Deregulation in the E.U. is racing ahead, posing a challenge for U.S. firms. Yet the outcome is uncertain, as EdF, the giant of Europe, has yet to show its hand.
Eighty percent of the European power market will be open to retail competition, or liberalized, by 2003. The fundamental framework for shifting to a competitive market in Europe has some striking differences to the transition in the United States. Some primary contrasts with the U.S. transition include
* the startling speed of change, especially in Germany;
* the central authority of the European Union to mandate an open pan-European market;
* a known date-certain for opening European markets;
* the distinct national cultures and business practices that characterize each E.U. member state; and
* the greater concentration of ownership of generation and transmission assets in European countries relative to the United States.
These fundamental factors will profoundly affect the transition and outcomes of the European and U.S. restructuring initiatives, as well as define and explain their differences. Comparison of these restructuring processes, and the strategic business models being adopted in each market, provides valuable lessons and opportunities for companies in the global power market.
The Grand Tour: Germany, UK, Spain et al.
The pace of transition is the first glaring difference between the United States and Europe. The speed of the move toward a free market in Germany is quite surprising to most U.S. companies, and a shock to many European market participants. For the German market to shift from a complete monopoly to open competition in less than one year is unlike anything seen in U.S. power. The final results of the German free market experiment and the strategic responses of industry participants, of course, are not yet known. Some conclusions, however, can be drawn from the experience of German power companies and applied to other power environments in transition.
Germany's decision to open its power market much faster than required by the European Commission was based on consensus among the government, power industry and consumer groups that Germany and its economy would benefit from a competitive market - in terms of energy costs and industry efficiency. "The German power industry opted to drive the restructuring process rather than have it controlled and mandated by the government," notes Kevin Casey, head of trading at PreussenElektra in Hannover, the second-largest German utility.
As the economic engine of Europe, Germany chose to be the leader in opening continental power markets. The German power industry has set the precedent for the new energy order, and its accelerated opening will create momentum for change throughout Europe.
Unlike in the U.S. market, there has not been a protracted debate regarding stranded-cost recovery for German power generators. There was some early opposition to the market opening, but the prevailing attitude now is that delaying tactics are futile and the emphasis should be on finding the best new corporate strategies and advantages for the future market.
The speed of power industry restructuring has varied among E.U. member countries during the last year. As noted, the German market opening significantly precedes the deadlines set by the European Union's Internal Electricity Market Directive for opening power markets to competition.
As summarized by Markus Suessmann, chief executive officer of German utility Energie BadenWürttemberg's trading division in Karlsruhe, "German market competition is now full-blown - truly fierce competition. Germany seems headed toward being the most open market for electricity in the world."
France, however, has lagged in meeting the timetable mandated by the E.C. directive that came into force in February 1999. In late November the European Commission announced that it was initiating legal action against France for its failure to end the monopoly of Electricité de France.
The E.C.'s French compliance action illustrates one of the other most striking differences in U.S. and E.U. power markets. In Europe the E.C. has ultimate authority over member states to compel the market opening, whereas in the United States there is no national authority nor federal law to require states to open their retail markets. That is rather ironic since a united Europe is a relatively new phenomenon by comparison to the U.S. federal structure.
In the United Kingdom, the gradual transition from a single state-owned electric utility to privatized companies and finally to an open competitive market has continued over a number of years. Yet in the highly concentrated U.K. supply structure created by the Thatcher privatization plan, the use of a pool system with formula-based wholesale pricing has not achieved a truly fair-priced market.
U.K. regulators have acknowledged that the current pool system allows pricing "anomalies" and tempts generators to game the system to achieve higher prices. Accordingly, UK authorities plan to reform the pool-pricing model. The difference in demonstrated results between pool operation vs. market-transacted pricing may influence the selection of market structures for the E.U. members that have yet to establish their wholesale market systems.
In Spain there is limited wholesale market trading, but the retail market remains concentrated with the two large, integrated Spanish utilities, Endesa and Iberdrola. Power imports into Spain are feasible but require a rather cumbersome government application. Endesa has expanded aggressively in South America and continues to build a trading and risk management organization to position itself for competition in Europe. One market focus concerns whether there will be cross-border business combinations between Spanish companies and other major European utilities in accessing the Spanish retail market.
France: The One to Watch
Thus far, Germany has been the happening spot in European power market developments. But the giant of European electricity - which has yet to fully exert its power in a pan-European market - is Electricité de France, the French state-owned national utility.
As the exclusive power supplier for all of France, Electricité de France, or EdF, is one of the largest utilities in the world, with more than 100,000 megawatts of generating capacity in France, 30 million customers and 116,000 employees. It is also one of the more interesting energy companies, with a high percentage of nuclear power generation (about 60 percent) and relatively low cost production. That could make EdF a winner in pan-European competition.
But unlike Germany, which has thrown open its market to unbridled competition, France has yet to comply with the E.C. directive and remains a closed market. Not only is its continued delay in meeting the directive's minimum requirements resulting in threatened enforcement action by the European Union, but other E.U. members are threatening legal action and retaliatory moves. For instance, some warn they might preclude the import of French power into their own countries unless France opens its domestic market to competition.
Forcing French compliance will be the most significant test thus far for the European Union because it will demonstrate whether there is the necessary resolve to assure that an open pan-European market becomes a reality, regardless of opposition or special interests. With the German market course now seemingly set, the pattern of the French transition is the key barometer to watch in projecting the ultimate pan-European market.
It is believed that the French market will be opened this year. In fact, most trans-European market participants are developing strategies based on the presumption of an early opening of the entire European market.
The French government has pledged to finalize by mid-February its long-delayed legislation to open the country's electricity market to competition. The difficulties for the French government in trying to reach consensus on restructuring legislation reflects the significant conflicting political party interests in that process. Also, the magnitude of EdF as a single entity complicates transition strategy development. France has a lot to lose and understandably wants to get it right.
Most observers expect EdF to be a global player, and EdF management views the new European marketplace as an opportunity. "EdF is fast becoming a global actor having as an aim to have a worldwide presence by making more than a third of its sales revenue abroad in a few years from now," says Dominique Ganiage, vice president for strategy, marketing and communications at the international division of EdF.
Given EdF's considerable size, financial strength and low-cost generation, that seems quite achievable - even probable.
The Trading Floor:
New Exchanges, in Cash
If the move to competitive markets for Europe continues on the course that now appears likely, exchange-traded electricity futures contracts seem certain to develop. In Germany, the process is well underway with the new European Energy Exchange, or EEX, in Frankfurt now developing an electronic screen trading system to offer German electricity futures. The EEX, which is backed by the Deutsche Borse stock exchange and the Swiss-German Eurex exchange, plans to launch its new electricity contract this year. The new Leipzig Power Exchange also intends to launch electricity spot contracts in May 2000, with futures contracts to follow. These LPX contracts also will be electronically traded and use the proven technology of the Nord Pool power system.
"The implementation of revised German grid access procedures should make for ideal timing for the new exchange contracts. We plan to adopt much the same contract structure as the U.S. NYMEX electricity contracts," notes Carlhans Uhle, chief executive of the LPX.
Successful trading of electricity futures in Europe 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 Nigel Burton, managing director of the global investment banking utilities group at Deutsche Bank in London, "The distribution of size of utilities in Europe is quite different than in the U.S. In the U.S. market there is a larger number of major utilities of similar size, whereas in the E.U. there is a concentration in a much smaller number of large power companies. These contrasting market structures have a major impact on competitive market strategies, and on merger and acquisition activities."
In the future there will be high-value power industry mergers, even by the current mega standards of the $110 billion Sprint acquisition, the Exxon/Mobil deal at $81 billion, or the Mannesmann $125 billion hostile takeover bid proposed by Britain's Vodafone Airtouch. There is a lot of money at stake in the power market merger and acquisition game, and firms should move now to best exploit opportunities in the new market.
In the longer term, power imports from the former Soviet Eastern Block countries or from Russia are a distinct possibility. Michael Moore, partner at Amerex in Houston, notes that "Eastern European countries, although not covered by the E.C. electricity directive, are beginning to restructure their power markets."
John Barr, managing director of SG Barr Devlin in New York says, "The strategic rationale driving European utility mergers and cross-border combinations are the same as those that have fueled the restructuring of U.S. utilities for the past five years: cost reduction and revenue enhancement. As Europe's large investor-owned utilities regain equilibrium in the new markets, through a combination of horizontal mergers, joint ventures and vertical disaggregations, we believe they will return their attentions to the U.S. markets. At that point, which for some could be before the end of 2000, we would look for a resumption of inward-bound acquisitions, following on the early moves by ScottishPower and National Grid."
British Energy's increasing investments in U.S. nuclear operations through its AmerGen joint venture with Peco is one example. With AmerGen's recent acquisitions of the Clinton and the Three Mile Island Unit 1 nuclear plants, Robin Jeffrey, AmerGen president and executive director of British Energy, North America, comments that "AmerGen has become a true part of the U.S. power generation scene."
In many of these countries, restructuring will involve first privatizing the state-owned utilities. That is slowly beginning in Poland with the country's initial sale of generating facilities. It will take four or five years, but it is part of the Europower equation.
For U.S. firms entering the European market, there are both distinct advantages and disadvantages. For example, new entrants are unencumbered by legacy positions, which can make it easier to formulate unique competitive positions. Innovation is the key ingredient.
Even for U.S. companies without any plans for expanding into Europe, close observation of European market developments can be valuable for assessment of strategic options, and for gauging the success of alternative business models for competitive environments. For example, the results of branding and pricing strategies in German retail marketing may provide a model for U.S. and other E.U. companies in developing marketing strategies.
It has been 10 years since the Berlin Wall came down and Germany was unified. It will not take another decade for the unified European power market to emerge. As we enter the third millennium, the European power industry is well on its way to change. In European power the future belongs to the swift, the innovative and the financially strong - but above all, to those who can adapt to change.
Shannon Burchett is president of Dallas-based Risk Limited Corp., a provider of strategic management services, merger and acquisition support and risk-management expertise. Burchett can be reached at 972-245-8300 or at sburchett@RiskLimited.com.
[Sidebar by R. R. Johnson]
The E.U. Market Directive: A Closer Look
The December 1996 law establishes common rules for the organization and functioning of the European electricity sector.
* For certifying new construction, member states may choose between an authorization procedure and a tendering procedure.
* Where they opt for the authorization procedure, member states set criteria for certifying new construction in their territories.* Where they opt for the tendering procedure, member states conduct an inventory and publish estimated new capacity. An independent body would organize, monitor and control the procedure.
Transmission System Operation:
* Member states designate a system operator responsible for guaranteeing security of electricity supply.
* Member states set minimum design and operational requirements for system interconnections. These requirements must be non-discriminatory.
* The member state may require the system operator to give dispatching priority to installations using renewable or indigenous primary energy fuel sources.
Unbundling and Transparency of Accounts:
* Integrated energy companies must keep separate internal accounts for their generation, transmission and distribution activities.
* Where the member state designates as a single buyer a vertically integrated electricity company or a part thereof, the state must require the single buyer to operate separately from the generation and distribution activities of the integrated undertaking.
* Member states most ensure there is no flow of information between the single-buyer activities of the integrated company and its generation and distribution activities, except for the information necessary to conduct the single-buyer responsibilities.
* Member states may choose between negotiated access, via voluntary commercial agreements, or the single-buyer procedure, whereby a single buyer is designated within a territory.
* Member states must take necessary measures to ensure the opening of their electricity markets.
* The national market shares are calculated on the basis of the U.C. share of electricity consumed by final customers consuming more than 40 gigawatt-hours per year. The share of national market will be increased progressively over a period of six years.
* Member states shall create mechanisms for regulation, control and transparency so as to avoid any abuse of market power.
* Member states must bring into force laws and provisions necessary to comply with the directive no later than Feb. 19, 1999.
* Belgium, Greece and Ireland may have additional time to comply with the law due to specific technical characteristics of their electricity systems.
The full text of directive 96/92/EC is available at www.europa.eu.int/en/comm/dg17/gazel_en.htm. - R.R.J.
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