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A Vision for the EU Target Model: the MECO-S Model

August 23rd, 2011 by Jean-Michel Glachant, European University Institute

The discussion on a target model for European gas network access has been going on for a while now,officially starting with the conclusion of the 18th Madrid Forum in 2010 which invited ““the Commission and the regulators to explore, in close cooperation with system operators and other stakeholders, the interaction and interdependence of all relevant areas for network codes and to initiate a process establishing a gas market target model””.

The desired target model shall provide a unifying vision on the future layout of the European gasmarket architecture. That vision shall assist all stakeholders in quickly and efficiently implementingthe 3rd energy market package on the internal gas market in a consistent way.

The following text describes a proposal for the European gas target model with a special focus on market architectures and investment.

The proposed gas target model is termed MECO-S Model.

The MECO-S Model is a Market Enabling, Connecting and Securing Model describing an endstate of the gas market to be achieved over time.

The MECO-S Model rests on three pillars that share a common foundation, the latter making sure that economical investments in pipelines are realized:

Pillar 1: Structuring network access to the European gas grid in a way that enables functioning wholesale markets so that every European final customer is easily accessible from such a market.

Pillar 2: Fostering short- and mid-term price alignment between the functioning wholesale markets by tightly connecting the markets through facilitating cross-market supply and trading and potentially implementing market coupling as far as the (at any time) given infrastructure allows.

Pillar 3: Enabling the establishment3 of secure supply patterns to the functioning wholesale markets.

The MECO-S Model aims at the creation of a number of functioning wholesale markets within the EU (together enabling easy access to all European final customers of gas), at connecting these markets tightly in order to maximize short- and mid-term price alignment between those markets, at enabling secure supply patterns to those markets and at making sure that all economic investments in gas transmission capacity are done.

Pillar 1 shall realize the goal of enabling functioning wholesale markets. Such markets are an essential feature of the internal market since they contribute to efficiency in managing gas and gasrelated assets such as supply contracts, storage and gas-fired power stations. Additionally and no less important such markets are an essential basis for retail competition. Finally, functioning wholesale markets are a basis for market based balancing and market coupling. Without functioning markets, both of these concepts could not be harnessed.

Pillar 1 is realized by structuring Europe into markets that are sufficiently large4 and well connected to sources of gas5 so that the emergence of a competitive traded wholesale market is likely. Where necessary with a view to that goal, member states have to create cross-border markets in order to increase market size and connectivity. Two models are presented to realize these markets, both based on the entry/exit regime:

. market areas, that implement integrated balancing zones reaching down to the final customers;
. trading regions that implement integrated wholesale markets which are tightly connected to national end user zones.

Both models may be used in parallel in Europe, whereby the market area model appears attractive for larger member states and the trading region model has specific merits for smaller member states that need to cooperate cross-border in order to gain sufficient market size and connectivity.

Pillar 2 aims at maximizing the efficiency of managing gas and gas-related assets on a European scale by making sure that the existing interconnecting infrastructure is put to the best use. The resulting tight connection of markets will lead to price alignment6 between European markets as far as the –– at any time existing –– infrastructure allows. Price alignment virtually unifies all European markets by enabling cross-portfolio optimisation via those markets on a European scale. Measures are foreseen so that TSOs do not suffer any loss from price alignment.

Pillar 2 is firstly realized by implementing hub-to-hub transport products and a number of harmonisation measures that make inter-market supply and trading significantly easier. The allocation of hub-to-hub transport products shall be by auction for the mid- and short-term markets and by first come first serve for the intra-day market.

Secondly it is proposed to implement pilot projects for day ahead market coupling to explore if the theoretical benefits of market coupling can be realized in practice for gas. If so, day ahead market coupling would become an integral part of the MECO-S Model.

Pillar 3 aims at enabling secure supply patterns to the European markets. Specifically Pillar 3 creates the preconditions for underpinning long-term supply contracts with appropriate transport products, taking into consideration that currently about 30% of all gas consumed in Europe crosses more than one border point. Additionally pillar 3 aims at providing a market based solution for realizing transport security of supply where collaboration with adjoining markets is required.

Pillar 3 is realized by foreseeing the execution (if demanded by shippers) of new long-term transport contracts. These contracts can be requested periodically in an open season style process for the full term of interest to the shipper, e.g. 15 years. If in the process the demand for long-term capacity proves higher than the availability of such capacities, then capacities will be expanded by investment if economical. In order to allow for such investment, the lead time for allocating long-term capacity shall always be at least as long as the time required for expanding capacity. Since in this structure capacity can always be expanded, long-term capacity is not a scarce good anymore and auctioning of that capacity can be avoided. Allocation questions at the fringe of the allocation problem can be solved by an optimisation procedure.

In order to deal with shippers interested in long-distance transport (e.g. from a European border point to the next but one market) link chain products are introduced. Link chain products are packages of (hub-to-hub) transport products at several border points on a continuous route that may be requested by the shipper as a whole and are allocated at the same level of capacity on all requested border points. After allocation they may be used as separate hub-to-hub capacities.

In the area of transport security of supply the instrument of the fallback capacity contract is introduced. It provides a means for member states to secure that sufficient capacity in a neighbouring market is made and kept available in order to cater to the security needs of said member states. Under a fallback capacity contract a TSO (A) of the member state in need of redundant transport capacity (as defined by a competent authority) books the required capacity long term with a neighbouring TSO (B). TSO B charges to TSO A only that part of the capacity that is not booked by shippers directly with TSO B (hence the name ““fallback contract””). TSO A allocates the cost for this security measure to final customers in his market.

The common foundation of the MECO-S Model is economic investment. Investment aims at supporting the other pillars in realizing their respective goals e.g. in contributing to the creation of functioning markets (by new interconnection to these markets) or in contributing to improved price alignment between markets (by new/expanded interconnection between these markets). Several issues are discussed in the study regarding investment including the structuring of investment appraisal processes, the evaluation of investment in interconnection and intraconnection11 pipelines and the financing of investment.

The key results on investment are:

- Investment appraisal and the allocation of long-term capacity should always (even on existing systems) be an integrated process in the style of an open season (see also above under pillar 3)

- The quantity of capacity that shall be reserved for the mid- and short-term market shall be created (and hence invested) on top of any investment required to satisfy (economic) long-term capacity requests.

- The economic appraisal of investment shall take into account the return from long-term contracts as well as the value13 expected to be generated by price alignment due to the capacity reserved for the mid- and short-term markets. The cost for mid- and short-term capacities that are not directly recovered by tariffs shall be allocated to the beneficiaries.

In case TSOs declare that they can/will not invest in an otherwise economic investment project, the project shall be tendered to the market. The scope of the tender would be to build and finance the pipeline (or other asset) against a yearly fee paid long-term. After construction, the realized project would be integrated into the operational responsibility of the respective TSO.

Jean-Michel Glachant, Loyola de Palacio Professor in European Energy Policy, European University Institute

P.S. This blog is based on a EUI Working Paper RSCAS 2011/38 ROBERT SCHUMAN CENTRE FOR ADVANCED STUDIES, Florence School of Regulation

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5 Responses to “A Vision for the EU Target Model: the MECO-S Model”

  1. Paul Hunt Says:

    It is difficult to decide where to begin to critique and suggest amendments to this fatally flawed Gas Target Model that is locked within the strait-jacket of the Third Legislative Package. It appears, however, that the European Commission and ERGEG are determined to charge ahead regardless. The public consultation process employed is a total farce. Any critique, irrespective how solidly it might be based on economic theory and practice, is simply ignored. Great faith is reposed in the ability of undocumented ‘bilaterals’ between ERGEG and major ‘stakeholders’ to achieve a ‘consensus’, without any apparent recognition that the interests of the owners, management and staff of many of these ‘stakeholders’ conflict directly with those of the majority of EU citizens and of all EU final energy consumers.

    The extent of the dysfunction of this energy liberalisation and climate change agenda will be fully revealed only when the inevitable excessive, unnecessary and unjustifiable costs will start hitting the pockets and wallets of EU citizens and their anger will be aroused. Unfortunately, by then this outcome will only be to the advantage of populist, nationalistic, xenophobic factions that are gaining increasing political traction – the extent of state ownership and unionisation of much of the EU’s energy industry is fatally compromising the left and the conventional right and centre are either still in awe or fear of the Neocons or too much in love with their vertically integrated (and expanding) ‘national champions’.

    Prof. Glachant has presented a brave and honourable attempt to make the proverbial silk purse out of a sow’s ear. ERGEG would be wise to pay heed to his observation “that regulators, however powerful, cannot tailor the market to their own wishes” (p61), but it is almost certain they will not. There are many far more competent than I am to rise to the challenge Prof. Glachant has issued on p61. (It would be wornderful if there were some effective engagement and debate on this blog – though it is not common here – since attempting to engage in the process employed by ERGEG is futile.)

    I will simply focus on one area where I detect a faint, but very faint, glimmer of hope and rationality. ACER has recently published its Framework Guideline on the Gas Capacity Allocation Mechanism which proposes the ‘bundling’ of transmission capacity on both sides of a border Interconnection Point. Prof Glachant speaks of the eventual emergence of hub-to-hub capacities. Of course, it is absolutely verboten to speak of ‘point-to-point’ capacity, but there is a hope that economic and commercial realities will compel some definition and quantification of the capacity into and between virtual hubs (even if it is comprised of both physical and virtual capacities) to allow the emergence of long-term, tradable capacity rights.

    There is a long, long way to go, but it could be a start – even if the ‘forces of darkness’ are very powerful.

    .

  2. Jeff Makholm Says:

    No one has a purer heart that Jean-Michel Glachant in trying to chart a course toward a competitive gas market in Europe–where consumers currently pay at the rate of 50 billion euros a year more than their American counterparts for their “invisible fuel,” for want of such a market. He brings all the players (but one!) together for serious seminars Florence, invites critics of his plans to speak up (including Sergio Ascari on his staff) and just generally encourages research and debate on the subject. And yet, his MECO-S model cannot avoid being, as the British say, a damp squib–something exciting and new that doesn’t work. Why is that?

    It’s the Third Package. From the perspective of European gas consumers, the Third Package is an awful piece of legislation. It is an entry-deterring engine that doggedly protects the interests of a small group of pipeline owners and gas suppliers while continuing consumers’ political and organizational disenfranchisement through “full retail access.” Gas consumers are the missing player at the table in Florence. Without well-funded organizations to press for their interests, that small group of pipelines and suppliers will always have the upper hand in shaping legislation. To gas consumers, the Third Package, in conjunction with other EU legislation, is a celebration of the myriad ways that pipelines and gas suppliers to Europe can work effectively to bar competitive entry for the transport and sale/re-sale of gas. Weak EU regulation permitting member states to favour “national champions,” a total lack of transparency, manifestly ineffective pipeline unbundling, a retreat from any form of physicality in pipeline contracting, and the further imposition of an absurd notional scheme–entry/exit–for pricing pipeline transport facilities. All of these features of the Third Package raise effective entry barriers to genuine pipeline rivalry in Europe–the prerequisite to competition in gas.

    The MECO-S Model targets none of these entry barriers but rather attempts to adapt to the Third Package. But competition exists to create threats to sellers; to destroy the value of the capital of inefficient or unresponsive suppliers. Legislation–like the Third Package–that avoids any hint that existing supplier capital can be threatened will never permit competition. Europeans cannot have it both ways–gas supply competition and the protection of existing suppliers behind potent barriers to entry. The MECO-S “markets” cannot mimic competition without an underlying competitive threat.

    A more fruitful path toward encouraging competition in European gas supply would be the targeted removal of entry barriers and the strengthening of European regulatory control over this continental business (without the annihilating derogations, inserted to protect existing pipeline and supply interests, present in the Third Package). The political economy of the pursuit of gas supply competition in Europe is a complicated institutional subject. It was similarly complicated in the United States. Nobody should expect the pursuit to be quick or harmonious. For my own part, I look forward to the kind of progress that will ensue with the Fourth Package–crafted with a genuine concerm for 115 million EU gas consumerrs who currently foot that 50 billion euro annual bill.

  3. Paul Hunt Says:

    @Jeff Makholm,

    It looks like we’re the only two prepared to engage in this debate. I expect Jean-Michel must be a little disappointed. I didn’t expect much engagement here, but I thought that there might be some. It reflects the nature of this ‘public consultation’ that is used to rubber-stamp major policy and regulatory changes such as the Gas Target Model and the Electricity Target Model. It looks like one, but it is not a ‘dialogue of the deaf’ because the deafness and blindness are all one one side. Those who will ultimately decide just go through the motions, solicit submissions, ignore those that are critical of what they have already decided, square major ‘stakeholders’ in behind-the-scenes ‘bilaterals’ and announce a ‘consensus’ on the way forward.

    And, as you put it, the final consumer, who ultimately pays for all of this, is not represented effectively and, inevitably, loses out – not to mention the resulting damage to the EU economy.

    But, depite all this huffing and puffing, the EU is not any nearer solving a fundamental problem. And this relates to the efficient financing of investment. The bulk of the assets – generation plants, electricity wires, gas pipelines – are long-lived, specific assets. There are specific in that the contractual arrangements around them are specific to the parties concerned and specific in that the assets have little, if any, value in any alternative use.

    Providers of finance – whether equity or debt – will not finance invetsment in these assets unless they have a cast-iron assurance that will they recover their investment at an appropriate risk-related rate of return. The traditional approach was based on explicit or implicit long term contracts. In the US, with most of these industries in the private sector, the reliance was on explicit long term contracts and these have been modified over time as the industries have been de-regulated, but the fundamental assurance of investment recovery remains intact.

    In the EU, with much of these industries in public sector ownership the ability of the state via its corporatised integrated businesses to levy whatever prices were required and the explicit or implicit back-stop of a sovereign guarantee provided the necessary assurance. But as the EU has progressed energy market liberalisation, it has found it difficult, if not impossible, to convert these implicit contracts into explicit long term contracts that would provide the assurance of investment recovery to providers of finance.

    As I understand it, in the US, local distribution companies (LDCs), providing a bundled (electricity and wires or gas and pipes), effectively monopoly service, act as credit-worthy counterparties to enter into these explicit long term contracts with electricity generators, gas producers or gas transmission pipeline businesses. The roll-out of retail competition in the EU means that retail suppliers have no assurance of retaining their customer base and are unwilling and unable to enter into these long-term contracts. The roll-out of retail competition in the US has matched the emergence of deep, liquid wholesale markets in both gas and pipeline capacity that reduce the universal requirement for these explicit long-term contracts. In the EU these markets are puny and are unable to take the weight being imposed on them to reduce the requirement for long-term contracts.

    As a result, regulators have been forced into the breach to provide the assurance of investment recovery providers of finance require. And, not surprisingly, they have been captured by the businesses they have been statutorily empowered to regulate. “If you don’t award us this amount of revenue this power plant won’t be built, or these power lines won’t be constructed or these gas pipelines won’t be laid – and the lights will go out and the gas won’t flow.” Moreover, with the requirement for additional investment under the climate change agenda, governments are being required to step in to provide further assurances and incentives to providers of finance in the form of guarantees, commitments and subsidies. So on top of market failure and regulatory failure we now run the risk of ‘government failure’.

    There is probably little hope of seeing the 4th Package you believe is required, since EU politicians, policy-makers and regulators have set their face against this. All we have is the 3rd Package. But, in the midst of all the chaff, there are some grains that may be ground to make flour. It probably makes sense to work with these and to seek to develop the market and regulatory arrangements that will banish market power and political meddling. A full repeal of the 3rd Package and its replacement with a 4th package may not be necessary. There is no reason why a limited set of enabling amendments to the 3rd Package could not be enacted. But what is required most of all throughout the EU is effective statutory advocacy and representation of the collective interests of consumers in the entire process.

  4. Angus Paxton Says:

    @Paul Hunt

    That’s a very good essay.

    Prior to the 3rd package I was firmly of the belief that what Europe needed to fix about the lack of progress towards a competitive internal market was to look at each Member State’s problems. There are particular, physical challenges that are non-contiguous within Europe, with many of them unique to a specific region. They had driven specific engineering solutions (not necessarily the most efficient) within vertically integrated, often state-owned monopolies. The one-size-fits-all attempts to liberalize Europe’s markets have required room for interpretation to fit these different physical situations and engineering practices but have also allowed the national champions to maintain strength and therefore dominance.

    I remain to be convinced that one-size-fits-all.

    Arguably the GB experiment has worked – upstream and downstream supply contracts refer to NBP prices, there is both competition and liquidity (although whether they are sufficient is another matter), and the market appears to deliver security of supply. Preceisely why the GB experience has been successful remains largely unexplored – I suspect that it is a happy coincidence of not only the apparent cornerstones of Europe’s one-size-fits-all approach (non-discriminatory TPA, daily balancing, auctions, UIOLI, etc) but also physical circumstances (demand growth and the dash for gas, oversupply, technological change, geographical boundaries, the reliance on linepack, metering practices, etc.), and accounting practices (mark-to-market of storage inventories).

    European policy makers needs to at least understand whether these are preconditions to developing successful markets, or better still identify the particular shortcomings of each market.

  5. Paul Hunt Says:

    @Angus Paxton,

    Many thanks for your kind words. I wouldn’t be quite be quite so sanguine as you appear be to about energy policy and regulation in the UK. The vertically integrated electricity and gas suppliers are employing every trick in the book to extract margin from final consumers to extract some part-financing of investment up-front and to meet the high cost of capital they are encountering on their own investments and the equally high cost of capital on the investments of those who provide them with services. Some have previously hollowed out their balance sheets to maximise shareholder return and achieved this partly by failing to maintain the level of investment required. There is a requirement now to make up this shortfall – primarily in the electricity sector – and to invest to meet the Government’s excessive climate change agenda objectives. In addition, the Big 6 are imposing significant search, information, switching and consumption management costs on final consumers. The possible policy and regulatory remedies being advanced – e.g., increasing the depth and liquidity of the electricity wholesale market, encouraging new entrant suppiers, passing the proceeds of fines on the energy suppliers back to consumers, etc. – are nonsensical and potentially damaging nonsense. Something will have to give.

    However, while common to both sectors, the deficiencies are more serious for electricity and I agree that a fortuitous happenstance has led so something like a competitive wholesale market for gas and a diversity of modes and sources of gas supply. But, with an entry-exit transmission pricing mechanism, it has been achieved at the cost of excessive complexity and the enjoyment of market power by NGG.

    It has proved possible to replicate aspects of this model in the highly developed national markets in NWE, and it may prove possible to resolve any outstanding issues there, but it’s successful expansion and replication to the rest of the EU is proving difficult and I share your unease about the ‘one-size-fits-all’ approach.

    An effective solution may be to mirror the Independent Banking Commission’s proposal for the banks and use competition law to break the vertically integrated supply businesses into upstream producers and suppliers in wholesale markets and downstream utility suppliers to final consumers (securing their supplies from the wholesale markets). But such a reform would have to be pursued throughout the EU. And statutory consumer bodies would have to be empowered and resourced to advocate and represent the interests of consumers in a robust adversarial manner.

    In addition, for the gas sector, the requirement in ACER’s Framework Guideline on Gas Capacity Allocation to ‘bundle’ the virtual capacity on both sides of an Interconnection Point (IP) should be developed by linking it to the underlying physical capacity and extending it to define and quantify hub-to-hub capacity. Indeed the approach should be extended to ‘into-hub’ capacity. The objective is to foster the emergence of deep, liquid markets in pipeline capacity which are a vital pre-requisite for deep, liquid wholesale markets in gas. ERGEG’s current approach which is based on replicating the ‘market-coupling’ applied to electricity markets is guananteed to present barriers to entry and exit, to retard the emergence of liquidity in the traded gas markets, to reinforce the primacy of the TSOs and to perpetuate the market dominance of the major incumbent suppliers.

    Unfortunately the chances of anything sensible being implemented that might benefit EU final consumers and the EU economy are slim. And, what is worse, most of those with the ‘standing’, knowledge and competence to advance sensible and consumer-benefiting proposals are conflicted or compromised to some some extent or other.

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