Competition on European electricity markets & regulation

Tor Arnt JohnsenNorwegian School of Management BI and Norwegian Water Resources and

Energy Directorate, Oslo

EIPM – Archamps - September 23 - 2005

Outline of the talk

• Determinants for the degree of competition

• Price formation in the electricity market(s)

– Theoretical considerations

– Empirical illustrations

• Regulation and market design issues

• Competition issues

• Summary

Competition and market power in the electricity market depend on:

• Historical background

• Fundamental physical factors

• Market design

• Competition policy and regulation

Historical background

• National or regional monopolies– Obligation to serve - exclusive delivery right– Bundling and little transparency

• Public ownership– Social contracts (industrial and others)

• Focus on supply and technical issues - not on demand

• Low interest in economics and efficiency

Fundamental physical factors

• Limited transportation and storage capacity

• Physical laws govern electricity flows

• Supply and demand have to balance continously

• Volatile demand (day, week and season) and in many cases price-insensitive demand, in particular in the short-run

Market design

• Unbundling, transparency and market access• System operation, transmission and reserve

management• Who pays and how?

– Cost socialization, averaging

• Supplier switching routines– TPA (prices, cong.), Balancing, Cross-border capacity

• Entry conditions, licensing, standards etc.• Regulation of network monopolies, revenue and

pricing schemes

Competition policy and regulation

• Merger control

• Divestiture of production capacity, virtual power plants

• Vertical integration

• Market monitoring

• Information and education

Price formation - theoretical considerations

• One hour within a given geographical area:– Generation

• Nuclear, wind, run-of-river hydro, combined heat and power (DH, Industrial cogeneration), electricity-only units (coal, gas, oil, bio), reservoir hydro, peaking plants

– Demand• Price independent demand (time of day, temperature)• Price sensitive demand

– Exchange with other regions• Transmission capacities• Relative prices

Price formation, cont.

MW

Price Night, off-peak demand

Day, peak demand

SupplyPnight

Pday

Maximum capacity

Nordic electricity consumption and production week 35-2005

25000

30000

35000

40000

45000

50000

Consumption

Production

Mon Wed Fri SunTue Thu Sat

Denmark’s import from Germany in week 35-2005

-2000

-1500

-1000

-500

0

500

1000

1500

MW

h/h

Mon Tue Wed Thu Fri Sat Sun

Locational marginal prices (LMP)

• Limited transmission capacity within and out of the Nordic area

• The TSOs declare capacities between zones • Nord Pool optimizes the use of the transmission

capacities as an integrated part of the day-ahead elspot-market

• Often there are more than one price within the Nordic area and price differences towards Europe

Electricity prices in week 35-2005

0

100

200

300

400

500

600

700

NO

K/M

Wh

South Norway

North-Norway

Sweden

Jutland

Finland

Zealand

Germany EEX

Mon Tue Wed Thu Fri Sat Sun

Implications for power purchasers

• Manage your own demand and reduce withdrawal when prices are high (day-time)

• The price difference between day and night indicates the current marginal value of having a more flexible electricity consumption and being capable of moving consumption from day to night

Regulation – the Nordic success

•NORDEL, The Nordic Council of Ministers, Nord Pool and FNER made together a good platform for coordination and supervision•Full TPA and market opening long before “directives” came into force•Transmission tariffs designed largely the same way (no border tariffs)•Significant inter-connector capacity •Continuous market clearing – electricity can always be bought or sold•Successful dilution of marker power attained by integration (Nord Pool)•Strong political support also when electricity is scarce&prices high•No constraints on the development of financial markets•Regulators pro – active

Regional Markets is a necessary step to the Internal Energy Market

Establishment of “regional markets” is important Various EU Market Design feasible if access and congestion management

of interconnections are coupled with running of competitive energy markets EU Market Design implies an explicit TSOs coordination mechanism +

PXs coordination EU Design can be handled at regional level under EC supervision +

effective mechanism between EU regions to be found EC “Model” removes trade barriers and trade will increase and create

markets The Scandinavian “Model”( NordPool, NORDEL and FNER) created a full

regional market well before the transposition of 2003 Directives Very slow transposition in most member countries and weak support to a

regional approach National Champion approach (political level) still important - regional and

cross regional cooperation still weak “Mini fora” did bring important issues on the agenda but progress still slow

Competition policy and regulation – reciprocity and active consumers will induce progress!

Market design issues

• Transmission capacity allocation– The Nordic area has implicit auctions:

• The Nordic power exchange, Nord Pool, collects bids for sale and purchase of electricity all over the Nordic area

• The four Nordic TSOs declares transmission capacities for all international links within the Nordic area

• Nord Pool derives the unconstrained and constrained market equilibriums

Implicit auctions – Nord PoolUnconstrained equilibrium:

Constrained equilibrium:

- One price (system-price) - Transmission constraints are not taken into account

- More than one price if transmission capacities bind

Transmission capacity allocation

• Nord Pool extend:– A German Elspot area at the border between Zealand

and Germany (in place from Sept-05)– Implicit auction of the capacity between Norway and

the Netherlands (2007/2008)

• Explicit auctions (widely used elsewhere)– Bid for transmission capacity year-, month-, week-,

day-ahead. Use-it or loose-it principle– Traders have to bid for transmission capacity before

the two respective spot-market outcomes are known– Quite large coordination and price risk

Transmission capacity allocation

• Implicit auctions give efficient power flow

• The income for the actual link (price difference times transmitted quantity) is collected and paid to the grid owner(s).

• Both implicit and explicit auctions leave the market with some area price risk!

Area price risk

• Futures and forward contracts in the Nordic area refer to the system-price

• Contracts for differences (Cfds) offer hedge between the system price and your local area-price

Implications for power purchasers

• Be aware of reference point (price area or system price) in your contracts

• If your contract refers to another area price than your own or the system price, you are left with the risk of your local area-price volatility. This may require additional hedging.

Competition policy

• Limit concentration– The electricity market’s physical

characteristics demand a larger number of competing producers than in other markets

• Monitoring, transparency, information and education is important to keep the market competitive

Summary

• The electricity market and prices are hourly. Manage your consumption – be flexible and price sensitive. Move consumption from day to night. Reduce own expenses and limit overall price volatility

• Physical limitations in the transmission system are real and will generate price differentials

• Be aware of area price risk• Participate and represent consumer interests when

market design is decided• Participate and represent consumer interests when

competition policy and regulations are decided