Have Europe's Power Sector Reforms Outlived Their Usefulness?

By Ross McCracken, Editor, Platts Energy Economist

The hard-won reforms of Europe's power markets are having trouble keeping pace with current needs.

WHILE THE EUROPEAN COMMISSION started 2007 with a renewed push for further liberalization of European power and gas markets, sentiment in many quarters continues to question whether fully liberalized markets can meet increasingly diverse energy policy goals. Europe is not blessed with the United States' relatively isolated geography. The growing interconnectivity of European energy markets and the reliance on imported gas lodges energy policy inescapably in the context of foreign relations, while climate change concerns give it a further global dimension.

European energy market designs have focused on liberalization, but policies which have taken years to reach fruition may no longer address current needs. The European Commission's free market ideology is set in stone in the EU's founding treaties. In moving forward, it has and can be successfully delayed and frustrated for years at a time. However, given the means at its disposal in the areas of regulation, competition policy and removal of state subsidies — combined with treaty commitments to an open and harmonized internal market — it is much harder to modify the Commission's fundamental direction.

Meanwhile, energy policy goals have multiplied. First, there is providing sufficient electricity to meet demand growth, with which investment has been unable to keep pace. This is in part historical. The supply of power to huge populations is a relatively recent phenomenon. In terms of generating capacity, the industry has moved from simple capacity growth to growth and replacement. The ensuing investment crunch has been postponed by plant and infrastructure life extensions, but can no longer be ignored.

Moreover, it has been hastened by policy, such as nuclear standstills, and the European Large Combustion Plant Directive, which heralds the end for Europe's oldest and most inefficient coal plants. While large monolithic state companies would have faced this investment challenge in the past, it is now the turn of the market to deliver and many are worried that — whether because of too much or too little liberalization — it may not be up to the task.

Second, is security of supply. Growth in energy demand coupled with declining domestic resources has led to growing dependence on imported gas. The extension of the EU into eastern Europe has incorporated countries once fully integrated into the Soviet energy system, further underlining the Union's need for Russian gas, while in Spain and Italy, there is a high level of dependence on Algeria and Libya. And market forces have not produced diversity. Rather, they have come up with one winner, the Combined Cycle Gas Turbine. CCGT has delivered in terms of affordability, but conflicts directly with security in terms of physical supply continuity because it increases Europe's dependence on imported gas.

And security of supply is not just a question of external threats. If EU energy sector investment falls short of demand growth, reserve capacity will shrink to dangerous levels. Europe's electricity transmission coordinator UCTE says in its latest system adequacy report that capacity margins are robust to 2010, but could deteriorate steadily over the following 10 years. In the more conservative of two scenarios, UCTE says that by 2015, generation adequacy is no longer met "unless further investment than those already decided and known by TSOs are made." And for 2015-2020, "the situation becomes quickly more and more tightened," as the Large Combustion Plant Directive continues to bite, growth in wind undermines baseload reliability and there is "no definite assumption concerning the evolution of nuclear generation."

Markets send price signals to investors indicating that new investment is needed. However, markets also promote efficiency and are not easily reconciled with the need for essentially strategic assets such as reserve capacity. Power markets need reserve capacity to meet demand volatility, but a rational investor does not want to invest in capacity that is used infrequently. In a privately owned competitive market, the trend towards efficiency means constantly paring away at reserve capacity. Investing in reserve capacity means lower prices and profits. The combination of a market with high demand volatility and long investment lead times suggests market signals will take the form not just of high prices but actual system failure.

Big investment requires big companies, and big companies want some form of protection if they are to make big investments. Moreover, externally, European companies face big competitors — Russia's Gazprom to the east and Algeria's Sonatrach to the south. These companies have large upstream resources, protected monopoly positions within their domestic markets, yet are free to compete in European markets, where the existing incumbents face increasing competition and attempts to unbundle their vertically-integrated operations.

In defiance of the European Commission's liberalization drive, continental European governments have been diligent in building national champions to compete with their neighbors. Now these giant incumbents say they are needed if Europe is to negotiate deals with big foreign state-owned enterprises. The national champions have been rebranded as European champions and have found in energy security a new justification for their privileged existence.

Third is climate change. European governments are increasingly willing to introduce what are in effect market distorting measures. These span a broad spectrum from soft renewables use targets, R&D support for otherwise non-commercial technologies, and preferential renewables tariffs to demand-side policies such as tighter fuel specifications. There is also the EU's flagship climate change policy, the EU Emissions Trading Scheme, which aims to create a price for carbon, turning emissions into a tradable commodity.

These changes mean that Europe's liberalized energy markets are coming to fruition in a world where a once irrelevant externality must increasingly be priced into every decision. On the one hand, there are considerable policy synergies — increased renewables use and demand-side efficiencies go hand in hand with limiting or even reversing dependence on energy imports. Biofuel and biomass use present opportunities for agricultural diversification with knock-on effects ranging from rural development to world trade talks.

However, climate change mitigation has created a new and evolving policy paradigm, which introduces a huge element of regulatory and economic risk for energy investment. This in turn creates a new constraint on whether liberalized markets provide the incentives to invest in a timely manner to meet demand growth and retain an adequate level of spare capacity. In the absence of climate change policies, the most cost-effective, low-risk energy investment would almost certainly be coal – an energy resource which, like the US, Europe has in some abundance. But given the potential future cost of carbon dioxide emissions, coal's future rests instead on the dubious promise of large-scale carbon capture and sequestration.

This has created a paradox; while steady progress is being made towards more liberalized and harmonized European energy markets, the level of regulation and market 'engineering' to meet non-commercial policy goals is increasing. This is raising investment risk just as investment needs are becoming more critical. Bringing power to the masses was an incredible achievement of the 20th Century; keeping the lights on in the 21st looks like being just as big a challenge.