1. Competition on European electricity markets & regulation Tor Arnt Johnsen Norwegian School of Management BI and Norwegian Water Resources and Energy Directorate, Oslo EIPM – Archamps - September 23 - 2005

2. 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

3. Competition and market power in the electricity market depend on: Historical background Fundamental physical factors Market design Competition policy and regulation

4. 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

5. 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

6. 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

7. Competition policy and regulation Merger control Divestiture of production capacity, virtual power plants Vertical integration Market monitoring Information and education

8. 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

9. Price formation, cont. MW PriceNight, off-peak demand Day, peak demand Supply P night P day Maximum capacity

10. Nordic electricity consumption and production week 35-2005

11. Denmark’s import from Germany in week 35-2005

12. 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

13. Electricity prices in week 35-2005

14. 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

15. 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

16. 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 toa 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!

17. 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

18. Implicit auctions – Nord Pool Unconstrained equilibrium: Constrained equilibrium: - One price (system-price) - Transmission constraints are not taken into account - More than one price if transmission capacities bind

19. 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

20. 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!

21. 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

22. 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.

23. 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

24. 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