House of Lords - European Union

Select Committee on European Union Fifth Report

CHAPTER 5: ENERGY

72. This chapter of the report considers the operation and progress of the Single Market within the energy sector. This part of the inquiry received the most submissions of evidence, and it was also the sector which proved the most controversial. During the course of our inquiry the Commission published its 3^rd legislative package on the energy and gas markets—much of the evidence received was in anticipation of those proposals.

Benefits of a Single Market in Energy

73. Competition within Europe's energy markets is central to the three interlinked policy objectives of a competitive and efficient energy sector, security of supply, and sustainability of energy sources.

COMPETITION AND EFFICIENCY

74. In our view, competitive and efficient markets are central to ensuring that citizens pay a fair price for their energy needs. High and volatile energy prices cause disproportionate hardship to vulnerable customers and reduce the competitiveness of some businesses. The FSB reported that SMEs are under "particular strain in a volatile energy market and this is coupled with unclear pricing policies and poor standards of service" (p 41). A recent npower survey[14], referred to in the FSB's evidence, reflected this view.

75. Respondents also provided evidence that imperfect competition leads to under-investment, hindering the effective operation of the market and reinforcing the lack of competition. Centrica pointed to examples of longstanding network congestion between Member States perpetuated by under-investment (Q 181). Under investment in network connection has also inhibited new entrants to the market. Furthermore, network reliability is also affected (National Grid claim that UK transmission network reliability is significantly greater than that of Continental Europe[15]).

SECURITY OF SUPPLY

76. There are well documented examples of gas flows between Member States temporarily not moving in the direction expected given the relative market prices in those states. A number of witnesses, including Centrica and National Grid, consequently highlighted the importance of further energy market liberalisation in ensuring security of supply against this kind of apparently anti-competitive behaviour.

77. Such essentially short term occurrences are not however necessarily indicative of uncompetitive behaviour. Shell provided evidence that energy markets, particularly gas markets, are largely long term in nature, whereas the regulatory focus tends to analyse short term signals and behaviours. They argue instead that long term gas supply contracts are central to Europe's security of supply (p 236).

SUSTAINABILITY OF ENERGY SOURCES AND CLIMATE CHANGE

78. Witnesses supported the need for a market-based approach to meeting the Commission's climate change objectives, through the EU Emission Trading Scheme (EU ETS), for example. For such mechanisms to work effectively energy markets need to be undistorted. The Association for Electricity Producers commented that "The completion of the Single Market is therefore necessary so that a level playing field can be achieved throughout Member States and carbon price drivers can act uniformly across Europe" (p 194).

79. The European Regulators Group for Electricity and Gas (ERGEG) highlighted the role of regulation in creating a stable and predictable context for private sector investment in new, green technologies. To achieve this investment, the market needs to provide longer term signals on carbon prices that can be factored into investment appraisal and analysis (Q 238). Within Europe, these signals are predicated on the length and terms of EU commitment to mechanisms like the EU ETS.

Restrictions to Effective Competition

80. It is widely felt that existing EU legislation[16], and its degree of transposition into national law by Member States, has not yet achieved the objectives of market opening and citizens have yet to benefit fully from a single energy market. We note the European Commission's recent work to investigate the root causes of restrictions to effective competition and their draft proposals to address them. The Commission's Energy Sector Inquiry was published on 10 January 2007[17] and was followed on 19 September by proposals for a 3^rd package of legislation to address the shortcomings in market functioning.

81. A number of our witnesses supported the findings of the European Commission's Energy Sector Inquiry. In particular, the Office of Gas and Electricity Markets (Ofgem) and Centrica drew attention to a range of significant problems, highlighted in the Inquiry, that were preventing effective competition emerging. These included: market concentration; collusion between incumbents to share markets; vertical integration; lack of access to infrastructure; lack of or delayed investment; and a lack of market transparency that is preventing new entrants from assessing the scope for profitable entry (Centrica p 72).

82. Ofgem also highlighted the limited scope of existing EU rules to address many cross-border issues, as well as their uneven and insufficient implementation by Member States. It argued that a 'regulatory gap' has been created which acts as a serious impediment to investment and cross-border trade (p 22).

Proposed Solutions to Restrictions on Competition

83. From the evidence received, four main themes emerge as central to the debate over how to facilitate effective competition in EU energy markets: legislation; unbundling; regulation; and market transparency.

LEGISLATION

84. The Commission has proposed a 3^rd package of energy legislation. A number of witnesses, including Ofgem, the former DTI and HM Treasury, support the need for further legislation, particularly to mandate ownership unbundling, as discussed in more detail below (paragraphs 86-89). However, the view was not shared by all. Some respondents cautioned against the enactment of new laws before reviewing, and ensuring compliance with, existing legislation (CBI p 215, Shell p 234).

85. Market investigations and sanctions against anti-competitive and protectionist behaviour in the private sector were supported by a number of witnesses, as were infringement actions by the Commission against Member States that failed to enact and enforce EU legislation (AEP p 193, Centrica p 73, DTI p 144)[18]. CBI noted, in respect of internal market legislation, that the "patchwork implementation [by Member States] has resulted in a number of national barriers remaining in place, restricting companies from truly benefiting from the advantages of a fully functioning internal market" (p 215). In their view, this situation is particularly evident in the area of energy policy where the market remains highly fragmented.

UNBUNDLING

86. Unbundling network assets from supply interests is the most significant and controversial of the proposed solutions to restrictions on effective competition. The argument is that whilst the ownership of energy transmission networks is controlled within the same vertically integrated group as a supply business, an inherent conflict of interest arises. This is between network investment or operational decisions which might benefit diversity of supply within the market and the competitive advantage enjoyed by the related supply business if that diversity is suppressed. The conflict also extends to preferential network and information access.

87. In practice, two separation models emerge as possible solutions to such a conflict; full ownership unbundling or an independent system operator model. Full ownership unbundling is where a group cannot have a controlling interest in both network and supply businesses in the same market. The independent system operator (ISO) model is where a group can have majority ownership in both, but all strategic, managerial and operational decisions in respect of the transmission network are licensed to an independent third party. The ISO model requires comprehensive regulatory oversight to be effective.

88. With the exception of Gaz de France (Q 178), all respondents were in favour of a greater separation of transmission and supply interests. The majority favoured full ownership unbundling, including National Grid who have direct experience of both models in the UK. National Grid argue that the ownership unbundling method has delivered significant benefits in the UK in terms of levels of investment, removing network congestion, non-discriminatory third party access, reliability and transparency. National Grid cautioned against promotion of the ISO model for which they point out there is limited precedent within gas markets[19].

89. Gaz de France provided oral evidence that continued integration of transmission and supply interests achieves a larger critical mass within the organisation, which is advantageous when negotiating supply contracts with dominant third country suppliers, such as those from Russia. In their view, integration and further market consolidation were central to the security of Europe's energy supply (Q 178). We also heard evidence from POWEO, a small operator in the French energy market, offering integrated electricity and gas services predominantly to business clients. Mr Frédéric Granotier, co-founder of POWEO, maintained that "complete separation of the network from incumbents … would of course help competition because we always fear that there exist cross-subsidies between activities" (Q 385). He argued that full unbundling offered the best scenario, as there would be more transparency and no conflict of interest (Q 390). However, he conceded that for political or historical reasons this situation was unlikely to be achieved in France, and that the ISO model, if properly policed, could also remove the risk of conflict of interest or cross-subsidies (Q 390).

REGULATION

90. A number of respondents referred to the divergence amongst Member States in the authority and powers of regulators, and their degree of separation from both industry and government. It is noted that in Member States with strong, independent regulation, the degree of liberalisation and level of competition is further advanced.

91. An overwhelming number of respondents called for greater co-operation of national energy regulators but there was no support for a European regulator. The Commission itself commented that "we do not need to have a European regulator that will replace national regulators; on the contrary, we still need strong national regulators and the regulatory function at EU level should be there to strengthen the national regulators, not to replace the national regulators" (Q 213). Instead, it has proposed the establishment of an agency for the cooperation of national energy regulators to coordinate the frameworks within which national regulators and network operators cooperate. The agency's powers would be limited to resolving cross-border investment issues, combined with an advisory role to refer matters to the Commission.

MARKET TRANSPARENCY

92. Free access to market information for all current and would-be participants is essential to an efficient market. Market transparency is currently limited to network capacity, informing participants if capacity is available, and if all available capacity is being offered. Vertically integrated utilities have greater access to information on, for example, the level of gas stocks, forecast demand and supply, and trading positions, giving them a potential competitive advantage over new entrants or less integrated participants. This assessment is supported by the FSB who submitted evidence that the "greatest barrier small businesses face entering the internal market is access to reliable information" (p 39).

93. This is not to say that company specific or commercially sensitive information should be publicised, a concern raised by Shell who support transparency where it serves a purpose (p 234). However, market information available solely within large, vertically integrated utilities, purely by virtue of that integration, goes against the principle of competition.

94. A number of respondents supported greater record-keeping by market participants regarding operational decisions and trades, and provision of information to regulators to enable market monitoring at a European level. CBI called for greater action by national administrators, the European Commission, national courts, and the European Court of Justice to improve monitoring of the functioning of Internal Market rules (p 216).

Conclusions for the Energy Sector

95. Good progress has been made in the liberalisation of EU energy markets, but that progress is not uniform across the Member States, and as a consequence, the benefits to consumers are restricted. The package of legislation proposed by the Commission is welcomed by the Committee as it is necessary to address, in particular, the practice of some network operators to discriminate against third parties in favour of their own related supply interests.

96. Having considered the evidence, we are of the opinion that full ownership unbundling more satisfactorily removes the incentives for discriminatory and uncompetitive behaviour by the network operator. To deliver just some of the benefits of ownership unbundling, the ISO model requires a level of regulation and monitoring which simply is not in place in a number of Member States.

97. There needs to be a stronger, more independent and more co-ordinated EU approach to regulation. This, combined with greater access to market information and a tough line against uncompetitive behaviour, will propel Europe further towards the key policy objectives of competition and efficiency, security of supply and sustainability. Therefore, we support the creation of an agency for the cooperation of NRAs but would reject calls for a European regulatory authority.

98. The Committee notes the concern raised by Gaz de France that unbundling the market may lead to a weakening of the negotiating position of the EU, as a single entity, in relation to large third country suppliers. We accept that security of supply is important but we are not convinced that the creation of a more comprehensive Single Market in energy would necessarily weaken international supply.