotiated or regulated access to networks was permitted, a number of Member States accepted the need for regulated access and established economic regulatory bodies - or extended the remit of existing regulatory bodies.

The 'Forces of Darkness' regroup

Having established its beachhead, the Commission over the next 6 years, culminating in a second set of directives in 2003, sought to consolidate and expand what had been established under the first directives and to mandate full retail competition for all final consumers from 1 July 2007.  This did not mean that the opposition to the changes it was advancing had been overcome.  During the '90s the incumbent integrated suppliers (some completely vertically integrated (e.g. GdF or EdF), others locked in to tight contractual and monopoly franchise arrangements with multitudes of local electricity and gas distribution companies) began to see the 'writing on the wall' and to recognise that the changes being advanced by the Commission were running with the 'grain of the times'.  They needed time to adapt - and to buy the time to adapt - their often unwieldy and ossified structures.  Delaying the enactment of the first electricity and gas directives for as long as possible bought some time - as did ensuring the enforced changes were as limited as possible.

But, even though they were limited, these changes seriously threatened the incumbents' existing comfortable and lucrative business models.  Rather than reduce prices to final consumes and to expand, in any meaningful or useful sense, the choice of service - though some evidence exists that both occurred, the changes initiated by the first electricity and gas directives resulted in a reallocation of the economic rents being captured along the electricity and gas supply chains.  The inevitable fragmentation of demand side market power allowed more rent to flow upstream to producers and external suppliers. The implicit 'property rights' of incumbent suppliers to use transmission capacity as they wished were curtailed. Network regulation squeezed allowed revenues and facilitated the transfer of rent to new market entrants. The squeezing of allowed revenues also resulted in a reduction of the rents being captured by network staff - and by suppliers to these businesses.



2The President of the Council has upbraided the Heads of State and Government for failing to make sufficient progress on Act I and for running the risk of delaying progress on Act II:  The Council meeting in May may make some progress in the energy area.

3The British approach also included the ‘virtual’ pricing of gas transmission services (Entry-Exit pricing) which, although it facilitates the trading of gas at notional hubs, entrenches the monopoly enjoyed by the Transmission Systems Owners/Operators (TSOs) and prevents the emergence of genuinely competitive markets in gas transmission pipeline capacity.  The Third Energy Package of 2009 mandates the use of Entry-Exit pricing and proscribes pricing on the basis of Point-to-Point (P2P) capacity.  The generally accepted, but rarely conceded, rationale for this provision is to break Gazprom’s hold on P2P transit capacity in to and across Eastern Europe.  Not surprisingly, the costs (higher prices for the EU’s final consumers) and the benefits (the possibility of lower external supply prices in the future) have never been assessed in a transparent manner.

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