1 THE COMPETITION OBJECTIVE A. Introduction 1.01 D. Why is Energy Special? 1.60 B. What is Competition? 1.05 (1) Electricity 1.63 C. Energy Markets and (a) The Europe Factor 1.66 Government Intervention: (2) Gas 1.67 The Energy Paradigm (a) The Europe Factor 1.68 {1) Historical Characteristics of (b) The Impact of LNG 1.72 the Electricity and Gas Industries 1.10 E. The Requirements of Liberalization 1.75 (2) The Pre-Libcralization Paradigm 1.11 (1) Regulation and Access 1.76 (3) Beyond the Pre-Liberalization (a) An Independent Regulator 1.79 Paradigm 1.17 (2) Structure 1.83 (4) A Three-Stage Evolution 1.22 (a) Elements of Natural Monopoly (a) Stage 1: Intervention 1.27 in Supply Phases 1.84 (b) Stage 2: Uncertainty 1.32 (b) Solutions: 'Unbundling' 1.85 (c) Stage 3: Globalization 1.37 (3) Liberalization 1.90 (5) Crisis and the Shift Towards (4) Ownership 1.93 'Energy Security' 1.45 (a) Licensing and Concession (6) Unfinished Business 1.47 Regimes 1.94 (a) Problems of Application 1.51 F. Conclusions 1.95 (b) Problems of Compatibility 1-55 (7) A New Paradigm Emerging? 1.58 (P)olitical and public opinion in the US is more ready to accept competition as a good in itself than opinion in most European countries. David Edward' A. Introduction The goal of promoting competition in European energy markets has always had 1.01 to jostle for policy space alongside two other important concerns: on the one hand, the provision of energy security in a region characterized by a high and growing 1 "The Modernization of EC Antitrust Policy. Tssues for Courts and Judges', paper presented at the Workshop on die Modernization of EC Antitrust Policy, European University Institute, Florence, 2000. 3 Chapter 1: The Competition Objective R. What is Competition? dependence on external sources for its primary energy consumption and, on the other, the achievement of environmental sustainability.2 Their uneasy co-existence has been a much nored feature of European energy policy over the years, particularly since the competition goal acquired the status ofprimus inter pares with the internal market programme since the late 1980s. Very recendy, the competition goal appears to have experienced a relative decline, even as the i n ternal energy market programme has begun to make a real impact. 1.02 The manner in which competition is being introduced into EU energy markets is partly responsible for the emergence of doubts about the benefits. The first legal measures were finalized ten years ago after many years of controversy and set out a timetable for market opening or liberalization. This gradualist approach or 'managed liberalization' was designed to give energy companies time to adjust to a more competitive environment. Ultimately, energy consumers—that is, largely industrial consumers of energy—were expected to benefit from a greater choice of supplier and possibly from lower prices. By the end of the fitst decade of'managed liberalization', consumer prices appeared to be volatile and lacking in transparency, markets for both electricity and gas remained segmented into national comparrments, and there was a marked absence of new entrants. Even more challenging were a number of new problems that had appeared during the first decade: large investments were required in the ageing network infrastructures to modernize and expand them; dependence on non-EU imports of gas for power generation had grown continuously, and the introduction of a Europe-wide emissions trading scheme was beginning to impact upon electricity prices. 1.03 A consequence of these developments was to underline—if that were necessary— how sensitive and strategic the energy sector remains for the economy of the nation-state, and in this case the Member States of the EU. For a number of participants it appeared to confirm their perception of energy as, essentially, a service of general economic interest, which should not be entrusted to the care of the market, at least not entirely. The notion of energy as a service public^ guaranteeing reliability and continuity of supply, preferably entrusted to the care of a privately or publicly owned national champion, has become again an influential idea in some parts of the EU, even if it lacks a coherent ideological framework. It is a challenge to the competition objective that has been the ultimate, if not the only, objective of the internal energy market programme over the past decade. All the more ironic then, that the key idea of service public has already been incorporated into the EU model for liberalized energy markets. In this chapter a number of issues are addressed that are preparatory to the examina- 1.04 tion of EU energy and competition law that follows. First, the issue is examined of what competition means in the energy sector and why the goal of competition appears to have a particular sensitivity (section B). Next, the wider historical and intellectual changes that drove forward the idea of energy market reform are described by reference to the notion of a changi ng 'energy paradigm' (section C). Some of the specific reasons why electricity and gas present special challenges for the introduction of competition are then explained (section D). The 'nodal points' of liberalization, that is, the sensitive areas that must be operated on for a programme of market opening to succeed, whether in the EU or elsewhere, arc also analyzed (section E). B. What is Competition? There are many ways of answering the question of what 'competition' really 1.05 means. From an essentially economic point of view, a leading competition lawyer, the late Daniel Goydcr, offered a convenient definition: Competition is basically the relationship berween a number of undertakings which sell goods or services of the same kind at the same time to an identifiable group of customers. Each undertaking having made a commercial decision to place its goods and services on the market, utilizing its production and distribution facilities, will by that act necessarily bring itself into a relationship of potential contention and rivalry with the other undertakings in the same geographic market... 3 The advantages often attributed to the operation of competition include:4 • Allocative efficiency, the part that competition plays in allocating tesources in the direction preferred by consumers. This has the benefit of reducing the risk that goods or services produced will not be wanted, or not wanted at the price at which they are offered. • Innovation: the constant process of dynamic adjustment to continual changes in consumer preferences is an incentive for producers to invest in research and development and to innovate, leading to the survival and growth of those companies which make the necessary changes in good time, whilst those that fail to do so inevitably fall behind. • Cost reduction: the continual pressure on all producers and sellers in the market to keep down costs, and therefore prices, for fear of losing custom to other sellers who find ways to attract business either by general price cuts or by special discounts to favoured buyers. 1.06 2 The co-existence of these goals is vividly illustrated in the European Commission's Green Paper, A European Strategy for Sustainable, Competitive and Secure Energy, COM (2006) 105 final, 8 March 2006, and in the Strategic F,u ropean Energy Review document: An Energy Policy for Europe, COM (2007)1 final, 10 January 2007. 3 EC Competition Law (4th edn, 2003) 8. 4 For a fuller discussion of this, see Prosser, T, The Limits ofCompetition Law: Markets and Public Services (2005) ch2. Chapter 1: The Competition Objective • Progress: the likelihood that a country whose economy is committed to the competitive process will enjoy greater advances in productive efficiency and in utilization of its resources of raw material and human capital. 1.07 All of these prospective benefits from competition could be said to lie behind the EU programme for energy market reform in recent years. The frequent linkage of energy marker reform to the so-called Lisbon Agenda of growth and competitiveness testifies to the influence of the fourth item on the EU thinking about competition in this area. 1.08 If one seeks to rely upon a definition in the EC Treaty, there is a reference to competition1 as a concept in both Articles 3(1) (g) and 81, but a proper definition is not offered. Article 81 has no application unless the agreement, decision or ptactice concerned has either the object or the effect of preventing, restricting or distorting competition, but the concept itself is not defined. At the same time, a perusal of the Treaty framework quickly reveals that competition is a policy with equivalent status to other policies, such as environmental or social policy. In the event of any actual or potential conflict there is a need ro establish some balancing of the policies concerned. 1.09 This co-existence of competition policy with other policies in the framework of the EC Treaty is the key to how competition in the context of energy markets should be approached if nor necessarily defined. The EC Treaty gives a particular importance to the notion of services of general economic interest (in which electricity and probably gas are included) and to notions of public service. By contrast, there is almost no mention of energy' in the EC Treaty at all. A balancing of the competition objective with the many possible interpretations of service public arid all that it implies is rooted in theTreaty itself. It makes a social interpretation of 'competition inescapable. Given the crucially important role that electricity and gas supply play in modem life in the EU as in most other parts of the world, this means that the scope for an unfettered form of competition is— at least within this legal framework—non-existent, and the way that competition in energy markets is introduced and promoted has to take fully into account the role of non-economic goals and values, not least those affecting the public service character of this sector. C. Energy Markets and Government Intervention: The Energy Paradigm (1) Historical Characteristics of the Electricity and Gas Industries 1.10 In every industrialized country it has been normal practice for governments to involve themselves in the energy business, and especially in the activities of the C. Energy Markets and Government Intervention: The Energy Paradigm electricity and gas industties. This has been encouraged by at least five principal characteristics of these industries: (1) They necessarily involve activities that develop in successive phases (generation or production; followed by transmission, distribution and supply/retailing).5 There are elements of natural monopoly in transmission and distribution activities which stimulate vertical integration of the above activities within a single company. Those integrated companies have traditionally been obliged by governments to provide and supply electricity and gas, and have in return been granted exclusive rights of supply over a specific area or territory (see below). (2) The services provided by these companies have traditionally been seen as essential for communities, and an obligation to supply has often been imposed by governments on the companies—electricity prices normally being controlled by government and based on costs. (3) The electrici ty and gas sectors are strategic for the overall economy and for the military capability of the nation-state. (4) They are capital-intensive industties with a high degree of technical complexity, which creates entry barriers and necessitates technical co-ordination in their operation. This has led to a structure of regulation that places strong emphasis on reliability of transmission and delivery. This has been particularly evident in the electricity sector, because electricity cannot be stored; rapid changes in demand can occur throughout any given day, and each request must be linked with supply. (5) There is a measure of integration between the various energy sub-sectors, so the regulatory status of one influences the other. Electricity is a secondary form of energy that derives from various primary natural sources such as gas, oil, coal, water or uranium. Gas is commonly found in conjunction with oil. But both electricity and gas can be substituted for each other and so compete for end-use in consumer markets. (2) The Pre-Liberalization Paradigm These characteristics contributed to a specific model or pattern of government-energy industry relations that, with some variations, was dominant in all the industrialized countries for several decades. Tts wide acceptance over a long period of time and its impact on the policies of governments suggest that it may be described as the 'traditional paradigm' of energy network regulation. By this it is intended to refer not only to certain ways of organizing government relations with the 5 Other phases can be distinguished, eg system operation and dispatch, spot' and contractual markets and, for gas, storage and possibly liquefaction and te-gasification. These, however, have different functional and cost chatacteristics and are less fundamental to the industries concerned. 1.11 Chapter 1: The Competition Objective C. Energy Markets and Government Intervention: The Energy Paradigm electricity and gas industries, but also to a set of ideas about the scope of competition and the appropriate legal and institutional methods to achieve public policy aims. Such ideas have had both a prescriptive and a constraining effect on choices in policy. These ideas were dominant in the period before the current liberalization of electricity and gas markets began. 1.12 The concept of'paradigm' has been defined in the context of the natural sciences as comprising universally recognised scientific achievements that for a time provide model problems and solutions to a community of practitioners'.6 In the electricity and gas sectors the traditional paradigm comprised a wide variety of legal and institutional arrangements that were predicated on a model of technical organization involving central control over a synchronized network. It was assumed that these network-bound systems were strategic assets for a national economy and that the natute of their production made it economic to have a single entity construct the system facilities and operate the transmission grids. It emphasized stability, reliability of supply, and public service. This model of centrally-controlled and vertically-integrated monopoly is still to be found in various forms in some OECD countries, and in many developing countries as well as the emerging markets. 1.13 For many years most countries favoured a common technical model of an electricity system, based on central station synchronized 'AC (alternating current). However, each system evolved its own structures for planning, decision-making, and other aspects of management. The technical feature was common, but die legal and institutional arrangements varied widely according to local history, politics, and culture. 1.14 The principal regulatory characteristics included: • exclusive rights to build and operate networks, granted under concessions or licences; • closure to competition; • detailed regulation; ■ vertically-integrated operations; • remuneration on the basis of historical costs; and • a high degree of planning with tight, centralized control. 1.15 They had another common feature: they did not allow the ultimate beneficiary— the electricity consumer—to participate in decision-making. The electricity user had 'almost no role in diis process except to switch things on and off'.7 The legal and financial arrangements were set up and supervised by governments, generally 5 Kuhn, T, The Structure of Scientific Revolutions (1970) viii. Alrhough Kuhns work is primarily concerned with the natural sciences, chc paradigm concept that he used has gained a wide currency in law and the social sciences, even if not always acknowledged. 7 Patterson, W, Transforming Electricity (1999) 5. 8 national governments. Technical arrangements were designed, manufactured, and installed by engineering companies. Electricity systems were operated by companies that had grown up with the systems—such as Electricity de France (EDF), Ontario Hydro, and Tokyo Electric Power. The activities of all of these participants were guided by a single basic idea: large 1.16 power stations generate electricity in large quantities and deliver it by wire ro every user in the area, continuously adjusting the total amount being generated to match the total amount being used at any instant. A serious shortcoming of this approach was that those who planned, managed, and operated the system did not bear any of the risk, and did not suffer if it failed. The costs of incompetence or bad judgment were passed on to customers and sometimes to taxpayers. A similar approach was adopted in die transmission and supply activities of the natural gas industry. (3) Beyond the Pre-Liberalization Paradigm The basic relationship between government and the electricity and gas industries 1.17 has for some time been undergoing a radical, and seemingly irreversible, change. With respect to electricity markets, the current state of change has been characterized as one in which the 'comfortable old certainties have evaporated'. Indeed, the 'basic premises that everyone involved accepted without thought, which guided the evolution of electricity systems worldwide throughout the 20th Century, suddenly no longer apply'.8Throughout the 1990s, governments in countries around the world began to change the ground rules. This change may be characterized as a movement from traditional regulation to 'regulation for competition'.9 The new idea behind this movement was that the institutional configuration 1.18 of a system based on the technically-centralized model can be restructured, and monopoly rights withdrawn to permit different suppliers to compete for customers. The technical reasons for this have been discussed in the literature,10 and include 8 ibid 3. 9 Ariiio, GO, Principles de Derecho Publico Econdmico (1999) 605-55, and see Ncwbery, DM, Privatization, Restructuring, and Regulation of Network Utilities (1999) ch 1. There is a considerable body of literature on economic regulation and on theories such as those of the public choice and public interest schools: see Newbery, ibid 133-69. An early overview of the arguments of the latter two schools is provided in Ogus, A, LegalForm andEconomic Theory (1994) ch 4. An introduction to the various meanings of the concept of regulation is provided by Daintith, T, 'Regulation: legal Form and Economic Theory in International Encyclopedia ofComparative Law, vol XVII (State and Economy) ch 10. For an overview of UK experiences in energy and non-energy sectors of the economy, see Robinson, C, (ed), Regulating Utilities and Promoting Competition (2006) and for an earlier period, Prossei, T, Law and the Regulators (1997). For a contrasting but highly stimulating view of national energy policy changes during this period, see De Jong, J, Weeda, E, Westerwoudt, T and Correlje, A, DeHigJaar Nederhnds Energiebelied{C\m^sichz\ International Energy Programme, 2005). 10 eg, OECD/IEA study, Electricity Market Reform (1999) 23^1; diis should also be read in the lighrofthe more recent assessment 'mO\yZX)l\\lA, Lessonsfwm Liberalised Electricity Markets {2Q^). 9 Chapter I: The Competition Objective particularly the development of the combined cycle gas turbine. As a result, a new paradigm in government-energy industry relations has emerged, based on a greater reliance on markets. It has sought to introduce competition whenever possible, encouraging openness, decentralized production with network access, and remuneration on the basis of market prices, not costs. If an activity has the potential for competition, the kind of regulation implied by the new patadigm facilitates competition by (inter alia) encouraging and supporting new market entrants. If an activity is a natural monopoly, then regulation provides a substitute for the competitive market by introducing measures which act as a surrogate for competition (eg, publication of tariffs for transmission and distribution). Many diverse approaches result from this. Several basic characteristics of this new kind of regulation may be identified as follows:11 • separation of activities in order to facilitate the introduction of competition wherever possible; • freedom of entry and freedom of investment in competitive activities, instead of a centrally-planned approach; • freedom of contract and competitive formation of prices; • access to networks and infrastructure; • supervision of the model by an independent regulator; and • adaptation to the use of information technology. 1.19 For effective regulatory oversight it is necessary that the regulators understand how the energy businesses work and how the various elements in them combine. In systems organized according to the traditional paradigm, where public sector monopolies predominated in the energy sector of many economies, problems of co-ordination and cost allocation among the elements of an electricity or gas network were concealed. And in the reformed electricity markets in particular it has become of critical importance to understand how the different components work and must work together. New rules (including those on cost allocation) must be designed to promote the economic benefits that liberalization is supposed to bring. Some co-ordination by a regulator is necessary to support competition. However, the profile of other government bodies should decline through arrangements set up under the new paradigm, except in relation to social and environmental matters. 1.20 The new energy paradigm has emerged in a context that displays some of the familiar characteristics of paradigm change noted by Thomas Kuhn.12 A radical shift involves the successful challenge by a competitor theory of the pt actice carried out within the traditional paradigm, and leads to a redefinition of the problems suitable " Atino, GO, PrincipiosdeDerecho Publico Emrwmico (1999) 608-09. 12 Kuhn,T, The Structure of"Scientific Revolutions (1970). 10 C. Energy Markets and Government Intervention: The Energy Paradigm for research and a change in world view. To promote this change, he notes, the proponents of a new paradigm will claim that they can solve the problems that have led the old one into its condition of crisis. In energy regulation, the advocates of the new market-oriented paradigm have successfully challenged the idea that network-bound energy industries defy the introduction of competition because of their natural monopoly characteristics. A new consensus emerged that was organized around a belief in markets. However, its supporters have not for the most part been proponents of some form of market fundamentalism in which all key issues are settled by way of reference to market principles. In challenging the traditional paradigm, it may well appear that this is being argued, but it is by no means inevitable and is expressly contradicted in some cases.13 It is not necessarily being argued that energy should be treated as just another commodity. On the contrary, in at least two ways the new paradigm's supporters acknowledge flexibility and open-endedness. First, the way in which governments introduce and promote competition has been and will remain highly diverse. Secondly, no one knows much at all as yet about the medium to long-term effects of liberalization (particularly on security and continuity of supply) because experience in most cases is still too recent. 1.21 (4) A Three-Stage Evolution The reasons for this paradigmatic shift are economic, ideological, and legal. They 1.22 can perhaps best be understood in an historical context since much of the power of the new paradigm comes from its claim that the traditional paradigm in the electricity and gas industries had—because of technological advances and globalization of trade—outlived its usefulness. A number of recent studies of energy market reform have been at pains to explain the historical developments that have led to the present market-oriented reforms and to claim their superiority. For convenience, three broad stages in the evolution of government relations with the energy sector may be distinguished. The first began with the reconstruction and expansion after the Second World 1.23 War. In Europe it saw the nationalization of energy companies (electricity, gas, town gas, coal, and, to a limited extent, oil companies) and the establishment of very close relationships between government and the state-owned (or controlled) energy companies. A characteristic of this stage was the consolidation of a highly fragmented electricity industry and, in Western Europe following the introduction of natural gas, the creation of state-owned monopoly suppliers. 13 OECD/IEA, Electricity Market Reform (1999); Hogan, WF, 'Making Markets in Power' (London, 2000) ; Helm, D, Energy, the State, and the Market: British Energy Policy since 1979 (2nd edn, 2004). 11 Chapter 1: The Competition Objective 1.24 A second stage can be seen as commencing with the energy crises in the 1970s and is characterized by first an intensification and then a critical reassessment of the government-energy relations that had been built up during the previous stage, particularly those that had been built up in relation to security of supply in the oil industry and the construction of nuclear power stations. The tentative begi n n i ngs of a new market-based approach to energy policy emerged during this stage, especially in the USA. 1.25 A third stage began from around 1985 onwards. Governments loosened the ties that bound them to their energy companies, whether through strategies of commercialization or privatization or both, and moved to set up independent regulators. Despite many national variations, a clear market orientation has now become evident in the energy affairs of most industrialized countries. 1.26 This three-stage scheme provides a useful framework for a brief review of the principal linkages between governments and the energy industry over these decades. (a) Stage 1: Intervention 1.27 The dominant view of governments in Western Europe in 1945 was that the control by the state of the commanding heights of the economy (which included the coal, electricity, and gas industries) was essential to the reconstruction of Western Europe and the creation of the new post-War society. Accordingly, those industries were nationalized and their assets vested in state agencies or state-owned companies which were responsible, subject to tight governmental control, for running them. In this way the high cost of investment incurred in production and infrastructure could be made to meet rising demand. Abuse of this concentrated power was to be avoided in most cases by public ownership or significant public control. Examples of this approach are to be found in France with the creation of EDF and GDF (Gaz de France) in 1946 and 1949, in Italy with the creation of ENEL in 1962, and in the UK with the establishment in the late 1940s of the Central Electricity Generating Board (CEGB), the Electricity Council and the regional Electricity Boards, and the establishment of the Gas Council and the area gas boards that were superseded by the state-owned British Gas Corporation in 1972.14 So close was the relationship between government and industry in these cases that the term 'regulation' seems inappropriate to describe the kind of government supervision it entailed.15 1.28 Further consequences of this assumption were that the operations of the industries were usually exempted from the scope of national competition law, and entry of 14 This even extended into the oil sector with the establishment of a state oil corporation which operated—successfully—for several years: see Cameron, P, Property Rights and Sovereign Rights: the Case of North Sea Oil (1983) 138-171. 15 Well-illustrated by the use in the UK in the 1970s and 1980s ofthe term'lunch-time Directive' to describe the means by which the minister responsible for a particular nationalized undertaking communicated his requirements to the Chairman of the undertaking. 12 C. Energy Markets and Government Intervention: The Energy Paradigm new players into the market was excluded or strictly limited by statute. Public service obligations were imposed on the industry with respect to equality of treatment and continuity of service. In return, these industries obtained exclusive rights that amounted to, in practice, a monopoly, although the exact form differed from one country to another according to institutional structure, cultural background, political style, economic policy, and of course, the energy resource base. In the USA, a different model was in operation: that of the private monopoly 1.29 regulated by a publicly-appointed state or federal regulatory commission. There were a number of federal or municipally-owned power companies in business. The nearest counterpart to this in Europe was found in West Germany, where large, privately owned electricity and gas (and oil) companies constituted the dominant force in the energy sector. There too, many smaller energy distribution companies were in municipal or mixed ownership. The highly interventionist role of the state during th is ti me appeared to be vindicated 1.30 by the rapid economic growth in which the energy industry played a major part by supplying increasing quantities of energy at affordable prices. It was also promoting the investment in networks that establ ished the modem electricity and gas businesses. This extensive and overr role of rhe state in national energy management had a 1.31 considerable impact on the first efforts at European integration. The EC Treaty addressed issues of economic integration, but energy was not expressly mentioned. Although nuclear energy and coal were treated in some detail in the two other Treaties of the period (ECSC and Euratom), the network-related barriers to competition in the electricity and gas sectors were not addressed. In practice, even the antitrust provisions of the ECTreaty were not applied to these sectors, allowing various kinds of exclusive rights to be exercised by monopolies in mast of the Member States. Indeed, it was not until the judgments oftheECJ in the Genoa and Corbeau cases (see paras 16.37-16.39 and 16.43-16.45) that it was established that holders of exclusive or special rights could be challenged under Article 86. (b) Stage 2: Uncertainty The energy crises of the 1970s led to the high watermark of government interven- 1.32 tion in the energy sector in the industrialized economies. This was a period in which the goal of security of supply figured largely in public policy. For oil supply, this was a matter of particular concern due to the dependence of most of the industrialized countries on imports from the OPEC countries. The energy crises called into question the reliability of that oil supply—at that time the principal input fuel to electricity generation after coal. There were many specific government interventions in energy markets. Some of 1.33 these were concerned to avoid possible politically-inspired disruptions to supply, 13 Chapter J: The Competition Objective but others were aimed at encouraging fuel diversification to reduce dependence on imported oil supplies and avoid a possible future scarcity of fossil fuels. Very expensive programmes were introduced to fund the construction of nuclear power plants and subsidies made available for alternative forms of energy generation. At intergovernmental level, the International Energy Agency was established to supervise an emergency allocation scheme and encourage fuel diversification. The European Community took related measures, including the adoption of a new Directive restricting the use of gas for electricity generation.15 A proliferation of national energy policies and plans emerged, as well as energy departments and agencies to implement them. 1.34 The results of these market-distorting interventions were on the whole mixed. On the positive side, there was reduced dependency on imported fuels, greater efficiency in oil production, and use of alternative fuels, especially nuclear energy. Indeed, much of the French nuclear energy programme resulted from policy decisions taken as a result of these interventions. However, in the USA, federal capping of wellhead gas prices had adverse and unexpected results. Moreover, the government-inspired investment in new power plant capacity subsequently proved in a number of cases to have been very costly and unnecessary. Examples of this were particularly evident in the nuclear energy sector in several countries. 1.35 The negative effects of such attempts at government direction of the energy economy led to a severe questioning of the assumptions on which the interventions had been made. This climate of doubt about the role of government in the energy sector in the face of considerable evidence of malfunctioning did not by itself bring about a change in thinking about the adequacy of the prevailing paradigm for government-energy industry relations. That change required another very important development—a synergy between advocates of an alternative, pro-market approach and decision-makers who were able to put their ideas into practice. Such pioneers were begi n ning to emerge in the UK and the USA by the end of the 1970s. 1.36 Those pioneers were encouraged by several developments that occurred from the 1970s. Alternatives to vertically-integrated electricity systems appeared possible from the experience of independent generators operating on existing grids without seeing any decline in the quality of service provided through the system. Technical progress was also shifting the minimum efficien t scale i n power generation away from the large fossil fuel consuming units towards smaller ones, creating the possibility of easier entry for new players into energy markets. These developments were seized upon to challenge the traditional mode of thinking and replace 16 Directive (EEC) 75/404 on the restriction of the use of natural gas in power stations [1975] OJ L178/24 (since repealed by Directive (EEC) 91/148 revoking Directive 75/404/EEC on the restriction of the use of natural gas in power stations [1991] OJ L75/52). 14 C. Energy Markets and Government Intervention: The Energy Paradigm it with the idea that some competition in energy networks was both possible and desirable. It was argued that the activities of generation/exploration, end-use supply, marketing, and billing could be unbundled and opened to competition without significant adverse effects. This laid the basis for an alternative paradigm. (c) Stage 3: Globalization From the mid-1980s onwards, the traditional patadigm of government-energy 1.37 industry relations was challenged again. There were two principal sources of this challenge. The first lies outside the energy sector—the complex of processes commonly referred to as globalization. The second came from within—specific initiatives taken by states to liberalize their energy markets. 'Globalization refers to processes that promote economic interdependence and 1.38 cut across the borders of nation-states, seeming to threaten the soveteignty of those states. These processes were greatly assisted by changes to the GATT agreed in the Uruguay Round (1994) bringing about both the crcarion of the WTO and increased opportunities for international trade. One of globalizations most striking features has been the expanded role of world financial markets which increasingly operate on a real-time basis on a global scale. Another has been its relationship to the spread of information technology and transformation of everyday notions of time and space. Support for globalization has come from corporations, states, and many NGOs. Its effects have been most visible in the OECD countries. Economic globalization triggered a debate on the future of the nation-state. With 1.39 a few notable exceptions,17 most writers have seemed to agree that there has been no decline in the nation-state but rather a transformation in its functions, some powers transferred away from nations and into a depoliticized global space or to supra-national entities.18 At the same time, there has been a trend for some decisionmaking to move from the centre of nation-states to sub-national level. However, the scope of government, taken overall, has appeared to expand rather than diminish as globalization proceeds.19 Nation-states remain the most important agents on the international scene. Although the phenomenon of economic globalization is not en ti rely new, the current 1.40 globalization processes have been occurring hand-in-hand with a widespread economic liberalization in which many functions associated with the state have been transferred to the private sector and made subject to different and often unfamiliar forms of regulation, either by the state or its agencies. There has also 17 Stiglitz, J, Globalization and its Discontents (2002); Ohmae, K, The End of the Nation State: The Rise of Regional Economies (1996). 18 Sassen, S, Losing Control? Sovereignty in an Age of Globalization (1996) xii-xiii. 19 See, eg, Giddens, A, The ThirdWay: the Renewal of'Social Democracy (1998) 32; TheThirdWay and its Critics (2000) 122; Stiglitz, J, Making Globalization Work (2006). 15 Chapter I: The Competition Objective been a change in the role of supra-national institutions i n promoting and facilitating these economic reforms. The nation-state has become more and more involved in the implementation of those laws necessary for economic liberalization and globalization, especially those concerning deregulation and the formation of legal regimes that favour the free circulation of capital, goods, information, and services. 1.41 The second and most significant challenge of all became from the actions taken by advocates of a new market-oriented approach to energy market organization. Their early experiments in liberalizing the electricity and gas markets first of the USA, the UK, and farther afield in Latin America showed that positive results could follow from the process, and went some way to confounding predictions of inefficiency and even system collapse. Amid much debate about the virtues and shortcomings of traditional regulation, a number of experiments were initiated in the liberalization of national energy markets. The significance of these early—and in rerrospect rather primitive—experiments in market reform is that they had sufficient success to persuade others that there were hard-headed arguments in favour of this paradigm. As the arguments multiplied, with the growing number of experiments, the converts grew. There was a basis in the real world for faith in the new paradigm. 1.42 Other countries soon followed this route. In doing so they showed that there was no single model to be replicated but rather a set of ideas that could be adapted to permit a liberalization tailor-made to each specific setting. In the Nordic countries, for example, an electricity pooling system was established but without the privatization that had been chosen i n the UK and in Chile. Australia and New Zealand also favoured approaches that suited their own special circumstances. The new paradigm became associated with 'progress', even if some stocktaking has taken place as a result of rhc concerns over various forms of energy security in recent years. 1.43 Differences between the two industries (electricity and gas) did present liberalizers with serious challenges. Take the USA for example. There the transition to greater reliance on competition to govern the performance of the natural gas market did not raise many important structural issues20 (in contrast to the UK). Essentially, the network of gas pipelines had reached a mature stage, and when access provisions were introduced in the legal regime a very large geographic market was created. After the elimination of west-to-east constraints in transportation capacity, a continental market was created making it virtually impossible for a single seller or a combination of a few sellers to exercise market power. By contrast, the transition to competition in electricity markets has raised a host of structural questions. As one commentator observed, 'depending on the locations and effects 20 Pierce Jr, RJ, 'The Antitrust: Implications of Energy Restructuring' in Natural Resources < Environment (1998) 269. 16 C. Energy Markets and Government Intervention: The Energy Paradigm of transmission capacity constraints, and depending on the way transmission is priced, the geographic market for electricity can be as large as a region of the country or as small as part of a single state'.21 As a result, the idea took root in the USA that it is technically possible and economically desirable to develop a model of regulation based on market principles. There was a growing pressure for reduction in gas and electricity prices, particularly from major energy users. In addition, somewhat fortuitously, this pressure coincided with a period in which oil and gas were available at historically low prices. Moreover, as consumer benefits of competition in other sectors such as telecommunications became clear, similar benefits were sought in electricity and gas. At a wider international level, there has been a growing acceptance of policies 1.44 aimed at generating revenues for state finances from privatizations and of the benefits of international trade. An effect of globalization has been to encourage governments to accelerate experimentation in market reform at national level. The various experiences of governments committed to energy market reform showed too that the chaos predicted by some critics was avoidable. As a result of all this, the mindset of most governments to competition in network-bound energy markets changed fundamentally. (5) Crisis and the Shift Towards 'Energy Security' Against the trend described in the preceding paragraphs it may be argued that the energy crisis in California in 2000 triggered conceins about the security risks of energy market liberalization. The California crisis comprised a lack of supply and artificially escalating prices resulting in the largest utility filing for bankruptcy. A combination of factors led to th is situation including: • lack of new generation capacity due to an uncertain regulatory environment and unusually strict planning controls; • rapidly incrcasingdemand due toSilicon Valley (high-tech industry) consumption; • existence of an obligatory pool leading to anti-competitive, oligopolistic pricing practices; • the impossibility of off-setting risk through long-term supply agreements; ■ locked retail prices and exposure to spot prices; • impossibility of TSO launching tenders for the construction of new capacity combined with power purchase agreements; • lack of interconnection capacity and supply arrangements with neighbouring states; • external factors, eg drought; and • lack of appropriate inter-state trading arrangements. 1.45 21 ibid. 17 MASARYKOVA UNIVERZITA Fakulta sociálních studií loStova 10 «12 00 B R N O Q£> Chapter 1: The Competition Objective C. Energy Markets and Government Intervention: The Energy Paradigm The result of this unusual combination of adverse conditions was a kind of 'petfect storm' that few, if any, systems could have survived intact, unless heavily protected by state subsidies and bail-outs funded by taxpayers. Nevertheless, the fact that interruptions to the power supply have occurred in many F.U countries (and North America) from 2003 onwards has been sufficient to foster a sense of vulnerability about electricity supply in liberalizing markets that has required some adaptation of the market paradigm, if only in emphasis. Uncertainties in gas supply and external dependence have only served to underscore this factor. The legal measures taken are discussed in Chapter 18. 1.46 However, several of these factors could have been anticipated when designing the legal and technical structure of the liberalized regime. If new generation capacity is an objective, then incentives for new investment should be included and unduly restrictive planning ot environmental laws should be eithet modifed prior to implementation or taken into account in the regime's design. In the HU, the Commission has been keen to emphasize that the EU internal energy market regime allows Member States to take emetgency action at an eatly stage if faced with an imbalance between demand and supply—notably by launching tenders for new capacity backed up by fixed price power purchase agreements.22 In addition, most EU Member States have an excess of capacity rhat could, if necessary, provide a cushion to any disruptive effects of liberalization. (6) Unfinished Business 1.47 In spite of the continued existence of systems otganized according to the traditional paradigm, by the late 1990s the contest appeared to have been decisively won by the new market-otiented paradigm: 'regulation for competition (see below) had become at least an organizing principle to which most governments aspired in those sectors of the economy characterized by networks. 1.48 However, a paradigm is more like an open-ended framework than a model, and the triumph of the market-oriented paradigm leaves a great many issues open for development by its supporters (and its converts). These may be divided into two categories. 1.49 First, there are problems that must be addressed that arise from the introduction of competition into network-bound energy sectors, such as the so-called 'stranded asset problem' (problems of application). They do not involve questioning the basic assumptions of the new paradigm but lead instead to the analysis and attempted solution of what might be called 'micro problems', using techniques compatible with the basic assumptions of the new patadigm. 22 European Commission, 'Communication on Completing the Internal Energy Market' (2001) 46; Commission Press Release MEMO/01/174, 'The California Powet Crisis', 11 May 2001. Secondly, there are problems that are not direcdy connected with the new paradigm 1.50 but which impact on it and present a possible threat to its implementation (problems of compatibility). They include the many environmental and public service issues that affect the energy sector and the issues concerned with the sustainable development debate. (a) Problems of Application Problems of application are already apparent and are certain to increase. Three sets 1.51 of problems may be noted. First, there are those concerning the transition to a liberalized matkct. As the IEA has noted, 'given that no competitive power market has operated for more than a few years, none has yet completed the stage of transition.23 Indeed, '[tlhe impact of market liberalization on investments in long-tetm generating capacity and diversity of fuel inputs to power generators is not yet fully clear'.24 The problem of stranded costs, or remuneration for sunk costs incurred in a regulated regime but not recoverable after the market has been opened to competition is only one example of such a problem of mopping-up after the basics of the new patadigm have been accepted. It has sparked off a very lively debate and interesting research into the possible solutions.25 More fundamentally however, it appears that the transitional period maybe a very 1.52 lengthy one, involving periodic revi ews by government and regulatory au f horities and furthet legislation. In other words, the role of government may well have changed but the electricity and gas industries will probably remain subject to a high degree of government interference for the foreseeable future. Another set of problems concerns the application of competition law in the 1.53 context of liberalized enetgy markets. Many established notions about energy markets became open to question because of the spread of liberalization. This is especially so when the actions of market incumbents are such as to anticipate and undermine the effects of liberalization while it is being introduced (through mergers and acquisitions, for example). Finally, outside the mature energy markets there are problems that affect those 1.54 developing countries in seeking to liberalize their energy markets and at the same time increase investment in new networks and plant. In a number of such cases, this has led to a rejection of the energy market paradigan itself (in Russia, for example). 23 OECD/IEA, Electricity Market Reform (1999) 93. 2" ibid 98. 25 See, eg, Sidak, G and Spuiber, D, Deregulatory Takings and the Regulatory Contract: the Competitive 'I'ransformation of Network Industries in the US (1998). 18 19 Chapter 1: The Competition Objective (b) Problems of Compatibility 1.55 Problems of compatibility primarily involve potentially market-distorting initiatives taken by governments. In particular they could involve measures to promote policies of sustainable development. It is early days for trying to discern how such problems will be addressed in ways that are compatible with the promorion of competitive markets. This is something of a 'black box'. The increasingly central position taken by environmental and social questions in energy law and policy is a powerful trend that is beginning to test the market orientation rhat developed in the 1990s. The new paradigm emerged during a period of abundant supply of electricity and gas but has increasingly had to concern itself with issues of security of supply. 1.56 The significance of these historically specific conditions for its long-term continuation is not yet clear: rhc complex relationships between markets, regulation, and investment behaviour (often cyclical in character when left to the market) are indeed 'not properly understood'.26 1.57 Paradigm changes also affect the method of inquiry in problem-solving. They will have a significant impact on the way in which a problem is defined and the way in which problems are prioritized.27 A paradigm shift will ensure that some problems are not placed on the agenda for solution, as they would have been under the preceding paradigm. (7) A New Paradigm Emerging? 1.58 In the pre-liberalizarion paradigm, a near absolute security of energy supply was provided but at unknown and inherendy high cost. As liberalization has proceeded, the excess capacity built up during these early years has been reduced by companies that are unwilling to pay the high costs of such teserve capacity, with a corresponding reduction in security of supply. In the UK this has triggered a fairly new emphasis by policy-makers on the need for investment in additional capacity to combat what is known as 'asset-sweating'. In itself, this is not an argument against market reform since there are many ways of providing incentives to investors to make the large invesrments that may be required. As Chapters 5 and 6 show, this has been done within the framework of the pto-competition legal framework. 1.59 Other developments have been identified by observers as indicative of a new paradigm shift: the various changes taking place in international gas markets28 26 Perceptive remarks by Robert Mabro underline this point: Oxford Institute for Energy Studies News, May 2001. Fof an assessment of the potential impact on eneigy of legal developments in combating climate change, see the contributions in Cameron, PD and Zillman, D, (eds), Kyoto: From Principles to Practice(2002), and Helm, D, (ed), Climate Change Policy (2005). 2? Kuhn.T, The Structure ofScientific Revolutions (1970) 110. 28 Clingcndael Institute, 'The paradigm change in international natural gas markets and the impact on regulation', 2006. D. Why is Energy Special? and the advent of a low-carbon economy29 are two examples. From a legal point of view, neither of these developments has yet generated the kind of sweeping changes that the market-driven paradigm initiated and effected over the past decade or more. The key to the success of this paradigm is the balance that it achieves with respect to three potentially divisive elements: market, security and sustainability. The weight given to each may change over rime but they are always present. As we shall see, they have always been present in EU law, and have deep and surely long-lasting roots. What is very striking in the European context is the extent to which the new market-orientated approach has made extensive efforts to incorporate the other objectives in the formulation of specific legal measures. On the environmental side, it is perhaps equally striking rhat efforts have been made to achieve sustainability goals through the adoption of market mechanisms. This does not lead us to the conclusion that at this stage a further paradigm shift is taking place. D. Why is Energy Special? The dependence of electricity and gas supply on fixed networks to transpott and 1.60 deliver enetgy to users is a serious complication for any policy of market opening. In practice, the transmission system is almost always a national monopoly. By contrast, the supply of oil and coal are not affected by such transportation bottlenecks. The physical characteristics of coal and oil have led to international trade and free market practices, with a declining government role except in fiscal matters. Customers can readily negotiate with competing suppliers to obtain the best deal for oil or coal purchase. The price obtained by the customer may be influenced by product quality and by differing levels and structures of taxation or subsidies. However, transportation and distribution constraints in a netwotk will not create problems of access for customers and producers in the way that they readily do in the gas and electricity sectors. A further characteristic of both sectors, linked to the above, is the high cost of 1.61 infrastructure and the element of sunk costs. This has often been used to justify anti-competitive features. Exclusive rights over a determinate period have been sought by investors to permit financing of these projects, with long-term contractual obligations, such as those involving 'take-or-pay' obligations. The tights granted may include an exclusive right to own and operate a transmission system over a specified period and an exclusive right to import gas or electricity. 29 Helm, D, 'The Assessment: the New Energy Paradigm' (2005) 21 Oxford Rev of Economic Policy 1—18. The investment argument and die end of a long period of low energy prices arc also used to suggest a paradigm shift. 20 21 Chapter 1: The Competition Objective 1.62 As the sections below illustrate, there are different obstacles to competition presented by the specific features of the gas and electricity sectors. For example, in the European context the production structures in each case are quite different and gas is obtained from a limited number of sources, many of which are located outside the EU. The markets are not however capable of being treated as entirely separate since a large part of the electricity generation market uses gas as a fuel: problems in the wholesale markets for gas can therefore impact upon electricity markets and upon the suppliers that make dual fuel offers. (1) Electricity 1.63 Electricity has a number of characteristics that are specific to it and impact on the design of any regulatory regime. (1) Lack of storage potential Electticity may not be stored in large amounts and at low cost, with the consequence that power at any point in time is not a good substitute for power at another point in time (except possibly in the case of small consumers of electricity). Power production and supply may therefore be seen as multiple time-differentiated products'.30 (2) High cost of outages There is a high cost involved when load exceeds supply, ot when there are so-called 'brownouts' ot blackouts. (3) Fluctuation The above features, when taken together with a third feature, one which electricity shates with gas—that demand fluctuates throughout the day and also differs according to the season (with random variations supetimposed, in large part due to the fact that much of it is used in weather-related uses such as heating and cooling)—create what is known as a 'peak-demand problem'. Essentially, if the entire load has to be supplied, capacity has to equal or exceed the load at all times. If not, there will be random supply intetruptions in the form of brownouts or blackouts, leading to considetable economic damage. Demand fot electricity can be subdivided into base-load power—electricity that is required seven days a week 24 hours a day—and flexible power—electricity required to absorb demand during peak hours. (4) Transformation Electricity demand requires transformation of electricity into some final form before it may be met. This form may be light, heat, and cooling-or motion-power. It means that some of the input energies to electricity such as natural gas are also its competitots in final energy markets. Moreover, demand is not very^price-elastic' in the short term since a customer's transformation equipment is generally long-lasting. Electricity supply assets such as generating capacity have an even longer working life. D. Why is Energy Special? (5) Technical specifications Further, technical and financial specifications of power stations differ considerably due to the fact that electricity can be genetated using different technologies and different raw materials (gas, coal, nuclear energy and hydro-power). The degree of flexibility of the generating units determines their ability to respond to changes in demand. The impact of these characteristics is that the cost structures of power stations lead 1.64 to the deployment of a 'merit order' or order of capacity based on the short-term marginal cost of a power station. Those power stations with relatively low marginal costs and/or which lack rhe capacity to generate electricity more or less quickly and on demand operate almost continuously and generate base load power. Those power stations that can increase or decrease production on demand and/or which have higher marginal costs operate mainly during peak hours. During the latter periods, when most facilities are fully utilized and cannot increase their generation further to meet peak demand, the number of effective competitors declines.31 Finally, there is another consequence that has relevance for competition policy. 1.65 Some of the characteristics of electricity mean that abuse of market power is fairly easy and therefore likely. Due to the fact that short-run demand elasticities are very low, the supply cannot be stoted and wholesale markets (even competitive ones) arc highly volatile. Companies with small market shares 'have both the ability and incentive to raise prices when markets are tight and suppliers pivotal, rendering standard tests of market power (HHI or market shares) less effective'.32 Among the consequences is a more complicated approach to the analysis of mergers. Moreover, where vertical mergers are planned between electricity and gas companies with market power in the gas market, this has the potential to increase the incentive to raise gas prices by the merged entity through ownership of power generation. (a) The Europe Factor In the European context two features of electricity supply organization may be noted. (1) Lack of import dependence Import dependence is practically zero. Self-sufficiency is very high as electricity companies have been able to locate generation close to where electricity is needed. Cross-border trade represents about six to eight per cent of total UCTE electricity consumption.33 Electricity is generated to 30 IEA, Ekctricity Market Reform: An IEA Handbook (1999) 11. 22 31 Netherlands Competition Authority, Consultation Document on Mergers on the Energy Markets in the Netherlands and a Possible Norrh-F.ast European Market, June 2006, paras 53-5. 32 Gilbert, R and Newbery, R, Electricity Merger Policy in the Shadow of Regulation (2006) EPRG 06/27:. 33 European Commission, 'Communication on Completing die Internal Market in Energy', COM (2001) 125 final, 13 March 2001. 23 1.66 Chapter I: The Competition Objective D. Why is Energy Special? 1.67 meet immediate demand and usually travels much shorter distances, requiring closer co-ordination between generation, transmission, and distribution elements of the industry, encouraging the creation of vertically-integrated monopolies. Where issues of cross-border trade have arisen, their focus has largely been on how to improve the efficiency, depth, and interconnected character of the existing transmission grids to promote exchanges between incumbent players. Consumer choice across borders has arguably been less important as a result. In this context, it is unsurprising that a major objective of the European Commission has been to identify and remove obstacles to cross-border trade in electricity (see Chapter 5). (2) Interconnections are poor A second notable feature of the European scene is that interconnections are poor. There are serious congestion problems, occurring when the state of the electricity networks and the transport capacities are such that the electricity that was planned to be transported from one point to another cannot be entirely physically transported. The levels of congestion can be serious: between Spain and Portugal they are almost permanent, and 'are not due to exceptional circumstances and are likely to keep occurring in the near future'.34 These levels of congestion are much higher rhan those observed on the Nordic electricity pool, which are in the range of 0 per cent to 7 per cent of the time.35 The limited interconnection capacity depends on the progressive implementation of a number of successive steps i ncluding not only technical measures on the electrical grids but also the elimination of regulatory and administrative barriers and the harmonization of the functioning and management methods of the systems' operators.36 (2) Gas Gas37 has seven principal contrasting characteristics that impact significantly on the design and pricing of transmission services. (1) Geopolitics Gas supply has an international characterwith the bulkof supplies coming from non-EU countries on the basis of long-term contracts, but is 31 EDP/ENI/GDP (Case COMP/M.3440) Commission Decision 2005/801 /EC, [2005] OJ T.302/69, para 83. 35 In its decision SydkraftlGraninge (Case COMP/M.3268) of 30 October 2003, the Commission found (p 26) tliat Sweden was isolated from all other areas in the Nordpool area only 5.5% (2000), 0.0% (2001), 0.1% (2002) and 0.0% (Jan-Sept 2003) of the time. Isolation percentages between individual neighbouring territories and Sweden were rather higher but also generally low (eg on average 7% between Sweden and Denmark Easr in the same period). 36 EnBW/EDP/Cajastur/Hidrocantabrico (Case COMP/M.2684) Commission Decision of 19March2002, para25. 3? 'Gas' means here natural gas and not so-called 'town gas', which is manufactured from coal or oil at gasworks located very near consumption areas. It includes liquefied natural gas (LNG) but not liquefied petroleum gas (LPG). much less exposed to competition in pricing than the oil sector. Its organization usually reflects this separation of the sources of production from the consumption markets. In Europe natural gas frequently travels very long distances and crosses many inter-state borders to reach i ts users. For many gas-consuming countries in Europe a dependence on external (non-EU) suppliers has been a fact of life for decades. More than 40 per cent of EU gas supply originated from non-EU sources such as Algeria, Norway, and Russia.38 Even with respect ro the EU's own gas production, the element of cross-border trade is considerable, one in every five cubic metres of gas produced in EU countries being exported. Just as non-EU gas from Norway is transported across the Netherlands to Belgium and France, gas produced from the Netherlands crosses Germany and Switzerland to reach Italy. About 50 per cent of all internationally-traded gas in the world is imported into the EU. This geopolitical element makes energy policy links with Russia, Algeria, and Norway of great importance. At the same time, such cross-border transactions normally take the form of transit and/or supply agreements between incumbent major gas wholesalers. There are few competition implications and it is misleading to describe it as 'trade' in the generally accepted sense of the term. (2) The gas chain Gas operations have a vertically integrated character from production to consumption (the so-called.£