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Europe GermanyUtilities
7 August 2003
German UtilityRegulation
Balancing the Risks
Mark C. Lewis+33 1 4495 [email protected]
Richard Smith+44 20 7545 [email protected]
Deutsche Bank AG
DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED AT THE END OF
THE BODY OF THIS RESEARCH
Emerging Themes
Germany to get an energy regulator from1 July 2004The
introduction of a new regulator willend the system of negotiated
third-partyaccess (nTPA) to energy networks thathas prevailed in
Germany since itselectricity and gas markets were firstopened up to
comply with EU directives.This has created uncertainty for
investorsin E.ON and RWE, whose future profitscould be threatened
by regulatory pricecuts. We analyse this threat in this report.
Glo
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Eq
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Ind
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Europe GermanyUtilities
7 August 2003
Balancing the Risks
Mark C. Lewis+33 1 4495 [email protected]
Richard Smith+44 20 7545 [email protected]
Germany to get an energy regulator from 1 July 2004The
introduction of a new regulator will end the system ofnegotiated
third-party access (nTPA) to energy networks that hasprevailed in
Germany since its electricity and gas markets were firstopened up
to comply with EU directives. This has createduncertainty for
investors in E.ON and RWE, whose future profitscould be threatened
by regulatory price cuts. We analyse this threatin this report.
Deutsche Bank AG
DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED AT THE END OF
THE BODY OF THIS RESEARCH
German Utility Regulation Emerging Themes
Companies FeaturedE.ON (EONG.DE), EUR45.36 Buy
2002A 2003E 2004EEPS (EUR) 4.26 3.26 3.48P/E 12.4x 14.1x
13.2xEV/EBITDA 7.4x 6.8x 6.4xRWE (RWEG.DE), EUR24.15 Buy
2002A 2003E 2004EEPS (EUR) 2.06 3.20 4.02P/E 17.7x 7.6x
6.0xEV/EBITDA 6.5x 5.5x 5.2x
The regulatory threat is to network-access chargesOur analysis
of network prices in Germany suggests that inelectricity, prices
for access to the very high-voltage (transmission)grid are in line
with or slightly below the EU average, but that pricesfor access to
the medium/low-voltage grid are well above average.In gas, both
transmission and storage charges look above therelevant European
averages. As a result, the threat posed by theintroduction of a
regulator is that the new authority couldimplement price cuts to
bring German network tariffs closer toaverage EU levels over time.
We think that this threat is greater ingas than in electricity.
Energy regulation in Germany: a question of RealpolitikAlthough
EU legislation requires an energy regulator, it still givesmember
states a fair degree of discretion over deciding which bodyassumes
this responsibility and what powers it should have. In ourview, the
German government will take a number of political factorsinto
account when making its decision and, on balance, we thinkthese
factors mean that the outcome will be less negative for theGerman
utilities than might be feared on purely economic grounds.
We think regulation is a manageable threat for E.ON and RWEA
hypothetical analysis assuming convergence of German networkcharges
with average EU price levels would require revenue reductions ofup
to Euro 716m in the case of E.ON and up to Euro 563m in the case
ofRWE. However, we think that tariff reductions of this magnitude
couldtake up to three to five years to materialise, and that both
companieswould be able to adjust their cost bases over such a
period tocompensate. In short, we think the threat posed by
regulation ismanageable, and we retain our Buy recommendations on
both RWE andE.ON.
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Table of Contents
Investment thesis
..............................................................................
3Outlook
........................................................................................................................3
Valuation
......................................................................................................................3
Risks
............................................................................................................................3
The structure of this report
..............................................................
4Section 1 Energy regulation in Germany: the European
context..............................7
Section 2 The German path to regulation: Realpolitik
............................................11
Section 3 The economics of the existing industry structure and
the politics .....17
Section 4 The range of possible outcomes
............................................................34
Section 5 Scope to reduce German transmission
prices........................................40
Section 6 Scope to reduce other network-related charges
....................................48
Section 7 Impact of price reductions on revenues
.................................................52
Summary of revenue and profit impact from network charge
reductions ................56
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Investment thesis
Outlook
Germanys announcement of an energy regulator by July 2004 has
increased theperception of regulatory risk for the German
utilities.
Our analysis suggests there is plenty of scope for a new
regulator to reducemedium/low voltage electricity-transmission
charges, balancing power costs, back-up power costs as well as
gas-transmission and storage charges. In our view, if allthese
charges were to fall to the European average then, over time,
revenue couldbe reduced by up to Euro 716m for E.ON and up to Euro
563m for RWE.
In reality, the key issue for investors will be to judge the
magnitude and timing ofany regulatory enforced price reductions and
the extent to which any revenuereductions can be offset by cost
reductions. To a large extent, the magnitude andtiming of price
reductions will depend on the political will to reduce electricity
andgas charges in Germany.
The Monitoring Report due to be published by 31 August 2003 will
no doubtinfluence the political will although our analysis of
recent speeches suggests thecurrent German government appears
satisfied with the results of electricityliberalisation, if not gas
liberalisation, so far.
In our view, the most likely outcome is a new energy regulator
formed within orunder the auspices of the Federal Ministry for
Economics. At least in electricity, weexpect the new regulator will
have responsibility for determining the methodologyto be used for
price setting, with the companies themselves still negotiating
priceson a case-by-case basis. The net result should be a
relatively slow convergence ofGerman electricity network charges
with European averages, allowing thecompanies the time to reduce
costs and maintain profitability.
The position in gas appears more uncertain and thus higher risk
for the utilities. Thismay result in faster regulated charge
reductions. However, the relative inefficiency ofRuhrgas in
particular, should allow E.ON the opportunity to cut costs more
quickly.
Valuation
The scope for revenue reductions appears very material compared
with profitability,representing 15% of 2005E PBT for E.ON and 18%
of 2005E PBT for RWE,assuming alignment of German network charges
with EU average price levels.However, we do not expect revenues to
be cut in the first year of a new regulator,thus allowing time for
cost cutting to maintain profits. We therefore maintain
ourlong-term profit forecasts and valuation of both stocks.
Risks
The choice of regulator and the powers conferred on the
regulator remain uncertain.The appointment of the Federal Cartel
Office with an ex-ante price-setting role,although unlikely, would
markedly increase regulatory risk. A critical view from
theMonitoring Report when published in August should also concern
investors.
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The structure of this reportThis report is divided into seven
main sections:
1. The European context. We begin by setting out the broader
European contextin which German energy policy has unfolded over the
last five years. In ourview, the key point about the EUs legal
requirement that all member statesestablish an energy regulator by
1 July 2004 is that it still leaves a lot ofdiscretion to the
governments of each member state in deciding on the natureand scope
of the regulatory framework.
2. The German path to regulation: Realpolitik. This section
reviews the GermanGovernments generally favourable attitude over
the last four years towards theenergy industrys system of
self-regulation through voluntary
agreements(Verbndevereinbarungen), and the chain of domestic
political events thatprompted the Government to set up a
regulator.
In our view, the sensitivity of Green-Party members of the
ruling coalition to thecharge that electricity prices have
increased too much as a result ofenvironmental surcharges was the
catalyst for the decision to introduce aregulator, but the legacy
of a generally favourable attitude towards the systemof
self-regulation remains in the Economics Ministry.
The next important step in the countdown to the setting up of
the newregulatory body will come on 31 August with the publication
of the so-calledMonitoring Report, a study commissioned by the
Government to assess thecurrent state of competition in Germanys
energy market.
However, the findings of this report will not be the sole
determinant of theGovernments decision that will also depend, to a
large extent, on certain keypolitical factors, most notably the
importance of municipal entities in thedistribution part of the
value chain and the severe constraints on municipalfinances
generally in Germany today.
3. The economics of the existing industry structure and the
politics.Germanys electricity and gas industries are concentrated
at the transmissionlevel, but extremely fragmented at the
distribution level. Moreover, thedistribution sector is highly
politicised, as it is dominated by municipal-utilitycompanies
(Stadtwerke) that provide a much-needed source of dependableincome
to the municipal authorities given the extreme budgetary
difficulties thatlocal authorities are now experiencing.
As we show by quoting at length from a recent speech given by
ChancellorSchroeder, the parlous state of municipal finances in
Germany is a majorconcern to the Federal Government, and we think
this will be an importantfactor in the Governments decision-making
process over regulation. Moreover,Chancellor Schroeder also appears
very keen to ensure that the new regulatoryframework for energy is
fair not just to industrial consumers of electricity, butalso to
the utility companies that have to invest in the networks ensuring
thatthe regulatory framework can maintain Germanys high standards
on reliabilityand security of supply is another key policy priority
for the Government.
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4. The range of possible outcomes. In this section we examine
the contendersfor assuming the role of regulator, and what the
powers of the regulator arelikely to be. As far as the identity of
the future regulator is concerned, we seethree main contenders: the
Federal Cartel Office, the Federal GovernmentsMinistry of
Economics, and the economics ministries of Germanys
regionalgovernments. In our view, there is probably no single
entity that can assume therole entirely to the Governments
satisfaction on its own, but if it were to opt forgiving
responsibility for the entire framework to one agency, then the
FederalEconomics Ministry looks to us the most likely choice at
present.
As far as the powers of the regulator are concerned, we take the
view that theGovernment is inclined towards an ex-post system of
regulation for the price-setting dimension of the regulatory
framework, but that this inclination issubject to the findings of
the Monitoring Report on the question of whethercurrent industry
arrangements represent good practice. As we see it, there is
agreater threat to this assumption in gas than in electricity.
5. The scope to reduce German prices. Here, we benchmark
Germanysnetwork prices in electricity and gas against those of
other EU member states.
Our analysis suggests that electricity prices for access to the
very high-voltage(transmission) grid are in line with or slightly
below the EU average, but thatprices for access to the
medium/low-voltage grid are well above average. In gas,transmission
charges look above the relevant European average.
As a result, the threat posed by the introduction of a regulator
is that the newauthority could implement price cuts to bring German
network tariffs closer toaverage EU levels over time. We think that
this threat is greater in gas than inelectricity.
6. The scope to reduce other network-related charges. In this
section webenchmark prices for ancillary services to Germanys
energy networks balancing and back-up power charges in electricity,
and storage charges in gas against those of other EU member
states.
Again, our analysis suggests that the price levels for Germanys
ancillarynetwork charges are well above average compared with those
of other EUmember states, particularly the prices for balancing
power and gas storage.
7. The potential impact of price reductions on the German
utilities revenues.This section considers the potential impact of
all our analysis on the futurerevenues of E.ON and RWE.
Our base-case analysis suggests that the introduction of a
regulator couldultimately result in a reduction in annual revenues
of up to Euro 716m in thecase of E.ON, and Euro 563m in the case of
RWE (see figures 1 and 2).However, we think that tariff reductions
of this magnitude could take up tothree to five years to
materialise, and that both companies would be able toadjust their
cost bases over such a period to compensate.
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Figure 1: Revenue reduction to achieve EU average price level
for E.ON
0
500
1000
1500
2000
2500
3000
3500
E.ON NetworkRevenues (2002E)
Cut to ElectricityTransmission
Charges
Cut to GasTransmission
Charges
Cut in ElectricityBalancing Charge
Cut in ElectricityBack-up Charge
Cut in Gas StorageCharge
E.ON Revenues atEU Average Price
Levels
Net
wo
rk R
elat
ed R
even
ues
(E
uro
m)
Source: Deutsche Bank estimates and company data
Figure 2: Revenue reduction to achieve EU average price level
for RWE
0
500
1000
1500
2000
2500
RWE NetworkRevenues (2002E)
Cut to ElectricityTransmission
Charges
Cut to GasTransmission
Charges
Cut in ElectricityBalancing Charge
Cut in ElectricityBack-up Charge
Cut in Gas StorageCharge
RWE Revenues atEU Average Price
Levels
Net
wo
rk R
elat
ed R
even
ues
(E
uro
m)
Source: Deutsche Bank estimates and company data
Our conclusion is that the threat posed by regulation is
manageable, and weretain our Buy recommendations on both
stocks.
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Section 1 Energy regulation in Germany: the European context
As in other EU member states, liberalisation of Germanys
electricity and gasmarkets is being driven in large measure by EU
directives, the most important ofwhich remain the 1996 EU
electricity directive, the 1998 EU gas directive, and theso-called
acceleration amendments made to these directives in February
2003.
However, although there is a clear and irreversible trend
towards increasingharmonisation of energy-market policy across the
EU, national governments haveuntil now retained a significant
degree of discretion over the interpretation andimplementation of
the EU energy directives, such that national policy responses
tothem has varied between member states (Figure 3 charts the
interplay of the mainEU and German policy initiatives concerning
the liberalisation of Germanyselectricity and gas markets since
1996).
The EU electricity directive passed in December 1996 required
member states tocommit themselves to a gradual opening of
competition in supply, legally toseparate energy networks
(transmission and distribution) from production, and tomake access
to these networks fair and transparent.
However, the directive did not require the appointment of an
independent regulatoryauthority to enforce these requirements.
Rather, it allowed member states to opt fornegotiated third-party
access (nTPA) or regulated third-party access (rTPA) tonetworks as
they chose. Member states were required to comply with
theelectricity directive by April 1998.
The EU gas directive passed in December 1998 similarly left open
the choice tomember states between rTPA and nTPA to networks, while
also requiring memberstates to commit to a minimum level of market
opening (43%) by 2008. Memberstates were required to comply with
the gas directive by August 2000.
The German response to date: the limits of ex post
regulationGermany was one of the first European countries to
liberalise its electricity market,opting for full liberalisation of
supply in one go as of April 1998 following theimplementation of
the German Energy Law (Energiewirtschaftsgesetz) that month.
However, Germany opted for negotiated rather than regulated
third-party access toits networks for eligible customers, and to
this day remains anomalous within theEU in not yet having a
regulatory authority to oversee pricing in those parts of
theelectricity value chain transmission and distribution that are
network businessesand hence de facto natural monopolies. (Note,
however, that electricity tariffs forresidential customers are
regulated, with the economics ministries of the relevantstate not
federal governments setting these charges ex ante according to a
cost-plus formula.)
In gas Germany was much slower to adopt the EU directive, and it
only became lawfour months ago, on 11 April 2003, when the Federal
Government passed anamendment to the 1998 German Energy law. As in
electricity, Germany opted fornTPA rather than rTPA in gas.
The system of negotiated third-party access to networks as it
has developed inGermany since 1998 is based on private, voluntary
industry agreements, the so-called Verbndevereinbarungen (the
workings of which we discuss in more detail ina separate section
below).
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The Verbndevereinbarungen set common pricing guidelines for
industry participants,but are negotiated on a case-by-case basis by
the parties involved. The currentelectricity agreement
(Verbndevereinbarung II+) runs out on 31 December 2003, andthe
current gas agreement (Verbndevereinbarung II) on 30 September
2003.
Figure 3: Chronology of network access developments in
Germany
2004
December 1996EU electricitydirective passed
April 1998German EnergyLaw passed
May 1998German VVI forelectricity agreed
June 1998EU gas directivepassed
July 1998German grid codeagreed out of VVI forelectricity
2003 2000 2001 2002 1999 1996-8
May 1999German distributioncode agreed out ofVVI
December 1999German VVII forelectricity agreed
February 2003EU amendments tooriginal energydirectives
passed
10 April 2003Industry talks onGerman VVIII forgas break down
11 April 2003German Govt passesamendment to EnergyLaw
31 August 2003Monitoring report intostate of competition
inGerman energy market tobe presented toParliament
30 September 2003Expiry of German gascode VVII
31 December 2003 Expiryof German electricitycode VVII
March 2000Second German gridcode agreed out ofVVII for
electricity
May 2000Second Germandistribution codeagreed out of VVIIfor
electricity
July 2000German VVI for gassigned
March 2002Germany achievesopt out at Barcelonasummit from
EUrequirement toimplementregulatory authority
May 2002German VVII forgas signed
November 2002EU agrees toaccelerate theopening up
ofenergy-supplymarkets in memberstates
March 2001First amendment toVV1 for gas agreed
December 2001German VVII+ forelectricity agreed
Q1 2004German Govt to finaliseregulatory framework
1 July 2004German regulatoryframework comes intoforce
Source: Deutsche Bank estimates and company data
As things stand at the moment, then, Germany does not have an
independentregulator in either electricity or gas. Instead, it has
a system of self-regulation basedon voluntary agreements between
industry participants.
Policing these industry agreements on an ex-post basis is
Germanys Federal CartelOffice (FCO). The FCO is a government-funded
but independent entity responsiblefor ensuring that German business
adheres to national and EU competition law. Assuch, it has a very
wide brief that covers investigating and controlling the abuse
ofdominant market positions across many different industries.
Under current arrangements, the FCO has the power to investigate
network-accesscharges when it has grounds for suspecting that grid
prices are excessive, both inresponse to consumer complaints and on
its own initiative. Where its investigationsfind against the grid
operator, it has the power to impose price reductions based
onbenchmarking, though the system is one of relative rather than
absolutebenchmarking: in order to assess whether a given grid
operator is chargingexcessively, the FCO compares the grid charges
of that company against thecheapest network-access price in the
same category. The concept of networkcategories is designed to
ensure that fair comparisons can be made.
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Under the terms of the current electricity Verbndevereinbarung
(VVII+), there are56 network categories, 18 for each of the three
voltage levels (high, medium, andlow). Each category comprises
companies with broadly similar structuralcharacteristics according
to four criteria:
Population density: companies are classified according to
whether theyoperate in high- (>3,500 inhabitants per km2),
medium- (2,5003,500) or low-population (75%), medium (50-75%), or
low (
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In short, ever since the adoption of the 1998 Energy Law,
network operators inGermany would appear to have enjoyed a benign
pricing environment. This isbecause the ability of the FCO as de
facto regulator to reduce grid prices has beentightly circumscribed
by the limitations of its ex post powers (a function of thecircular
methodology available to it for assessing the fairness of prices),
by its ownlimited financial resources, and by the appeal procedures
open to the gridcompanies against the FCOs rulings.
However, this could all be about to change.
The EU acceleration amendments of February 2003: a regulator for
GermanyIn a surprise move, the German Government announced in March
of this year that itwill establish an independent energy regulator
beginning 1 July 2004.
Ostensibly, this announcement came in response to amendments
made by the EUin February of this year to the 1996 and 1998
electricity and gas directives. Theseamendments require full
competition for all non-residential electricity and gascustomers by
1 July 2004, and for all residential customers by 1 July 2007.
The amendments also require the legal separation of the
ownership and operationof network assets (for transmission by 1
July 2004, for distribution by 1 July 2007),and the establishment
of a formal regulatory authority with responsibility forensuring
fair and transparent access to networks.
Concerning the establishment of a regulatory authority, the
amendments say that:
Each member state shall designate one or more competent bodies
with thefunction of regulatory authorities.
With specific regard to the competencies of the regulatory
authority/authoritiesconcerning access conditions and charges, the
amendments of February 2003define these thus:
Fixing or approving prior to their entry into force, at least
the methodologiesused to calculate or establish the terms and
conditions for transmission anddistribution tariffs.
With regard to the enforceability of regulatory rulings, the
amendments state that:
Any party having a complaint against a transmission and
distribution systemoperator with respect to the regulatory
authorities responsible for ensuring non-discrimination, effective
competition and the efficient function of a market ()may refer the
complaint to the regulatory authority () which shall issue
adecision.
In other words, although the acceleration amendments to the
original energydirectives require a regulator, they still give
member states a fair degree ofdiscretion over deciding which body
should be responsible for regulating the energyindustry, and what
powers it should have.
The question is, how will the German Government exercise this
discretion?
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Section 2 The German path to regulation: Realpolitik
The first step towards establishing a regulator in Germany
following the passing ofthe EUs acceleration amendments in February
of this year came on 11 April, withthe Federal Governments passing
of the amendment to the 1998 Energy Law.
In addition to bringing Germany formally into compliance with
the EU directive ongas, this amendment enshrined in law the
existing Verbndevereinbarungen in bothelectricity and gas, but with
the crucial caveat that the legal status of
theseVerbndevereinbarungen rests on the general assumption
(Vermutungsregel) thatthey represent good practice.
In other words, the legal status of the Verbndevereinbarungen as
established in theamendment to the Energy Law passed in April would
appear to be provisional onlyat this stage. The German Government
will now seek to assess whether theassumption that they represent
good practice is valid, and has alreadycommissioned a report by a
group of academics and consultants the so-calledMonitoring Report
to help them establish this.
This Monitoring Report will be published on 31 August, and will
give an assessmentof the current state of competition in Germanys
electricity and gas markets. Assuch, its findings will be an
important consideration in the Governments decision-making process
regarding the regulatory framework to be established.
A surprise moveThe announcement in March that the Germany energy
industry would receive anindependent regulatory authority to
oversee its functioning came as a surprise inthat the Government
had previously seemed content with the system of self-regulation
through the Verbndevereinbarung, at least as far as electricity
wasconcerned (it would be fair to say that the Government had been
less impressed bythe progress made by the gas industry towards
liberalisation).
Indeed, Germany had previously blocked an EU initiative to make
the establishmentof an independent energy regulator mandatory in
all member states at theStockholm summit in March 2001. The draft
proposal at the Stockholm summitcalled for an independent regulator
in all member states with the power to settransmission and
distribution tariffs but was firmly opposed by the
GermanGovernment, as both the German Economics Minister at the
time, Werner Mller,and even the president of the Federal Cartel
Office (FCO), Ulf Bge, expressed astrong preference for Germanys
system of self-regulation.
Moreover, Economics Minister Mller stated soon after the
Stockholm summit thatthe rate of price declines in the German
electricity market was evidence thatvoluntary self-regulation was
working. One year later, at the Barcelona summit inMarch 2002,
Germany was still insisting on its right to be different and
achieved anexemption from the requirement to impose an independent
energy regulator thatwas agreed by all the other member states.
In gas, the German Government has been more sceptical concerning
self-regulation,mainly because the industry has been much slower to
reach agreements onnetwork access that facilitate market
liberalisation to its satisfaction. Indeed, in 2002Economics
Minister Mller threatened to introduce a regulatory authority in
gas inexasperation at the slow progress of talks to establish the
secondVerbndevereinbarung (the first Verbndevereinbarung in gas
came into force in July2000, fully two years after the first
industry agreement for electricity had beensigned in May 1998).
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Overall, though, it would be fair to say that the Government
had, before March ofthis year, generally been favourably disposed
towards the energy industrys systemof self-regulation, particularly
with regard to electricity.
that creates uncertainty for investorsPrecisely because there
had been a widespread perception before March that theGerman
Government saw no need for an independent energy regulator,
thedecision to introduce one beginning 1 July 2004 has created a
lot of uncertainty forinvestors concerning the nature and scope of
the framework to be established, andhence the extent to which the
German utilities profitability might be affected.
In particular, there is uncertainty with regard to three main
questions:
1. Which body will act as the regulator and how independent of
Government will itbe?
2. Will the regulator have ex-ante price-setting powers of its
own, or will it simplybe responsible for determining the
methodology to be used, with industryparticipants themselves still
actually negotiating the prices on a case-by-casebasis? (In other
words, will Germany opt for a radical change to existing
industrypractice, or simply enshrine in law with only minor
modifications the currentmodus operandi?)
3. Will the same methodology be used for regulating both
electricity and gasnetworks?
The current uncertainty surrounding these questions is
understandable, as there isno pre-ordained answer to any of them.
Regulatory frameworks vary considerablybetween countries in terms
of the independence enjoyed by the regulatoryauthority, and of the
way in which prices are set.
There are many reasons for such variations, but the most
important one is politics.Even in the most economically liberal of
regulatory frameworks (like that of the UK,for example), political
considerations are always a crucial element in determining
theacceptable level of profitability for a natural monopoly.
What this means is that until the German Government makes its
final decisionsregarding the powers to be exercised and the
price-setting methodology to be usedby the new regulator decisions
that may not be taken until the beginning of 2004 it will be
impossible to say for sure how the profitability of the German
gridcompanies will be affected by the introduction of a
regulator.
In our view, however, this does not mean that it is futile to
attempt an analysis ofthe potential impact of regulation on the
German utilities at this stage. Preciselybecause regulatory
frameworks do not exist in a vacuum but rather reflect a
givenpolitical context, we think it is already possible to discern
at least the broad outlinesof what the new German regulatory
authority might look like, and how extensive itspowers might be
(see Section 4 of this report).
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The political dimension to regulationAlthough the ostensible
driver of the German Governments decision to introducean
independent energy regulator is the EUs acceleration of the
liberalisationprocess, we think that an equally if not more
important factor is the politicalcontroversy created in Germany by
the cost of balancing power supplied to the gridcompanies by the
generation companies.
Here we briefly review the background to the political
controversy caused by theissue of balancing power, before outlining
how we think the interplay of this andcertain other key domestic
political factors will ultimately determine the shape,identity, and
powers of the regulatory framework to be established in Germany
from1 July 2004.
The increasing burden of taxes and eco-friendly surchargesThe
German Government has been a strong supporter of renewable energy
in thelast few years, but the increasing proportion of German power
generated fromrenewable sources has led to higher surcharges on
consumers, as electricitygenerated from renewable sources is more
expensive than energy produced fromtraditional fuels like coal and
gas.
There are two main laws governing the use of, and payment for,
renewable andeco-friendly energy:
The Renewable Energy Law of 1 April 2000. This replaced the
Electricity FeedLaw, shifting the burden of subsidising electricity
production from renewableenergy sources from individual companies
to the industry as a whole (to ensureequal burden sharing). Under
this law, tariffs for renewable energies are fixed.The Law assumes
that the subsidy obligation is passed on in full to the
supplycompanies, who then pass it on to their end customers in
proportion to theirrespective sales.
The Co-generation Protection Law of 1 April 2002. This replaced
the Law ofthe same name originally passed in May 2000. The
Co-generation Law aims toencourage this form of electricity
generation, and requires local networkoperators to make bonus
payments to combined heat-and-power (CHP) plantsfor the energy they
generate that is fed into the public grid. As with renewableenergy,
this cost is ultimately borne by end consumers.
When viewed in isolation, the implementation of these laws has
led to sharpincreases in the overall cost of electricity for all
customer categories, and this hasbeen compounded by sharp increases
in the federal and municipal taxes imposedon electricity in recent
years.
According to the electricity industry association, the VDEW, the
total amount ofstate burdens imposed on electricity customers in
Germany will reach Euro 12.6bnin 2003, and this figure excludes VAT
(Figure 4). This figure compares againstEuro 2.3bn in 1998, such
that electricity customers will have to pay more than fivetimes as
much in taxes and in subsidies for eco-friendly energy in 2003 than
in1998.
State and regional taxes account for the largest share of the
overall state burden.Total tax burdens are expected to reach Euro
7.7bn in 2003, nearly four times thelevel of 1999. The VDEW
estimates that charges to be paid under the RenewableEnergies Act
will reach about Euro 2.1bn in 2003 compared with Euro 300m
in1998.
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Figure 4: Taxes and surcharges on German electricity (Euro
m)1998 1999 2000 2001 2002* 2003*
Electricity tax 0.0 2,090 3,480 4,210 4,950 7,650
Concession fee 2,000 2,000 2,100 2,110 2,130 2,140
Renewable energies act** 280 260 890 1,180 1,680 2,100
Co-generation act*** 0.0 0.0 610 990 680 690
TOTAL 2,280 4,350 7,050 8,490 9,440 12,580
% increase against 1998 na 910 209 272 314 452
Source: VDEW; *estimated; **since March 2002, before that
Federal Law to promote the use of renewable energies; ***former
Co-generation Act of May 2000 replaced by new Co-generation Act of
April 2002
The burden for co-generation charges was reduced in 2002
compared with 2001owing to an amendment of the Co-generation Act in
2002, and the VDEW expectsthe co-generation charge to remain flat
in 2003 at nearly Euro 700m.
What all of this means is that the proportion of total
electricity costs billed to end usersthat emanates from direct and
indirect taxes has risen dramatically between 1999 and2003. E.ON
estimates that taxes and eco-friendly subsidies now account for
about 40%of the total cost of electricity to end consumers,
compared with only 25% in 1999.
From a political point of view, the important point about the
increase in eco-friendlysurcharges is that to the extent they
represent the Governments widerenvironmental policies, there is
only a limited amount of pressure that even thepowerful
industrial-consumers group, the Verband der industriellen Energie-
undKraftwirtschaft (VIK), can put on the Government to reduce
them.
However, the increasing use of one form of renewable energy wind
has raisedthe price of electricity not just because it requires
subsidising, but also becausewind-generated electricity is more
difficult to regulate on the high-voltage grid. As aresult, it has
been blamed for the sharp increases in balancing-power costs over
thelast two years, and in our view this has been a catalyst for the
FederalGovernments decision to introduce a regulator in
Germany.
The controversy over balancing power: the real catalyst for
regulation?The amount of installed wind capacity in Germany today
is about 13,000MW, just overdouble the amount of 6,000MW in 1998
when the electricity market first began toliberalise. By 2010, this
figure is expected almost to double again, to about 23,00024,000MW.
In 2002, the total amount of electricity generated from wind was
about17TWh, up sharply from the 10.5TWh generated in 2001 and the
5.7TWh in 2000.
This increasing proportion of electricity generated from wind
has led to an increase inthe need for balancing power, in turn
increasing grid charges as the networkcompanies have to pay the
generating companies for providing this balancing power.And the
increasing cost of balancing power over the last couple of years
has led tointense lobbying from German industry on the Government
over electricity prices.
As the name suggests, balancing power is the marginal amount of
electricityrequired at any given moment to ensure that the
frequency on the high-voltage gridremains within the limits
required to keep it technically in balance. Mechanismshave to be
established to ensure that top up energy can be provided if
suppliersare short of electricity, and that spill energy can be
disposed of if there is excesspower on the grid as a result of
customers taking less than expected. By definition,it is generating
companies who must provide the grid with this balancing power,
andthey are remunerated for this.
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Wind power increases the need for balancing power because it is
dependent on theweather, such that its scheduling cannot be
accurately pre-determined. The high-voltage grid simply has to take
wind power whenever it can be generated, which isabout 2530% of the
time, on average, in Germany. Because its scheduling cannotbe
accurately pre-determined, it is liable to create imbalances on the
grid, hence theneed for the generators to provide top up or spill
services.
Industrial users have been very concerned by the rise in the
balancing-chargecomponent of grid fees in the last couple of years,
and their industry lobby group,the VIK, presented a complaint
against RWE and E.ON to the Federal Cartel Officeon this issue
earlier this year.
After examining this complaint, the FCO initiated price-abuse
proceedings againstboth companies on 26 February 2003, suspecting
them of charging excessive feesfor the supply of balancing energy
in the RWE and E.ON network areas. The FCOstated in its press
release announcing the proceedings that high fees for
balancingenergy contributed to a 10% rise in fees for the use of
transmission networks in2002. In launching its proceedings, the FCO
also said creation of a single Germanbalancing area would reduce
the overall requirement for primary and secondaryenergy (for
example, owing to the effect of intermixing electricity surpluses
in theRWE area and electricity deficits in the EnBW area). The FCO
said that this wouldalso bring about a significant improvement in
conditions for supply competition.
Interestingly, in a press release of 22 April this year, the
German association ofnetwork operators, the VDN, stated that the
increase in grid costs at the high-voltage level since mid- 2002
attributable to balancing-power charges was actuallyslightly higher
than this, at 15%. The VDN was keen to point out that
althoughprices for the use of electricity systems had decreased in
underlying terms by onaverage 38% across all voltage levels, these
decreases had been virtuallycompletely offset by the increase in
balancing charges, so that grid prices overallhad fallen by only 1%
over this period.
At the same time it was lobbying the FCO, German industrial
consumers haveconsistently made representations to the Federal
Government over the last twoyears about the high costs incurred as
a result of eco-friendly surcharges. This led toincreasing pressure
on the Environment Ministry, in particular, to exempt certainlarge
industrial users from the requirement to buy wind- and bio-mass
generatedpower.
However, the Environment Ministry has been keen to downplay the
role ofenvironmental subsidies as an explanation for rising German
electricity prices, andhas put most of the blame for higher
industrial prices on the utility companiesinstead. On 3 March, for
example, the Environment Minister, Juergen Trittin, wasquoted in
the German newspaper Handelsblatt as saying that the prices that
the gridcompanies charge industrial companies are bizarre and not
covered by therenewable energy policy. In the same interview in
Handelsblatt, Mr. Trittin called forthe appointment of an
independent regulator to oversee the electricity companiesand
ensure that they do not overcharge.
In our view, it is no coincidence that the Environment Ministry
first called for anindependent regulator only one week after the
FCO launched its inquiry into theprice of balancing power charged
by RWE and E.ON. After all, the FCO inquiry gaveprima facie
credibility to the Ministrys claim that rising prices for
industrial userswere as much if not more a result of the utilities
overcharging for balancing poweras of the surcharge on wind power
itself.
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Three weeks after Environment Minister Trittin gave this
interview, the FederalGovernment surprised investors by saying that
it would indeed appoint anindependent regulator beginning 1 July
2004. It would appear that, despite theEconomics Ministrys
long-held view that the electricity industrys system of
self-regulation worked effectively, the sensibilities of the Green
Party members of theGovernment (notably Mr. Trittin himself) had to
be respected on this point.
However, once the announcement was made, a Pandoras box was
opened thatgoes way beyond the single issue of balancing power. As
we said above, thedecision to introduce a regulator raises the much
broader question of whether it willhave ex-ante price-setting
powers of its own, or whether it will simply beresponsible for
determining the methodology to be used, with industry
participantsthemselves still actually negotiating the prices on a
case-by-case basis.
In our view, what the Government ultimately decides will depend
on the answer totwo questions:
Is the Government generally happy or unhappy with the way the
electricity andgas markets have developed so far in the absence of
a regulator?
Even if it is unhappy and wants to make radical changes to
existing industrypractices (as might, for example, be the case in
gas much more than inelectricity), is the Government constrained in
what it can do?
8. To answer these questions, we have to be aware of a whole
range of politicalfactors that will influence the decision-making
process.
The art of the possibleFollowing Aristotle, Bismarck defined
politics as the art of the possible (Die Kunstvom Moeglichen), and
the same idea is encapsulated in the German wordRealpolitik.
Politics is determined by circumstances, and for this reason we
think that the natureand scope of the regulatory framework to be
introduced next year will to a largeextent reflect the interplay of
certain key political realities in Germany today:
The desire of German industry for internationally competitive
electricity and gasprices
The fragmented nature of the existing industry structure in
electricity and gas,and the importance of municipal entities in the
distribution part of the valuechain
The constraints on municipal finances
The Federal Governments stated policy objective of ensuring
security of supply
Since we benchmark German electricity prices internationally in
Section 5 of thisreport, we next review the last three of these
factors, examining how we think theinterplay between them will
determine the Governments decision-making processover the next few
months, and the range of regulatory outcomes we expect thisprocess
to lead to.
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Section 3 The economics of the existing industry structureand
the politics
Germanys electricity market is very concentrated in terms of
generation andtransmission, but extremely fragmented in terms of
distribution and supply.Generating companies like E.ON and RWE
typically supply electricity to endcustomers on both a direct and
indirect basis, as indicated in Figure 5.
This means that they either sell to end consumers directly
themselves or through awholly- or majority-owned regional electric
company; or, they sell to end usersindirectly through partly-owned
regional distributors, or partly owned municipalutilities
(Stadtwerke).
Looking purely at the network components of the value chain,
there are in total over50 high-voltage grid companies in Germany,
but most of the countrys transmissionnetwork is in the hands of
four players (E.ON, RWE, EnBW, and Vattenfall Europe).In terms of
the medium-to-low voltage part of the network, however, there
areabout 900 players operating, most of them being municipal
companies, typicallymajority-owned by local authorities.
Figure 5: Structure of the German electricity market
4 grid companiesGenerationTransmission - domestic and
international
Distribution
Ca. 75 regional utilitiesOwn generation 20%Electricity purchases
80%
Transmission - regionalDistribution
Ca. 900 municipal utilitiesGeneration 10%Electricity purchases
90%
Distribution
Ca. 1/3
Ca. 1/3
Ca. 1/3
EN
D C
US
TOM
ER
Source: RWE
Germanys highly fragmented industry structure at the
distribution level is verydifferent from that of most other
European countries. As can be seen in Figure 6,with a total of 880,
Germany has far more distribution companies than any other EUmember
state, although Finland, Sweden, Denmark, and Austria all have a
higherratio of distribution companies to total population.
Germanys gas-transportation industry displays a similar
structure to that ofelectricity in that the high-pressure
(transmission) part of the value chain is veryconcentrated, whereas
the low-pressure part (distribution) is very fragmented.
Asindicated in Figure 7, there are only 19 high-pressure networks
in Germany, (fivesuper-regional transmission and 14 regional
transmission companies), but 725companies distributing gas to end
consumers at lower pressures.
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Figure 6: The structure of the electricity-transportation
industry across EU member statesNumber of transmission companies
Number of distribution companies
Germany 4 880
Austria 3 155
Belgium 1 33
Denmark 2 77
Finland 1 100
France 1 172
Greece 1 1
Ireland 1 1
Italy 1 219
Luxembourg 0 15
Netherlands 1 18
Portugal 1 3
Spain 1 297
Sweden 1 248
UK 4 15Source: European Commission, Second benchmarking report
on the implementation of the internal electricity and gas market,
Brussels, 7 April 2003
Comparing Germanys gas-transportation industry with those of
other Europeancountries it can be seen that only Italy has a higher
number of distributioncompanies, with 814 compared with Germanys
725. Interestingly, although Austria,Denmark, Finland, and Sweden
have very fragmented distribution sectors inelectricity, they all
have much more concentrated gas-distribution sectors.
Figure 7: The structure of the gas industry across EU member
statesNumber of super-regional
transmission companiesNumber of regional
transmission companiesNumber of
distribution companies
Germany 5 14 725
Austria 3 5 20
Belgium 1 3 21
Denmark 1 0 4
France 2 1 21
Ireland 1 0 1
Italy 1 1 814
Luxembourg 1 0 4
Netherlands 2 0 25
Spain 1 3 26
Sweden 1 0 7
UK 1 0 1Source: European Commission, Second benchmarking report
on the implementation of the internal electricity and gas market,
Brussels, 7 April 2003
Industry fragmentation and price variation: the network
componentIn the European Commissions recently published study
concerning theimplementation of the internal electricity and gas
market European Commission,Second benchmarking report on the
implementation of the internal electricity andgas market, Brussels,
7 April 2003 (hereafter abbreviated as EC, SBR 2003) end-user
electricity and gas prices of various customer categories are
indexed againstthose of large industrial users across the EU member
states. The study reveals thatGermany has the highest differential
of any EU member state between retailelectricity prices and those
of large industrial consumers, but more modestdifferentials in both
absolute and relative terms between retail gas prices andthose of
large industrial consumers.
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According to the Commissions report (EC, SBR 2003: page 18), in
electricity theaverage price for German retail customers consuming
7.5MWh per year or less is120% higher than the price for large
industrial users consuming 24GWh per year(Figure 8). This
differential compares with a more modest differential between
theseuser groups in the UK, Sweden and Finland of 90%, and a
differential that is slightlysmaller still for the average of the
other EU member states of 85%.
Interestingly, while the differential between prices paid by
different customergroups increases progressively in the most
liberalised markets (the UK, Sweden,and Finland), it is actually at
its highest in both Germany and the remaining EUmember states
between the large industrial users on the one hand, and the
small-tomedium-sized consumers (50MWh per year) on the other.
Again, however, it is Germany that displays the largest
differential in Germany it is145%, while in the UK and the Nordic
countries it is only 68%, and in the remainingEU member states
98%.
Figure 8: Electricity price differentials across the EU indexed
against users consuming 24GWh per yearPrice for customersconsuming
24GWh
per year or more
Price for customersconsuming 2GWhper year or more
Price for customersconsuming 50MWh
per year or more
Price for customers consuming 7.5MWh
per year or more
Germany 100 128 245 220
UK, Sweden, Finland 100 113 168 190
Other EU member states 100 128 198 185Source: European
Commission, Second benchmarking report on the implementation of the
internal electricity and gas market, Brussels, 7 April 2003
In gas, Germany comes out of the comparison slightly better.
According to thesame report (EC, SBR 2003: 25), the average price
for German retail customersconsuming 2000 cubic metres per year or
less is 75% higher than the price for largeindustrial users
consuming 10mcm per year (Figure 9).
This compares with a differential of 65% in the UK, 95% in
Spain, Belgium, Italy,and Luxembourg, and 115% in Denmark and
France. This differential of 115% wasthe highest found in the
survey across all customer categories. Unlike the case
ofelectricity, the differential between prices paid by different
customer groupsincreases progressively across all countries
surveyed in the study, and Germanydoes not display the highest
differential in any customer category.
Figure 9: Gas-price differentials across the EU indexed against
users consuming 10m cum per yearPrice for customersconsuming
10mcm
per year or more
Price for customersconsuming 1mcmper year or more
Price for customersconsuming 10,000cm
per year or more
Price for customersconsuming 2,000cm
per year or more
Germany 100 120 155 175
UK 100 125 145 165
Spain, Belgium, Italy, Lux 100 112 172 195
Denmark, France 100 125 195 215Source: European Commission,
Second benchmarking report on the implementation of the internal
electricity and gas market, Brussels, 7 April 2003
The wide range of price differentials found by the European
Commission in its studyprompted it to conclude that market opening
to date had not been as effective aswould intuitively have been
expected. The Commission emphasised this point withregard to
electricity in particular, noting that only the UK, Sweden and
Finlanddisplayed the price-differential profile one would expect a
priori: namely, that end-user prices should increase progressively
as volumes consumed get smaller giventhe incremental wires and
supply costs of smaller customers (EC, SBR 2003: 18):
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Normally one would expect the ratios to be similar in each
MemberState since prices should reflect the additional network and
billingcosts of serving small customers. However, in many cases the
ratiobetween prices at different levels and those for large users
variesconsiderably. This is a clear indication that certain
consumer groups,either households, small businesses or both, are
payingdisproportionately high prices in some member states as a
result ofincomplete or ineffective market opening. This contrasts
with theposition in the UK and Nordic countries where the ratio
betweenprices would appear to be more cost reflective.
In terms of the forthcoming introduction of a regulator in
Germany, the crucialquestion raised by this EU study particularly
with regard to Germanys electricitymarket is this: to what extent
do the very wide price differentials betweendifferent customer
categories reflect the network component of electricity
tariffs?
This is a crucial question because if the reason the price
differentials betweendifferent customer categories in Germany are
so wide is because the networkcompanies are abusing their
monopolistic positions (particularly at lower voltagelevels), then
there would be a strong case for giving the new regulatory
authority tobe established 1 July 2004 ex ante price-setting
powers.
On the other hand, if there are other reasons that explain the
wider end-user pricedifferentials in Germany than in any other
country such as the structuralfragmentation of the industry then
the pressure for a radical change to the existingsystem of
self-regulation would probably not be so great.
So, what is the evidence with specific regard to network charges
themselves? As isindicated in Figure 10, the range of absolute
price levels for network charges inGermany clearly increases as the
voltage level decreases. Other things being equal,this is what one
would intuitively expect, since as the EC study quoted
aboveemphasised, the network costs of serving smaller customers are
higher than thoseof serving large industrial consumers.
However, the range of price levels at lower-voltage levels is
not only higher inabsolute terms than those at high-voltage levels,
it is also much wider. For example,while the difference between the
highest and lowest high-voltage access charge is37% (1.59/1.16),
the difference between the highest and lowest low-voltage
accesscharge is 240% (6.98/2.05).
As we see it, this means that the central question in the debate
over Germanregulation is whether this difference can be justified
or not. In other words, do thesevariations in network-access
charges simply result from the highly fragmentednature of the
German distribution sector, and therefore fairly reflect
structuraldifferences between different companies (as the industry
association of electricitycompanies, the VDEW, maintains)? Or are
these price differentials a reflection ofthe network companies
ability to abuse a monopolistic position, particularly withregard
to smaller customers?
To answer this question, we need to know how network prices are
actually setunder the current nTPA regimes of the industry
Verbndevereinbarungen, and howprices have developed since they came
into force. We look first at the arrangementsin electricity, and
then in gas.
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Figure 10: The range of network access charges in Germany
2.05 - 6.98 ct/kWh
0
1
2
3
4
5
6
7
Low voltage Medium voltage High voltage
Eur
o c
ents
per
kW
h1.89 - 5.11ct/kWh
1.16 - 1.59ct/kWh
Source: VDN, VIK
Electricity: the current network-access arrangements (nTPA)As
electricity is infrastructure-bound and the costs of building an
alternative networkare prohibitive, competition is dependent on
guaranteed fair access to the existingtransmission and distribution
grid. To ensure this, the Utilities Association (VDEW),the
Federation of German Industry (BDI) and the Association of
Industrial EnergyProducers (VIK) established the first German
Industry Agreement(Verbndevereinbarung) for electricity in July
1998.
This general agreement then spawned more specific guidelines for
definingnetwork-access terms at high-voltage and
medium-/low-voltage levels soonafterwards, namely the first Grid
Code (July 1998) and the first Distribution Code(May 1999),
respectively. Both the first Verbndevereinbarung and the
networkcodes based upon it have subsequently been updated, and the
current industrystandards are based on Verbndevereinbarung II+
(VVII+), which came into force on1 January 2002 and expires on 31
December 2003. Industry participants arecurrently negotiating an
agreement to replace VVII+ beginning 1 January 2004.
Under VVII+ the price of network access is determined according
to a cost-plusformula that allows for a return on equity of 6.5%
(pre-tax real) to ensure that thevalue of the network assets is
preserved (a concept known asNettosubstanzerhaltung). The industry
agreement is meant to ensure that there isbroad comparability in
access charges between structurally similar networks, withthe
auditing of network access and charges being carried out by the FCO
on an ex-post basis (as already explained above). The agreement
ensures the separation ofnetwork and supply activities.
With regard to the pricing principles, customers (but not
producers) pay a use-of-system charge that incorporates all voltage
levels above that at which they taketheir power from the network
(the so-called point-of-connection tariff). Since thecharge is
defined at the point of connection, there is no distance element in
theprice, but the tariff also includes the cost of losses, and
ancillary services.
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The components that are taken into account in the pricing
formula are set out inFigure 11.
Figure 11: The components of the cost-plus formulaCosts and
revenues/earnings items Data basis
Costs Profit and loss account
Material
Sub-contract charges
Personnel
Other costs
Taxes
Miscellaneous income
Financial result
Plus
Calculated depreciation Cost accounting
Taxes on the paper profit
Notional interest on equity capitalSource: RWE
The nTPA arrangements in Germany are only valid under EU law if
they genuinelyensure non-discriminatory access to networks (except
where there are validtechnical reasons to deny a third party
access). This means that where a gridoperator is part of a
vertically integrated company that also has subsidiaries active
inelectricity supply, the prices charged to these intra-group
companies must be thesame as those charged to third parties.
So much for the theory, but what does the experience of VVII+
and its predecessorstell us regarding the questions posed above,
namely (1) why the differentialbetween different customer groups
for total end-user electricity prices is so great inGermany, and
(2) why the range in network-access prices increases so much as
thevoltage level declines?
Does experience offer conclusive proof either way concerning
whether theindustrys modus operandi under VVII+ is obstructive to
competition and hence tolower prices? Can we establish whether
network operators are taking advantage ofthe nTPA arrangements by
discriminating in particular against smaller consumers?
Electricity prices and network charges under the
VerbndevereinbarungenSince we consider the absolute level of German
access charges relative to those ofother EU member states in detail
in Section 5 of this report, we here restrict ourobservations to
the trend in German electricity prices both total end-user
prices,and network charges more specifically since market
liberalisation began.
Again, our source for most of the information we analyse is the
recently publishedstudy of the European Commission (EC, SBR
2003).
The trend in total end-user electricity prices
As can be seen in Figures 12-14, as far as the trend in total
end-user electricityprices is concerned, there is a common pattern
since the beginning of 1999,whereby German electricity prices for
all customer groups have been high by EUstandards, but falling
across all customer categories (large industrial, smallcommercial,
and household) over the last four years.
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Figure 12: Electricity prices for large industrial users in the
EU since January 1999Low Medium High
Falling Sweden Luxembourg, UK,, Spain Germany
Stable Finland France, Netherlands, Greece
Rising Denmark Italy, Ireland, Belgium, PortugalSource: European
Commission, Second benchmarking report on the implementation of the
internal electricity and gas market, Brussels, 7 April
Figure 13: Electricity prices for small commercial users in the
EU since January 1999Low Medium High
Falling Sweden, UK Austria, Italy Germany, Belgium,
Luxembourg
Stable Finland Portugal, Spain, France Ireland
Rising Denmark Netherlands, GreeceSource: European Commission,
Second benchmarking report on the implementation of the internal
electricity and gas market, Brussels, 7 April
Figure 14: Electricity prices for household users in the EU
since January 1999Low Medium High
Falling Greece, Austria Spain, UK Germany, Italy
Stable Sweden France Belgium, Portugal, Luxembourg
Rising Denmark, Finland Ireland, NetherlandsSource: European
Commission, Second benchmarking report on the implementation of the
internal electricity and gas market, Brussels, 7 April
To the extent that the pattern is consistent across all customer
categories, thiswould appear to be prima facie evidence that full
market opening as it hasdeveloped in Germany under the aegis of
VVII+ has not benefited one group morethan another unjustifiably.
In this respect, it is instructive to quote the
Commissionsinterpretation of experience across the different member
states since liberalisationbegan in 1998, as it quotes the case of
Germany approvingly (EC, SBR 2003: 7):
For electricity, it can be seen that prices in the UK, Germany
andAustria have fallen across all consumer groups as a result of
fullmarket opening, while prices in Sweden and Finland are also
falling orreasonably stable at low levels. In other member states,
there isusually a group which is either missing out on falling
prices, orexperiencing price rises.
At the very least this means that one cannot conclude that the
wider differentialbetween retail and large-industrial end-user
prices in Germany than in any other EUmember state noted above is
necessarily due to incomplete or ineffective marketopening
(although this possibility is not disproved by the falling price
trend across allcustomer groups in Germany since 1999 either). As
we said above, the differentialbetween the total end-user
electricity price for households and large-industrialconsumers may
reflect other factors such as the fact that lower-voltage grid
feesare higher, and their range wider, owing to structural
factors.
The trend in network-access charges: the problem of balancing
power
The most recently published data on trends in German network
charges comesfrom the network operators association, the VDN. The
VDN published its secondannual survey of trends in network charges
in April 2003, and the data covered thesix-month period between 10
October 2002 and 18 March 2003. The trends acrossall three voltage
levels are indicated in Figure 15.
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Figure 15: Evolution of network charges, October 2002 March
2003High voltage Medium voltage Low voltage
Change over period excluding balancing charges (%) -8 -6 -4
Change over period including balancing charges (%) -0.4 -1.6
-1.2
Change in spread (%) -13 -34 -32Source: VDN
The good news in this data is that both the underlying fees
themselves (that is, gridfees excluding balancing charges) and the
range of fees paid in each voltagecategory have fallen across the
board. High-voltage grid fees have fallen by 8% inunderlying terms,
medium-voltage fees by 6%, and low-voltage fees by 4%. Thespread
that is, the difference between the cheapest and the most
expensiveaccess charges in each category has fallen by 13% at the
high-voltage level, 34%at medium voltages, and 32% at low
voltages.
As such, these trends in pricing and price differentials are
consistent with theevidence in the EC survey quoted immediately
above concerning the developmentof total end-user prices for each
customer category. Thus, the fact that total end-user prices across
all customer categories have been falling since liberalisationbegan
in Germany is consistent with the fact that the network component
of thetariff has also fallen across all end-user types.
However, the bad news in this data is that after adjusting for
the increase inbalancing-power charges, the decrease in grid fees
over this period is much lower.At the high-voltage level it is only
0.4%, at medium voltages 1.6%, and at lowvoltages 1.2% This
indicates that the balancing-power component is of
relativelygreater importance in the total-network charge for
high-voltage customers than forlower-voltage consumers, and
underlines why the German industrial usersassociation, the VIK,
brought a formal complaint against E.ON and RWE to the FCOearlier
this year.
Moreover, the problem with balancing charges in Germany is not
just that they haveincreased so much in the last couple of years,
but also that they display the biggestdifferential between top-up
power-provision and spill-power-managementservices.
According to the European Commissions second benchmarking study
on theimplementation of the internal market in electricity and gas,
the price differentialbetween the price paid to generators for
providing top-up power (known as thesystem buy price) and the price
paid to generators for providing spill-energymanagement services
(known as the system sell price) is on average more thanEuro 60MWh
in Germany (EC, SBR 2003: 67).
The EC study notes that the system sell price in Germany rarely
exceeds zero (EC,SBR 2003: 67), and that the size of this spread is
negative from a competitivestandpoint as it creates an unfavourable
situation with respect to new entrants,particularly pure retail
suppliers without generation assets or companies with
smallportfolios of customers which have less predictable demand
than a large groupingof customers (EC, SBR 2003: 67-8).
In short, while grid charges appear to have fallen on an
absolute basis in underlyingterms and the differentials within each
voltage category appear to have narrowed,the impact of higher
balancing charges has offset most of this benefit over theperiod
most recently surveyed.
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Conclusion on industry structure and current pricing
mechanismsOn the basis of the information reviewed above, we would
conclude the followingconcerning the effectiveness of the German
electricity-industrys current method ofself-regulation with regard
to liberalising markets in a manner consistent with theobjectives
of the EU directives:
End-user prices in Germany have traditionally been high compared
with otherEU member states, and display wider differentials between
large industrialusers and residential consumers than those of other
EU member states.However, prices have been falling across all
customer categories since marketliberalisation began.
It is hard to say whether total end-user electricity prices in
Germany are high inthe first place and display wider differentials
between different user groups thanthose of other EU countries owing
to overcharging by the network companiesmade possible by their
ability to exploit their monopolistic position in theabsence of a
regulator (especially at lower voltage levels), or for other
reasons.These other reasons could include the structural
characteristics of the industryat medium- and low-voltage levels
(the fact that there are nearly 900 distributioncompanies and that
this creates disparities concerning consumer density in
theirservice areas, the volume carried over their networks, and so
on).
However, in our view the fact that network charges have been
falling across allvoltage levels in underlying terms, and that the
differentials in each voltagecategory have been narrowing, make it
difficult to conclude that VVII+ and itspredecessors have
necessarily discriminated unfairly against different
customercategories. Moreover, we show below (Section 5) that German
high-voltageaccess charges do not look out of line with those of
other EU member states,so the question is more urgent at the level
of medium- and low-voltage charges(where, as shown in Section 5,
prices do appear to be well above those of otherEU member
states).
Ultimately, judging whether prices at lower-voltage levels are
high as a result ofthe abuse of monopolistic positions or because
of structural factors requiressignificant resources to make
credible comparisons of Germany's 900 utilities.As we show below,
this question of resources is likely to be a very importantfactor
in the Governments decision-making process concerning which body
isgiven responsibility for regulation, and how extensive the powers
that body isgiven are.
In any case, we think that the importance of the municipalities
in the distributionsector of the value chain means that there is a
political dimension to theGovernments decision-making process over
regulation that also has to befactored into the equation (we
discuss this below).
E.ON and RWE may be exposed on the question of balancing power,
and theprofits their generation businesses are making in this area
at the moment fromproviding top-up and spill energy-management
services at allegedlyunjustifiably high prices.
Gas: the current network-access arrangements (nTPA)Unlike its
electricity counterparts, the Verbndevereinbarungen in gas have
from theoutset distinguished between the pricing methodologies to
be used in transmissionon the one hand, and in distribution on the
other. The industry currently operatesunder the terms of reference
of VVII, which replaced the original agreement, VVI, ofJuly 2000.
On the network providers side, the gas-industry agreements
wereentered into by the industry groups representing their
interests (the German Gasand Water Association, or BGW, and the
municipal utilities association, the VKU).
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On the network users side, it was the Federation of German
Industry (BDI) and theAssociation of Industrial Energy Producers
(VIK) that helped define the agreementsparameters.
VVII came into force in May 2002 and expires on 30 September.
However,negotiations for VVIII, which was the agreement due to come
into force from1 October, broke down in April, and it looks
increasingly unlikely that the differentparties will now be able to
broker VVIII in time for it to enter into force by that date.This
makes it quite likely that the Government will have to replace the
industryssystem of self-regulation with a temporary regulatory
framework for the six monthsbetween the ending of the validity of
the general assumption that the currentindustry agreement
represents good practice, and the start date for the newregulator
(31 December 2003 30 June 2004).
VVII is legally obliged to ensure non-discriminatory access, and
the main features ofthe agreement as they relate to access and
charges are as follows:
Transmission: Unlike the charges for electricity transmission,
access chargesto the high-pressure gas network are distance
related, and operate under asystem of so-called point-to-point
pricing. Network users pay a fee based onthe distance between the
points on the grid over which they carry their gas,multiplied by
the volume transported. Significantly, there is no cost-plusformula
for setting prices, but since suppliers are restricted in terms of
the high-pressure pipelines they can use to transport their gas, it
is not exactly a market-price-setting system either. The absence of
realistic alternative transportationroutes and of a clear even if
voluntarily agreed upon rather than regulatedcost-plus pricing
formula (such as exists in electricity) has led to
persistentaccusations of de facto monopolistic rent-seeking on the
part of the networkcompanies.
Distribution: As with electricity, the price of network access
is determinedaccording to a cost-plus formula but the return on
equity allowed is higher at7.8% (pre-tax real). Again, the industry
agreement is meant to ensure that thereis broad comparability in
access charges between structurally similar networks,with the
auditing carried out ex-post by the FCO. Access charges are
calculatedon a stamp-fee basis, and are thus unaffected by the
distance over which gasis carried by the supplier. The agreement
ensures the separation of network andsupply activities.
In our view, it is by no means intuitively obvious that access
to gas-transmissionnetworks should use a different pricing
methodology from that used by theelectricity industry, and this
apparent anomaly has been the biggest obstacle to therelevant
parties ability to agree VVIII. The user organisations had been
pushing forVVIII to abandon point-to-point pricing in favour of a
point-of-connection basedaccess-charge formula, but the
high-pressure network companies proved unwillingto accede to this
demand.
As we explain further below (see The political dimension), this
may ultimately resultin the methodology used to regulate
gas-transmission networks being different fromthat used for the
high voltage power networks.
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Figure 16: Gas prices for large industrial users in the EU since
July 2000Low Medium High
Falling France, Sweden Spain Luxembourg
Stable Belgium, Denmark, Italy Germany
Rising Austria, UKSource: European Commission, Second
benchmarking report on the implementation of the internal
electricity and gas market, Brussels, 7 April
Figure 17: Gas prices for small commercial users in the EU since
July 2000Low Medium High
Falling Sweden, Spain Denmark
Stable Belgium, Luxembourg, Ireland Italy
Rising UK, Netherlands France, Germany AustriaSource: European
Commission, Second benchmarking report on the implementation of the
internal electricity and gas market, Brussels, 7 April
Figure 18: Gas prices for household users in the EU since July
2000Low Medium High
Falling Denmark
Stable UK, Luxembourg Ireland, Belgium, Italy Spain
Rising Netherlands Sweden, Austria Germany, FranceSource:
European Commission, Second benchmarking report on the
implementation of the internal electricity and gas market,
Brussels, 7 April
The trend in gas prices under the VerbndevereinbarungenAs we saw
above, the differential between large industrial and retail
consumers inGermany in terms of the total end-user gas price is
smaller than in the case ofelectricity, but this does not
necessarily mean that the gas Verbndevereinbarungenhave been more
effective in ensuring competitive network pricing.
For one thing, this could simply reflect the fact that the
electricity distributionnetwork is slightly more fragmented than
that of gas (880 companies comparedwith 725 in gas). Moreover, if
we compare the trend in total end-user prices sincemarket
liberalisation began in gas in EU member states in July 2000, it is
clear thatgas prices in Germany have been much more resistant to
falls than those inelectricity.
Figures 1618 show that no customer group in Germany of the three
categoriessurveyed (large industrial, small commercial and
household) has enjoyed falling end-user prices since the process of
liberalisation began. It could be argued that end-user price
reductions would have been more difficult in gas than electricity
due tothe rise in natural gas input prices since 2000 (which are
linked to oil prices).However, other countries, also on oil-linked
gas contracts, have achieved falling end-user prices over the same
time period. Moreover, not only are prices high comparedwith the EU
average in two of the categories (large industrial, and household),
theyhave actually risen for small commercial users (albeit from
levels consistent with theEU average), and for households (from an
already high base). While this data is notconclusive concerning the
network component of the total end-user price, it is primafacie
evidence that the Verbndevereinbarungen in gas have not delivered
theeffective market opening that the EU directives require. Not
surprisingly, this wasthe verdict of the recent EC study on the
basis of this evidence (EC, SBR 2003:7).
We conclude from this that the progress made by the gas industry
under self-regulation has been less effective than that of the
electricity industry in terms ofdelivering the degree of market
opening required by EU energy policy. This couldhave consequences
for the regulatory methodology the German Governmentultimately
adopts for gas as compared with electricity.
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The political dimensionThere is no doubt that the introduction
of a regulatory framework in Germany isgoing to change the energy
industrys existing pricing mechanisms for networkcharges, but this
change will be a function not only of the economics of
currentpricing mechanisms (as reviewed above and as analysed
comparatively in Section 5below), but also the politics.
In particular, as we mentioned above, the Government has to
balance a number offactors in making its decision on regulation,
the most important of which we see asthe following:
The desire of German industry for competitive electricity and
gas prices
The existing industry structures and practices, and the
importance of municipalentities in the distribution part of the
value chain
The constraints on municipal finances
The Federal Governments stated policy objective of ensuring
security of supply
So, how important is each of these factors on Government
thinking?
In our view, the most instructive way to answer this question is
to review what theGerman Chancellor, Gerhard Schroeder, himself
said concerning the factors that willinfluence the Governments
decision on regulation at the speech he gave to theVDEW Conference
in Berlin last month. Since no English translation of the speechwas
made by the VDEW, we quote from the original German, accompanying
eachextract with our own English translation.
The importance of transparent and competitive energy
pricesChancellor Schroeder emphasised in his speech that with
regard to theestablishment of a regulator the framework will have
to be rules-based, transparent,and non-discriminatory, in order to
ensure competition and sustainably low prices forindustry and the
economy more generally:
Von der Politik wird ein ordnungspolitisches Geruest verlangt.
MehrKonkurrenz und niedrige Preise werden wir nur dann
dauerhafterhalten koennen, wenn der Staat in enger Kooperation mit
derWirtschaft fuer faire Marktbedingungen sorgt. Ueber diese Frage
wirdim August ein Monitoring-Bericht des Bundesministeriums
fuerWirtschaft und Arbeit vorgelegt, der exakt ueber den Stand
derEnergiemarktliberaliserung in Deutschland informiert. Danach
wird dasBundeswirtschaftsministerium im Herbst dieses Jahres
Vorschlaegevorlegen koennen, wie die neue Wettbewerbsbehoerde fuer
dieStrom- und Gasmaerkte organisiert werden kann und
welchekonkreten Verfahren der Regulierung sie anwenden wird.
Policy here requires a rules-based framework. Increased
competitionand low prices can only be sustained if the State
cooperates closelywith industry and the economy to ensure fair
market conditions. Thisquestion will be addressed in a monitoring
report to be presented tothe Ministry of Economy and Employment in
August, which will give aprecise assessment of the (current) state
of liberalisation in theGerman energy market. The Federal Economics
Ministry will then beable to propose how the new authority
responsible for competition inthe electricity-and gas markets can
be organised, and exactly whatregulation methodology it will use.
(Chancellor Schroeder, VDEWconference, Berlin, 3 June 2003)
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At the same time, Herr Schroeder emphasised that the right
balance needs to bestruck between competitiveness on the one hand,
and the ability of the gridcompanies to invest on the other:
Was ist uns dabei wichtig? Ungehinderter Marktzugang fuer
Anbieter vonStrom und Gas und faire Durchleitungsentgelte. Fair
heisst: nicht nurkostenguenstig fuer den, der durchleiten will;
Fair heisst eben auch, dass essich fuer diejenigen, die
investieren, die auch in Zukunft investierenkoennen und wollen,
auch betriebswirtschaftlich rechnet. Fairness indiesem Bereich
heisst also zweierlei: Die Preise muessen stimmen, und sieduerfen
den Marktzugang nicht verhindern; Aber die Netzinvestitionenmuessen
sich auch in Zukunft lohnen.
What is important in all of this? Unimpeded market access for
electricityand gas suppliers and fair remuneration of the network.
The concept offairness means not only competitive prices for those
wanting access to thenetwork, but also sufficiently attractive
prices for those who invest (in thenetwork), and who can and want
to continue investing in it in the future.Fairness on this point
thus means two things: prices must be right, andmust not hinder
market access; but investment in the grid must also
remainworthwhile, must also be rewarded, in the future.
(Chancellor Schroeder, VDEW conference, Berlin, 3 June 2003)
Indeed, the Chancellor said in his speech that while a key
concern behind theintroduction of a regulatory authority was
ensuring the competitiveness of Germanindustry, this included
ensuring the competitiveness of the energy industry itself,not
least because German utilities have to be able to compete in Europe
and evenglobally. In this respect, Herr Schroeder said that the
Government would want tolearn from the experience of regulating
other German industries -- notably thetelecommunications industry
which had not always been positive:
Es gibt auch bei der Regulierung nicht nur positive Erfahrungen
inanderen Bereichen, zum Beispiel bei der Telekommunikation;
Ichmoechte gerne, dass die Klage ueber die Neigung
zurUeberregulierung und die schlechten Moeglichkeiten der
betroffenenUnternehmen, sich auf der Weltmarkten oder jedenfalls
auf deneuropaeischen Markten zu behaupten, sich nicht wiederholt.
In einemvernuenftigen Dialog zwischen Bundesregierung und der
Wirtschaftkoennen wir verhindern, dass sich diese Erfahrungen,
soweit sienegativ waren, wiederholen.
Experience of regulation in other spheres, for
exampletelecommunications, has not been exclusively positive. I am
keen toavoid a repetition of accusations concerning a tendency
towards over-regulation and the difficulties this creates for the
firms affected toassert themselves on world markets, or at least on
the Europeanmarket. Through sensible dialogue between the
Government andindustry, we can avoid a repetition of the negative
aspects of pastexperience. (Chancellor Schroeder, VDEW conference,
Berlin, 3 June2003)
In our view, these extracts are a fair reflection of the content
of Herr Schroedersspeech concerning the need of the new regulatory
framework for energy to ensurecompetitive electricity and gas
prices for German industry.
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We think that he was careful to balance this consideration
against the need toprovide incentives for future investment in
energy networks, and to ensure thecompetitiveness of German
utilities in a European context is not damaged by
over-regulation.
Does this mean that the Government is generally happy with the
way the energymarket has developed in the absence of a regulator?
In other words, to the extentthat Chancellor Schroeder is concerned
about ensuring that the future regulatoryframework continues to
provide incentives for investment in grid networks (aconcern that
reflects the fundamental energy-policy aim of any Government
ofensuring security and reliability of supply), does this mean that
he thinks theindustrys system of self-regulation under nTPA has
been effective in deliveringreliability?
And to the extent that the Chancellor does not want the
internationalcompetitiveness of German utilities to be damaged by
over-regulation, does thismean that the Government thinks that the
energy industrys current structures andpricing mechanisms have
produced efficient electricity and gas companies, andhence that it
might be worth retaining a large part of the
Verbndevereinbarungen?
The Governments attitude towards existing industry structures
and practicesChancellor Schroeder stated in his speech that Germany
could, on the whole, takepride in the way in which the countrys 900
utility companies delivered energyefficiently and reliably:
Es gibt nahezu 900 deutsche Energieversorger: kleine
odermittelgrosse Stadtwerke oder aber die, wenn ich das so sagen
darf,global player in der Energiewirtschaft. Ich sage ohne
irgendeineEinschraenkung: man kann stolz darauf sein, dass diese
Unternehmeninsgesamt natuerlich gibt es da Unterschiede ein
Musterbeispielfuer die Effizienz und die Zuverlaessigkeit der
Energieversorgung inDeutschland sind.
There are nearly 900 German energy companies: from small
andmedium-sized municipal utilities to those that, if I can put it
this way,are global energy players. I say without any reservation
that we can beproud of the fact that overall clearly, there are
differences betweenthem -- these companies exemplify Germanys
efficiency and reliabilityin energy supply. (Chancellor Schroeder,
VDEW conference, Berlin, 3June 2003)
As far as the claim for reliability of supply is concerned,
Chancellor Schroeder coulddefend this by pointing to the findings
of the recent EC report on the internalmarkets implementation
across the EU member states. For example, de