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Historical approach of European electricitymarketpar Bianka SHOAI TEHRANI,I­tésé

In a context of electricity market liberalization in Europe, we investigate theinvestment decision in generation capacities using a historical approach. Ourpurpose is to understand how the drivers for investment decisions evolved withtime in the European context. The considered period ranges from 1945 up to now.The economic theories of the time are confronted to the decisions that were made,analyzing the existence of a gap between rational behavior described by the theoryand actual behaviors of investors. In the end, the drivers identified as key are statepolicy, availability of the resource or technology, and market structure.IntroductionIn a context of electricity market liberalization inEurope, this paper addresses the issue of investment inelectricity generation capacities using a historicalapproach. The evolution of the generation mix isdetermined by the decisions of power generationcompanies.These decisions are influenced by many factors (forinstance political decisions for state monopolies), andobey to different drivers according to historical context.What were the past drivers for investors’ decisions on theEuropean electricity market and how did they evolvewith time? To answer this question, first we give a reviewof the economic theories from 1945 up to now; they arethen confronted to historical facts through two periods :first, the 1945­1986 period before liberalization, duringwhich the European mix was constituted; second, the1986­2012 period of liberalization which was unequallysuccessful in the different EU countries. We focus onFrance, Germany, United Kingdom, Spain and Italy, sincethese five countries represent 65% of EU27 powergeneration.Review of dominant economic theoriesThe dominant economic theory after war, the one thatwill be used to help investment choices is theCost–Benefit analysis issued from the Welfare Economicstheories founded in the 1930s and 1940s by Hicks [1],Pigou [2], Samuelson and Allais. In the early fifties, thistheory is diffused in France by Massé [3], and Boiteux [4] [5].The application of these theories to electricity investment[1] starts off with demand analysis and with thecomparison between different production alternatives(hydropower and thermal power plants at the time).

Figure 1 : Historical landmarksThe first optimization model is built in 1955: according toP. Massé, the electricity industry has found an objectivetool to make investment decisions [6]. This theory leadsstate choices about electricity investments mostly inFrance but also in other European countries. It remainsthe dominant current until the start of the liberalizationprocess in 1986, though it already starts being questionedin the 1960s. Effectively, after the Suez crisis in 1956 [7],works of economists start to show some of the lacks in theCosts/Benefits analysis: it does not properly include risksand in particular exogenous risks, like the risk on fuelsupply [8][1]. In Pierre Massé’s calculation electricityinvestments [1], the main risks are identified, but notintegrated to the modeling, or only in a very limited way.Economic theories have though emerged on the subject:Von Neumann, Morgenstern and Savage in the 40s and50s address the issues of the risk on decision makers’rationality; Weisbrod, Arrow and Henry in the 60s and70s complete these works by addressing the issue ofpublic decisions in uncertain environment.

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At the same time, the efficiency of the integrated modelaccompanying the Costs/Benefits analysis also starts tobe questioned by economists: negative effects areidentified on both the firms’ side and the regulator’s side :a tendency to over­capitalize (Averch Johnson effect [9]), alack of incentives for efficiency since there is nocompetition (Leiberstein [10]). On the regulator’s side, therelationship with the firms may result in having theregulator protecting the firms’ interest rather than generalinterest, as shown in Buchanan, Stiglitz and Peltzman’sworks. This reflection is pursued in the 1970s by Kahn,Baumol, and Sharkey who ask themselves what a naturalmonopoly is. Their works show that in a grid sector suchas electricity, the natural monopoly does not concern thewhole sector but mainly one activity, this is to say, thegrid management. Competition can thus be introducedon the activities of the sector suitable for it, likeproduction and distribution, and would be beneficial forconsumers. The works of Laffont and Tirole in the 1990s[11] show that monopolistic firms have an asymmetricalinformation relationship with the regulators. Theirinterest is thus to take advantage of this situation toincrease their revenue.These new currents will eventuallylead to liberalization in Europe. Some countries havingalready experienced the process successfully such as theUK in Europe, the liberal theory will be legitimized by aconcrete example.

Figure 2 : Overview of Economic TheoriesIn the end, what comes out of these observations is thatthe two identified drivers for electricity investments are :­ The state policy, supposed to follow economic theory­ The availability of resources based on their price.From 1945 to 1986 : Post­war reconstruction and oilshocksIn a post­war Europe, the first objective of the electricitysector in every country is to build enough generationfacilities to supply the whole country as soon as possible.In order to achieve this goal quickly, states increase their

control on the electricity industry. Nationalization is theanswer in France (1946), in UK (1947), and in Italy (1946),where the whole electricity sector becomes a statemonopoly and where the state has direct control onpricing and technology choices. Germany and Spain haveno state monopolies and no centralized planning [12], [13]but their electricity industry still corresponds to anintegrated model. In Germany, the electricity industrykeeps its structure of local and regional firms, because ofGermany’s particularity to have a federal state withpowerful Länder, but very integrated on both verticaland horizontal scales due to numerous exclusivitycontracts. The electricity industry is not submitted tocompetition and prices are indirectly regulatedby the1935 law on Energy. Technology choices are adopted at afederal level “Energiemix”. In Spain, the electricity sectorintegration happens via the coordination of privatecompanies promoted by themselves [13] : 18 electricitycompanies decide to create UNESA, Asociación Españolade la Industria Eléctrica in 1944, in order to promote a“real national electricity system” [14] through thedevelopment of interconnections, which allows bettersupply. The government also controls prices through the“Unified limited rates” system established in 1951,Whether they are national companies or not, the state hasundoubtedly control on these industries: if not nationalcompanies, the state influences the entrants on the marketand price regulation and is involved in investmentschoices to answer demand. In a context of post­warindustrialization, this model seems to be the mosteffective [12].In the fifties and sixties, cheap oil coming from importsthreatens domestic coal production in Europe. Domesticproducers ask thus for protection against oil importsarguing the risks they represent: risks on the productionof oil, on the transport of oil (the Suez Crisis in 1956 is agood example), and on the price of oil and also politicalrisk with Middle East producers.In France, choices being dominated by the marginalisteconomists’ reasoning coming from the Cost­Benefitanalysis, coal production is reduced in favor of oilimports and EDF has no obligation to burn more coalthan it wants to. (French pragmatism is still distortedwith the seek for “pétrole franc”, which make them buyAlgerian oil more expensive that Middle East oil.)Contrary to France, the UK and Germany take measuresto protect domestic coal production. In the UK, thegovernment establishes a tax or ban for oil imports thatcould substitute themselves to coal [7], measures that weredetrimental to fuel users and thus to consumers.In 1973 and 1979 occur the two oil shocks that will launchthe start of a transition period. The huge increase of fossilfuel prices involves a large shift in the electricity pricing,for instance in France. It is not possible anymore to set theprices at the marginal cost of the last used plant (oftenfossile fuel fired plants). The rent of existing plant (suchas hydro or nuclear) would be too large, involving huge

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benefits of electric utilities. Thus, the prices was more orless rescaled by the the total cost of energy, and thebenefit of electric utilites remained almost stable. So, thesituation forced the real practice to escape from thedominant theory. In reaction to high oil prices, allcountries also take measures to reduce their dependencyto oil, such as UK exploring North Sea for new resources.As a predictable effect, firms return to coal use, andconfirm their interest in developing nuclear programs.The success of these programs depends on how nationaleconomies and firms have resisted the oil shocks, howthey manage their nuclear development strategy andindustry development, and also on public acceptance. InFrance, the high cash­flows generated by EDF allow tolimit the impact of high oil prices on consumers bylowering EDF’s prices [15]. They also allow EDF tomanage low cost financing for the building of its nuclearfleet. As for the choice of nuclear technology, EDF hasalready chosen in 1969 to go with American PressurizedWater Reactors (Westinghouse license) rather than FrenchGraphite Gas Reactors developed in the Commissariat àl’Energie Atomique, for economic reasons; the nuclearprogram (“Plan Mesmer”) is launched in 1974. In the UK,the approach is the opposite: Advanced Gas­cooledReactor being researched nationally, it is the one chosenfor the nuclear program [12].The program is yet abandonedin the mid­1980s due to a lack of economiccompetitiveness.Another program based on Westinghouse PWRtechnologies is launched in 1982 but will be abandonedafter only one reactor in 1988 (Sizewell B). In Germany,the technologies chosen by the firms are PressurizedWater and Boiling Water technologies. Nuclear energyexperiences a fast development in Germany, but alsocontroversies from the beginning. In Italy only fourreactors are built, and in Spain, five between 1980 and1986.We have seen that criticism towards monopoles andintegrated models had started to emerge in economists’works in the 1960s and 1970s. The questioning of theintegrated model starts to spread after the oil shocks. Thecosts of overcapitalization, as well as the expensive stocksconstituted after oil shocks revealing to be unnecessarywhen counter shocks come, are supported by thecustomers.More generally, it becomes clear that political preferencesprotecting inefficient domestic industries and denyingconsumers cheaper electricityis questionable. Besides, thequestion of public acceptance of technologies becomesmore and more important. Local and environmentalopposition first focus on coal, demanding that coal plantswould be outside of cities, but soon include nuclear aswell.Moreover, the apparition of a new gas technology CCGTallowed building facilities smaller than coal or nuclearplant but with high profitability; besides, the end of cold

war opens access to Russian gas. Competition onelectricity market seems thus viable for producers withmoderate investments and cheap gas.

Figure 3 : Overview of 1945­1986 periodAs a result of the analysis, state policy clearly tends tochoose security of supply and local employmentprotection over economic rationality in times of crisis,which is an argument to replace state­controlledintegrated sector by liberalized market. Beyond resourceavailability, the mastering technological know­howshould be considered for technology choices. In times likethis, the availability of the resource or technologybecomes crucial and its effects exceed state policy’seffects. Lastly, there is an additional driver that statepolicy should take into account which is publicacceptance.1986­2012 : The liberalization processAs a result of the political construction of the EuropeanUnion after World War II, different EuropeanCommunities for trade and economic solidarity arecreated over the years, leading to the Single European Actin 1986 and the creation of a unique European electricitymarket with the 1996 Directive on common rules for theinternal market in electricity.European market integration has two goals : offer cheaperelectricity to the consumer thanks to competition andenlarge the resources perimeter for better systemoptimization [12]. Each member country can choose itstools to achieve the following tasks: open the market tonew entrants, stop controlling prices, and create anindependent regulator for each activity submitted tocompetition [17], [18]. Given the heterogeneity ofinstitutions, markets, industries in European countries,and given the flexibility of European CommissionDirectives, the results are quite heterogeneous.

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Figure 4 : HHI per country [12]

The UK is the model for the European Market Reformsince it is chronologically the first European country toliberalize its electricity market [19]. The result of the reformcan be assessed using the market concentration indexHHI1 , since market concentration is often used toevaluate competition. According to the EuropeanCommission Guidelines about competition, a market inwhich HHI is lower than 1000 is competitive and lowconcentrated whereas a market in which HHI is in excessof 2000 is highly concentrated and thus not competitive.Today the UK market is really competitive with an HHIequal to 901 [12].This can be explained by an institutional approach. Toachieve efficient liberalization, a certain institutionalconfiguration seems to be more favorable [19] :­ In the industrial sector: completely integrated andnational firms so that the changes (transfer properties,changes in horizontal and vertical integration) would beeasier to perform than on multiple private companies­ In the institutional environment: a unitary state withgovernment having strong influence on legislation, ratherthan a federal state that would be much slower to takedecisions affecting the whole country.This ideal institutional combination corresponds exactlyto the profile of the UK before liberalization: CEGB is anintegrated national firm and the institutionalenvironment consists in a unitary state with stronggovernment. There from, the reform can be carried on inthe whole country with the minimum of hurdles.The countries with the institutional configuration theclosest to the UK’s one before the reform are France andItaly (Glachant [19][18]). Germany, with private companiesand federal state, has the exact opposite configuration.Spain’s case is intermediate between Italy and Germany:the electricity industry is state property but nothorizontally integrated and partly vertically integrated.As the resemblance between institutional configurationscould let think, Italy’s market reform has given visibleresults. The Italian state was favorable to the reform andhas limited market shares for historical operators and

transferred property by making them sell part of theirassets. The HHI of the Italian market is now 1351 [12],which, among the 4 countries, it is the lowest. Germany’sattitude towards liberalization seems favorable, but inreality the reform has reinforced state control on electricyoperators, who used to auto­regulate themselves. Themarket is still very concentrated with an HHI equal to2008 [12]. The relative failure of market reform in Germanycan thus be attributed partly to the institutionaldifferences, the reform increasing state control in anunintended way, and state policy protecting domesticproduction. Spain has adopted an attitude similar toGermany’s: state control on prices and protection ofhistorical operators (Endesa and Iberdrola) still continue.HHI is equal to 1716, which describes to a moderatelyconcentrated market. France, which has the sameinstitutional profile as the UK before the reform, isparadoxically the country where the liberalization wasthe less successful. There is still only one main operatorvery promoted by state policy and HHI is equal to 7000which is very concentrated. This phenomenon could beexplained with the previous historical analysis: the pastrationality in investment choices and the economicsuccess of these choices allowed France to avoid some ofthe mistakes of integrated models (no protection on non­competitive coal, change of tariff after oil shock, successof nuclear power thanks to the choice of the mostprofitable technology), contrary to the UK, where aregalian management lacking economic rationality fedthe need for rational management by the market. Thisexplains the reluctance to abandon a successful model inFrance.We can thus conclude that on the one hand, Europeancountries’ institutional constitution is not necessarilycompatible with an efficient market reform, as it is thecase for Germany and Spain. This first conclusion isconsistent with other analysis such as Newbery’s [20],who argues that European countries lack the necessarylegislative and regulatory power to mitigate generatormarket power. On the other hand, our analysis showsthat institutional configuration is only a necessarycondition but not a sufficient one to achieve liberalizedmarket, another necessary condition being politicalsupport to the reform at the national level, as the Frenchcase shows.As a result from the liberalization process, a new driverappears: it is market structure. It lessens the reach of statepolicy and makes the use of Costs/Benefits Analysis farless relevant since decentralized decision making can bevery difficult to coordinate. It is thus interesting to noticethat after promoting liberalization, the UK now comesback to forms of stronger state policy in order tocoordinate investments, with recent developments ofnuclear policy.Parallel to the liberalization process, environmentalconcerns have grown from the end of the eighties withthe creation of the Intergovernmental Panel on ClimateChange (IPCC) in 1988 and the signature of the KyotoProtocol in 1997. Regarding our analysis, it induces that

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the focus of the state policy driver has thus evolved fromthe protection of local coal and employment to thereductions of CO2 emissions and promotion ofrenewables. One consequence is that the recent rise ofrenewables (wind and solar) induces strong difficulties tofind a unified theory allowing for optimal pricing andinvestments. [21].

Figure 5 : Overview of 1986 ­ 2012 periodConclusionThrough this historical analysis we have identified thedrivers for electricity investment and their evolution from1945 up to now :­ The state policy, which can follow economic theory orpriviledge political issue such as security of supply orenvironment­ The availability of the resource or technology taking intoaccount the local character of the resource, its price, theknow­how it requires.­ The market structure driver, as a result from theliberalization process. It can lessen the reach of statepolicy and thus makes investment coordination muchmore difficult.­ There is an additional driver “public acceptance” that isnot to be neglected given the influence it can have onstate policy.Let us add that with the increasing importance ofenvironmental issues, the past models are not sufficientanymore. First, policy incentives (carbon tax, feed­intariffs or green certificates for renewable) distort the datafor such models based on costs; second, there is no modelthat can define prices and companies’s revenue withoutcoordinate investmentsergy choices (for instance inGermany or UK today) and thus of the state policy driver.1 HHI definition, with si the market share of firm i in the market, and N the

number of firms :

The more HHI is low, the less the market is concentrated, and the more HHI

is high, the more the market is concentrated.

Références[1] J. Hicks, "The Foundations of Welfare Economics", EconomicJournal, 1939[2] A. C. Pigou, The Economics of Welfare, Macmillan and Co,1920[3] P. Massé, “Les investissements électriques”, Revue destatistique appliquée. Tome 1, N° 3­4, pp. 119­129, 1953[4] M. Boiteux, On the management of Public MonopoliesSubject to Budgetary Constraints”, Journal of Economic TheoryN°3, pp. 219­240, 1971[5] M. Boiteux “Sur la gestion des monopoles publics atteints àl’équilibre budgétaire », Econometrica 1956[6] A. Beltran M. Bungener, “Itinéraire d'un ingénieur,"Vingtième Siècle. Revue d'histoire. N°15, pp. 59­68, July­Sept.1987[7] M. Chick, Electricity and Energy Policy in Britain, Franceand the United States since 1945, Edward Elgar Publishing, 2007[8] L. Denant­Boèmont, C. Raux, « Vers un renouveau desméthodes du calcul économique public ? », Métropolis N°106­107, Evaluer et décider dans les transports, pp 31­38. 1998[9] H. Averch and L. Johnson, “Behavior of the Firm underRegulatory Constraints”, Americain Economic Review, N°52,pp. 1052­1069, 1962[10] H. Leibenstain, “Allocative Efficiency and X­Efficicency”.The American Economic Review, N°56, pp. 392­415, 1966[11] J.­J. Laffont, J. Tirole, A theory of Incentives in Procurementand Regulation, MIT Press, 1993[12] E. Grand, and T. Veyrenc, L'Europe de l‘électricité et du gaz,Editions Economica, Paris (2011.[13] D. Ibeas, “Review of the History of the electric supply inSpain from the beginning up to now”, Proyecto fin de carrera,Supervisors: Prof. Dr.D.Arlt. Prof.Dr.R.Zeise UniversidadCarlos III de Madrid, Fachhochschule Düsseldorf, 2011[14] UNESA Website, Historia, on line:[http://www.unesa.es/que­es­unesa/historia], consulted in2013[15] M. Francony, “Theory and practice of the marginal costpricing : the experience of “Electricité de France” Annals ofPublic and Cooperative Economic,s Volume 50, Issue 3, pp.9–36, July 1979[16] European Commission, Directive 96/92/CE, Journal officiel,N° L 027 du 30/01/1997 pp. 0020 ­ 0029[17] D. Newberry “Privatisation and liberalisation of networkutilities”, European Economic Review N°41 pp. 357­383v, 1997[18] Perrot Anne. Les frontières entre régulation sectorielle etpolitique de la concurrence. In: Revue française d'économie.Volume 16 N°4, PP. 81­112, 2002[19] J.­M. Glachant, “Les pays d'Europe peuvent­ils reproduire laréforme électrique de l'Angleterre ? Une analyse institutionnellecomparative », Économie & prévision. N°145, pp. 157­168, 2000.[20] D. Newbery, « European Deregulation. Problems ofliberalizing the electricity industry”. European EconomicReview N°46 pp.919 – 927, 2002[21] OECD­NEA, “The interaction of Nuclear Energy andRenewable: System Effects in Low Carbon Electricity System”,2012

Cet article a été co-écrit avec Jean-Guy Devezeaux de Lavergne (I-tésé) et

Danièle Attias (ECP) et présenté à la conférence European Electricity

Markets EEM 13 à Stotckholm le 29 mai 2013