TCS Daily

Grid Lock

By Benedikt Koehler - April 29, 2005 12:00 AM

Europe's nascent single market has been suffering teething problems. Monetary union is a case in point. Uniform interest rates across member states have exposed in stark relief growth-rate differentials between countries which adapt (think of Spain or Ireland) and those that find economic transition hard labor (think of Germany or France). Now, another major wave of structural innovation is sweeping through Europe. This time it is the turn of the power sector. Once again, everyone welcomed the idea in principle. Now, some are having second thoughts. The question is whether implementation of the EU Energy Directive, once it is played out, unbundles the ownership of generators and grids. This would be a direct challenge to the market power of established oligopolies. First, the story so far.

EU member countries have signed up to the Union's 2003 Energy Directive, which requires compliance with a set of rules for competition. There is a broad consensus that a single market in energy is a good thing. A bigger market offers bigger prizes to go for. So far, so good. But, the power sector is one of the continent's most heavily subsidized industries and so it is no surprise that contention has broken out how to apply these rules. Once the realization dawned that the Energy Directive requires an overhaul of every national industry's framework, vested interests realized their business models were under threat. Yet now the genie of market reform is out of the bottle, it is too late to reach for a plug.

The energy sector is big. In common with every other sector, success goes to those competitors which produce at lowest cost. In the power business, big generators produce more efficiently than small ones. New entrants face enormous start up costs until they match the scale of existing producers. That explains why power companies, once they get big, stay big. Over time, competition weeds out the smaller producers and the big ones get even bigger. For big power companies, life is good.

The EU Directive aims for a level playing field for competition. That means domestic producers have to let foreign competitors reach out to customers across all member states. To make this happen, says the EU, power companies have to open up access to power grids. Incumbent companies are hardly enthusiastic about this idea. Who can blame them. It is one thing to accept that competition is a good thing in principle. It is quite another to accept competitors should be allowed access to the grid you laid out for the power you produced in your own generators. After all, this is my grid.

The drafters of the EU Directive must have seen this coming. So, they inserted a requirement that power companies have to adapt their corporate structures. Where energy companies generate power and distribute it across their own grid, the EU wants them to put up Chinese Walls between the two layers of their companies. Separate management, separate accounts, separate profits. That way, conflicts of interests will be avoided.

That looks good, on paper. In practice, it means that companies can no longer maneuver assets and profits up and down the vertical chain of value creation. To make matters worse, power companies will need to ensure their Chinese Walls are not breached, incurring further overheads. Whereas before, an integrated power company could count on achieving synergies by getting bigger, now they have extra costs. This pulls the rug from underneath the rationale for having an integrated power company in the first place. That is hardly a recipe for living happily ever after.

Companies will have to pass round the hat to pay for the extra costs. Consumers will not be keen to pick up the tab. Shareholders will not be amused. Plus, regulators will have their work cut out in making sure that grid and generator managers are not colluding. Lots of overheads, lots of admin, lots of aggravation. You do not need a crystal ball to forecast that shareholders will start asking questions.

We have seen this process unfold before, so it helps to see what happened then. Today's state of Europe's energy sector has much in common with Great Britain's after privatization of British Gas. Back in the early 1990s, Britain's energy behemoth had a corporate structure like that in the EU's blueprint. British Gas thought it worked just fine. Britain's gas regulator was not so sure and requested the Monopoly and Mergers Commission to review whether vertical integration of British Gas was in the public interest.

The MMC's 1993 conclusions were unequivocal. It was, said the report, "inconceivable" how British Gas as a corporation could act without protecting its dual presence in generation and networks. There was only way to make sure obstacles to competition were cleared away: separate listings for generation and networks. Unbundling assets was a good start, but unbundling ownership had to follow. In due course, British Gas did just that. British consumers have never looked back. Nor have the owners of British Gas shares. Britain has seen sustained real price reductions in sourcing energy. The market share of its biggest companies has declined. Shareholders made substantial gains. It has been a win/win scenario all round.

The EU's Directive is anything but an open-and-shut case. It is difficult to envisage that some countries can opt for a protectionist model for energy markets when neighbors favor competition. Something will have to give, and somebody will have a lot of explaining to do if prices do not come down.


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