[pic] | COMMISSION OF THE EUROPEAN COMMUNITIES |

Brussels, 14.11.2006

SEC(2006) 1467

COMMISSION STAFF WORKING DOCUMENT Accompanying document to the COMMUNICATION FROM THE COMMISSION

Economic reforms and competitiveness: key messages from the European Competitiveness Report 2006{COM(2006) 697 final}

TABLE OF CONTENTS

1. Introduction 7

2. Economic growth and standards of living 8

2.1. Introduction 8

2.2. GDP PER CAPITA AND GDP GROWTH 8

2.3. Growth determinants 15

2.3.1. Employment 16

2.3.2. Labour productivity 18

2.3.3. Capital deepening, total factor productivity 20

2.4. Concluding remarks 25

3. Liberalisation of European Energy markets: challenges and policy options 27

3.1. Introduction 27

3.1.1. Liberalising European energy markets 27

3.2. LIBERALISATION AND EFFICIENCY 29

3.2.1. Introduction 29

3.2.2. Performance of energy markets in improving efficiency 30

3.2.2.1. Productive efficiency 30

3.2.2.2. Allocative efficiency 33

3.2.2.3. Dynamic efficiency 35

3.2.3. A review of measures used to improve market efficiency 38

3.2.3.1. Introduction 38

3.2.3.2. Unbundling, merger control, divesture and privatisation 38

3.2.3.3. Virtual Power Plants, long-term contracts and site availability 39

3.2.3.4. Efficient allocation and extension of transmission capacity 40

3.2.3.5. Enhancing end-use efficiency 41

3.3. LIBERALISATION AND SECURITY OF SUPPLY 42

3.3.1. Introduction 42

3.3.2. Performance of energy markets in delivering stable and secure supply 43

3.3.2.1. Volatility of prices 43

3.3.2.2. Balancing supply and demand 46

3.3.2.3. Reliability of networks 50

3.3.3. Performance of energy markets in delivering an efficient level of supply 50

3.3.4. Policy discussion 52

3.3.4.1. Allocation of rights and responsibilities 52

3.3.4.2. Price and capacity regulation of wholesale markets 52

3.3.4.3. Encouraging liquidity of markets 53

3.3.4.4. Regulation of energy mix 54

3.3.4.5. Investment in strategic stocks 54

3.3.4.6. Optimal regulation of grids and system operators 54

3.4. LIBERALISATION AND ENVIRONMENT 55

3.4.1. Introduction 55

3.4.2. Effects of liberalisation on environment 56

3.4.2.1. Electricity consumption 56

3.4.2.2. Fuel efficiency 56

3.4.2.3. Mix of generation technologies 57

3.4.2.4. Voluntary initiatives and environmental regulation 57

3.4.2.5. Empirical evidence 58

3.4.2.6. Conclusion 60

3.4.3. Effects of the European Emissions Trading Scheme on Competition 60

3.4.3.1. Introduction 60

3.4.3.2. Free allocation and insufficient competition 61

3.4.3.3. Allocation rules for new entrants and closures 62

3.4.3.4. Multi-period nature of allocation (updating) 63

3.4.3.5. Non-harmonised allocation 63

3.4.3.6. ETS as part of a comprehensive policy mix (Hybrid allocation) 64

3.4.3.7. Conclusion 64

3.5. SUMMARY AND CONCLUSIONS 64

4. The Regulatory Environment in the Context of the Strategy for Growth and Jobs 71

4.1. INTRODUCTION 71

4.2. PRODUCT MARKET REFORMSAND ECONOMIC PERFORMANCE: THEORY AND EVIDENCE 72

4.2.1. Empirical findings 75

4.2.2. The case of administrative costs 79

4.2.3. Summary 82

4.3. AN ASSESSMENT OF THE CURRENT REGULATORY ENVIRONMENT IN THE EU 82

4.4. Policy action 87

4.4.1. Simplification of existing legislation 88

4.4.2. Measurement and reduction of administrative costs 90

4.4.3. Impact Assessments of new legislation 91

4.4.4. Conclusions 92

4.5. SUMMARY AND CONCLUSIONS 93

5. The Financing of Innovation 116

5.1. INTRODUCTION 116

5.2. UNDER-INVESTMENT BECAUSE OF APPROPRIABILITY PROBLEMS 118

5.2.1. Missing markets for knowledge 118

5.2.2. The principles of ‘additionality’ 119

5.2.3. Empirical trends 120

5.2.4. Direct funding 122

5.2.5. Fiscal incentives 123

5.2.6. Summary and policy conclusions 124

5.3. UNDER-INVESTMENT BECAUSE OF CAPITAL MARKET IMPERFECTIONS 126

5.3.1. The financing gap 126

5.3.2. Innovation and the stylised ‘pecking order’ of corporate finance 127

5.3.3. Private equity and venture capital 129

5.3.4. Summary and policy conclusions 134

5.4. INNOVATION FINANCING MEASURES IN THE NATIONAL REFORM PROGRAMMES 137

5.5. SUMMARY AND CONCLUSIONS 142

6. The “Lead Markets” approach to innovation policy 146

6.1. INTRODUCTION 146

6.2. THE CONCEPT OF LEAD MARKETS 148

6.2.1. Market diffusion of innovations 148

6.2.2. Case studies on globally successful innovations 150

6.2.3. Marketing studies on the international diffusion of innovations 151

6.2.4. Studies on the market-linkage of R&D 152

6.2.5. Competing technologies and locational advantages 153

6.2.6. Lead market factors 155

6.3. LEAD MARKETS AND PUBLIC INTERVENTION 156

6.3.1. Potential role for policy intervention 156

6.3.2. Potential instruments to stimulate the emergence of a lead market 157

6.3.3. Limitations and potential risks of lead market oriented policies 159

6.3.3.1. Competition in product markets 159

6.3.3.2. Competition among innovation designs 160

6.3.3.3. Cost effectiveness of innovations 160

6.3.3.4. Anticipation of global trends 161

6.3.3.5. Restricted exportability 161

6.3.4. Towards a lead market oriented technology policy 162

6.3.5. Policies for lag markets 164

6.4. CONCLUSIONS 164

7. The competitiveness of the EU ICT sector 171

7.1. INTRODUCTION 171

7.2. A PROFILE OF THE ICT SECTOR 172

7.2.1. ICT market 174

7.2.2. Structure and location of the EU ICT sector 175

7.2.3. Comparison of the industry composition with other regions 178

7.2.4. Economic Impact of ICT 180

7.3. THE COMPETITIVENESS OF THE EU ICT SECTOR 183

7.3.1. Trade 184

7.3.2. FDI 189

7.3.3. R&D 189

7.3.4. Location of production 190

7.4. CHALLENGES FOR THE FUTURE COMPETITIVENESS OF THE EU ICT SECTOR 192

7.4.1. Defining trends of ICT cycle in its deployment phase 192

7.4.2. Generalisation of electronic components (embeddeness) as realisation of digital convergence 194

7.4.3. Social computing as exploitation of digital convergence 195

7.4.4. Evolving business strategies in the context of emerging trends 196

7.4.5. Policy considerations regarding the competitiveness of the EU ICT industry 197

7.5. SUMMARY AND CONCLUSIONS 200

8. Competitiveness in the Pharmaceutical industry 215

8.1. INTRODUCTION 215

8.2. PROFILE OF THE INDUSTRY 215

8.3. PRODUCTIVITY AND COST COMPETITIVENESS 222

8.4. R&D AND INNOVATION 228

8.5. INDUSTRY STRUCTURE AND COMPETITION 237

8.6. Summary and conclusions 246

9. Annex: Sectoral competitiveness indicators 251

9.1. EXPLANATORY NOTES 251

INTRODUCTION

This is the ninth edition of the Commission’s European Competitiveness Report since the 1994 Industry Council Resolution that established its basis. Competitiveness in this Report is understood to mean a sustained rise in the standards of living of a nation or region and as low a level of involuntary unemployment. Maintaining and improving its position in the global market is the main competitiveness criterion at the level of an industrial sector.

Over the last years, the Report has focused on analysis of the determinant factors of productivity developments, as the most reliable indicator for competitiveness over the longer term and connected issues, such as the likely impact of enlargement and the role of the public sector in the competitiveness of European economies.

The present Report continues in the same direction but, in the same time, marks a new beginning. Continuity as concerns its ambition to approach the issues from the point of view of economic theory and empirical research and its objective to contribute to policy making by discussing analytically the likely outcomes of the various policy options. A new start in its ambition to support much more directly than before the Lisbon process by focusing on the microeconomic issues of the Strategy for Jobs and Growth.

Thus, the Report addresses various aspects relating to three of the four priority actions of the reform agenda that the Spring European Council of 2006 put forward: knowledge and innovation , unlocking the business potential and towards an efficient and integrated energy policy . In addition, the Report examines the competitive position of two high technology European industrial sectors, the production of Information and Communication Technology goods and services and the pharmaceutical industry.

The Report is structured as follows: a first chapter reviews recent developments concerning growth; productivity and employment in Europe. Following chapters deal with, successively, the liberalisation of European energy markets, the Regulatory environment in the context of the Strategy for Growth and jobs, the financing of innovation, the concept of “Lead Markets” in innovation policy, the competitiveness of the ICT sector and the competitiveness of the pharmaceutical industry. Finally, a statistical annex presents indicators of competitiveness at sectoral level. This structure of thematic and sector specific chapters, followed by a statistical annex should continue in future versions of the Report.

ECONOMIC GROWTH AND STANDARDS OF LIVING

Introduction

A popular view sees countries competing among each other in the same way as enterprises are competing for a market of a given size. But comparing competition between countries with competition among enterprises is misleading. Losing market shares to other countries is not necessarily synonymous of losing competitiveness. Indicators such as the trade balance recording a deficit are often invoked as suggestions that a country is losing competitiveness. However, a surplus may be a sign of weakness (such as when the economy is not growing) and a deficit a sign of strength (such as when the economy imports international capital to finance domestic investment opportunities).

A widely accepted definition of country competitiveness refers to the ability of an economy to provide, on a sustainable basis, its population with high and rising standards of living and employment for those willing to work. This is the approach we follow in this chapter: competitiveness describes the overall economic performance of a nation. The objective is to provide an aggregate picture of recent trends in the EU-25 and to describe main differences among the Member States.

In the past decade GDP per capita (taken as a measure of the standards of living) in the EU-25 has been lagging behind that of the US and the growth rate of real GDP, labour productivity and total factor productivity in the European Union have been slowing down or remained stagnant during the 1990-2005 period. It is by now clear that these trends have structural features and this awareness, shared among European policy makers, dictates that adequate policy responses are needed. In 2000, the European Council agreed in Lisbon to re-launch European competitiveness. In 2005, the Lisbon strategy was revamped, with increased focus on policies aimed at delivering growth and employment.

Clearly the rise of oil prices in 2005 and 2006 has had a negative impact, though limited, in the EU growth performance. In order to put into perspective the current debate over effects of the fast rising of oil prices since 2003, the chapter also includes a simulation of the impact on the EU of alternative oil price shocks.

The chapter is organised as follows. Section 2 reviews evidence on GDP per capita and GDP growth. Section 3 analyses the supply determinants of GDP growth, distinguishing between the contribution of factors affecting employment and the supply of labour and of those having an impact on labour productivity, Section 4 concludes.

GDP PER CAPITA AND GDP GROWTH

Between the mid 1990s and up to 2000, the growth of EU-25 GDP per capita accelerated and remained at a good pace (annual average growth rate of 3%). The deceleration witnessed after 2000 seemed to start reversing in 2003, although 2005 turned out to be rather disappointing.

Table 2.1 (last column) illustrates the standards of living across individual Member States, the EU-25 and the US. With the exception of Luxembourg, where GDP per capita is more than twice as high as the EU average, living standards in the EU-25 range from 50% of the EU average (Latvia) to 139% (Ireland). Four Member States have a GDP per capita level below 60% of the EU-25 average.

Over the period 1990-2005, differences in developments in GDP per capita were mainly driven by GDP growth, the contribution from population growth being of a secondary importance. As Table 2.1 shows GDP in the EU grew less fast than in the US both during the slow-growth period in the first half of the 90s and during the high-growth, “new economy” years of the second half of the decade. In the 2000-2005 period, growth again slowed down considerably in most EU Member States. Many of the new Member States however continued to register strong growth rates exceeding 7% annual averages in the three Baltic States. Encouraging recent data point to an acceleration of economic growth in the EU from 1.7% in 2005 to 2.7% in 2006[1].

Overall, the growth pattern in Europe follows quite closely the convergence hypothesis according to which countries with relatively low levels of per capita GDP grow more rapidly. Graph 2.1 plots the average annual growth rate of GDP per capita from 1990 to 2005 against the initial level of GDP per capita in 1990 for each the 25 Member States, the EU-25 and US. Even in this relatively short time period, there is a clear negative relation between the initial level of GDP per capita and its growth rate since 1990: countries that lagged behind in 1990 have typically grown faster.

Table 2.1: Real GDP Growth & real GDP per capita in PPS (EU25=100) |

Average annual GDP growth | 2005 GDP per capita |

1990 – 1995(*) | 1995 - 2000 | 2000 - 2005 | 2005 |

Austria | 2,2 | 2,9 | 1,5 | 2.0 | 123 |

Belgium | 1,6 | 2,7 | 1,5 | 1.1 | 115 |

Cyprus | 5,3 | 3,8 | 3,2 | 3.8 | 81 |

Czech Republic | -1,0 | 1,5 | 3,6 | 6.1 | 73 |

Denmark | 2,3 | 2,9 | 1,4 | 3.0 | 124 |

Estonia | 1,4 | 5,6 | 8,3 | 10.5 | 60 |

Finland | -0,8 | 4,8 | 2,5 | 2.9 | 119 |

France | 1,2 | 2,8 | 1,5 | 1.2 | 111 |

Germany | 2,2 | 2,0 | 0,6 | 0.9 | 108 |

Greece | 1,2 | 3,4 | 4,4 | 3.7 | 83 |

Hungary | 0,4 | 4,0 | 4,2 | 4.2 | 61 |

Ireland | 4,7 | 10,4 | 5,2 | 5.5 | 139 |

Italy | 1,3 | 1,9 | 0,6 | 0.0 | 106 |

Latvia | -11,8 | 5,4 | 8,1 | 10.2 | 50 |

Lithuania | -10,3 | 4,2 | 7,6 | 7.6 | 53 |

Luxembourg | 4,0 | 6,1 | 3,3 | 4.0 | 235 |

Malta | 5,3 | 4,5 | 0,3 | 2.2 | 72 |

Netherlands | 2,1 | 4,0 | 1,2 | 1.5 | 120 |

Poland | 2,2 | 5,4 | 3,0 | 3.2 | 51 |

Portugal | 1,7 | 4,1 | 0,6 | 0.4 | 75 |

Slovakia | 6,4 | 3,7 | 4,6 | 6.0 | 56 |

Slovenia | -0,6 | 4,4 | 3,4 | 4.0 | 80 |

Spain | 1,5 | 4,1 | 3,2 | 3.5 | 94 |

Sweden | 0,7 | 3,2 | 2,2 | 2.7 | 122 |

United Kingdom | 1,7 | 3,2 | 2,4 | 1.9 | 115 |

EU-25 | 1,7 | 3,0 | 1,8 | 1.8 | 100 |

US | 2,5 | 4,1 | 2,4 | 3.2 | 152 |

(*) Hungary, Malta ‘91-‘95; Slovakia ’92-’95; Estonia ’93-’95; Germany, EU-25 backward extrapolations of respectively West-Germany, EU-15. Source: Commission Services, AMECO. |

Graph 2.1: Real GDP per capita growth (1990–2005) versus real GDP per capita in 1990 (*) |

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(*) Germany, Hungary, Malta ’91; Slovakia ’92; Estonia ’93. Source: Commission Services, AMECO. |

The GDP growth reported was obtained in spite of strong increases in oil prices in 2005 and 2006. However, persistently high oil prices could trigger potential second-round effects in wage and price-setting behaviour, which pushes up inflation and as a consequence dampens Europe's potential economic performance. Evidence on the macroeconomic effects of oil price fluctuation on economic performance is ample. During the surge in crude oil prices in 1999, for example, household savings rates declined by more than 2 percentage points in the Euro area, directly impacting investment behaviour and hence economic performance during this period (cf. European Commission 2004, Graph 19).

But why should oil prices remain high? For a disruption in global oil supply by 7% an OECD (2004) study estimates an increase of international oil prices by 20-25%. But security of supply and associated price premiums are not only determined by production, but also by the demand side. Over the decade 1995-2004, China and India accounted for more than 30% of the incremental demand in crude oil (OECD 2004). Given their continuously high economic growth the two countries are likely to demonstrate further incremental demand for crude oil in the future, hence contributing to persistently high prices for crude oil.

As we have observed crude oil prices to increase throughout 2006 from 60US$/barrel to about 80US$/barrel in a rather erratic manner and to plunge back to 60US$ within only two months, the debate about the impact of such rapid and radical price changes remains highly topical. In order to contribute to the quantification of the potential effects of changing oil prices on the EU economy, we provide an analysis of two alternative oil price scenarios, which is presented in Box 1 below.

Box 1: Changes in energy prices and EU economics performances

The relative price of energy vis-à-vis other commodities is an important determinant for economic performance and the growth of GDP. This is particular true for international crude oil prices, but also for the prices of other primary energy sources. Over the past two decades, crude oil prices show substantially larger volatility than other commodity prices (OECD 2004), which reflects the frequent disruptions in global oil supply. Such disruptions may occur through adverse weather conditions (hurricanes), technical interruptions (leaks, fires), sabotage, and geo-political risks.

Using the WorldScan[2] model (Lejour et al, 2006), we estimate the effects of an increase in average EU import prices for crude oil of 10% (approx. 6.5 US$/barrel) and their decline of 22% (approx. 14.0 US$/barrel) respectively [3] . While the first scenario reflects continuously high energy prices, the second scenario mimics the possible return from the currently high oil price levels to more moderate levels, a medium-term prediction of many analysts.

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The economy-wide effects of both scenarios for the EU-25 are presented in Graph 1[4]. If the average import prices for crude oil increase by 10% in 2006 (and persistently remain at such higher levels until 2020), real GDP for the EU-25 is 0.75% lower as compared to the baseline (business-as-usual) scenario in 2020[5]. Individual Member States are affected quite differently depending on their respective sectoral structure, the energy intensity of their production processes, and their dependency on energy imports (see Graph 2). The drop in GDP, which is caused by a decline in real wages that is due to the lower average productivity in the economy, corresponds to a decline in national income of the same magnitude. While final private consumption is in line with the change in GDP, the change in domestic capital stocks is more moderate reflecting their sluggishness even over medium-term periods. Since the EU is a net importer of energy, higher international energy prices translate to a relatively larger increase in aggregate import than export prices for the EU-25 area and hence a slight decline in Europe’s terms of trade vis-à-vis the rest of the world.

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The effects vary across sectors and countries as illustrated in Graph 3 for the changes in production of low-tech manufacturing across European economies in 2020 as compared to the baseline. Most obviously, the relative changes in the low-tech sector output differ substantially at individual country level. In part, this reflects country-differences in total energy intensity of production and dependency on energy imports. More importantly, it also reflects differences in the relative energy-intensities across sectors (by country), which not only cause different relative adjustments, but may also cause different directions of adjustment.

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The second scenario approximates the impacts of a permanent decline in average EU-25 import prices for crude oil by 22% as compared to the price levels for 2006-20 in the baseline. The economic gains from such persistently lower energy prices would be substantial, accounting for a 1.6% increase of GDP in 2020 vis-à-vis the baseline. The mechanisms at work are the same as explained above just taking effect into the opposite direction. Apart from the favourable conditions for most net energy importing European economies the marginal improvement of the terms of trade allow for some additional benefits. Consequently, the relative changes are even slightly larger than twice the changes of the first scenario.

Due to its relatively high energy demand and its dependency on energy imports, the European economy undoubtedly is going to suffer measurably under prevailing high energy prices and potential further increases herein. However, the economic losses can be dampened through structural adjustment and technology innovation that aim at increasing energy efficiency of production processes. In this respect, the current analysis does not capture the full potential benefits, because it does not consider technological change through (endogenous) R&D investment beyond the steady technological progress defined in the baseline. In particular, it does not consider the substitution from current technologies generating conventional energy sources to innovative technologies generating alternative energy sources such as, for example, second generation biofuels.

Growth determinants

Output per capita growth can be broken down into employment growth and labour productivity growth. The first captures the contribution to output arising from growing labour inputs available for production. The latter summarizes the contribution to GDP growth related to additional capital inputs, enhanced quality of labour inputs and technological progress[6].

Employment

Employment rate in the EU-25 fell in the first half of the nineties. This was followed by a rapid increase until 2001; since then, the employment rate has remained nearly unchanged at 65% of the 15-64 year old population[7]. Clearly, progress towards the EU Lisbon target of a 70% employment rate by 2010 has been slow and significant efforts will need to be made for this objective to be reached.

Although some Member States recorded an increase in employment growth in 2000-2005 (see Table 2.2), for the EU-25 as a whole the employment growth in this period declined to 0.6%, or half of that in the late 1990s. In 2000-2005, total employment declined slightly in Germany (which has an employment rate significantly above the EU-25 average), and steeply in Poland (which currently posts the lowest employment rate in the EU-25). Luxembourg, Spain and Ireland recorded strong employment growth, exceeding 2.5% at annual level, although also these countries experienced a deceleration of employment growth in comparison to the late 1990s.

Table 2.2: Employment growth and 2005 Employment rate |

Average annual employment growth | 2005 Employment rate |

1990 – 1995(*) | 1995 - 2000 | 2000 - 2005 | 2005 |

Austria | 0,2 | 1,0 | 0,2 | 0.3 | 74 |

Belgium | 0,1 | 1,1 | 0,5 | 0.9 | 61 |

Cyprus | : | 1,3 | 1,5 | 3.2 | 65 |

Czech Republic | : | -0,8 | 0,1 | 1.6 | 69 |

Denmark | -0,1 | 1,0 | 0,1 | 0.7 | 78 |

Estonia | -5,3 | -2,0 | 1,1 | 2.0 | 66 |

Finland | -3,7 | 2,3 | 0,9 | 1.3 | 69 |

France | -0,1 | 1,4 | 0,6 | 0.3 | 62 |

Germany | 0,0 | 0,8 | -0,2 | -0.1 | 70 |

Greece | 0,6 | 0,6 | 1,1 | 1.3 | 55 |

Hungary | -4,0 | 1,2 | 0,2 | 0.0 | 56 |

Ireland | 1,7 | 5,7 | 2,9 | 4.6 | 69 |

Italy | -0,6 | 1,0 | 1,2 | 0.2 | 63 |

Latvia | -7,2 | -0,5 | 1,6 | 1.5 | 65 |

Lithuania | -2,4 | -1,1 | 1,1 | 1.4 | 64 |

Luxembourg | 2,8 | 4,1 | 3,1 | 2.9 | 100 |

Malta | 1,5 | 0,8 | 0,8 | 1.5 | 54 |

Netherlands | 1,3 | 2,6 | 0,0 | 0.0 | 75 |

Poland | -0,9 | -0,4 | -0,6 | 2.3 | 53 |

Portugal | -0,6 | 1,9 | 0,4 | 0.0 | 71 |

Slovakia | 0,2 | -0,8 | 0,6 | 1.4 | 54 |

Slovenia | : | -0,4 | 0,6 | 0.3 | 66 |

Spain | -0,3 | 3,9 | 2,9 | 3.8 | 64 |

Sweden | -2,1 | 0,8 | 0,3 | 0.3 | 74 |

United Kingdom | -0,8 | 1,3 | 0,9 | 1.0 | 72 |

EU-25 | -0,3 | 1,2 | 0,6 | 0.9 | 66 |

US | 1,0 | 2,1 | 0,7 | 1.8 | 73 |

(*) Hungary, Poland ’92-’95; Slovakia ’94-’95; Germany, EU-25 backward extrapolations of respectively West-Germany, EU-15. Source: Commission Services, AMECO. Note: “employment rate” means persons employed in all domestic industries as % of population 15 to 64 years. |

The employment rate in the EU-25 is some 7 percentage points lower than in the US, this difference explaining a great deal of the persisting gap in the level of GDP per capita between the two economies. But to assess fully the contribution of employment to GDP growth, data on employment rates need to be complemented by information on average working hours per worker. This information is relevant especially for the comparison of the EU with the US as that Europeans work now fewer hours than Americans. In the 1970s the number of hours worked per employee in the then EU-5 was around the same as in the US, but since then the number of hours worked has fallen in both the US and the EU-15, with a steeper reduction in Europe. Shorter working weeks and longer holidays seem to explain the trend.

Labour productivity

Labour productivity (GDP over total employment) in the EU showed a rapid convergence towards the higher US productivity level until 1995. Since then a marked divergence emerged, despite an annual average labour productivity growth in Europe of around 2% for the period 1995-2000 and 1.3% afterwards. Latest available data suggest that labour productivity accelerated in the first semester of 2006 (on a year to year basis the annual growth rate in the second quarter of 2006 was 1.7% for the EU25).

Table 2.3 presents the labour productivity growth rates by Member State. Most of the new Member States – in particular the Baltic States, Poland, Hungary and Slovakia – as well as Greece and Ireland recorded strong labour productivity growth rates in the period 2000-2005. Conversely, productivity growth was weak in Malta, Luxembourg, Italy, Portugal and Spain.

Table 2.3: Growth of Labour Productivity per person employed & 2005 levels of real GDP per person employed (ppe) and real GDP per hour worked (phw) |

Average annual labour productivity growth | GDP ppe 2005 | GDP phw 2005 |

1990 – 1995(*) | 1995 - 2000 | 2000 - 2005 | 2005 |

Austria | 2,0 | 2,2 | 1,0 | 0.7 | 120 | 108 |

Belgium | 1,5 | 1,5 | 0,9 | 0.1 | 118 | 137 |

Cyprus | : | 2,4 | 1,6 | 0.5 | 76 | 71 |

Czech Republic | : | 2,7 | 2,4 | 4.4 | 62 | 56 |

Denmark | 2,5 | 1,8 | 1,3 | 2.2 | 100 | 114 |

Estonia | 6,5 | 8,2 | 6,5 | 8.3 | 53 | 45 |

Finland | 3,1 | 2,4 | 1,5 | 1.6 | 107 | 110 |

France | 1,5 | 1,5 | 0,8 | 0.9 | 117 | 132 |

Germany | 2,9 | 2,2 | 1,6 | 1.6 | 117 | 116 |

Greece | 0,7 | 2,8 | 3,3 | 2.3 | 92 | 78 |

Hungary | 5,4 | 2,9 | 3,9 | 4.3 | 68 | 58 |

Ireland | 2,9 | 3,7 | 2,2 | 0.9 | 122 | 132 |

Italy | 2,1 | 1,1 | 0,0 | 0.4 | 107 | 102 |

Latvia | -5,0 | 5,9 | 6,4 | 8.6 | 47 | 43 |

Lithuania | -8,2 | 5,4 | 6,5 | 6.1 | 50 | 48 |

Luxembourg | 1,2 | 1,9 | 0,2 | 1.0 | 145 | 161 |

Malta | 3,8 | 3,8 | -0,7 | 0.7 | 78 | 80 |

Netherlands | 1,3 | 1,5 | 1,3 | 1.8 | 125 | 124 |

Poland | 6,2 | 5,8 | 3,6 | 0.9 | 57 | 50 |

Portugal | 2,3 | 2,2 | 0,3 | 0.3 | 66 | 68 |

Slovakia | 5,6 | 4,5 | 4,0 | 4.6 | 60 | 59 |

Slovenia | : | 4,8 | 2,8 | 3.7 | 72 | 74 |

Spain | 1,9 | 0,3 | 0,4 | 0.4 | 93 | 91 |

Sweden | 2,9 | 2,4 | 1,9 | 2.4 | 105 | 116 |

United Kingdom | 2,4 | 1,9 | 1,5 | 0.9 | 100 | 106 |

EU-25 | 2,2 | 2,0 | 1,3 | 1.1 | 100 | 100 |

US | 1,3 | 2,0 | 2,2 | 1.8 | 137 | 129 |

Source: Commission Services, AMECO. |

Productivity per worker can be decomposed into productivity per hour and average working hours per worker. In fact, when labour productivity is measured by hours rather than by worker, a reduction of almost 25% in the productivity gap between US and EU is observed. Since the short EU working hours do not apply for all member states -people in Central and Southern European countries tend to work longer hours- results change when comparing worker and hour productivity. Thus Belgium, France, Ireland, Sweden and Denmark where the average number of hours worked per year and per person employed is lower than the EU average, present higher hourly productivity while the reverse is true in the Czech Republic, Estonia and Greece. The last two columns in Table 2.3 present data on productivity per worker and per hour worked in 2005.

An ongoing debate concerns whether this difference in the supply of working hours is due to different preferences for leisure in the EU and the US, to different taxation systems, or to differences in labour market regulations (see Blanchard (2004) and Prescott (2003), CPB (2006) contains a recent literature review).

Capital deepening, total factor productivity

Developments in labour productivity may stem from changes in the per-employee capital stock, i.e. capital deepening, or by technological progress, as measured by growth in total factor productivity (TFP). Capital deepening is usually the prevalent source of labour productivity growth for middle income countries, the catching up process being characterized by relatively high investment rates and a capital/labour ratio approaching that of high income countries. Conversely, TFP growth is the dominant source of labour productivity growth in high-income countries, whose potential growth is mainly driven by product and process innovations, reallocation and reorganization of production activities, and enhancement of factor quality. Recent analyses (e.g. European Commission (2006)) show that for most EU-15 countries during the 2001-2004 period, TFP growth was the major contributor to output growth, while in the EU-10 countries the picture is mixed, with some of these new Member States having a stronger contribution from capital accumulation.

In past decades, the capital/labour ratio in most EU countries has been growing faster than in the US. Graph 2.2 shows that an increasing capital/labour ratio in the EU-15 helped to catch up with the US until the mid nineties. Subsequently, capital deepening in the EU slowed down, while that in the US grew at a faster pace, especially during the period 2000-2005. Changes in EU capital deepening are mostly related to changes in employment. Where capital deepening is most marked is where performance in terms of employment growth was weak, while the opposite is true where employment has grown. However, the decreasing trend of capital deepening in the EU is also related to a downward trend in gross fixed capital formation. Gross fixed capital formation contributes, also, in explaining the EU - US differences in growth. There is consensus that the faster investment growth in the US was related with higher investment in enhancing productivity information and communication technologies (ICT), which manifested, inter-alia, in more sustained dynamics of TFP growth.

Graph 2.2: Capital Deepening |

[pic] |

Source: Commission Services, AMECO. |

Table 2.4 shows that all the EU-15 countries have exhibited a decline in the growth rate of their capital/labour ratios compared to the first half of the 1990s. As for the EU-10 countries, over the 2000-2005 period capital deepening growth in these countries was on average higher than in the EU-15 (see European Commission 2005) and in the US, but with declining growth rates.

Table 2.4: Capital Deepening growth rate (*) 1990 - 2005 |

1990 - 1995 | 1995 - 2000 | 2000 - 2005 |

Austria | 1,1 | 0,8 | 0,7 |

Belgium | 0,9 | 0,4 | 0,4 |

Denmark | 0,4 | 0,3 | 0,6 |

Finland | 1,4 | -0,5 | 0,3 |

France | 1,0 | 0,3 | 0,6 |

Germany | 1,5 | 0,9 | 0,7 |

Greece | 0,6 | 0,7 | 0,9 |

Ireland | 0,3 | -0,2 | 0,9 |

Italy | 1,0 | 0,4 | 0,5 |

Luxembourg | 0,6 | 0,2 | 0,8 |

Netherlands | 0,4 | 0,0 | 0,8 |

Portugal | 1,4 | 0,9 | 0,9 |

Spain | 1,4 | 0,0 | 0,6 |

Sweden | 2,0 | 0,7 | 0,8 |

United Kingdom | 0,7 | 0,3 | 0,5 |

EU-15 | 1.1 | 0.4 | 0.6 |

US | 0.4 | 0.4 | 0.9 |

(*) Average annual growth rates of the labour-capital substitution ratio (%), 2000 = 100. Germany ’91–’95. Source: Commission Services, AMECO. Note: data for EU-25 are not available. |

The rate of growth of total factor productivity corresponds to what is also called “Solow residual” in growth accounting exercises. It measures the excess of the actual growth of output over the growth attributable to growth of labour and capital inputs. TFP incorporates the effects of changes in the degree of factor utilisation, in their quality, and in innovation and technological progress. One of the key factors enhancing TFP in recent years has been investment in new ICT capital goods which have a higher marginal product than others.

Graph 2.3 shows that during the first half of the nineties TFP growth in the EU was higher than in the US, while since then TFP growth has always been higher in the US. By historical standards, TFP growth in the EU was very low in the period 2000-2005.

Graph 2.3: Total Factor Productivity Growth |

[pic] |

Source: Commission Services, AMECO. |

Several explanations have been put forward to explain the disappointing TFP performance of the EU[8]. First, it has been argued that EU countries have been less concerned by innovations in IT-producing sectors and less prone to benefit and adopt such innovations in IT-using industries (e.g. Colecchia and Schreyer (2002)). Secondly, it has been emphasized that EU countries have been lagging behind especially in TFP growth in service industries, notably in the retail sector, due to stricter national regulations compared with the US (Van Ark (2002)). Third, the general point has been raised that the EU lags behind the US in terms of fundamental infrastructures and institutions for competing in innovative industries on a global scale (e.g. Sapir et al. (2003)).

Table 2.5 shows that the picture is quite differentiated across the EU Member States. Nordic and Anglo-Saxon countries have in general TFP growth rates that are high on a global standard, higher than those of the US in some cases. At the opposite end, most South European countries (with the notable exception of Greece) performed poorly. A great deal of the sharp slowdown in EU TFP growth since 2000 is related to slow TFP growth in several large euro-area economies.

Table 2.5: Total Factor Productivity Growth 1990 – 2005 (average annual growth rate) |

1990 – 1995 (*) | 1995 - 2000 | 2000 - 2005 |

Austria | 1,0 | 1,4 | 0,4 |

Belgium | 0,6 | 1,1 | 0,5 |

Denmark | 2,1 | 1,5 | 0,6 |

Finland | 1,7 | 2,9 | 1,4 |

France | 0,6 | 1,2 | 0,2 |

Germany | 1,4 | 1,3 | 0,7 |

Greece | 0,1 | 2,2 | 2,4 |

Ireland | 2,6 | 4,6 | 1,4 |

Italy | 1,1 | 0,7 | -0,5 |

Luxembourg | 0,6 | 1,7 | -0,6 |

Netherlands | 0,9 | 1,5 | 0,7 |

Portugal | 0,8 | 1,3 | -0,6 |

Spain | 0,5 | 0,3 | -0,1 |

Sweden | 1,5 | 2,2 | 1,5 |

United Kingdom | 1,7 | 1,6 | 1,0 |

EU-15 | 1.3 | 1.2 | 0.4 |

US | 1.0 | 1.5 | 1.2 |

(*) Germany, EU-15 ‘91-’95 Source: Commission Services, AMECO. Note: data for EU-25 are not available. |

Concluding remarks

During the period 1990-2005 the competitiveness performance of the EU-25 has been characterized by a slight acceleration of GDP growth accompanied with stagnant productivity growth. Although recently there has been some progress in terms of increasing employment rates, the gains in labour productivity are sluggish. Both weak investment and slow total factor productivity (TFP) growth explain the weak performance of EU labour productivity growth.

Despite an increase in employment in many EU Member States, the overall employment rate in the EU remains low. Regarding TFP growth, no visible sign of recovery is present since the slowdown started at mid nineties. In fact, TFP growth further decelerated over the 2000-2005 period. Productivity gains stemming from re-organization and reallocation of production, from improved labour skills, from the introduction of new products and processes, would pave the way also for increased investment demand and further progress in labour productivity in terms of capital deepening.

These developments highlight the dual challenge facing Europe, i.e. raising employment rates and generating faster productivity growth at the same time. Yet both are necessary for sustaining standards of living and social welfare over the medium to long term, especially with regards to a fast ageing population.

The policy response lies in the Strategy for Jobs and Growth. The paramount emphasis put on reforms improving the business environment and innovative capacity, on enhancing human capital and on making labour markets more efficient reflect the focusing on improving the performance of European economies as concerns potential growth, productivity and employment. In following chapters, the Report will review three of these reforms, the liberalisation of energy markets, Better Regulation and in financing innovation as well as developments in two growing sectors of the economy, the ICT and the pharmaceutical industries.

References

Blanchard, Olivier J., (2004), The Economic Future of Europe , MIT Economics Working Paper No. 04-04, Forthcoming, Journal of Economic Perspectives

Collechia, A. and P. Schereyer, (2002 ), ICT investment and economic growth in the 90’s, is the United States a Unique Case? , Review of Economic Dynamics, 5, 408-442.

CPB (2006). European Times. Public Opinion on Europe and Working hours, compared and explained. European Outlook 3.

ECB (2004). Oil prices and the Euro area economy. In: ECB Monthly Bulletin November 2004. ECB, Frankfurt.

European Commission (2004). How vulnerable is the euro area economy to higher oil prices? Quarterly Report on the Euro Area, Vol 3(2):14-20.

European Commission (2005), The Lisbon Strategy and the EU’s structural productivity problem , European Economy, Economic Papers No 221.

European Commission (2006), Enlargement, two years after: An economic evaluation , European Economy, Occasional papers No 24.

Lejour, A.M., P. Veenendaal, G. Verweij, and N. van Leeuwen (2006). WorldScan: A model for international economic analysis. CPB Document 111. CPB, The Hague.

OECD (2004). Oil price developments: Drivers, economic consequences, and policy responses. ECO Working Papers No.412. OECD, Paris.

Prescott, E., (2003 ), Why do Americans work so much more than Europeans? , Federal Reserve Bank of Minneapolis, Research Department Staff Report 321.

Sapir et al (2003), An Agenda for a growing Europe. Making the EU Economic System deliver, Report to the European Commission.

Van Ark, B., R. Inklaar and, R. McGuckin, (2002), Changing Gear: Productivity, ICT investment and service industries: Europe and the United States , Groningen Growth Development Centre, Research Memorandum GD-60.

Wobst, Peter (2006). Technical paper on the implementation of energy price scenarios using WorldScan. Mimeo. European Commission, DG for Enterprise and Industry (B.2). Brussels.

LIBERALISATION OF EUROPEAN ENERGY MARKETS: CHALLENGES AND POLICY OPTIONS

Introduction

Liberalising European energy markets

The European energy markets have been going through a process of liberalisation[9] since the early 1990s in order to increase efficiency of the supply of energy (e.g. EC, 2005). This liberalisation process of the electricity and natural gas market is managed through EU Directives, prescribing non-discriminatory regulated third-party access to the networks in order to accommodate entry by competitive suppliers, and open end user markets to competing suppliers.

According to the EU Directives on the liberalisation of the electricity and natural gas market, the management of both transmission and distribution networks has to be legally and functionally unbundled from commercial activities by 2007. European countries have made progress in satisfying this requirement in particular in the case of transmission networks. Almost all countries have legally or fully (ownership) unbundled transmission of both electricity and gas, although a few unbundled Transmission System Operators (TSOs) do not have an independent management (EC, 2006). Nevertheless, concerns exist about third-party access to the transmission infrastructure, in particular in the gas market where third-party shippers appear to be subject to more costly access procedures. Moreover, distribution system operators remain closely linked to the supply business of the incumbents in a large number of EU countries. Consequently, the current level of unbundling in electricity and natural gas markets is viewed as being insufficient by regulators and many participants in these markets (EC, 2006). During 2006 the Commission lauched infringement cases against twenty Member States whose transposition of the Directives was considered to be insufficient.

In its preliminary report on the inquiry on the energy markets, the European Commission (EC, 2006) concludes that the functioning of the gas and electricity markets is seriously hindered by a number of factors, i.e. horizontal concentration, vertical foreclosure (e.g. entrants having limited access to the infrastructure), lack of market integration at EU level (e.g. incumbents controlling import capacity), lack of transparency (e.g. insufficient information on technical availability of interconnectors) and the still ill-developed price-formation process (e.g. prices not responding to changes in supply and demand).

Although the potentially adverse effects of concentrated markets are widely acknowledged, the EU Electricity Directives have not required horizontal separation of dominant producers and retailers to achieve less concentration in wholesale and retail markets. The electricity market has shown an ongoing process of concentration, which may seriously limit effectiveness of competition (Jamasb, et al., 2005)[10]. For both the electricity and gas market, wholesale supply is often highly concentrated. For example, in all countries except the United Kingdom, incumbent natural gas firms control a large majority of imports as well as domestic production. Moreover, market opening is as yet not fully realised in all EU-countries. Currently, about 75% of the gas in the EU-15 countries is consumed by end-users who are free to choose their gas suppliers (Eurostat, 2005).

The welfare effects of introducing competition in energy markets have been subject to significant debate. As Joskow (2003) states, “replacing the hierarchical governance arrangements with well functioning decentralised market mechanisms is a very significant technical challenge, about which even the best experts have disagreements”. The key challenge in electricity markets is to create an optimal design of regulating institutions to ensure effective working of market mechanisms and to induce sufficient long-term investment in each segment of the markets.

In decentralised competitive electricity markets, price uncertainty could possibly lead to too low levels of investment. In less competitive (oligopoly or monopoly) markets, control over prices reduces this uncertainty but results in allocative inefficiencies and possibly also in too high levels of investment, for which consumers pay the price.

In his assessment of experiences in the United States, Joskow (2003) concludes that the liberalisation process “has encountered more problems and proceeded less quickly than some had anticipated when the first restructuring and competition programs were first being implemented in the late 1990s”. In California, for instance, retail prices increased by 30 to 40% due to market design imperfections, market power problems and poor responses of federal and state authorities. On the other hand, liberalisation of electricity markets in the United States has also produced successes, such as substantial investments in new generating plants by merchant generating companies as well as lower electricity prices for the largest customers (Joskow, 2003).

The most appropriate structure of the electricity industry is also still under debate, also because models which work well in some circumstances perform less well in other places (Newbery, 2002A). On some issues, however, theoretical and empirical evidence is quite straightforward. For instance, practice shows that ownership unbundling of the transmission system operation from competitive activities improves welfare.

In addition to the efficiency considerations, the liberalisation of the gas market has generated concerns about security of supply. IEA (2004A), for instance, states that the key question is “whether the (gas) market itself will value security of supply and deliver timely signals and competitive incentives for investments to guarantee secure and reliable gas supply all the way to the final consumer». Furthermore, the introduction of competition is also likely to impact on patterns of energy production as well as consumption and, hence, affects environmental outcomes. The direction of the net effect is not clear in advance as both price and substitution effects could emerge: both price and substitution effects. For instance, the opening of markets might encourage the supply from small-scale combined-heat-power (CHP) power plants. This substitution effect would lead to a reduction in overall emissions. On the other hand, the opening of markets may also lower prices and, hence, raise total emissions.

This chapter presents an assessment of the effects of liberalising the European electricity and gas markets, addressing the following questions:

What are the expected potential effects of liberalisation of energy markets in terms of efficiency, security of supply and environment?

What are the policy challenges in addressing the performance of energy markets and what other complementary measures might be needed to deliver Community competitiveness objectives?

The analysis of the effects on efficiency as well as security of supply covers both the gas market and the electricity market. The environmental section is restricted to the electricity industry, given its relatively high environmental impact compared to gas.

LIBERALISATION AND EFFICIENCY

Introduction

The liberalisation of the energy industry is largely motivated by expected efficiency improvements. A more efficient supply of energy contributes to the competitiveness of the European economy and, hence, increases welfare. In order to assess the effects on efficiency, three efficiency concepts have to be distinguished: productive, allocative as well as dynamic efficiency[11].

In theory, the relationship between competition and productive efficiency is at least non-negative (neutral or positive). Traditional theoretical models assume profit-maximising and cost-minimising behaviour of firms, which implies that firms should be always productively efficient. Agency models[12], however, stress the effect of the competitive environment on firms’ incentives, concluding that competition increases productive efficiency.

Liberalisation might also improve allocative efficiency as price reductions will lead to a higher demand for services, hence, increasing the sum of consumer and producer surplus. Moreover, if consumer surplus is weighted higher than producer surplus, a lower price would result in even stronger improvements of total welfare.

The effect on dynamic efficiency is complex. On the one side, firms need to have profit in order to innovate (the Schumpeterian view); on the other side competitive pressures may also create incentives to innovate in some areas. Moreover, competitive pressure is also a source of dynamic efficiency to the extent that it leads inefficient firms who do not catch up to exit the market, being replaced by more efficient firms.

This section first gives a brief overview of empirical literature on the efficiency effects of liberalising the energy sector. Afterwards, the focus is on policy options to improve the performance of the energy markets.

Performance of energy markets in improving efficiency

Productive efficiency

An economy achieves productive efficiency when it produces a given amount of output at minimum total costs. The empirical literature generally finds positive effects of liberalisation on productive efficiency of generation plants, both in and outside the EU. Newbery et al. (1997) document benefits from privatisation and restructuring of the Central Electricity Generating Board (CEGB) in the UK. These benefits are achieved by shifting from inefficient coal production supported by the government to a less costly technology[13], resulting in a structural reduction of generation costs by about 5%.

Empirical studies by Bushnell et al. (2005) and by Fabrizio et al. (2006) for the US also show an improvement in the efficiency of generation plants after the implementation of reforms. In the course of these reforms, some plants were divested and began to compete in the market, while some other (non-divested) plants were subject to more stringent regulation. According to Bushnell et al., both competition and incentive regulation of generating plants have lead to fuel efficiency improvements (up to 2%). The authors argue that the change of incentives, but not the change of ownership itself, was the main driver of these improvements. Fabrizio et al. (2006) find that competitive pressures reduce non-fuel operating expenses of electricity plants. In anticipation of increased competition, plant operators most affected by restructuring reduced their labour and non-fuel expenses per unit of output by 3-5% relative to other investor-owned plants, and by 6-12% relative to government and cooperatively owned plants which were not affected by the reforms. Also IEA (2005A) finds an increase in labour productivity in the energy industry as a result of reforms.

Besides fuel efficiency and operational efficiency, liberalisation might affect the utilisation of production capacity. IEA (2005A) reports a 12% higher utilisation of generation capacity in New South Wales (Australia) compared to the pre-liberalisation period. Also in Europe, the utilisation rate of generation capacity increased over the past decades which might be partly the result of liberalisation (figure 3.1).

Graph 3.1: Utilisation of generation capacity in EU-15 |

[pic] |

Source: Eurostat. Utilisation is measured as the ratio between actual production and theoretical maximum production given the size of the generation capacity. |

In some circumstances, however market power might lead to inefficient productive decisions, in the sense that production is not always undertaken by the least-cost units. This may happen when firms on both sides of the spot market (selling electricity as generator and buying it as retailer) gain market power. Kühn et al. (2004) find for the Spanish market that although market power of large vertically integrated sellers and buyers has had little effect on spot market prices, substantial productive inefficiencies may have arisen from the exercise of bilateral market power. However, this effect might be overstated. Mansur (2003), analysing the effect of vertical links among firms on market efficiency and firm conduct in the Pennsylvania-New Jersey-Maryland (PJM) electricity markets, emphasizes the effect of production constraints (such as start up costs). Accounting for these constraints, the author finds that the costs in the PJM markets were only 3.4% above the competitive levels.

Productive efficiency of energy transportation and distribution networks may increase as a result of the introduction of incentive regulation. Regulators in Europe often choose a price-cap mechanism, according to which the prices should change by no more than RPI-X, where RPI represents a price index and X represents a productive efficiency target[14]. Firms outperforming this target (with efficiency increases above X) can keep the resulting increased profit during the regulatory period. The empirical literature shows that firms respond to regulatory incentives and reduce their costs. For the UK, there is evidence on cost reductions by the National Grid after adoption of sliding scale incentive mechanism (see, e.g., Joskow, 2005)[15]. Several other studies (Burns et al., 1996, Tilley et al., 1999, and Domah et al., 2001) report cost reductions of UK distribution firms after the introduction of price-cap regulation, especially towards the end of the second regulation period (the end of the 90s). Both selling the golden shares – shares held by the government, giving it potentially large influence over the companies - by the British government in 1995 and stronger regulatory incentives in the second regulatory period could be seen as drivers behind these productivity gains.

Hjalmarsson et al. (1992) find no significant impact of ownership and economic organisation on productivity change of Swedish electricity retail and distribution firms. However, they find a substantial influence of economies of density, as well as a relative increase in productivity in rural areas. These authors relate this to the mergers of small regional utilities, thereby implicitly implying the existence of economies of (regional) scale. In a reaction, Mork (1992) states that the lack of impact of ownership results from the fact that neither private nor the public utilities are profit maximising. In a later Swedish study, Kumbhakar et al. (1998) find that privately owned firms in electricity retail and distribution are more efficient than municipal companies. The difference in technical progress between public, private and mixed firms, however, appears to be small.

It has been argued that in retail, liberalisation has introduced new costs, such as loss of potential economies of scope between the network and retail activities. However, since retail cost is a small part of the overall cost, a large effect of these costs on overall productive efficiency is unlikely. The conclusion from this evidence is that liberalisation of energy markets (such as change of regulation and ownership structure) improves firms’ productive efficiency, if this process succeeds in changing firms’ incentives.

Allocative efficiency

An economy is allocatively efficient when it produces the quantity of goods that maximises total welfare. This generally implies that prices equal marginal costs of production[16]. For the energy industry, which is capital intensive, this usually refers to long run marginal costs. Liberalisation is expected to lead to competitive pricing and, hence, to improved allocative efficiency. In practice, however, the relationship between liberalisation and allocative efficiency may be affected by the market situation. Market power of firms may lead to inefficient outcomes. Therefore, when evaluating the impact of liberalisation on allocative efficiency, it is necessary to address the question whether market structure in the energy sector is adequate for delivering sufficient competitive pressure.

Market power can be measured by the margin between price and the marginal cost of production. However, in electricity markets market power can still be present even when the price equals the marginal cost of the most expensive producing unit since dominant companies might raise prices by withdrawing generators with lower marginal costs.

Borenstein et al. (2000) present an indicator of market power that reflects the difference between the price and the marginal cost that would occur if all firms behaved as price takers . According to their estimate for California, the average mark-up over the competitive outcome was 15.7% in the period June 1998 to September 1999. Mansur (2001) and Bushnell et al. (2002) provide similar analyses for the Pennsylvania-New Jersey-Maryland (PJM) and New England electricity markets respectively, using somewhat different indicators that are based on the same idea. Comparing the results of these three studies over the period when they overlap (May to December 1999) controlling for the level of spare generation capacity at the various demand level Bushnell et al. conclude that “the performance of the two eastern markets was comparable, and that both were more competitive than California at all but the highest capacity ratios”[17]. Hence, market power can be present even in a fairly unconcentrated electricity market.

There is also some evidence on the allocative efficiency effects of reforms in the UK. Newbery et al. (1997) conclude that the productive efficiency gains achieved by privatisation and restructuring of the electricity industry mainly went to producers, not to customers. However, according to a comment by Littlechild (2006), one should take into account that the prices would probably have gone up under state monopoly (regulated by rate-of-return regulation). In this view, the benefits of reforms in the UK were actually shared between consumers and producers.

However, as competition in the European wholesale market is currently seriously hindered by lack of market integration and by horizontal concentration (EC, 2006), European energy markets do not perform as well as they could in terms of allocative efficiency.

In transmission and distribution, allocative efficiency effects are likely positive. Most networks are subject to regulated Third-Party Access (TPA). Not only does regulatory pressure encourage firms to operate more efficiently, it also leads to more efficient pricing of services, and hence to closer to optimal use of the network by the firms and customers. Customers in many countries (such as UK, the Netherlands, and Norway) benefited from the price decreases that were forced by the X-factors set by regulators. For example, in the Netherlands, only for electricity the X factors saved the consumers 1.1 billion euros over 2001-2006 (Haffner at al., 2005).

In retail, liberalisation generally increases allocative efficiency in the large consumer segment, but the effect in the small consumer segment is ambiguous. Large industrial users face lower prices than small users[18] for three reasons: their stronger buyer position, less fluctuating demand, and lower network cost, since these users are often connected at a higher network level, e.g. to transmission networks. Empirical work by Steiner (2001) (for earlier years of reforms) presents evidence that liberalisation is associated with a reduction of industrial user prices in the EU.

The effect of liberalisation on retail prices is less straightforward for small users. Joskow and Tirole (2004) stress the problems for retail competition associated with the absence of real-time pricing for small users. This is currently dealt with via load profiling but there is some evidence that the lack of a real-time price signal for smaller users creates additional volatility, for instance in the UK market in 2005-06 where winter peaks in demand leading to wholesale price volatility were created by households paying a flat price for gas for the whole year.

When assessing market performance, an important issue is what would be the alternative to retail competition. Littlechild (2006) discusses two policy options that seem to be the most reasonable alternatives: regulation by benchmarking and tendering. He stresses that both alternatives require a large involvement of the regulator, which is costly. Besides, benchmarking is not always feasible because of the insufficient number of benchmarks. In the case of tendering (applied in some states in the US), the regulator has to determine the terms of tendering, but it is unlikely that the regulator knows more about consumer preferences and is able to make a better choice for consumers that the consumers themselves. So, both alternative policies are unlikely to outperform competition. This conclusion is much stronger if we account for the welfare increase from product innovations in retail (stressed by Littlechild, 2005; see also next section), especially those promoting energy-efficient technologies (addressed in Directive 2006/32/EC[19]).

The overall picture here is that the allocative efficiency benefits of liberalisation of European energy markets may have been limited due to imperfect competition on the energy markets up to now. If the reforms succeed to adequately improve competition on these markets, allocative efficiency benefits could be significant. In networks, however, regulation has generated allocative benefits by imposing more efficient prices.

Dynamic efficiency

Dynamic efficiency relates to the extent to which process and product innovation occurs. The relationship between liberalisation and dynamic efficiency is not straightforward. Competition might stimulate as well as dampen incentives to innovate, and is also likely to change the type of research and development[20].

Evidence on private R&D expenses, which is often used as a measure for innovations[21], in liberalised energy industries suggests that the overall effect of market reforms on private innovation activity is negative. R&D activities in the electricity industry in many countries have declined over the past decades (e.g. Eurelectric, 2003; Hattori, 2006; IEA, 2005C; Jamasb et al., 2005; Sanyal et al., 2005). In the Japanese electricity industry, for instance, the R&D intensity, i.e. the ratio between R&D expenditures and total sales, declined somewhat since the mid 1990s when the process of liberalisation started (see graph 3.2). We should note that R&D expenditure may have been either inefficiently high or ill-directed before liberalisation, when it was carried out by regulated public utilities, which did not necessarily act as profit-maximisers. A lower level of R&D expenditures might be closer to optimal and is therefore not necessarily an indication of a lower level of dynamic efficiency.

Graph 3.2: R&D Expenditure and R&D intensity in Japanese Electricity Industry |

[pic] |

Source: Hattori (2006) |

Jamasb et al. (2005) conclude that vertical as well as horizontal unbundling[22] of the industry negatively affects R&D spending and technology adoption. This negative relationship follows from the fact that the size of a firm is an important factor behind innovation. Uncertainty created by the introduction of competition is also seen as a factor reducing the level of innovation. Regarding the effect of ownership, these authors conclude that privatisation shifts the focus of research towards applied and commercial projects. The overall conclusion of Jamasb et al. (2005) is that “competitive electricity markets will deliver sub-optimal amounts of R&D input and output”. According to these authors, the lower emphasis on profits of public utilities before liberalisation, as well as the larger scale of companies, would have allowed for the positive externalities associated with knowledge spillovers. These authors also argue that the introduction of competition dampens incentives to conduct fundamental research, thereby requiring additional policy measures to encourage fundamental energy research if the pre-liberalisation situation is to be restored.

This conclusion is challenged by the results of other authors. In their analysis of the relationship between liberalisation and R&D in the US electricity industry, Sanyal et al. (2005) find mixed results. They conclude that even if the uncertainties in the face of anticipated restructuring and deregulation have adversely affected R&D activities by energy utilities, once these have occurred, a higher level of deregulation and competition positively affect R&D. A higher likelihood of changing the structure of the industry probably creates uncertainty about future benefits of investments and, hence, reduces the incentive to invest in R&D. When a higher level of competition has been reached, R&D might be encouraged by the prospects of using new technologies to achieve competitive advantages. Liberalisation might also affect the composition of R&D. Hattori (2006) finds for the Japanese electricity industry a shift in the R&D mix towards cost-reducing technologies while R&D in joint research programmes for public-interest technologies seems to be reduced. In the latter programmes, research is directed at technologies such as clean-coal generation, fuel cell power generation and power-system technologies to address the further development of generation techniques using combined cycle power and renewable energy. The author notes, however, that the decline in public-interest research may be a result of R&D activities having been genuinely ill-directed before liberalisation.

A shift of R&D towards efficiency-enhancing technologies due to liberalisation is confirmed by Markard et al. (2006). These authors find a move from technology-oriented innovation towards market-oriented innovation. The latter includes both cost-reducing activities and innovations directed at new products for consumers. In general, they conclude that liberalisation increases the variety of innovations paths. This picture of the impact of liberalisation on R&D is also described by Eurelectric (2003).

Hence, liberalisation of the electricity industry does affect the innovation process. R&D seems to be more directed at technologies contributing to cost reductions in the short term. Conversely, company funding for more basic research has been reduced in several countries, but it is still an open question whether this is the result of termination of inefficient R&D activities or whether it indicates a market failure which calls for additional government intervention compared to the pre-liberalisation situation.

Liberalisation and the ambition to create a single energy market have not been mirrored by a similar effort to better structure energy related research, where one can witness a large fragmentation of Member States' activities. A better coordination of Member States' energy research efforts between themselves and with the Research Framework Programme could ultimately improve the efficiency of energy research funding.

Besides evidence on R&D expenses, there is also evidence on product innovations in retail. Littlechild (2005) stresses the effect of competition on product innovation in retail businesses. From the experience of the Nordic electricity market, Littlechild concludes that retail competition stimulates the development of new value-added services to customers, such as offering new terms of contracts, fixed-price contracts of different duration and spot-price related contracts. In addition, Littlechild (2006) lists numerous recently emerged products, such as energy efficiency packages, duel fuel contracts, various discounts (e.g. for self-reading meters, for prepayment meters), green tariffs, etc. The recent European Energy Services Directive (2006/32/EC) stresses the positive role of product innovation in retail for the development of more efficient energy services.

A review of measures used to improve market efficiency

Introduction

Policy options to improve efficiency of the energy supply industry concern measures to improve competition in the markets and to encourage optimal use and expansion of network capacity. These measures can be divided into structural (i.e. affecting the industry structure) and behavioural measures. Although structural measures are often more effective for competition, they also involve higher cost. We discuss below some of these policies.

Unbundling, merger control, divesture and privatisation

A key component of the liberalisation of energy markets has been the vertical unbundling of networks from production and supply, in order to ensure efficient pricing of network transportation services and to create a level playing field for power generators and suppliers, including entrants. The latest EU directives require legal unbundling (by 2007) of the networks but, given the importance of independent functioning of transmission networks for good market facilitation, several EU countries have fully unbundled these networks from commercial businesses. The net benefits of ownership unbundling of transmission from production and retail are widely acknowledged (see e.g. Joskow, 2003A, and Jamasb et al., 2005). In contrast, in the distribution industry less experience has been developed. In New Zealand, for instance, separation of network activities from retail and generation was followed by an increase in competition and a decrease in wholesale prices. However, some of this improvement came from improved switching possibilities and splitting of the dominant incumbent. Despite a clear theoretical argument regarding the adverse effect of a high concentration in the industry on the performance of firms, empirical evidence on the effect of merger control is scarce because of the unclear counterfactual: what would be the market development if a merger actually takes place? Especially in emerging markets, the consequences of a wrongly approved merger can be large. Therefore, some economists plea for more proactive policy in such markets, emphasising the relevance of strengthening merger control (see e.g. Canoy et al., 2003). The key issue here is that of the relevant market. At the moment, energy markets in Europe are still largely segmented, which underlines the importance of getting the market structure right at the national level. At the same time, several important market players are becoming active in many countries. Hence, merger control at the EU level becomes important too, especially in the light of more integration of the EU markets and more interconnections.

The studies on the US show that the performance of generation plants improves after restructuring because of the improvement of the incentive structure, which is achieved by privatisation and the change of regulation in divested generation plants. Although such divestitures are effective, they may involve high cost or be infeasible in practice for political reasons. Especially with the trend towards more integration of the EU market, some countries are afraid to split their energy companies as they may be taken over by large foreign utilities. In these conditions, political lobby groups push towards creating national champions. Behavioural measures (discussed hereafter) have also been used to mitigate market power.

Virtual Power Plants, long-term contracts and site availability

An alternative to actual divestiture to remedy market power in the wholesale market is virtual divestiture in the form of a Virtual Power Plant (VPP). VPPs reduce the scope for strategic behaviour in the market by reducing the amount of the generation capacity over which the dominant producers have discretion in bidding. They can be physical or financial. A physical VPP is a contract to deliver electricity (against some fixed price); a financial VPP is a contract on price which works similarly to a usual insurance contract. Willems (2006) argues that the type of the virtual divestiture is unimportant in the case of monopoly, but it does matter in oligopoly markets. This is because a physical VPP involves the delegation of production decisions by the dominant generator, while a financial VPP does not. Hence, in the oligopoly setting, the spot market is more competitive with a physical VPP divestiture that with a financial VPP divestiture.

Practical applications of VPPs can be found in several EU countries (such as Belgium, France, Italy, Denmark and Czech Republic). For example, in accordance with the agreement between the EC and Electricité De France (EDF), the company had to make available access to 6000 MW of generation capacity in France available (in exchange for the approval from the EC to acquire a further interest in the German electricity utility EnBW in 2001), which is partly done through VPPs and partly through Power Purchase Agreements.

Long-term forward contracts decrease both the possibility for a dominant producer to exercise market power and the gains from doing so. Examples are the so-called vesting contracts that have been used in the US and UK when their electricity industries were restructured. Many economists (e.g., Newbery, 2002, Wolak, 2001, Bushnell, 2004) emphasise the importance of long-term contracting for stability of electricity markets. For example, Wolak (2001) stresses the necessity of “sufficient forward market commitment for fixed-price wholesale electricity to cover retail obligations.”

However, long-term forward contracts may create problems for entrants, as they may decrease the liquidity on the market. Another problem arises in particular in gas markets, where the incumbent large producers/traders have bought a large number of such contracts, increasing their market power.

Incumbent producers often also own or control many of the suitable sites for new generation plants, enabling them to foreclose the market for new entrants. Options to improve site availability are enforced (negotiated) release of sites, requirements to auction vacant sites and revising the licensing agreement to limit the scope for capacity expansion by the dominant player. This would limit the scope for incumbent firms to engage in strategic behaviour to control the number of market players.

Efficient allocation and extension of transmission capacity

Optimal use of the European transmission grid involves sending efficient price signals to both generators and energy users. Since power flows along different transmission lines are interrelated, individual lines cannot be viewed (and priced) in isolation. Coordination among TSOs can enhance efficiency of TSO decisions in the EU context. Also, harmonisation of regulation is essential for efficiency of the future integrated European market. In order to achieve this goal a greater consistency is needed in actions of national regulators in different countries (High Level Group on Competitiveness, Energy and the Environment, 2006). A necessary condition for this is that the regulators have similar powers to promote the market development and to adopt efficiency-increasing policies, as well as policies enhancing security of supply.

With respect to the allocation of network capacity, non-market mechanisms are often replaced by market mechanisms, such as explicit auctions[23]. These mechanisms are supposed to deliver efficient capacity allocation, though in practice this is still not always the case due to inconsistent trading rules on either side of the border. Efficiency would imply that in the presence of a price difference between two regions, all transport capacity available between these regions is fully utilised (as a result of arbitrage). Frequently, however, one observes unutilised capacity in the presence of large price differences between neighbouring countries. This may result from illiquidity of markets, uncertainty in scheduling flows on a day-ahead basis, or the existence of market power.

Theoretically, the problem of assigning transmission capacity in an efficient way, including capacity taken up by the loop flows[24], can be solved in a competitive market by so-called locational marginal pricing (or nodal pricing). This assigns a different generation price to each ‘node’ in the transmission system. Such systems of locational marginal prices are in operation in some regions in the US. However, appropriate determination of locational prices is only feasible in a centralised system where power markets in the system are centrally cleared, which is a long way from the European system based mostly on bilateral, decentralised markets that operate in the different countries.

One approach currently actively pursued is market coupling. In this set-up, instead of auctioning interconnection capacity on individual borders to individual market participants, the allocation of transmission capacity on all borders in one region is jointly carried out, on the basis of the bids for supply and demand of energy on the power exchanges in the regions involved. In this way, energy markets and transmission markets are simultaneously cleared, taking into account the relations between flows on the different borders[25]. Issues in gas transmission markets are to some extent similar to those in electricity transmission. The key difference is that gas wholesale markets are currently much less developed than electricity markets in Europe. Access rights to cross-border gas transmission connections are largely allocated in long-term contracts, leaving little room for market-based allocation of short-term capacity. Furthermore, short-term wholesale markets for gas in most countries are still in their infancy. Given the longer distances between gas production regions (often outside Europe) and consumers and the associated larger specific investments, there may be a greater need for long-term contracting, making market-based allocation of short-run capacity more difficult.

In the long run, efficiency of the transmission market involves efficient investment in transmission capacity expansion. Major policy issues arise with respect to accommodation of transit flows and extension of interconnection capacity.

The first issue involves the remuneration of transit flows: expansion of capacity for transporting power flows between two regions usually not only involves investment by the two regions’ transmission system operators themselves, but also expansion of capacity in grids that are used for transit flows. The incentive for capacity investment by the operators of these transit grids depends on the ways in which such transit flows are remunerated.

A second issue is to what extent investment in new interconnections may be carried out by independent ‘merchant’ parties, and if this occurs, whether these merchant operators should be subject to regulation. The trade-off here may be between market failure, leading to potential underinvestment by private investors, and regulatory failure, leading to overinvestment by regulated transmission investors.

Enhancing end-use efficiency

In addition to policies directed at the efficiency of the energy production, transportation and supply, policies stimulating the efficient use of energy by consumers can contribute to European competitiveness as well. Retail competition might play an important role in moving towards energy-efficient technologies on the consumer side. The recent European Energy Services Directive stresses this positive role of product innovation in retail for energy end-use efficiency. It requires Member States to create the conditions for a market for energy services in order to improve the implementation of energy-efficiency measures by final consumers.

In a competitive retail market it is likely that retailers extend their activities to end-user services contributing to a more efficient use of energy by reducing the costs of implementing energy-saving measures. Environmental policy measures raising the price of energy, such as the European emissions trading scheme, can have a significant effect on energy use (see further on this issue in section 4).

LIBERALISATION AND SECURITY OF SUPPLY

Introduction

In the pre-liberalisation era, investments in electricity and gas sectors were centrally coordinated. Security of supply was generally the responsibility of the incumbent vertically integrated monopolist incorporating engineering reliability standards in its decisions on capacity investments. The concept of supply security was chiefly that “all customers should be able to consume as much electricity as they want at a constant price at any given time” (Bushnell, 2005). As a result, the pre-liberalisation energy industry was characterised by a high level of overcapacity where costs could be passed on to consumers. Moreover, the role of the demand side in achieving supply-demand balance was hardly recognised. Liberalisation has led to a shift of investment risk from consumers to the investors themselves, creating incentives to increase efficiency. In addition, liberalisation gives stronger incentives to consumers to respond to supply shortages.

A consequence of the abolition of the supply monopoly is that the responsibility for supply security is no longer explicitly assigned to an identifiable party. Rather, in the liberalised environment the market mechanism is relied upon to generate optimal investment. The question, therefore, is to what extent the security of supply is compromised by the decentralised management of energy supply. In order to address this question, it is important to note that two different perspectives on ‘security of supply’ can be distinguished.

Some view security of supply as guaranteeing a stable supply of energy at an ‘affordable’ price, no matter what the circumstances are (see e.g. EC, 2000).

The North-American Electricity Reliability Council (NERC) defines adequacy as “the ability of the system to supply the aggregate electric power and energy requirements of the consumers at all times”, and security as “the ability of the system to withstand sudden disturbances” (Meade, 2006).

The 2005 Directive on Security of Supply (2005/89/EC) defines: “security of electricity supply means the ability of an electricity system to supply final customers with electricity, (...) the satisfaction of foreseeable demands of consumers to use electricity without the need to enforce measures to reduce consumption”. This definition implies that supply and demand should not be artificially made equal through "enforcement" measures such as rota cuts and brownouts, but through a normal response to market conditions by producers and consumers. Similarly the definition recognises that some disturbances are not foreseeable and that the system cannot be 100% reliable 100% of the time.

Some of these definitions are close to pre-liberalisation goals as they take demanded volumes as an exogenous factor[26]. From a purely economic point of view, however, the concept of security of supply should be related to the efficiency of the provision of electricity or gas to consumers. Markets will always show variations in supply and demand, and, hence, in prices.

These differing definitions indicate that there are sometimes conflicting policy goals. From an economic welfare point of view supplying all demand is bound to be inefficient, and prices will have to fluctuate to clear the markets. However in some cases the extreme movements in prices could be viewed as politically unacceptable[27]. The remainder of this section looks at supply security from both perspectives.

Performance of energy markets in delivering stable and secure supply

Volatility of prices

Liberalisation of markets leads to decentralisation of operational and investment decisions, coordinated through the price-formation process. Comparison of prices (or marginal value derived from consuming energy) with short-run marginal costs of supplying to the market informs market participants in making these strategic decisions. In the days of the vertically integrated monopolists supplying to consumers in a centralised fashion, such short-term price signals were not required, and consumers typically faced average prices for energy (which for gas were usually indexed to oil price fluctuations). Liberalisation resulted in more volatile wholesale short-run prices, which were effectively hidden under the centralised regime. Typically, however, prices for final consumers are based on longer term wholesale markets, typically for one year forward contracts, hiding the effect of day to day variations.

Compared to other commodities, the volatility of short-run prices of electricity and gas in a liberalised environment is large. As examples of the volatility in energy markets, figure 3.3 plots the daily spot prices for the Dutch APX electricity market as well as the UK gas market spot prices NBP. While overall volatility of prices is noticeable, the short-lived price spikes to values which may exceed normal prices by tenfold are particularly visible.

The volatility of prices results from the particular characteristics of electricity and gas, in particular the inelasticity of both demand and supply in the short term. These in turn are related to the difficulty of storing electricity and the high costs of storing gas, respectively, as well as to the strict capacity limit of production and transmission capacities. The high investment costs of production equipment discourages companies to keep large amounts of spare capacity available, which leads to congestion on infrastructure in times of high demand, and therefore to rising spot prices.

Graph 3.3: Daily spot prices at UK gas market (NBP) and Dutch electricity market (APX) |

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Source: Datastream. |

The volatility of short term prices need not be worrying for consumers if they can sufficiently contract their electricity and gas in longer term contracts. The extent to which longer-term contracts are available differs according to the maturity and liquidity of markets. IEA (2005A) notes that in the mature Nordic market, traded volumes of longer-term contracts equal over four times annual consumption[28]. The financial market for electricity contracts has grown to over eight time’s total consumption over the first decade of liberalised markets. Also in the US Pennsylvania-New Jersey-Maryland (PJM) market, liquidity of the over-the-counter (OTC) market is growing fast. Even in slightly less mature markets in Northwest Europe (e.g. in the UK and Scandinavia), contract prices for 2 to 3 years in advance are quoted and traded (IEA, 2005A).

Also liberalised retail markets seem to be able to provide for longer term contracts to smaller consumers. Littlechild (2006) documents the wealth of contract structures that evolved, partially in response to price increases due to drought, in the Nordic market. Similarly, in the liberalised Dutch retail electricity and gas markets, offers for two or three year fixed price contracts have become more common.

While short-term volatility may be less of an issue, volatility on the longer term may be looked upon less favourably. Some argue that liberalisation may lead to longer-run price or investment fluctuations, which may result in higher contract prices. A case in point might be the current longer-term price rises in the UK gas market, where faster than anticipated decline of indigenous production resulted in a sequence of several winters with tight supply-demand conditions (see Graph 3.4).

Graph 3.4: Gas prices in US (Henry Hub) and UK (NBP), monthly average, 2000 – 2008, spot market prices until December 2005 / forward prices from January 2006 onward |

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Source: Datastream, European Spot Gas Markets (various issues). |

The UK system so far has been able to withstand this above-mentioned shock in terms of balancing supply and demand, as a result of price signals and a significant demand response. Before liberalisation, such conditions were less likely to happen as risks of over-investment were not only borne by the investor, but also by the consumer (who would pay a higher average price) as well as, where subsidisation was involved, also by the tax-payer. As a result, the larger margin of spare capacity (to be on the safe side) in the pre-liberalisation period tended to dampen such price fluctuations at the cost of higher average prices over the longer term.

The long-run average energy price fluctuations are comparable in magnitude to those in other commodity markets (e.g. oil, metals). A major difference with these markets is that electricity and, to a smaller extent, gas prices are of a more local nature: as a consequence of infrastructure capacity constraints, global arbitrage of prices cannot occur (see e.g. Graph 3.4 for differences between UK and US prices). Average price conditions across various local markets may diverge more significantly than in other commodity markets, creating larger fluctuations in relative competitiveness between regions, and potentially reducing liquidity of forward markets. These international price differences are likely to decrease as the gas market becomes more global. Consumers may deal with long-run price fluctuations through long-term fixed price contracts. However, the market for such longer term contracts (of many years’ duration) features limited liquidity.

Balancing supply and demand

Shortages may occur in gas and power markets as a consequence of inadequacy of generation capacity, inefficient use of energy, outages in the transmission system, or local problems in distribution grids. One may furthermore distinguish between involuntary curtailments of consumers on the one hand and voluntary demand responses to price signals on the other.

Real physical shortages[29] have always been mainly restricted to problems in system management or distribution grids, and have not in general been caused by insufficient production capacity. A well-known exception might be the Californian power crisis, where indeed consumers did experience (controlled) forced disconnections. Even here, as explained in Bushnell (2004), this appeared not so much a consequence of insufficient capacity, but rather of insolvability of the utility firms.

Graph 3.5: Effect of Norwegian 2002-2003 price spike (red line) on electricity consumption by the boiler market. |

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Source: Bye (2003) |

On the demand side of the market, on the other hand, responses to high energy prices (such as closing of production activities in other sectors of the economy have been more widespread: liberalised markets do generate market prices where consumers decide to reduce their energy use. In the UK gas market, for instance, demand response over the high priced winter 05/06 was significant. Regulator Ofgem estimated this as up to 10% of total gas consumption; the majority of this came about by electricity producers switching to other fuels. Energy intensive firms (e.g. in the ceramics and paper industries) shut down during large parts of winter. Also in the US, higher gas prices have led to the de-location of some of the more energy intensive consumers (e.g. fertilizer production, see Fertilizer Institute, 2005). In the Norwegian market, in the 2002-2003 Winter, price spikes emerged, provoking significant demand response, even from domestic consumers, who were generally on short-term contracts and were therefore soon confronted with the price rise. As a result the market coped remarkably well in preserving supply-demand balance (Bye, 2003; see graph 3.5).

Apart from actual experience of incidents where economic shortages appeared, one may also investigate whether risks of supply shortages have increased since liberalisation. One indicator of this is the evolution of spare electricity generation capacity after liberalisation. Declining capacity margins make the system more susceptible to incidental supply shortage. In the EU-15, the growth in electricity demand over the last two decades has slightly outpaced growth in capacity: average utilisation of capacity increased by 7% (see also Graph 3.1). Focussing on individual technologies, it appears that the average spare capacity margin[30] on nuclear and conventional capacity has decreased (with utilisation rates increasing by over 10% for each) (Eurostat). When looking at the last 5 years, this trend is even more apparent.

However, the lower margins of spare capacity in EU-15 have to be viewed in the perspective of increased power trade among countries. In addition, allocation of rights to use interconnection capacity has become more flexible and swifter response of power flows to short-run local supply or demand changes is now possible. As a result, with better pooling of national spare capacity margins (diversification), similar levels of security may be attained with lower spare capacity margins. It is also generally acknowledged that the level of spare capacity typical of the pre-liberalisation period was inefficiently high and often one of the key motivations for market opening in the first place.

Another indicator of risks of supply shocks is the level of diversification of supplies. More diversity of supplies leads to pooling of risks of interruption of supplies from individual sources. If alternatives are equally reliable[31], and shocks are uncorrelated, diversification will lead to lower aggregate risk. In electricity generation, one often looks at diversity of technology and fuel. Gas-fuelled production, and wind energy have grown significantly, at the expense of nuclear and, mostly, coal (see Graph 3.6). Given the traditionally high shares of the latter two fuels, diversification seems to have increased. This is indeed confirmed by analysis of diversity indices in the UK (see Grubb et al., 2006), but may differ across countries.

Graph 3.6: Contribution of various technologies to total generation |

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Source: Eurostat. |

In gas, diversification is often associated with geographic sources of gas. Currently, imports of gas into Europe come predominantly from Russia, Algeria and Norway (IEA, 2004A). As indigenous European production will decline over the next decade, the reliance on imports will only increase. Risks can be related both to (political and technical) production risks and to transit and facility risks, which may increase as transit routes become longer. The importance (and risk) of dependence on specific facilities is exemplified by the 1998 Longford incident in Victoria, Australia, where domestic and business consumers’ supplies were cut during two weeks, in the wake of an explosion at the Longford gas processing plant. All supplies depended on this plant (NERA, 2002). Such dependence of large volumes of gas on single pieces of infrastructure is not uncommon (and often indeed motivated by cost efficiencies). For example, for the UK, NERA (2002) and Stern (2003) point to the importance of the Bacton gas terminal in delivering gas to the country. Experience in recent winters demonstrates the sensitivity of the British gas market to the unavailability of the Rough storage facility, which accounts for some 80% of UK storage capacity.

It is not obvious whether liberalisation leads to more or less diversification. Generation portfolios in the traditional systems may have been biased towards some technologies (e.g. as a result of coal subsidisation in the UK before liberalisation), while liberalised markets may focus on different technologies. The Longford incident in Australia was attributed to the monopolistic status of the gas sector.

Reliability of networks

The reliability of the electricity system is intimately connected with security of the transmission system. Indeed, all major power failures of recent years did not originate from inadequacy of generation capacity, but were a consequence of failures of system operations. System operators are in charge of balancing electricity demand and supply over the network. Failure to do so results, firstly, in overloaded transmission lines, and soon afterwards, in loss of equipment that may send the system into a cascade of failing components and loss of power over large areas. Well known examples are the 2003 black-outs in the Eastern US and Canada, leaving 50 million people disconnected for up to 4 days, and in Italy, leaving citizens without power for a day.

IEA (2005B) provides some evidence indicating that the frequency and extent of (smaller) North-American outages may have increased since the early 90s. Secondly, IEA also notes that larger blackouts occur mostly when systems operate close to their security limits. EU-15 cross-border trade volume has increased by 4% per annum over the last decade, compared to a 2% increase in generation (Eurostat). As a result of liberalisation and increased trade, many interconnections between European countries are congested a large part of the time (UCTE, 2005).

Another reason for strain on transmission capacity may be the higher share of intermittent generation (in particular, wind) in Europe. The more erratic supply patterns resulting from these energy sources cause larger short-turn variation in transmission flows across European networks, and hence place greater strains on reliability. A near-incident jeopardizing stability of the Belgian power grid as a result of German wind production is an example of this (UCTE, 2005).

The impact of liberalisation on the distribution sector is mainly through stronger requirements on unbundling and regulation in the member states. A stronger focus on efficiency as a result of increased regulatory incentives might impact on distribution grid quality, though much depends on the form of regulation. Figures on outages in the UK grid do not show significant increases of distribution disruptions, while outages as a result of planned maintenance have decreased (see CPB, 2004).

Performance of energy markets in delivering an efficient level of supply

From a welfare economic point of view, the question of an optimum level of supply security can be rephrased as whether the market succeeds in achieving efficient balancing of supply and demand in the short run, and efficient levels of investment in the long run. Efficiency requires that prices fluctuate to reflect changing supply and demand conditions. This may lead to substantial price variations over time. The high prices in peak periods are required to recover the investments. In these periods, furthermore, demand responds to the high price levels, as energy users reduce their consumption of energy. Security of supply interpreted in terms of short- and long-run efficiency may therefore be at odds with some of the concepts of supply security analysed above.

Since security of supply is itself costly, the optimal cost-benefit evaluation may well involve lower levels of supply security than were enforced by central planners in the past or is currently imposed through public-service obligations. In this approach, policy measures are called for when markets may fail to achieve a given level of security.

An evident reason for intervention in energy markets hinges on the fact that small consumers are not aware of (real-time) electricity prices and many consumers do not have the opportunity to react to short-lived price rises by reducing their demand. The potential failure to balance the system as a result of such demand rigidities might lead to system collapse, imposing an externality on all users. System security is therefore a public good. In practice, the adopted solution to this failure is that responsibility for balancing the system and making decisions on curtailing consumption is assigned to a system operator. In fact, the Transmission System Operators have to procure expensive idle reserve capacity for peaks. This decision is taken, not by the market but set out in regulations, standards etc., therefore liberalisation has no direct effect here.

Uncertainty over peak prices is sometimes mentioned as an impediment to efficient levels of investments on the grounds that producers would not invest if they perceive the revenues to be too risky. However it can also be argued that companies invest in order to avoid the risk of having to purchasing energy for their needs from these volatile markets.

Market failures may occur if prices in periods of price spikes do not adequately reflect the value of energy. This may result from ill-designed real-time (balancing) markets, or balancing mechanisms, but also for instance from (investors’ anticipation of) interventions by governments or system operators in mitigating temporary price rises (e.g. Bushnell, 2005). As Joskow (2005) points out, especially under scarcity conditions, prices will be extremely sensitive to the system operator’s discretionary actions.

Incompleteness of markets can also result in su