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European electricity market reform Principles, outcomes and issues

European electricity market reform Principles, outcomes and issues. Lars Bergman Stockholm School of Economics Presentation at CCER, Beijing University, April 9, 2007. Plan and background literature. Plan of the presentation Economics of ”created markets”

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European electricity market reform Principles, outcomes and issues

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  1. European electricity market reformPrinciples, outcomes and issues Lars Bergman Stockholm School of Economics Presentation at CCER, Beijing University, April 9, 2007

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

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

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

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

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

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

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

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

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

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

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

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

  14. Impact of the 2002-03 supply shock • Background • The extremely dry autumn 2002 lead to the lowest water reservoir level in several decades • Result • The price of electricity reached unprecedented levels, but supply-demand balance was maintained • Question • Was the price increase just a result of increased scarcity of hydropower, or did the major generators exercise market power?

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

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

  17. Comparison of actual and simulated prices 2002-2003

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

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

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

  21. Computed impact of a uniform €25 CO2 per tonne charge 2010Source: Bergman-Radetzki, Global klimatpolitik. Konsekvenser för Sveriges ekonomi och energisektor. Stockholm: SNS Förlag 2003Electricity: TWh; CO2: Tonnes; Price €/MWh

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

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

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

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