Grid externalities and the application of competition law in the gas and electricity industries

1. Grid externalities and the application of competition law in the gas and electricity industries Yves Smeers Balancing Regulation and Competition Center for Competition Policy, University of East Anglia, July 7-8, 2008

2. Introduction

3. A survey of the talk The reform of electricity and gas sectors in Europe: focus is on market power • Mitigation of market power can result from a mix of regulation and competition law: the current focus is on the application of competition law within a persistent context of soft regulation. • This will not work: there are other aspects of the reform of the gas and electricity sector that competition law cannot address. • One should thus return to a more balanced mix where special purpose hard regulation, addressing the characteristics of these sectors, is developed as a prerequisite to the application of competition law.

4. To develop the argument I take a single theme, grid externalities, that are present (in different forms) in the gas and electricity sectors they are poorly addressed by current regulation competition laws cannot properly treat them I discuss two versions of the theme short term transmission problems in electricity (well understood both in theory and experience) long term security of gas supply (badly understood both in theory and experience) 4

5. Short term externalities of the electricity grid

6. Reminder: the economics of short term transmission of electricity (1) The engineering problem of electricity transmission is an economic problem of externalities. An extreme example: wind in Germany ETSO refers to network problems. Yes! But there is more. Consider the generators in N, B, F • They are constrained by the flow coming from ND and going to SD • In economic terms: their production capacities are constrained by activities of other agents • This is an “externality” • Externalities distort the functioning of competitive markets N ND B SD F

7. Implications • Externalities require regulatory interventions that can be of different types • Integration of all operations (generation and transmission) !!! More realistic but still very unlikely: integration of PXs and TSOs in a single body. • Taxes: impractical because they need to be ever changing • Property rights: right to use the grid Compare a regulation that gives priority access to wind and one that internalizes grid externality and requires wind to pay for the use of existing capacity • The creation of property rights and of a market that clears these property rights is the regulatory intervention • Comparison with a well known externality: an emission allowance is a property right

8. All property rights are not alike: electricity network externalities have unusual physical properties The more usual GHG externality and property right: CO2 accumulates through time and on a global scale: 1 ton of CO2 emitted in China today is the same thing as one ton of CO2 emitted in the US in six months. Electricity is quite different: it cannot be stored. This has impacts Does in-feed take place • in real time? • or 24 hours before real time? What do we know about wind speed ? • it varies • it can be reasonably forecast a few hours before real time • it cannot be forecast 24 hours before real time N ND B SD F

9. The implication: a rather complicated organized market that the market does not spontaneously create • Wind exacerbates the difficulties of constructing a good trading platform for electricity: it served to introduce the subject • But these difficulties exist independently of wind (because these externalities are inherent to electricity) “Forward” Day-ahead Intraday Real time  Temporal dimension  zone A  zone A  zone A  zone A spatial dimension    zone B  zone B  zone B  zone B

10. Summing up on the need for regulatory intervention • Electricity is difficult to transport: this has implications • transmission of electricity creates externalities • externalities are market failures that need to be corrected • this is usually done by a special purpose regulation • in this case by creating property rights on transmission services • Electricity cannot be stored: the market for these transmission rights is • changing continuously • Interacting continuously with the commodity market • All this leads to a possibly complicated trading platform • That we understand quite well in theory • And have implemented successfully in several systems that work well (~ 600 GW in North America). • That we have been trying to simplify in Continental Europe: but we have little evidence to show that “simplifications” work, or at least work in the best possible way  The regulatory work is significant

11. The lacking regulation 11

12. Electricity cannot be stored • Which implies somehow that a real time market should exist • We see no trace of real time market in the law (something on balancing service) • In fact we see no trace of any organized commodity market (the law does not refer to any organized energy market) • And because there is nothing in the law about the commodity market, there is obviously nothing in the law on the link between the commodity and the transmission services markets. • But a real time electricity market can only be an (very sophisticated) organized market because it needs to clear in real time!

13. Electricity is difficult to transport Regulation 1228/2003 on cross border trade treats the problem • The underlying principle is totackle the diversity of national market architecture without imposing a common architecture (see the  ”ETSO vision" papers of the time). This would be done by addressing two network externalities • The short term: the EU market is decomposed into zones separated by interconnections. Managing the interconnections will solve the short term externalities. This is a physical flaw when zones are large countries. • Some longer term issues (not discussed here) • Regulation 1228/2003 does not refer to loop flows but to transmission capacities which have to be allocated by market based solutions • Before explicit and implicit auction • Now implicit auction with two activities underway: contract path market coupling (CPMC) and flow based market coupling (FBMC) • Some studies are now pointing to the inadequacy of the current system (Duthaler et al. July 2008)

14. Different possible regulations A graph often used by Hogan (here taken from “Electricity market design: coordination, pricing and incentives”, ERCOT Energized Conference, Austin, TX, May 2, 2008) 14

15. Today in Continental Europe (since November 2006) The copper plate model (or the constraint path model) that we know from theory and experience is erroneous (in Hogan’s figure we are in the contract path regulatory model and hesitate to move to the flowgate model) Set of zones connected by transmission capacities An extremely simplified contract path model NL B F 15

16. But notwithstanding its defects CPMC was a major improvement

17. Alternatively

18. Summing up • The first directive did not provide for the necessary regulation: just the opposite. The second package could not correct the situation. • Theory and practice point to the existence of well functioning systems but the current EU regulation finds it very difficult if not impossible to implement because of initial condition • EII complained about the inadequate functionning of the current system that could have been caused by an inadequate market organisation • But was instead attributed to anticompetive practices. • Competition law was then called upon. Can it help ?

19. Can competition law help ?The Sector Inquiry 19

20. The Sector Inquiry • The Sector Inquiry looked at the power sector in competition law terms. What did it find? • the market is too concentrated • there is vertical foreclosure • there is lack of market integration • there are barriers to entry

21. Finding 1: The market is too concentrated • DG COMP proceeds according to its jurisprudence: it first defines the relevant market • Product market: wholesale = production and imports • Imports depend on infrastructure ( the jurisprudence) and congestion management (not considered by the jurisprudence) • Geographic market: no wider than national • In market design terms: congestion management and transmission infrastructure geographically segment the market • DG COMP computes several indices and (not surprisingly given the history of the industry) finds that the wholesale market is concentrated! • This is important. The definition of the relevant market is determinant for any action of Competitive Authorities

22. Finding 2: There is vertical foreclosure • DG COMP wonders whether a supplier can enter without generation capacity: the need for generation capacity increases the cost of entry. DG COMP finds that entry is indeed difficult in current market conditions • In market design terms: • Entering without generation requires a liquid power exchange and associated financial markets; this makes it possible to dispense with long term contracts. Conversely, long term contracts prevent the development of the liquid PX. • This can only be developed in a market that simultaneously trades energy in different locations. The lack of adequate market design hampers the development of this liquid power exchange.

23. Finding 3: There is lack of market integration • The Sector Inquiry finds a set of defaults that are all of the market design type • insufficient interconnecting infrastructure (incentive to invest supposed to come in third package with ownership unbundling) (investment is not discussed here) • insufficient incentives to improve cross border infrastructure: this is part of the regulators’ claim that there is “regulatory gap” (also for third package) (not discussed here) • insufficient allocation of existing capacity: implicit vs. explicit auction of transmission capacities • incompatible market designs: these are due to obvious lack of harmonization (e.g. differences between balancing regimes, nomination procedures, opening hours of power exchanges, TSO's and/or spot market operators) • this is what we argue prevent the emergence of a good market of transmission property rights

24. Finding 4: There are barriers to entry • DG COMP finds that balancing is often a barrier to entry • Balancing market is a separate product market (different from energy) • It requires machines of different characteristics • Geographic market is no wider than national • Given the above, one expectedly concludes that balancing is still more concentrated than energy • Its pricing is punitive (at least at the time of the inquiry, balancing is in flux); there is an incentive to remain in balance • In market design terms • Energy, congestion management and balancing are just one product (quite different from DGCOMP thinking) and it can be wider than national. But this is only possible if the proper trading platform exists. We are back to our internalization of externalities (at least when we limit ourselves to transmission)

25. Lessons from DG COMP • Most of DG COMP’s findings can be traced to • obvious issues of harmonization: (e.g. different opening hours of markets) • inadequate market design (implicit and explicit auctions of TCs) • lack of harmonization with a consequent insufficient integration: e.g. fragmented balancing • insufficient centralization of some decisions and computations: e.g. insufficient interconnection capacity • That restrict the geographic market of companies • and hence increase concentration • and pave the way to action from competition authorities • Will these actions be useful? They will have an impact, will it be useful?

26. The impact of competition law in today’s market is uncertain

27. The Jurisprudence: A vast set of problems that I reduce to one example • The definition of the relevant market • The finding of dominance or the change of dominance as a result of a concentration • The assessment of the impact of remedies I concentrate on the first problem: the definition of the relevant market that I limit to the definition of the geographic market and further restrict to two tests: the role of transmission capacities and the convergence of prices

28. The definition of the relevant geographic market (1) • The relevant geographic market with CPMC and FBMC (Perekhodtsev June 2008)) • A surrogate of the SSNIP test: take a set of countries (e.g. B, D, F, NL) and consider different possible groups of these countries : B or B-NL, or BF, NL… • Define: a group of countries is a market if satisfying the demand of the group requires more than 50% of the generation capacity of the group • Conclusion of the study: going from CPMC to FBMC enlarges the market even though the infrastructure did not change

29. The definition of the relevant geographic market (2) • A country is a zone in that study • We know that the PTDF (the representation of the grid) drastically change if one changes the zonal description (Duthaler et al. 2008) • We know that the results of the above test will change if one changes the PTDF • And that only the nodal description properly represents the grid • Conclusion: the definition of the relevant geographic market depends onthe assumptions of the TSOs on how they represent the grid; and they are themselves limited by a very restrictive representation

30. More intriguing: price convergence as a criterion in the definition of the relevant geographic (1)

31. More intriguing: price convergence as a criterion in the definition of the relevant geographic (2) • The Commission used a criterion of that type in Sydkraft/Graninge and Dong/Elsam • But seemed to modify it in GDF/Suez:     • it is probable that there will continue to be congestion, especially during peak periods • Apply this reasoning to a PJM like system: nodal prices are different a significant fraction of the time (it is the norm, not the exception!) • DG COMP would reason: the geographic market is restricted to each node • While FERC concludes that the relevant geogprahic market extends over the whole set of nodes controlled by the RTO! • And PJM is undoubtedly a competitive electricity market (the geographic market is not limited to nodes)

32. Long term externalities in the gas grid

33. (Possibly less of) A reminder: the economics of gas transport (1) The reliability and adequacy of the gas grid embeds a problem of externality Increasing the capacity of a line (whether intra EU or EU-non EU) increases the capability of the system to sustain short and long term defaults (whether on transport or production) - reliability is an engineering problem - adequacy is an economic problem consumers producers 33

34. (Possibly less of) A reminder: the economics of gas transport (2) The gas grid can also mitigate the market power of the producers and non EU transit countries; this is also an externality Increasing the capacity on a line (whether EU or EU-non EU) increases the substitution pos- sibilities at the supply side and hence enlarges the relevant geographic market - the relevant geographic market is a legal problem producers consumers 34

35. Security of gas supply in Europe The arithmetic of the problem is known domestic production is decreasing imports are increasing there are not many producers some of them raise concerns LNG could help but one then has to account for competition with the Atlantic and Pacific Basis, which is not known at this stage 35

36. The deep nature of the problem is less understood The EU recognizes an externality problem (not necessarily in the grid) “decisions to rely largely or wholly on natural gas for power generation in any given Member State have significant effects on the security of supply of its neighbours in case of gas shortage”(Green paper) But believes that competition will solve the problem “Liberalised and competitive markets help security of supply by sending the right investment signals to industry participants” Commentators go in all directions e.g. on Russia On more general grounds, some claim there is no market failure “Is their market failure, there?” In case of short term disruption, yes because of free riding in the provision of security But no problem for the market to ensure long term adequacy (e.g. installed capacity) (Lévêque, CESSA, June 2008) 36

37. A very careful statement (Joskow, 2005) “There is no inherent conflict between the liberalization of electricity and gas sectors that meet reasonable supply security goals as long as the appropriate market, industry structure, market design, and regulatory institutions are developed and implemented”. “However the effective liberalization of the electricity and gas sectors does create a number of challenges for institutions building and governance that must be recognized and addressed for liberalized systems to perform reasonably well from a supply security perspective”. A finding: there might be a problem of market failure since Joskow mentions the need to develop “appropriate ... market design and regulatory institutions ...” And two questions Did we create the type of conditions that Joskow mentions? If not, can we create them by regulation by competition law? 37

38. A first step: a (comparatively) simple adequacy problem Consider the following (less sanguine) view of security of supply (Stern, CESSA, December 2007) Drop strategic consideration of security of supply and take a pure (long-term) risk management view of the grid externality problem; consider the following long term risks Russia may have a commercial interest in limiting exports to Europe Liquefaction facilities may not develop sufficiently in West Africa and the Middle East The reformed gas sector may not provide sufficient incentives for domestic infrastructure investments!!! Can the market treat these long-term risks? 38

39. A DG COMP response: Gauer (CESSA, June 2008) Competition is a mean to achieve Security of supply at competitive prices Competitive integrated markets ensure more investments greater diversity of supply better sharing of risk within the EU lower prices 39

40. The claims raise two questions Do we agree With the above statements? Tentative response: yes With an implicitly associated statement that competition law creates the type of competitive system that will ensure the result? Tentative response: no If not can regulation help? Tentative response: not clear; requires further thoughts 40

41. Investing in an over capacitated grid for security of supply? Today From 2015 on Invest/Decide to invest capacity is remunerated at cost before knowing what will happen of service/market price in normal condition capacity is remunerated at cost of service/market price during shortage The question: will competition/regulation guarantee a remuneration of the capacity that creates the adequate over capacity ? 41

42. Thought/computational experiment Imagine the textbook model of perfect competition, alternatively Construct a computable model of the EU gas system subject to these long term risks What can one imagine/see from the results? e.g. coal plants being built that only operate when gas resources (molecule) are not adequate, much less otherwise e.g. pipeline/regasification plants that only operate when gas resources (molecule) are not adequate, much less otherwise High gas/electricity prices during shortage that pay for these otherwise partially redundant infrastructures 42

43. Will the market function properly in case of shortage? Will the high prices be there? (1) Joskow 2005, again “In particular, will commercial arrangements between participants in different countries be honored or will governments in Europe try to capture gas that might otherwise be exported for their own citizens during supply emergences using out-of-market mechanisms and government induced behaviour that restricts the transportation of gas when it is most valuable”….  or, again “The big question here is whether pipeline suppliers controlled by other EU countries will honor commercial commitments during supply emergencies or divert supplies to their own citizen using out-or market mechanisms and the « socialization » of recovery of the associated costs”  43

44. Will the market function properly in case of shortage? Will the high prices be there? (2) What does Joskow 2005 suggest this competitive market will not exist during these periods of inadequacy the necessary remuneration of infrastructure will not be there and hence, these equipments will not come on line Competition will be suppressed during shortage and hence will not properly reward the capacity (which is no longer redundant in case of shortage). The excess capacity will not be built 44

45. Will the market function properly in case of shortage? Will the high prices be there? (3) But suppose (very optimistically) that governments will not intervene during shortage and that the competitive market will function during shortage There is an other market imperfection that will prevent this infrastructure to come on line Observing the results of the thought/computational experiments, one finds that some infrastructures break even in average but are at considerable risk 45

46. Can one expect the market to develop the adequate risk instruments to trade today the risk of a shortage in 10 years? In principle, yes: one can imagine that the market will trade the risk associated to insufficient infrastructure In practice, this is very unlikely very long term horizon (beyond 5 years) very huge capacity (the risk of a 10 billion euro investment remaining idle) very complex set of risks (impossible to analyse and decompose) 46

47. Some parts of the law do not help The following may be clear or unclear depending on whether one is a lawyer or not Recital 25 of Gas Directive (quoted by vanderWoude in CESSA, June 2008) “Long-term contracts will continue to be an important part of the gas supply of Member States and should be maintained as an option for gas supply undertakings in so far as they do not undermine the objectives of this Directive and are compatible with the Treaty, including competition rules. It is therefore necessary to take then into account in the planning of supply and transportation capacity of gas undertakings” To be contrasted with emphasis put by DG COMP on exchange 47

48. Can competition law remedy these imperfections?

49. The Sector Inquiry and the Jurisprudence Sector Inquiry: findings are similar to electricity market concentration vertical foreclosure lack of market integration The Jurisprudence similar uncertain methodology: the definition of the relevant market Application of competition law: very far from creating the conditions that would enable investment in a redundant network elimination of territorial restrictions fighting restriction of access to the network 49

50. Compare to the reference competitive regulated gas transmission system in the US A system that Clears through prices even during disruption, and hence can (in principle) induce investments in redundant infrastructures Also guarantees a cost of service remuneration of pipelines Operates with unbundled pipelines with many buyers and sellers of transmission services a single regulation after proper introduction of property rights 50