Market liberalization: an analysis of the Austrian electricity market

Table of Contents

1 Introduction

2 Background
2.1 Market components
2.2 Market basics and participants
2.3 Balancing demand and supply
2.4 Accessing the electricity network
2.5 Unbundling
2.6 Retail and wholesale markets
2.7 Pricing electricity in a competitive market

3 Liberalization issues
3.1 Regulation
3.1.1 EU Directive for regulation
3.1.2 Reasons for development of a single market
3.1.3 Stranded costs
3.2 Deregulation
3.2.1 Deregulation difficulties
3.2.2 Pricing
3.2.3 Safety of long-term supply
3.3 Impact on Industry Structure
3.3.1 Restructuring
3.3.2 Mergers and acquisitions

4 Austrian electricity market
4.1 Deregulation
4.2 Market access
4.3 Participants
4.4 Generation
4.5 Fuels for generation
4.6 Balancing
4.7 Unbundling and price
4.8 Foreign involvement

5 Conclusions
5.1 Future work

6 References

Abbreviations

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Table of Figures

Figure 1: Market components in the electricity market [GAO04]

Figure 2: Structural relationships [Mell01]

Figure 3: Electricity balancing [EC04]

Figure 4: Overview of the electricity market in general

Figure 5: Implementation of the EU Directive [EC04]

Figure 6: EU energy price levels in July 2003 [Capg03]

Figure 7: Electricity prices in January 2003 [Capg03]

Figure 8: Residential electricity prices in January 2003 [Capg03]

Figure 9: Peak load, installed & remaining capacity in 2002 [Capg03]

Figure 10: Minimum remaining capacity versus capacity margin [CaGe02]

Figure 11: OECD electricity production by fuel [IEA04]

Figure 12: Status of Europe electricity liberalization [FINE03]

Figure 13: Electricity sales of market leaders in Europe [Cern02]

Figure 14: Power deals 2002 [Pric04]

Figure 15: Austrian electricity market structure [HaHu02]

Figure 16: Electricity lines and generation plants [Haid04]

Figure 17: One day of electricity demand in Austria [Econ04]

Figure 18: Structure of domestic electricity prices [HaHu02]

Figure 19: Domestic energy prices of network areas in Austria 2003 [Econ04]

Figure 20: Electricity wholesale market partners [Verb04]

1 Introduction

In 1990, the UK Government privatized the UK Electricity Supply Industry in England and Wales. Since then, the European Union is in the process of creating the largest competitive electricity market in the world. This integration of energy markets is supposed to lead to a greater efficiency and it will contribute to the security of the supply. Moreover, the liberalization of the electricity sector induces substantial structural changes and consequences for the European countries, which are difficult to predict. In 1996, as stipulated in the European Community (EU) Directive 96/92/EC, the European countries officially decided to develop a single market for electricity [Ceer04].

Before liberalization, the structure of the electricity market had territorial monopolies, extensive public ownership, federalized organizational structures, and a lack of a market-pricing mechanism [HaAu01]. On the basis of the above mentioned Directive each EU Member State is obliged to gradually open its national electricity market with the objective of the full liberalization of the electricity market by the end of 2005 [Econ04], though each Member State is at its own pace of market opening, trying to harmonize existing rules with measures to accomplish the requirements of the Directive [MaJo01].

Electric power, or electricity for most consumers, is generated by utility companies usually using coal, oil, nuclear, or hydropower. It involves the production and delivery of electrical energy in sufficient quantities so business and households can operate according to their demands. Some of the generating capacity is presently based on renewable energy sources such as solar power and wind power. But their share as part of the total energy system has been rising since the mid seventies and amounted to 25% of total energy supply in 2003 [EVA04].

In this way, nowadays, a 24-hour on-demand, access to electrical power is taken for granted for residents of most developed countries but, in many countries, electric power companies own the whole infrastructure from generating stations to transmission and distribution infrastructure. The industry generally is heavily regulated, often with price controls, and is frequently government-owned. For this reason, electric power has been viewed as a natural monopoly [Haas03a].

The latest Directive 2003/54/EC, repealing Directive 96/92/EC, concerns common rules for the internal market in electricity and, asks Member States to ensure that consumers are informed about the fuel mix of the electricity supply. Along with liberalizing electricity markets, environmental arguments are increasing. Therefore, it is becoming vital to agree on common principles on how to give the consumer information about the fuel mix and the environmental consequences of the electricity produced [Ceer04].

In this way, the last Directive, (adopted in June 2003 and due in summer 2004), introduces the concept of "electricity disclosure" where consumers are provided with information about the attributes of the electricity they are buying. Member States are required to ensure that the information about the used fuel mix to produce the electricity is provided. Environmental information must also be provided, in terms of at least CO2 emissions and radioactive waste, together with the billings and promotional materials [EC04].

The EU Directives set out the requirements under which competition can be developed in a fair and transparent way. Opening up electricity production to competition is an important tool to improve the efficiency of electricity production industry and therefore should benefit all electricity consumers. Competitive forces can drive producers to innovate and operate in more efficient and economic ways. Innovation can lead to lower prices and a better use of energy resources. Cost savings due to increased efficiency gains will lower prices for electricity users. This is the expectation that drives deregulation processes in the European countries but unknown side effects might prevent this outcome [EC04].

This paper is organized as follows: Firstly, we introduce basic concepts of electricity markets such as electricity market components and participants, balancing demand and supply, accessing the electricity network, unbundling, retail and wholesale markets, and pricing in the competitive market. Secondly, we discuss significant topics of liberalization-related issues, such as regulation, deregulation and the impact on the industry structure. Finally, an analysis of the processes and conditions in the Austrian electricity market will show the current state of development.

2 Background

There are many players and different concepts involved in the generation, distribution and consumption of electric energy [EC04]. This chapter is devoted to present some of the most significant background informations of electricity markets, such as: the electricity market components, the participants, the demand and supply mechanism, the access to the market, the unbundling and finally, the functioning of the retail and wholesale markets.

2.1 Market components

There are three components of the electricity market, namely generation, transmission to the substations, and distribution system from the substations to the end consumers addressing their electricity demand (see figure 1).

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Figure 1: Market components in the electricity market [GAO04].

Electricity generation is the first of the three processes. As we already mentioned, utility companies are using coal, oil, gas hydropower, or nuclear power to generate electricty. After generation, the transportation of electricity is split up into two processes, transmission and distribution system [Wiki04b].

The first kind of systems consist of transmission lines and substations carrying voltages of between 110 and 400 kilovolts. Substations at points of connection to a distribution system bring the voltage down to distribution levels. The transmission system operator (TSO) is the entity responsible for operating the high-voltage transmission grid, to which electricity producers deliver their production [Wiki04b].

Each TSO has typically several interconnections with the transmission grids of neighboring utilities (the so-called "international tie lines"), because cross-border imports and exports of electricity flow via the transmission grid [EC04]. An interconnection provides a link (lines, cables and equipment, including transformers, etc) that may be used to convey electrical energy in either directions between networks, power stations, or between power stations and networks [Vasc03].

After transmission, the distribution companies tap from the grid via substations and transformers that lower the voltage level to distribution levels. The distribution system operators (DSO) are the entities responsible for operating the medium and low voltage distribution lines. Power lines are used for the lower voltage electricity flow from transmission facilities to commercial and residential customers. In most countries, there is one transmission system operator and several distribution system operators [EC04].

Moreover, the electricity system in most European Countries is vertically integrated. One large utility owns and operates all three primary aspects of electricity operations, generation, transmission, and distribution, in a given area of service. The deregulation splits or “unbundles” the electricity package, separating the three elements into different products that can be marketed and traded independently from each other.

Before deregulation, only bundled services were available and only local-utility- produced energy could be delivered over its transportation system. Under the former monopoly model they had exclusive rights to supply electricity to residential, commercial and industrial retail consumers within a defined geographic area. After deregulation, customers are able to purchase energy from suppliers other than the local utility company [Josk03].

2.2 Market basics and participants

One of the market participants in the electricity industry are electricity suppliers. Utilities and energy service providers, which sell electricity and related services at retail to local customers. Generators sell their generated energy to suppliers and balance the bids and offers to system operators, who have contracts with local suppliers. Suppliers buy electricity from generators and sell to consumers, such as households or businesses [Mell01].

Figure 2 shows the structural relationship between generators, system operators, and suppliers selling electricity to consumers.

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Figure 2: Structural relationships [Mell01].

Electricity is by its nature difficult and extremely expensive to store and has to be available on demand. Consequently, it is not possible, under normal operating conditions, to keep it in stock, or to have customers queue for it. Moreover, demand and supply vary continuously.

The system operator coordinates the dispatch of generating units to meet the expected demand of the system across the transmission grid. If there is a mismatch between supply and demand, the generator speeds up or slows down causing the system frequency to increase or decrease. If the frequency falls outside a predetermined range the system operator will act to remove either the generation or the load [Wiki04b].

Suppliers, however, may not be able to guarantee that the electricity purchased by their clients will, at all times, match the amount of electricity they have contracted to buy from generators. This is particularly the case for companies with a small amount of customers, like new market entrants to the electricity market [Mell01].

2.3 Balancing demand and supply

Balancing supply and demand at any point, within a given control area, ensures the functioning of the electricity market [Econ04].

The system operators of the power system control center are responsible for ensuring this short-term balancing of supply and demand of power. As a controlling agency, it coordinates the dispatch of generating units to meet the expected demand of the system across the transmission grid [EC04].

In the case of a failure affecting their system, operators are required either to obtain more power from generators or other regions or to shed load (meaning cut power to some areas) until they can be sure that a worse remaining possible failure won't cause an unplanned system collapse. In an emergency, they are expected to immediately shed load as required to bring things into balance. There are computer systems to assist the operators, with backups that ensure information does not get lost. Power-flow modeling tools let them analyze what is currently happening on their network, so they can predict whether any parts of it may be overloaded. If necessary they can change the power generation, load or transmission to prevent a failure when accidents happen [Wiki04].

Network operators, for instance each one of the four largest German grid companies (RWE, E.ON, EnBW, Vattenfall) fulfill this task within their respective balancing area by increasing and reducing available power at short notice [Bund04].

Balancing mechanisms differ relating to whether balancing is carried out at regional

(R), national (N), or supranational (S) level. Austria is an example of a country that is using regional balancing within 15 minutes by a single generator, while charging market based prices as well [EC04].

Figure 3 shows an overview of EU countries balancing electricity supply within a certain amount of time. In Belgium and Luxemburg the transmission system operator (TSO) sets the balancing prices [EC04]. Energy demand is expected to grow in the coming years.

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Figure 3: Electricity balancing [EC04].

Member States attempt to ensure that policies are in place to control growth in demand. The goal of the so-called demand management is to maintain security of supply [Econ04]. There exists debate as to whether this approach or a supply-side approach ensuring growth in supply capacity may lead to a higher quality of life [Haas03b].

2.4 Accessing the electricity network

Access to the electricity network can be defined in two ways:

- Under the negotiated third-party access (NTPA) system each user of the network negotiates the terms of the access with the system operator. Depending on the market power of the third-party who tries to access the network, there could be different tariffs negotiated. It can be an extra burden to companies to renegotiate the access conditions and prices at the end of each contract.

- A regulated third-party access (RTPA) means that the tariffs are fixed by authorities and are equally applied to all users of the network. Those tariffs are openly published and transparent, and therefore they will produce the most effective competitive market. This ensures that discrimination against competition cannot take place and companies can plan ahead future electricity purchases knowing the openly available charges.

Regulated third-party access is the option that most Member States have chosen, like Belgium, Finland, France, Luxembourg, Austria, Netherlands, Spain, Sweden, UK, Ireland, Italy and Portugal. Only three European countries, Greece, Germany and Denmark, established a negotiated third-party access [EC04]. Germany, the largest electricity market in the European Union uses NTPA and charges higher transmission fees, although they do not publish these rate charges [MaJo01].

2.5 Unbundling

In Europe, the transmission network is owned largely by vertically-integrated electricity companies that generate, transport and sell electricity. As already mentioned in section 2.1, the transmission network is a very essential asset.

All the functions performed by local utilities to produce high-quality, reliable electric service (power production, transmission, distribution, voltage regulation, etc.) are sold as a package. Under deregulation, transmission must be offered on equal terms to all market participants. There is a risk that transmission owners may discriminate in favor of their own group companies when granting access to the network. To prevent this situation the EU Directive requires Member States to take three basic preventive measures:

- ensuring management unbundling of the transmission system operator;
- ensuring accounting separation of transmission and distribution activities from other parts of the company and;
- ensuring that appropriate mechanisms are in place to prevent confidential information from being passed by the transmission system operator to other parts of the company.

In order to ensure fair access for all market players in the network, it is necessary that, during the management of unbundling, confidential information does not pass from the transmission system operator to other parts of the group. It is an essential precondition to allow competition in generation and distribution to obtain more efficient and effective operations. Unbundling of accounts also will increase transparency in the operation of electricity undertakings. An alternative to the management unbundling approach of the Directive is to legally separate the transmission system operator from the vertically-integrated company. It will then become a separate operation and function independently from other electricity companies. This approach is the most effective in ensuring that discrimination does not take place, and it's been followed by most European countries, like in Austria where the Verbundgesellschaft is established as a separate entity [EC04].

The complementary relationships among generation, transmission, distribution and system operations must not be overlooked when pursuing deregulation. This means that there might be negative outcomes occurring because of the unbundling processes. Furthermore, the unbundling of a network relationship may bring about a loss of social welfare if the positive effects of competition are less than the negative effects of the vertical unbundling. This effect, established by Antoine Cournot in 1838, is known as the Cournot Principle [Cour91].

2.6 Retail and wholesale markets

A retail electricity market exists when end-use customers can choose their supplier from competing electricity retailers. Electricity retailing is the final process in the delivery of electricity from generation to the consumer whereas the wholesale market exists when competing generators offer their electricity output to retailers. Electricity retailers have to be able to perform billing, meter reading, and customer management via, for example, a call center that can handle energy distribution through the use of system contracts and reconciliation agreements. Trading on power exchange markets and hedging contracts in risk management can also be facilitated [Wiki04].

Figure 4 shows an overview of producers, suppliers and consumers participating in wholesale and retail markets. In the retail market, electricity is delivered to consumers by suppliers and in the wholesale market producers and suppliers interact with each other [Wiki04].

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Figure 4: Overview of the electricity market in general

2.7 Pricing electricity in a competitive market

During most time periods in the electricity spot market, the generation price of electricity will be set by the operating costs of the most expensive generating unit needed to meet demand or what in economics is referred to as the “marginal cost” of production. In general, a supplier will not be willing to sell power below the market price of the most expensive facility operating at a given time, because consumers will be willing to pay a higher price [Haas03a].

Similarly, consumers will be unwilling to pay more than the cost of the most expensive operating available generator, since other suppliers will be offering lower prices. With prices set to marginal costs, the market will clear which means that all suppliers willing to provide power and all consumers willing to purchase power at the market price will do so [SaNo01].

During periods of extremely high demand (peak demand), typically on very hot summer (or cold winter) days, when the demand for electricity approaches the available generating capacity, prices rise above the operating costs (including fuel costs) of the most expensive generator operating. In the long-term view, the target is to allow electricity prices to reflect the long-term marginal cost of the society it operates in at all times [Haas03a].

3 Liberalization issues

This chapter describes the ongoing liberalization issues of the electricity markets, firstly, representing conditions of regulation, secondly the deregulation topics, and at last, the impact on the industry structure in the EU Member States.

3.1 Regulation

Electricity consumers have no other choice but to use the network connecting them to the available grid in their surrounding area for delivery of electricity. This has helped to create monopolies. As a consequence it is important to regulate these transmission and distribution system operators. Otherwise, where vertically integrated, they may actively discriminate in favor of their own group companies, which would limit the effect of competition. They may even try to charge excessive prices for transmission services, generating monopoly profits. In Austria, E-Control Ltd. was set up by the legislator on the basis of the new Energy Liberalization Act in March 2001. It is responsible for monitoring, supporting and regulating, if necessary, the liberalization of the Austrian electricity market. E-Control's first action was to cut back excessive tariffs and create more price transparency while guiding the market transition [HaHu02, Econ04].

3.1.1 EU Directive for regulation

The EU Directive 96/92/EC sets the rules for the implementation in Member States to ensure equally and fairly applicable rules. This regulatory role will be carried out by partnership between national regulators, competition authorities and the European Commission. The transformation process starts from different points of departure which are determined by the local history of the sector, the economic system, and the political institutions. As a consequence, there are variations in the degree of unbundling of companies, the nature of the system operator, the design of the regulated market, or the structure of the institution entitled with governing the sector with regulation. The European Member States are opening their markets at different speeds. Some countries have chosen to limit the opening to the minimum of 26%. Others, like Austria, have chosen an opening of 100%. The common goal is the development of one efficient single market for electricity [Ranc03, MaJo01].

3.1.2 Reasons for development of a single market

The EU main aim is to increase efficiency by introducing competitive forces into the electricity market. Currently, the price levels in the EU Member States varies enormously. This causes unacceptable and unnecessary distortions in competitive conditions across the single market. More efficient markets can lead to lower prices [HaHu02, MaJo01].

Electricity in the EU is significantly more expensive than in many other countries with which the EU trades, like the USA and Australia. The protection of the environment is another goal to achieve. A market that is interconnected requires less reserve capacity, which is very expensive to maintain. Moreover, the introduction of competition means that producers will have to make better use of available resources while avoiding waste, which is expensive and pollutes the environment. The right to choose the supplier of electricity lies in the hand of the customer who can then decide on the criteria, like cheapest, cleanest or best service provider. Electricity companies will then have to improve their service to customers or gain new ones. The aim is to lower the price levels in all countries and to produce more efficiently [HaHu02].

3.1.3 Stranded costs

As the electricity market becomes more competitive, electricity prices are generally expected to fall. If prices are too low, utilities may not be able to recover all the costs they have incurred in the past to serve their customers. The differential costs will become “stranded" [RiSm02].

Stranded costs (or assets) are costs that have been incurred by utilities to serve their customers but may not be recoverable if the consumers choose other electricity suppliers. These stranded costs exist during the transition from a regulated to a more competitive market for electricity. Stranded costs are those fixed and sunk costs that were imposed by the regulator in the regulated market that may not be recoverable via market pricing if the market is opened up for competition [MaBr99].

Under deregulation, producers and suppliers have to grant access to their wires or compete with new entrants to the market that are not faced with these extra costs.

These above-market costs could be a result of government policy to favor certain fuels (for example renewable energy sources, like solar and wind) above others. Stranded costs refer to past investments made by utilities that must be written off because these assets cannot generate electricity at competitive prices. There may be no way that an electricity company will be able to recuperate these costs under a competitive market regime [MaBr99].

In order, to deal with those issues the EU Member States can compensate companies for these extra costs, for instance by limiting the market opening to new entrants, to favor dispatch of electricity from certain fuels, or to give financial compensations. Each Member State has the right to decide how it wishes to meet those costs, and whether it even should compensate for them. The discussion on the stranded cost issue typically focuses on the following questions:

- What is the exact definition of stranded costs?
- What should be considered as a stranded cost?
- Should the industry be able to recover stranded costs?
- And if so, who should pay for them? How should they be recovered?

One study estimated 1995 stranded assets at $88 billion USD, and estimates of projected stranded costs have ranged from $10 billion to $500 billion USD in the US [Nati00]. As a switching cost this should fall on the departing customers. Recovery of the different types of stranded costs has been one of the most contentious issue confronting regulators in promoting competition [MaBr99].

3.1.3.1 Types of stranded costs

Stranded costs generally fall into three categories:

- Assets, primarily in expensive power plants and excess generating capacity. For example, some utilities own nuclear plants that cost much more to build than do today’s power plants. In a competitive electricity market, the price received for the electrical output from these expensive plants would not be enough to repay the remaining (undepreciated) capital costs of the plants.
- Liabilities, primarily in expensive power-purchase contracts and fuel-supply contracts, as well as contingent liabilities such as nuclear-plant decommissioning.
- Regulatory assets, whose value is based on regulatory decisions rather than on market forces, include deferred expenses and costs that regulators allow utilities to place on their balance sheets, such as those associated with public-purpose programs. For example, a regulatory commission might agree to defer some of the costs of an expensive new power plant to avoid “rate shock.” The commission might allow the utility to add these costs to rates gradually over several years. In essence, this agreement is a promise from the state regulator to the utility that ultimately, although not today, it will recover all its costs. If the utility’s customers can choose alternate suppliers, however, the regulator may have difficulty keeping this promise to the utility [RiSm02].

Stranded costs can have both positive and negative values, although for many utilities the positive costs exceed the negative ones. Stranded assets are described as the capital costs for a generating plant that cannot be fully recovered in a competitive market, because the revenue at the market price is less than total operating cost, including the cost of capital. The major driving force for deregulation of the electric utility industry is to reduce electricity prices. Large industrial customers want to be able to buy power from any supplier precisely because the competitive market price will be less than the rate of return required to pay the full cost of power supplied by their current utilities [MaBr99]. The question is who, should pay for the utilities' resulting "stranded costs"?

3.1.3.2 Paying for stranded costs

A deregulated electric industry does not automatically result in a competitive market for the electric industry. Stranded costs can make some firms far less competitive, or even non-competitive, in a deregulated market. Policy makers can structure the transition to a competitive market in such a way that the benefits and costs of competition are shared among all who are affected: customers, investors, and taxpayers. EU Member States are responsible for assigning (or not assigning) stranded costs and benefits to regulate the utility businesses within their borders.

Countries will have a significant role in creating a level playing field for all competitors and customer classes in a restructured electric industry [RiSm02].

Because estimates of stranded costs represent large sums of money, assigning them to any one group could create problems in the transition to a competitive market. If utilities are required to pay for stranded costs, many could go bankrupt and cause large financial losses for their shareholders. If ratepayers are required to pay, either through higher rates, or through high exit fees, it will not be worthwhile for customers to leave the system. Some people hold that if stranded costs are to be recovered, the costs should be divided fairly among all classes of consumers and shareholders [RiSm02].

Typically, industries rely on market pressures and signals for planning their investments. Under regulation, decisions to construct new generation facilities are made by regulators and utilities rather than by markets. Return on investment can be planned through rates, and because electric rates are set according to accounting formulas and depreciation schedules, return on investment is predictable and does not fluctuate in response to market pressures [RiSm02].

The reason that stranded costs in the electric industry are viewed as other than just “bad investments” is because they were made in good faith by the investors at the request of the regulators. Many utilities are claiming that because of the historical regulatory impact of shareholders and regulators, shareholders are owed full recovery of these costs and should not be required to accept any losses. Large customers do not want to pay stranded costs because it will delay the lower rates they want from competition [RiSm02].

The options for stranded costs payers are:

- to write off these capital costs and make shareholders take the loss;
- to minimize the loss by improving the efficiency of utilities as business entities, thereby reducing their overall operating costs;
- to redistribute these costs onto captive customers (residential and small commercial customers) who will not be able to buy power from competitive suppliers until many years after large customers can do so;
- to distribute costs over all customers, through exit fees, transmission or distribution surcharges, or other mechanisms;
- to distribute costs over all customers by delaying the transition to retail competition, to allow more time for capital recovery;
- to redistribute some of these costs onto the public sector through nationalization of particularly uneconomic assets.

Utilities have the obligation to serve the customer and all usual and customary costs for capacity that they build to meet that obligation should be fully recovered. In a fully competitive market, however, simply owning capacity does not create stranded costs. It owns capacity that is operationally inefficient, and costs more than the market is willing to pay, what creates stranded costs. Recovery of stranded costs in a fully competitive market should require utilities to show that service obligation. They should be able to show the costs are due to the good faith compact and not to bad management [MaBr99].

3.2 Deregulation

Deregulation changes the way in which supply capacity is determined. Each player decides whether to alter their individual supply capability [Haas03b]. The California crisis, in the summer of 2001, emphasized the painful consequences of a chronic supply/demand imbalance and market manipulation [Crow02].

Electricity prices were high in California partly because of the regulated market, by assuring producers of a high rate of return on their investments, provided incentives to build too much generating capacity. When California opened its electricity generation market to competition, policy makers hoped that competition would reduce electricity prices but they also imposed a price ceiling to maintain stable retail prices [HaAu01]. During 2000 the rising energy prices and the reduced availability of capacity decreased electricity supply in California. Rising gas prices increased the cost of production for the plants that mainly rely on natural gas as fuel. Additional strong economic growth, in particular because of growing computer-based businesses in the Silicon Valley area, and severe weather conditions boosted electricity demand. The market-clearing price was higher than the price ceiling and could not be charged to the consumers. Furthermore, there were problems on the supply side because polluting plants were idled and old power plants (55 % of California's plants were more than 30 years old) operated less efficiently [HaAu01].

With the price ceiling from the government in place, consumers tried to purchase much more electricity than producers were willing to sell at the ceiling price. Critics warned that blackouts might be resulting because demand and supply could not match at the fixed level of the market price. But California’s utilities were legally obligated to supply all the electricity consumers wanted to purchase at the ceiling price. To do so, utilities were forced to pay a much higher price for electricity on the open market. Because the utilities did not quite succeed in obtaining all the electricity that customers want at the ceiling price, the result was a combination of shortages and utilities paying higher prices for electricity than they could sell it for to their own customers. In the tight supply situation, some generators were shut down because of unscheduled power-plant maintenance [HaAu01].

By the end of 2000, California utilities were paying a wholesale spot price of about 40 cents per kilowatt hour while they were only allowed to sell it for about 10 cents per kilowatt hour to their customers. In summer 2001 the disruption to businesses and homes as a result of the ongoing blackouts and extreme prices was enormous. California’s failure to allow retail prices to rise to reflect market conditions has put a financial burden on the utilities. In addition, low prices discouraged the development of additional supply while encouraging customers to continue uses of electricity [HaAu01].

3.2.1 Deregulation difficulties

In existing EU Member States, there has been some progress in the electricity sector since the start of deregulation in terms of the general functioning of the market. However, these following areas, causing particular difficulties, remain:

- different rates of market opening continue to reduce the scope of benefits to customers from competition, leading to higher prices than otherwise would exist to small businesses and households, and also promote distortion of competition between energy companies by allowing the possibility of cross- subsidies at a time when companies are restructuring themselves into pan- European suppliers;
- disparities in access tariffs between network operators which, due to the lack of transparency caused by insufficient unbundling and inefficient regulation, may form a barrier to competition;
- the high level of market power through acquisitions and mergers among existing generating companies associated with a lack of liquidity in wholesale and balancing markets which impedes new entrants;
- insufficient interconnection infrastructure between Member States and, where congestion exists, unsatisfactory methods for allocating scarce capacity because of lack in coordinated planning of transmission networks and interconnectors [Vasc03].

Figure 5 summarizes the position in each Member State and candidate country in relation to the obstacles identified above.

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Figure 5: Implementation of the EU Directive [EC04].

The more boxes that are shaded red, the less likely it is that competition will develop to its full potential. The table highlights a number of improvements for existing Member States in terms of the market opening timetable and unbundling of the transmission networks [EC04].

Unbundling for distribution networks shows, however, a generally unsatisfactory position. Network charges still appear high in certain Member States, like Germany, and there is still evidence that balancing mechanisms are unfavorable to new entrants. Wholesale market concentration remains an issue in most Member States and little progress has been made. Although transmission unbundling has generally been carried out in a satisfactory way, there remain obstacles in terms of incomplete market opening and possible concentration. Only Austria, Denmark, Finland, Germany, Spain, Sweden and the UK have yet a fully 100% declared market opening which allows to develop cross-border trade and facilitates the convergence of regional markets towards the single European market [EC04].

Deregulation makes it sometimes harder, not easier, to maintain balance in the market. On the plus side, companies recognized that it was easier to access the opportunities that arose. On the negative side, two factors combine themselves to make achieving energy balance much more difficult. These two factors are firstly, the economic uncertainty arising from competition and secondly, the uncertainty over market rules. There is a strong feeling that governments and regulators do not recognize the problems caused by a prolonged period of uncertainty around market start-up. There is a concern as to whether regulators and government will allow the market to develop without intervention. There is also a need for better co-ordination between environmental and planning issues and the development of energy markets [EC04].

3.2.2 Pricing

Price is by far the most important factor for customers in competitive markets [Capg02]. Due to the enormous market pressure the average electricity prices have been substantially reduced since the market opening. Producer prices are almost half of what they were three years ago [MaJo01].

Electricity prices in Austria dropped for domestic customers by about 10% of their yearly bill. Businesses and large industrial users received up to a 50% price reduction [HaHu02].

Figure 6 shows the actual trends in the electricity industry.

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Figure 6: EU energy price levels in July 2003 [Capg03].

It reviews the price level of July 2003 in the European countries and Member States have been grouped according to whether prices are lower, medium or higher than the EU average [Capg03].

During 2002-2003 as a result of the wholesale market conditions, electricity prices have increased. In the year 2001/02 prices fell. But now it seems like there is a tight balance between supply and demand of electricity. Nordic markets (Finland, Sweden, and Norway) during winter 2002-03, and continental (Austria, Germany) markets during summer 2003, have shown an increase in prices because of higher levels of demand [Capg03].

Those higher prices encouraged new market participants to generate more capacity. This forced the demand management to handle tight supply conditions. In the UK in contrast falling customer prices have been occurred, reflecting the continuing influence of lower wholesale prices. In general, it seems that European countries with a higher level of market opening processes are remaining lower in prices [EC04].

Figure 7 shows a significant variation of electricity prices for the industry across Europe. For very small industries, prices in Germany, Belgium, Ireland, Luxembourg, Portugal and Austria are nearly twice as much as those in Sweden, Great Britain or Finland.

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Figure 7: Electricity prices in January 2003 [Capg03].

This can be partially explained by the fact that Germany and Luxembourg have regions with very high network access tariffs and different mixes of generating capacity. For the use of higher-voltage transmission networks there are high fees demanded for balancing energy. Due to a 10 % rise in fees for the use of transmission networks in 2002, these fees for network use are passed on to all downstream electricity consumers (municipal utilities, electricity traders, industrial customers, households) and place a considerable burden on them [Capg03].

Small to medium industries show a similar picture with Ireland, Belgium, and Italy on a rather high side. For medium to large industries, the highest prices are experienced in Italy, Ireland, Sweden and Belgium [Capg03].

In the domestic market segment the retail competition did not lead to the same price drop in percentage as in the industrial sector.

Figure 8 shows the residential electricity market prices in January 2003 which exposes significant residential customer high prices in the Nordic area [Capg03].

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Figure 8: Residential electricity prices in January 2003 [Capg03].

In Norway, the much higher price levels reflect the very rapid pass-through of wholesale prices to residential customer prices. By contrast, Sweden, which is part of the same wholesale market has seen lower price increases for residential customers. In UK price reductions of around 10% were experienced again reflecting the substantial decreases in wholesale prices [Capg03].

This fact shows that the falls in residential retail prices have been substantially lower than for nonresidential customers. In international comparison, this can be viewed as general price discrimination for households compared to significant price reductions for businesses [Haas03a].

The domestic regulator has begun to express concern about this as a possible sign that competition is not sufficiently effective. There were price increases experienced in the newly fully deregulated Austria and Spain, together with a price increase in Germany. Price differences can be observed in eligible residential markets as well as in non-eligible residential markets. One reason for these differences is the impact of transmission and distribution tariffs they charge [Capg03].

3.2.3 Safety of long-term supply

A massive power outage produced a blackout in parts of the northeastern United States and eastern Canada on 14th of August, 2003. It was the largest blackout in North American history and affected an estimated 10 million people in Ontario, Canada and 40 million people in eight U.S. states. Estimated financial losses related to the outage were put at $6 billion [Wiki04].

There was a need to shut down about 100 plants causing wide-ranging power failures on other systems. Water systems had to be shut down as well as sewage dumps, air and ground transportation halted, gas stations and refineries closed down. Cellular networks were interrupted, police and fire communications did not function and a large amount of manufacturers had to shut down their businesses [GOA04]. It was estimated that the blackout covered an area of roughly 24,000 square kilometers leaving the area in Cleveland, Toledo, New York City, Albany, Detroit, and parts of New Jersey without power. Any great overload or underload of power can cause hard to repair and costly damage, so they disconnect from the power grid if a serious imbalance is detected. These can sometimes cause cascade failures in the areas [Wiki04]. Chain reactions seem to have occurred making the financial and social outcome of the blackout even more dramatic [GOA04].

In June 2003 Europe experienced blackouts in Italy and France did send warnings out to its population, due to the heat wave in summer, that there might be brownouts coming up. These events have created concern about electricity availability for consumers. There are different causes behind each electrical power outage that need to be addressed to solve the problems. This is rather a very complex area and circumstances are not always clear [Capg03b].

A reliable supply of electricity is based on an expensive, capital-intensive infrastructure. If construction of power plants and transmission grids fails to keep up with growth in consumption, there is a danger of blackouts, uncontrolled interruptions of supply and dangerous fluctuations in voltage and frequency. These phenomena can cause significant economic damage [Haas03a].

The massive black-out in the USA and Canada in August 2003 documents well that industrialized countries are also vulnerable to these problems. Serious disruptions in power networks were experienced in Europe as well in 2003. Problems could be addressed to the extremely warm summer weather. Four massive blackouts at the end of August and in September in the UK cannot be attributed to weather-related causes. Despite the fact that the causes of these power outages were varied and, to a certain extent, quite complex, they clearly underlined one important point:

sufficient investments must be decided on and made in due time in order to stabilize and secure the supply of electricity. This aspect must also be borne in mind in the course of political efforts to liberalize electricity markets and regulate transmission networks [Pric04, Pool02].

3.2.3.1 Required Excess Capacity

Electricity has specific attributes which make it difficult to compare with other goods. Electricity is a non-storable commodity [Vrie03, Wiki04]. Therefore balancing supply and demand is needed continuously, virtually in real time with the help of modern technologies [GAO04]. If supply is smaller than demand the results are brownouts or, worse, blackouts. It is not possible to produce more than is consumed, unless you store it in a battery which is not a commercially viable way. As a result there is a need for accurate demand forecasting to predict the outcome [Mell01].

At the Energy Exchange Austrian (EXA), an electricity spot market, market participants, like EON and others use an electronic trading platform with an auction system for trading electricity. Trading activities are more efficient, because of the use of technology, in closing deals in real time rather than in bilateral trading. Industrial companies need high levels of security of energy supply. Before deregulation this was met by a single supplier who also had to carry the difficult to forecast energy balancing risk. Soon, in order to save energy costs, industrial customers will have to forecast their electricity requirements intensively - mostly by the hour - in order to buy electricity in a demand-oriented way. An important consideration is that suppliers can set prices for supply of electricity with specific characteristics - such as continual band supply - at a substantially lower level than that for supply under a conventional full supply contract. When demand is greater than forecasted electricity consumption, on the next day settlement for the difference may then be made up at the energy exchange. This allows the industrial company to buy additional needed electricity volumes without losing time and still be assured of a fair price, namely the market clearing price. Companies with their own generation have even more scope for optimization. If the plant is not run exclusively for own consumption, its operation can be closely geared to market prices. When market prices are high electricity production can be raised and any surpluses sold at the exchange [EnEx04].

In order to balance supplies into a network to meet the needs of ever-changing demand and the inevitable supply disruptions, there needs to be a factor that serves as a buffer (or “inventory”). This buffer is the excess capacity to produce. It is not only the generator that must have the excess capacity, it is the transmission network as well that needs an excess. A fundamental feature of electricity markets is the requirement to construct and maintain extra capacity for generating electricity [Capg03].

Excess capacity is necessary for short-run balancing and for meeting expected and unexpected spikes. An unexpected climate condition, like a heat wave, can dramatically increase the demand for electricity. It is even more critical for the long- run social welfare because power failures can cost peoples lives if electricity is not available in emergency [Pool02]. As figure 10 shows, all countries have capacity margins for safety reasons and total generation capacity is always greater than peak load [Capg03].

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Figure 9: Peak load, installed & remaining capacity in 2002 [Capg03].

Figure 9 shows data during winter 2002/03 where in Scandinavia (Sweden, Norway, and Finland) bad hydrological conditions reduced effective generation capacities to a point where operating margins were dangerously low. Extreme cold spells in Europe in early January 2003 let to an enormous increase in demand. These poor conditions did lead to supply shortages and therefore higher electricity imports. Peak loads increased, compared to the winter before, more than 10%.

Denmark also experienced an increase in peak load of about 8% [Capg03]. The UK also experienced several blackouts with complex causes. Like Scandinavia, it operates a system of self dispatch where participants themselves decide which plant should run, with the system operator intervening only where necessary. The system operator is responsible for signaling the expected capacity margin to participants, and can also procure additional capacity via reserve contracts. This latter mechanism was used in Sweden to encourage generators to bring plants out of temporary mothballing. France, Germany, Spain and Italy had actual capacity margins below 5% in 2001/02 but are now up at around 10%. The target percentage for the EU is 15%. It is always a worrying situation when excess capacity margins are too low because you have to consider the time needed until new capacity is available [Capg03b].

Figure 10 shows countries within Europe that can be segmented into three groups: In the first grouping are the countries, like Belgium and Greece who cannot guarantee the stability of their system alone and must rely on imports. The second group includes Germany, France, Italy, Spain and Portugal, which have a moderate level of excess capacity, though not enough to meet peak demand. Thirdly we have Netherlands, Switzerland and Austria, each of them has significant levels of excess, even overcapacity [CaGe02].

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Figure 10: Minimum remaining capacity versus capacity margin [CaGe02].

During the winter 2001/2002, operational margins of less than 5% were observed in several European countries. Set against a typical target for a 15% operational margin, this represented a very tight situation [Capg03]. This surplus generating capacity of some 10 to 15% is expected to disappear within a few years [MaJo01].

3.2.3.2 Generating long-term capacity

Demand for electricity grows over time in a relatively predictable and stable manner. Supply of capacity grows in a very pronounced step-wise fashion [Crow02]. There are long lags between the planning, construction and then the bringing on line of new capacity, therefore careful demand forecasting is essential. A level of investment in generating capacity needed to ensure social welfare must be ensured in the marketplace [Mell01].

As shown by de Vries, electricity markets have several weaknesses that may cause the investment to be below that which is optimal. [Vrie03]. One of the weaknesses is the fragility of the optimum. It is susceptible to cyclical disturbances thus is easily disturbed. Another is the market’s vulnerability to price manipulation. Regulatory uncertainty and related price restrictions also add to investor uncertainty and thus to the risk premium required by the investors [Vrie03].

The market is also subject to non-market interferences. Price ceilings or caps, administrative or emergency rationing protocols, and others were used under the regulated monopoly situation and have been kept under the reasoning or justification of overcoming market imperfections. There also are restrictions placed on generation and distribution because of the physical nature or special stability needs of the network. All these regulations and restrictions may impact the de- regulation in a negative way. They may also impact the incentive to invest in a negative manner as well [JoTi04].

As stated earlier, there is a need to understand and to account for the lags that exist from the time the need for more productivity capacity is recognized to the planning, construction and actual bringing online of the new capacity. The longer the lags, the more excess capacity will be needed to exist in a market that is as critical as the power supply market. Thus, having productive capacity greater than current demand is a necessity [Haas03b].

Demand rises in a more linear way than capacity, which rises in steps. Some economists believe that the generation segment of the electricity industry can include a larger number of smaller suppliers thus making for more competitive markets. Though even these economists believe the distribution system needs to stay a regulated industry [SaNo01].

3.2.3.3 Cross-border transmission

The European Commission promotes cross-border transmission (interconnector) to increase competition among EU members. The target level is 10% of peak load from each member as an import capacity. It is facilitated by subsidies up to 20% of the total capital investment cost on certain key interconnectors of wider EU interest under the Trans European Networks (TENS) initiative. Its aim is to push wholesale electricity trading between countries. But on the other side it contradicts the market-based philosophy of the Directive by using central planning as a method for identifying and funding cross-border electricity transmission infrastructure investment [Bowe03].

Transmission prices are fixed and therefore not volatile, but prices differ within different areas (up to 15 areas depending on the voltage level). The pricing system gives no locational signals for new generation. Therefore generators have no incentive for efficient location decisions [Verb04].

Three conditions must be met in order to connect the electricity networks by building interconnectors:
- Firstly, differences in the price between the host and destination markets need to exist and need to be significant.
- Secondly, the markets must be functioning markets. They must be able to respond to changes in supply and demand forces.
- Thirdly, there needs to be guarantees of supplies to justify such an investment in the interconnectors.

As in the case with generating capacity, there can be significant lags from the conception or planning period to the actualization or commercialization phase of the new interconnectors. In the European Union this lag is a decade or more [Bowe03]. The changes in electricity trade in reality are, to varying degrees, severely restricted by current cross-border transmission line capacities, or connection capabilities, which are unlikely to be substantially increased in the near future due to their high capital intensity (and the related high investment risk). Another restriction is the market directives and rules, which may need to be changed. It took almost a decade of discussions and meetings to address the interconnection problems among England, Wales and Scotland. Market access rules will be critical to the success of interconnector investment. [Capg01].

3.2.3.4 Renewable energy sources

Meeting the EU energy demands requires the burning of fossil fuels or generating nuclear energy. Appropriate energy can be generated from natural forces, such as the sun (with photovoltaic cells), wind, ocean tides, and geothermal heat. Fuel is also available in plant biomass and organic waste. Burning fossil fuels contributes to climate change. Oil, gas and coal are used in power stations to generate electricity. Nuclear power stations use uranium to generate electricity via controlled nuclear fission.

Renewable resources offer some of the best environmental options, but these technologies need to be further developed. Electricity from renewable energy sources, like solar, hydro, wind and biomass, (also called green electricity) is seen as clean fuel. This is because in the production process the emission of CO2 Carbon dioxide is either zero or in the case of biomass, neutral. That clear environmental advantage of renewable-sourced electricity, together with the increased diversity of supply has initiated the promotion of electricity from renewable energy sources as a high priority of the EU. The goal is to increase the share of renewable energy sources in the total fuel mix because they do not add to the greenhouse effect and can be secure, indigenous source of supply.

Reacting to the agreement in the Kyoto protocol the EU aims to raise the percentage of renewable energy in the total energy supply from the current 6% to 12% by 2010. Much of that green power capacity, such as wind farms is uneconomic at current market prices. Though the energy resources are practically free of charge, the technologies to convert them into useful energy are still extremely expensive. Wind and sunlight have the potential to help meet the European Union's electricity needs without adverse environmental effects associated with other energy sources [Econ04]. Figure 11 shows a current overview of the OECD countries using four different kinds of fuel for generating electricity.

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Figure 11: OECD electricity production by fuel [IEA04].

These four are: Hydropower, geothermal, nuclear and combustible (coal, oil, gas, biomass) fuels. Geothermal includes also others which are wood waste, wind, geothermal and solar. Combustible fuels are comprised from animal products, gas/liquids from biomass, industrial waste and municipal waste. Biomass is defined as any plant matter used directly as fuel or converted into fuels or electricity [IEA04].

3.3 Impact on Industry Structure

Restructuring goals are to increase competition through an increased number of buyers and sellers. Current information is provided which will enable customers to make their choices. Consumer benefits could be in form of lower prices, access to new online services, increased efficiency, and more innovations. Electricity restructuring is changing the sector while opening generation and transmission lines to competition. As a result multiple entities interact to perform the key functions needed to deliver electricity to consumers. Increased merger and acquisition activities within the electricity markets are a result [GOA04].

3.3.1 Restructuring

The intention of the European Council Directive was to deregulate the strongly- regulated electricity markets and develop a single European market for electricity, hoping that competition would result in lower overall costs and more innovations over the long run. As an outcome of this Directive, the electric power industry is in transition as it moves toward a competitive environment in the wholesale and retail markets. As figure 12 shows not all countries are at the same level of electrical competition [FINE03].

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Figure 12: Status of Europe electricity liberalization [FINE03].

So far only Austria, Denmark, Finland, Germany, Norway, Spain, Sweden, and UK have developed a market liberalization completely yet. Ireland, Italy, Netherlands and Poland have partly liberalized electricity markets [FINE03]. This transition includes moving from a highly regulated, where local monopolies provide customers with a full package of all electric services towards the development of competition among the participants [CaGe03b].

Transmission and distribution will remain regulated functions with rules to assure open access to lines for all competitors [Crow02]. The electricity market liberalization, like in other network-based industries, initiated substantial structural changes and consequences in the European countries. The impact this has on the electricity supply sector are often hard to predict because it depends on different factors and conditions that vary throughout the EU countries [CaGe03b].

European Energy Market Deregulation Observatory (EEMDO) monitors the deregulation of the electricity markets in the European countries. Findings show that it will take time and effort till the electric sector passed the transition phase to competitive markets and receive the advantages of the benefits of deregulation. Power shortages in California, Norway, Sweden, Brazil, New Zealand and most recently, Italy, show possible side effects of intentions for ongoing restructuring. The reasons for the shortages differ widely due to specific circumstances in those countries. The social cost of electricity shortages to businesses, households and other institutions is very high [CaGe03].

The nature of cross-country issues is complicated due to the necessity to get multiple parties to agree. This is never the easiest of processes, especially since there is no pan-European regulator. The slow progress is also a reflection of the absence of standardization across European markets. The incentive to participate in multiple markets should include benefits like reduced costs, reduced IT development and maintenance costs for an outcome. The data transfers and operational processes can be managed to be more efficient as well as a better alignment of inter-market trading rules. Overall, these specific benefits should contribute to greater liquidity and enhanced security of supply for the end consumer of electricity [Capg01].

Competitive markets are expected to encourage investments in new electric generating capacity to meet growing customer needs [Crow02]. These evolving markets are also expected to ensure that sufficient future capacity will exceed the projected peak demand. The extra capacity is needed to act as a buffer against unexpected increases in customer demands and losses of generating supply due to events like equipment outages, which might cause electricity blackouts. Since blackouts are costly and security of supply at all times is critical, electricity companies merge together or acquire competitors to be able to provide service at all times and gain market power [GAO04].

3.3.2 Mergers and acquisitions

Faced with a combination of regulatory and competitive pressure to improve efficiency, companies consider consolidation as a means of reducing costs. The challenge for players is to deliver value through this process. The challenge for regulators is to balance this trend, and its associated benefits, against the emergence of oligopolies that would limit competition [Bowe03].

Continuous increases in size can be found as the European electricity market becomes more concentrated In general the main purpose of the M&A activity and the creation of alliances is to increase the size in order to achieve the economies of scale needed to survive in the increasingly competitive European generation and supply markets. The generation sector is highly concentrated across the EU with only a few competing firms and close to monopoly conditions. This industry concentration is crucial because it determines the extent to which the generators can exercise their market power [Bowe03].

Regulators and domestic competition authorities continue to encourage dominant players to reduce their market share to less than 40%. However there are continued consolidations, mergers and acquisition activities at national level ongoing. In their balancing areas companies belonging to the two German RWE and E.ON groups hold a very strong position in the power station sector due to their own production capacities and long-term supply contracts with operators of power stations. An increase in the concentration ratio is observed as the large sellers gain in market position and prominence [Cern02].

Over recent years, however, the merging and takeovers of companies were resulting in the concentration of the market to a small number of companies (EDF, EON, REWE, and ENEL). The avoidance of market dominance is of particular importance in this sector as electricity cannot be stored and the potential to exercise market power is much greater than in other commodities. There is an increased danger of increasing monopoly building and exercising market power [Haas03a]. The importance of this phenomenon has been highlighted during the crises in California in chapter 3.2.

Figure 13 shows an overview of the large electricity companies measured by electricity sales during 1998-2002. [Cern02].

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Figure 13: Electricity sales of market leaders in Europe [Cern02].

Firstly, the UK electricity provider EDF Energy is the largest energy company by sales. It generates electricity for over 5 million customers. They are one of the few vertically integrated companies, which mean they have expertise in generation, transmission, and distribution. They run power stations and wind farms and also buy and sell power on the wholesale markets to fulfill the needs of their generating plants. In the last five years they transformed themselves into a major energy player with the acquisition of the supply businesses of power stations and network businesses [EDF04].

The second leader by sales is the new German RWE Power AG created from the merger of RWE Rheinbraun and RWE Power, ranking second among Europe's largest power producers in 2002. International activities of the company, especially in Norway and Egypt, but also in the UK, Kazakhstan, Poland and Denmark, are being pursued in cooperation with competent partners [REWE04].

In Germany, privately owned E.ON Energie is Europe's third largest provider of energy services and operates in the field of power generation, transport and distribution both in Germany and Central Europe. E.ON Energie's main operations are in Germany, Poland, the Czech Republic, Slovakia, Hungary, the Benelux countries, Austria, and Switzerland [Eon04]. ENEL, the leader in electricity generation in Italy is the fourth-largest electricity producer in Europe [ENEL04].

Vertical integration remains the dominant strategy for European utilities, and portfolios with strong positions in both generation and network capacity look like they will continue further. On a regional level Germany's dominant players are EON and RWE. Trends show several acquisitions also in Finland and Netherlands, trying to secure direct access to local customers and reinforcing a presence in distribution assets to provide continuous electricity flows [Cern02].

Renewable energies, like solar and wind power, are treated as specific market and receive special subsidies from the EU to increase the market share of green energy. European wind capacities are mostly concentrated in three countries Germany, Spain and Denmark representing 85% of the total European wind capacity. Wind power capacity is representing about 30% growth per year and has been exempted from the deregulation market [Capg03].

Europe is part of worldwide fast changing processes due to existing deregulations of utilities in the electricity supply sector. Because of overlapping supply areas the interface to the customer becomes increasingly important. In the future, the development of market power depends on how well the organizations can establish long lasting relationships with the customers. On the other hand the electricity company must find ways to position themselves on the markets by restructuring their processes with the use of IT systems in a more efficient way. Coinciding with new market participants from outside or inside the country, established electricity providers are part of takeovers. An increase of market position is the intention when thinking about co-operations [Capg01].

Networking in meshes (electricity lines and plants) remains high in demand and each network participant is using its local strengths by concentrating on core competencies [Capg01].

As figure 14 shows, in 2002 companies have sought to gain an optimal degree of vertical integration (40%) in their structure, between retailing at one end and generation and production at the other end. Horizontal integration is second with 29%, new market entry thirdly with 17% and the convergence of electricity and gas (14%) is on fourth place seen as a driving force behind merger and acquisition activities [Pric04].

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Figure 14: Power deals 2002 [Pric04].

The restructuring of the electric power industry is on its way to transform the historically monopolistic industry into one that will have increased competition in its generation and retail sales components, thereby changing the way electricity is priced, traded, and marketed [GAO04].

4 Austrian electricity market

In this chapter we present and discuss the liberalization of the Austrian electricity market with the introduction of the structure, market access and players, generation, fuels to produce electricity, results of price reductions, unbundling, and the foreign involvement in Austria.

4.1 Deregulation

The Electricity Directive 96/92/EC was first made into Austrian law with the Electricity Act (ElWOG Electricity Industry and Organization Act) in 1998, which opened the Austrian electricity market for a part of the customers. The amendment to the Electricity Act in 2000 completed the hundred percent market opening effective as from 1 October 2001. Based on the legislation regulatory authorities in the electricity sector have been set up for the regulation and monitoring of the difficult development from a monopoly market to a fully liberalized electricity market [Econ04].

The Austrian electricity market has been open for full competition for almost four years. Liberalization delivered to some segments what customers were looking for. Electricity prices have decreased as energy users were given the power to negotiate. Nevertheless, not every consumer segment was pleased equally. Whereas large companies could significantly cut their electricity costs, households were left with very little savings [HaHu02].

4.2 Market access

The Austrian Electricity Regulator, or E-Control, is responsible for fair market entry issues, and therefore, access to the electricity market in Austria is still dominated by a strong governmental influence. The following authorities are responsible for the liberalization process:
- Federal Ministry of Economic Affairs and Labor (BMWA): The BMWA is the main body responsible for energy matters on the federal level. Other ministries play a minor role in energy policy matters.
- Electricity Board: The Electricity Board is the advisory body to the Federal Minister for Economic Affairs and Labor and develops proposals for tariffs, by-laws, and other energy related matters.
- Austrian Electricity Regulator Commission: This commission is an authority responsible for jurisdictional matters. It consists of three members, and settles disputes between market participants and issues notifications accordingly.
- Austrian Electricity Regulator Authority ("E-Control"): E-Control is
responsible for monitoring, supporting and regulating the liberalization process. The major functions of E-Control are the monitoring of a fair form of competition, guaranteeing the necessary transparency of the liberalization process, and ensuring collaboration between all market participants [Econ04].

4.3 Participants

The Austrian Electricity market has nearly four million customers (three million households, 150.000 farms, 19.000 industrial and public sector customers and 730.000 other commercial customers). In 2000 the annual total electricity consumption amounted to 50,7 TWh and is expected to rise to 63 TWh by 2015. [HaHu02]. Producers, like Verbund, EVN, STEWAEAG, and Wienstrom are making up the wholesale market with new suppliers, like Energiea, My Electric, and others. The retail market is made up with suppliers (Wienstrom, EVN) and the end consumers (industry, commercial, public sector, private households) [HaHu02].

The VERBUND Austrian Power Grid is the country's largest producer and distributor of electrical energy. The company operates the Austrian super-regional, high-voltage grid with important connections to neighboring countries in Central Europe. It generated sales revenue in the amount of $1.15 billion in 2001. Within the EU, the Verbund has a reputation of a very eco-friendly electricity generator. The structure of the Austrian electricity market is divided into an eastern controlled area and a western controlled area.

Figure 15 shows the different retail market participants who were state-owned and often of political interest to the region. Austria's provincial power providers are (from west to east): VKW - Vorarlberger Kraftwerke, TIWAG - Tiroler Wasserkraft, Salzburg AG, KELAG - Kaernten Elektrizitaets AG, Energie AG - Upper Austria, STEWAG - Energie Steiermark AG, EVN - Lower Austria, WienStrom - City of Vienna, and BEWAG - Burgenländische Wasserkraft [Hahu02].

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Figure 15: Austrian electricity market structure [HaHu02].

In 2001, Wienenergie, EVN, Energie AG, and BEWAG did establish a strategic alliance through cooperation given the name “Energie Allianz” (see blue area in Figure 15), which successfully strengthened their dominant position in the consumer market in the Eastern control area [Hahu02].

Before liberalization generation and importing was mainly run by Verbund, and distribution by the provincial and municipal electricity utilities. Apart from the larger companies, there are many smaller ones in Styria, Tyrol and Upper Austria. Despite a number of mergers, there are currently some 135 grid operators in Austria. There are 150 distribution networks/operators and a strong interconnection and exchange with Germany. It is anticipated there will be future interconnection needs in the south, with Slovenia (Austria's "gateway" location in central Europe can be a benefit to companies working from here into the region) [Econ04].

4.4 Generation

The vast majority of electricity is generated by Verbund, which accounts for almost 50%, secondly by provincial utilities with about 27% and others. Verbund is running hydro-power plants and is operating the high voltage transmission network. Nine provincial and several municipal utilities of the provincial capitals and smaller private utilities are serving local customers. Verbund and the German generator EON operate together as the European Hydro Power company taking advantage of each others hydro-power plants capacity. A co-operation like this has an impact on the retail market because they are controlling the majority of the generation capacity and are major suppliers of electricity preventing other companies from entering the supply market [Hahu02]. Figure 16 shows the electricity lines and generation plants in Austria exhibiting a surplus of generation in the northern part and a under production of electricity in the southern area of Austria [Haid04].

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Figure 16: Electricity lines and generation plants [Haid04].

Electricity generation costs depending largely on the type of generation (nuclear or hydro power) and the age of the capacity. There must be distinguished between fixed (cost of building the plant and financing the investment) and variable (maintenance, fuel and operation costs) costs of production. The age of a power station influences variable costs to the extent that newer thermal plants tend to covert energy more efficiently. Hydro power stations are often operated far beyond their statutory depreciation periods. This can make hydropower generation a highly profitable business. There are often trade-offs between the fixed and variable costs. While hydro and nuclear power stations are expensive to build, they have low operating costs. In reverse, the construction of oil and gas fired plants is relatively cheap, but the high cost of the primary energy sources means that they are more expensive to operate.

Once a power station has been built, in the short term, whether or not it will be operated depends on whether the market price for the electricity is sufficient to cover at least the variable costs. If this is not the case, no power will be generated until market prices reach the necessary level [Econ04].

4.5 Fuels for generation

Austria depends heavily on hydro-power production, whereas fossil-fuel plants are used merely as back-up system in times of unexpected high power demand or low river flows. This leads to a considerable amount of fossil-based reserve capacity which is a kind of stand by capacity. This is relatively expensive because excess capacity is relatively expensive to have, but is difficult to reduce. The level of reduction possible depends on the market situation which involves a level of uncertainty making predicting difficult. Market influencing factors are, demand growth, rising fuel prices, change of options for the electricity imports, and transmission capacity constraints [Majo01].

With regard to the overall electricity consumption in Austria, around 70 % is generated by hydropower plants. Some power imports are used to balance the seasonal variations of demand during peak demand in winter when water supply is low. Power imports usually come from Hungary, the Czech Republic and Germany. During summer excess hydropower is exported to Italy, Slovenia and Switzerland. The second largest fossil fuel to generate electricity is natural gas. [HaHu02].

Using renewable sources of energy for electricity generation is a key objective for Austrian as well as European energy policy and represents a significant contribution to protecting against climate change (greenhouse effect) and reducing dependency on imports as well as promoting the opportunity to use domestic potential for producing electricity. The utilization of renewable sources of energy

usually involves higher costs and depends therefore on state support. Under the present system, network operators will retain the ability to accept or reject renewable sources of energy. The extra costs resulting from this system will be covered by a surcharge on the transit fee payable by all electricity consumers.

As of October 1, 2001, at least 1% of retail power needs to come from renewable energy sources. This percentage will be increased gradually until it reaches 4% by 2007. Network operators will have contractual obligations with guaranteed minimum prices set by regional governments. The regulator has the supervision over this process. Combined heat and power stations will be subsidized according to regional laws until the end of 2004 [Econ04].

4.6 Balancing

By nature, most electricity systems lack storage for all practical purposes, and the electricity markets experiences volatility due to the need for continuous balancing of demand and supply. Volatility in the electricity market is rooted in hourly, daily, and seasonal uncertainty associated with fundamental market drivers and the physics of generation and delivery of electricity. As it is impossible to store electricity efficiently, the power generated must always correspond to demand at any given point in time. Balancing energy is used to balance the supply and demand within an area [Econ04].

To balance the electricity market the control area manager needs generating capacity that is available at all times. This capacity (minute reserve) is procured via the balancing group coordinator from the balancing market. Balancing groups, with dispatchable capacity, give in their daily offers. The balancing group coordinator compiles a merit order list, ranking capacity in order of the prices offered and bid. The control area manager can then dispatch balancing energy in order of the merit, if necessary. The balancing markets are currently limited to the control areas. There are three control areas with control area managers: Austrian Power Grid - APD (also a control block); Tiroler Wasserkraftwerke AG - TIWAG (part of the German control block); and, Vorarlberger Kraftwerke AG - VKW (also part of the German control block) [Econ04].

The settlement of balancing the energy costs is performed by a way of a clearing process, on the basis of prices established at quarter-hourly intervals. Figure 17 shows a load curve from March 2004 representing the temporal development of the domestic supply in quarter-hour increments.

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Figure 17: One day of electricity demand in Austria [Econ04].

The load is the technical term for total demand for electricity. The lowest demand is observed around 3 a.m., and then a steady rise starting at 5 a.m. with a peak around 8 a.m. when most households and businesses start using electricity the most. There is a continuous use of electricity throughout the day with another peak at 7 p.m. in the evening and then demand is falling until 10 p.m. A slight increase around 11 p.m. and then demand is decreasing again throughout the night till the next day starts [Econ04].

The domestic load curve comprises the sale to consumers, grid losses, and the consumption of auxiliaries covered by the grid. The domestic load curve roughly corresponds to the domestic electricity consumption [Econ04].

4.7 Unbundling and price

In the Austrian electricity sector only the transmission and distribution segments are considered natural monopolies requiring continued state regulation [Econ04]. Austria has opted for a regulated TPA (Third-Party Access) to the network as its legal obligation to provide network access under non-discriminatory conditions. There are still some vertically integrated companies operating on each level of the whole value chain. Austrian electricity industry is operating mainly in generation and transmission. Several provincial and municipal utilities operate in distribution and supply segments. Distribution network charges have been very high and vary up to 100% across the country. Regulators, like E-Control, try to give subsidies for increasing operational efficiency and reducing network tariffs [HaHu02].

During liberalization price reductions averaged around only 12% not including taxes. This relative low price drop is due to the current structure of the electricity price. Figure 18 shows the current structure of one kilowatt hour (KWh) of electricity charge for households. A domestic customer pays a total of 14,72 cent per KWh in the retail market. Included are the fee for energy (20%), grid operator charge (51%) as well as taxes and surcharges (28%) that are paid to the government [HaHu02].

Figure 18: Structure of domestic electricity prices [HaHu02].

That expresses the result that even large price reductions have only a little impact on the overall electricity bill. In 2000 the Austrian government increased energy taxes by 100% limiting the savings through price reductions even more. For example a family consuming 3.500 KWh per year ended up with savings of about

20 Euro in a year [HaHu02]. In 1999, wholesale prices dropped by 50 percent. Rates increased slightly in 2000, but they are still 30 percent below their 1998 levels. End users rates have decreased only recently, because consumers have been free to choose their own supplier only since October 1, 2001. "ElectricityPools" aggregate demands for customers with similar interests and allows the reduction in purchase prices by 10 to 15 % [Econ04, Haas03a].

Before liberalization the price was set by the Minister of Economic Affairs and Labor at levels which allowed companies to cover their costs. There were not many incentives to identify and exploit potential efficiency savings. Electricity markets were set up as geographically demarcated areas where no direct competition was in place. Liberalization broke up old vertical integrated industry structures according to the requirements set in the EU Directive [Econ04].

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Figure 19: Domestic energy prices of network areas in Austria 2003 [Econ04].

As shown in figure 18 and figure 19, price savings to consumers due to efficiencies in the liberated areas are very limited in opportunities. Over half of the cost of a kilowatt hour of electricity is taken up by the transmission segment [Haas03a]. This segment retains a monopoly position. Almost 30% of the cost of a kilowatt hour of electricity is comprised by taxes. This means that only 20% of the cost has been liberalized and possesses the power to gain market efficiencies. For instance, improving efficiencies by 10% will lead to a mere 2% reduction in the cost of a kilowatt hour to the households. Even this savings would be offset in part by the increased number of government agencies overseeing this new market structure [Econ04].

4.8 Foreign involvement

The Austrian electricity sector is dominated by cross shareholdings, which are one way to obstruct outsider takeovers. By liberalizing the market, the value-added chain was divided into monopolistic and competitive areas of operation. The distribution and transmission network remains, due to the high fixed costs, still a natural monopoly [Haas03a]. Generation and the retail sides have been opened to competition. Verbund is Austria's leading electricity company, and is the largest producer and distributor having important connections to the neighboring countries in Central Europe like, Germany, Poland, Slovenia, Hungary, Czech Republic, Italy and Spain [Verb04].

Figure 20 shows an area overview of the wholesale partners and distribution partners of Verbund in Europe.

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Figure 20: Electricity wholesale market partners [Verb04].

Cooperations between regional and national companies as well as municipal and provincial utilities are joining forces to gain efficiencies. Salzburg AG was formed by the successful merger of a former provincial and a municipal utility. Tyrolian Electricity Company TIWAG and EON established partnerships to control the Western areas together. Outside the cooperations, the companies are expected to remain independent. The following foreign companies are holding stocks of Austrian electricity companies: RWE, EON and EnBW Energie Baden- Württemberg AG (all from Germany) and EdF in France [HaHu02, Econ04].

Electricite de France (EdF), which managed in the last few years to get a presence in some of Europe's most significant markets, holds a 25% share in the Austrian "Estag", in the province of Styria. The German E.ON and the Austrian Verbund cooperate on the "European Hydro Power" merger which would combine Verbund's and E.ON's hydropower stations. REWE acquired 49% of Carinthia's Energieholding company which controls the southern region of Austria. It acts as a starting point for REWE to have access to the domestic retail market [HaHu02].

Before liberalization, all the business was conducted directly between buyers and sellers. Market opening allowed the emergence of exchanges enabling new actors (international trading companies and banks) to enter the wholesale market. Anonymous exchange trades resulted in increased transparency of transactions with regard to price information influencing market prices in general [Econ04].

Finally, the Austrian-wide grid in the center of Europe constitutes an important center point in the international power exchange and power electricity trade. Austrian Power Grid AG (APG), Austria’s leading electricity transporter, and Austrian Power Trading AG are the internationally-active wholesale and trading divisions of the Verbund group. Their core business is trading in over-the-counter (OTC) electricity markets and on international power exchanges. The Internet distribution channel www.austrian-power.com is used to trade with others on the wholesale electricity trading markets. Verbund is the first supplier in the EU to offer innovative, independent Internet power selling to industrial customers [Verb04].

5 Conclusions

Liberalization aims to allow market forces to operate more effectively. There are many different ways to address liberalization processes but it is usually efficient to revoke rules and regulations that restrict competition. Deregulation and new wholesale electricity trading markets, which were previously nonexistent, are now operating in many regions of the EU, and they create new opportunities. Establishment of viable markets gives rise to threats and challenges. The vertical integration to achieve scale economies was echoed in the merger and acquisition activity throughout the past years.

The drive towards even bigger size is a key factor motivating additional merger and acquisition activity. A wider customer base and geographical expansion influence the merger and acquisition activities of European utility companies. Increasing regulations and obligations together with continuing wholesale price volatility top the list of factors that will have the most impact upon the European utilities boardroom over the next five years. Power cuts in the US, UK and Italy acted as a wake-up call for the electricity sector. Investment in new transmission and generation is required and companies believe governments and regulators need to support them [Crow02].

The old, monopolistic position of the electricity utilities prevented Austrian customers from choosing freely from where to obtain their electricity. With the 100 percent liberalization of two of the segments of the electricity market in Austria, consumers now have the chance to choose their supplier. Competition will increase, which should decrease prices [HaHu02].

The results of the analysis of the Austrian electricity market show that obviously the price cuts in the industrial rates were compensated by higher electricity prices for households. In general, price savings to households may be negligible, however, due to two key factors. The transmission segment was granted a monopoly position. Their monopoly protected high transmission costs account for more than 50% of the price of electricity Another 30% of the price of electricity is due to high government taxes. Both of these factors will act to minimize any price savings to the households.

5.1 Future work

In some areas, deregulation has been followed by re-regulation [Haas03a]. While evidence has shown that government enterprises are generally less efficient than private enterprises, there are some exceptions. Certain French public enterprises including the French Electricity Company are more efficient than their private counterparts in the United States [Stig00].

An alternative to polluting fuels, such as would exist with an increasing dependence on foreign oil, is to explore and utilize renewable energies, which are environmentally cleaner, though these are considerably more expensive in cost. Only 14% of the world power is currently provided by renewable energy sources. The development of renewable energy sources is one of the clearest environmental pressure points by regulators on utility companies.

The expected benefits of changes in consumer behavior also will need to be explored. There are very few possibilities of altering demand, or modifying behavior, in the short run. Demand is not very price-elastic in the short run, especially since electrical costs are such a small part of the budget [Vrie03].

Is it possible that a two meter solution would be a better modifier of behavior than an uncertain price through an auction? Introducing a second meter at properties for a dual pricing system, peak and off-peak pricing was accomplished in the United States quite successfully even before deregulation. Moreover, this lead to behavior modification, something necessary to make the new habits of usage become old habits, and at a significantly less degree of complexity. Businesses and households reduced peak usage and increased off-peak usage in the United States [DoKl02].

The lack of viable markets with significant numbers of participants and trading, especially wholesale markets, means that there are insufficient market indicators for future needs and trends. We do not have good price signals in place. The question here is related to the demand and the need for long-term supply security and short term price and supply volatilities. There are also concerns that price changes may be due to market manipulation as well as to fundamental factors. The inclusion of gas, and its convergence with electricity at the point of production, creates a new dynamic to be taken into account. Along with this should be a study of the impact of renewable energy sources. Perhaps industrial, commercial and even residential users may produce more of their own supply. Solar power, windmills, and other own generating capacity mechanisms are examples of what are now being used [EC04].

A successful electricity industry must deliver a continuous equilibrium between supply and demand of electricity while also allowing for competition between different generators and suppliers. In addition to the market opening measures already in force, deregulation and competitive forces may need to be established in the monopoly transmission segment which comprises over 50% of the cost of a kilowatt hour of electricity. Along with this governments may want to look at reducing the taxes on electricity. This would reduce the costs of doing business and may increase employment. Lower costs for electricity may also increase the utilization of air conditioning which may improve quality of life for households.

Finally, there are some central issues to social wellbeing objectives, such as the appropriate incentives to invest in both transmission and distribution networks, as well as for demand management or electricity generation [Haas03b]. Without such investments the reforms of the electricity sector will not succeed and there will be an increasing risk of interruptions if demand for electricity continues to grow at its current rate and the strain on the network increases.

6 References

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