EU Energy Policy Blog

Until now the European Union has relied on standard competition rules to deal with abuse of market power in the generation sector. We argue that relying only on general competition rules is insufficient to address those concerns, given the specific characteristics of the electricity market and the high level of concentration in some segments. As a complementary ex ante regulation, we suggest regulators should incentivize firms to sign contracts with retailers by regulating their contract portfolio risk exposure, i.e. a capital adequacy requirement should be imposed.

One of the arguments that standard competition rules are largely insufficient in the electricity sector for the following reasons:

(1) Article 82 only applies when a firm is dominant. Legally, this is the case when a firm has the largest market share in the relevant product market. However, the technical characteristics of the electricity sector make it possible for relatively small players to abuse market power. Hence, even if firms do not have a dominant position in the strict legal sense, they might be able to abuse market power.

(2) It is hard to legally define “abuse” in the electricity sector. In contrast with other sectors, abuse of market power is not always related with specific practices, but rather with selling too little at too high prices, or taking too much time for maintaining a plant.

(3) Even if abuse and dominance have been established, effective structural remedies might not be available to the judge or regulatory body. Often the only feasibly remedy may be to impose regulation.

(4) The judicial process if often too slow to deal with market power in the electricity sector. It might be hard to undo the transfers to market power abuse which went on for years. The size of these transfers is a lot larger than in most other sectors due to the inelasticity of demand.

A form of a priori regulation is therefore required to address market power of generation companies.

In a recent paper, we suggest that, complementary to the existing competition rules, the regulator should imposes a capital adequacy requirement on generation firms that is based on the riskiness of the firms’ contracting portfolio. As a result of this requirement, firms will sell more electricity forward to retailers (as it lowers the overall riskiness of their portfolio), and behave more competitively in the spot market (as they only compete for the contracted retail market). This regulation should take the form of a capital adequacy requirement similarly to the one used in the banking sector.

Such a requirement has several advantages:

(1) A capital adequacy requirement reduces market power and complements the existing competition rules.

(2) The requirement does not destroy economic incentives for production and investments decisions, unlike more direct forms of regulation by -for instance- a price cap.

(3) A capital adequacy requirement will oblige firms to be financially healthy and have a sufficient amount of liquid assets to deal with unexpected events. Such a regulation may therefore have additional benefits by increasing the security of supply of the electricity system.

A capital adequacy requirement also entails some risks with respect to market development, but those risks can be addressed if the regulation is carefully designed:

(1) Contracts between retailers and producers might form an entry barrier, which is reinforced by the capital adequacy requirement. However, national and European competition authorities are well equipped to address such concerns and to test which contracts are exclusionary and which are not.

(2) A capital adequacy requirement may distort the financial position of firms, if the regulation is too crude. In order to minimize this risk, we would allow firms to use their own risk analysis, and base the regulation on a general ‘Value at Risk’- measure, similarly to what is used in the banking sector.

Hence, we are confident that -with good designed regulatory frameworks- those risks can be addressed.

Nevertheless, additional research is required before the regulation can be implemented in practice. We propose the following regulatory changes to introduce contract portfolio regulation:

• Firstly, generators should be obliged to analyze and report their contract position and risk exposure. Sector regulators should obtain an additional role of oversight on the security of supply in the sector, and be able to put in place reporting requirements on the risk firms take, and regulations with respect to the solvency of market participants. The regulator should work in close co-operation with financial regulators, competition authorities, power exchanges and the network operator.

• Secondly, part of the monitoring role of the regulator should shift away from the regulator to the network operator and/or the power exchanges. As the network operator is responsible for balancing demand and supply, it has the right incentives to ensure that generation firms do not threaten system stability by taking too much risk. The network operator also has the capacities to deal with the large amount of data which are available in the market. This requires however that the network operator is fully independent of the generation firms.

The role of contracts has, to a large extend, been neglected in the European debate on market power mitigation methods. The aim of our paper is to emphasize the potential benefits of such a contract regulation compared with several alternatives, and to open the debate on its implementation. Can we improve the effectiveness of the existing national and European competition rules without relying on regulation? Is such a capital adequacy requirement feasible within the current legal framework? Are the existing risk models sufficiently developed to be used in regulation?

We want to stress that we do not believe that contract regulation can substitute for a sound market design and a lowly concentrated market structure. These two problems should be dealt with head-on, and require additional legislation at the EU- and national level. Instead contract regulation and capital adequacy requirements should become an extra tool for sector specific regulators and competition authorities at national and supranational level..

Bert WILLEMS and Emmanuel DE CORTE, Tilburg University

P.S. If you want to read more about this topic, please check-out our paper (restrictions may apply).

This entry was posted on Tuesday, September 9th, 2008 at 8:19 am and is filed under Electricity. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.