[pic] | COMMISSION OF THE EUROPEAN COMMUNITIES |

Brussels, 10.1.2007

SEC(2006) 1724

VOLUME I

COMMISSION STAFF WORKING DOCUMENT Accompanying the

COMMUNICATION FROM THE COMMISSION Inquiry pursuant to Article 17 of Regulation (EC) No 1/2003 into the European gas and electricity sectors (Final Report) {COM(2006) 851 final}

DG COMPETITION REPORT ON

ENERGY SECTOR INQUIRY

10 January 2007

EXECUTIVE SUMMARY 4

A. INTRODUCTION 18

B. FIRST PHASE OF THE SECTOR INQUIRY 22

a. GAS 22

I. Introduction 22

I.1 Main market features 22

I.2. The regulatory framework 29

I.3. Gas wholesale markets 33

II. Issues 37

II.1. Concentration 37

II.2. Vertical foreclosure 47

II.3. Market integration 67

II.4. Transparency 90

II.5 Price issues 101

b. ELECTRICITY 111

I. Introduction 111

I.1 Main market features 112

I.2. The regulatory framework 114

I.3. Electricity wholesale markets 119

II. Issues 130

II.1. Concentration and market power 130

II.2. Vertical foreclosure and vertical integration 151

II.3. Market integration 170

II.4. Transparency 188

II.5 Price issues 198

C. SECOND PHASE OF THE SECTOR INQUIRY 206

a. RESULTS OF THE PUBLIC CONSULTATION 206

I. Gas 206

II. Electricity 223

b. GAS 232

I. Competition on downstream markets 232

II. Balancing in gas market 245

III. Gas study - Liquefied Natural Gas 261

c. ELECTRICITY 283

I. Downstream markets 283

II. Balancing in the liberalised electricity market 295

III. Electricity study – Analysis of hourly variations of concentration 311

D. CONCLUSIONS 323

ANNEXES 329

EXECUTIVE SUMMARY[1]

Introduction

Well functioning energy markets that ensure secure energy supplies at competitive prices are key for achieving growth and consumer welfare in the European Union. To achieve this objective the EU decided to open up Europe’s gas and electricity markets to competition and to create a single European energy market. The process of market opening has significantly changed the functioning of the markets, provided new market opportunities, led to the introduction of new products and services. Competition initially lowered energy prices in Europe in line with market fundamentals.

However, while progress has been made, the objectives of market opening have not yet been achieved. Despite the liberalisation of the internal energy market, barriers to free competition remain. Significant rises in gas and electricity wholesale prices that cannot be fully explained by higher primary fuel costs and environmental obligations, persistent complaints about entry barriers and limited possibilities to exercise customer choice led the Commission to open an inquiry into the functioning of the European gas and electricity markets in June 2005. This inquiry, based on Article 17 of Regulation 1/2003[2] on the implementation of the Treaty rules on competition, aimed at assessing the prevailing competitive conditions and establishing the causes of the perceived market malfunctioning. The Final Report (Commission Communication) summarises the results of the inquiry, which are presented in more detail in this Technical Annex[3] to the Final Report.

While the Sector Inquiry was launched amidst perception that consumers were not reaping the full benefits of liberalisation, it should be underlined from the outset that it was not the object of the inquiry to describe the progress made in the liberalisation process and the advantages resulting from it. There are many such achievements and customers in markets where liberalisation has been successfully introduced are still among those benefiting from the widest choice of suppliers and services. They also pay – compared to customers in other Member States – more cost-reflective prices on average. The Commission remains thus convinced that there is no alternative to the liberalisation process. It is, therefore, essential to ensure that existing liberalisation Directives are fully and effectively transposed.[4] However, more needs to be done before consumers can reap the full benefit.

The Energy Sector Inquiry has focused on identifying areas where competition is not yet functioning well and those areas which need to be addressed the most rapidly in order for liberalisation to bear fruit. For the purpose of the inquiry the key areas were grouped under the following headings: (1) market concentration/market power, (2) vertical foreclosure (most prominently inadequate unbundling of network and supply), (3) lack of market integration (including lack of regulatory oversight for cross border issues), (4) lack of transparency, (5) price formation, (6) downstream markets, (7) balancing markets, and (8) liquefied natural gas (LNG).

The shortcomings identified in these key areas call for urgent action and priority should be given to four areas: (1) achieving effective unbundling of network and supply activities, (2) removing the regulatory gaps (in particular for cross border issues), (3) addressing market concentration and barriers to entry, and (4) increasing transparency in market operations. The Commission's intentions concerning regulatory proposals to be made in this regard are set out in its Communication on "Prospects for the internal gas and electricity market"[5] which is presented in parallel to the Final Report.

The wider context

The introduction of competition in Europe’s gas and electricity markets is an integral part of European energy policy which is directed at achieving the three closely related objectives of: a competitive and efficient energy sector, security of supply and sustainability. All European consumers, i.e. households, commercial users and industrial users, heavily depend on the secure and reliable provision of energy at competitive prices. Also, the achievement of the Union’s goal of adequate protection of the environment is of fundamental importance as can be demonstrated by the commitment to reduce the emission of greenhouse gases in implementation of the Kyoto Protocol. The Sector Inquiry therefore has to be seen against this wider policy context.

European energy policy was set out in the Commission's Communication to the 2006 Spring European Council[6] concerning the renewed Growth and Jobs strategy. That Communication puts the creation of an efficient and integrated energy policy at the heart of the Commission’s priorities. This goal was further underlined in the Commission’s Green Paper “A European Strategy for Sustainable, Competitive and Secure Energy”[7] which was adopted by the Commission in March 2006.

The Final Report of the Sector Inquiry is presented in parallel to the Commission's Strategic EU Energy Review[8] and the Energy Package that includes the "Communication on Prospects for the internal gas and electricity market" referred to above and the follow-up to the Green Paper. Account is also taken of the work undertaken within the High Level Group on Competitiveness, Energy and the Environment, which underlined the need for better functioning electricity and gas markets in its first report adopted in June 2006.

It transpires from all these documents that the three policy objectives “competitiveness, security of supply and sustainability” are closely interlinked and complementary. Competitive markets provide the necessary signals for investment, which leads to supply security in the most cost efficient manner. Similarly, the creation of a competitive internal market will allow the Union’s energy companies to operate in a market of a larger dimension, which will improve their ability to contribute to security of supply. At the same time, market forces oblige European operators to use the most cost effective methods of production, which in the appropriate regulatory environment can benefit sustainability. Consumers will be able to choose between different providers and contract schemes, and could thus reduce their electricity costs and adapt their consumption to market developments. Competitive, cost reflective prices will help encourage energy efficiency, which can reduce the dependence on external suppliers and which supports the Union’s objective for sustainability and security of supply.

The Final Report concentrates on the competition aspects of Europe’s energy policy and the remaining obstacles to creating a single European energy market. Quite apart from the fact that this aspect merits a thorough analysis in its own right, the focus is also dictated by the procedural framework (Regulation 1/2003), in which the inquiry was carried out. This does not mean that e.g. security of supply goals are not taken into account when assessing likely pro- and anti-competitive effects in the context of applying the Community competition rules in individual cases. Indeed a competitive internal market is a key instrument in delivering this objective. However in the context of the Sector Inquiry the main focus has been on competition.

The procedure leading to the adoption of the report

The Sector Inquiry into the European energy markets was launched on 17 June 2005. Initial results were presented in the form of an Issues Paper published on 15 November 2005. Following publication of the Preliminary Report on 16 February 2006 the Commission launched a public consultation. In their submissions stakeholders welcomed the report, generally praising its objectivity as well as the wealth of information. Contributions came from companies operating in the sector, both from incumbents and new entrants, from national regulators, competition authorities, consultancies, law firms, energy traders, grid operators, customers, industry associations and national government agencies.

The majority of the stakeholders support the findings, although there were variations in the assessment of the gravity of the situation and whether the situation is improving or not. As regards the possible ways forward there was both support and opposition to the ideas put forward in the Preliminary Report such as structural unbundling, while some called for even more radical remedies. Generally speaking the vertically integrated incumbent companies were not in favour of further measures, whilst consumers, traders/new entrants and authorities supported the call for legislative initiatives.

The Findings

The main findings of the Sector Inquiry can be grouped – as indicated above – under eight headings. Whilst there are some obvious differences between the gas and electricity sectors, the many similarities and inter-relationships between the sectors plead for a common presentation..

1. Market concentration

At the wholesale level, gas and electricity markets remain national in scope, and generally maintain the high level of concentration of the pre-liberalisation period. This gives scope for exercising market power.

Wholesale gas trade has been slow to develop, and the incumbents remain dominant on their traditional markets, by largely controlling up-stream gas imports and/or domestic gas production. Incumbents trade only a small proportion of their gas on gas exchanges (“hubs”). With little new entry in retail markets, customer choice is limited and competitive pressure constrained. The overall picture for potential new entrants is one of dependency on vertically integrated incumbents for services throughout the supply chain.

Although electricity trading is more developed, sales on wholesale electricity markets generally reflect the significant level of concentration in generation. Analysis of trading on power exchanges shows that, in a number of them, generators have scope to exercise market power by raising prices, a concern also expressed by many customers. Analysis of trading positions on forward markets, which overall shows less concentration, demonstrates that the electricity markets depend on few suppliers with long positions (i.e. generate more than they resell). Analysis of generation portfolios also shows that the main generators have the ability to withdraw capacity to raise prices.

In the context of the inquiry, a study has been conducted on concentration levels in the electricity sector.[9] An analysis of concentration on an hourly basis shows that even during off-peak hours markets remain highly concentrated and that concentration levels, even in the less concentrated markets, reach significant levels at peak hours. The analysis based on measurements of the structure of the market in every hour also reveals that, in certain markets, long-term contracts and, to a lesser extent, the reserve requirements can reinforce concentration levels. Further, the analysis shows that the existing level of interconnection capacity is not sufficient to significantly reduce concentration.

2. Vertical foreclosure

The current level of unbundling of network and supply interests has negative repercussions on market functioning and on incentives to invest in networks. This constitutes a major obstacle to new entry and also threatens security of supply.

New entrants often lack effective access to networks (in gas, also to storage and to liquefied natural gas terminals) despite the existing unbundling provisions. The operators of the network/infrastructure are suspected of favouring their own affiliates (discrimination). Vertical integration also leads to a situation where operational and investment decisions are not taken in the interest of network/infrastructure operations, but on the basis of the supply interests of the integrated company (including grid connection for competing power plants). This is highly damaging to security of supply.

Another form of vertical foreclosure was found to exist by way of the integration of generation/imports and supply interests within the same group. This form of vertical integration reduces the incentives for incumbents to trade on wholesale markets and leads to sub-optimal levels of liquidity in these markets. In particular, the prevalence of long-term supply contracts between gas producers and incumbent importers makes it very difficult for new entrants to access gas on the upstream markets. Similarly, electricity generation assets are in the hand of a few incumbent suppliers or are indirectly controlled by them on the basis of long-term power purchase agreements (PPAs) giving the incumbents control over the essential inputs into the wholesale markets. Low levels of liquidity are an entry barrier to both gas and electricity markets.

3. Market integration

Cross-border sales do not currently impose any significant competitive constraint. Incumbents rarely enter other national markets as competitors. Insufficient or unavailable cross-border capacity and different market designs hamper market integration.

For gas, available capacity on cross-border import pipelines is limited. New entrants are unable to secure transit capacity on key routes and entry capacity into new markets. Very often, the primary capacity on transit pipelines is controlled by incumbents based on pre-liberalisation legacy contracts which are not subjected to normal third party access rules. Incumbents have little incentive to expand capacity to serve the needs of new entrants. This is reinforced by ineffective congestion management mechanisms, which make it difficult to secure even small volumes of short-term, interruptible capacity on the secondary market. In many cases, new entrants have not even been able to obtain a sufficient amount of capacity when there have been expansions of transit pipeline capacity. Expansions have generally been tailored to the needs of the incumbents' own supply businesses.

In electricity, integration is hampered by insufficient interconnector capacity and a lack of adequate incentives to invest in additional capacity to eliminate long-established bottlenecks. In addition, on certain borders, long-term pre-liberalisation capacity reservations still exist despite the ruling of the European Court of Justice that such reservations are not compatible with EC law, unless they were notified under Directive 96/92/EC. Improving access to existing interconnectors requires better methods of congestion management. However, better use of capacity is often not in the interest of vertically integrated network operators.

4. Transparency

There is a lack of reliable and timely information on the markets.

Network users require more transparency going beyond the current minimum requirements set by EU legislation. Of particular importance is data relating to network availability, especially for electricity interconnections and gas transit pipelines. Data on the operation of generation capacity and gas storage also needs to be more widely available. For electricity, in particular, it was noted that rules on proper market conduct and supervision differ significantly between Member States, as there is little harmonisation at EU level of the transparency requirements.

To ensure a level playing field, all market participants require information to be made available on an equal footing and in a timely manner. At present there is an information asymmetry between the vertically integrated incumbents and their competitors. Improved transparency would minimise risks for new market players and so reduce entry barriers and improve trust in the wholesale markets and confidence in price signals. Obviously it needs to be ensured that no collusion takes place on the basis of the published information and, although commercial confidentiality is important, this should not be allowed to undermine effective transparency by being given too wide an interpretation.

5. Price formation

More effective and transparent price formation is needed in order to deliver the full advantages of market opening to consumers. Many users have limited trust in the price formation mechanisms, while regulated supply tariffs below market prices discourage new entry.

Gas import contracts use price indices that are linked to oil derivatives (e.g. light fuel or heavy fuel) and prices have, therefore, closely followed developments in oil markets. This linkage results in wholesale prices that fail to react to changes in the supply and demand for gas, which is damaging to security of supply. No clear trend towards more market based pricing mechanisms can be observed in long-term import contracts. Ensuring liquidity is crucial to improving confidence in price formation on gas hubs, which will allow for a relaxation of the linkage to oil.

Electricity price formation is complex. Increases in the price of primary fuels have certainly played a role in recent electricity price developments especially in marginal plants. However this does not appear to fully explain the recent price rises. Similarly, the effect of the EU CO2 emissions trading scheme on electricity prices is not yet entirely clear.

In several Member States, regulated tariffs have generated adverse effects for the development of competitive markets, since they have been set at very low levels compared to market prices and cover a large part of the market, thereby effectively leading to re-regulation. Similarly, in several Member States, special measures to reduce electricity bills for energy intensive industries have been considered. Such schemes must be compatible with antitrust and state aid rules.

6. Downstream markets

Competition at the retail level is often limited. The duration of retail contracts for industrial customers and local distribution companies can have a substantial impact on the opportunities for alternative suppliers to successfully enter the market.

The cumulative effect of long contract durations, contracts with indefinite duration, contracts with tacit renewal clauses and long termination periods can be substantial. The analysis shows that the degree to which the industrial customers are tied to incumbent suppliers on a long-term basis differs significantly between Member States.

Customers demand more competitive offers from non-incumbent suppliers and regret the absence of pan-European supply offers. The number of competitive offers that customers receive is particularly unsatisfactory in some Member States characterised by a high level of concentration.

For gas, restrictions on how customers can dispose of their gas, in combination with restrictive practices by suppliers regarding delivery points, limit competition and prevent the achievement of efficiencies by these customers. In electricity, certain standard contracts contain restrictions, which may also raise competition concerns.

7. Balancing markets

Currently, balancing markets often favour incumbents and create obstacles for newcomers. The size of the current balancing zones is too small, which leads to increased costs and protects the market power of incumbents.

For gas, the small size of current balancing zones increases the complexity and costs of shipping gas within Europe. Costs are increased by highly complex and divergent rules in each zone, and by the obligation to reserve capacity at each border point. These problems are exacerbated by the time dimension: the shorter the balancing period, the higher the risk of imbalance for the supplier. All these aspects create major obstacles for new suppliers to enter the market, which the vertically integrated incumbents have little incentive to remove. Furthermore, balancing charges, clearing costs and penalty charges are not transparent and often contain unjustified penalty charges, favouring incumbents. Effective unbundling is necessary to create a level playing field in the balancing markets and to reduce barriers to entry.

In electricity, the markets on which transmission system operators have to acquire balancing and reserve energy are highly concentrated, which gives generators scope for exercising market power. This can result in entry barriers for new suppliers facing a high risk of high imbalance prices and/or high network charges (to the extent that balancing costs are included in the costs of the network). Concentration in balancing markets could be reduced if the geographical size of control areas was enlarged. Harmonization of balancing market regimes would be an important step to increase the size of control areas, improve market integration and simplify trade. In some Member States the structural relation between TSOs and their affiliated generation provides an incentive for the TSO to buy excessive reserve capacity and/or to pay high prices, thereby favouring their affiliated generation arm. Results indicate that the amount of capacity reserves bought differs substantially between TSOs.

8. LNG markets

LNG supplies widen Europe’s upstream supplier base and are therefore important for both security of supply and competition between upstream suppliers. The potential for LNG supplies to favour less concentrated downstream markets still needs to be realised.

Traditionally LNG has been imported by national incumbents who also own LNG terminals, and this situation has prevented LNG imports from increasing downstream competition. 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 anticompetitive rules or behaviour. Strong investment in LNG terminals has taken place and is scheduled to take place in the coming years. Investments in some LNG terminals have benefited from exemptions from third party access obligations under a test applied by national regulators with Commission supervision. This test seeks to achieve a balance between ex ante incentives to invest and competition once the investment has been made. While experience is largely positive, improvements are possible.

Remedies

In order to address the malfunctioning of the market identified in the Sector Inquiry and to significantly improve the scope of competition, it is essential to apply both competition and regulatory-based remedies. Competition law enforcement can make a significant contribution, but cannot by itself open markets and resolve all the shortcomings identified by the Sector Inquiry: a number of regulatory measures are, therefore, also needed.

Competition law enforcement

Full and combined use of the Commission’s powers under antitrust rules (Articles 81, 82 and 86 EC), merger (Regulation 139/2004)[10] and State aid control (Articles 87 and 88 EC) is needed to maximise the impact of the Commission’s enforcement action. The Commission is forcefully pursuing infringements of Community competition law (antitrust) in the sector wherever the Community interest so requires, in close cooperation with National Competition Authorities.

Market Concentration

Market concentration has been identified as a major concern for the success of the liberalisation process. The market power of pre-liberalisation monopolies has not yet been eroded. This makes the Community's action under the merger regulation essential so as to ensure that the competitive structure in relevant markets (which currently are at most national in scope) does not further deteriorate. In recent merger cases remedies such as divestitures, contract and/or gas release have been applied. In addition, the impact of long-term upstream contracts on downstream concentration has emerged as a major theme.

Energy release programmes (i.e. electricity Virtual Power Plant auctions and gas release programmes) are a means to develop market liquidity and increase entry opportunities. They constitute suitable remedies to competition concerns not only in the merger area but also under antitrust rules. In order to be fully effective they must be well-designed and large scale. Substantial experience has been gathered with such programmes by competition and regulatory authorities at national level (e.g. in Spain, France, Austria, Germany) and by the European Commission (in merger cases) allowing the authorities to avoid pitfalls and ensure their effectiveness. For gas, such release programmes have the additional advantage that they are likely to increase hub liquidity which supports the introduction of price signals not biased by the gas-oil-price link.

In certain circumstances applicable antitrust law also permits the application of farther reaching structural measures as a remedy to infringements of competition rules. This is the case where behavioural remedies would be less effective to bring the infringement to an end, where there is a substantial risk of a lasting or repeated infringement that derives from the very structure of the undertaking, or where behavioural remedies would be more burdensome.[11]

Vertical foreclosure

Wherever competition infringements are facilitated by vertical integration between supply and generation and infrastructure businesses and insufficient unbundling, the full force of the Commission’s powers to prevent future abuse needs to be applied.

The Sector Inquiry has also confirmed the vertical tying of markets by long-term downstream contracts as a priority for review of case situations under competition law and of providing guidance where required. When such contracts, concluded by dominant firms, foreclose the market, Article 81 or 82 EC may be infringed unless there are countervailing efficiencies benefiting consumers.[12] Similarly, power purchase agreements in the electricity sector can have foreclosure effects.

Furthermore, the concentration of gas import contracts in the hand of a few incumbents is one of the main reasons why competition at the subsequent level of trade does not take off. Whilst this does not as such put into question existing and future upstream contracts, it requires attention with respect to their effects for the downstream markets.

Market integration

Foreclosure can also arise at other levels of the value chain, most prominently as regards access to infrastructure (transmission and distribution networks and/or storage facilities), particularly in cases where cross-border access is concerned , thereby preventing market integration. Such access can be blocked through long-term transmission contracts and through the associated risk of capacity hoarding. Action in this field should include an analysis of the competition effects of pre-liberalisation long-term contracts and the compatibility of such contracts with competition rules.

Additionally, lack of investment and delayed investments by transmission companies with vertically integrated supply companies are another serious source of concern. It is recalled that one National Competition Authority has found that a vertically integrated network operator deliberately stopped an investment project in order to benefit its supply branch by depriving competitors of access to more capacity.[13]

Market partitioning remains one of the most serious obstacles to market integration. The fight against collusion between incumbents remains a priority of antitrust enforcement action, reflecting the overall priority of the Commission to fight attempts by undertakings to coordinate rather than to compete.

Structural issues and pro-competitive regulatory environment

The findings of the Sector Inquiry will enable the Commission to focus its enforcement action on the most serious concerns identified in the report. They also make it easier for the Commission to identify efficient remedies that can effectively resolve the competition problems identified in individual cases.

However, key issues relating to market structure and the regulatory environment will have to be addressed in parallel , in order to remedy the malfunctioning of the markets that has been demonstrated by the inquiry.

The Sector Inquiry has identified the following main fundamental deficiencies in the competitive structure of current electricity and gas markets:

- Structural conflicts of interest: a systemic conflict of interest caused by insufficient unbundling of networks from the competitive parts of the sector;

- Gaps in the regulatory environment: a persistent regulatory gap particularly for cross border issues. The regulatory systems in place have loose ends, which do not meet;

- A chronic lack of liquidity , both in electricity and gas wholesale markets: the lifeblood for our markets is lacking and the market power of pre-liberalisation monopolies persists;

- A general lack of transparency in market operations in the sector.

Options for regulatory action at EC level are discussed by the Commission in its Communication on “Prospects for the internal gas and electricity market”. The findings of the Sector Inquiry and the resulting deficiencies identified below support and confirm the analysis brought forward by the Commission in that Communication.

Unbundling

The Sector Inquiry confirms the finding that it is essential to resolve the systemic conflict of interest inherent in the vertical integration of supply and network activities , which has resulted in a lack of investment in infrastructure and in discrimination. It is crucial to ensure that network owners and/or operators do not have incentives that are distorted by supply interests of affiliates. This is particularly important at a time when Europe needs very large investments to ensure security of supply and to create integrated and competitive markets.

To achieve this, it will be necessary to decisively reinforce the current inadequate level of unbundling. This would, in turn, also facilitate cooperation among network operators.

Economic evidence shows that full ownership unbundling is the most effective means to ensure choice for energy users and encourage investment. This is because separate network companies are not influenced by overlapping supply/generation interests as regards investment decisions. It also avoids overly detailed and complex regulation and disproportionate administrative burdens. The independent system operator approach would improve the status quo but would require more detailed, prescriptive and costly regulation and would be less effective in addressing the disincentives to invest in networks.

Furthermore, the public consultation has not revealed any significant synergy effects linked to vertical integration. Indeed, where ownership unbundling has been implemented, experience shows that both the network business and the (production and) supply business continue to thrive after separation.

The regulatory environment

Whilst ownership unbundling would substantially contribute to reducing problems of market power and lack of liquidity, it is clear that also other measures will be needed. As the Sector Inquiry confirms, Europe needs a substantial strengthening of the powers of regulators and enhanced European coordination . This goes in hand with the findings presented by the Commission in its Communication on “Prospects for the internal gas and electricity market”. Only a strengthened regulatory framework can provide the transparent, stable and non-discriminatory framework that the sector needs for competition to develop and for future investments to be made.

The main ingredients of such a strengthened framework should be:

- enhanced powers for independent national energy regulators,

- reinforced coordination between national energy regulators,

- reinforced cooperation between Transmission System Operators (TSO), and

- substantially enhanced consistency of regulation in cross-border issues.

Reinforced coordination between national energy regulators, with a stronger role for Community oversight to ensure the Internal Market interests , particularly as regards cross-border issues and areas most critical for market entry, will be necessary to overcome the current regulatory cross-border gap which cannot be remedied by application of competition rules alone. Options for regulatory measures are discussed in the Communication on “Prospects for the internal gas and electricity market”.

Chronic lack of liquidity

Reinforced unbundling rules and an improved regulatory environment for cross border issues in particular should, in the medium term, substantially reduce the problems of market power and lack of liquidity in a sustained manner, by bringing additional supplies to concentrated national markets. However, there remain serious concerns in the short term, as regards the lack of sufficient liquidity and sustained market power in wholesale markets, which is leading to higher prices in retail markets just as full liberalisation is to be implemented on 1 July 2007.

As already indicated, competition law enforcement will be an important tool to address any anti-competitive conduct concerning this issue. However, more may be needed. As the levels of concentration in gas and electricity markets have remained high, often reflecting pre-liberalisation monopolies, national energy regulators should analyse conditions in their respective markets in co-operation with competition authorities and make appropriate proposals. Measures taken in the past by a number of Member States include release programmes (i.e. electricity Virtual Power Plant auctions and gas release programmes).

It is also recalled that certain Member States have introduced under national law ceilings on ownership of electricity generation and control over long-term upstream gas contracts (imports and national production), as an effective measure to rapidly reduce market power. For electricity, such measures could imply either divesture or asset swaps of power plants on a European scale. For gas, it could mean contract release, contract swaps and/or divesture of domestic production, as have been applied in recent merger cases. Widening of small TSO areas and introducing more open and flexible tendering procedures for balancing energy could reduce the current high levels of concentration in balancing markets and remove obstacles to entry, with a positive knock-on effect in wholesale markets.

Furthermore, the Sector Inquiry has highlighted the importance of enhancing the scope for entry through investment in new generation and gas import infrastructure as well as strict application of use-it-or-lose-it provisions for infrastructure and suitable generation sites.

Lack of transparency in market operations

There is general recognition that access to market information should be further enhanced. All relevant market information should be published on a rolling basis in a timely manner. Any exceptions should be very strictly limited to what is required to reduce the risk of collusion. Guidelines as well as monitoring and eventually adaptation of existing regulation should serve to further enhance transparency in the gas and electricity sector. Intended proposals are outlined in the Communication on “Prospects for the internal gas and electricity market”.

Other important issues

In addition to these four fundamental areas, other issues of pro-competitive market environment need consideration. On these issues, specific suggestions for regulatory action at EC level are made by the Commission in its Communication on “Prospects for the internal gas and electricity market”.

Regulated retail tariffs can have highly distortive effects and in certain cases pre-empt the creation of liberalised markets. It is of crucial importance to assess the impact of remaining regulated supply tariffs on the development of competition, and remove distortions.[14]

In order to achieve that access to new infrastructure is not unduly restricted, the Commission should continue to ensure that exemptions from access provisions are not detrimental to the development of competition . It is important that projects continue to be scrutinized on a case by case basis with strict application of competition principles striking a proper balance between incentives for ex-ante investment and ex-post competition, and that the exemption procedures are streamlined.

In order to achieve a single European network from the perspective of the network user, there is a need for appropriate harmonisation of market design, especially regarding methods having an effect on cross border trade . Action is needed, wherever current capacity is insufficient, to develop interconnector capacity as a necessary condition for the development of competition and the integration of markets. These aims can only be achieved through increased cooperation between national regulators inducing increased cooperation among TSOs across national borders within a well-defined procedural framework.

In order to put more gas transmission capacity on the market , it will be important to clarify the legal position of pre-liberalisation long-term gas transmission contracts under the Second Gas Directive[15], which are already now subject to strict use-it-or-lose-it rules and to the rules of competition law.

Further changes are needed regarding the method for allocating limited interconnector capacity . For electricity, implicit day-ahead auctions or equivalent measures should be promoted as much as possible to ensure that interconnectors are used to their maximum extent. TSOs should also have incentives to maximise the amount of cross border capacity made available to the market.[16]

In order to provide sufficient guarantees for effective access, third party access for gas storage should be reviewed so as to strike the right balance between the need for effective access and maintaining incentives for new storage developments.

A monitoring system for trading on wholesale markets (e.g. power exchanges) would increase market participants’ confidence in the market and limit the risk of market manipulation. Regulators should be empowered to collect and exchange relevant information in this respect. They should have the power to make recommendations for enforcement action or have the power to carry out such enforcement action themselves.

Conclusion

The Sector Inquiry has identified a number of serious shortcomings which prevent European energy users and consumers from reaping the full benefit of the liberalisation process. The findings support the conclusions of the Communication on “Prospects for the internal gas and electricity market”, which has been carried out by the Commission in the follow up to the Green Paper and in the course of the preparation of the Strategic EU Energy Review. These initiatives bring forward the Commission's intentions as to proposals for regulatory reform, aiming at an Internal Market for energy that contributes to sustainability, competitiveness and security of supply. In addition, and in parallel, the Final Report also draws conclusions with regard to enforcement action under EC competition law. Both these documents aim at identifying and remedying obstacles to creating a single European energy market, in which consumers fully benefit from the opening of markets to competition.

A complete version of the report is available on

http://ec.europa.eu/comm/competition/antitrust/others/sector_inquiries/energy/

INTRODUCTION

1. Well functioning energy markets that ensure secure energy supplies at competitive prices are key for achieving growth and consumer welfare. To achieve this objective, the EU has decided to open energy markets to competition and to create a single European market energy. The process of market opening has significantly changed the functioning of the markets, provided new market opportunities, lead to the introduction of new products and services and initially lowered energy prices in Europe in line with market fundamentals. Nevertheless, the objectives of market opening whilst showing some progress have not been achieved.

2. Significant rises in gas and electricity wholesale prices and persistent complaints about barriers to entry and limited consumer choice led the Commission to open an inquiry into the functioning of the European gas and electricity markets in June 2005. The inquiry, based on Art. 17 of Regulation 1/2003, aims at assessing competitive conditions and establishing the causes of market malfunctioning.

3. When analysing the gas and electricity markets, the broader implications of the development of these sectors should be kept in mind. Both the European consumer and European industry[17] are heavily dependent on the secure and reliable provision of energy at competitive prices. Also, the achievement of the Union’s goals for the environment need to be respected, including the reduction of greenhouse gases in the energy sector and meeting the Kyoto commitments.

4. The wider context has been set out in the Commission's Communication[18] to the 2006 Spring European Council concerning the renewed Growth and Jobs strategy, that puts the formulation of an efficient and integrated energy policy at the heart of the Commission’s priorities. The Commission also adopted the Green Paper “A European Strategy for Substainable, Competitive and Secure Energy” (COM(2006) 106 final) on 8 March 2006[19].

5. Whilst there are similarities between the gas and electricity sectors – not least when it comes to the unsatisfactory state of the liberalisation process - there are also some important differences. The main differences are: (a) electricity is not a natural resource, whilst gas is (i.e. electricity can in principle be produced everywhere in the Community whilst gas can only be produced where found); (b) electricity cannot be stored whilst gas can; (c) electricity is generated through different production technologies characterised by significant differences of marginal costs (e.g. for base load and peak load); (d) liberalisation in electricity started at EU level earlier than in gas. These and other differences have to be taken into account when describing the state of liberalisation of the gas and electricity markets.

Essential Steps in the Inquiry

6. Little reliable quantitative data is available on many aspects of electricity and (especially) gas markets. A thorough market investigation was therefore needed as a basis for the assessment of energy market functioning. Following the Commission decision launching the inquiry on 13 June 2005[20] the Commission sent out over 3000 questionnaires in the summer 2005 in order to establish the facts for a solid competition analysis. This makes the Sector Inquiry one of the most thorough investigations in the Commission’s history.

7. An Issues Paper setting out initial findings was prepared in November 2005[21]. In particular, five areas of possible market malfunctioning were identified in the Issues Paper:

8. gas and electricity markets in many Member States continue to be concentrated, creating scope for incumbent operators to exercise market power;

9. there is an inadequate level of unbundling of network and supply activities; in addition, wholesale markets are not liquid: either because of vertical foreclosure due to long-term contracts (gas) or because companies are active both in generation and retail, limiting the development of wholesale markets (electricity).

10. barriers to the cross border supply of gas and electricity prevent the development of integrated EU energy markets. There is not enough cross border capacity and existing capacities are not efficiently used;

11. a lack of transparency regarding market sensitive information aggravates mistrust in market functioning and benefits incumbents, undermining the position of new entrant;

12. there is little trust by industry and consumers in current price formation mechanisms on electricity and gas wholesale markets, and prices have increased significantly.

13. The initial indications in the Issues Paper were discussed with national competition authorities and electricity and gas regulators on 15 November 2005. The Issues Paper, which was generally welcomed, was also presented to the Energy Council in December 2005 by Commissioner Kroes. The Council discussion on the state of the Internal Energy Market also took account of the 2005 Communication from the Commission reporting on progress in creating the internal gas and electricity market[22].

14. On 16 February 2006 a Preliminary Report was published[23], which builds on the Issues Paper. A more detailed analysis was undertaken of the data gathered in the Sector Inquiry and these further findings were integrated in the Preliminary Report. The main indications of the Issues Paper have been confirmed. As in the Issues Paper, the main concerns for the gas and electricity sector are therefore grouped under the five broad categories:

15. Market concentration;

16. Vertical foreclosure;

17. Lack of market integration;

18. Lack of transparency; and

19. Price issues.

20. On 16 February 2006 the detailed findings of the Preliminary Report were also presented to the general public at a conference in Brussels followed by a discussion with all stakeholders concerned (consumers, industry, network operators, traders and other market participants; regulators, competition authorities and other national administrations; representatives of unions, environmental and consumer organisations and other stakeholders)[24]. The event was widely covered by the press and received very favourable comments.

21. On the day of the public presentation the Commission also launched a public consultation on the Preliminary Report and possible ways forward. The overall reactions in the public consultation were again very favourable. Commentators praised in particular the objectivity of the Preliminary Report as well as the quality and novelty of the findings allowing policy makers to take an informed position on the energy sector. A number of commentators called for urgent action to complete the liberalisation process.

22. In May 2006 – however outside the scope of the Sector Inquiry – the Commission carried out surprise inspections at approximately 25 companies in six Member States (Austria, Belgium, France, Germany, Hungary and Italy). These investigations concerned allegations that market participants engaged in activities foreclosing markets and collusive arrangements. At the time of the publication of this report these investigations are ongoing.

23. In spring 2006 two studies were commissioned, one concerned the importance/potential of liquefied natural gas (LNG) for Europe’s future gas supplies, the other the level of concentration and the price formation in electricity wholesale markets. The results of these studies are summarised in this report (2nd part).

24. At the same time the scope of the Sector Inquiry was extended to cover also downstream and balancing markets. The results of this analysis are presented in the 2nd part of the report. With the exploitation of the corresponding data all information received in the context of the Sector Inquiry has now been assessed.

25. At the same time the existing chapters were revised to take into account comments made by stake holders in the public consultation. In particular the chapters on unbundling have been revised. The market integration chapter for the gas sector was also complemented by an inquiry into the question why no more gas was flowing from the European continent to the UK in winter 2005/2006 when price hikes occurred in the UK.

26. The proposal by certain stakeholders to update the information in order to take into account subsequent market developments was taken up to the extent possible (e.g. for the electricity study). However a complete update was considered to be disproportionate as it would have substantially delayed the publication of the report. Moreover, the public consultation largely confirmed the previous findings.

27. The report was presented to national competition authorities and national energy regulators on 30 November 2006. The report was adopted by the Commission on 10 January 2007. The main messages are that even after 8 years of liberalisation in the electricity sector and 6 years in the gas sector and despite some encouraging (initial) progress particularly regarding the electricity market:

a. markets have remained highly concentrated giving incumbent operators scope for exercising market power;

b. the unbundling of infrastructure/network and supply activities is inadequate rendering market entry for new suppliers very difficult;

c. there is a lack of transparency causing distrust in the markets and undermining the level playing field for new entrants.

28. It is in this light that the report proposes further legislative measures and the reinforced application of EC competition law taking into account the priority enforcement areas identified in the report.

FIRST PHASE OF THE SECTOR INQUIRY

GAS

Introduction

Main market features

Gas production, supply and transport

29. Natural gas is a “primary” source of energy consisting of hydrocarbons (mainly methane)[25]. It is used in industrial processes as fuel and raw material, for electricity generation, and by households for cooking and heating. Other energy sources can often be used for the same purposes. Substitution is nevertheless partial and imperfect. Changing from one energy source to another can often give rise to important switching costs.

30. Natural gas consumption in 2004 amounted to 460 billion cubic metres (bcm) in the European Union. It accounts for approximately a quarter of primary energy consumption by type of fuel. The most important European gas markets are: UK (consumption 96 bcm), Germany (87 bcm) Italy (73 bcm) and France (45 bcm)[26].

31. Consumption is likely to continue to grow. According to IEA forecasts, the European gas consumption (EU-25) is predicted to grow at an average rate of 2.1% per year between 2000 and 2010, of 1.4% between 2011 and 2020, and is predicted to shrink by 0.2% between 2021 and 2030. Gas would then become Europe’s second fuel after oil, with 23.7% of the total primary energy supply in 2030[27].

32. Around 42% of the natural gas consumed in the EU is produced within the EU, in particular in the United Kingdom, the Netherlands and Denmark, as well as in Italy, Hungary, Austria, Poland and Germany[28]. This means that the EU currently imports around 58% of its gas needs, and this proportion is growing. The graph overloaf shows increasing gas consumption in Europe since 1985 for all current Member States, as well as the increasing share of gas imports from third countries. Between 1985 and 2005, imports have increased from roughly 40% to 60% of consumption.

33. Gas prices have risen sharply in the last few years. This is true both for gas imported on the basis of long-term contracts with an oil-price link (Figure 2 shows prices at some key EU border crossings) and prices on the few traded markets in Europe (some gas hub prices are shown in Figure 3).

Figure 1

[pic]

Source: BP Statistical Review 2005

Figure 2

[pic]

Source: Heren European Gas Market

Figure 3

[pic]

Source: Argus Media

34. Natural gas is found in underground reserves. For geological reasons the degree of flexibility of gas extraction varies. From some fields the gas must be extracted at a continuous rate and there is limited margin to influence the production rate, without jeopardising the overall volume of gas available. Other fields do not allow control of the rate of gas production where gas is merely a by-product of oil production. More flexible gas fields do exist and these have different economic characteristics, since they can often be used as a source of market flexibility in competition with storage. Therefore, they have an additional value relating to the expected value of gas during peaks periods.

35. Natural gas is mostly transported from production to the markets through pipelines. In addition, after being cooled and condensed, it can be transported in liquefied form (LNG) by sea. Compared to other primary energy sources, transport costs for gas are high in relation to the price of the commodity. This is a key reason why gas markets have remained regional in character rather than global. Transport by pipeline remains less expensive than LNG-shipments for shorter distances. However, decreasing costs for the LNG chain have made longer transport routes economically viable, bringing new sources of gas to the European markets. This may mean that LNG becomes a viable alternative, displacing gas from longer pipeline routes. Nevertheless, many specific geographic factors play a role, and new pipelines are being considered to bring gas from relatively remote areas to Europe (e.g., the proposed Nabucco project that could transport gas from the Caspian region and Iran).

36. Roughly 250 bcm were imported to the EU in 2005 by pipeline, whereas only 50 bcm were imported as LNG-shipments. The majority of imports come from the three major gas producing countries close to the EU: Russia, Algeria and Norway. The following graph illustrates that the major part of EU’s gas imports comes from Russia and Norway. This gas flows via pipeline, whereas Algerian imports are partly transported as LNG.

Figure 4

[pic]

Source: BP Statistical Review 2005

37. The number of upstream producers supplying EU gas markets is gradually increasing as LNG supplies become more competitive and new LNG-terminals are built in Europe. This diversification of upstream supply should enhance competition between exporters to EU gas markets.

38. Increasing LNG-imports will contribute to the globalisation of gas markets and strengthen links between the EU and US markets. LNG-imports are also expected to grow in the US and a number of facilities allowing for LNG-imports are planned. Countries like Qatar, Algeria, Trinidad or Nigeria can already supply LNG both into the EU and into the US.

39. As a consequence of increased LNG-shipments around the Atlantic Basin[29], increased competition for short-term LNG between the US and EU can be expected. For example, LNG quantities originally foreseen to be delivered into the EU might be diverted to the US when better profits can be made (or vice-versa)[30]. In assessing the effect of US prices on EU markets it must, however, be kept in mind that most EU imports are based on long-term contracts. This is also true, at present, for LNG - supplies to Europe, which means that these gas flows are not totally flexible in reacting to changing market conditions. Nevertheless, it cannot be excluded that short-term LNG might become the marginal unit of supply during certain periods in some markets, which might create a link to US prices. Even so, pipeline gas prices are currently often indexed to oil products. These gas imports therefore do not react to changes in the market price of gas on global markets.

40. The pipelines to bring gas from a production region to the European market are generally specific to that purpose. In this respect pipeline investments often constitute a sunk investment and create an interdependency between the supplier and the market served by the pipeline. The same is true of some of the investment in LNG-facilities, although to a much lesser extent, as shipments can be brought to alternative markets.

41. Onward transport from the point of import to consumers within the EU takes place by pipeline networks, which gives the gas industry the character of a network industry. The supply of gas to customers in fact depends on the possibilities to use existing pipeline infrastructure. In most cases, the construction of competing parallel gas networks is not economically viable: the network operator on a given transport market can, therefore, often be considered to be in control of a natural monopoly.

42. The largest-volume and/or highest pressure pipelines are typically used to transport gas over long distances between or within Member States. These networks are called transmission networks, and those that are used to transport gas between and across Member States are also often referred to as transit networks.

43. Transmission networks are generally interconnected so that inputs or off-takes at one point affect the rest of the network to some extent. The very high and relatively stable flow rates often associated with transit lines have meant that operational arrangements for these have historically developed somewhat differently to those applying to purely national transmission networks. For instance, some transit pipelines are interconnected with a wider network only to a limited extent, and can be managed on an end-to-end basis.

44. Connected to off-take points from transmission networks are lower-pressure networks, called distribution networks. The majority of end-customers are connected to distribution networks, although some large users connect directly to transmission networks. Distribution system operators (DSOs) are generally also responsible for metering their customers’ consumption, and therefore in competitive markets often have a vital role in ensuring the availability of accurate consumption data and in ensuring a smooth customer transfer between suppliers.

45. The off-take of individual users of gas varies in ways which might be predictable (e.g., space heating in homes will consume more gas in winter than in summer; and might be turned down at night), or less so (e.g. if a production line breaks down). Gas supply therefore needs to be flexible: it must have a seasonal and daily shape, and it must also be able to adjust to unexpected changes in demand[31].

46. Flexibility of gas supply can be assured in a number of ways. Flow change may be secured through turning up or down particularly flexible gas fields as discussed above. Storage facilities are also available meaning that production and demand do not need to be in balance in the same way as for electricity. Balancing inflows and outflows over the short term is nevertheless necessary to ensure system integrity of the gas network, although there is a certain margin to alter the pressure in gas pipelines, a flexibility instrument known as “line-pack”.

47. Gas infrastructure is designed to operate safely within defined quality and pressure parameters. Transmission system operators (TSOs) have access to a range of facilities to ensure this (e.g. blending facilities to ensure appropriate quality; storage, compressors and line-pack[32] to maintain safe pressures). However, as markets develop TSOs should have alternatives for maintaining safe operating conditions through their interactions with other market players, and would not necessary have to own all of the technical facilities to ensure system balance.

48. Storage facilities offer different degrees of flexibility, because their physical characteristics often limit the speed with which gas can be injected or withdrawn[33]. For this reason, some storage sites are most suitable for seasonal storage (being filled steadily during the warmer months, so as to partly equalize winter and summer imports, which means less investment in pipelines is required), although others permit quicker injections or withdrawals. Access to storage is of particular importance to serve customers who require gas deliveries that vary over time, and in general is essential to serve household customers.

Gas market operators

49. Gas exploration and production (E&P) requires geological and engineering competences quite different to the rest of the value chain. Therefore, although in some cases E&P is carried out by companies that are also active lower in the chain, there are not necessarily great synergies in combining production and other activities. The production companies operate on a scale that is often global. In planning development of a field, they would typically consider selling the gas to any country or company, although the economic range is influenced by transport mode and distance[34]. Many European national importers have also bought gas from several producers, notably to guarantee security of supply.

50. Historically, gas producers’ main partner within each European Member State has been a national monopolistic importer. This company might have helped to fund the construction of long-distance import infrastructure, and has also in most cases built the national transmission network and national storage facilities. In a few Member States more than one company had this kind of role, within separate geographic regions. In some cases, this incumbent importer also had a monopoly on sales to end-users in the Member State’s territory. In other cases, the incumbent importer had long-established business relationships with downstream monopolies, or with other companies that in turn sold to downstream monopolies[35].

51. Market opening implies a modification of this type of vertically integrated organisation, which was the guiding principle of the previous market structure. In principle, a range of new business models should be possible in the gas supply chain and new entrants should be able to compete on only some parts of the value chain. Notably, shippers/suppliers should be able to buy gas on wholesale markets, arranging transportation with the network company, and signing retail contracts with end-user customers. New companies should also be allowed to import gas from external sources, in competition with the previous incumbent. Finally pure traders focussing largely on buying and selling gas on wholesale markets may emerge, arranging transportation only to the extent necessary to trade on Europe’s wholesale markets. Such new business models rely on the development of functioning wholesale markets, and on access to transport networks.

52. Liberalisation legislation specifically requires separate companies for the transport activities, so as to ensure non-discriminatory market access. TSOs are required to be legally and functionally unbundled from competitive activities, and DSOs will have similar obligations from 2007. Fully unbundled networks, however, would have different incentives compared to vertically integrated companies. Whereas integrated companies might have incentives to restrict the flow of gas so as to keep the price of gas high, independent networks would have incentives to maximise the amount of capacity sold because their profit would depend purely on transport incomes.

53. It should also be noted that the networks are regulated, which means that their profitability and solidity are not directly determined by markets. The profitability is both capped and “guaranteed” by the regulatory system. Their financial solidity (balance sheet) depends also on the way that unbundling has been implemented.

The regulatory framework

54. The main objective of European energy policy in the area of gas has been the gradual liberalisation of the sector and the creation of a competitive integrated internal market, with security of supply ensured. The Community legislative process of liberalising the gas markets began in the 1990s, first with the Price Transparency Directive[36] and with basic non-discrimination requirements in the Transit Directive[37] and the Hydrocarbons Directive[38] and then, under the First Gas Directive[39], with the abolition of import monopolies, gradual market opening, accounting unbundling for vertically integrated network companies, and an option of regulated third party network access.

55. The Second Gas Directive[40] was adopted in June 2003 and was to be implemented by 1 July 2004, although implementation has been late or otherwise unsatisfactory in many Member States[41]. It requires full market opening, national sector regulators, regulated third party network access, regulated or negotiated access to storage and further unbundling of integrated companies. It is complemented by the Gas Regulation[42], which expands on several of the provisions in the Directive. It introduces qualitative obligatory minimum requirements for access to transmission systems (network tariffs, third party access services, capacity allocation, transparency, balancing and trading of capacity rights).

56. Community legislation is supplemented by other binding and non-binding instruments, such as the binding guidelines under the Gas Regulation, voluntary guidelines developed within ERGEG[43] and the Madrid Forum[44] (e.g. Guidelines for Good Third Party Access Practice for Storage System Operators – GGPSSO) and technical standards prepared by EASEE-gas[45].

57. In order to increase competition on a liberalised market, the Second Gas Directive requires full market opening. All commercial customers must be free to choose their supplier by 1 July 2004, while, for household customers, the corresponding date is 1 July 2007. By that date, at the latest, the retail market should, consequently, be fully open to competition (although several Member States have already now introduced full market opening)[46].

58. Community legislation does not include measures that directly address the concentrated market structure inherited from the monopoly era, which remains a key problem of the internal gas market. In certain Member States further measures have been introduced to tackle concentration (e.g. gas release programs or market share caps).

59. The supply of gas to final customers depends on the possibilities to use existing transport infrastructure, which can in many cases be considered as a natural monopoly. A regulatory framework is, therefore, essential to ensure that access is granted in a non-discriminatory and transparent manner.

60. To ensure the implementation of the regulatory framework in this respect, the Second Gas Directive requires the creation of national energy regulators[47]. Their main roles include approving and controlling tariffs (or tariff methodologies), ensuring non-discriminatory network access and effective unbundling, and dealing with complaints.

61. Regulated third party access, based on approved and published tariffs, now applies to transmission, distribution and LNG operators, as well as to balancing services (i.e. negotiated access is no longer allowed). The operators must refrain from discriminating between system users, and provide them all with the information needed for efficient access.

62. However, regulated access to necessary infrastructure is far from universal. Member States still retain a choice between applying negotiated or regulated access for storage, line pack and other ancillary services. Derogation from third party access rights, whereby investors can reserve the capacity for themselves, can also be granted in order to provide incentives for risky investments in important new infrastructure. The Second Gas Directive foresees a number of criteria to be fulfilled in order to allow such exemptions including the condition that competition is not adversely affected. Such derogations may be limited in time and to a part of the capacity.

63. In order to improve access, and reduce risks of discrimination and cross-subsidy, the Second Gas Directive requires unbundling of integrated network operators. Transmission and distribution system operators must, in addition to the previous accounting unbundling (i.e. the keeping of separate accounts), also be legally unbundled and management unbundled (i.e. independent from activities not related to the network operation as regards legal form, organisation and decision making). Whereas ownership unbundling is not required by EU legislation, several Member States have found it necessary also to require separate ownership of network and supply companies.

64. Currently, unbundling requirements are more limited for distribution system operators, as the legal unbundling only has to be completed by 1 July 2007, and Member States can also exempt small distribution system operators, serving fewer than 100.000 connected customers, from the obligation of legal unbundling (but not from accounting unbundling). Moreover, only accounting unbundling is required for storage and LNG operators.

65. The Gas Regulation provides further requirements aimed at ensuring fair access to transmission networks. Services must be offered in a non-discriminatory manner on terms that may also suit new entrants (e.g. firm and interruptible capacity; long and short-term contracts). It requires non-discriminatory capacity allocation mechanisms, congestion management procedures based on a use-it-or-lose-it principle, and a functioning secondary capacity market. Balancing rules must reflect genuine system needs (excessively stringent rules hamper new entrants), and imbalance charges must be cost-reflective, while still providing appropriate incentives for balance.

66. Despite the increased obligations in the Second Gas Directive, difficulties in accessing infrastructure remain a competition concern. Effective unbundling is one of the keys to fair access, not least in view of alleged discrimination by infrastructure companies in favour of their related supply businesses.

67. In order to create an integrated European gas market, EU legislation needs to enable and facilitate cross-border trade. Twenty-five liberalised markets will not in themselves guarantee competition at EU-level.

68. Under the Second Gas Directive and the Gas Regulation, transit pipelines are covered by the same access rules as other transmission services. However, the continued validity of existing long-term transit contracts (negotiated under the now repealed Transit Directive) constitutes an important practical obstacle to introducing regulated access. If cross-border trade is to increase, access to transit capacity is vital, making these legacy contracts a key issues for market integration.

69. Market integration is also hampered by limitations in the competences of national regulators. In the absence of any single cross-border regulator, national regulators must cooperate with each other in monitoring the management and allocation of interconnection capacity. ERGEG provides a forum for co-operation. However, the powers of regulators vary between Member States, since Community legislation only provides for certain minimum competencies. Moreover, the manner in which Community rules have been implemented varies between Member States, and may in some cases even give rise to regulatory vacuum – especially in cross-border situations. In addition to the requirements under Community law, there is also a considerable scope for Member States to apply their own specific national rules[48].

70. Transparency is a necessary component of non-discriminatory access, and for ensuring a level playing field on wholesale markets. The Community legislation does not include rules on all aspects of transparency of gas markets. The Gas Regulation, however, supplements the basic transparency requirements of the Second Gas Directive, and provides for certain further transparency requirements in relation to transport services. As regards storage, transparency provisions are set out in the non-binding Guidelines for Good Third Party Access Practice for Storage Operators, but not in binding EU legislation. Even within the scope of the binding Gas Regulation, the availability of information can suffer from lack of precision on the exact obligations of network operators and from exemptions aimed at protecting network users’ commercial data. Specifically, it appears that in some cases the Directives and Regulation have to date been interpreted – in the Commission’s view erroneously – in a way that would allow important transit lines to automatically benefit from the confidentiality exemptions. The Commission has already launched infringement cases against some Member States in this respect.

71. The Second Gas Directive requires that prices for accessing transmission, distribution and LNG infrastructure, as well as balancing charges, are regulated (although this does not apply to storage, line pack and other ancillary network services). Nevertheless, in many Member States end-user prices are also regulated, often in a system where regulated prices co-exist with the market price (effectively capping the market price).

72. The Second Gas Directive takes fully account of the new regime emerging from Directive 2003/55/EC and includes certain general requirements for Member States to monitor security of supply issues. These provisions are complemented by a specific Directive[49] on security of gas supply adopted in April 2004. The Security of Gas Supply Directive requires Member States to define transparent and non-discriminatory security of supply standards that are compatible with a competitive internal gas market. A non-exhaustive list of possible instruments for security of supply is also included (e.g. storage capacity, cross-border pipeline capacities, domestic production, liquid markets, LNG facilities, diversification of supply sources, long-term contracts, etc). Member States are required to define clear roles and responsibilities of market actors, and publish them, and must also establish standards to ensure supplies for household customers (e.g. for protecting against temporary disruptions at times of high gas demand in cold periods), thus guaranteeing the necessary minimum level of security of supply to household customers.

Gas wholesale markets

73. The large majority of gas consumed in the EU is bought by the incumbent wholesale players under long-term contracts from producers, both outside and inside the EU. As noted, these companies historically had special or exclusive rights to import and transport gas and normally controlled the major import and storage facilities.

74. The business models of pure retail supplier/shippers or pure traders do not necessitate procurement of gas from remote regions (or their own production), provided gas is available on liquid wholesale markets. Such companies would be building a supply business from a much smaller starting position (not having inherited a set of monopoly customers) and would be looking to purchase smaller quantities of gas. Traders may be less focused on a single geographic region, more interested in arbitraging price differences between regions, and therefore more interested in buying short-term tradable packages of gas and network capacity, rather than long-term supplies.

75. Against this background, natural gas is increasingly bought and sold in a number of quite different ways at different levels of the wholesale market, as well as at the retail level[50]. Because of the variety of players involved in gas markets, the distinction between levels of the market is not always clear-cut. The exact meaning of liquidity on wholesale markets equally varies. Considering the current stage of EU gas market development it is not necessary to use any refined definition of liquidity. In the gas part of this report we use the term broadly, to mean a level of market activity that ensures a counter-party can generally be found to enable the buying or selling of gas in sufficient volumes to meet a commercial need, and at competitive prices.

76. Some trading at wholesale level takes place through more-or-less organised exchanges, generally referred to as “hubs”. This kind of trading is potentially more accessible to new market entrants and the non-integrated business models referred to above. Such hub trading has been, so far, slow to develop, but the future development of traded wholesale markets is crucial for market integration and competition in EU gas markets.

77. Developing liquid gas hubs is vital to allow new business models to develop in gas markets and to ensure that new entrants can secure access to gas at wholesale level. Liquid hubs would underpin the functioning of the market in many ways. They would provide a price formation mechanism that reflected supply and demand, and therefore create price signals for investment (which in turn would strengthen supply security). They would enable suppliers to optimise their portfolios in a cost effective manner. They would enable traders to take advantage of short-term price differentials, and this arbitrage would keep the market efficient. Arbitrage between hubs would also help integrate geographic markets. Given the usefulness of hubs, we might expect them to develop if market conditions allow. However, the converse is equally true: the absence of liquid hubs creates significant entry barriers, so hindering the development of competition.

78. Gas hubs can be “virtual” in character, allowing trading of gas that has been physically injected into any point on a national grid. This is the case for the UK hub (NBP) and the recent hubs in the Netherlands (TTF) and Italy (PSV). In these cases, gas is usually traded on an “entry-paid” basis meaning that entry capacity into the networks has been settled. Others are “physical”, requiring gas to be transported to and from a particular trading point or zone. This is true for Zeebrugge (Belgium), Baumgarten (Austria) and Emden (Germany), for instance.

79. Certain gas hubs offer transparent title-transfer facilities, standardised contracts, and brokers helping traders to match bids and offers. Some offer the assistance of a market operator to arrange the physical transport of gas between different points around the hub, or the provision of liquidity support. Other hubs consist simply of groups of flanges across which companies arrange private swaps. No European gas hub has an operator ensuring the clearing function of the market, which is common in electricity. In the most developed gas markets (UK, US), financial derivatives of gas products are traded; this also happens in some Continental markets, but is not common.

80. The total level of activity on European trading hubs is relatively low: a balanced sample of 30 companies bought in total over 600 bcm during 2003-2004 on hubs[51], which suggest Europe as a whole sees trading churn[52] of around 1:1. However, each unit of gas within the traded part of the market might be expected to be bought and sold many times over, so this churn rate does not mean that most consumed gas has been sold on hubs. Indeed, in more competitive markets like the UK or US churn rates are many times higher. In addition, the distribution of activity across these hubs is extremely unequal and almost all trading on European gas hubs is in the UK or at Zeebrugge, which at least partly serves the UK market (see Figure 5).

81. The UK NBP is by far the most heavily traded hub, and the UK also sees significant “beach trading” activity (where gas is traded around entry terminals of offshore pipelines), and also trading of gas forward contracts on the International Petroleum Exchange (IPE).

82. The most important hub in Continental Europe is located at Zeebrugge. This hub is near the end of the UK-Belgium interconnector, as well as being physically adjacent to a number of sources of gas supply (LNG, North Sea pipeline, transit lines on the Fluxys network). Over past years the interconnector has typically flowed gas to the UK during the winter, and Zeebrugge trading therefore should be understood as partly meeting UK demand. It is therefore more appropriate to compare UK-related trading activity (including a proportion of Zeebrugge trading) to consumption in that country[53].

83. Gas is traded in a number of other locations on Continental Europe, and Figure 6 shows other locations and the volumes of trading during 2003-2004[54]. The volumes of trading in these other countries are extremely low, with gas bought on these hubs representing collectively only 1% of total consumption in the relevant countries[55]. Even this very limited liquidity is concentrated in North-West Europe[56].

Figure 5

[pic]

Source: Energy Sector Inquiry 2005/2006

Figure 6

[pic]

Source: Energy Sector Inquiry 2005/2006

84. Liquidity on the hubs is caught in a vicious circle. A lack of liquidity increases the risks of trading, since it reduces the chances of finding an acceptable counter-party when a trader needs to close a position. It also facilitates price manipulation and therefore makes it more difficult to analyse and manage risk. Low liquidity therefore deters entrants (particularly pure traders), and tends to mean liquidity stays low. For these reasons, traders (e.g., banks or commodity trading houses), who have no inherent need to buy or sell gas, are largely absent from Continental hubs.

85. It should be noted that away from the North Sea coast, trading has been reported in the answers to the inquiry in a number of locations that are not formal hubs: storage sites, LNG facilities and flanges are mentioned. Most Continental formal hubs have a number of disadvantages. The UK-related hubs, for example, are a focus for broker activity which assists with match-making and credit management, but this is not generally true with the less active Continental hubs. It could also be the case that difficulties transporting gas to hubs would deter their use, although this is less likely to be a factor for virtual hubs such as the TTF in the Netherlands or the Italian PSV. Whatever the reason, the dispersal of trading reduces the already low liquidity of individual hubs.

Issues

Concentration

Market structure

86. The Sector Inquiry looks at wholesale markets with a view to assessing the competition issues that hamper the development of these markets within the EU. Competition between upstream producers outside the EU falls outside the scope of the Sector Inquiry, although competitive conditions on these markets influence the price of the basic commodity.

87. There are a number of global players active on the upstream gas producer level. If the market is considered global then concentration is unlikely to be excessively high[57]. However, such a geographical delineation is difficult given that the feasibility of buying gas from various different gas producers depends on gas transport costs and the availability of gas infrastructure (notably, pipelines and LNG terminals). Due to infrastructure constraints some regions in the EU are dependant on a limited number of upstream producers for their gas. Therefore, defining this upstream market is not straightforward. However, the future development of new infrastructure and LNG sources is likely to provide new economically viable sources of gas to Europe thereby reducing dependence on a few producers and hence reducing concentration, where it exists, at this level of the gas supply chain.

88. The Sector Inquiry is concerned with the competitive conditions within the EU. At the wholesale level of the gas supply chain EU liberalisation has not, so far, significantly changed the market structure. The high level of concentration which existed in most national markets at liberalisation largely remains. This is true at both the national wholesale and retail levels for most countries, although the distinction between wholesale and retail is not clear cut. In many national markets no liquid wholesale market has emerged and traded markets (gas hubs) represent a minor part of gas supply.

89. The lack of liquidity on European wholesale markets is crucial for competition, as such markets would contribute to market integration and price formation based on the supply and demand for gas. Liquid wholesale markets also crucially affect competitive conditions at the retail level, because most new entrants wishing to enter the retail market do not have access to gas supplies directly from gas producers and so they need to procure gas on wholesale markets.

90. For a competition analysis of market structure (concentration and market dominance) it is necessary to delineate the product and geographic dimension of the gas market[58]. This must be done on a case by case basis. The different degrees of market developments in Member States play a key role for defining the relevant market.

91. The definition of the relevant product market(s) must according to Commission practice take into account the existing and foreseen degree of market opening[59]. The fact that gas customers are captive or eligible to choose their supplies will influence their behaviour on the demand side. Eligible customers may further be subdivided into separate markets, according to their gas consumption and profiles[60].

92. In more developed markets a separate market for wholesale supplies of natural gas can be distinguished. Amongst factors to be considered are: on the demand side, whether there is a need for gas supply at the wholesale level and on the supply side, whether there is an offer of such wholesale gas[61]. The Commission has considered that at the wholesale level, gas is supplied to local distribution/supply companies, power generators and industrial customers. The Commission found that at the retail level, gas is supplied by local companies to final customers[62].

93. It should also be noted that gas is not a completely homogenous product. Traditionally EU gas has been classified in two gas qualities: on the one hand, so called H-gas (high calorific value), which is the most widely produced type of natural gas, and on the other hand, L-gas (low calorific value)[63]. However, even within the most common category of H gas, technical quality differences remain, which continue to hamper cross-border gas flows, into the UK amongst others[64].

94. It is the Commission’s experience that gas supply markets are not broader than national in scope[65]. Network congestion may be an important (but not the only) constraint on the boundaries of the relevant market, since new entrants may simply be unable to gain access to a market because they cannot transport their gas to it.

95. Besides gas supply markets, gas infrastructure operations constitute another category of relevant product markets[66]. The two main types of infrastructure operations are transportation and storage[67].

96. Also for gas infrastructure, the geographic scope of the market needs to be defined. Where a network is owned by a sole company operating in one country or region, the definition is rather straightforward[68]. However, the question arises whether transit lines for which no alternative exists may constitute separate geographical markets.

Concentration in imports and domestic production

97. Competition brings benefits through lower prices, greater choice, enhanced efficiency and more innovation. However, highly concentrated markets may indicate that competition is not effective and therefore that these benefits are not being realised.

98. The Sector Inquiry looks at wholesale markets with a view to assessing competitive conditions within the EU, not only on traded “wholesale markets”, but also on the part of these markets where competition is not fully developed. In this respect it is essential to recognise that natural gas consumed in the EU comes from imports, domestic production (in some countries) or traded markets.

99. The “wholesale level” that is considered relevant in this inquiry includes domestic production and imports on the supply side as well as traded “hubs”[69]. In some countries like The Netherlands, Italy, the United Kingdom, Germany and Denmark, where national production is (or has been) important, producers have been active themselves at the wholesale level. It should also be noted that “gas release programmes” may also provide liquidity at wholesale level[70].

100. Incumbent shares of imports and domestic production are illustrated in the table below. Incumbent suppliers source the vast majority of their gas through long-term contracts, which may relate to gas imports or to domestic gas production. The Gas Sector Inquiry has analysed 400 of these contracts so far, representing about 360 bcm of gas in 2004. Many of these contracts were entered into at a time when incumbents were national monopolies. Long-term gas supply contracts were often linked to infrastructure development such as a pipeline or gas fired power station, since in order for the investment in such a project to be viable a long-term supply of gas needed to be secured. Even after liberalisation, incumbents have been allowed to retain this access to gas as well as the associated infrastructure capacity.

Table 1

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Source: Sector Inquiry, Eurostat, National Regulatory Authorities

Note: “Total imports” means gas imported for use in domestic consumption and do not include transit gas or imports that are subsequently exported. Due to differences in countries reporting methodologies percentages are presented in ranges.

101. For most countries represented in the table the incumbents control the vast majority of the gas either through import contracts or through control of domestic production. The exception is the UK where there has been full ownership unbundling of the former monopoly gas supply company (Centrica), the network operator (NGT) and gas production (BG Group). Here we can see that the incumbent share of domestic production and imports is relatively low. In Germany there are a few vertically integrated gas companies. Here we see a much higher concentration of the gas in the hands of the incumbents. France, Czech Republic and Slovakia have very little domestic gas production whilst Belgium has none. In these countries, therefore, the incumbents retain control of the gas through their import contracts.

Concentration on traded gas markets

102. Given that most domestic production and imports are controlled by incumbents, traded gas markets or ‘hubs’[71] are an important potential source of gas for new entrants. However, the limited role of traded markets means that competitive conditions at wholesale level in gas markets are in most national markets mainly determined by the companies with access to most available gas through their contracts with gas importers and producers. The incumbents are also the major players on most of the gas hubs. The following graph shows the distribution of activity on a number of hubs between different types of company[72].

Figure 7

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Source: Energy Sector Inquiry 2005/2006

103. The majority of trading on Continental hubs is carried out by companies with established gas positions, as “pure traders” play a minor role. On each of the most important Continental hubs, incumbents were significant buyers during 2003-2004 (49% by volume of all TTF purchases, 58% in Zeebrugge, 76% at Baumgarten and 86% at Bunde). Gas producers were the next most important group of traders. New entrant suppliers bought small volumes at Zeebrugge (2% of all purchases), and almost nothing anywhere else on the continent except Italy.

104. Italy represents a significant exception to the general pattern. In that country incumbent and producer involvement in trading is extremely low, and therefore new entrants predominate on the PSV. However, the low volumes involved must be stressed: total purchases on PSV in 2003-2004 represented less than 0.1% of total Italian consumption.

105. Incumbents are, then, of some importance in providing liquidity. However, the distribution of incumbent activity is sharply unequal. As Figure 8 shows, across all European hubs[73], over 90% of all incumbent hub purchases during 2003-2004 were by just three companies. One of these companies (Company F) is barely active except as a major buyer at Zeebrugge.

106. A good deal of incumbent trading is local. For instance, Company A bought very little except on the TTF and at Bunde, which are close to its historic area of operations.

Figure 8

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Source: Energy Sector Inquiry 2005/2006

107. Data on incumbent sales on hubs (see Figure 9) show even more concentration, with just two companies reporting 87% of all hub sales in 2003-2004 (the same two as represented nearly 80% of hub purchases). Again, we see localised activity: for instance, Company B reported major sales at Baumgarten and no activity at other hubs.

Figure 9

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Source: Energy Sector Inquiry 2005/2006

108. The picture is therefore that only a small number of incumbents trade actively on a significant scale. Indeed, for most incumbents trading is insignificant as a proportion of the gas sold (see Figure 10). This graph does not show incumbents engaging in a trading pattern typical of liberalised markets, which would be likely to see trading of more than 100% of total supply[74].

Figure 10

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Source: Energy Sector Inquiry 2005/2006

109. The localised pattern of incumbent trading is also important. Only two incumbents are active across all European hubs, providing the arbitrage across geographic distance that will be necessary to create price convergence[75].

Barriers to new entry

Entry and expansion barriers

110. In view of the continued high level of concentration on many gas markets, it is important to seek to identify the entry and expansion barriers facing new market entrants.

111. In order for new suppliers to enter the gas market, as well as to expand existing activity, companies depend on a number of factors. New suppliers are dependent on stable access to gas, which has to be available both over a time-scale corresponding to the contractual time-scale required by customers, and at a competitive cost (including mechanisms for managing price risks).

112. Suppliers also need to have transparent and non-discriminatory access to the transportation network on terms matching customer needs (this can include, for example, short-term capacity on the secondary market, reasonable liabilities, etc).

113. Linked to the previous two factors, a supplier also needs access to flexibility – both as regards predictable (gas volumes varying according to the known patterns of customer needs) and unpredictable events (such as production break downs). Such access to flexibility includes, inter alia, storage, balancing and contract terms, all of which need to be accessible in a form that is appropriate for the supplier’s portfolio.

114. Downstream, the supplier obviously needs access to customers, which means that there must exist appropriate switching processes and an absence of exclusionary practices from incumbent suppliers.

115. Overall, the supplier must be able to achieve a sufficient gap between prevailing retail prices and costs. If gas is controlled by incumbents, networks are congested, flexibility is not easily available or customers cannot easily switch supplier, market entry or expansion will be difficult.

116. New entrants (including companies expanding their markets) in the gas sector are not a homogenous category. Since many countries/regions have in the past been dominated by a single (often monopoly) supplier, a broad definition would include all companies except the incumbents in that country/region.

117. The entrants with least barriers to overcome should be the gas incumbents (national or regional) expanding their business into a new geographic area, since these will normally already have a portfolio (including gas, network capacity, swapping capacity, storage, etc) constituting a good starting point for expansion. Nevertheless, as shown in chapter B.a.II.3, the activity of many of the larger incumbents has been surprisingly small outside their traditional markets.

118. Other entrants can typically include electricity companies moving into the gas sector (often bringing with them good customer relationships). Producers moving down-stream will normally have access to gas and flexibility, while (rarer) gas consumers moving up-stream would have their own demand as a stable customer base. Pure new entrants lack initial access at all levels, and therefore face greater difficulties in building a successful wholesale business.

New entrants’ experiences

119. Given the continued high level of concentration on wholesale markets, it could be expected that new entrants would express concern over all or some of the above-mentioned barriers to entry. This is indeed confirmed by many of the responses from companies that have responded to the Inquiry. The following responses mainly concern entrants with operations in Belgium, France, Germany, Italy, Netherlands and UK, since the majority of relevant responses have referred to these markets. The absence of comments for other markets should, therefore, not be interpreted as an absence of barriers to entry. Indeed in some cases a lack of response indicates that there has not even been any attempt to enter the market. It should, moreover, be noted that many small new entrants had difficulty responding to the inquiry due to resource constraints.

120. As regards access to gas, many new entrants have replied that they source their gas from the incumbent importer or domestic producer of gas, who is also in most cases the former monopoly supplier to end customers (i.e. a competitor). The exact nature of these relationships varies: from a framework contract allowing flexible offtake to a series of precise volume contracts. The delivery timescale is typically medium-term (a few years or shorter). Whereas the responses show that incumbents expanding into new markets, producers or large electricity companies can often manage to source at least part of their gas from producers/exporters, this is normally not the case for most other entrants.

121. A number of responses have pointed to poorly functioning wholesale markets, resulting in difficulties obtaining access to gas. In some countries, entrants can access gas through gas release programmes, but several entrants have commented that these programmes are not adequately designed to meet their needs (for example, in Italy, comments included criticism of procedures, small programmes and high prices). Comments as to the lack of liquidity, including on hubs, were made by a number of entrants in several countries (for the UK, such comments referred to the forward market). The lack of availability of L-gas and/or conversion capacity of H-gas to L-gas was also raised by entrants in different countries.

Quote from a new entrant: “[ Incumbent ] offers exclusive and non-exclusive agreements. The onerous terms of the non-exclusive agreements, which expose the purchaser to volume risk, and the