How joining the EU may transform the Central and Eastern European electricity sectors
It is not coincidental that energy assets are for sale across Central and Eastern Europe the same year that 10 new countries join the European Union (EU). New member states had to demonstrate significant sector reforms to qualify for EU membership. These sectors have historically had miserable economic results due to artificially maintained low prices, poor and often corrupt management, and significant political interference. On this dawn of EU expansion, we assess accession countries' progress in meeting the EU energy directives, the remaining hurdles to further liberalization, and obstacles for private investors.
European Union Framework
The objective of EU electricity legislation was to create an internal market for energy, thereby maximizing competitive forces in generation and supply and developing a non-discriminatory environment in transmission and distribution, with the ultimate ambition of improving efficiency and reducing costs for end consumers. Directive 1996/92/EC served as the key legislative catalyst for market deregulation. Electricity Directive 2003/54/EC replaced it and put in place more explicit regulations regarding regulators and the independence of grid operators. Other EU energy legislation addresses environmental issues, such as meeting the EU's commitment to the Kyoto Protocol by increasing the amount of renewable energy used and reducing environmentally harmful emissions from power plants.
Member countries are moving ahead of the legislated schedules, with some states such as Sweden, Finland, Germany, the United Kingdom, and Austria having achieved full market opening. EU accession states need to implement these energy policies by 2007 as part of their commitment to , the process of implementing all EU legislation into national legislation.1
Electricity Markets in Central and Eastern Europe
In Europe, generation, transmission, distribution, and supply traditionally were integrated, and massive energy companies functioned almost as branches of government ministries. Indeed, economically, energy companies were not necessarily meant to make profits but rather to meet the public's need. At the same time, while all EU member states (and candidates) are striving toward the same goal of an increasingly open and competitive energy sector, the path toward this goal is not necessarily the same. The different original market structures in each country, their varying geographic composition and natural resources, and any potential social and economic constraints all affect which path is chosen.
An effective way to compare electricity markets in the accession countries is by looking at their market structures (whether vertically integrated or fragmented) and their supply arrangements-whether supply is organized by a single buyer or is non-centralized, that is, where eligible consumers (including distributors and suppliers) can buy from any generator directly.
This matrix results in four categories of market approaches that can describe all electricity markets. Three of these categories exist in the accession countries: the fragmented single buyer model, the fragmented non-centralized model, and the non-centralized vertically integrated model.2 The fourth category, the vertically integrated single buyer model, is not present in the accession countries but is seen in other regions of the world, such as Quebec.
The first approach is the fragmented single buyer model, which has been used by Bulgaria, Hungary, and Poland. An independent entity, often a subsidiary of the transmission system operator, becomes responsible for acquiring power (under long-term contract) from the generators and reselling power at regulated prices to distributors and suppliers. Countries often choose this approach to simplify the process by which generation can be made competitive without risking the economic viability of distributors. This model often is applied to consumers that are not yet eligible to choose their supplier, or those that have elected not to switch suppliers.
The second approach is the fragmented non-centralized model. The Czech Republic, Slovakia, and Romania are implementing this model. Such an approach is characterized by an unbundled and competitive generation sector, a market structure based on bilateral contracts (and sometimes supplemented by a wholesale day-ahead exchange), a fully independent transmission company, and distributors and suppliers that can purchase from any generator. An independent market operator is usually required for this model. In such a market structure, the allocation of wholesale energy costs is crucial. All three countries are still in the process of putting in place these market structures, though the Czech Republic is more advanced than Slovakia and Romania.
The third approach is the vertically integrated non-centralized model used by countries that are too small to have their own competitive market. This is the case in the Baltic countries (Estonia, Latvia and Lithuania3), as well as in Slovenia. These countries generally continue to have one main actor in generation, a transmission company, and a couple of distributors, and the sector usually remains largely state-owned. The Baltic states are trying to create a regional transmission grid operator and dispatch center, which might result in a regional competitive market, much like Nord Pool in Scandinavia. However, this is not likely in the near or medium term.4
None of the accession countries is in full compliance with the EU directives yet. Some of the non-compliance problems are structural. Several countries (Slovakia, Czech Republic, Hungary, Bulgaria, Estonia, and Latvia) still have one dominant utility in generation, which makes it potentially more difficult for a new entrant to penetrate the market successfully. At the same time, significant state ownership remains in many accession countries, including Slovenia, Estonia, Latvia, Romania, and Bulgaria, which does not help to foster competitive pressure to improve efficiency. And, although all accession countries have set up ostensibly independent regulators, real independent regulators (appointed to set terms with outside financing and full tariff setting authority) are rare: regulators in Romania, the Czech Republic, Hungary, Poland, and Bulgaria do not have full tariff-setting authority, potentially opening the tariff-setting process to political pressure. Regulators in the Czech Republic, Estonia, Slovakia, and Bulgaria are either not appointed for fixed terms, or do not have funding independent of the government.5
In addition, certain regulations or practices are not in compliance with the EU directives. Cost-reflective pricing is not yet consistent across the region, as politicians resist increases in tariffs to keep voter support. Specifically, end-consumer tariffs are not yet fully cost-reflective in Hungary, Romania, and Slovenia. Another problem is that certain countries have imposed obstacles for distributors and suppliers to access imports, either by implementing quotas on the amount of power that can be imported, or by imposing high interstate transmission tariffs to protect domestic less efficient generation. This is seen in countries such as Slovenia, Hungary, and Latvia.
Finally, nuclear and environmental compliance is also an important issue in several countries. The EU is particularly concerned about the older Soviet reactors and has explicitly stated that Lithuania's Ignalina, Bulgaria's Kozloduy, and Slovakia's Bohunice V1 should be closed. In addition, the EU wants reactors in the Czech Republic, Hungary, Slovakia and Bulgaria to be upgraded, and the reactors in Romania and Slovenia to be closely monitored. Yet given that these countries need alternate sources of supply and technical assistance before the plants can be closed or upgraded, timely compliance with these nuclear safety regulations will be challenging.6
Compliance with other environmental regulation is also a major issue in the region. While all countries in the region have started to address the serious environmental problems that are a Soviet legacy, much remains to be done, and only a few countries, such as the Czech Republic, have actually come close to completing the needed rehabilitation.
Opportunities for Investment
Although the accession countries have not fully complied with all EU electricity directives, they nonetheless harbor numerous opportunities for investment. The fact that these countries have joined the EU, or are in line to do so, differentiates them substantially from their neighbors, as this decreases the amount of uncertainty investors face regarding expected economic development and the anticipated evolution of their energy sectors.
Using a relatively simple approach to assess investment needs based on existing infrastructure status in the accession countries, the potential need for equipment going forward, estimates for electricity demand growth, and average equipment costs, we calculate that the accession countries have a total investment need of $50 billion through 2018 for electric generation and distribution investments alone (the breakdown of the total was split 50:50 between the two categories).7 It is likely that an additional $3 billion to $5 billion will be required for transmission upgrades and expansions. These investments will manifest themselves in a variety of ways, including direct investments through asset and company privatizations, concessions for distribution networks, long-term O&M contracts to sites or companies, service contracts, and equipment sales.
Electricity generation constitutes a major opportunity for investment, given that additional capacity is required in many countries and that old, outdated, inefficient or polluting equipment, including nuclear sites, needs to be replaced or rehabilitated. In addition, the accession countries also need to increase the amount of renewable energy they use to generate electricity. Thus, wind-fired, biomass-fired, and small hydro will become key investment opportunities. Some countries, such as Estonia, Latvia, and the Czech Republic, already have put in place economic regimes that favor renewable energies. The European Bank for Reconstruction and Development (EBRD) recently identified Hungary, Poland, the Czech Republic, Russia, Ukraine, and Latvia as countries with the highest potential for such investments.8
Electricity distribution also will provide significant opportunities for investment. Distribution losses in accession countries continue to be higher than the Western European average and can be stemmed only by investments in capital equipment. New wires can help to decrease technical losses while metering equipment helps the distributor to better track and monitor consumption, thereby reducing commercial losses. In addition, automatic control equipment and software is required to decrease operational costs.
Electricity transmission also will require additional investment, as countries expand and enhance their transmission networks. As the internal market grows, the region will need new interconnections between different markets. In addition, investment opportunities are emerging in software and services to support nascent marketplaces and exchanges.
Challenges Faced by Private Investors
At the same time, there are numerous hurdles-both region-wide and country-specific-that investors will face in this region. Clearly understanding and addressing these obstacles are key to successful investments in the region.
Numerous obstacles to investment are seen consistently across the region. A major concern is that the market structures in most of these countries are still evolving, which could affect the cash flows of purchased assets. This is particularly true for generation assets. In a liberalized electricity sector, wholesale energy is compensated by a market price that is determined by the intersection of supply and demand. However, in the accession countries, predicting wholesale energy prices for the next five years, let alone the next 10 to 20 years, which an IPP project would require, is extremely complex.
Even when spot markets exist, they are highly illiquid, and there are few futures transactions except for the long-term contracts that were signed by the state in an earlier era. Market fundamentals, such as the shutdown of old, inefficient plant, can be uncertain for many years. Finally, the role of incumbent generators and their market power is a subject that is rarely addressed in the region, and yet is one that can have a large impact on strategic bidding scenarios when a wholesale market does evolve. The issue of market evolution also affects distribution and transmission assets, as the methodologies that determine tariffs for such services contain variables that are periodically changed, such as the allowed cost of capital, the regulated asset base (in particular following significant investments), and the efficiency target (X factor) in performance-based ratemaking regimes.
Another major concern is the challenge that investors face in accurately valuing companies or assets prior to an acquisition. Valuations are complicated in the accession countries due to the immaturity of financial and energy markets, local accounting practices, and concern about regulatory risk. The immaturity of financial markets complicates the determination of an appropriate cost of capital, while new energy markets usually are not reliable as long-term price indicators. At the same time, historic accounting of companies or plants (often distorted during years of state planning) is dubious at best, further complicating the analytical process. Finally, given the ongoing changes in market structure and regulatory framework, determining long-term cash flows with any certainty becomes a major challenge. That said, the ongoing accession process and the obligation for accession countries to quickly adopt EU auditing and legal standards will help to enhance investor confidence regarding some of these issues.
One last concern that is consistently observed across the region is the lack of fully independent regulators. The problem with regulators that are not fully independent is that government officials can lean on them to minimize rate shock to protect the officials in the next elections, or that asset sales can be encouraged or discouraged for political reasons. Ideally, regulators should be appointed to minimize political control for a fixed term with dismissal possible only within a narrow range of circumstances. Funding for regulators should come from industry, not from the government budget. Tariff-setting should be free from political influence. Thus, the regulator should be able to approve tariffs without interference from politicians, or the methodology for tariff setting should be officially published, reducing the regulator's role to that of an administrator.
Some challenges to investment are country-specific. The countries that chose fragmented single buyer models (Hungary, Poland, and Bulgaria) as their way to transition to a competitive electricity market are now facing the challenge of what to do with the long-term power purchase agreements (PPAs) that they set up at the onset of deregulation. The problem of the PPAs is multifaceted. On the one hand, they inhibit full competition within the generation sector as they are generally for fixed prices for the life of the contract. This decreases the total amount of competitive generation capacity available. In addition, the contracts were sometimes signed at high fixed prices, especially to entice Western developers, and are now considered "out of the money." Renegotiating these contracts can be expensive. There are, however, creative solutions to this issue. In Poland, the government is planning to renegotiate all of the outstanding PPAs (called KPN in Poland) and to finance the stranded costs via a bond issuance that would be collateralized by imposing a small levy on end consumers. Neither Hungary nor Bulgaria has started the restructuring process, and it may be that they are waiting to see if the Polish solution is workable.
In addition to its concerns about its single buyer model, Hungary also has struggled with the politicization of tariff setting, which has endangered the economic viability of the state-owned transmission company. Hungary's first tariff review in 1996 suggested the need for 35-percent tariff increase in end consumer tariffs. The government rejected this and increased tariffs by only 25 percent by postponing costs such as reserves for nuclear decommissioning, closing coal mines, and not recognizing some expenses such as insurance. During the second price review in 2000, increased generation prices were not reflected in end-consumer prices. This threatened the distributor's financial viability, causing them to actively protest to the regulator. Ultimately, the government forced the state-owned transmission company to cover the gap between the actual cost of power and the cost the government was willing to pass through to end consumers. The transco then sold the electricity to the distributors at the pre-established artificially low price.
While most of Central and Eastern Europe has addressed the cash collection issue, the problem of bill nonpayment or regular late payment continues to be a concern in Romania and Bulgaria, and the other countries of the former Soviet Union. Cash collection rates for the region vary dramatically. For the countries that joined the EU in 2004, the average rate of cash collection was 95.6 percent, while Romania and Bulgaria had 62 percent and 85 percent respectively.9 Cash collection is essential to the financial viability of the electricity sector and thus is an important first step in the reform process.
While this article has focused on the issues that still remain to be accomplished in accession countries to meet the EU electricity directives and on the obstacles that could inhibit private sector investment, significant and impressive progress has been made in reforming the energy sector in most of these countries. There are many ways investors can address these obstacles. Being fully aware of the regulatory and market context in the target country is of paramount importance. Exhaustive modeling of different possible regulatory scenarios to determine asset value will be essential in making realistic acquisition bids. In addition, attempting to have some of the market rules and regulations confirmed in the sale or privatization contract also can be useful for gaining more certainty about future cash flows from the investment. Finally, ensuring that the investor has recourse to an international body of arbitration in the case of future disagreement will help to give the investor more confidence that investment will be appropriately reimbursed.
- Exemptions are likely for isolated markets such as Greece and the Baltic states.
- London Economics International LLC, , Cambridge, MA: London Economics Press, forthcoming.
- Lithuania is somewhat of an exception to this category as it is larger than the others, and has substantial overcapacity. As a result, it has more than one generator, and a few private investors have purchased small plants.
- The EU and the International Energy Agency (IEA) also are encouraging the development of a regional electricity market in Southeast Europe as a way to integrate this region into the European electricity system. Participating countries are Albania, Bosnia and Herzegovina, Bulgaria, Croatia, FYR Macedonia, Romania, Serbia, and Montenegro.
- Kennedy, David, EBRD Working Paper No. 78, February 2003.
- Richards, Mark and Georgia Quick, "Eastern Europe, Nuclear and EU Accession," , Oct. 31, 2002.
- , London Economics International LLC.
- , "Hungary Wind Power," July 2003.
- Kennedy, 2003.
Key Points of EU Energy Legislation:
- Create an independent regulator
- Oblige utilities to produce public audited accounts
- Unbundle accounts of vertically integrated utilities
- Restrict legal barriers to entry in generation
- Ensure transparent, fair third party access to transmission and distribution wires
- Ensure the independence of transmission system operators
- Allow consumers to choose their supplier (2004 for non-residential; 2007 for all)
- Delineate public-service responsibilities
- Evolving market structures
- Lack of fully independant and experienced regulators
- Unwillingness to pay full cost of energy
- Inetrnal opposition to private sector
- High levels of technical and commercial inefficiency
- Challenges in valuing assets and companies
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Acceding to Succeed
How joining the EU may transform the Central and Eastern European electricity sectors