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The development of comprehensive European

electricity and gas markets is still far from

complete. Approval of a comprehensive and

mandatory European energy policy only

occurred in 2005, while the Agency for the

Cooperation of Energy Regulators was

established quite recently in 2009. There is a

recognition that the extension and deepening of

the energy market cannot precede further

without appropriate European-level institutional

development.

Central to this reform identified by the European

Commission is ownership unbundling of energy

generation and transmission (EC, 2007a;

2007b). The EC has missed this opportunity for

reform with the Third Energy Package that

came into effect in April 2011. Despite

consistently recommending complete

ownership unbundling, most notably in the 2007

communication “An Energy Policy for Europe”,

the final legislation allows member-states to

choose between ownership and operational

unbundling. The latter option, introduced from

pressure from France and Germany, is a poor

substitute for ownership unbundling and will not

solve the anticompetitive practices the Third

Energy Package was designed to address.

Potential for Unbundling in European

Energy

The decision to bundle or unbundle for the most

part is determined by whether the benefits of

horizontal competition outweigh the increased

costs of vertical coordination. Of all

infrastructure sectors, energy is generally

regarded as the most ripe for vertical

unbundling (Gómez-Ibáñez, 2003). Within the

provision of energy, generation is the segment

most open to competition, leading to sustained

improvements in productivity, and is also the

segment that contributes the most to overall

cost, providing significant possibilities for

reducing price. Compared with former national

markets the size of Europe will also go a long

Future Prospects for Unbundling in the European Energy Sector

Future Prospects for Unbundling in the European Energy Sector

Jonathon Flegg j.c.flegg@nus.edu.sg

Jonathon Flegg j.c.flegg@nus.edu.sg

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way to realising the number of independent

generators needed to achieve strong and

dynamic competition.

Costs of unbundling remain low because there

are minimal common assets or functions

between generation and transmission.

Unbundling gas provision has the added benefit

of low coordination costs between vertically

segmented entities.

Problems of Vertical Foreclosure and

Strategic Under-Investment

While cross-border liberalisation policy officially

began in 1996 with the First Energy Directive, in

practice European electricity and gas markets

remain anything but competitive. In many

member-states, particularly in Eastern Europe,

the energy sector remains controlled by

national enterprises, and in France and

Germany the industry is dominated by a small

number of vertically integrated conglomerates

(Lévêque, 2006). The transmission of gas

similarly remains dominated by a handful of

vertically-integrated giants led by Gazprom, the

Russian state-owned enterprise.

The European Commission has argued that it

possesses evidence of “widespread”

anticompetitive behaviour among vertically-

integrated energy giants, including in the

instance of gas, outright denial of access to

pipelines for third parties (Mortished 2006;

Jozwiak 2011). This practice of vertical

foreclosure, a firm‟s use of its monopoly control

over bottleneck infrastructure to promote its

interests in other sectors at the expense of

competitors, is closely linked to the lack of

adequate market competition (Gómez-Ibáñez,

2003: 255).

Monopoly control of network assets by national enterprises

and gas giants hold the key to anti-competitive practices

European energy enterprises that control

bottleneck infrastructure are also believed to be

engaging in more long-term anti-competitive

behaviour. Until recently the European

electricity network consisted of a series of

relatively autarkic national networks with very

little cross-border interconnector capacity

(Pielow et al, 2009). In a liberalised market with

national enterprises that control electricity

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transmission, there may be incentives to

strategically underinvest in these transmission

linkages with the rest of market in order to

effectively maintain control over access to a

domestic market (Pielow and Ehlers, 2008;

Pielow et al, 2009; Cardoso et al, 2010). This

incentive holds conditional on the gains from

higher domestic prices being greater than the

gains from selling excess supply to external

markets, so is likely occur in member-states

with an undersupply of electricity compared with

its own market.

Policy Response with Ownership and

Operational Unbundling

With these practices in mind, in January 2007

the European Commission laid out in a

communication, “An Energy Policy for Europe”,

its long-term blueprint for energy sector reform.

The plan sited the problems of vertical

foreclosure and strategic underinvestment as

requiring a European policy response:

The Internal Market Report and Sector enquiry

show the danger of discrimination and abuse

when companies control energy networks as

well as production or sales, protecting national

markets and preventing competition. Such a

situation also creates a disincentive on

vertically integrated companies from investing

adequately in their networks, since the more

they increase network capacity, the greater the

competition that exists on their “home market”

and the lower the market price (EC, 2007a: 7).

The EC‟s strong recommendation was for

mandatory ownership unbundling, known

elsewhere as line-of-business restrictions.

Electricity and gas enterprises that have vertical

integrated production and network interests

would have to divest themselves of one or the

other. This initial plan came under strong

opposition from France and Germany (Reuters,

2007) and from the Russia‟s Prime Minster

Putin, who claimed it was a “confiscatory”

measure (Jozwiak, 2011).

Pressure from large countries has led to a

watering-down of this ownership unbundling

requirement in the Third Energy Package. The

final legislation also permits member-states to

choose instead an operational unbundling

model.

… vertically integrated companies [...] retain the

ownership of their network assets, but [which]

requires that the transmission network itself is

managed by an ISO [Independent System

Operator] – an undertaking or entity entirely

separate from the vertically integrated company

– that performs all the functions of a network

operator (EC, 2007c).

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The European Commission must uphold their vision for an

integrated and competitive energy market

A „Third Way‟ proposal by France and

Germany, also incorporated as an option in the

final legislation, is to have the operation of the

network asset remain within the vertically

integrated company, but stringent regulations

be placed on the management of the network to

ensure its independence. Both operational

unbundling solutions leave ownership of the

network on the balance sheet of the vertically-

integrated company, but the first purports to

achieve independence through separating

operations, while the second attempts to

achieve it through discretionary regulation.

Prognosis for Unbundling in the Third

Energy Package

Ultimately allowing operational unbundling is a

poor substitute for ownership unbundling and

will not solve the problems of anti-competitive

practices in the European energy market.

Firstly, there are significant problems of

information asymmetry and complexity for the

regulator (Gómez-Ibáñez, 2003: 249). Prior to

the 2011 reforms the European Commission

found it almost impossible to convict energy

conglomerates of anti-competitive practices,

despite launching various investigations

including raiding offices (Mortished 2006). It is

likely to be even more difficult to prove strategic

underinvestment in transmission capacity.

Secondly, there will be the strong potential for

regulatory capture, given the potential

confluence of interests between national

regulators and distribution networks that are

almost exclusively national entities. Gómez-

Ibáñez (2003: 256) argues that the regulator

invariably comes under pressure to relax

unbundling restrictions, and presumably even

more so given the blurring of the lines implicit in

operational unbundling.

Finally, by reintroducing a significant regulatory

burden to all segments of the industry,

unbundling‟s added value to both society and

enterprises might be hardly worth the effort.

This is the point of view of Groenendijk (2009)

who argues that by entities effectively handing-

over control of transmission to independent

operators or stringent rules they are:

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… having capital tied up in assets over which

one has no control, with a return much lower

than in the remaining part of the company, and

getting exposed to a heavy regulatory burden

on the entire undertaking.

Groenendijk (2009) predicts the regulatory

burden of operational unbundling is only going

to incentivise the more rapid departure of major

energy conglomerates from unprofitable

transmission assets. He cites Shell and

ExxonMobil as examples of conglomerates who

have already left transmission. If this is the

future, then it might be market forces rather

than regulatory ones that determine the future

of unbundling of energy in Europe.

Will the regulatory burden further incentivise flight from

network assets?

A Missed Opportunity

The Third Energy Package was a missed

opportunity to extend and deepen the

European energy markets. Placating the

large member-states, has meant the

introduction of the option of weak

operational unbundling. It is unlikely the

measures are going to reduce problems of

vertical foreclosure and strategic

underinvestment. Member-states wishing

to avoid the spirit of the law will be drawn

to the weakest unbundling option and

could install a weak national regulator.

To be effective unbundling must separate

the ownership of the network from

competitive segments of energy provision.

Unbundling is advisable for such an

extensive energy market as Europe, but in

the long-run the European Commission is

going to have to make the provisions

stronger if it going to overcome the power

of national enterprises in using

uncompetitive practices in protecting their

domestic markets.

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