The Divine Comedy

If patience is a virtue, European energy regulators are saints. Reform of the power industry at the European Union level was first mooted in the early 1990s. The idea met plenty of resistance, but by the middle of the decade it had been worn down by the tenor of the times and the practical example of more or less successful reforms in the Nordic and British power industries.

The first European Union electricity directive was duly passed in 1996. It freed the largest consumers across the Union to choose their suppliers from 1999.

Deregulation was very popular by the turn of the decade and several states marched to the pulpit, pledging to go much further than required by the elders of Brussels. By 2003, market opening in the EU-15 reached 78% of power consumption, compared to a target of just 33% under the first directive.

A second electricity directive, passed in 2003 and in force since 2004, called for the liberation of all remaining captive customers in the business sector by July 2004 and all household customers by July 2007.

The second directive and an accompanying regulation on cross-border trading also introduced a number of important qualitative reforms, such as a demand for market-based solutions when contested network capacity is allocated to traders.

The central aim here was to increase support for international trade, which should be a driving force in any competitive European market, and so promote the development of the single European power market, as envisaged by the second directive.

A New Approach

The devil, as all saints know, is in the details. The reforms up to the second directive were ambitious, sweeping and clear in their spirit and intention. The results, though, have deeply disappointed many stakeholders, including the European Commission (EC).

Concerned and coming under heavy pressure from industrial customers, in June 2005 the commission’s competition and energy directorates launched a joint enquiry into both power and gas.

The commission published a preliminary report of its findings in February, drawing on extensive consultations with market stakeholders.

The report makes for grim reading for free-market-loving liberals: the problems are numerous, serious and difficult to tackle effectively without dramatic and potentially highly divisive policy action.

In fact, for the commission, the whole energy market chain has weaknesses.

In power generation, many markets are national in scope and dominated by a handful of leaders who are in a position to raise prices.

Higher cross-border trading could shift national market balances, but foreign traders are frustrated by low interconnector capacity, long-term import contracts from the monopoly era that are still in force today, and poor coordination between nations.

In domestic system operations, transparency is lacking. If trading is to grow, more data is needed on production, network flows, and demand trends.

Finally, many customer supply markets are dominated by the same players who lead in generation. They are vertically integrated companies — they have energy sources and customers, and so little need to trade in wholesale markets. This can effectively foreclose wholesale competition. 

Seven Years of Feasting

The catalogue of woe should not obscure the many achievements since European market opening in 1999. They include the following:

While they are not without their own controversies, the British and Nordic power markets have delivered results. Many customers have changed suppliers, the markets are fairly easy for new entrants to penetrate, and transparency is relatively high.

In other markets that are still seen as reform laggards, there has at least been a lot of action in the large industrial user segment. Competition needs to be extended, but it has a base to start from. These markets include Germany, Italy and France.

Cross-border operations are easier than they have ever been before. There is obviously room for improvement in many areas, but skilful operators can now make fortunes — and save money for their customers — where they were once essentially unable to operate.

Utilities across Europe have raised their efficiency levels substantially since the turn of the decade. The monopoly years, when gold-plating was generally the rule and energy economics were a matter for ministers who cared more about security and politics than commercial performance, are a distant memory. Some may consider the share of gains claimed by utility shareholders rather than customers exorbitant, but there is at least a bigger pie to squabble over.

Forward power trading in the Continental market is a booming business. More and more banks and investment funds are entering the market and trading volumes are surging. A utility looking to secure its financial position in 2007 or 2008 can start the job today, on the trading floor.

The power project business is booming too. Utilities and new entrants are well aware that Europe needs new capacity and are developing scores of very large projects. The important hurdle here is local authority resistance to projects, not market confidence. What’s more, if several new entrants succeed, the structure of the market will change, weakening the grip of leading incumbents.

For a correspondent long enough in the tooth to remember the great reluctance of some member states to accept even partial market opening in the 1990s and the brazen attempts of some incumbents to violate the spirit of pro-market laws around the turn of the decade, these developments verge on the miraculous

There Be Dragons

The trouble is that even what has been achieved could be lost. Look at the bigger picture: the European Union is passing through what increasingly looks and feels like an existential crisis.

And then pity Europe’s energy ministers. They are officially committed to market solutions — so many orthodox liberal boxes have already been ticked — and a number of them have indeed supported deregulation on the ground, more or less enthusiastically.

Yet the market has few true friends these days in the fearful ‘European street’, including the cafés frequented by many in the political elite. The latter may not buy the whole fear pitch themselves, but they will certainly use it if it reaches the votes market.

Just think of the irresistible bogeymen. We are not talking about some poor Asian sweatshop workers making cheap clothes and shoes. In energy we have first class villains: Putin’s mean Russia shutting down pipelines in the middle of winter; oil-rich Arab tyrants teetering on the edge of a revolutionary Islamist abyss; cheeky China and India staking their claims to energy resources in ‘our’ part of the world; and, last but never least, greedy American oilmen finding ways to profit from Europe’s plight while happily wrecking the planet.

Many Europeans are simply terrified and want comfort and protection, not competition and exposure.

However, there are many reasons to relax about energy security.

Perhaps a good place to start is the development of a taste for extravagant Russian rhetoric. Just twenty years ago, Germany’s Wirtschaftswunder was partly fuelled by a bunch of blustering old Soviet thugs who needed the money. What has changed? When was Russia ever cute and cuddly, or not interested in mountains of cash?

Al Qaeda’s failure to strike even one vital oil industry target outside Iraq is important too. The terrorists did go for a crown jewel in February ­— the giant Abqaiq oil processing facility in Saudi Arabia — but both car bombers were killed before they reached the second security perimeter. For al Qaeda, it was an embarrassing exposition of their weakness when faced with strong Saudi security forces.

This is a real clash and the Saudi government is fighting hard. It knows where its jewels are and is ready to protect them.

Sadly, it remains much easier to bomb residential compounds or other ‘soft’ targets. Nor can all ‘hard’ targets be successfully protected for all time, so caution should be the watchword.

Nonetheless, after years of threats of spectacular attacks, at present al Qaeda in Saudi Arabia is looking decidedly weak. If it is on the run in its spiritual and financial heartland, and continues to face set backs in Iraq, then it could start to disintegrate.

Even if Islamists are at the table when the energy contracts are signed, they will be practical — as in Sudan. 

My Moat Is Bigger Than Yours

What is arguably most worrying, in fact, is that Europeans are turning on each other. Earlier this year the Spanish and French governments rushed to protect two of their leading energy companies, Endesa and Suez, from foreign takeovers. The Italians — in the shape of giant electricity utility Enel — and the Germans — championed by E.ON, Europe’s biggest power and gas group — were the targets of this economic patriotism campaign.

Rome and Berlin reacted with indignance, and rightly so. The free movement of capital is the most basic of European freedoms. Yet both Rome and Berlin have their own record of helping favoured leaders and frustrating foreign investors.

This is a moment of truth: if several governments talk up markets but actually want protected national champions, what hope is there for competition?

Optimistic liberals with an eye on the limits of their influence might cite the Nordic region as one reason to hope the market can find a way to live with the state. It is widely considered the most sophisticated and best-established power trading market in Europe, but national, regional and local Nordic governments still play important roles as utility shareholders and masters of the energy policy framework.

For example — Vattenfall of Sweden — the region’s biggest utility, is wholly owned by the Swedish state and there are no formal plans to privatise it. In Norway, the state is loath to let foreigners gain control of hydro assets, which are seen as a national treasure.

Nonetheless, Vattenfall, Norwegian utilities and their peers in Finland and Denmark operate on a commercial basis and must face competition in their markets. In wholesale trading, this means low prices. Industrial energy buyers in Continental Europe and Britain can only envy their Nordic colleagues, who appear to live in paradise.

This is a characteristic Nordic balance between markets and politics that is employed in many fields beyond energy.

It is no surprise that some Continental governments see these Nordic models as an enticing template for the reform of their economies without being overly neoliberal, unlike the British fans of privatisation and freewheeling markets with the lightest of regulatory touches.

Yet one must doubt the capacity of Europe’s remaining old-style dirigistes to adopt strict Nordic market rules and stick to them. For the most part, Nordic governments have embraced competition and worked hard on regional market integration. Whilst the region is no paradise, it is many miles from limbo. The Continent’s economic patriots, by contrast, are starting their journey from an inner circle of the inferno.

In fact, it would be best for liberals to take a clear stand. If there is resistance to change, this is an excellent time to size it up, challenge it, and hope for the best. Their opponents are numerous but weak, demoralised and adrift.

Even better, if the market’s opponents regroup and strike back successfully, failure would not be the worst outcome. If the European project has had its day in energy, let’s shout it from the rooftops rather than grumble discreetly on the sidelines of industry conferences after mouthing pieties on the podium. Then we can make new industry arrangements based on full transparency.

A Europe-wide liberal offensive would be the strategy, but tactics are a different matter. Detailed EU-wide measures may be a distraction. The bureaucracy involved is cumbersome and some rules may work well for one market but not in another. Brussels should confine its ambitions to setting general frameworks and busting any miscreants its competition officials can corner, not the minutiae of local regulation.

For national governments and industry stakeholders, detailed regional solutions are a more promising idea. Here is a short wish list:

National governments should formally recognise the regional nature of the power business. Power flows obey the laws of physics, not national rules. The production decisions a generator in western Germany makes, for example, can affect his peers across the border in The Netherlands. It is high time to found a Northwest Europe Energy Authority, with a mandate to establish a fully integrated regional marketplace encompassing Germany and the Benelux. French pride willing, Paris would join next.

Transmission system operations should be regional as well. The failure of system operators to cooperate, whether out of mere fecklessness or under national policy direction, is one of the most depressing sights in the European marketplace. Indeed, this is one of the Nordic region’s peccadilloes; if even the Scandinavians can’t get diversity right, unity must be the only way forward.

Germany could start by creating a national system operator of its own, getting its top four utilities out of this sector in the process. Energy groups competing for customers should have no role of any kind in network operation, which can and has been used as a monopoly weapon to frustrate new entrants. Germany is synonymous with excellence in many fields, but in system operations the right descriptive terms are unprintable.

Transparency should be enhanced by internet publication of extensive physical market information, from production to network flows to demand trends. This data should be presented in the same format for all markets in a region and made easy to enter in trading information systems.

Once regional markets are in place, concentration can be considered in a new light. Perhaps today’s giants will look smaller and be forced to work harder. Managers would get the scale they want, while customers would have more choices. If instead concentration remains a problem in regional markets, harsh measures should be taken, as they were in the UK in the 1990s, when leading generators were broken up to reduce their market power.

It is very hard to see some important stakeholders adopting this wish list. Many have struck a sort of sneaky St Augustine pose, loudly proclaiming ‘Lord, make me virtuous’, and then muttering ‘but not yet’. Bring on the liberal brimstone. 

Ben Tait can be contacted at Prospex Research Limited on +44 20 7870 6307 or e-mail ben.tait@prospex.co.uk or visit www.prospex.co.uk