[pic] | COMMISSION OF THE EUROPEAN COMMUNITIES |

Brussels, 19.9.2007

SEC(2007) 1179

COMMISSION STAFF WORKING DOCUMENT Accompanying the

legislative package on the internal market for electricity and gas IMPACT ASSESSMENT

{COM(2007) 528 final}{COM(2007) 529 final}{COM(2007) 530 final}{COM(2007) 531 final}{COM(2007) 532 final}{SEC(2007) 1180}

Lead DG : DG TREN

Other involved services : SG, SJ, DG COMP, DG ECFIN, DG EMPL, DG ENTR, DG ENV, DG INFSO, DG MARKT, DG SANCO, JRC.

Agenda planning or WP reference : 2007/TREN/007

Political context

A first liberalisation package was adopted in the late 1990s. Directive 96/92/EC concerning common rules of the internal market in electricity entered into force on 19 February 1997, whereas Directive 98/30/EC on common rules for the internal market in natural gas entered into force on 10 August 1998. These Directives were repealed following the adoption of a second regulatory package in 2003 (in particular Directive 2003/54/EC for electricity[1] and Directive 2003/55/EC for gas[2]).

During this time, the basic concepts of the internal energy market have become embedded in terms of the legal framework, institutional arrangements and the physical infrastructure such as IT equipment. However, at the same time, meaningful competition does not exist in many Member States. Often customers do not have any real possibility of opting for an alternative supplier. Even customers who have successfully changed supplier are often not satisfied with the range of offers they receive. In summary, stakeholders do not yet have a high degree of confidence in the internal market.

Since the informal Hampton Court meeting of Heads of State and government in 2005, followed by the Green paper on an European Strategy for sustainable, competitive and secure Energy adopted by the Commission in March 2006 (COM (2006)105 final), energy and especially the energy internal market, have increasingly become political priorities on the European Commission’s, Council's and Parliament's agenda.

As a consequence of shortcomings identified, the Commission conducted throughout 2005 and 2006 an inquiry for the gas and electricity sectors under competition law. The problems are not just the result of incomplete implementation of the existing 2003 Directives, but also the result of built-in structural and regulatory problems not yet addressed. Even in Member States where the current legislation is being fully implemented, problems remain to be solved.

On 10 January 2007, the Commission presented a Communication to the European Parliament and the Council titled "Energy for a changing world". Within this general framework, the Commission adopted two specific papers related to the functioning of the internal market for electricity and gas.

One is a Communication named "Prospects for the internal gas and electricity market", whereas the other is a sector enquiry launched on 13 June 2005, pursuant to Article 17 of Regulation 1/2003 EC. In both documents, the Commission concluded that consumers and businesses were losing out because of inefficient and expensive gas and electricity markets. Particular problems include high levels of market concentration; vertical integration of supply, generation and infrastructure leading to a lack of equal access to, and insufficient investment in infrastructure; and possible collusion between incumbent operators to share markets.To tackle these problems, the Commission announced it would pursue follow up action in individual cases under the competition rules (anti-trust, merger control and state aids) and act to improve the regulatory framework for energy liberalisation in place since 2004.

The persistent nature of infringements demonstrates to a certain extent also the insufficiencies and shortcomings of the current EC legal framework arising from the directives. Energy regulators are not granted the necessary powers and independence enabling them to ensure that open markets that function in an efficient and non discriminatory manner are put into place. In addition, the existing legal framework does not allow for a proper and efficient regulation of the cross border issues relating to gas and electricity network access. The fact that access to cross border interconnectors is often granted in a preferential manner shows that current rules are insufficient. Finally, the legal and functional unbundling of network operators that are vertically integrated with production and supply activities, which is provided for under the current directives, does not succeed in ensuring equal access to the networks for all suppliers.

The 2007 Spring European Council invited the Commission to propose further measures, in particular as regards effective separation of supply and production activities from network operation, the further harmonisation of the powers and strengthening of the independence of the national energy regulators, the establishment of an independent mechanism for national regulators to cooperate, the creation of a mechanism for transmission system operators to improve coordination of networks operation and grid security, cross-border trade and grid operation, and increased transparency in energy market operations. The European Council also underlined the need to strengthen security of supply in a spirit of solidarity between Member States.

The European Parliament, in its Resolution on Prospects for the internal gas and electricity market adopted on 10 July 2007, expressed a strong political support in favour of a common energy policy. As regards the internal market, the European Parliament considered in particular that " transmission ownership unbundling is the most effective tool to promote investments in infrastructures in a non-discriminatory way, fair access to the grid for new entrants and transparency in the market" . It underlined however that other measures are also necessary and that the differences between the electricity and gas markets may call for a partially different implementation. The European Parliament also called for enhancing "cooperation between national regulators at EU level, through a EU entity, as a way to promote a more European approach to regulation on cross-border issues". Finally, the European Parliament report entails a series of indications on the functioning of the internal market of electricity and gas.

Summary of the Commission services' analysis

In the following impact assessment, a number of options were examined and compared. The Commission services' analysis can be summarised for each of the main policy measures.

- Further TSO unbundling: complete separation of ownership between the transmission networks and generation/supply interests (full ownership unbundling) is the solution that offers the best guarantees from a competition point of view. The level of regulation required to implement full unbundling is also lower than for an ISO and even more so than in the case of regulated unbundling.

- Enhancing the role and coordination of regulators: the status quo is not a viable option, as it emerged from both the findings of the Commission and the stakeholder consultation. Increasing regulators' powers and independence should be extremely beneficial for competition, ensuring a level-playing field for companies in Europe. The costs are very limited compared to expected benefits in terms of market functioning. The lack of coordination between regulators, which was unanimously criticised, would be better addressed through the structure of a Community agency with strong involvement of all EU regulators. The option of setting up a single European regulator is premature at this stage and is likely to encounter strong resistance from a number of Member States and stakeholders.

- Co-ordination between TSOs: Increasing TSO co-ordination is absolutely essential. A balance can be struck between regulatory oversight and "do nothing" by introducing formal coordination between TSOs, the so-called "ETSO+/GIE+" option, which appears to be suitable for attaining the objective pursued.

- Increased transparency for wholesale markets: Stakeholders supported a full range of data disclosure covering capacity, storage and energy flow data. This is not contradictory with the necessity to protect confidentiality and prevent collusion. A unified approach to improving transparency based on a set of pan-European high level standards of data disclosure for gas and electricity, as proposed by the Commission services, would be very much welcomed by market players.

- Actions to regulate long-term contracts in gas. At this stage, the conclusion of the cost-benefit analysis of further legislative measures concerning long-term contracts in gas was not conclusive.

- Access to gas storage facilities: competition on the gas storage market would benefit from legal unbundling and the implementation of current ERGEG guidelines on gas storage operations.

- The Commission services will look further into the potential benefits that could be expected from creating strategic stocks for gas at EU level. The level of support from stakeholders for such measures is limited for the time being.

- Changes to the framework for investment in gas import infrastructures: Article 22 of Directive 2003/55/EC (gas Directive) for investment in gas infrastructure and criteria for TPA exemptions need to be amended. There is a clear added value from EU action at this level, in order to create favourable conditions for investment.

- DSO unbundling: the benefits from further unbundling at the distribution level are not overwhelmingly higher than costs. Due to the recent entry into force of the last liberalisation date in a number of Member States, it would seem to be disproportionate to go a step further in forcing unbundling in this activity.

- Further actions relates to consumer protection: the Commission services propose to adopt an Energy Charter which should provide a suitable level of protection at EU level, in particular against energy poverty.

- A combination of regulatory measures could ensure that the strategic importance of the EU gas and electricity networks is properly taken into account and that the EU unbundling requirements are correctly respected also by third country companies.

TABLE OF CONTENTS

COMMIS SION STAFF WORKING DOCUMENT Accompanying the legislative package on the internal market for electricity and gas COM(2007) 528 final COM(2007) 529 final COM(2007) 530 final COM(2007) 531 final COM(2007) 532 final SEC(2007) 1180 Impact Assessment 1

Section 1: Procedural issues and consultation of interested parties 9

1.1. Organisation and timing 9

1.1.1. Chronology of the IA 9

1.1.2. Follow –up on previous Directives and Regulations 9

1.1.3. Benchmarking report and country reviews 10

1.1.4. Sector inquiry 10

1.2. Involvement of other Directorate Generals 10

1.3. Consultation and expertise 11

1.3.1. Information sources 11

1.3.2. Stakeholder consultation 11

Section 2: Problem definition 14

2.1. Main issues 14

2.2. Causes 14

2.3. The current framework does not address all issues 15

2.4. Expected benefits 16

2.5. Does the EU have the right to act? 16

Section 3: Objectives 18

3.1. Improving competition through better regulation, unbundling and reducing asymmetric information 18

3.1.1. Right to supply and right to buy 18

3.1.2. Ensure a level playing field through improved regulation 18

3.1.3. Efficiency and productivity of the sector and competitiveness of EU companies 19

3.2. Improving security of supply by strengthening the incentives for sufficient investment in transmission and distribution capacities 20

3.2.1. Coordination of investments between TSOs 20

3.2.2. Security of supply and energy dialogue with our main suppliers in gas 20

3.2.3. Promotion of technological developments 20

3.3. Improving consumer protection and preventing energy poverty 20

3.4 Control of Third Country Investments in EU Energy (Electricity and Gas) Infrastructure 21

Section 4: Policy options 22

4.1. Improving competition through better regulation, unbundling and reducing asymmetric information 22

4.1.1. Strengthened TSO unbundling including the two options of full ownership unbundling and ISO 22

4.1.1.1. Fully (ownership) unbundled TSOs. 22

4.1.1.2. Independent system operators (ISO). 23

4.1.1.3. Regulated Unbundling 23

4.1.3. Improving co-operation between EU energy regulators (either: 1. through existing ERGEG function, 2. a more formal Agency approach or 3. an EU regulator) and increasing TSO coordination 24

4.1.3.1. Cooperation between regulators 24

4.1.3.2. TSO coordination 25

4.1.4. Increasing transparency 26

4.1.5. Modifying the treatment of pre-liberalisation long-term contracts for gas transmission 27

4.1.6. Enhanced Unbundling of DSOs including increasing regulatory scrutiny and reviewing the 100,000 limit 27

4.1.7. Control of third country investment in EU networks 27

4.2. Improving security of supply by strengthening the incentives for sufficient investment in transmission and distribution capacities 28

4.2.1. A new framework for gas storage and the imposition of requirements for strategic gas storage 28

4.2.2. Modifying the framework for new investments in gas infrastructure 29

4.3. Improving consumer protection and preventing energy poverty 29

4.4. Interaction between the shortcomings of the internal energy markets and the proposed measures 30

Section 5: Analysis of impacts 32

5.1. Further TSO unbundling 32

5.1.1. TSO unbundling micro-economic impact analysis 33

5.1.2. Impact of ownership unbundling on investments in the network 33

5.1.3. Impact of ownership unbundling on investments in LNG terminals 35

5.1.4. Impact of ownership unbundling on share prices 35

5.1.5. Impact of ownership unbundling on credit ratings 36

5.1.6. Impact of ownership unbundling on market concentration 36

5.1.7. Impact of ownership unbundling on prices 37

5.1.9. Case Studies: Compared impacts of OU and ISO 41

5.1.10. Impacts on Research and Innovation 43

5.2. Enhancing the role of national regulators 45

5.3. Co-ordination of regulators at EU level 47

5.4. Co-ordination between TSOs 52

5.5. Increased transparency for wholesale markets 54

5.6. Actions to regulate long-term contracts in gas 55

5.7. Access to gas storage and LNG facilities 55

5.8. Strategic gas stocks 56

5.9. Changes to the framework for investments in major electricity and gas infrastructure 57

5.10. DSO unbundling 58

5.11. Other measures to enhance retail competition 59

5.12. Further measures related to consumer protection 60

5.13. Analysis of macroeconomic impacts 61

5.15. Analysis of environmental effects 71

5.16 Impact on third country investment 74

Section 6: Comparing the options 75

6.1. Further TSO unbundling: 75

6.12. The comparison of options led the Commission services to draw up a summary table of its proposed actions: 81

Section 7: Monitoring and evaluation 82

Annex I: Development of stock prices after unbundling 83

Annex II: Development of market shares after unbundling 90

Annex V: Views of stakeholders on the impact of proposed policy measures 94

Further TSO unbundling 94

Enhancing the role of national regulators 95

Increased coordination of regulators at EU level 96

Increased TSO coordination 96

Increased transparency for wholesale markets 97

Actions to regulate long-term contracts in gas 98

Access to gas storage facilities 99

Strategic gas stocks 100

Changes to the framework for investments in gas import infrastructures 101

DSO unbundling 102

Further measures on consumer issues and energy poverty 103

Annex VI: Credit ratings of large European energy companies (S&P ratings) 105

SECTION 1: PROCEDURAL ISSUES AND CONSULTATION OF INTERESTED PARTIES

This impact assessment was prepared in view of a package of legislative measures designed to address the issues identified by the Commission in its Communication of 10 January 2007 (reference: COM(2006)841)

1.1. Organisation and timing

This impact assessment accompanies the legislative proposal which is part of the Commission's 2007 Work Programme under reference 2007/TREN/007.

1.1.1. Chronology of the IA

The Energy and Transport Directorate General of the European Commission (DG TREN), launched in September 2006 the preparatory work for this impact assessment to assess policy options related to the completion of the internal energy market for gas and electricity.

Whilst preparing the internal energy market report (COM 2006(841), published on 10 January 2007, DG TREN decided also to study a number of possible changes to the legislation currently in force. The policy options contained in this impact assessment were developed in the following way.

1.1.2. Follow –up on previous Directives and Regulations

Nearly all Member States failed in implementing properly and on time the second liberalisation package. Infringements proceedings were started against 20 Member States in 2004; some are still open and may eventually be brought to the Court of Justice.

Most of the Member States were not able to comply with the two Directives within the one-year timeframe set by the directives . The "2003 second package" was quite ambitious and required important changes in the sector. The most important changes concerned the structure of the vertically integrated companies (legal unbundling), the preparation of the full opening of the market by 1 July 2007 and the reinforcement of the powers of the national regulators.

1.1.3. Benchmarking report and country reviews

In addition to the annual benchmarking exercise of the Member States, DG TREN decided in 2006 to adopt a new approach, based on on-site visits to most of the Member States in order to assess the functioning of the internal market at national level. These reports were made public as an annex to the main 2006 report.

1.1.4. Sector inquiry

Decided in June 2005 by the Commission and completed in January 2007 [3], the sector inquiry led by DG COMP (in close cooperation with DG TREN) provided a significant input for the assessment of the functioning of the Energy internal market.

The Commission's 2006 assessment of progress incorporating both the sector inquiry and in-depth country reviews of the functioning of the electricity and gas markets in Member States confirmed the slow progress in building a truly competitive integrated European market. This was not just the result of incomplete implementation of the existing 2003 Directives, but also the result of in-built structural and regulatory problems not yet addressed. Even in Member States where the current legislation is being fully implemented, problems remain to be solved.

In March 2007, the European Council formally asked the Commission to prepare new legislative measures.

1.2. Involvement of other Directorate Generals

Given the cross-cutting nature of the planned impact assessment work, DG TREN set up an inter-service steering group. The steering group included the Secretariat General, the Legal Service, and the following Commission Directorate Generals: Competition, Economic and Financial Affairs, Employment, Enterprise, Environment, Information Society and Media, Internal Market, Health and Consumer Protection and the Joint Research Centre. The first meeting of the steering group took place on 9 November 2006, in order to discuss, amend and finally approve the Terms of Reference of an external study (contractor: ECORYS). The contract was signed in December 2006. Due to the sensitivity for stakeholders (in particular market players) of some policy options, an additional consulting firm (Moffatt Associates)was chosen in order to support the work of ECORYS, specifically to assess the questions of ownership unbundling of transmission system operator and transparency of data.

In addition to this external consultation, the Commission services used their own econometric model in order to quantify the impacts of certain measures.

1.3. Consultation and expertise

1.3.1. Information sources

The Commission services used several information sources in order to prepare this impact assessment.

- First, it drew upon the results of the abovementioned report on the internal market and the competition sector enquiry.

- Second, it has maintained very regular contacts, usually under the form of meetings or conferences, with a wide range of stakeholders, including Member States, regulators, companies operating in the electricity and gas sector, consumer organisations, trade unions, financial institutions…

- Third, DG TREN decided to rely on a consultant in helping it prepare the impact assessment, in particular concerning stakeholder consultation on a number of policy options contained in the 10 January communication.

- Fourth, the Commission requested the advice of the European Regulators Group for Electricity and Gas (ERGEG) on possible new legislative measures. These ERGEG papers are public[4].

On 12 January 2007, a kick-off meeting between the consultant and the steering group took place. The objective was to verify the full understanding of the scope of the project with consultants, as well as to indicate some specific organizational and practical arrangements of the team. The log-frame methodology was chosen. ECORYS also proposed to adopt a web questionnaire to meet scale and time constraints, disseminating via a web site and enabling on-line answers.

It was agreed that the consultant would draft a preliminary report, based on a questionnaire which was to be prepared on the basis of input provided by the Commission. The members of the steering group established the list of stakeholders who should be targeted for consultation. The scope of the list offered an opportunity to a wide spectrum of stakeholders to provide their views.

1.3.2. Stakeholder consultation

Stakeholder consultation on the measures to complete the internal market for gas and electricity started very early. The Commission invited stakeholders to give their views to the green paper adopted in March 2006. This document already included the idea that the internal market legislation for electricity and gas should be amended. 1500 contributions were sent to the Commission.

With regard to consultation of Member States, following the adoption of the January 2007 Communication "An energy policy for Europe", the Commission presented its Communication to the Council, and explained the main findings in several Council Energy working group meetings. Member States commented on it and, via the Council of Ministers, each Member State finalised a position paper. Some Member State have expressed detailed views on the content of the internal market report.

In addition, a targeted consultation took place early 2007, which was conducted by ECORYS and Moffatt Associates. The following stakeholders were consulted:

Regulators: ERGEG (European Regulators' Group for Electricity and Gas)

Transmission system operators: ETSO (for electricity), GTE (for gas)

Associations of electricity and gas companies: Eurelectric, Eurogas, GEODE (small distribution system operators), GIE (Gas Infrastructure Europe)

Independent producers associations: EWEA (European Wind Energy Association), EREC (European Renewable Energy Council)

Consumer associations: BEUC (European consumers' organisation)

Industrial energy users' Associations: IFIEC EUROPE (International Federation of Industrial Energy Consumers), EuroMetaux, EFMA (European Fertilizer Manufacturers Association), Cefic - European Chemical Industry Council, Cimeurope, VEMW Association for Energy, Environment and Water, VIK Verband der Industriellen Energie- und Kraftwirtschaft e.V., MEUC Limited ( Major Energy Users Council), UEAPME (the European Association of craft, small, and medium size enterprises)

Traders and new entrants: EFET – European Federation of Energy Traders, BNE Bundesverband Neuer Energieanbieter

Trade Unions EPSU - European Federation of Public Service Unions, European Mine, Chemical and Energy Workers Association – EMCEF

NGOs: World Wildlife Fund (WWF)

Moffatt Associates consulted additional stakeholders, mainly companies which could be affected by the unbundling of their assets but also possible buyers of such types of assets. Financial institutions and investment funds were consulted as well to test the financial feasibility of the policy options of the Commission. In this context, 56 stakeholders were consulted.

The stakeholder consultation by ECORYS focussed on 23 relevant European representative platforms and their members. A total of 339 questionnaires have been filled out by organisations having their roots in 19 countries linked to 15 stakeholder platforms. In addition 73 questionnaires have been filled out by organisation not connected to a particular country or one of the actively approached stakeholder platforms. It should be noted that responses sent to this consultation came, to a significant extent, from vertically integrated companies, which created a bias in the assessment of some of the proposed options. There was no possibility to redress this imbalance in an objective manner. The consultant's report weighted a company response in the same manner as the response by an association no matter how many members it had. The Commission services did not modify the weighting, took account of that fact while drawing conclusions from the consultation.

The stakeholder consultation showed overall support for proposed Commission measures. For instance, concerning ownership unbundling, a majority of respondents to the questionnaire of Moffatt Associates saw the proposed measures as necessary or essential. Regarding the intended effect of the legislative proposals, this support is higher with regard to full ownership unbundling (62%) than with regard to the creation of independent system operators (52%). There were mixed opinions on the cost effects of an extension of the regulator powers, but a clear majority supporting the measure. Respondents also welcomed increased coordination of regulators and TSOs at EU level, as well as increased transparency. Measures for strategic gas stocks did not receive strong support. Regarding consumer protection, replies were understandably mixed, given the differences of views between companies and consumers' associations. (The detailed results are given in the consultant's report.)In parallel, there have been consultations and regular contacts between the Commission services and established stakeholder groups. Example of such contacts are the Florence (for electricity) and Madrid (for gas) forums. Such forums were set up to discuss issues regarding the creation of a true internal electricity and gas markets. The participants are national regulatory authorities, Member States, the European Commission, transmission system operators, traders, consumers, network users and exchanges. The Forums usually convene once or twice a year. The first meeting was held in 1998 for Florence and 1999 for Madrid. These forums ensure that most stakeholders are fully informed throughout the preparatory process.

SECTION 2: PROBLEM DEFINITION

2.1. Main issues

In its Communication of 10 January, both in the Internal Market report and the Energy Sector Enquiry, the Commission had identified a number of issues to be solved, possibly by introducing new legislation. They are the following:

market concentration and market power;

vertical foreclosure (in particular the inadequate unbundling of network and supply;

lack of market integration (including lack of regulatory oversight for cross border issues);

lack of transparency; price formation mechanisms; downstream markets for gas;

balancing markets

liquefied natural gas (LNG) markets.

Section 4.4 discusses the relationship between the proposed policy options and the structural problems of the electricity and gas markets. Annex IV presents a corresponding table.

2.2. Causes

Most of the problems are linked to the existence of vertically integrated companies, which not only control essential facilities (such as electricity transmission systems, gas transport networks or main gas storage facilities) but also enjoy significant market power in the wholesale and sometimes retail markets. It is important that new entrants are able to invest in new generation and gas import capacity since incumbents, if not properly unbundled, are likely to gain from a position of artificial shortage. In practice, EU companies are often not able to sell electricity and gas across the EU on equal terms as incumbent suppliers. In particular, non-discriminatory network access and an equally effective level of regulatory supervision in each Member State do not yet exist. The high concentration of production, transmission and distribution structures characterising the European electricity and gas system have led to extremely high entry barriers for newcomers. For the transmission systems and distribution systems, economies of scale have typically led to the establishment of natural monopolies, characterised by high fixed and relatively lower variable costs. The emergence of vertically integrated natural monopolies (up- and/or downstream) exacerbates barriers to market entry, thus being an important obstacle to competition and efficiency gains.

These vertically integrated companies have an incentive to hinder the entry and expansion of rivals in order to maintain their market power and thus achieve higher profits. There are many ways in which control of the transmission/transport system can be used for this purpose, ranging from a lack of transparency on available transmission capacity and load profiles to discriminatory terms and conditions for third party access. If access charges are not properly regulated, they may give rise to a "margin squeeze", whereby the vertically integrated incumbent sets access charges at such a high level relative to its end-user prices that the margin is too small to provide an incentive for a new firm to enter the market.

Technical progress and new policy priorities are paving the way, amongst others, for the development of renewable energies and LNG. This puts an additional burden on production and transmission systems, which should able to cope with more decentralised production facilities and effectively connect these new facilities with the overall transmission system. Vertically integrated incumbents, who are usually specialised in centralised structures, have little incentive to do so, as opposed to unbundled TSOs that would have any incentive to get access to as many new suppliers of energy as possible.

A direct link exists between network capacity and competition. Vertically integrated companies have a disincentive to invest in their networks; "congestion revenues" are often higher than expected profits from building new links. This disincentive hinders the entry of companies providing energy from renewable sources and is an obstacle to the integration of European markets through of the development of cross-border interconnections.

There is insufficient co-ordination between national energy networks, in terms of technical standards, balancing rules, gas quality, contact regimes, and congestion management mechanisms, which are necessary to permit cross-border trade to work effectively. If TSOs are also active in the supply markets, there is a danger that such collaboration could lead to collusion (e.g. market-sharing) in those markets.

A related problem is that vertical integration may prevent the formation of companies that genuinely operate across national borders (rather than using control of the network to perpetuate market segmentation and thus maintain their market power).

Transmission system operators possess commercially sensitive information about the companies that use the system. Experience in the energy sector and others shows that, in a vertically integrated company, despite the existence of "Chinese walls", it is difficult to prevent the leakage of such information from one part of the company to another. Such information gives the vertically integrated firm an advantage over its rivals which it can use to keep its market power. Even if no abuse takes place, the existence of links between the TSO and a supplier could damage market confidence and thereby discourage new entry and the development of competition. The market power of the vertically integrated company can be increased by cross-subsidisation from network activities to supply activities. This cross-subsidisation does not necessarily have to involve cash flows: network revenues can boost the credit rating of the whole group, thus lowering capital costs for the competitive parts of the group. The regulation of vertically integrated companies is costly and complex, in particular because of the strong incentives and multiple possibilities for discriminatory behaviour that vertical integration produces.

2.3. The current framework does not address all issues

Although the measures taken so far to mitigate these problems have had a positive impact, they have proved insufficient. There are signs that the continuous persistence of dominant positions in wholesale and retail markets is leading some Member States to impose generalised caps on electricity and gas prices. Depending on the level at which such price caps are set, they can prevent the Internal Energy Market from functioning and suppress price signals that new capacity is needed, thus exacerbating the problem of underinvestment.

Although significant progress has been made, status quo is not an option. Already, the shortcomings identified by the Commission, both in the implementation of current legislation and in competition law, are impeding the positive effects of liberalisation. The EU internal market does not truly exist yet and each ministry, national energy regulator and competition authority continues to act without taking into account the EU common interests. In some cases, this may lead to disproportionate advantage for “national champions” in the name of security of supply's objectives.

2.4. Expected benefits

As well as improving efficiency, the internal market contributes strongly to the objectives of security of supply . The prospect of a large EU market for electricity and gas with common rules is a strong incentive for new investment. Competitive markets also encourage diversification since flexibility to react to market conditions is encouraged. An integrated market also provides a more powerful bargaining position for European energy companies when sourcing energy in global markets since there is a larger range of options available as regards supply routes and better access to customers. Security of supply can no longer be considered to be only a national issue. The development and operation of Europe’s energy networks must, in the future, be conducted in much more coordinated way, at least on a regional basis, if future disruptions are to be avoided. This is not the case at present and the objective of a coherent and secure European network is far from a reality.

The proper functioning and optimization of the EU electricity transmission system - in terms of reliability, robustness, efficiency and costs – is clearly in the interest of all European citizens and industries. However, in the current regulatory framework, no market actor has an economic incentive to support the R&D activities necessary to drive the future evolution of electricity networks, particularly of the European interconnected system. The main barrier for this type of Research activities is the dichotomy between the actor(s) which are supposed to finance the research/innovation activities and those who will receive the benefits. The pan-European blackout of 4 November 2006 demonstrated the vulnerability of electricity supply in Europe. In its advice delivered at the request of the Commission on 20 December 2006, ERGEG concluded that lessons from the 2003 Italian blackout have not been followed through, and that the following was needed to keep the lights on in Europe in the future:

- Adoption, on proposal of the European Commission, of legally binding operational security rules;

- Development by the Commission of a framework for the electricity network as part of its energy strategy;

- Improvement of the co-operation between EU electricity grid operators which should be publicly accountable for their actions.

The assessment made by the European Commission in its January Communication is widely shared and there are vivid requests from interested parties, especially from electro intensive consumers, to open the markets effectively and ensure a level playing field.

2.5. Does the EU have the right to act?

The European Council and the European Parliament have called on the Commission to propose new legislative measures in order to improve the functioning of the internal market for electricity and gas. The Commission intends to propose amendments to current legislation in force. The Treaty base would continue to be Articles 47(2), 55 and 95, as in the current electricity and gas Directives.

In the discussion on ownership unbundling, the issue of property rights have been raised Property rights are usually protected by the Constitution at national level. At European level, it is included in Article 17 of the Charter of Human Rights of 2000, which is compatible with tradition, legislation and practice in all the Member States. According to European caselaw, fundamental rights are not absolute prerogatives, but should be taken into account due to their function in the society. As a result, Article 17 caters for restrictions to the exercise of property rights if the following four conditions are met:

1. Public interest: public interest is protected to the extent that only ownership unbundling allows for effective separation of assets.

2. Conditions defined in legislation: condition met with the adoption of a Directive or Regulation.

3. Proportionality ("to the extent necessary for the general interest"): ownership unbundling and ISO are only proposed because they are really necessary.

4. Adequate compensation for the loss is to be determined in the Regulation or Directive. The case of the Spanish electricity TSO, Red Electrica de España, is interesting: since being listed in 2002, the company value tripled in 5 years, with subsequent benefits for its shareholders (see Annex I). In the case of the UK gas industry, a share splitting approach was used to preserve the interests of shareholders which have subsequently benefited considerably from the break up British Gas (see Annex I).

Regarding the fundamental rights limits, it is clear that if any divestiture would be imposed to the company owning the assets, financial compensation should be put in place. The Treaty is neutral regarding the nature of the property. The Commission services do not intend to propose TSOs' privatisation.

A justifying element for any restrictive effect of the proposed options to the right of establishment and the freedom of capital movements could be found in imperative reasons of general interest (e.g. security of supply)

SECTION 3: OBJECTIVES

The European Council and Parliament recalled earlier in 2007 that a European energy policy was necessary. One aspect of this policy is the completion of an internal market for electricity and gas. The measures examined below aim at contributing to this general objective. In addition, an energy single market will have a positive contribution to the completion of the objectives of the Lisbon strategy, in terms of competitiveness of the European economy, (through efficient energy prices) and sustainability (via an additional incentive to develop renewable energy sources). There is also an obvious link with other policies of the European union, such as the review of the Emissions Trading Scheme (ETS) or the reduction of CO2 emissions thanks to the growth of renewable energy sources. The Commission also has a role to play in ensuring that all EU citizens benefit from the liberalisation process.

A range of secondary objectives will play an important role in the overall strategy.

3.1. Improving competition through better regulation, unbundling and reducing asymmetric information

3.1.1. Right to supply and right to buy

The European Union is still far from the objective of achieving a true internal energy market where every EU consumer has the actual possibility to choose his or her electricity and gas supplier freely between any EU company.

In addition, the European Union has not yet adequately addressed the challenge of investing in the right level of new infrastructure based on a common stable European regulatory framework in support of the internal market. The necessary degree of co-ordination between national energy networks, in terms of technical standards, balancing rules, gas quality, contract regimes, and congestion management mechanisms, which are necessary to permit cross-border trade to work effectively, is largely absent.

3.1.2. Ensure a level playing field through improved regulation

Both the sector inquiry and the country reviews conducted by the Commission during 2006 have unearthed a variety of specific examples which demonstrate the shortcomings of the existing regulatory framework.

In addition, the existing regulatory framework has given rise to problems in the field of capital movements

The Commission noted these ongoing problems in the electricity and gas market in its report issued at the end of 2005. At the time, it was considered too early to draw definitive legislative conclusions. However, the Commission did commit itself to a number of actions. These have been delivered as follows:

1. The Commission has undertaken detailed country reviews, interviewing market participants in each Member State, including smaller companies and new entrants.

2. Based on the advice of the European Regulators Group for Electricity and Gas (ERGEG), the guidelines on congestion management for cross border electricity exchanges were adopted on 9 November and entered into force on 1 December 2006.

3. ERGEG has developed the regional initiatives in 2006 and is working, via mini fora, towards removing barriers to market integration in the following areas: transparency, access to capacity, and the development of gas hubs.

4. The Commission has completed the sector inquiry. A number of investigations have been launched against companies in the electricity and gas sectors.

The Commission started infringement proceedings related to freedom of capital movements.

The Commission announced it would take action to address the remaining issues in the following areas:

- Ensuring non-discriminatory access to networks,

- Improving regulation of network access at national and EU level,

- Reducing the scope for unfair competition,

- Providing a clear framework for investment,

- Resolving issues relating to households and smaller commercial customers.

The Commission's main objective is to have a complete internal energy market with open competition and effective regulation in place.

3.1.3. Efficiency and productivity of the sector and competitiveness of EU companies

Liberalisation has clearly led to some efficiency improvements in energy supply and delivered savings to customers, particularly in the initial phase. However, Recent increases in wholesale electricity and gas prices have, to a greater or lesser extent, fed through into the bills of end-users and now offset some of the earlier reductions, particularly for the very largest industrial energy users. It is highly questionable that gas and electricity prices are the result of a truly competitive process rather than being the direct result of decision of companies with market power. This is confirmed by the recent London Economics study on wholesale electricity markets[5], which states that these prices "are significantly higher than would be expected on perfectly competitive markets" event after taking into account the rise in generation fuels.

Thanks largely to the benefits of the implementation of previous EU legislative packages, retail electricity prices have, on average across all users, remained relatively constant in real terms over the period, despite very obvious price increases in the cost of primary fuels, clearly demonstrates the effect of increasing efficiency in electricity supply. The electricity price in particular for households would in fact have decreased if the effects of taxation were excluded. As far as gas is concerned, the factors affecting prices, such as the need to move to higher cost sources of supply, for example liquefied natural gas (LNG), and the continued linkage of some gas imports to the price of oil, would have occurred whether or not competition had been introduced. It must be recalled that energy prices cannot be expected to always remain low regardless of external factors.

3.2. Improving security of supply by strengthening the incentives for sufficient investment in transmission and distribution capacities

3.2.1. Coordination of investments between TSOs

In order to make sufficient transmission capacity available to meet demand and integrate national markets, network operators would need coordinated long-term planning of system development to plan network investments, and monitor the developments of transmission network capacities.

3.2.2. Security of supply and energy dialogue with our main suppliers in gas

The internal market contributes strongly to the objectives of security of supply. The prospect of a large EU market for electricity and gas with common rules is a strong incentive for new investment. New investment is clearly responding to the price signals in wholesale and balancing markets where these are allowed to function properly.

Competitive markets also encourage diversification since flexibility to react to market conditions is encouraged. An integrated market also provides a more powerful bargaining position for European energy companies when sourcing energy in global markets. This has all been delivered as a result of the liberalisation process and further improvement to security of supply would result from a more competitive framework.

Security of supply can no longer be considered to be only a national issue. The means of addressing such issues cut across national boundaries and will be beyond the powers of any individual country. Specifically, the development and operation of Europe’s energy networks must, in the future, be conducted in much more co-ordinated way, at least on a regional basis, if future disruptions are to be avoided.

3.2.3. Promotion of technological developments

The future electricity infrastructure will have to face three major challenges: a) the integration of the national systems into a properly managed single European system, b) the massive integration of intermittent and non-dispatchable sources, like wind and combined heat and power (CHP), c) the security of the system and its robustness to large scale cascading system problems (for instance to avoid or limit blackouts). Solving these problems with the technologies and operational models which are used today will be either impossible or extremely uneconomical. In theory, several alternatives routes could be followed to implement better solutions. However, at this stage it is still unclear which one would be the best, both technically and economically. The Commission services are taking such developments into account in this impact assessment.

3.3. Improving consumer protection and preventing energy poverty

The Commission believes that improved competitive conditions and security of supply are in the interest of all consumers. Therefore all policy options directly related to these two objectives are contributing to consumer protection.

Enabling easier price comparisons is also a very important measure for all consumers, from the largest companies to all households.

3.4 CONTROL OF THIRD COUNTRY INVESTMENTS IN EU ENERGY (ELECTRICITY AND GAS) INFRASTRUCTURE

OUTSIDE THE EU, IT WILL BE DIFFICULT, EVEN IMPOSSIBLE FOR THE COMMISSION TO PROVE THAT THE UNBUNDLING RULES ARE PROPERLY APPLIED AND IMPLEMENTED FOR SUPPLY COMPANIES INVESTING IN EU TRANSMISSION SYSTEM OPERATORS. THIS NEEDS TO BE ADDRESSED, TOGETHER WITH THE CONFLICTS OF INTERESTS THAT EXTERNAL SUPPLIERS MAY FACE. CONFLICTS OF INTEREST INCLUDE STRATEGIC UNDERINVESTMENT TO PREVENT SUPPLY DIVERSIFICATION, ABUSIVE MANIPULATION OF TRANSMISSION SYSTEMS TO FAVOR SUPPLY ARMS, AND USING SUPPLY MONOPOLIES TO OBTAIN TRANSMISSION ASSETS AT BELOW MARKET PRICES; ALL OF THESE HAVE ALREADY BEEN IDENTIFIED WITHIN THE EU.

SECTION 4: POLICY OPTIONS

The Commission, in its Communication in January 2007, outlined main policy options for improving the performance of energy markets and achieve the abovementioned objectives.

4.1. Improving competition through better regulation, unbundling and reducing asymmetric information

4.1.1. Strengthened TSO unbundling including the two options of full ownership unbundling and ISO

One of the possible options is "business as usual" which would mean relying on current legislation including legal and functional unbundling for TSOs. Concerning the necessity to further unbundle transmission from other activities within vertically integrated companies, three options were considered. One is ownership unbundling. The TSO would both own the transmission assets and operate the network. It would be independently owned, i.e. supply/generation companies could no longer hold a significant stake in the TSOs. The other option is the independent system operator (ISO) whereby the transmission network would be operated and developed by a third party, fully independent from the vertically integrated companies. A further option was presented at the March European Council, called "regulated unbundling". It consists in the "status quo" from the point of view of unbundling, but would grant further powers to the regulators to regulate in more detail such issues as third party access.

4.1.1.1. Fully (ownership) unbundled TSOs.

The TSO would both own the transmission assets and operate the network. It would be independently owned, i.e. supply/generation companies could no longer hold a significant stake in the TSOs In some Member States, vertically integrated companies are still partially or completely state-owned. In that case, transmission assets would stay public but, in order to guarantee the independence of the TSO towards the generation companies, different ministerial departments could be responsible for the newly separated activities.

In the electricity sector, 13 Member States have gone beyond the requirements of legal and functional unbundling of the present Directive by implementing full ownership unbundling of the transmission networks. In the gas sector, 6 out of the relevant 21 Member States have opted for ownership unbundling of the TSOs[6]. While ownership unbundling of TSOs has often taken place as part of the privatisation process of state owned monopoly companies, some countries such as the Netherlands, Italy and Spain have, in recent years, carried out full ownership unbundling of largely privately owned energy companies. In Spain and Italy, ownership unbundling was achieved by gradually restricting the shareholding of the integrated companies in the network operators. In the Netherlands, a law passed in the year 2000 required state ownership of all essential grids which resulted in the full separation and nationalisation of the electricity and gas networks by buying out the private shareholders for € 1 billion and € 2.77 billion respectively.

4.1.1.2. Independent system operators (ISO).

Separate system operators without ownership unbundling: in this case, integrated companies can keep network assets, but the network is managed by ISOs in which they can have no (significant) stake. ISOs need to be "strong" (ISO+), with decisional power over operation, maintenance and investment.

This solution would require separation of system operation from ownership of the assets. Supply/generation companies could no longer hold a significant stake in the independent system operator (ISO). However, the transmission assets themselves could remain within a vertically integrated group. The system operator would be solely responsible for operation and dispatch, being the primary interface with network users, and would exercise control over network maintenance and development decisions. System operators would require sufficient funds and personnel not employed at the same time by a vertically integrated group. The ISO model would require detailed regulation and permanent regulatory monitoring, bearing the following questions in mind:

- What are the tasks of the ISO?

- Does an ISO have investment capacity of its own?

- How would generation companies be prevented from using ISO as a way to stabilise their market shares?

. System operators would require sufficient funds and personnel not employed at the same time by a vertically integrated group. The ISO model would require detailed regulation and permanent regulatory monitoring.

A sub-option of the ownership unbundling (OU) option was elaborated, due to the possible negative impact of the full OU on integrated companies. In this case, the shares of the vertically integrated undertaking are divided into shares of the undertaking owning the transmission system on the one hand and shares of the generation or supply undertaking on the other hand. These shares are attributed to the shareholders of the previously vertically integrated companies.

This option requires closer supervision from the regulator whereas some more detailed requirements will be requested from the national authorities. This option was not defined at the beginning of the stakeholder consultation and it is not possible to assess to which extent it would be supported by market players. One can expect a strong support because this option allows the vertically integrated company not to sell its transmission asset.

4.1.1.3. Regulated Unbundling

The Commission services examined the "regulated unbundling" option presented at the March energy Council in relation to the objective of further market liberalisation. It is very much a "business as usual" scenario, as it does not force further unbundling, and relies heavily on implementation of rules at national level, with the associated risk of further divergence between national markets. It has already been highlighted that consistency of regulatory conditions was the key to the completion of a truly Internal Market for electricity and gas. As confirmed by regulators[7], the potential for undue discrimination will always exist where a vertically integrated company undertakes both competitive and monopolistic businesses. This is because a network business can favour the competitive company in its own group over other competitor businesses. 4.1.2. Strengthening of national energy regulators so that powers are harmonised

The 2003 electricity and gas Directives extended the powers of national energy regulators and required to establish authorities with specific competences. However, in many cases, experience suggests that the effectiveness of regulators is frequently constrained through a lack of independence from government and sufficient powers and discretion. For example, the country reviews have revealed that there are many issues for which regulators do not have the necessary effective ex-ante powers such as establishing rules on functional unbundling or on non-tariff access conditions. In other cases, regulatory duties are split between the specific regulatory authority and a ministry or the competition authority.

Regulators would need strong ex-ante powers over the following areas: i) all aspects of third party access to networks, ii) access to gas storage, iii) balancing mechanisms, iv) market surveillance of e.g. power exchanges, v) compliance with functional and account unbundling for distribution system operators, vi) all cross border issues, vii) consumer protection including any end-user price controls viii) information gathering, ix) sanctions for non-compliance. It therefore intends to propose a strengthening of the Directives on this basis.

It is also essential to ensure that decisions at national level do not have an adverse effect on the aspects most critical for market entry and the evolution towards an EC internal market, respectively for gas and electricity. To this effect, certain individual national regulatory decisions, in particular as regards cross border issues and the effective development of competition, should be notified to the Commission. This structure is already used in relation to exemptions for third party access for new infrastructure (under Article 22 of the Gas Directive 2003/55/EC and Article 7 of the Electricity Regulation (EC) No 1228/2003) and in the electronic communications sector since 2003.

4.1.3. Improving co-operation between EU energy regulators (either: 1. through existing ERGEG function, 2. a more formal Agency approach or 3. an EU regulator) and increasing TSO coordination

4.1.3.1. Cooperation between regulators

The creation of an integrated EU transmission network implies modifications to the regulatory framework. Removing inconsistencies in investment decisions and network operation has financial implications, including the allocation of costs and risk associated with increasing capacity. In addition, ongoing problems exist in relation to inconsistencies at national level between, for example, tariff structures, capacity allocation rules, balancing arrangements and trading timetables and security of supply measures. The result of these differences in market design is market segmentation with even some national markets remaining split into different local “tariff” or “balancing” areas, which act against the development of the internal market. This segmentation of the European market increases the effect of the dominance of a small number of suppliers and is damaging to security of supply.

Regulators are already seeking to resolve such issues through ERGEG and, explicitly, the regional initiatives for electricity and gas. ERGEG (European regulators group for electricity and gas) has been created by a decision of the European Commission in November 2003.Despite the fact that ERGEG has now become an important player, it does not have the power to take binding decisions .It relies on each individual national regulator to implement or not the recommendations adopted by ERGEG. There are encouraging signs that significant improvements will be delivered in this way. However, progress is dependent on all the involved regulators agreeing on improvements, and having the necessary powers and duties. A greater impetus is therefore required, including more detailed EU co-ordination requiring increased resources. This will be underlined in the Commission report on experience with Regulation (EC) No 1228/2003 which will include a concrete list of actions. Three main configurations might be considered, embodying the necessary delegations of powers in compliance with the EC Treaty, which would require amendments to the legislative framework, in particular as regards the second and third options.

- Gradually evolving the current approach: reinforcing collaboration between national regulators by notably requiring Member States to give national regulators a Community objective, and introducing a mechanism whereby the Commission could review some decisions of national regulators which affect the internal energy market.

- A European network of independent regulators (“ERGEG+”): Under this mechanism, the role of ERGEG will be formalised, and it would be given the task to structure binding decisions for regulators and relevant market players, such as network operators, power exchanges or generators, on certain precisely defined technical issues and mechanisms relating to cross border issues. It would need the appropriate involvement of the Commission, where necessary, to ensure that due account was taken of the Community interest.

- A new, single body at Community level would be set up. It would in particular be granted the responsibility for adopting individual decisions for the EU electricity and gas market related to regulatory and technical issues relevant to making cross border trade work in practice.

4.1.3.2. TSO coordination

The present framework contains very few or no references for TSO coordination. There would therefore be no change to the current situation of relatively low cross-border trade unless new legislation is introduced in this field.

An enhanced level of TSO co-ordination would require a new legislative framework at EC level. Existing associations of TSOs (ETSO - European Transmission System Operators and GTE - Gas Transmission Europe ) work at present on a voluntary basis. These associations can issue recommendations and play a very important role in the different regulation forums (Florence Forum for electricity and Madrid Forum for gas). They regroup all the national transmissions systems operators in electricity and gas.

It is envisaged that the TSO cooperation structures publish network development plans which include the modelling of the integrated network, scenario development and the assessment of the resilience and deliverability of the integrated system. This development plan should be sufficiently forward looking (e.g. at least 10 years) to allow for the early identification of investment gaps, notably with respect to cross border capacities.

In order to ensure complete interoperability between the national grids, a possible option would be to promote the creation of a European transmission system operator focusing on the two main areas of competences which are crucial for the good functioning of the EU internal market: a common planning of necessary investments at EU level and the drafting of harmonised technical rules.

The Commission proposes to reinforce the cooperation between the TSOs, but as stated in the January communication "efforts should also be made to have a gradual evolution towards regional system operators. These would be independently owned and would require additional unbundling" .

The European Council of March 2007 endorsed the idea of creating "a new Community mechanism for Transmission System Operators to improve coordination of network operation and grid security building on existing cooperation practices. "

In the future, the Commission needs to rely more on TSO associations' competences and time has arrived to grant them an institutional role with formal obligations and objectives being added to their consultative role (“ETSO+\GTE+ solution").

They may, for example, be required by the Commission or the regulators, in particular in view of ensuring security of supply, to report on European grid operation and investment as well as the development of technical standards for network security discussed above. ETSO+\GTE+ could be granted the task of adopting recommendations on precisely defined technical issues such as standards and operational rules. They could also, in particular, be responsible for monitoring the developments of networks so as to improve the transmission capacities between Member States. ETSO+\GTE+ would also be responsible for reviewing progress with infrastructure investments, for example on a rolling two year basis as well as interacting with local populations affected by such investments.

4.1.4. Increasing transparency

The problem of concentration is made worse where dominant companies are not required to reveal information to other market participants. For example, wholesale price movements are often caused by variations in production or the use of import capacity by the largest electricity and gas companies. If smaller market participants are unable to track the underlying causes of changes in market price, they will be at a disadvantage. A higher degree of transparency would also allow for improved market surveillance.

In the current framework, transparency is only partially addressed. ERGEG has therefore already proposed guidelines on transparency and advised the Commission that these should be made legally binding. The Commission intends therefore to introduce binding guidelines for transparency either through new legislation or by modifying the existing electricity Regulation (EC) No 1228/2003. It also intends to improve the transparency requirements for gas using Regulation (EC) No 1775/2005. While the current regulatory framework has limited scope as far as transparency is concerned, the business as usual is also considered in this report.

4.1.5. Modifying the treatment of pre-liberalisation long-term contracts for gas transmission

Article 32(1) of Directive 2003/55/EC exempts long-term contracts for gas transmission concluded pursuant to Article 3(1) of Directive 91/296/EEC. A possibility would be to delete or change this provision in order to clarify that the legislation also applies to such contracts.

4.1.6. Enhanced Unbundling of DSOs including increasing regulatory scrutiny and reviewing the 100,000 limit

Full market opening requires distribution companies to ensure fair access to networks, a workable procedure for switching and confidentiality in data handling. However this is often not yet the case. The are many concerns about the incidence of cross subsidies, discrimination in the way information is handled as well as problems with switching procedures and load profiling, including the interaction with balancing rules. Many of these difficulties can be traced back to insufficient unbundling of network companies from supply businesses. Under the existing Directives, DSOs above the threshold of 100 000 customers have the same unbundling regime as TSOs.

Moreover, some market participants argue that the existing Directives do not provide sufficient enforcement at Member State level. ERGEG has already set out a recommendation on best practice for supplier switching and this needs to be enforced. The Commission therefore intends to strengthen the powers of regulators to enforce functional unbundling. Furthermore, DSOs with fewer than 100 000 customers are currently excluded from the basic unbundling requirements in the current gas and electricity Directives. This makes it rather unlikely, without very strong regulation, that other potential users will get fair access to networks.

4.1.7. Control of third country investment in EU networks

Measures may be needed to control the investment of third country companies in the EU gas and electricity networks. The concern is that effective TSO unbundling may be undermined by third country companies active in both supply and network operation and, more generally, that ownership unbundling would lead to a sell-off of European networks.

The Commission services have identified three options that will assist in attaining the objectives. These options are understood to be complementary. In any event, the first option is essential for the implementation of ownership unbundling. The options are related to:

(1) Ownership unbundling / TSO Designation: A new Article could be included in the gas and electricity directives to give the Commission the right to verify the unbundling implementation in a so-called certification procedure.

(2) Strategic Importance of energy networks: this is designed to shield EU energy networks by protecting them in trade terms. The option could be effected by (1) a declaration of strategic importance, without an implementing piece of legislation, (2) legislation followed by a declaration in the event of a trade dispute, or (3) both at the same time.

(3) Ownership or Control of transmission systems: transmission systems shall be majority owned by persons established in a Member State of the European Community. Transmission system operators shall be established in a Member State of the European Community.

The proposals for effective unbundling specify that supply companies active anywhere in the EU cannot acquire EU network companies. This would exclude also external producers and suppliers active in the EU, including state-owned companies, from operating or acquiring networks in the EU. As it would be difficult to ensure effective unbundling of companies outside the EU, the fear is that two companies outside the EU may discriminate against third parties in Member States where one owns networks and the other supplies.

More generally, the concern is that the EU is vulnerable to a strategy of third countries to dominate the EU markets not only in terms of supply but also by acquiring the networks. As this strategy would give third countries an influence on network operation and development, the EU objective of diversifying gas supply could be put at risk. Since long-term supply agreements and the acquisition of network assets are usually concluded with the individual EU companies and have a national focus, there is a risk that the individual companies and Member States do not stand up to political pressure to agree to these deals even if security of supply considerations may speak against these deals.

Another issue is the lack of reciprocity in market opening. While the EU energy market is open for non-EU investors including producing companies, the markets of major EU supply countries are largely closed. The Commission may therefore be interested to ensure reciprocity to obtain better access to third country markets.

4.2. Improving security of supply by strengthening the incentives for sufficient investment in transmission and distribution capacities

4.2.1. A new framework for gas storage and the imposition of requirements for strategic gas storage

Competition in the gas sector is limited by the availability of storage, which is often in the hands of the incumbent companies. Although storage is not a natural monopoly, facilities in certain locations may have a large impact on the functioning of the internal market. Voluntary guidelines for good practice for storage system operators (GPSSO) were agreed in 2004 but ERGEG, in its 2006 report on monitoring the implementation of the guidelines, found that compliance was lagging behind. Similarly the sector inquiry highlighted a number of problems in this respect. The Commission services will examine measures to best balance the need for effective access with maintaining incentives for new storage developments. This may need a specific regulatory framework requiring the following: a) legal unbundling, b) the adoption of binding guidelines following further advice from ERGEG, and c) increased powers of regulatory agencies over gas storage on an individual facility basis.

Recent crises in the supply of gas in 2006 and 2007 showed the dangers of relying on a single supplier. There is a question mark on the appropriateness whether or not to impose strategic stocks in gas to companies or Member States in order to guarantee the EU security of supply, in case of major disruptions like the ones the EU faced from different disputes between Russia and transit countries. .The Commission intends to propose a solidarity mechanism between the Member States in order to mitigate the effects of such future possible disruptions. A specific study is going to be launched in 2007 in order to assess in detail the costs and the benefits of such measures. Without questioning the reliability of this supplier, the damages caused to the economy of some Member States led the Commission to consider whether the mechanism already in place in present Directives 2003/55/EC and 2004/67/EC needed to be reinforced.

Option 1: impose mandatory strategic stocks on the companies as required by the existing oil directive;

Option 2: improve the existing mechanism by imposing more transparency and reporting obligation on the levels id commercial stocks ;

Option 3: create a solidarity mechanism at regional level between Member States.

4.2.2. Modifying the framework for new investments in gas infrastructure

Reinforcing security of supply and ensuring a competitive gas market are two objectives which the EU has to reconcile. The current possibility to exempt major new infrastructures from regulated third party access (Article 22 of the gas Directive 2003/55/EC) has sometimes proven difficult to interpret and the implementation varies between Member States. Firstly, the "business as usual" scenario has been considered. The second option is to improve the procedure and to clarify the criteria for granting an exemption.

4.3. Improving consumer protection and preventing energy poverty

Concerning consumer protection, experience to date has demonstrated that wholesale energy prices exhibit considerable volatility. This raises the question of whether and how end-user customers, including vulnerable customers, should be exposed to such fluctuations. The gas and electricity Directives require safeguards to protect consumers as well as includes the concept of universal service for electricity. Finally, the annexes of the Directives require that consumers also have to be given rights to transparent contract structures, a dispute settlement mechanism, the right to switch free of charge and protection from mis-selling. The Commission will also keep under constant review the retail markets to assess the effects of liberalisation on households, in view of increasing consumers’ confidence in the energy market and limiting the risk of market manipulation.

Time has come to develop "energy awareness" at household consumers' level. The Commission would propose to include specific provisions in this respect in annex A of the Directive.

Some stakeholders (such as energy intensive users and vulnerable customers) face specific problems. Their concerns can be addressed either through the present directive (article 3 on public service obligations) or by the means of specific national measures which have to be compatible with EU competition law (ex special scheme for energy intensive users with long term contracts between the supplier and the big customers).

The Commission announced it would launch a major information and awareness raising campaign in the run up to full market opening in July 2007.

On 5 July 2007, the Commission adopted a Communication to reinforce consumer protection and to strengthen their right to choose supplier. A fully functioning EU internal energy market is the best guarantee for an open and competitive energy sector with high standards of service, safety and quality. Consumers can influence the opening of the European energy markets by promoting competition between suppliers.

A possibility would be to set up an Energy Consumers’ Charter; Such a Charter aims at helping citizens in their role as active players on the energy market. To be able to make best use of their right to choose their supplier – and switch suppliers if they want to – they must be informed of their consumer rights and reassured that these rights will be safeguarded.

Consumers will have sufficient information on which to base decisions about choosing suppliers. They also need clear terms and conditions in contracts and to feel confident that changing supplier – if they wish to do so – will be free of charge.

The charter is not a binding document but the Commission is expecting more awareness of the EU consumers and the public consultation will provide inputs for a future Charter on the Rights of Energy Consumers .

4.4. Interaction between the shortcomings of the internal energy markets and the proposed measures

The proposed measures form an overall package to address the current shortcomings of the internal energy market. This package displays a high degree of complexity for a number of reasons. Firstly, the identified shortcomings concern different types of market players at different levels of the value chain. Secondly, individual measures, for example the creation of a regulatory agency at European level, do often not only target one specific market problem but are meant to alleviate several shortcomings, in the example the different problems underlying the lack of cross-border trade in gas and electricity. Finally, to solve a particular market problem, such as for example distorted price formation, several different measures targeted at different market participants may be necessary, involving for example TSOs, generators, power exchanges and regulators. It is therefore not always easy to describe and assess the significance of a particular measure in isolation. Moreover, the interdependence of the overall package entails that a modification of a particular measure may require modifications of other measures to achieve the same objective.

To illustrate how the proposed measures tackle the underlying market problems, the Commission services have drawn up a comprehensive table which can be found in Annex IV. The table relates the main structural problems of the energy markets as identified in particular by the Energy Sector Inquiry to the main legislative proposals. It appears for example that more effective TSO unbundling helps to tackle almost all structural problems of the gas and electricity markets. TSO unbundling is expected

- to tackle the problem of vertical foreclosure at is very root,

- to reduce market concentration by improving third party access and thus market entry,

- to promote market integration by facilitating cooperation and mergers between then-independent TSOs,

- to promote transparency by eliminating preferential information flows within vertically integrated companies,

- to help to remedy distorted price formation for example by eliminating the risk of cross-subsidies within vertically integrated companies and

- to contribute to the security of supply by stimulating investment for example in interconnection.

The table in Annex IV also shows that to tackle a specific market problem several different measures are usually necessary. To overcome the lack of market integration within the EU, for example, it is proposed to create new institutional bodies or strengthen existing ones such as ERGEG, ETSO, GTE and national regulators. Moreover, market integration will be helped by structural or regulatory measures such as more effective TSO unbundling and improved rules on transparency and access to storage and LNG.

While necessarily remaining at a rather abstract level, the table in Annex IV provides an overview of how the many of the specific measures are linked to the more general policy options as well as to the underlying market problems.

SECTION 5: ANALYSIS OF IMPACTS

The impacts of the Commission's main proposals are summarised for each of them. The Commission services have used a cost-benefit analysis to assess and quantify where possible the impact of the proposed policy options.

5.1. Further TSO unbundling

No EU action

The consequences of no EU action or "business as usual" scenario have been described at length in the Commission Communication of January 2007, notably in the energy sector inquiry. The main issue is that vertically integrated companies have a disincentive to behave in a pro-competitive manner. The Commission services have identified problems of foreclosure and abuse of dominant position by established players. Restrictions to market entry and market integration would persist, should the regulatory status quo continue.

Existing legislation requires that network operations are legally and functionally separated from supply and generation or production activities. Member States have complied with this requirement by applying different organisational structures. Several Member States have created a totally separated company for network operation, others have created a legal entity within an integrated company. The requirements of legal and functional unbundling have indeed positively contributed to the emergence of competitive electricity and gas markets in several Member States. However, experience has shown that where the transmission system operator is a legal entity within an integrated company, three types of problems arise.

Firstly, the transmission system operator may treat its affiliated companies better than competing third parties. In fact, integrated companies may use network assets to make entry of competitors more difficult. The underlying reason is that legal and functional unbundling do not solve the fundamental conflict of interest within integrated companies whereby the supply and production interests aim to maximise their sales and market share while the network operator is obliged to offer non-discriminatory access to competitors. This inherent conflict of interest is almost impossible to control by regulatory means as the independence of the transmission system operator within an integrated company is impossible to monitor without an excessively burdensome and intrusive regulation.

Secondly, under the current unbundling rules, non discriminatory access to information cannot be guaranteed as it cannot be effectively prevented that transmission system operators do not release market sensitive information to the generation or supply business of the integrated company.

Thirdly, investment incentives within an integrated company are distorted. The vertically integrated network operators have no incentive to develop the network in the overall interest of the market with the consequence of facilitating new entry at generation or supply levels. Instead, the investment decisions of vertically integrated companies tend to be biased to the needs of supply affiliates. Such companies seem particularly disinclined to increase interconnection or gas import capacity which allow for more competition in the incumbent’s home market to the detriment of the internal market.

5.1.1. TSO unbundling micro-economic impact analysis

In view of the fundamental nature of any future requirement to fully separate networks in terms of ownership, the Commission services have made a detailed economic analysis of the effect of such a measure in terms of:

- the effect on network investment

- the effect of investment in LNG terminals

- the effect on share prices and credit ratings

- the effect on market concentration

- the effect on prices

- the effect on relations with external suppliers and security of supply

- the effect on research and innovation.

Finally case studies are made comparing experience with the ISO models against ownership unbundling.

5.1.2. Impact of ownership unbundling on investments in the network

Experience from several Member States demonstrates that ownership unbundling is conducive to infrastructure investment, thus correcting the distorted investment incentives of vertically integrated companies which have no incentive to develop the network in the overall interest of the market with the consequence of facilitating new entry at generation or supply levels.

While it is difficult to compare the absolute investment levels across the EU due to country specific characterstics such as population density and primary energy sources it appears worthwhile comparing the evolution of TSO investment over time, in particular in Member States where ownership unbundling has occurred. Such an analysis shows that the TSOs for which data was available show a significant and constant increase in investment levels after ownership unbundling took place (see Annex III). Three to four years after the ownership unbundling the investments in the networks had doubled, in the case of some TSOs, i.e. Spanish REE, Czech CEPS, Portuguese REN and Dutch Gasunie, the increase in the investment amount was even more pronounced. Notably, this observation can be made for TSOs in both the gas and the electricity sector.

In the case of vertically integrated TSOs, there is generally less data on network investment publicly available (see Annex III). The available data for some German, French and Italian TSOs show an increase in network investment in recent years, however less pronounced than in the case of the above mentioned TSOs after ownership unbundling. For instance, the network investment of the German electricity TSOs, which are all part of integrated energy companies, halved between 1995 and 2002/2003 and has only recently shown signs of recovery.

It should be noted that tariff regulation also exercises an important influence on the TSOs' willingness to invest as it is an important factor for the profitability of their investments. Part of the steep increase in investments after ownership unbundling may therefore be explained by a stronger willingness of regulators to finance the investments through tariffs. The independence of ownership unbundled TSOs from supply and generation interests is, however, likely to have contributed to the regulators' willingness to finance the investments through tariffs. Another factor influencing investment decisions is the conclusion of long-term supply agreements. These reduce investors' risk that the infrastructure will not be used adequately. There are however no indications that this factor would in recent years have influenced investment level in any particular manner.

Investment in interconnectors may be regarded as a particularly suitable indicator to examine the potential of ownership unbundling to promote investment. The reason is that vertically integrated companies have an interest to protect their supply business in their home market by limiting cross-border capacity. As shown in the below table, the share of congestion revenue reinvested in interconnector capacity was about twice as high for ownership unbundled TSOs as for vertically integrated TSOs.

Relationship between ownership of TSOs and reinvested congestion revenue

Ownership unbundled TSOs in EU-15 | Vertically integrated TSOs in EU-15 |

Congestion revenue (2001-6/2005) | 387 | 623 |

Interconnector investment | 129 | 104 |

Share of reinvested congestion revenue | 33.3% | 16.8% |

Source: Energy sector inquiry

It should be noted that these results need to be interpreted with caution because, firstly, interconnector investment is influenced by a number of factors and not only by the unbundling, secondly, investment planning and implementation takes some time and, thirdly, situations in which an ownership unbundled TSO at one side of the border faces an integrated TSO at the other side of the border can be an obstacle to investments. This being said, these caveats apply to all TSOs in an equal manner and should not systematically influence the above findings.

The case of the Nordic countries is another example of how ownership unbundled electricity TSOs have agreed to tackle cross-border congestion[8]. In the framework of Nordel, the body for co-operation between the TSOs in Denmark, Finland, Iceland, Norway and Sweden, the TSOs have identified five major cross-sections in the Nordic transmission grid which will be substantially reinforced in the coming years. The total investment volume of all five project is about € 800 million.

As stated in the energy sector inquiry, the German electricity TSOs which are all part of vertically integrated companies have invested only a small fraction of their revenues from cross-border congestion into expanding or building new cross-border interconnectors: "In the period 2001 to 2005 three German TSOs managing interconnectors generated congestion revenues of [400-500] million Euro. Of these revenues only [20-30] million Euro were used to reinforce/build new interconnectors (one TSO said that it does not know how much of the investment into the net had the effect of reinforcing interconnectors). All TSOs maintained that the remaining revenues were used to reduce the transmission tariffs" [9]. While it must be acknowledged that building a new line is a difficult and lengthy procedure, the striking findings in the case of the German TSOs seem to confirm the view that unlike ownership unbundled TSOs vertically integrated companies have little incentive to invest in interconnectors which risk to expose them to more supply competition in their home market.

5.1.3. Impact of ownership unbundling on investments in LNG terminals

With respect to investment, it is also important to note that the main Member States in which LNG terminals are in an advanced stage of planning or are being built by companies other than integrated energy companies are the Netherlands, the UK and Spain, i.e. countries in which the gas networks are ownership unbundled. Moreover, in these three Member States the number of LNG terminals being close to construction phase or being constructed has been significantly higher than in countries in which the gas TSOs are still part of integrated companies. This is particularly so when taking into account projects by companies not affiliated with the incumbent companies.

These findings are in line with the Commission's energy sector inquiry which concluded that "traditionally LNG has been imported by national incumbents who also own LNG terminals, which has not permitted the potential of LNG imports to increase downstream competition to be realised. Recent trends, however, point to more capacity going to new entrants and to producers themselves. This is likely to have a positive impact on fostering downstream competition unless such effects are frustrated by access, LNG-storage or emission rules with negative effects on competition, or by anti-competitive behaviour" [10].

5.1.4. Impact of ownership unbundling on share prices

The Commission has analysed the impact of ownership unbundling on the share value of previously vertically integrated energy companies. The analysis has been triggered by fears that ownership unbundling allegedly destroys shareholder value by forcing the break up of companies. In this perspective, ownership unbundling has been considered to correspond to an 'expropriation' of the shareholders. The following examples show that shareholders have in fact in almost all cases benefited from increasing share prices during and after the ownership restructuring.

Three Members States appear particularly suitable to investigate this impact. These are Spain for its gas and electricity TSOs Enagas and REE, Italy for its electricity TSO Terna and the UK for National Grid which is both the TSO for gas and electricity. These TSOs are ownership unbundled, the majority of the shareholding is in private ownership and they are listed on the stock exchange. As a general rule, the share prices of all four TSOs as well as the prices of their previous owners display a massive increase. Generally, the TSOs clearly outperform the national stock market indices as well as their former parent companies, however, the latter still outperform the national stock market indices or display at least a comparable performance (see all relevant graphs in annex).

To illustrate the share value evolution at the example of British Gas: On 14 February 1997, immediately before the demerger of Centrica, British Gas shares closed at a price of 247.5p. If you had bought 100 shares at that price and had subsequently reinvested all dividends and returns of capital you would now hold 126 BG Group shares, worth 739p each, 125 Centrica shares, worth 373.5p each, and 60 National Grid shares, worth 795.5p each. Thus an investment of £100 would now be worth £756.05. On the same basis £100 invested in the FTSE 100 would be worth £197.45. In the case of Scottish and Southern Energy and Scottish Power, the introduction of an independent system operator in Scotland in 2005 does not seem to have had a negative effect on the share price which, on the contrary, has increased substantially since 2005.

In Spain stock prices for Iberdrola, Endesa and Union Fenosa, which sold their electricity network assets at the end of 2002, and TSO Red Electrica de Espana (REE) increased by up to 600% (for the period November 2002 to April 2007), compared to an increase of the Spanish stock market index IBEX 35 of 68% over the same time period. Similar patterns can be found for the unbundled Spanish TSO Enagas and its former vertically integrated parent Gas Natural.

In the case of Italy, the share price of the incumbent electricity company ENEL was in the period from June 2004 to March 2007 developed similar to the evolution of the gneral stock market index even though during this period, ENEL gradually divested its network company Terna to a remaing shareholding of presently 5% (sale of 50% of Terna in July 2004, 13.86% in March 2005 and 29.99% in September 2005). During the same period,, Terna outperformed the Italian stock market.

5.1.5. Impact of ownership unbundling on credit ratings

Comparing the credit ratings of vertically integrated companies to energy companies without network assets, no significant or systematic differences can be observed (see Annex VI). This seems to provide some evidence against the common view that the predictable revenue stream of the network business makes a vertically integrated companies less risky than a company without network assets, allegedly giving it cheaper access to investment capital.

It appears that the particular financial situation of the individual companies, their private or public ownership, the degree of international expansion and country specific circumstances play a much more important role in explaining the differences in the credit ratings than the level of vertical integration. It is also worth noting that the credit rating for National Grid's gas TSO is the same as for its former parent Centrica. In fact credit ratings before and after this ownership unbundling did not change at all. Likewise, in the case of ENEL, the divestiture of the Italian electricity TSO Terna in the years 2004 and 2005 changed nothing in ENEL's A+ rating by Standard & Poor's[11]. The same is true for the Spanish gas supplier Gas Natural which, between 2002 and 2005, was obliged to gradually divest its gas network without experiencing any effect on its credit rating.

5.1.6. Impact of ownership unbundling on market concentration

Market shares of the largest generator in the electricity market (as a percentage of total generation) are significantly higher in Member States with legal unbundling than in those with ownership unbundling. Abstracting from countries with incomplete data, small and isolated countries, and the special case of Germany (where four former regional monopolists dominate the market), average market shares of the largest generator were in 2005 in Member States with legal unbundling 73% versus 47.7% in Member States with ownership unbundled TSOs (see table in Annex II).

While it is true that this difference already existed to a large extent before some of the Member States concerned implemented ownership unbundling, the cases of Spain, Italy and Portugal demonstrate that the market shares of the largest generator dropped significantly following the implementation of ownership unbundling. In all three countries, the market share of the largest generator fell, within three years after ownership unbundling, by more than six percentage points. In more general terms, the degree of market concentration as measured by the market share of the largest electricity generator decreased between 1999 and 2005 more strongly in Member States with ownership unbundling than those with legal unbundling.

In the gas sector, ownership unbundling has equally led to an erosion of the incumbents' market share. In particular in the UK and Spain, the wholesale market shares of the incumbent companies such as British Gas and Gas Natural have fallen below 50%.

5.1.7. Impact of ownership unbundling on prices

Electricity and gas prices may not automatically decrease because of ownership unbundling as other elements such as rising commodity prices, investment costs, taxes and environmental fees may exert a strong upward pressure on prices. However, weakening the market power of vertically integrated companies has potentially a dampening effect on prices by encouraging efficiency and new entry. In any event, the objective of ownership unbundling is not necessarily to bring prices down but to achieve a price setting which reflects the real costs of efficient operation and which gives the right signals for the future investments needs, for example in renewable energy.

A possible approach to examine the impact of ownership unbundling on energy prices is to compare the price evolution of Member States with and without ownership unbundled TSOs. Such a comparison has been carried out on the basis of biannual Eurostat price data for wholesale and household customers in EU-27 excluding all taxes. Based on the entry into force of the first electricity Directive, the year 1998 was chosen as the starting point. As of the moment a Member State implemented ownership unbundling, the relative price change of this Member State was included in the calculation of the price index for Member States with ownership unbundling. This methodology takes into account that the composition of Member States that apply ownership unbundling is changing over time and that price data for the newer Member States is not available for all years[12].

The results of this calculation show that in ownership unbundled markets, the electricity price for industrial consumers decreased from 1998 until 2006 by 3.0%, while in markets without ownership unbundling this price increased by 6.0%. The price difference between the two country samples over the entire period of nine years was thus 9% in favour of Member States with ownership unbundling (see table below and detailed table in Annex VII).

Household electricity prices show an even larger difference between countries with and without ownership unbundling. In countries with ownership unbundling, household electricity prices rose from 1998 until 2006 by 5.9%,, while the price increase in countries without ownership unbundling was 29.5%. The difference between the two country samples was thus 23.6% in favour of Member States with ownership unbundling (see table below and Annex VII).

Cumulative and aggregated electricity price changes in EU-27 for the period 1998-2006

Electricity prices |

Industry | Households |

MS with ownership unbundling | MS with integrated TSOs | MS with ownership unbundling | MS with integrated TSOs |

Cumulative and aggregated price changes 1998 - 2006 | -3.01% | 6.01% | 5.91% | 29.46% |

Source: Eurostat data, own calculations; all prices without taxes, see also Annex VII

It should be noted that the comparison of the evolution of household prices is prima facie less meaningful than for industry prices since, in the period under examination, numerous Member States have applied regulated tariffs for household customers. Household prices are thus less sensitive to changes in market conditions.

Moreover, it is not possible to carry out the same comparison for gas prices. For most of the period since 1998, there was only one Member State which had a fully ownership unbundled gas TSO, namely the United Kingdom since 2000. While the UK household and industry gas prices developped subsequent to unbundling more favourably than in the total of other Member States the statistical basis is too small to be representative[13].

Another indicator to measure the level of competition in a market is the margin between wholesale prices and retail prices. The higher this margin, the more retail suppliers benefit and the more end customers have to pay for their electricity. In the Netherlands and the UK, the wholesale prices for electricity were in 20