Competition and Regulatory Mix in the Restructuring of the European Electricity System

Principles

The restructuring of the European electricity market is still rather chaotic today, more than 10 years after the inception of the first electricity Directive. We certainly understood well in the early days of restructuring that competition in the electricity market requires access to an essential infrastructure, namely the power grid. It is only later that we realized that the problem was much more complicated than guaranteeing access to an infrastructure. Different services come with this access. Issues such as congestion management (bottlenecks in the grid), balancing, and maintenance of the product quality (reliability) require more than an infrastructure. They need some services and one needs to have a good understanding of what these services are and what their characteristics should be.

While the two first legislative packages produced by European Institutions in 1996 and 2003 and the guidelines that they generated did not settle the definition and characterization of these services, proposals for a third package today redirect the debate on who should provide them. Should the System Operator (SO) that delivers these grid services be also the owner of the network (TO) and can a generator own this essential infrastructure? The problem is posed in terms of conflict of interests between generators and providers of network services, especially after an inquiry of competition authorities revealed dubious practices of certain System Operators. The restructuring of the European electricity system now focuses on horizontal and vertical integration, in other terms, on market structure. Improving the market structure, and particularly more fully separating the grid and generation is now seen as the key to competition.

While matters of market structure are obviously fundamental to competition, they do not resolve the fundamental problem of whether the geographically segmented European power system is ready to be made competitive to start with. We thought we had solved that problem by recognizing that the transmission infrastructure is a natural monopoly and hence had to be withdrawn from competition that could develop in the generation and supply activities. That was certainly necessary but far from sufficient. Natural monopolies that characterize certain infrastructures and market concentrations inherited from the past are not the sole causes of market failures. The grid, besides being a natural monopoly, offers services that are affected by considerable externalities. Reliability is another possible cause of market failure in the sense that it presents different characteristics of public good. Discussing both electric public goods and externalities in a European institutional context would exceed the scope of this presentation. I will limit myself to grid externalities and begin by recalling a basic economic principle: competition does not work well in a market where externalities have not been properly internalized. In particular, an electricity system affected by grid externalities (that always occur when the grid is not oversized) should first be redesigned in a way that internalizes these externalities before competition law remedies are applied. A similar message can be made for reliability and public good, but I limit myself to externalities. 

The grid creates two types of externalities. The System Operator handles short-term externalities. These occur in a given infrastructure when transactions between two nodes influence the set of possible transactions between other pairs of nodes. It is now ten years that Europeans are trying to handle that problem, even though it is very well understood from both academic research and international experience. The Transmission Owner tackles long-term externalities. These occur when the infrastructure is changing and an investment in a line in one region modifies the transmission possibilities in another region. Europeans have not started thinking about long-term externalities yet. At least we can be happy that the proposal for a third legislative package that is discussed today implicitly recognizes the problem. In short, it is not very difficult to tackle short-term externalities in a properly designed electricity market; in contrast, it is extremely difficult, if not impossible, to cast the expansion of the grid in a market process. I will limit myself in this talk to short-term externalities. In order to further simplify the conversation, I further restrict the discussion to one of these externalities namely grid congestion. These problems are in fact well understood both from academic research and practical implementations. The institutional difficulties encountered in Europe to deal with these known congestion issues are thus the tip of an iceberg that we will hit, possibly with considerable damage, when we shall have to grasp reliability and investment questions where our knowledge is much less developed. 

Externalities are a well-known problem in basic microeconomics but the standard solutions are not easy to apply in the transmission of electricity. Textbooks commonly suggest three approaches. One is to integrate the firms at the origin of the externalities under a single management. Given the objective of competition in generation and supply, it is obviously out of the question to integrate all generators under a single management. Textbooks solutions also include Pigovian taxes as a mean to internalize externalities. But these are practically impossible to apply to the instantaneously changing externalities created by the electricity grid. Another option is to introduce tradable property rights: this means creating a market of rights to access some resources of the network. This approach is now well understood both in theory and in practice but it remains complex and possibly difficult to understand. It would solve many of European problems and in any case lay the ground for a sounder debate on the structural issues raised by Competition authorities. We are still struggling with this third approach, more than ten years after the inception of the first Directive. 

The difficult of tackling short-term grid externalities in electricity is that they occur in real-time: energy markets, because electricity cannot be stored, need to clear in real time, at least in principle. But traditional markets cannot clear in real time. One thus needs to introduce non-traditional markets (in current jargon e-markets or intelligent or artificial markets) that can operate on an instantaneous basis. This is nothing really new in electricity provided one recognizes the non standard markets in the traditional functions of the industry. Specifically a System Operator that balances load and injections by solving an optimal dispatch problem at short terms intervals of a few minutes constitutes such a market. One only needs interpreting this balancing function as a market. In economic terms, balancing internalizes in real time the grid externalities created by the real time (non standard) electricity market. This is recognized by creating a non standard market of property rights in transmission and giving the System Operator the responsibility of clearing it together with energy in real time by solving an optimal dispatch problem. Even though this problem is now well understood and solved in technological terms, its economic interpretation remains non trivial to explain and the (physical) communication that it entails between System Operators and economic agents possibly difficult to implement on top of existing infrastructure. This is the origin of our institutional problems. Its solution lies in first understanding the role of these two non standard energy and transmission rights markets and second implementing the technology that can make them operational. Because externalities are cross-border in Europe, these non standard markets for energy and property rights solution must also be cross-border. This solution perfectly fits with the view of market integration that is at the root of the European construction. Difficulties on pursuing that path have persisted so far and will plague the restructuring of the European power market as long as they are not solved. Whether the unsatisfactory internalization of grid externalities has important practical consequences or not depends on the importance of these externalities and can only be determined from the experience of the market. European authorities currently complain that this experience is not very favorable.

The European context

The European Union has 27 member states, which are not subject to a common energy policy. In contrast with the common wisdom, the European Commission does not have much power except in competition law. Japan will not face a similar problem to the EU, which has to find a system that can reconcile 27 different opinions. This has certainly slowed down the restructuring. Technically, the interesting problem is how the EU can integrate national electricity systems into a common market. Referring to the sole short-term grid externalities, the question is how the EU can properly internalize them. The Commission can rely on two types of instruments: competition law and Council and Parliament harmonization Directives and Regulation. A mix of both must be found. Competition law is the domain where the Commission has most power and can act essentially on its own. The question, in this conversation, is whether applying standard competition law to the electricity sector can internalize grid externalities or substitute for the need to internalize them. The answer seems to be an obvious no. Harmonization Directives and Regulation is the path followed in the two first legislative packages: it requires a consensus among Member States and the European Parliament. The question here is whether Directives, Regulation (and mandatory guidelines) can introduce a system that can tackle the intricacies of electricity externalities. The answer of principle is yes, but practice has so far responded by "unlikely." To sum up, it seems obvious that competition law is not the right instrument to transform a system affected by externalities into a competitive market. Competition law corrects a market affected by certain market failures that derive from the creation or exercise of market power. Competition law does not eliminate market failures due to externalities. Harmonization directives are the true instruments to do so, at least again in principle. They can create special rules that deal with the peculiarities of some sectors. As the case of the CO2 EU-Emission Trading Scheme shows, they can create special markets to internalize externalities. The way to go is thus in principle very clear: special legislation that tackles the intricacies of the market should be introduced after competition law has removed the obstacles of principle to competition (e.g. exclusive production and important rights). But this solution did not work so far in electricity. The law removed the obstacles of principle against competition and hence allowed for the creation of national energy markets. The law also introduced regulated System Operators. But it did not do so in a way that internalizes the cross border externalities created by the network and hence did not create the conditions for these markets to function competitively, especially when it comes to functioning at the European level. 

Focusing again for the sake of the reasoning on the grid problem, the overall question boils down to determining the degree of harmonization needed to internalize grid externalities. Theory suggests a strong market design, that is, a careful definition of property rights on transmission that are common to all Member States. The idiosyncrasies of these property rights also suggest introducing very strong institutions to organize their trade. The U.S. experience shows that markets based on these principles work well. Other experiences like Nordpool suggest that it may not be necessary to go as far, at least when the grid is not tightly meshed. This observation confirms common sense: efforts to internalize grid externalities should be stronger when these are more important: one should put more effort to solve a more difficult problem. Political European contingencies leaned toward departing from that basic logic and letting Member States act more or less independently, subject to minimal harmonization and the threat of competition law. In support of this position, some even moved the discussion to the sole domain of market structure and claimed that competition law measures of the divestiture type will achieve what harmonization did not realize. I follow a more basic reasoning and explain that competition law will be ineffective and possibly destructive if applied to a system where important externalities created by a meshed electricity grid have not been internalized before. I could make similar claims for public goods related to reliability but this is beyond the scope of this conversation. How should the competition and harmonization law instruments be mixed and in what order? The institutions determine how it is done but not necessarily how it should be done. What did the institutions do so far and what do they plan to do? 

The history of European restructuring

The first attempts to introduce a legislation to complete the internal electricity market go back to the early nineties. The proposals were based on a mix of competition law (to remove monopolies and hence obstacles of principle to competition) and harmonization (to create the common regulation that would handle the idiosyncrasies of electricity). Member States initially objected to the application of competition law. They correctly argued that this is not the right instrument to construct the internal electricity market: electricity requires a special regulation. But the opposition to competition law was the only common position of Member States who could not come up with any meaningful proposal to create the non-standard markets required by electricity. 

The first electricity directive was adopted in 1996. A consensus was found on extremely soft measures that are disguised competition law measures. The underlying philosophy was that electricity is a standard commodity. Member States removing monopolies in generation and supply would normally suffice to create the market. Except for these basic requirements, Member States were allowed to do almost whatever they wanted. The outcome was a disaster. Whether intentional or not most Member States organized their national electricity markets in a way that substituted clearly defined exclusive rights by murky barriers to trade. Specifically, no attempt was made to tackle questions such as grid externalities. The outcome of this first directive is still felt today. The first directive introduced a set of entrenched national markets that would be quite difficult to integrate later on.

The second directive was adopted in 2003. It tried to correct the worst consequences of the first law without effectively removing barriers. It did not create the necessary non-standard markets and property right on transmission that are the necessary conditions for a competitive market. But there was some progress: the second directive recognized that it is not enough to get access to the infrastructure. It stated more explicitly the requirements imposed on the network and tried to impose some common minimal tasks to Member States. It created national regulators and placed them in charge of competition objectives. All this falls short of what is necessary to integrate markets but it went into the right direction.

The Regulation on cross border, also dated 2003, is a failed attempt to tackle network externalities. The aim of the Regulation is to remove some of the barriers created by the first directive. It indeed does so, but in a very awkward way. The Regulation pretended to tackle the diversity of national market organizations without imposing a common architecture, let alone without addressing the need to create non-standard markets and property rights for transmission. The Regulation sees Europe as consisting of different control areas linked by interconnections. It reasons that one only has to manage interconnections. This may be a valid simplification in a radial network but it completely neglects the externalities of the meshed continental network. This is bound to fail and the failure indeed took a particularly interesting form in the Regulation. In order to manage these interconnections the Regulation introduced the notion of transmission capacities, a concept that disregards the externalities of the grid. Flawed concepts do not solve problems, they only postpone them. And indeed, the Regulation defines transmission capacity in a way that gives priority to national transactions over international ones: the transmission capacity is what remains after all domestic transactions have been taken care of. It is remarkable that a European law introduces a discrimination against non-national transactions. It is also remarkable that competition authorities that rightfully spot these discriminations in normal markets did not intervene in the electricity market. As we shall see, they might have reserved their action for a domain where they feel they are better equipped to act.

Not surprisingly, the Directorate-General for Energy and Transport (DG TREN) lamented during all these years that the market did not work very well: one cannot expect the market to open if one first introduces transmission capacities that close it. Lamenting is all DG TREN could do without the support of the Council and the European Parliament to change things. But competition authorities (DG COMP) do not need the Council and the Parliament. They came in and also found that the market was not working very well. How did this start? Large consumers justifiably complained that the market does not work well. Competition authorities launched a "Sector Inquiry" and came up with four findings: the market is too concentrated; there is vertical foreclosure (DG COMP would probably arrive at the same conclusion in the Japanese market); the market is not integrated (which was obvious from the beginning); and there are barriers to entry (balancing costs are a deterrent for entrants and financial markets that would allow one to hedge risky transactions are illiquid). Interestingly these findings are all of the market design type and some of them a direct result of the need to protect, for grid security reasons, against an improper internalization of grid externalities. Ironically, the Regulation on cross border trade reinforced some of these findings. The very inadequate internalization of network externalities introduced by the Regulation on cross-border trade gives priority to national transactions; it therefore artificially confines generators inside their national border. This enhances concentration, prevents market integration and creates barriers to entry (vertical foreclosure derives from other arguments and is truly a question of market structure). Except for vertical foreclosure, all findings of DG COMP suggest conditions of dominance and hence offer a justification for this Directorate General to intervene. Competition authorities therefore gained legitimacy to intervene from this very inadequate treatment of network externalities. The approach of the stakeholders, which was to come up with a very weak legislation that would protect them, backfired: it empowered the Directorate-General for Competition (DG COMP).

What can competition authorities do on the basis of these findings? They cannot directly act on market design, but they can interfere with market structure. They can launch infringement procedures and in extreme case take structural remedies. The problem is that this amounts to turning the problem upside down. The Commission has a lot of power to enforce general-purpose competition law even though it does not apply well in a market plagued by externalities and its consequences. The Commission is much less equipped to enact particular sector laws that would internalize these externalities and create the condition for this competition. In other words the Commission has a lot of power in the least effective instrument capable of restructuring the electricity system. The Commission apparently decided, since it could not make enough progress with the adequate harmonization instruments, to resort to the less adequate means and to put pressure on the stakeholders. The pressure may work but it cannot substitute the adequate market design. The final outcome therefore remains to be seen.

The new legislative package currently in discussion could help restore some of the situation on healthier grounds. This package is a first, long awaited for, attempt to treat the problem of the grid at a European level. Externalities take place at the supranational level and should hence be handled at the supranational level. European Regulators asked for a European Transmission System Operator (TSO). They are only offered an agency to control the national TSOs. This is admittedly not much but it is something: for the first time, regional (supra-national) aspects of transmission are clearly recognized. The agency is unlikely to solve the problem of internalizing externalities of the grid but it is a step in the right direction in the sense that it poses the problem at the right level. But as with everything in Europe, the law is extremely vague and it is only a "non paper" that suggested the truly meaningful solution, namely an integration of the ISO: this is indeed the only way to internalize the externalities of the grid at the supranational level. One does not know today what is going to happen; at least one understands the problem better.

Discussion

The above discussion is conducted in terms of grid externalities. Externalities are used here as a generic term that covers many practical problems for which a longer and more detailed discussion would be warranted. I want to emphasize a conclusion that I believe is general: it is necessary to treat the problems of restructuring with the right instruments. These problems can be quite complex and should not be treated lightly. Competition law should only be applied to the exercise of market power and not to handle externalities or public good problems that one does not have the political capability or technical expertise to properly solve. Specifically and with reference to European parlance, it is not sufficient to adopt a vaguely defined "market based solution" to have a well functioning market. Congestion management is a case in point in Europe because of the meshed nature of the continental grid. I will now argue that the consequences of an improper treatment of some fundamental problems like congestion can be far reaching. This is a particular application of what is now commonly referred to as "the law of unintended consequences." It is well taken that the Japanese situation where the grid is more radial could lead to a quite different situation. But "the law of unintended consequences" is probably universal. It will apply here as it applies there.

The inadequate treatment of grid externalities can have far reaching consequences. In its discussion of barriers to trade, Competition Authorities argued in the Sector Inquiry that the illiquid power exchanges contribute to barriers to entry. They explained that entering a supply market without generation capacity in that market is costly when power exchanges are illiquid. The reason is that illiquid power exchanges do not allow one to hedge cross border transactions. Cross border transactions can obviously be affected by congestion but this can be mitigated by financial transmission contracts that compensate for the cost of buying locally when transmission is curtailed. This type of hedging obviously requires a financial market for transmission. The underling of that market is the transmission property right than we mentioned before. It is not clear at all from reading European texts, that stakeholders and European Authorities clearly realize that there will never be a market of financial transmission contracts if there is no properly functioning market for transmission property rights. But this latter market depends itself on a proper treatment of grid externalities. The absence of proper internalization of grid externalities will thus contribute to the illiquidity of the power exchanges. It will in a second stage reinforce the barriers to trade correctly identified by Competition Authorities and used by them to build their cases. 

Barriers to entry have themselves important consequences that directly affect the life of companies that at first thought that they would be protected. Power companies and consumers in Europe desire long-term contracts because of the security that they provide in these uncertain times. Competition authorities object to these contracts on the grounds that they foreclose the market. DG COMP argues that power exchange cannot develop in a market covered by long-term contracts. This is an intricate problem of chicken or egg. Long-term contracts prevent the development of power exchanges but they offer the only market prices in the absence of liquid power exchanges. It is hard to know where to act first. If DG COMP considers long-term contracts as an infringement of dominant position and stops them, it may still take some time before power exchanges develop to acquire a sufficient liquidity with the obvious question as to where meaningful (that is from liquid markets) price signals will come from. Here again the Japanese situation maybe different even though the cause seems identical: the power exchange is not well developed but competition authorities do not seem to worry.

The law of unintended consequences also applies to TSOs. Ad hoc solutions such as the use of "transmission capacities" that may at first sight seem to make life easier for TSOs can also backfire. The Regulation on cross border trade mandates TSOs to maximize transmission capacities and to compensate users of transmission services in case of curtailment. "Maximization" and "compensation" can be interpreted weakly or strongly: The Regulation says nothing about the interpretation that entirely depends on the national Regulators. The TSOs may find themselves in a dilemma in the latter case. TSO that increase transmission capacities are putting themselves at risk, in case they have to pay compensation. The risk depends on how the transmission capacity is "maximized" (the reality is that this problem is ill defined and subject to completely arbitrary interpretation) and the rules adopted to compensate. A TSO that has to pay a compensation equal to the difference between the prices between two control areas could go bankrupt. In contrast it runs little risk if it only pays the price contracted ex ante for the transmission capacity. TSOs obviously argue for this last solution. But it amounts to an insurer whose only liability is to repay the insurance premium in case of an accident. Financial transmission contracts are made for insuring a proper compensation. But as we argued before, they cannot meaningfully develop if there is no adequate market for the underlying property rights in transmission.

Quick solutions that simplify life at some stage can become real hindrance later. This is today the case of balancing. Balancing is a key element of the restructuring process. We argued that balancing is this fundamental non-standard market of energy and property rights that underlies the whole market, at least in principle. Balancing internalizes grid externalities by clearing energy and transmission rights in real time. The questions is what happens when one takes an alternative point of view that balancing is just a function to induce generators and consumers to stick to plans that they announced one day in advance. DG Competition rightly explains in the Sector Inquiry that current balancing systems in Europe create barriers to entry: balancing is a very thin market where incumbents have extremely dominant positions. Difficulties begin when one wants to remove these barriers. The proper approach is to see balancing for exactly what it is namely a special market that clears energy and transmission rights in real time. But this implies unraveling everything that has been constructed in the last 10 years. Any other position entails the complications that Europeans are facing today. It is indeed difficult to harmonize and integrate balancing system devised independently of each other and without any common idea of their role as a fundamental real time non-standard market. It is also not easier to develop a significant intraday market to compensate the discrepancies between day ahead and real time that rely on "transmission capacities." DG COMP will still for a long time find plenty of reasons to claim barriers to trade in balancing services.

Conclusion

All these difficulties could have been, if not easily avoided, at least mitigated by an adequate reference to current knowledge. There are still many things that we do not understand well in electricity restructuring but those related to short term grid externalities are well mastered. Lack of sound principles combined with weakness of the institutions in charge of installing these principles have entailed a drift of action from market design to competition law. Is this beneficial?

One can conjecture that the intervention of competition law in a system that by construction does not have the suitable characteristics to be transformed into a competitive market is dangerous. It applies an inadequate instrument. It is like applying a cancer treatment on patient suffering from a heart condition: it can only weaken the patient but will offer no benefit. But the involvement of Competition Authorities has at least a good aspect. It forces thinking in a structured way, something that DG TREN has so far not been in a position to impose on stakeholders. Competition law has developed in all Member States with the result that it has produced a lot of jurisprudence and doctrine. The reasoning is strict and explicitly stated even if one may sometimes believe that it is wrong (as in the definition of the relevant market). But it is clearly articulated and hence contestable for those who think that it should be contested.

Q: I think integration of balancing markets will make it more difficult to handle congestion management. Do you think it is possible to integrate the balancing market?

A: There are economies of scale in integrating balancing. There are not many machines that can provide balancing services. In the two settlement system, you have a day-ahead market which operates in one regional area, and you have a real time market which operates in the same regional area. In fact, the balancing market is just the real time market, and the day-ahead market is a forward market: they both apply to the same area. In that case, you get the bids from all the plants from the different areas, and you run your balancing market on an integrated basis. That is quite natural to do. If you enlarge balancing, you provide more balancing resources, you enlarge the market, and you make it more competitive.

Suppose there is no problem of market power: you have an interest in having more machines than in having few machines, because the supply curve of balancing is less steep if you have more machines. If you also have more agents, then you reduce the risk of unbalance as well as the risk of exercise of market power in balancing. I was told of a case in Spain where bids have disappeared from the day ahead and move to the balancing with the result that the prices are extremely high. The technical difficulty is that balancing requires some very tight control in real time.

I referred above to a two-settlement system as applied in the U.S. This is a design where market clearing, including the internalization of grid externalities is done at two levels in the day ahead and in real time. It can only make congestion management simpler. One could think that is a technical problem of congestion management when one enlarges the system. But the experience of PJM in the U.S. suggests that current solvers (in this case CPLEX) can easily cope with that computational problem.

We are moving a little bit toward this type of solution in Europe, possibly without being fully aware of it. We do not have a two-settlement system, but we try to introduce intraday trading on an integrated basis. That should start on January 1, 2008. Intraday trading means you can re-trade in real time minus 18 hours, minus 12 hours, minus six hours, and finally you get close to real time balancing.

Q: Which DG was promoting the third package, DG TREN or DG COMP?

A: This time there was collaboration between the two DGs. Some academic advisers worked for DG COMP and DG TREN. One can see some ideas from Competition Authorities embedded in the new package. One can also see the Commissioner for Competition and Energy referring to each other. DG COMP has realized it can do certain things, but not everything. DG TREN has realized that the threat of DG COMP is very strong and can help.

Q: In Japan, the big problem for the transmission managers is whether the transmission line is open or not. They have to check before accepting those bids, and that will slow down the process of transaction.

A: This is the key difficulty that will always occur in a way or another without horizontally integrated TSOs. A horizontally integrated TSO can cover a wide area and current software can also cope with wide areas. I believe that it is much more important to horizontally integrate TSO than to vertically disintegrated transmission and generation. Bids are then submitted for the whole system and simultaneously taken into account in the dispatch of the whole grid. It is difficult to impose that way of thinking in Europe. The proposal in the third package is not for an integrated TSO (even though this is mentioned in a "non-paper" of the Commission). Coordinated TSOs will always encounter the type of problem that you mention. Problems will still become more difficult with the penetrating of wind because of the externalities of the network. Again the experience of PJM has shows that it is easier to integrate wind when the system is wider (and transactions with wind can change rapidly).

Q: I think the policy of aiming to realize a Europe-wide electricity market comes from the desire to introduce effective competition. But its coordination cost is very high, it may take time, and it creates uncertainty. Maybe this is not a good approach. Having a Europe-wide market is, perhaps, too ambitious. If you want to introduce competition, is it better to introduce competition in the national markets?

A: The problem is that the answer is, probably, yes. In the 1980s, there was all that movement toward the completion of the internal market, at the time when Jacques Delors was president of the Commission. Gas and electricity were part of the movement: energy was going to be treated as an ordinary commodity. The issue though was made politically more difficult by the idea that there was some public service component in electricity. This was also technically more difficult. When we started in 1992, we had neither the literature nor the international experience. We began with four years of discussions, but these were non-technical. The French wanted to protect their system and keep their (very successful) organization of the electricity sector. The Germans thought that their system was quite good too. The United Kingdom was completely different. So the ideas, to start with, were quite different. We did not have any clear idea of convergence. We did not know where we wanted to go.

Many economists explain today that what counts now is to have a competitive national market. I do not want to abandon the idea of an integrated market, which I liked a lot in those days and I still like a lot now. Moreover, it is nonsensical to claim one needs four companies to get a competitive market in small markets like Belgium; this is not a satisfactory situation. But I must confess that I am more skeptical now than 15 years ago, when our models were finding some huge gains from the internal market.

It seems a lot of progress can be made with small things. In November 2006, we started coupling the markets of Belgium, France and the Netherlands. We implemented a very primitive form of congestion management; but suddenly the prices in the three countries started to move together most of the time. So something very primitive has already achieved a lot.

The real question there is whether Germany can be part of this market coupling, because of the loop flow and wind power in Northern Germany. But if so, a system that includes Germany, France, Belgium, and the Netherlands is quite large. If we can do that, the rest should not be too much of a problem. The islands will always be islands, so the UK will always be outside. There will always be a bottleneck to get into the Italian peninsular and the same will be true with the Iberian peninsular.

In fact, when we say we have to integrate the market that does not mean that we really have to integrate the whole thing. As a matter of fact, the Commission is thinking in terms of regional markets. There is a company, which originates from the Amsterdam power exchange, with determined and well-informed people who sell the idea of market coupling. They are pretty confident that they can attract some additional Member States into their market coupling. They know what they want, and they know how to sell the idea. This is what we need.

Q: In Japan, there is the problem of transmission lines, especially between east and west. On the western side of Japan, interconnection is reasonably strong: we could have more competition.

A: In Europe, the real problem we have with such matters is with gas. The margin that is made by the suppliers with respect to the price of gas at the border is really small. On a price of five, you have at most one which is made inside the EU, and at least four at the border. If you replace the one with 0.5, in terms of gain from competition by having a supply market, then you are completely dependent on the producers. The producers are extremely aggressive.

There, the reasoning of the Commission is flawed. It refers to the idea that if you make the downstream market competitive, irrespective of the market power of the producers upstream, you will gain. This is far from clear, and we definitely have a problem. At the end of the day the gain is not what we expected, given the difficulties of implementing the system. The transaction costs of that system are huge. The worst is on retail competition; there you see advertisements for changing sellers who essentially provide the same contract.

An integrated company is much better equipped to deal with wind power. It is extremely difficult to decentralize the management of wind power in the grid. The broader the geographic scope, the easier it is to manage wind power and its variability.

Q: You point out that something is wrong if you only trust the competition policy authority to drive this reform. Does this stem from the lack of expertise? What is the real essence?

A: There are different reasons. One is just theoretical. Was it right to get competition authorities involved? The answer from a theoretical point of view is quite simple: if one admits that the problem is in the externalities created by the network, then you first have to solve the problem of externalities to have a market to which you can apply competition law. The problem of externalities cannot be solved by competition law. There is the matter of a lack of expertise. There is also a problem for stakeholders to understand what is really going on. Stakeholders have developed the idea that they can fool DG TREN and always manage to produce very weak laws. Stakeholders should realize there is no point in playing games with DG COMP. Those people are powerful, they have rules that they can and will apply whether they fit electricity or not. They can also blackmail you (by threatened higher fines). Stakeholders should realize that it is of the essence to get the system right as soon as possible in order to avoid problems, both for companies, but also for the supply of electricity in Europe: a permanent threat of DG COMP is not good for investments.