1. Experiences of opening the markets so far, expected vision of the network energy systems Dr. Szörényi Gábor director Energy Service and Consumer Protection Department HUNGARIAN ENERGY OFFICE Experiences of opening the markets so far, expected vision of the network energy systems Dr. Szörényi Gábor director Energy Service and Consumer Protection Department HUNGARIAN ENERGY OFFICE

2. I. Experiences of opening the electricity and natural gas market so far 1)Analysis of the conditions of efficient competition in the energy industry, as well as of its existence or partial lack on Hungarian markets. 2)Competition, free consumer choice - but what is it like? Justified criticism aimed at inefficient competition. Efficient competition and/or security of supply? 3)Opportunities for increasing the efficiency of competition for consumers, as well as the competitiveness of consumers and the economy as a whole. 1)Estimated changing environment and changing background (political, economic, environmental protection, technical,...) 2)Presumed impact of changing requirements on certain segments of the industry II. Expected vision of network energy systems

3. I/1.Analysis of the conditions of efficient competition in the energy industry, as well as of its existence or partial lack on Hungarian markets Access to the networks (electricity and natural gas), storages, system level services (balancing of deviation from schedule, other additional services) and information should be regulated, transparent, and free of discrimination (elimination and management of network bottlenecks /congestions/) An adequate number of players on the market on both the supply and the demand (customer) side Consumers ready for switching service provider/trader - providing a real opportunity (or statutory provision) for freedom of choice, existence of incentives Existence or partial lack of a market structure and operating model facilitating efficient competition and the operation of market players Critical size of the market(s), as well as the possibility to provide for these 1.1 1.3 1.2 1.4 1.5

4. I/1.1. Access to the networks (electricity and natural gas), storages, system level services and information should be regulated, transparent, and free of discrimination (elimination and management of network bottlenecks /congestions/) - 1 Electricity system – The rules of accessing electricity networks, system level services, and information (operating rules, trading rules) are relatively transparent and mature → the system operator, who is also unbundled from commercial activities and interests on an ownership level, has a major role in this and is our excellent partner. – The structure and level of network fees is adequate (also based on international comparison) → provides incentives for developing the continuity of supply (dilemma of regionally different network fees) – We support the implementation of new (public purpose) cross-border lines and their preparation with comfort letters, and these are being prepared – Legal and management level unbundling of network activities is awaiting the amendment of relevant statutory provisions (which may be followed by the creation of detailed regulations, implementation and control) → (we are issuing a draft regulatory guideline to help preparations) – Uniform non-discriminatory rules need to be developed regarding the conditions of connecting small, new generating units to the network (gas engines, renewable sources)

5. I/1.1. Access to the networks (electricity and natural gas), storages, system level services, and information should be regulated, transparent, and free of discrimination (elimination and management of network bottlenecks /congestions/) -2 –During the past 1.5 years, rules of operation have been refined continuously following discussion carried out with stakeholders (Regulation Committee) –Total physical cross-border capacity does not represent a bottleneck, but congestion has appeared at certain cross-border points; capacity allocation procedures are market based (auction) where this is also accepted by the neighboring system operator (to be also extended to the Austrian side next year) → we are planning a coordinated auction for the start of 2006 together with our neighbors we have solved the problems of system regulation (relatively "inflexible" share of nuclear power plants; base load import on behalf of major eligible consumers; continuous generation of several gas-motors that must be taken over) → this has been solved by indirect regulatory actions (new price regulation for the off peak period, providing incentives for night /off peak/ export) as opposed to the authority limiting the import at the end of 2003, high fees had been specified at the auction → we have refined the regulatory environment: we have introduced the possibility for secondary trade of cross border capacity rights we must conduct further harmonization with neighboring regulators regarding the principle of transparent and uniform specification of free capacity (ATC) values (application of EU regulation)

6. I/1.1. Access to the networks (electricity and natural gas), storages, system level services, and information should be regulated, transparent, and free of discrimination (elimination and management of network bottlenecks /congestions/) -3 Natural gas system –The natural gas system (especially the Eastern cross-border capacity) is characterized by bottlenecks, further hampered by the capacity allocation system of statutory provisions that provide a disadvantage to market players and the obscure detailed regulation of capacity allocation (iÜKSZ); the amendment of the Act is underway to eliminate discrimination promoting the need for the installation of a new (public purpose) cross border pipeline (Parliament - Economic Committee, HEO) the planned new international transit pipeline (NABUCCO) from new gas sources → coordinated authorization currently being negotiated –We are working to make access possibilities of players on the competitive market to Eastern import pipelines and storage facilities transparent, foreseeable, and free of discrimination → as a result, the actual possibility and practice to enter the market (switch suppliers) is quite limited (23 eligible consumers; 5.2% consumption ratio; via 3 traders) –We are promoting release of temporarily unused transit pipeline capacity –According to EU DG TREN, a review of negotiated rules (nTPA) of access is needed where there is no competition between storage facilities (the interpretation of the Directive → refinement of the statutory provision is needed)

7. I/1.2 Adequate number of players on the market on both the supply and the consumer (customer) side Electricity market –High number of independent generator licensees (17) held by a relatively high number of separate investors, but a significant portion of competitive power plant capacity is held by a single entity (MVM - public utility wholesaler) (legal obligation to offer capacity + long term private agreements /PPAs/) –High number of trading licensees (20) out of whom (7 to 9) are relatively active both domestically and in the area of import (enforcing their interest is strengthening) –Potentially all "non household" consumers are eligible, but their activity levels are low - with the exception of large consumers (due to lack of offer on supply side) Natural gas market –Domestic production and the booking of dominant sources of import is held by a single party –Due to cross-border bottlenecks and their public utility preferences, several traders were unable to enter the market –Potentially all "non household" consumers are eligible, but their activity is low - with the exception of a few large consumers (due to lack of offer on supply side)

8. I/1.3 Consumers ready for switching service provider/trader - providing a real opportunity for freedom of choice, (or statutory provision) existence of incentives Theoretical possibility is given (non-household consumers) Large consumers have undertaken preparations to get ready for entering the market and switching suppliers/traders The obligation to provide schedules and nominations has become accepted. Consumers would like to share the risk of deviating from the schedule with trader. (As of yet, consumers have inadequate incentives on the natural gas market to comply with the schedules.) Supply is insufficient, especially for eligible consumers and traders on the natural gas market (the public utility "holds back" capacity, does not "market" a sufficient quality), as therefore eligible consumers are unable to "leave" public utilities. Statutory preference for the safety of public utility supply, and the immaturity of capacity allocation rules decreases the willingness to take risks on the competitive natural gas markets within the scope of eligible consumers Regulated end user public utility prices that are subject to change typically once a year, together with expectations of future changes in the price (official interference with prices; price changes on the European market; expected impact of CO 2 emission limitation) provide incentives for potentially eligible consumers to decide whether to enter the market that changes over time. A key question: does the supply of Hungarian industrial consumers at regulated (non-market based) prices comply with EU Directives? (legal harmonization and change of model) In addition to all this, the strengthening of the electricity competitive market is imposing: 24% of energy is now traded via new traders. After 6 months, this value is 5.2% on the natural gas market.

9. Eligible customer of electricity entering the market

10. I/1.4. Existence or partial lack of a market structure and operating model facilitating efficient competition and the operation of market players - 1 When establishing a double market (so-called hybrid) model, main considerations had been the safety of supply and the official control of end user prices → efficient, multi-player wholesale market competition and helping new market entrants remained in the background Potential eligible consumers may remain in the public utility sector → MVM and MOL Natural Gas Supply (the public utility wholesalers) are also dominant players on the competitive market with their market presence exceeding 50% The classification of government subsidies of wholesale and official end user prices and PPAs that are different from market prices is an issue → how long can public utility price regulation and the hybrid model be maintained? → creation of new operating model (security of supply, efficient competition on the market, political guarantees regarding household consumer prices, investor safety) Uncertainties of the operating model do not help new power plant investments → problems may arise in the security of supply on the long term (danger of political interference) The lack of indicative prices (power exchange and balancing market prices) on the market makes investor decisions difficult → liquid balancing market + own or regional power exchange could help a lot.

11. I/1.4. Existence or partial lack of a market structure and operating model facilitating efficient competition and the operation of market players -2 The market entry barriers of new market players (traders, eligible consumers) could be reduced by continuous supply and capacity availability for them (MVM capacity auction, cross-border auction, gas release → difficulties in this area: –power plants and MVM do not wish to shorten the timeframe of their long term agreements (PPA), the extent of committed capacity, the release of reserve capacity required for system regulation → the principle of incremental opening of the markets is violated – MVM capacity auctions are hard to forecast in advance (extent, distribution, time) –the composition of virtual capacity released depends on the decision of MVM (represents a non-average power plant portfolio) –the stranded cost compensation system needs modification (DG Competition - State Aid analysis) –MAVIR cross-border auctions are organized on a market base (but the capacity announced proves to be insufficient due to the lack of sufficient and competitive domestic capacity) –on the natural gas market, the public utility may "reserve" all capacity based on its own demand forecast → there is insufficient capacity entering the free market, and of inadequate structure (Eastern import, storage) → a "gas release" program could help (until then: capacity commitment check

12. I/1.5 Critical size of the market(s), as well as the possibility to provide for these 35-40 TWh/year, and 14-15 bn m 3 /year, ~100 m m 3 /day peak demand; national markets of a relatively small size The current size of competitive markets (20-25%; ~5%) is even smaller! Resources of neighboring countries could help ensure supply The road to the uniform European energy market leads through regional markets (EC, CEER) Regulatory cooperation → and the coordination of rules has started (firstly in the field of the allocation of cross-border capacity): talks have started between Italy, Austria, the Czech Republic, Slovenia, Slovakia and Hungary; –we are promoting a bilateral coordinated auction as of January 2005, with the introduction of daily timeframes if possible –we are aiming to introduce an integrated system of auctions organized on a joint platform starting with January 2006 –the long term goal is introducing an implicit auction (market splitting)

13. I/2. Competition, free consumer choice - but what is it like? Justified criticism aimed at inefficient competition. Efficient competition and/or security of supply? - 1 What are consumers expecting of the competitive market? –more freedom of choice → this expectation is only realistic in case there are several players on the market and sufficient supply –better quality of service → generally a network issue, what is left is monopoly + better supplier/trader service (generally satisfied) –simple switch of supplier/trader, low barriers of entering the market → a market (and consumer) friendly regulatory environment is needed, as well as network and system operation activity well unbundled from commercial interests (we are before and during the formulation of requirements and implementation) –dropping prices and offers of a structure in line with consumption habits → this can only be expected in an efficient wholesale and retail competition

14. I/2. Competition, free consumer choice - but what is it like? Justified criticism aimed at inefficient competition. Efficient competition and/or security of supply? - 2 The operating model, the market structure, and market dominance (supported by statutory provisions) can act as a significant hindrance on relevant markets working against the evolution of efficient competition and the enforcement of advantages expected of competition Before criticizing the results achieved on domestic competitive markets so far, it is recommended that we hold a self-review; –Is the market competitive? [is it easy to enter the market?, are there many strong market players?, is there no dominant player?, is this the right environment for the development of marginal cost based market prices?, isn’t there a distortion at public utility consumers who make up 75-80% of the market (95% in the case of gas)?] –Is the market efficient? [market players with equal amount of information?, foreseeable risks?, willingness to assume risks?, minimum transaction costs?, foreseeable, solid system of rules?] –80% of capacity on the electricity market is held in one hand, and the law also stipulates the obligation to offer this capacity, MVM plays a dominant role on the relevant market → a multiplayer, efficient, balanced market cannot evolve without interference → we should not expect results similar to efficient competitive wholesale markets –On the natural gas market, ~98% of capacity and energy is held by the same owner, there is no obligation for the release of energy and capacity, there is rather a preference for public utilities → we should not expect a significant assumption of risks and entering of the market on behalf of consumers

15. I/2. Competition, free consumer choice - but what is it like? Justified criticism aimed at inefficient competition. Efficient competition and/or security of supply? - 3 When restructuring the operating model and market structure, lessons learnt from faulty models (e.g. California, Ontario), results of efficient markets (e.g. Scandinavia, United Kingdom), and our own background must be taken into account. One question that has come up frequently is what is more important; security of supply or more efficient competition: –the question is misleading, as in addition to efficient and balanced market conditions and indicative market prices, new power plant capacity is being established, and the security of supply is guaranteed –on an inefficient market with a dominant player, lacking authentic market price information, power plant investors will wait → supplemental (state) incentives and measures may be necessary

16. I/3. Opportunities for increasing the efficiency of the competition for consumers, as well as the competitiveness of consumers and the economy as a whole - 1 Refinements of the single player wholesale model, or the establishing of an efficient wholesale market with several players? → the hybrid model also makes progress and refinements possible (especially on the natural gas market, by eliminating the preferential treatment of public utilities) → determined political will and commitment is needed instead of the current public utility wholesale monopoly and market advantage in strength so that an efficient wholesale and retail market may be developed (maintaining investor security while releasing capacity) Dilemma of releasing power plant capacity → new players could become new dominant factors Opportunities for refinement in addition to the current hybrid model: –real market of power plant reserve capacity → inclusion of MAVIR via MVM option rights → balancing market price –foreseeable long and short term capacity auctions of an appropriate structure based on average power plant portfolio

17. I/3. Opportunities for increasing the efficiency of the competition for consumers, as well as the competitiveness of consumers and the economy as a whole -2 Transparent, coordinated cross-border auctions on several timelines (annual, monthly, daily) (secondary capacity market) Further reduction of system operation difficulties → lower feed in tariff at off peak hours; opportunities at night export; incentives for regulations Official liberation of prices tied to the decrease of dominant players on the wholesale market → introduction of market based price-regulation in case of a multi-player, more efficient markets + loosening of public utility end user price specification Facilitating power plant investments with new incentives (if market incentives are insufficient) Further comforts for network development → reduction and elimination of bottlenecks Release of natural gas capacity (elimination of differentiating between public utility demand; gas release program) Reduction of administration limitations hindering eligible consumers in entering the market (measurement costs, termination period)

18. II/1. Estimated changing environment and changing background (political, economic, environmental protection, technical,...) More pronounced environmental sensitivity and requirements Introduction of CO 2 emission trade Continuous erosion of rules protecting national producers and market players in the interest of regional EU markets and uniform energy market EU competition authority action to limit current mergers, acquisitions Strengthening EU and national requirements for real and efficient unbundling of network (line) activities from commercial interests (providing incentives for ownership unbundling) Providing incentives for provisioning new power plants and networks (lines) Strengthening of the consumer side, more active participation in the changing of the rules Higher demand for continuous availability of networks Increased demand for security of supply Consumers and politicians slowly "getting acquainted" with price changes (volatility) on the market

19. II/2. Presumed impact of changing environment, requirements on certain segments of the industry - 1 Electricity market Wholesale market prices rise (CO 2 quota, using up of existing reserve power plant capacity) Balancing market and regional power exchange trade coming into being on the medium term New power plant investments based on indicative market prices Increase of the weight of distributed generation (including renewable sources) Determined network development efforts (reduction of bottlenecks) Definite strengthening of cross-border trade Tighter coordination of system operator tasks Regional markets coming into being within a few years Lower potential opportunity for state subsidies, state aids Investors of networks (lines) are expected to be unbundled from production and trade Other energy sources gaining ground following possible negative effects of exaggerated dependence on natural gas

20. II/2. Presumed impact of changing environment, requirements on certain segments of the industry -2 It is expected that as regional trade becomes widespread, relevant markets broaden, and the efficiency of competition grows, political sensitivity of end user prices will drop → regulated prices can be released Public utility service will be replaced by a universal service last resort serving the small consumers Natural gas market Provisioning of new cross-border transmission lines and storages Appearance of several strategic investors in trade (possibly in transmission, transit, and storage) Appearance of free capacity on the market (elimination of physical and trade bottlenecks /congestion/) The consumer making use of an increasing number of benefits (and assuming increasing risks) as the end user price of players of the industry remaining in the public utility sector becomes market based, and free capacity appears

21. II/2. Presumed impact of changing environment, requirements on certain segments of the industry -3 "Gas release" program "forced" by market players Transparent and foreseeable rules of access (also to transit capacity) Regulated access (rTPA) also to storages Development of a secondary market Lower intensity operation of the market (compared to electricity markets) Heat supply 71% of district heating is provided using natural gas, and 70% is cogenerated with electricity. As a consequence, the district heating sector is sensitive to changes in the price of both natural gas and electricity. Direct resulting impact: –due to the deregulation/liberalization of the electricity market and new directives (cogeneration, „renewable”), the support system based on mandatory reception of cogenerated electricity and electricity generated using renewable energy sources must be reviewed, –due to the deregulation/liberalization of the natural gas market, suppliers of district heating must face the potential advantages and risks of purchasing natural gas on the free market.

22. II/2. Presumed impact of changing environment, requirements on certain segments of the industry - 4 The opportunity for using renewable sources of energy as well as cogeneration may also provide a competitive advantage for district heating depending on the following: –what direct and indirect support is provided by energy policy makers in order to make use of these environmental opportunities that are so important from a social point of view, –to what extent consumers are willing to also recognize a higher comfort level provided by the district heating supplier in price levels. As a result of strengthening competition on the market, district heating companies are forced to: –increase their efficiency in the interest of cheaper services, –make maximum use of the advantages of the use of renewable energy sources and cogeneration, including the use of direct and indirect subsidies, –improve the level of their services in order to achieve higher customer satisfaction.

23. Thank you for your attention!