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Regulatory economics I:

Regulators’ role in competitive markets

Prepared by

dr. Gábor Szörényi

ERRA

21st Training Course: Fundamentals of Energy Regulation

May 2 – May 4, 2018 • Nicosia, Cyprus

Regulators’ role in competitive markets and on the road

reaching effective competition - Table of Contents

─ Problems hindering efficient market operation

─ Wholesale market structures in the market building

process

─ Conditions of efficient competition

─ Special effects of the financial and economic crisis in

the transient period of market building

─ Foreseen international tendencies in wholesale market

conditions

─ Potential Regulatory actions supporting the national

and regional market building

Discussing specificities of the Cypriot market structure,

operational model, geographical situation and potential

regulatory tools supporting market building and competition



General regulatory attitude in most national markets

Belief of Regulators; the functioning, competitive wholesale and retail markets (efficient competition) could „control”;

➢energy component of end-user prices,

➢quality of supply

Problems identified:

– ERRA market structure analysis

– ERRA wholesale market monitoring system

– European Commission „Report on progress in creating the internal gas and electricity market” SEC(2010)251-Brussels, 11.3.2010



Market Structure and Market Condition problems

hindering efficient market operation (1)

Key Problems on EU and non-EU ERRA markets (but to different extent and with different focus):

– Concentrated markets

– Lack of investment

– Security of Supply

– Supportive legislative framework

– Market integration

– Price trends, price regulation, regulated end-user prices (in several EU member states has end-user price control for households and in some member states for non-households as well)

– Independence of network operators

– Regulatory power

– Customer protection



Conditions of effective competition

─ Market structure, which facilitates efficient competition

─ Access to networks

─ Supply market - reserves, import

─ Market size, possibility of regional markets

─ Number of players

─ Eligible customers with willingness to changesupplier

─ Adequate pricing, price signals







Concentrated (national) markets

less chance for effective wholesale and retail competition

potential solutions:

- restructured incumbent (more generation comp.)

- renegotiated PPAs

- creation of regional markets (mitigation of market power)

Proposed solution in „The new electricity market arrangement in Cyprus”?Decree of Concentration:





Development of Market Structures

There are four main ways to structure the electricity industry.

The main models are defined by the degree of competition:

– Model 1. has no competition at all

– Model 2. Allows or requires a single buyer or purchasing agency to choose from a number of different producers, to encourage competition in generation.

– Model 3. Allows former distribution companies (Distcos= distribution + retailer) to choose their supplier, which brings competition into generation and wholesale supply.

– Model 4. Allows all customers to choose their supplier, which implies full retail competition.





Market structures



Model 2. Purchasing Agent (SB) Competition in Generation





The features of transition: competition dimension





Power Sector Reform Path in Hungary

1945

Vertically

integrated

1992

Legal Separation: - generation

- transmission

- distribution/supply

1897-1945 1995

Privatization

State-owned

Enterprise

State-owned

Corporation

Wholesale

Competition

Ow

ner

ship

Str

uct

ure

Scope for Competition

Retail

Competition

Single

Buyer

Monopoly

Private

Corporation 2003 Limited Competition

2008 Competition





Power Sector Reform Path in Hungary

GENERATORS (EXCEPT NUCLEAR)

2003/20041995/96

4-5 YEARS

1991/92

RESTRUCTURING

TRANSMITTER/WHOLESALER

DISTRIBUTORS/SUPPLIERS (6)

COMPETITION

DISTRIBUTORS/SUPPLIERS

6-7 YEARS

PRIVATIZATION

GENERATORS (8)

WHOLESALER





Power Sector Reform Path in Hungary –Market Concentration after Restructuring

TITÁSZ

12% ELMÜ

27%

ÉMÁSZ

16%

DÉDÁSZ

12%

ÉDÁSZ

22%DÉMÁSZ

11%

RWE

43%E.oN

35%

EdF

22%

Tiszai

18%

Vértes

5%

Paks

26%

Mátra

11%

Others

10%Dunamenti

30%

AES

18%

Others

10% Tractabel

30%

RWE

11%MVM

31%

MARKET SHARES OF

POWER SUPPLIERS AND

THEIR OWNERS ON THE

BASIS OF ELECTRICITY

SALES

MARKET SHARES OF THE

IMPORTANT POWER PLANTS

AND THEIR OWNERS ON THE

BASIS OF PRODUCTION

CAPACITY



Benefits, Results of the Hungarian Restructuring,

Privatization and Liberalization

RESTRUCTURING (1991/92):

- SEPARATION OF ACTIVITIES, ASSETS → MORE PLAYERS ON THE MARKET

- PRACTICE IN COMMERCIAL BUSINESS BETWEEN COMPANIES → READINESS FOR

PRIVATIZATION

PRIVATIZATION (1995/96):

- PRIVATIZATION INCOME FOR THE STATE BUDGET → REDUCTION OF PUBLIC DEBT

- TRANSFER OF KNOW- HOW, AND MANAGEMENT PRACTICE

- NEW INVESTMENT (GENERATION, DISTRIBUTION)

- COST CUTTING → READY FOR COMPETITION

- LONG TERM PPAS → NEGATIVE EFFECT ON FUTURE COMPETITION

LIBERALIZATION, COMPETITION (2003, 2008):

- 5 – 10% PRICE SAVING OF ENERGY TRADED FOR ELIGIBLE CUSTOMERS (18-

20%) → INCREASED COMPETITIVENESS OF LARGE CUSTOMERS



– Clear model (responsibilities, rights, duties)

– Take into consideration domestic constraints (ownership

structure, market power, given commitments, PPAs, price

structures, political support or unconcerned environment,

lobbying power of market players, etc.)

– Preparing feasibility studies (possibility of effective

competition; impact on prices, on new investment)

– „Negotiation” with investors on the accepted level of new

risk elements

– Clear written procedure on the stranded cost issues

regarding renegotiation of PPAs

Lessons learnt during preparation of liberalization





Potential regulatory measures

on concentrated marketsWhat to do, when the competition is not efficient enough

controlling the wholesale and retail prices?

US – FERC practice: Competition test

EU Telecom practice: Significant Market Power (SMP) concept

– Ex Ante (compared to the Ex Post interaction of Competition

Authorities)

– Market analysis of the different markets (identification of

players with significant market power on the relevant markets)

– Impose Ex Ante obligations (gas release, auctioning capacity,

cost based pricing [instead of market based], more

transparency)

– Hungarian SMP procedures as examples in the energy industry

(could be useful practice handling Cypriot Dominant Participant)



Restructuring, Privatization, Liberalization (Competition)

– Present structure of the industry

– Capacity balance situation (generation adequacy)

– Size of the system, the number of potential players

– Necessity of privatization income and/or involvement of

private capital and modern technology

– Price structure (internal , end-user), pricing system ®

– Level of non-payment (private involvement into distribution,

and retailer/supply side)

– Political will to privatize and to introduce competition

Too many changes in one step could jeopardize supply security!

Discussing specificities of the Cypriot market structure,

operational model, geographical situation and possibility

creating competitive model

Aspects determining the sequences of changes



Access to the Networks – as Condition of

Effective Competition

─ All elements of Good TPA Practice is important (clear definition of free capacities ; congestion management rules; system services market; market conditions at electricity balancing market)

─ Strong rules on non-discrimination especially with regard to incumbent „public wholesaler, public suppliers”, strengthened promotion of new traders

─ New cross border capacities (PCI projects) could help, if managed by transparent access rules (yearly, monthly and daily auctions)

─ Adequate network charges (Supporting network development)

─ Effective unbundling



Lack of real independence of network operators

Decision making practice of network operators in network

access independently from trading interest is essential for

functioning markets

Without clear separation of activities and with „indirect”,

sometimes not identified, but possible commercial influence

of holding companies (owning TSOs and DSOs) could result

in;

– discrimination,

– lack of level playing filed,

– entry barrier for new entrants,

– lack of transparent and predictable congestion management

»» Discovering the discriminative technical/commercial

decisions of the TSOs and DSOs is not easy!



Supply market – as Condition of Effective

Competition (1)

Free capacity is important for the new/alternative suppliers to compete with the incumbent suppliers;

─ Over (generation) capacity (adequate reserve +)

─ Import possibility

─ Capacity release of incumbent (imposed by legal/regulatory framework and/or Regulator

─ Renegotiation of long term Power Purchase Agreements (PPA) with potential stranded cost management

─ Limitation of incumbent company withholding available capacities

─ Market place, where the free capacity could be offered to suppliers (DAM)



Supply market – as Condition of Effective

Competition – Lack of Investment in Generation

Special circumstances which slow down or hinder new

investments:

- during the long lasting market building process the regulatory risk

and merchant risk is relatively high (no liquid wholesale market with

indicative and predictable prices; the financial institutions ask for risk

sharing and risk mitigation, which could freeze the market structure),

- the (affordability led) regulated end-user prices could have an effect

on wholesale and generation prices, which do not „allow” adequate

return on new investment,

- regulatory risk of emerging energy markets (market building process)

- higher risk sensitivity of banks (higher risk premium; cost of capital↑)

- lack of harmonized capacity allocations rules and harmonized

regulatory frameworks in most cases (hindering cross border network

investments)



Special Effects of Financial and Economic Crisis

in Transient Period of Market Building

Consequences of new position of financial institutions in

countries with emerging markets:

Anxious hesitation → Investment programs postponed (newly

calculated financial conditions)

Limited availability of funding → Only the „best” projects will

attract financing

„Best projects” mean in financial language;

– Limited country/political risk: countries with transient

economy → higher risk premium

– Limited regulatory risk: transient period of market building

→ continuous changes → higher risk

Shorter lending period + lower leverage → higher equity

requirements → strong strategic investors + incumbents could

build new projects



Potential regulatory incentives

assisting generation investment

Simplified licensing conditions (harmonized license/permit

application requirements and procedures with other relevant

authorities, and time limit for the licensing period)

Ensure possibility for investors to have indicative market price

signals from the relevant market (Power Exchange, published cost

elements necessary for wholesale market price calculation)

Transparency (require frequent, updated publication):

- TSO’ network availability (both for connecting new capacities +

operation/maintenance and development plans/schedules)

- Non-discriminative cross-border capacity allocation

Allow medium/long term contracts if the market conditions are not

matured enough (risk mitigation)

General reduction of market entry barriers for foreign investors as

well as locals (clear rules for market players and „cheap” procedures)



Market size – as Condition of Effective

Competition

─ Wholesale competition requires several competing generation units

─ Small national market - without strong interconnectors, of which cross-border capacity allow import - cannot be liquid

─ Regional market building could reduce the chance abusing market power of dominant player

─ Small, concentrated national market without available cross-border capacity require strong regulatory control and binding rules on capacity release



Foreseen international tendencies on

market conditions

Some additional circumstances can hinder efficient wholesale competition in the future:

– renewables with increasing ratio could be exempted from

wholesale competition (feed-in tariff system)

– CHP generators (under the new energy efficiency regulation) could

be preferred (must run)

– new nuclear units (if any) foreseen to be invested under long term

PPAs

– part of flexible gas fired units taking part in system regulation

(compensating weather dependent renewable generation)

contracted by system operators

– possible new capacity market/payment (CRM)

→ The wholesale market could further shrink in longer term!



Number of players – as Condition of Effective

Competition

─ Several number of investor on the generation side (different owners of power plants) of the national market is advisable

─ New suppliers, traders could step by step increase their market ratio

─ Foreign traders could be active on the wholesale competition without present on retail market (Regulator could create more simple licensing procedure for wholesale trader without end-users)

─ New players (aggregators, energy communities)



Development of market shares of players

on the Retail Market in Hungary



Market shares of players on the Retail Market

B2B segment in Hungary in 2017



Eligible customers with willingness to switch

supplier – as Condition of Effective Competition

Hungarian experience in the first years of market opening:

─ 18-20% of electricity consumption traded on the free market (through bilateral contracts) in the first year

─ More advantages on eligible consumer side in the first year (5-10% price advantage in 2003), less advantage in the second year (less different between the price of import and local wholesale energy + relative high cross border capacity auction price)

─ Limited available capacity (no successful renegotiation of existing PPAs; one nuclear unit was on outage)

Weak financial incentive of the Hungarian eligible consumers:

– Regulated end-user prices in public segment (compared to market price)

– Relative higher risk on the free market (unstable /continuously developing/ market rules; non-liquid national market)

Eligible consumers entering the

Hungarian free market in 2003 - 2004

4,01%

0,80%

1,88%

0,81%

6,31%

0,04% 0,30% 0,17%

1,88%

0,72%0,05%

0,46%-3,36%

17,26%

3,20%

7,21%

8,01%

16,81%16,76%

20,12%

19,40%

17,52%17,35%17,05%17,01%

9,89%

10,70%

-5,00%

0,00%

5,00%

10,00%

15,00%

20,00%

25,00%

Febr.-

tény

Márc.-

tény

Április-

tény

May June July August Sept Oct Nov Dec Jan Febr MarchDe

ma

nd

Ra

tio

of

Eli

gib

le C

on

su

me

rs E

nte

rin

g i

nto

Fre

e M

ark

et

Demand ration of New Eligible Consumers Entering into Free Market

Total

New Consumption Site:

5 3 2 13 3 51 2 5 2 1 10 2 -35 1

1041 + 1303 + 260 + 611 + 262 + 2050 + 14 + 98 + 55 + 610 + 101 + 202 + 76

GWh/év

1041 + 1303 + 260 + 611 + 262 + 2050 + 14 + 98 + 55 + 610 + 233 - 1106 + 15 + 150

GWh/év

8



Adequate pricing, price signals

– as Condition of Effective Competition (1)

Price trends, price regulation, regulated end-user prices

EU: The EC sector inquiry report highlights the phenomena

of regulated end-user prices acting as a market

distortion, especially for industrial users

Most ERRA members: Hybrid model and regulated

Universal Service Provider (USP) (the regulated end-user

price in the substantial ratio of the retail market

indirect cap for the free market as well)



Potential Consequences of the Disturbances in Regulation

Price cap on end-user prices (not market based);➢ Expenditures on operation, maintenance and development of

networks fail (reduced)

➢ Lack of incentives building new generation units

➢ Poor service quality

➢ Re-scheduled introduction of climate change measures (smart grid, smart meter rollout, energy efficiency assistance)

➢ Lack of adequate renewable support schemes → slowed down investment

Financial support for end-users (outside of vulnerable consumer circle);

➢ Lack of energy saving incentives

➢ Cross subsidy

➢ Hindered competitiveness of the industry (large end-users)

Reduced competences of regulators;➢ Political/regulatory risk premium

➢ Slowed down new investments (generation, network)



Conflict of Regulators regarding potential political influence on end-user prices

How could some Regulators convince politicians not to interfere (distort) network price regulation and allow market based energy prices;– In countries, where the belief in the market has less tradition?

– In countries, where ; the affordability issue is very serious

– Where the wholesale and retail markets are not functioning well?

– Where the end-users (industry) are not competitive with higher energy

prices?

– In countries, where the social welfare is already on very low level with

present energy prices?

– The non-economic (non-price) support schemes for vulnerable

customers is not strong enough?

The political interaction into price regulation has medium/long term effects

which could be in contradiction with other political goals (climate

change measures)!



Potential Regulatory actions supporting the

national and regional market building

─ Empowerment of consumers (targeted information,

supporting end-users’ learning process on selection of

suppliers and on risk management)

─ Supporting active Demand Respond

─ Supporting new Generation investment

─ Supporting network investment (incentive network tariff)

─ Transparent TPA rules and general Transparency

requirements

─ Unbundling requirements and enforcement

─ Clear cross border capacity allocation rules

─ Harmonization of network planning and market rules with

neighbors



Monitoring wholesale and retail markets (if functioning)

Monitoring the different markets:

- Hiring staff for market analysis and monitoring functions

(preferably young economists)

- Cooperating with the Competition Authorities (learning

from them how analyse and evaluate markets)

- Identifying different markets (wholesale, retail, reserve

markets, balancing market,…)

- Creating data reporting requirements, building up data

management system and introducing analytical tools

- Data collection scope and frequency should be adjusted to

the market liquidity (stages of market building)



Monitoring wholesale markets

Analysing market

tendencies on

Websites of

Power Exchanges



Monitoring wholesale markets

Analysing market

tendencies on

Websites of Power

Exchanges and in

published Reports

(Platts, Reuters,…)



Role of Regulators in the Competitive Market

- What are those new regulatory tasks, which

require more training, or knowledge transfer

regarding regulatory support of market building

process?

- What are those regulatory responsibilities targeted

by „The new electricity market arrangement in

Cyprus”, which need future training?

- What are the market monitoring activities, which

you understand important in medium term?

W

THANK YOU

FOR YOUR ATTENTION!



Gábor Szörényi

E-mail: [email protected]

Web: https://erranet.org

https://erranet.org/

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