• Preliminary European Commission Energy Inquiry Findings Confirm Market Malfunctions
  • February 28, 2006
  • Law Firms: Squire, Sanders & Dempsey L.L.P. - Miami Office ; Squire, Sanders & Dempsey L.L.P. - Brussels Office
  • Immediate Competition Enforcement Actions and Future Measures for Opening up Gas and EU Electricity Markets Identified

    On February 16, 2006 the European Commission published its Preliminary Report on its findings on competition conditions in the European gas and electricity markets, following the Sector Inquiry launched by its Directorate General for Competition in June 2005. The Preliminary Report identifies many serious malfunctions in the energy sector and confirms the results of the Issues Paper published by the Commission on November 15, 2005 (EU Alert, December 2005).

    The Commission is inviting comments on its Preliminary Report with a view to publishing a definitive report by the end of the year. The Final Report will recommend EU actions intended to remove barriers in the market, whether by competition enforcement action, regulatory action or structural measures. However, the Commission will not defer competition enforcement action as regards certain contractual practices of individual companies. In the coming months, it will look into long-term downstream contracts and those that restrict access to gas and electricity transport infrastructure and storage capacity. When sharing the Preliminary Report, European Commissioner for Competition Neelie Kroes gave a "gentle word of warning": "I can only encourage everyone to take a close look at their practices. Prevention is always better than cure".

    Competition Enforcement Action More Prevalent

    Indeed, competition enforcement action in the sector is clearly set to become more prevalent both in Brussels and at the national level. The Commission's Inquiry in the energy sector runs parallel to, and may well encourage, national competition authority actions in energy markets. For example, in January 2006 the German Federal Cartel Office found that long-term gas supply contracts between E.ON Ruhrgas AG and distributors, combined with long-term purchase obligations, are contrary to both EC and German competition law. It has required E.ON immediately to cease such practices. This month, following a complaint from Endesa, the Spanish competition authority has opened individual investigations into alleged price fixing by Gas Natural and Iberdrola in the market for electricity generation between 2004 and 2005. Companies need to be mindful of possible complaints to both the Commission and local authorities.

    Single Competitive EU Energy Market Crucial to Success of Other Policies

    More broadly, the goal of ensuring full and open competition in the sector is viewed as an inherent element in the success of other key policies relevant to the sector. The Competition Directorate's Inquiry dovetails with the review by the Commission's Energy Directorate into progress in achieving an internal energy market, with proposals on possible further regulatory action anticipated at the end of the year. The Commission's general position on the Community's energy policy will be set forth in the Green Paper on Energy Policy due in March 2006. From an environmental perspective, a single competitive energy market is seen as essential to ensuring the development and use of new environmentally friendly technologies on the basis that market players should want to minimise their costs and invest in efficient technologies (perhaps too optimistic a view). From a security-of-supply perspective, an "open and competitive, liquid and interconnected single EU market" is viewed as "embracing new energy mixes" and mustering the "internal strength needed to maintain stable relationships with the main producers outside the EU".

    Industry Consultation

    Industry consultation on the Preliminary Report is invited until May 1, 2006. The Sector Inquiry is important to the full range of market players in the sector, including producers, importers, wholesale supply companies, traders, transmission and distribution network operators, large industrial customers and consumer groups.

    Status of the Sector Inquiry to Date

    In its inquiry to date, the Commission has reviewed more than 3,000 questionnaires and reached a series of preliminary conclusions described below. It will now engage in further analysis of data received and make inquiries into a number of issues on which it currently believes it premature to take a decision, concerning, inter alia:

    • Pricing on electricity wholesale markets, including power exchanges and downstream supply contracts.
    • The competitive issues relating to the linkage between the prices of oil and gas.
    • The exemption from third-party access provisions in the gas directive (in the case of new investments in pipelines, storage and LNG terminals).
    • Further use of gas- and electricity-release programmes as well as other measures to reduce the effects of concentration.
    • Further measures to reduce upstream supply concentration.
    • The impact of the Emission Trading System on electricity prices.

    Preliminary Findings on Market Malfunctioning

    However, the Commission has already found on a preliminary basis that five malfunctioning areas can clearly be identified:

    Market Concentration. At the wholesale level, the Commission has confirmed that the gas and electricity markets are characterised by a high level of concentration, similar to what existed in the pre-liberalisation period, by virtue of control over gas imports or over production or electricity generation assets. This concentration allows historic operators to remain largely dominant on their traditional markets and to raise prices, while customer choice is limited and competitive pressure reduced.

    Vertical Foreclosure. Low levels of liquidity in the wholesale markets and limited access to infrastructure have prevented new suppliers from entering markets and offering services to consumers. Long-term supply contracts between gas producers and incumbent importers make it difficult for new entrants to access gas on the upstream market. Moreover, essential infrastructures are to a large extent owned by the incumbent operators, with inadequate separation between infrastructure and supply functions preventing new operators from entering the market. Despite EU rules on unbundling obligations and third-party access, it would appear that historic operators continue to discriminate in favour of their own affiliates.

    Market Integration. Despite the Community's efforts to create a single market for gas and electricity, such markets remain largely national, with a low level of cross-border trade. This lack of integration results in insufficient competitive pressure on dominant operators in national markets. Moreover, new entrants into the gas market are unable to access capacity on pipelines and gas storage, while in the electricity market, further integration is handicapped by insufficient interconnector capacity and long-term downstream contracts predating the liberalisation.

    Transparency. New entrants have emphasised that they lack information useful for effectively competing against incumbent operators. Network users in the gas market request more detailed information on access to networks, transit capacity and storage that would go beyond the current minimum obligations under EU law. Operators in the electricity market call for more transparency on technical availability of interconnectors, transmission networks and so forth. This lack of transparency again benefits incumbents and weakens effective competition.

    Price Formation. Prices often do not adequately reflect supply and demand. Because gas prices are linked to oil products, wholesale gas prices fail to react to changes in the gas market. Similarly, the complexity of electricity price formation and the co-existence of regulated and free market prices in some Member States have had an adverse effect on the development of competitive pricing. Moreover, electricity users distrust the price-formation mechanisms.

    The Way Forward

    The Inquiry continues alongside the parallel review of implementation of the Liberalisation Directives, and industry comments are still being solicited. However, in its Preliminary Report, from a competition enforcement perspective, the Commission is already indicating the following:

    • Market concentration. The preliminary findings of the Inquiry reinforce the need for Community action under the EC Merger Regulation; the Inquiry will help the Commission identify the most relevant criteria and the most efficient remedies when reviewing individual transactions.
    • Vertical foreclosure. Addressing the use of long-term contracts to foreclose downstream markets is an immediate priority.
    • Market integration. A major stumbling block toward market integration lies in the current arrangements for access to capacity on pipelines, gas storage and interconnectors; their review is also an immediate priority. In addition, any remaining market-partitioning clauses will be pursued.
    • Other Actions. Any other cases of clearly anticompetitive and exclusionary activities will merit immediate action. As an example, the Commission points to any practices inhibiting customers from switching suppliers.

    In terms of regulatory actions and, as a contribution to the Energy Competition Directorate's review, the Competition Directorate General raises a number of issues that have emerged in light of competition concerns about the implementation of the Gas and Electricity Liberalisation Directives:

    • A broad consensus emerging from industry responses to the Inquiry is that transparency obligations should be strengthened, either by regulatory or competition law means.
    • So-called "grandfathering rights", or capacity rights stemming from pre-liberalisation monopoly contracts, are serious barriers to new entry in the market.
    • Purely voluntary schemes fixing common rules regarding the interconnectors between national grids do not appear to provide the investment certainty and regulatory protection needed to develop (and open up) international pipelines and interconnectors in a stable environment.
    • In a number of Member States, the powers of national regulators should be increased (for example, allowing them to review the conditions and prices underlying third-party access).

    From a structural perspective, the Report talks about "systemic conflict of interest resulting from the vertical integration of supply, transport and distribution". The Commission suggests that "a real breakthrough towards effective competition" may not be possible unless the "root causes of market malfunctioning" are addressed. The Commission warns that, unless the unbundling provisions of the Directive are fully implemented "not just in their letter but also in their spirit", further measures such as full "structural unbundling" should be considered. Structural unbundling may mean a reinforced version of legal, organisational and management unbundling or may extend to ownership unbundling.

    Conclusion

    The Report demonstrates that the Commission intends vigorously to address problems in the sector by taking competition enforcement action both immediately and in the future and by actively proposing regulatory action intended to further open up the markets. It does not shy away from issues that have proved very sensitive to Member States in the past, such as ownership unbundling. However, it does not yet suggest how to reconcile issues such as security for investors while avoiding market foreclosure via long-term contracts. Industry can be expected to comment further on these issues.

    Initial reactions to the Report suggest that the Commission's overall task may not be easy. The chairman of the UK Office of Gas and Electricity Markets, who welcomed the Commission's stance, nonetheless felt it would face resistance from the large energy groups that dominate the market. The chief executive of E.ON, Germany's largest utility, has indicated that "the timing of the collection of data for Germany is unfavourable. The situation looks a lot different now than in 2005". However, industrial customers and consumers, still facing high energy prices, will clearly support the Commission moves.