What’s Happening to the European Electricity Market?

Abstract

1. Introduction Since the first Electricity Liberalisation Directive (96/92/EC) a complex process towards the restructuring and deregulation of the electricity market was accomplished. Actually, market opening is slightly over 90%. EC Directives represented a successful, centralized approach to market liberalisation. Notwithstanding, switching levels being still low in households and heavy losses suffered by new entrants--then leaving the market--seem to point to a situation of legal opening rather than a real opening. Except for UK and North Pool countries, this may apply to a significant share of the European electricity (and natural gas) market(s) (EC, 2011). Serious deficiencies in the competitive structure of current market can be easily identified. They are related to: insufficient unbundling, highly concentrated market structures, insufficient network connections and significant differences between network costs and wholesale prices. Natural gas market distortions remain crucial, as gas is a major fuel for electricity generation. Its non-competitive market structure and still poor regulation of transmission and storage affect both markets. The problem of concentration seems chronic. Furthermore, both the European Commission and national regulators are facing increasing difficulties to control mergers on each market and between companies with activities in both markets, which is particularly problematic for a fair competition. The state direct or indirect aid to National Champions is still another problem as it can help concentration. The electricity sector is moving into a period of major investments, thus state resources can have important foreclosure effects on competition (Lowe, 2006). Furthermore, under a serious economic and budget crisis, some national governments as utilities shareholders, can have a strong influence on future market structure through the sale criteria (and final decision) of their corporate shares. Like other network industries (telecom, railways, aviation, postal services) electricity (and gas) have unique characteristics: significant economies of scale or scope (extending to natural monopolies); far-reaching externalities in production or consumption; and large vertical and horizontal integration. These features explain why the introduction of competitive mechanisms and the creation of open markets had equal impacts on both innovations and disruptions (Joskow and Schmalensee, 1983; Baumol and Sidak, 1994). Furthermore, beyond being capital intensive, the European electricity industry presents two other characteristics: price elasticity of demand below 1 and severe storage constraints. In what concerns the game and the strategic variables the electricity generation market is very much like a Cournot market with capacity constraints (Kreps and Scheinkman, 1983) where the quantities correspond to the decision variable. Even when the price is assumed as a strategic variable, the results of the strategies are similar to the Cournot game due to capacity constraint. Due to the nature of the electricity generation, the exercise of market power occurs almost naturally. In this paper we present a regulatory game played among the key group of electricity companies, the customers and the regulatory authority, discussing the strategic features under the process of taking liberalization measures to lower electricity prices or tariffs to end-users. The development of the game allows us to state for a clear commitment to entry freedom reducing the informational strategic advantage of incumbents. As the assumption of such a commitment involves another game, we develop it and we find that the sector opening to potential competitors and the liberalisation of entry are also a key factor for credibility and effectiveness of flexible regulation and tariffs reduction as well. The rest of the paper is organized as follows. …