Electricity market reform: From experience to future prospects

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Reference

Electricity market reform: From experience to future prospects

ROMERIO-GIUDICI, Franco & Swiss Academy of Engineering Sciences

Abstract

This article, written for the Swiss Academy of Engineering Sciences, provides an overview of electricity reforms, examines experiences since the early 1990's and outlines medium to long term prospects. It focuses on industrialised nations.

ROMERIO-GIUDICI, Franco & Swiss Academy of Engineering Sciences. Electricity market reform: From experience to future prospects. Swiss Academy of Engineering Sciences, 2010

Available at:

http://archive-ouverte.unige.ch/unige:86263

Disclaimer: layout of this document may differ from the published version.

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Future electricity supply – Swiss Academy of Engineering Sciences

Electricity market reform:

From experience to future prospects

Franco Romerio

Institute for Environmental Sciences Energy policy and economics

University of Geneva [email protected]

1.INTRODUCTION

This article provides an overview of electricity reforms, examines experiences since the early 1990’s and outlines medium to long term prospects. It focuses on industrialised nations.

First, it analyses concepts in light of past experiences ; then it examines the case of Nordic countries, Norway in particular, which was the second country, after England and Wales, to open its markets to competition ; it then studies the case of Switzerland, which adopted this path at a much later date ; finally, it takes a look at future prospects. For each of these themes, we highlight 1. Points of reference; 2. Electric system, unbundling and system operators; 3. Networks; 4. Wholesale and retail markets; 5. Market power; 6. Wholesale and retail prices; 7. Investment and diversification; 8. Regulation. In the conclusions, two scenarios are defined, an “Electrical Reform Reinforcement” (ERR) scenario and one of a

“New Energy System” (NES).

This paper also includes an appendix, where we propose a set of more concrete measures that should be implemented in Switzerland in order to take advantage of experience acquired abroad.

We carried out this analysis on the basis of existing literature, which although very rich, rarely examines long term scenarios. Articles published in ‘The Economist’ since 2000 on the subject of electricity were also used.

2.ELECTRIC REFORM: CONCEPTS AND EXPERIENCES

2.1. Points of reference

As from the late 1980’s, we began to see markets opening to competition, accompanied by the emergence of new forms of regulation. The electricity industry wasn’t simply

‘deregulated’, as is sometimes stated, but there were regulatory and market design reforms.

Electricity reforms don’t necessarily involve the privatisation of companies. Whilst England opened markets to competition and at the same time privatised state monopolies, Norway created competition without such privatisation. Debate for and against privatisation rests on factors that could prevent the efficient management of electricity companies, for example their use to pursue costly political agendas or the lack of strict budget constraints.

At the origin of these reforms, is a political movement that began during the 1980’s which favoured privatisation and competition as a way of making the economy more dynamic.

However the majority of the social-democratic parties that later took power conformed, pursuing the electrical reforms that had been initiated by conservative parties. Political action by Margaret Thatcher and Tony Blair symbolises this trend.

Without advances in information technology, it wouldn’t have been possible to open markets to competition. The Treaty of Rome (1958) made provisions for the creation of a single market open to competition, but in the case of electricity it wasn’t until the end of the century

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that it could be implemented. It can be said that technological advances strongly contributed to electric reform.

The reform’s aims are to provoke a reduction in electricity prices and increase efficiency in the sector, as a result of the market’s invisible hand and the integration of markets. This in turn should provide a stimulus to economic growth. In fact, energy is a critical input to businesses, manufacturing in particular, especially when margins become tight due to competition from emerging low-wage economies. Monopolies of the past, on the other hand, focussed on electricity supply security, through planned investment and even autarchy.

Prices were influenced by a multitude of distortions and in general there was overinvestment.

We soon realised that liberalisation lead to a whole series of unwelcomed problems. As we will see later in this article, there are uncertainties as to whether markets can assure the realisation of the different types of investment needed in order to guarantee supply security.

This problem remains a cause of much debate. Furthermore, prices inevitably rise in a competitive market faced with tensions between supply and demand, as we have seen on the European wholesale markets before the financial crisis. These problems are amplified in presence of market power, as was the case in England during the early years of reform.

They become extremely serious if reforms are implemented incompletely or incorrectly. The Californian electricity crisis of 2000/01, due to a market and regulatory failure, is a powerful lesson on this matter.

Electric reforms present problems that are both complex and controversial. Joskow asks

“Why is electricity sector liberalization so difficult and subject to so much opposition?” (2008, p. 10). Opposition is tightly linked to the interests in play and the ideologies in question, as was observed during Switzerland’s referendum against the law on electricity markets in 2002. Difficulties stem from the physical characteristics of electricity. Supply must always be equal to demand; electricity cannot be stored; electrical current diffuses through networks according to laws of physics and not market law; flow can be limited by bottlenecks.

Equilibrium between supply and demand is assured through increasing or decreasing production and through demand side management to a certain extent. We can also allow frequency to fluctuate within certain limits. If equilibrium is determined outside the market, resources aren’t allocated in an optimal manner. If on the other hand we count on price, the problem resides in adjustment delays. Furthermore, the creation of reserve equipment depends upon investment decisions, which can lead to cycles of over and under-equipment.

The pioneers of electrical reform are England and Wales (1989), followed by Norway (1990).

Chile can also be cited as a example. By 1995, the trend towards the liberalisation of electricity markets was underway in a significant number of developed, and also developing, countries. The European Union opted for electricity market reform with the directives of 19 December 1996 and 3 June 2003. The Member States had, with some exceptions, translated the first directive into their national laws by February 1999. The European commission was able to implement electricity market reform where governments and regulators had failed to do so. The integration of the European market is however limited by bottlenecks on interconnections. The Economist pointed out that “Europe remains a patchwork of national energy policies and regulation” (February 9th 2006).

It should be pointed out that to a certain extent reforms depend upon the institutions and infrastructures of the different countries, in addition to the organisation of electricity sectors prior to opening markets to competition. For instance, the difference between the reforms adopted by Paris and Berlin lies notably in the French traditionally interventionist approach in the energy sector as well as the presence of the national giant EDF. Another example is provided by Spain, which didn’t face the same problems experienced by well interconnected countries due to its very low cross-borders capacity.

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2.2. Electric system, unbundling, system operator

Electric systems are composed of power plants, transmission and distribution lines at different voltage levels, and supply to large, medium and small consumers. Electricity networks represent natural monopolies. Generation and supply, on the other hand, can be open to competition. Supply, demand, transport and distribution are coordinated by a system operator (SO), in order to assure supply security. The generation of different types of equipment (base and medium load, peak and super-peak load) must be integrated, taking into account uncertain variations in consumption and bottlenecks on electricity lines.

Opening markets to competition involves the unbundling of generation, transmission, distribution and supply. There are three options: ownership separation, accounting and management separation and legal separation. In some European countries, legal unbundling is still the rule; however the Commission now requires ownership unbundling. In “legal unbundling”, there is a legal separation of two entities and the creation of two autonomous managements, but one entity is still allowed to own the other.

Unbundling should prevent discriminatory practices such as limiting access to networks by competitors. It should also guarantee transparency, notably in terms of access to information.

Furthermore, a vertically integrated company could potentially block investment in interconnections in order to limit competition in a given region. Finally, unbundling should prevent cross-subsidies between generation, transmission, distribution and supply. However, opponents claim that the traditional vertically integrated system assures a higher level of security and benefits from greater economies that in fact exceed the efficiency gains resulting from competition in generation and retailing.

The coordination of different elements of the electric system is carried out by the SO, who is is in charge of dispatching and bottleneck management, and must maintain the balance between generation and consumption in order to assure network stability. Frequency and voltage can fluctuate within a very tight margin. In this respect, it provides a balancing service, i.e. various types of reserves (notably, spinning reserves), voltage support, black- start services, etc. In Europe, it runs the real-time market. It should be stressed that, at certain times, as real-time approaches, market dynamics should be coordinated and supplemented by a “visible hand”. In other words, the SO needs to manage the system in real-time to keep it physically secure.

There are two SO models: the “Independent Transmission System Operation” (ITSO), based on a full unbundling of production and transmission, and the “Independent System Operation” (ISO), based on legal unbundling, although vertically integrated electricity companies of the past can maintain ownership of transport networks. The ISO is not completely independent. Britain, Spain, the Netherlands and the Nordic countries have all adopted the ITSO model, whereas ISO is defended by EDF in France and RWE and e.ON in Germany.

Governance is fundamental, as the SO must be completely neutral. In fact, it possesses privileged information regarding power trades between generators and consumers and physical characteristics of the power system (Glachant and Pignon, 2002, p. 20). A radical separation between SO and market operators must be guaranteed. Generally, the SO’s motivation to act efficiently stems from public scrutiny.

2.3. Networks

Electricity networks represent natural monopolies, as monopoly allows the service to be provided at a lower cost than in competition. In the case of very high voltage, it is however possible to envisage parallel lines belonging to different companies. The situation can be qualified as a ‘’natural oligopoly’’.

Bottlenecks are another fundamental element to understanding the characteristics of electricity systems and markets. When power flow reaches a certain threshold, transmission lines attain their physical limit. These congestions lead to different energy prices in different

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locations. A congested network makes it difficult to achieve wholesale market performance.

The European Union has prescribed that interconnections should be able to carry at least 10% of national consumption, but few States have this capacity.

Finally, loop flows make it impossible to choose the path by which power will flow. This results in externalities that should be internalised. This means, in particular, compensating owners of electricity lines that can be affected by the injection or extraction of electrical current somewhere in the network.

For these reasons, networks are regulated by a public authority, notably in terms of price, costs, investments and service quality. In particular, to face the natural monopoly, the principle of “Third-Party Access” (TPA) was developed, which allows wholesale buyers and sellers to use transport and distribution lines freely at a non-discriminatory price. In general, the “negotiated Third Party Access” (nTPA), which was adopted for example in Germany, is abandoned in favour of “regulated Third Party Access” (rTPA), which sets rules on network access ex-ante. The regulated “postage stamp” pricing system is now applied in Europe and involves fixing a toll independent of distance between suppliers and consumers but dependent on voltage.

Regulation of transport and distribution prices can be based on “cost-of-service”, which ensures that suppliers recover all of their costs but no more, or “price-cap”, which sets a cap on the supplier’s price according to a formula that takes into account inflation, technical progress and efficiency goals. In the United Kingdom, for instance, the formula used is (RPI- X), where RPI represents the retail prices index and X the expected efficiency savings. The risk with cost-of-service regulation is that it guarantees cost coverage (including a “normal”

rate of return on investments) potentially to the detriment of efficiency. Incitative regulation, on the other hand, bears the risk that efficiency is encouraged to the detriment security.

Regulators must be attentive to service quality (such as the number of interruptions).

Bottlenecks prevent the formation of a unique price in the regions affected. ‘Zonal’ or

‘national’ prices can emerge, such as in Europe, or ‘nodal’ prices (prices at the network knots), such as in certain American States, which provide signals to investors as to where new power stations should be positioned. In principle, the spot price difference between two regions represents the price of congestion. With the opening of markets to competition, these prices are increasingly managed through the auction of transport capacity. As a rule, the allocation of revenues should be controlled by the relevant authority.

In order to eliminate bottlenecks, new lines should be built or Demand Side Management (DSM) adopted. More generally, in most countries networks should be reinforced and modernised. Such investments can be stimulated by the regulator. An alternative is the

“marchant line”, created by private investors with the sole aim of profit maximisation. The advantages and disadvantages of these options are sources of much debated. For example, Littlechild, the ex English regulator, states that “In the case of interconnectors between electricity regions in Australia, there seems no doubt that regulatory failure was more serious than market failure” (2008, p. 54).

2.4. Wholesale and retail markets

Wholesale markets include bilateral markets, power exchanges and power pools. In bilateral markets buyers and sellers trade directly, although this is often facilitated by a broker.

Exchanges use auctions and provide security for traders by acting as the counterparty to all trades. A pool is an exchange which possesses particular features: in general, generators bid their marginal costs and some other costs and limitations into the pool; the pool computes a price and a set of accepted bids; a very complex computer program finds the optimal solution, assuming that bid data and demand forecasts are correct. The archetype of pools was the “Electricity Pool of England and Wales”, created 31 March 1990 and replaced by a more conventional exchange ten years later following a somewhat controversial evaluation of its performance.

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All except real-time markets are financial markets in the sense that the delivery of power is optional and the seller’s only real obligation is financial. Real-time and day-ahead markets – often called “spot markets” – take the form of either exchanges or pools. In Europe, real-time markets are run by the SOs as they require central coordination in order to cash out imbalances. Forward and future markets allow generators and customers to hedge some risks of trading power. Power trading begins 2-3 years in advance and is continued until real time, the actual time at which the power flows out of a generator and into the load.

Generally, participation in power exchanges or pools is voluntary, and a significant proportion of power is traded bilaterally through long-lasting contracts, which however are contested because they hinder competition. For instance, Joskow states that “Long term contracts…

may deter further improvements in wholesale market institutions” (2006, p. 4-5), and Germany’s Cartel Office argued with e.ON about its long-term contracts, on the grounds that they were unfair to newcomers seeking access to the market (The Economist, 9 February 2006). Nevertheless, Amundsen and Bergman point out that “the restrictions on the long- term power contracts implied lacking hedging opportunities” (2006, p. 152).

Since opening markets to competition, numerous power exchanges have been created in Europe, for example: APX Amsterdam, EEX Leipzig, EXAA Graz, Gestore del Mercato Rome, OMEL Madrid and Powernext Paris.

Retail markets include small, medium and large customers. Generally, medium and large parties negotiate prices with electricity companies opting for the cheapest supplier. The problem is somewhat different with small consumers. In fact, in some countries, only medium and large customers can access the market (so-called “qualified consumers”). In other instances, households are better off remaining with their incumbent supplier who must offer them electricity at a regulated price. Sometimes they are quite simply not inclined to look to change suppliers.

Following the opening to competition, we expected a proliferation of innovation in the domain of energy services and demand side management (DSM). We also anticipated the creation of new opportunities for service quality differentiation to better match individual consumer preferences. In general, however, realisations remain less than expectations in this domain.

2.5. Market power

Market power exists when certain companies have the ability to influence prices, preventing much of the potential gains of competition to be realized. There are two ways market power can be achieved. The first, through the formation of oligopolies and duopolies; mergers and acquisitions between operators, in the context of both friendly and hostile takeover bids;

cooperation agreements, cross participation, etc. In this respect, certain observers are critical of the situation in Europe. For example, The Economist pointed out that “After several years of frenetic mergers and acquisitions, Europe is dominated by a few cross-border giants, such as France’s EDF, which is 85% owned by the French state, Germany’s E.ON and RWE, and Enel” (February 26th 2009).

The second route to achieving market power is through certain forms of “strategic behaviours”. In the measure that one or two companies control essential installations, for example critical peak power plants, they can manipulate prices. It would suffice that they withdraw capacity at certain times. The same can happen with a high voltage line. If a company is able to create a bottleneck, or hold but not use a passage right, it can develop so-called ‘’pockets of market power’’, where it can benefit from an almost monopolistic situation. This is why the European Commission requires that “use it or lose it” rules should apply to transmission networks. The Economist, which is acutely aware of these problems, cited for example that Germany’s federal cartel office “suspects that generators may have been keeping prices artificially high by, for instance, shutting power stations in concert to limit supplies” (April 23rd 2009).

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Market power represents a problem of significant importance in the case of electricity markets due to the technico-economic characteristics of the industry, for example the impossibility of storing electricity or electricity’s very weak price-elasticity of demand. In the United States, market monitoring and power mitigation protocols have been a central component of certain electrical reforms. The presence of potential new entrants is a factor allowing the mitigation of market power.

Another problem is posed by the presence of “national champions”, for example EDF in France and e.ON in Germany. However, “national champion” is not synonymous of “market power” as long as “the firms’ wholesale and retail supply businesses are sufficiently dispersed geographically that there are several competing suppliers in any given region and that the transmission network is owned and operated independently”, as pointed out by Joskow (2006, p. 41).

The risk does however remain high for consumers, small operators and national regulators of being faced with a very limited number of giants, who by their size and range of action become extremely difficult to control. There could even be confrontations between giants, the consequences of which are hard to predict. On this subject, it is interesting to reflect upon the fact that the German Government decided to ignore arguments by both the Cartel Office and the Monopolies Commission by allowing e.ON to merge with Ruhrgas in order to see the creation of a national champion capable of standing up to EDF and GDF (The Economist, February 9th 2006). The British on the other hand, adopted a completely different strategy, allowing the fragmentation of their companies, as well as a certain number of acquisitions by foreign groups (USA, Germany and France).

It is also worth pointing out that the process of concentration can stimulate competition if it allows small and medium companies to regroup, unite with a leader and raise their market profile. The acquisition of a certain number of local German companies by Sweden’s Vattenfall seems to illustrate this form of dynamic (Romerio, 2007, p. 89).

2.6. Wholesale and retail prices

Price formation on spot markets can be modelled by the laws of supply and demand. In reality, this can prove a difficult exercise due to the complexity of phenomena and associated uncertainties. Supply is determined by the marginal costs of power plants, which are activated incrementally (“order of merit”). There are at least two demand curves, peak and off-peak. Price is determined by the marginal cost of the last power plant brought into service. If we approach capacity limits however, prices can soar. In this instance, we have a

“rationing price” that should limit demand to the quantity available.

Since the beginning of electrical reforms, the markets of continental Europe have shown an upward trend, due to the reduction of surpluses as well as rises in oil and gas prices. Spot prices are extremely volatile; this phenomenon is particularly acute due to the fact that electricity can’t be stored and price-elasticity of demand is so low.

With market opening and integration, wholesale prices tend to converge towards a single international price. Bottlenecks remain an obstacle nonetheless. Generally, in Europe marginal power plants are German gas turbines. For instance, we notice that prices in France are less and less dependant on nuclear power plants and increasingly dependant on German gas turbines, which pushes prices upwards (Percebois, 2008, p. 4).

In the past, relationships between retail and wholesale prices were relatively weak. Demand price-elasticity was very low, particularly given the fact that electricity consumption depends upon fixed equipment that can have a relatively long life (electric heating, engines, etc.).

Following the opening of markets to competition and the abolition of regulated prices of monopolistic times, innovative tariff arrangements and structures are conceived.

Technologies allowing real-time billing are developed, even for small consumers, for instance

“smart meters”, which enable consumers to manage their own consumption more effectively (The Economist, May 14th 2009). Certain countries have made significant progress, even in

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the case of small consumers; others have not moved away from the “default service tariff”, i.e. a tariff that applies to customers who have not actively chosen to change supplier.

2.7. Investment and diversification

The opening of markets to competition took place at a time when, in general, Europe had a significant excess in generating capacity. As a result of increasing demand and aging infrastructure, the development of new power generation capacity and networks is perceived as a growing problem in many countries. As pointed out by The Economist, a shortage of power generation capacity could lead to blackouts across Britain and other regions if no new capacity is built in the near future (August 6th 2009).

The problem resides in the fact that electric reforms don’t necessarily offer a favourable framework to the realisation of new investments. Firstly, regulators and SOs curb investment through their behaviours and protocols. Frequent regulatory interventions that limit wholesale market prices, SOs’ reliability actions that depress market prices and other regulatory imperfections represent disincentives to private investors in the liberalized markets.

Secondly, wholesale electricity markets do not provide adequate revenues to attract investment in new generation that meet operating and investment reliability criteria. Thirdly, short-term wholesale electricity prices are too volatile to support new investment in long-lived capital intensive generating capacity without specific support. Finally, one notes that electricity security is a public good, because of the physical attributes of networks. This is a controversial argument, that accepts the hypotheses of ‘’non-rivalry’’ and ‘’non-exclusivity’’

(Abbott, 2001).

We have seen that wholesale prices can soar when electricity system capacity limits are reached. It is during this time that generators should collect revenues high enough to cover fixed costs and realise new investments. In other words, the profitability of new investments depends upon the scarcity rent, given by the difference between market price and marginal cost. If insufficient, the so-called ‘’missing money’’ problem presents itself, which could represent a deterrent to investment in new generating capacity in liberalized markets. As stated by Joskow, “Based on U.S. experience, a large part of the problem can be associated with the failure of wholesale spot markets for energy and operating reserves to produce prices for energy during periods when capacity is constrained that are high enough to support investment in an efficient (least cost) mix of generating capacity” (2006, p. 58). The problem is particurarly significant with reserve equipment that is put to use as little as a few hundred hours a year. We could also imagine cyclical movements, with periods of overinvestment when prices are high and underinvestment when they are low.

Different types of measures have been conceived to deal with these imperfections. Reserve capacity markets are emerging in a number of countries to create incentives for investment.

Forward capacity markets that occur sufficiently far in advance of delivery that new entrants can participate in auctions are also mentionned. The application of “capacity payment” or of

“capacity requirement” principles represents another potential response. In the case of the capacity payment, the regulator sets a price for capacity and lets the market determine the quantity. In the case of the capacity requirement, the regulator sets the amount of capacity that has to be available and lets the market determine its price. A more interventionist approach is the definition of “security of supply obligations” (SSOs) by regulators that force SOs or retailers to ensure a sufficient reserve through appropriate investment or contracts.

Investment in a market which is open to competition remains a problem of much debate.

Micro-economic models don’t necessarily fully capture “business dynamics”. Electric companies have medium and long term strategies. They are not only led by short term market fluctuations. As pointed out by Newbery, “… large irreversible investment decisions are based on analysing market fundamentals, not just current trading views…” (2005, p. 10).

In this perspective, investment isn’t perhaps as problematic as first thought. A large firm with substantial balance sheets may be willing to consider its power plant portfolio as a whole and

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accept certain cross-subsides, in order to show its reliability to customers, regulators and politicians.

Similar questions have been raised on the subject of electricity supply diversification, which could be threatened by markets. Markets could in fact penalise capital intensive investments with long payback periods, such as nuclear and hydro power plants, to the benefit of combined cycle gas turbines. It is also argued that private investors favour quicker payback, while public sector investment takes the opposite approach. England is often cited as an example, where there was a so-called “gas rush” in the years following markets being opened to competition. Only recently, The Economist pointed out that “The imminent closure of dirty coal plants… and old nuclear power stations threatens a supply crunch. Left to its own devices, the market would fill much of the gap with natural-gas plants…” (Oct 9th 2008). In this case, the State or the regulator can orient investments through a system of authorisations or tenders, possibly introducing a moratorium on a particular technology.

Last but not least, the part of renewable energies in a country’s energy mix needs to increase in order to limit dependence on fossil fuels and reduce carbon emissions. Here the problem lies in the fact that the majority of new technologies are not yet competitive. In order to ensure their development, several measures have been adopted. In this respect, it is worth mentioning the ‘’feed-in tariff’’, used to safeguard the take off of renewable energies in Germany, as well as ‘’green and white certificates’’, which are however under-developed and insufficiently integrated in wholesale and retail market design.

2.8. Regulation

Experience shows that it is important to create a regulatory authority for the electricity sector.

Germany and New Zealand’s decision to proceed with electrical reform without any such regulator, relying instead on negotiated prices and the constraints of competition law, was a mistake. A light and strong regulation can be defined. The regulator should be independent from the Government.

In general, the regulator of the electricity sector possesses relatively large competencies in terms of networks, which are natural monopolies. The SO is subject to its authority. The same applies to supply security. Other problems on the other hand, can depend upon other agencies. For example, it is usually up to competition commissions to address problems of market power. Environmental questions are treated by cabinet offices.

The coordination of the different agencies is of great importance. For example Politt analyses the case of the Office of Gas and Electricity Markets (Ofgem) and the Department of Energy and Climate Change in England, and notes that “allocating responsibilities between these two offices will need to be carefully done”, in order to avoid conflicts in the definition of objectives and measures (2008, p. 85).

Regulation can present as many drawbacks as markets. As pointed out by Littlechild, the former electricity regulator in England and Wales, “The regulatory world… is often a well- intentioned world but not always one that maximizes the economist’s concept of welfare, and is often a serious imperfect world” (2008, p. 60). Furthermore, experience shows that it is extremely important to avoid incoherencies between market design and regulatory design.

For example, the crisis that turned upside down California’s electricity system between 2000 and 2001, was worsened by the ‘’cap’’ on end-user prices. This cap had the effect of preventing the repercussion of wholesale price increases on retail prices. Consumers had no reason to modify their behaviour. The main utilities faced bankruptcy.

On this subject, it is worth noting certain well-known regulatory problems: information asymmetry, which can seriously hinder the effectiveness of regulation; capture of the regulator by pressure or rent-seeking groups, which distort public policy for their own ends;

and regulatory risk (“hold up”), which represents a major concern for a company involved in sunk cost investments, as the rules of play can be unilaterally changed by the regulator.

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3.THE SCANDINAVIAN CASE

Between 1991 and 2000 electricity markets in Denmark, Finland, Norway and Sweden were opened up to competition and the countries integrated into a single Nordic market. A form of light regulation was created.

State ownership remains significant in the Nordic power industry. However, as indicated by Amundsen and Bergman (2006 and 2007), the reform has brought about changes that have lead to a stronger focus on profitability. There has been a shift from a ‘‘public service’’

approach, to more of a ‘‘business’’ approach. Furthermore, many Norwegian power companies have been changed from municipal to limited companies. Some public bodies have sold ownership interests in their power companies, which have been bought by Statkraft, owned by the Norwegian State, and other Nordic power companies.

Similarly to in other European countries, convergence between conservatives and social democrats allowed these electric reforms to take place. A pragmatic approach was adopted, marrying business with welfare State.

The electricity market reform was inspired by the idea that increased competition would improve power industry efficiency to the benefit of consumers. Increased efficiency both in generation, transmission and distribution would result in generally lower electricity prices.

In general, the Nordic reform is viewed quite positively. Amundsen and Bergman (2006) indicate that the success may be attributed to a simple but sound market design, a dilution of market power within the different countries in the Nordic market, strong political support for liberalization and informal commitment to public service by the power industry. However, households and power consuming industries have expressed certain criticism, partly concerning tax increases on retail electricity, and also in relation to the new European system of CO2 emission permits (ETS), which has led to rising wholesale prices.

The Nordic electric system is based on hydroelectricity, nuclear power and fossil fuels.

Recently there have been significant developments in wind power in Denmark.

Hydroelectricity allows the generation of peak and super-peak power, but is dependant upon hydrological variations. Wind farms have an intermittent production. Nordic countries are relatively well interconnected. They are also connected with Russia, Germany and the Netherlands. Because electricity is used for heating, the distribution system in Norway and in Sweden has been constructed with the ability to carry high loads. Per capita electricity consumption is high, particularly in the latter two countries where the reference to electric heating is particularly pertinent and industry is electricity intensive.

Norway and Denmark opted for accounting and management unbundling, whereas Sweden and Finland chose the legal separation of generation, distribution and retail. Amundsen and Bergman point out that “As a result the three major generating companies… have become dominating players on the Swedish retail market, while independent retailing companies to a large extent have left the market. (2007, p. 3392).

Each of the Nordic countries possesses its own “Independent Transmission System Operator” (ITSO). If unbundling is guaranteed at this level, the countries’ integration is not complete. In this respect, it should be mentioned differences in transmission pricing, use of ancillary services and balancing requirements. The SO operates a real-time market in order to continuously balance generation and load at minimum cost.

3.3. Networks

In Nordic countries, “regulated Third Party Access” (rTPA) was adopted. A key feature is that transmission prices are independent of the geographical distance between traders. Price

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regulation is indicative. In order to improve efficiency, in Norway they determined a specific income target for each power company which limits distribution tariffs.

Transactions across national borders, as well as between different regions, are subject to congestion charges. Whenever the interconnector capacity is insufficient, the Nordic countries are divided into several ‘‘price areas’’. Norway is divided into five price areas. In Denmark the transmission system is separated into two parts. Sweden is always one single area, and the same applies to Finland. Within these two countries, bottlenecks are managed by means of a counter-trade system.

Within each price area the buyers pay, and the generators are paid, the corresponding ‘‘area price’’. If transmission constraints are not binding, the price is the same for the four countries and is determined by the spot price prevailing on the Nord Pool. When bottlenecks occur, congestion charges are added, equal to the difference between the adjacent area prices.

Nord Pool is the Nordic countries’ power exchange which operates spot as well as forward markets. Futures contracts aim to provide buyers and sellers with opportunities to hedge against the price risks associated with spot market trade, up to three years in advance. There is no obligation to exchange electricity via the Nord Pool. As with other countries, a significant share of trade is carried out within the frame of bilateral contracts outside the Pool.

As already pointed out, the real-time markets are operated by the national SOs in order to balance generation and load at minimum cost. In general Nordic wholesale markets are considered to have worked relatively well.

The retail market also appears to be developing well. Many residential customers have switched away from their incumbent suppliers. Many others have accepted or negotiated more attractive contracts. In particular, it has been recognised that Norwegian consumers are attentive to price variations by their suppliers. Some even choose to carry the price risk themselves.

When the Nordic markets opened there were over 600 different suppliers in total. Most of them were small municipal companies. Since then there has been considerable consolidation, with the largest companies taking over the mid-sized as well as smaller ones.

There are still about a hundred suppliers in each country, although many of them do not offer supply outside of their geographic areas.

A few major producers have a dominant position in their respective national markets. At the same time none of them has a share of the Nordic market higher than 20%. This suggests that the degree of competition depends on the national markets’ integration, which in turn depends on inter-connector capacities and institutional barriers (in particular balancing requirements) to trade between Norway, Sweden, Finland and Denmark.

Market power has been the object of a number of studies. It seems that the Nordic market is quite competitive, with market clearing prices close to the relevant marginal costs. The high wholesale price event in late 2002 and early 2003, which was perceived as a cause for alarm, was caused by a scarcity of hydropower combined with the very low elasticity of demand. It should be noted that the major Swedish generating companies became dominant players on the retail market as a result of the adoption of legal unbundling.

Forward contracts negotiated by Nord Pool may play a role in the mitigation of wholesale market power. Generators have fewer incentives to reduce output in order to raise spot prices. Furthermore, trading rules adopted by the Nord Pool impose the diffusion of information to all market participants. The market is relatively transparent which limits the possibilities of exercising market power. Finally, Amundsen and Bergman pointed out that

“The Nordic power companies may still have a ‘‘public service mind’’ and are thus not particularly eager to exercise market power” (2006, p. 153).

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In the Nordic countries, wholesale prices show large variations within the year as well as from year to year due to the fluctuations in precipitation levels. For instance, as a consequence of the extremely dry hydrological conditions in 2002/03, the average daily spot price reached US$ 130 per MWh, 4.2 times the 2002 average. Prices did not increase further thanks to the creation of the Nordic market, which allowed the integration of hydro power plants, that supply peak load, and thermal power plants, that deliver base load. Trade with the Continent also allows the benefits of resource complementarities and limits the risk of extreme price volatility.

In Norway and Sweden customers can choose between spot-price, fixed-price (with different duration) and variable-price contracts. Annual variations of retail prices are quite significant and relatively well correlated with spot price variations. During the drought of 2002/03, retail prices in Norway reached unprecedented levels with a certain delay in relation to spot price increases. This led to a significant reduction in electricity consumption during the winter months, for industry and households alike. Some factories not only reduced their consumption, but also earned money selling power back into the spot market, thus actively contributing to the general power supply. They showed increased interest in energy-saving technologies as well as in decentralised small-scale power supply sources. Households and industrial consumers became increasingly active in switching suppliers and changing contracts with new or old supplier.

Since the introduction of the new electricity markets there has been almost no new investment in electricity generation in Norway and Sweden. It is not yet possible to judge whether the new markets are capable of creating the new generation capacity which will be needed in order to support increasing demand in the two countries. A strong signal was sent to investors during the drought of 2002/03, when spot prices soared: “By confirming that prices will be allowed to be high in ‘‘dry’’ years - noted Amundsen and Bergman – the politicians in effect increased the expected rate of return on investments in new generation capacity” (2006, p. 156).

In Finland, a new nuclear power plant is currently under construction (Olkiluoto III), financed by a ‘‘lifetime power-purchase contract agreed at zero profit’’, as stated by The Economist (July 9th 2005). This was presented as the revival of the nuclear industry. In Denmark, advances in wind power have been made thanks to a system of subsidies.

Entry into generation is subject to authorisations. In Sweden, the development of hydropower has been limited by a Parliamentary decision banning further exploitation of national rivers and other hydro resources. Nuclear power has been blocked by a controversial moratorium.

In Norway, a temporary halt to the development of new hydro projects was imposed after the reform. Investment in gas-fired generation, seeking to take advantage of Norway’s offshore natural gas resources, has been hobbled by political and regulatory uncertainty as to future environmental standards.

3.8. Regulation

On the contrary to England and Wales, who created a strong regulation, Norway and Sweden opted for a ‘’light touch regulation’’. It should be noted, however, that network access and market rules are imposed by the transmission companies and the Nord Pool, which also oversee their implementation. An indirect form of regulation is probably present through public ownership of a number of companies.

Governments have not sought to be directly involved in the electricity sector. On the contrary, there has been continued political support for a market-based electricity supply system even when prices soared due to electricity being scarce. The Scandinavian experience shows that in principle, it is possible to minimise regulation if the market (including the SO and networks) have been well designed.

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4.REFORM IN SWITZERLAND

The Swiss electricity sector began restructuring in 1998. It wasn’t however, until the law on electricity supply of the 23rd March 2007 that there was a specific legal basis for the opening of electricity markets to competition.

The majority of Switzerland’s electricity companies are owned, at least in part, by cantons and councils. Reforms were not accompanied by privatisations. There were however transformations to limited companies.

Electric reforms were strongly opposed by the left and some of the green party. The Government managed to obtain a compromise between the different political forces, allowing the introduction of a law aimed at electricity supply security, as well as the creation of competition. The law equally set out general conditions introducing guarantees across all parts of the country of a reliable electricity supply and in line with the principles of sustainable development. Finally, it aimed to reinforce the competitiveness of the Swiss electricity sector on an international level.

The aim of liberalisation is to improve efficiency of the electricity sector, thus stimulating economic growth. Furthermore, Switzerland had to adapt to European Union rules in order to allow its electricity companies to continue operating beyond their national borders (Eidgenössisches Volkswirtschaftsdepartement = Département fédéral de l'économie, 2002, S. 30, p. 29).

A sharp increase in electricity prices that should have taken place in 2008, leads the government to modify the ruling of the law’s application, and the regulator intervening in order to avoid public unease. This largely related to calculations of network usage tariffs as well as the determination of ancillary service costs. The opening of markets does not appear to have deterred investment in new production projects.

Approximately 60% of Switzerland’s electricity production is of hydraulic origin and 40%

nuclear. In general, energy is imported during off-peak periods and exported during peaks.

The country is situated in the centre of the European interconnection.

The Federal electricity act of 23 March 2007 outlines accounting unbundling between generation, distribution and supply. The network must be managed in an independent manner and cross-subsidies are forbidden.

Swissgrid is the SO which monitors the nationwide transmission system, guarantees the provision of ancillary services, deals with congestions in the grid, works together with foreign SOs, and in the event of a threat to stable grid operation, imposes the necessary measures.

From 2013, it will be the owner of the high-voltage transmission lines which it operates. The current owners of high voltage lines – generally the interregional companies that shared the Swiss market in monopolistic times – will receive shares as compensation.

Swissgrid is a limited company of private law based in Switzerland. The majority of voting rights must belong to cantons and councils. It cannot have interests in the domains of electricity generation, distribution, supply or trade.

4.3. Networks

Switzerland adopted “regulated Third Party Access” (rTPA) as well as the “postage stamp”

principle. The Federal electricity act states that transmission prices must cover capital and operating costs relating to a safe, effective and efficient network, payments to public bodies, as well as an adequate return. The regulator should compare network companies’ efficiency levels in order to verify tariffs. It will take into account structural differences that are out of companies’ control, such as territorial characteristics, and supply quality.

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Today, congestion at Swiss borders is already partially managed through auctions. The law provides Swissgrid with this possibility. Revenues should be used to internalise external costs relating to cross-border exchanges, assure the maintenance and development of transmission lines, and cover costs.

Unfortunately, Switzerland was not able to anticipate the evolution of the European electricity market by creating a platform at Laufenburg, where an electricity exchange existed since the 1960s, which was created to optimise hydro power production. Today the Laufenburg market plays a relatively marginal role and is mainly known for the SWEP index (electricity wholesale price). Swiss electricity companies operate on the main European markets, notably the Leipzig energy exchange EEX.

Until 2013 small consumers are not able to access the markets. Provision and prices are regulated in order to safeguard public service (see the Federal electricity act of 23 March 2007, articles 6 and 7). Subsequently, small consumers will be able to choose between the

“status quo” and the market. Public service is safeguarded for those opting for continuity.

This will unquestionably hinder market dynamics. For medium and large consumers, on the other hand, the market has been open since 2008.

In the past, the Swiss electricity sector was comprised of seven interregional companies (the well-known ‘’Ueberlandwerke’’) and a thousand or so regional and local companies, some of which directly or indirectly linked to the Ueberlandwerke. Today, there are still several hundred companies, whereas two Ueberlandwerke (ATEL and EOS) merged to create Alpiq.

The largest companies were and remain active on the European market. Companies from the European Union have acquired interests in the Swiss electricity sector.

In the current situation, the Swiss wholesale market is not particularly vulnerable to market power. There is also the possibility to sell and buy electricity on the European markets.

Furthermore, in a hydropower system the exercise of market power is quite difficult. At any given time generators have to decide whether to store water in the reservoir or to use it. The decision depends on the expected precipitation before and during the winter season, the length of the winter period, the expected demand and price volatility. In order to evaluate the degree of competition of the retail market, we will have to wait several years, notably following the effects of the Federal electricity act of 23 March 2007.

Taking into account current levels of fragmentation of electricity companies, it is somewhat unlikely that Switzerland can create a ‘’national champion’’ that can capitalise on the Alps’

hydroelectric production. In addition, one should the competition between the two majors, Alpiq and Axpo.

Swiss companies trade electricity on the Leipzig market, and other European markets including Laufenburg. In particular, they valorize the peak and super-peak hydro production.

There is a relatively strong correlation between price evolution at Leipzig and at Laufenburg.

In order to cross borders between Germany and Switzerland, participation in transport capacity auctions is needed.

Medium and large consumers can now negotiate prices. Household prices on the other hand, still follow the tariff systems dating back to monopolistic times. Bills should clearly outline energy costs, transport and distribution costs, taxes and any other contributions. Given political and public pressures, companies must seek a compromise between price reductions and profit increases.

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Investment has not been curbed by electricity reforms in Switzerland. It is likely that companies continue to enjoy rents on production, transport, distribution and supply. In June 2008, Alpiq sought permission to build a new 1'600 MW nuclear power station near to the old nuclear plant of Gösgen. In December that same year, Axpo Holding AG and BKW FMB Energie AG, made requests to replace old nuclear plants of Beznau and Mühleberg with new plants. Several electricity companies have completed, or are in the process developing, projects aimed at increasing peak power of a number of large hydroelectric facilities. Unlike the construction of a nuclear plant, which requires authorisation, hydroelectric installations require water concessions. In the current system, they are awarded by cantons or councils on the basis of political and economic criteria. In the future, pressures may appear for them to be attributed through an auction process. Photovoltaic, aeolian, small hydro and biomass are promoted through feed-in tariffs; finance is assured through a tax levied on the high voltage transmission price.

4.8. Regulation

The Commission of electricity (ElCom) is the Swiss regulator. It is independent of the Government and the administration. The legal basis is given in the Federal electricity act of 23 March 2007. It intervenes in the domains of networks and electricity prices. Furthermore, it checks market evolutions in order to guarantee electricity supply security in all regions of the country. ElCom coordinates its efforts with relevant foreign authorities. It is too early to draw conclusions on its behaviour.

5.PROSPECTS

In the long term, it remains possible that electricity reforms are challenged. It should be noted that opening markets to competition, and in some cases the privatisation of electricity companies, began forty years after the wave of nationalisation that marked the post war period. England, France and Italy, for example, had created state monopolies towards the end of the 1940s. We do not expect such a U-turn without a serious electricity crisis, linked to electric reforms. Such a crisis would be characterised by power cuts and significant price increases.

Without such a crisis, we will nonetheless experience a continual process of improvement because, as stated by Joskow, “Initial reform programs are followed by additional reforms, some major and some minor, to respond to performance problems that emerge in practice or lessons learned about best practices from other countries” (2008, p. 36). Here, we just add that more competition should be introduced in the different energy sectors, notably gas, in order to reduce market distorsions.

Climate change policy can represent another important factor for change in the electricity sector. On this subject, the definition of specific rules should be considered, which require greater coordination between the different regulating agencies, as well as the creation of grey, green and white markets. Pérez-Arriaga and Linares (2008) go even further, proposing the adoption of “indicative energy planning”, taking into account the stakes and extent of risk.

It is an approach that has always faced controversy that although not entirely incompatible with the market, is refuted by opponents of all forms of state regulation (cf. Robinson, 2000).

Pérez-Arriaga and Linares stress that “Indicative energy planning comprises the characterization of the relevant features of a future energy model, the identification of the major required strategic measures; and the definition of the regulatory instruments that will make all this possible” (2008, p. 155). The change of approach they suggest can be illustrated by the following assertion: “In such a complex context as the one of energy planning, a key issue is to avoid reducing its multiple dimensions to a supposedly common monetary unit, with the subsequent lack of information” (p. 157).

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The electricity system may experience profound modifications in the medium to long term due to the development of renewable energies. Decentralised production can change the configuration of the electric system, with the diffusion of small renewable facilities (photovoltaic, micro hydro, wind farms…) and the creation of micro-networks (cf. The Energy Journal, Special Issue on Distributed Resources, 1997). New interregional networks should be created in order to connect those energy sources that are dispersed across the areas where they are found, and to benefit from their integration, particularly in order to face up to intermittent production. In relation to this, we should mention the agreement of January 2010 between nine European countries who decided to work together to develop a super-grid, which will unite wind farms on British coasts with Dutch and Belgian tidal power, the vast hydroelectric potential of Norway’s fjords and Germany's solar arrays. We should also mention the German “Desertech” project, which plans the construction of solar plants in the Sahara, as well as the development of an interconnection stretching from North African countries through to Northern Europe.

The development of decentralised production could potentially make the market more competitive as consumers would become less dependent on the network and on centralised production. In making the market “contestable”, electric reforms have further encouraged independents to invest in decentralised production.

Finally, we should highlight three problems to which satisfactory solutions have yet to be offered: unbundling, which continues to face resistance; market integration that may require the creation of a multinational SO; SO governance, particularly in relation to the respect of the principle of neutrality.

5.3. Networks

The application of the principle of “Third-Party Access” (TPA) will continue to be a source of controversy as we are faced with complex problems both conceptually and practically, as well pressures from different lobbies involved in this field. The same applies to the role of the regulator and business, as we saw in the case of merchant lines.

From a medium-long term perspective, it is important to take into consideration the financing needs for investment in modernisation and the development of high, medium and low voltage lines, which are significant in certain countries. The use of replacement costs instead of historical costs in the definition of transmission prices would help find sources of finance, but would have a considerable impact on electricity prices.

In this respect, the development of renewable generation should be taken into consideration, as evoked earlier, whether decentralised or not. Network configuration will experience significant modifications should we wish to integrate renewable parks, and transport their energy to locations of consumption. The presence of a myriad of small units of production alongside large plants will bring about new challanges. Increasing amounts of renewable generation will lead to greater power flows and further congestion, amplifying the significance of these issues. Transmission prices and congestion charges can help but also hinder these evolutions, this can be observed at present in Scotland where renewable energies are penalised by the transport costs imposed by the National Grid (The Economist, January 14th 2010).

In general, it can be said that wholesale markets work relatively well. The problem of “market power” is analysed below. The creation of reserve capacity markets would improve the market design and provide signals regarding the gap between electricity demand and available generation capacity. The development of emissions markets and the emergence of green and white markets will undoubtedly have repercussions on power markets. Models are beginning to emerge for example on the interactions between power prices and CO2

emission prices.

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Retail markets have experienced slower developments, particularly when it comes to households. Their development will depend notably upon progress in information technology, as well as, for residential customers, on the abandonment of regulated tariffs defying all competition.

The opening of markets to competition should be viewed as a process that does not necessarily result in ‘’perfect competition’’ as described in microeconomic textbooks. It is worth carrying out a ‘’realistic” interpretation of the evolutions of the electricity market, particularly given that the companies possess medium/long term strategies and do not react passively to market evolutions.

Some authors highlight the fact that it is thanks to imperfect competition that electricity companies manage to generate the returns needed in order to fund investment in supply security which would otherwise not take place. The fact that they require political support is another explanation for investing in security. The trend is to fight against market power nonetheless, as it is exercised to the detriment of consumers.

It is difficult to predict whether competition regulators will ever be able to eradicate market power. The battle remains a challenge, as demonstrated by the question of implementing a real unbundling in the European Union.

It may be in a country’s interests to support a ‘’national champion’’, particularly if it is public, as it can maintain a certain control over a strategic decisional centre, generate revenue, create jobs and penetrate foreign markets. At the same time, a “national champion” can represent a threat to competition, if its market share is relatively high or if its investments benefit from ‘’state guaranties’’.

It is likely that in the medium term we will observe an amplification of market tensions and rises in wholesale electricity prices. Supply will in fact be affected by rises in fossil fuel prices, taxes and CO2 emission certificates. New investments are needed, in order to renew and upgrade existing power plants and to develop renewable energy. As for electricity consumption, it is worth counting on its stabilisation, which does not necessarily exclude a gradual reduction in total energy consumption. In fact, our society depends upon technology, which itself depends greatly on electricity.

Increases in wholesale prices will have repercussions on retail prices, which also include transport and distribution prices. The latter will be affected by investments aimed at renewing and reinforcing existing networks. We are therefore heading towards an increase in electricity prices, which almost paradoxally will take place 10 to 20 years after markets were opened to competition. The economy must adapt. The market is most likely already in a position to provide pertinent signals in this respect. There does need however to be improvements in its design in order to activate certain dynamics, for instance by increasing real-time demand response resources.

It will not be for another ten or so years that we will be able to ascertain the performance of electric reforms in terms of investment and diversification. Both market and regulatory design are in question. Debate on the measures conceived on this matter remains unresolved. The challenge is great when considering the need to renew and reinforce electricity infrastructure.

Furthermore, renewable energies must be developed in order to reduce dependence on fossil fuels and lower CO2 emissions. Today Governments and big companies have a

‘’historic responsibility’’ on this matter.

5.8. Regulation

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Regulation and market represent two sides of the same coin. They should be both well conceived and well integrated. Strong political support is of extreme importance, which could be lacking if electric reforms fail to provide satisfactory results or if it is misunderstood. The regulator’s responsibilities must be clearly defined and relations between different agencies effectively coordinated. Climate policy will undoubtedly present new problems for the electricity sector regulator to face. Finally, greater coordination between national regulators is needed.

6.CONCLUSION

The table below provides the ‘’General Framework’’ and two scenarios (‘’Electrical Reform Reinforcement’’ and ‘’New Energy System’’) concerning the electricity sector’s future and reforms in particular. In the two scenarios, we assume continuation of a market oriented approach. In the ‘’Electrical Reform Reinforcement’’ (ERR) scenario, we focus on perfecting electrical reforms. In the ‘’New Energy System’’ (NES) scenario, we suppose the adoption of strong climate policy and count on the development of renewable energies and energy efficiency. It is not only possible to integrate these two scenarios, but to a certain extent it is possible to achieve NES only if ERR is taken for granted. It isn’t necessary to describe the table, as it resumes the problems already evoked in this article. The statements are self- explanatory.

Suffice to say that this paper brings to light the difficulties, risks and controversies of electrical reforms, but also their creative potential. If in the future we wish to assure electricity supply security at an adequate price, as well as protect the environment, particularly the climate, we must tap into this potential extensively, clearly defining objectives and the measures allowing their realisation.

Table I – Electrical reforms and future scenarios

“General Frameworks”

(GF)

Scenario

“Electrical Reforms Reinforcement” (ERR) (continuing process of

improvement)

Scenario

“New Energy System”

(NES)

(possibly combined with ERR)

1. Points of reference No political changes that challenge electrical reforms Climate policy emergence

Market oriented approach in the different energy sectors

Mild climate policy

Market oriented approach in the different energy sectors

Strong climate policy Indicative energy planning

2. Electric system, unbundling, system operator

Significant

technological progress in production, supply and networks

Successful unbundling Creation of a

multinational system operator

Renewable energy promotion and Demand Side Management

Strong development of renewable energy (decentralized and not) and Demand Side Management

3. Networks Confirmation of rTPA

and auctions for congestions

Introduction of a “nodal price” system (?)

Creation of new networks connecting geographically dispersed renewable parks