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A Continent United? Some Thoughts on Prospects for a Single Energy Market in Europe

Fortnightly Magazine - January 15 2000

could be the start of large-scale electronic screen trading in lieu of open-outcry pit traded futures or over-the-counter markets for power. There generally is a lack of opposition to electronic trading by European exchanges and wide acceptance by users of the technology. The reliability of electronic trading systems also has been demonstrated in Europe, such as in the Nord Pool. The market consensus seems to be that German futures will be well-received by market participants and actively used as price-hedging instruments. That is all premised on an active physical spot and forward market developing once the new grid rules are in place.

Establishing open access to the transmission grid is a critical step in implementing a competitive pan-European market. Early this year, the new German "V-V2" grid access rules will be implemented and should mark the beginning of more active power trading in the wholesale European market. The lack of physical transmission constraints in Germany's highly interconnected grid may be an important factor in avoiding the extreme volatility that has been so destructive to the U.S. power market. Within most European countries, the grids generally are free of significant bottlenecks; however there could be isolated transmission constraints at national interconnects such as that between France and Spain. That could have an impact on price volatility and variations between price levels at different hubs or basis points.

Chitru Fernando, assistant professor of finance at Tulane University's Freeman Business School in New Orleans and a specialist in power transmission economics and pricing, notes, "It is impossible to have competition in generation without the support of a well-functioning and well-incentivised transmission network. The problems in the U.S. - i.e., transmission not being available when it's most needed - have a lot to do with the lack of attention to this important 'detail.'"

Even with the benefit of E.U. law driving the structural move to competition, the U.S. experience suggests that trading and risk management could be big challenges. Europeans, however, have the benefit of American hindsight.

"Europe need not reinvent the wheel in power risk management," says Anthony M. Lerner, partner at U.S.-based Arc Oil. "They can look at the American experience in credit exposure management and other risk factors in free market trading and management of price volatility. The message is to plan for the unexpected."

European generators also can learn from the trading experience of U.S. companies in the wholesale electricity market. In fact, a number of major European utilities have recruited talent with U.S. trading experience. There also is the opportunity for U.S. companies entering the pan-European market to use their trading and risk management experience as a competitive advantage.

Looking East: Poland Next?

The best estimate is that going forward the market in every E.U. member state will, at the minimum, open in accordance with the E.C. directive. Most will exceed the minimums. With the sizeable price reductions that already have occurred, the margins for power producers are being affected. They are reacting with actions such as mergers and acquisitions designed to gain market share and cut costs.

As noted by