Regulation of access to Hydro and Lignite energy in Greece

Transcription

1 Report for PPC Regulation of access to Hydro and Lignite energy in Greece FTI CL Energy 29 September 2014 Final

2 Table of contents Section 1 Executive summary 2 A Introduction 2 B Description of the mechanism 3 C Summary of our analysis and conclusions 4 D Recommendations 5 Section 2 Introduction 7 A Background 7 B Objective of this report 8 C Structure of the report 8 Section 3 Analysis of the general principles of the mechanism proposed by RAE 9 A Introduction 9 B General principles of the proposed mechanism 9 C Analysis of the parameters related to volumes 11 D Analysis of the price formation mechanism 14 E Assessment of the general principles of the design 20 F Conclusion of this section 22 Section 4 Analysis of the specific features of the mechanism proposed by RAE 23 A Introduction 23 B Description of the specific rules of the mechanism 23 C Analysis of the effect generated by these specific rules 27 D Assessment of the specific rules 33 E Conclusion of this section 35 Section 5 Recommendations 36 1

3 Section 1 Executive summary A Introduction 1.1 Despite opening up the power market to competition, PPC remains the main supplier for most Greek consumers, whether they are individuals or companies. Therefore, Greek authorities are considering ways to stimulate competition and to create a favourable environment for alternative suppliers to enter. These measures encompass the creation of small PPC, by separating and privatising of 30% of PPC, and the introduction of a regulatory mechanism, which allows independent retail suppliers to access the base-load lignite and hydro energy from PPC. The regulatory mechanism is often presented as similar to the mechanism implemented in France under the loi NOME, which aims to regulate the access to the historical nuclear energy (ARENH) from EDF. 1.2 After the first consultation in spring 2014, the regulator has requested consultation for a revised proposal, which is based on an auction mechanism to allocate base-load products to PPC s competitors. 1 The purpose of the mechanism is: to create suitable conditions for the development of effective and fair competition, especially for the retail market; and to provide adequate tools and means for alternative suppliers to manage risk in the market and to develop stable business plans. 1.3 PPC requested our external advice and expertise to evaluate the proposed measure submitted for consultation by RAE. In this report, we have analysed the details of the proposed mechanism, looking first at the high level design, and then at the specific rules envisaged by the regulator. 1.4 Based on our understanding of the objectives of the regulator, we have assessed the proposed regulatory mechanism against four main criteria: Development of competition; Impact on end consumers; Valuation of PPC; and Legal / EU compatibility. 1 the initial response date was 15 September 2014, but a 15-day delay was granted. 2

4 B Description of the mechanism 1.5 According to the proposal, the proposed mechanism will be launched in a three phase process where the degree of regulatory intervention is decreasing in each new phase. Once retail competition has developed, the regulatory intervention will be gradually eliminated. 1.6 The first phase creates forward products dedicated to independent retailer suppliers. These products correspond to a fraction of lignite and hydro production (around 30-35%) and their access are conditional to the size of each supplier s consumer portfolio. They will be allocated through regulated auctions, in which PPC will not be allowed to participate as a buyer. RAE suggests setting a minimum starting price at the auctions, but there has been so far no information either on its value or in the methodology to calculate it. 1.7 The rights of use are based on the customers load during off-peak hours. This aims to give alternative suppliers access to base-load generation, which is assumed to be cheaper, and to allow alternative suppliers to provide competitive retail offers to end consumers. The process to acquire and use the products is envisaged as follows: Auctions for yearly and quarterly products are organised around 5-6 weeks before the start of product delivery. Settlement price in the auction is based on pay-as-bid. Participants acquiring products must provide a cash deposit corresponding to 1% of the total value. 15 days before each month, the rights to use the products for this month are calculated for each supplier based on the consumption of their customers during the same month of the previous year. The products may be transferred until 14 days before delivery to other eligible suppliers. Alternative suppliers may also keep the rights to sell back on the market or to PPC, who is obliged to accept the resale. 10 days before delivery, suppliers must nominate the products for the next month. They must pay 50% of the corresponding value. Actual price paid by the alternative suppliers is different from the auction settlement price. A price differentiation is calculated depending on the category of consumers served by the supplier: for instance, the price for high voltage consumers is 30% less than the auction price, whereas the price for residential consumers is 30% higher than the auction price. Volumes of the acquired rights will be controlled ex-post and are based on real consumption of consumers. Excess of volumes must be returned to PPC. A penalty, based on the 1% cash deposit, is applied only for excess volumes above a margin of 15% for consumers with hourly meters, and above 30% for consumers without hourly meters. 3

5 C Summary of our analysis and conclusions 1.8 The mechanism envisaged by RAE in the latest public consultation presents several advantages compared to other options that were put forward previously. In particular, we consider that an auction-based mechanism may likely reveal the value of the base-load products for alternative suppliers if its parameters are adequately defined. Thus, it may pave the way for the establishment of a competitive forward market, helpful for the development of new suppliers in the retail market. 1.9 In performing the analysis we were often confronted by the lack of clarity or details on how the regulator expects certain features of the mechanism to be defined or to work. As a consequence, significant uncertainty remains on key implementation issues, aside from the questions and concerns raised in the report Nevertheless, the analysis shows concerns both with regard to the general design and main features of the mechanism, as well as to the specific details that create adverse incentives. These concerns are listed below: The disequilibrium between volumes that are auctioned off and volumes alternative suppliers are eligible for is unlikely to create a competitive environment and to reveal a price reflecting the value of base-load product for alternative suppliers: indeed, the regulator intends to oblige PPC to sell up to 1,200MW during the auctions, whereas, during the first auctions, the demand of alternative suppliers will likely be limited (~50MW), so the price will likely be set at the auction starting price; This disequilibrium strengthens the importance of correctly setting the auction starting price; however, there is a lack of transparency on the methodology envisaged by RAE to define the auction starting price; uncertainty around the starting price definition may undermine the ability of the mechanism to create a competitive environment in the long term; If the starting price is set too low and does not fully cover PPC s costs, it will raise concerns with regard to the valuation of PPC; the latter point could constitute a major issue in the short term, with the project to privatise 30% of PPC; undermining the value of PPC will have impacts on the Greek national budget. The penalty regime is unlikely to avoid freeriding and misuse of the mechanism, and to incentivise participants to properly take into account the eligible rights in the auction, and not only in the monthly right nomination process; indeed, the financial penalty seems very low (based on the 1%-deposit, applied only above a 15 to 30% tolerance margin); it applies only to the accuracy of the nomination of the product, so suppliers may try to acquire as much product at the auction as possible without risking penalty, as long as they nominate them according to the actual consumption of their customers; 4

6 Price differentiation between categories of consumers is not justified and should be amended, because it creates undue discrimination between categories of consumers: indeed, for the same products, high voltage consumers would pay 70% of the auction price, whereas low voltage consumers would pay 130% of the auction price; it would distort the price signals sent to consumers and it may also prevent the long term establishment of a sound and effective competition, and thereby increase cost for consumers in the long run The assessment is summarised in the table below: Table 1: Assessment of the mechanism against the four criteria Criteria Evaluation Problem raised Development of competition +/- Impact on end consumers +/- Valuation of PPC -- Legal / EU compatibility -- + Favourable to new entry BUT - Pay-as-Bid is not optimal - Freeriding/misuse due to penalty regime - Does not prepare for a long-term competition environment + Favourable to customers of new entrants in the short term BUT - Unjustified price discrimination - Does not prepare for long-term competition environment - Likely to increase costs for PPC, and therefore retail prices for end consumers - Starting price may have a significant negative impact on PPC s value and may oblige PPC to sell at loss - Financial risk linked to freeriding and too low penalty regime - Consequences on privatisation of small PPC and on national budget - Risk of obliging PPC to sell at loss - Risk of creating discrimination towards other generators - Unjustified price discrimination D Recommendations 1.12 Our analysis provides a few suggestions to improve the design of the mechanism and to address more effectively the objectives of the regulatory intervention: Prepare the transition to a competitive market without regulatory intervention. There is a risk that the mechanism would induce a self-sustained need for regulatory intervention because the low starting price for base-load energy may create windfall profits for new entrants, making the economic profitability of the alternative suppliers dependent on the regulated level of this price. To avoid this situation, one should ensure that the mechanism specifies in advance the expected duration of the mechanism and the process to phase out regulatory intervention in more details. 5

7 Define parameters of the mechanism so that the auction reveals a market price. We would recommend reducing the volumes to be auctioned so that supply and demand can cross at a competitive price: in particular, we would recommend not including hydro in the definition of the product and the volumes, as hydro is not base-load generation. Also, the rationale for pay-as-bid should be explained. Alternatively, a pay-as-cleared mechanism should be used. Establish a transparent methodology to set the auction starting price. This may be accomplished by a) Defining sound principles to establish the starting price, including the full cost recovery and the right incentives for PPC to maintain and upgrade the base-load power plants; b) Setting out a clear and transparent methodology to establish the starting price, specifying the assumptions, the process and the frequency of updates; and c) Consulting upon this methodology with stakeholders. Implement a penalty regime that gives adequate incentives for bidders. The details of the penalty regime should be clarified. The penalty regime should be set in a way to effectively prevent free-riding and receiving windfall profits from gaming the mechanism without imposing excessive burden. Align the mechanism with ongoing regulatory reforms. Interaction with other ongoing market / regulatory reforms, such as the creation of small PPC or the reform of the capacity mechanism should be analysed and properly taken into account in the design of the RAE mechanism. 6

8 Section 2 Introduction A Background 2.1 The Greek power market is under gradual liberalisation since Over the past years, competition has developed on the generation side. Independent power producers (IPPs) entered through the construction of combined-cycle gas turbines (CCGTs) and renewable energy sources (RES) power plants. At the same time, base-load lignite and hydro assets have remained under control of the historical operator PPC, since for various reasons, third parties have not built new lignite and large hydro power plants. 2.2 In contrast, the retail market has remained highly concentrated. Although alternative suppliers have gained market shares in small and medium commercial customer segments by 2012, the crisis and recent bankruptcies of alternative suppliers have increased PPC s market share in the retail market to over 98% in Greek authorities, primarily the energy regulator RAE, are considering options to stimulate competition and to create a favourable environment for the entry of alternative suppliers. In particular, RAE envisages introducing a regulatory mechanism allowing independent retail suppliers access to base-load lignite and hydro energy from PPC. This mechanism is similar to the access to historical nuclear energy (ARENH) in France under the loi NOME On 30 May 2014, the regulator, RAE, put forward for consultation a first proposal, including different options on how to regulate existing hydro and lignite assets. In this report we refer to the regulatory mechanism proposed by RAE as the RAE mechanism. In this mechanism, access is provided through forward auctions, where a fixed starting price or a range of minimum/maximum prices is defined. These auctions would allow third parties to gain access to lignite and hydro electricity production. Only electricity retail suppliers other than PPC are eligible to participate in these auctions. The NOME-type auctions are planned to be used as a transitional mechanism for a limited period of time, until the privatisation of 30% of PPC s mining, generation and supply business ( Small PPC ) is completed A new consultation was launched in August 2014, and responses from stakeholders are expected on 29 September RAE, Τελικές προτάσεις της Ρυθμιστικής Αρχής Ενέργειας για την αναδιοργάνωση της εγχωριας αγοράς ενέργειας, November 2012 Energia.gr, Ζήτημα Ημερών η Ανακοίνωση Από τη ΡΑΕ για το ΝΟΜΕ, as assessed on the initial response date was 15 September 2014, but a 15-day delay was granted. 7

9 B Objective of this report 2.6 In this report we assess the design of the regulatory mechanism proposed by RAE. We first review the high level design choices, and then consider the available technical details of the mechanism functioning. We assess various elements of the RAE mechanism according to their expected impact on: Development of retail competition; Impact on end consumers; Valuation of PPC; and Legal / EU compatibility. 2.7 We conclude that a number of crucial parameters of the mechanism proposed by RAE are not defined in sufficient details. Depending on how these parameters are set, the mechanism proposed by RAE could be more or less efficient in meeting its objectives and could create more or less distortions. C Structure of the report 2.8 The rest of the report is structured as follows: Section 3 analyses the high level design of the mechanism proposed by RAE; Section 4 analyses the detailed rules of the mechanism proposed by RAE; Section 5 summarises our findings and presents preliminary recommendations on the mechanism to regulate access to lignite and hydro assets for Greece. 8

10 Section 3 Analysis of the general principles of the mechanism proposed by RAE A Introduction 3.1 In the consultation document, RAE describes the high level design of the mechanism (hereafter RAE mechanism ). In this section we analyse the general design of the mechanism proposed by RAE: First, we describe the high level functioning of the proposed mechanism; Second, we define the criteria for mechanism assessment based on the general principles of the mechanism; Third, we analyse the high-level parameters related to volumes and price formation; Finally, based on these analyses, we assess the mechanism based on the defined criteria. B General principles of the proposed mechanism Context 3.2 RAE s proposal aims at ensuring competition development in the electricity retail market. The objective of the mechanism is to also provide a stable signal to investors and to be a tool that facilitates hedging and improves risk management. 3.3 The RAE mechanism will be launched in a three phase process where the degree of regulatory intervention is decreasing at each phase. Once competition improves, RAE plans to gradually lift the regulatory intervention. The first phase creates forward products sold by the historical operator (PPC) to independent retail suppliers. In the second phase (Phase B), similar products or other equivalent mechanisms may be used to restrict the market power of lignite and hydro producers. The form of these products has not been described yet but the amount of regulatory intervention is supposed to decrease. 9

11 In the final phase, regulatory intervention of phase B will be removed and according to the competition developed in the market, several alternative additional measures may still be necessary. 3.4 Among the descriptions of the three phases RAE has provided, the first phase of the mechanism is the most detailed. In this report we mostly focus on the first phase. Product definition 3.5 The forward products envisaged by RAE in the first phase correspond to a share of lignite and hydro production. The retail suppliers access to these products will be conditional on the size of each provider s customer portfolio. The rights of use will be based on the customer s load in the off-peak hours. The aim of the mechanism is to give alternative suppliers access to the low-cost base-load generation and to allow them to provide competitive retail offers to end consumers. 3.6 The forward products proposed in the first phase of RAE mechanism are virtual and do not correspond to the actual operation of lignite and hydroelectric plants. PPC will continue to integrate their units into their bids submitted into the pool, but it will be forced to accept the financial transactions associated to the RAE mechanism. It means that the contractual obligations apply regardless of the technology used to produce energy. The allocation process through auctions 3.7 Forwards products will be allocated through regulated auctions. The right to participate will be granted to licensed holders who are registered as participants of the trading system. In practice, this means that only the alternative retail suppliers will be allowed to participate. PPC will not be able to participate in the auctions as a buyer, but it will be bound by the seller s obligations at the conditions determined by the auction outcomes. The auction will be constrained by a starting price fixed by RAE. 3.8 Neither the starting price nor the methodology to calculate it have yet been published and it is not known if the starting price will be sensitive to the lignite cost or will vary with the season. The supply volume of forward products 3.9 RAE mentions that the financial products to be auctioned will represent between 30% and 35% of total annual lignite and hydro production. For the first year, the allocated volume of forward products will correspond to approximately 1200 MWh/h. The overall volume will be split between one year products and quarterly products in proportion 2: RAE plans to monitor the effectiveness of the volume allocation on an annual basis and to revise the allocated volume if necessary. 10

12 C Analysis of the parameters related to volumes 3.11 We analyse the expected consequences of the RAE mechanism on the electricity market, especially on the retail market. Below we present our analyses on two aspects of the volume element of the RAE mechanism: Target volumes exceed target volumes of the comparable mechanisms; and Target volumes are inconsistent with the sales of alternative suppliers. Target volumes exceed target volumes of the comparable mechanisms 3.12 The RAE s proposal envisages to allocate forward products up to 30-35% of the total hydro and lignite production. This amount seems quite high, especially if we compare it with previous similar French mechanisms. The Virtual Power Plant (VPP) mechanism 5 implemented in France between 2001 and 2011 concerned between 8% and 9% of the total nuclear production (the methodology to calculate these figures is explained in the text box below). The ARENH mechanism, 6 which was devoted to the redistribution of the nuclear benefits, was also set a lower percentage (around 25%) According to these comparisons, the target volume envisaged in the RAE s proposal appears high, especially taking into account the concurrent measures of promoting competition, such as the plans of splitting PPC activities and the creation of small PPC. 5 6 A VPP is a commitment (voluntary or requested by authorities) of a dominant generator to sell the rights of using its plants to its competitors. Implemented in 2011 after the end of VPPs 11

13 Methodology of the proportion calculation in VPP and ARENH mechanisms We compare the RAE proportion of lignite and hydro generation allocated through auctioning with the share of nuclear (and peak units) involved in French mechanisms (VPPs and ARENH). With the VPP mechanism, EDF committed to sell 5,400MW (4,400MW of base load option and 1,000MW as peak load option) of generation capacity located in France through virtual power plant s auctions from 2001 to We used the ratio (1) to compute the proportion of nuclear energy concerned by the mechanism; ratio (2) includes hydro generation, corresponding to a proxy of peak load generation for peak load option: According to the French TSO data, nuclear and hydro production was 421TWh and 50 TWh in 2011, respectively. We found then that proportion of nuclear (and hydro) generation concerned by the VPP was between 9.15% (1) and 8.8% (2). The calculation of nuclear proportion concerned by the ARENH mechanism is more straightforward. A maximum of 100 TWh may be allocated to alternative suppliers. In 2011, this represented 23.7% of the annual nuclear production Furthermore, the definition of actual product volumes to be auctioned exceeds the 30-35% target: The proposed volume of forwards products is set at 1,200MW. It is a base-load product. So this represents a total volume of 10.5TWh. In 2013, lignite and hydro generation represented 53% of the total production and hydro and lignite power plants produced 5.6TWh and 23.2TWh respectively. The 1,200MW would represent 36.5% of the total hydro and lignite production. According to PPC s data, this percentage would actually rise to 38% looking at the past 12 months (September 2013 August 2014) The amount of forward products proposed by RAE is hence higher than the target range (between 30% and 35% of the total annual hydro and lignite production). To comply with the range of 30-35% the amount of forward products should decrease down to between 985-1,150MW It is worth mentioning that many lignite-fired plants operate at technical minimum at off-peak hours. As a result, according to PPC s estimations, 1200 MWh/h are approximatively 50% of lignite and hydro production during off-peak hours. 12

14 3.17 In addition, RAE includes hydro power to define a base-load product, whereas hydro power is not a base-load generation type and is used at peaks mainly. We would therefore recommend not including it in the volume calculation Excluding hydro from the calculation reduces the volumes to be auctioned by 20%, based on 2013 data. Thus, maximum volumes to be auctioned would be between MW at most. Target volumes are inconsistent with the sales of alternative suppliers 3.19 It is likely that the proposed amount of forward product (1,200MW) would exceed the eligible volumes of alternative suppliers, for which they should be entitled to bid in the RAE mechanism In 2012, based on RAE national report to the European Commission published in December 2013, alternative suppliers held 0.7% of the low voltage market share and 1.1% of the medium voltage market share, and had no customers in the segment of large industries connected to high voltage. The total market share was then around 0.85%. Market share by eligible volume in 2012 (GWh and in %) Supplier Low voltage Medium voltage Large industries Total % PPC 30,458 9,888 6,507 46, % Elpedison Energy % Watt & Volt % Heron % Greek Env&Energy % Volterra % Total IPP % Source: 2013 National Report to the European Commission, RAE 13

15 3.21 Independent suppliers served 407GWh of electricity to their customers in 2012, which corresponds to an average hourly delivery of 46 MWh/h 7. In comparison, the RAE proposes to allocate to independent retailers forward products up to 1,200MWh/h. Even if the entire consumption of alternative suppliers customers was concentrated in off-peak hours, the capacity to be auctioned will be significantly exceed the eligible rights of alternative suppliers This approach relies on the assumption that customers of alternative suppliers have flat load profile. This is obviously not conform to reality, however, different effects may counterbalance each other: Most of the consumers have higher demand during peak hours (not all of them, for instance the load profile of public lighting is the exact opposite of the regular load profile). So a flat-load approach overestimates rights for suppliers. In contrast, it is possible that we underestimate the eligible volumes since RAE rights are based on the maximum monthly consumption while capacity auction is annual 3.23 Nonetheless, even if our results might be sensitive to the methodology, a huge gap appears between RAE target (1,200MW) and the potential eligible volumes (~50MW) and will exist in practice in the short-term at least Although it is clear that the RAE mechanism is intended to improve the retail competition and to allow the alternative suppliers to gain market shares in the medium term, the volumes currently planned for allocation appear excessive as compared to the potential demand for the forward products in the short term. D Analysis of the price formation mechanism Price formation mechanism 3.25 RAE proposes to allocate forward products through auctions. The use of an auction system enables in theory to reveal the actual value of a product and to efficiently select buyers who value the product the most. The RAE mechanism should therefore be efficient in providing alternative suppliers access to lignite and hydro power However, a number of parameters set by RAE may distort the efficiency of the process, because of various constraints set on the ways sellers and buyers can participate and bid in the auction. 7 To compare the amount of capacity to be auctioned proposed by RAE (1,200MW) with the potential eligible volumes for alternative suppliers, we used the following approach: the eligible volume for alternative suppliers is computed based on their previous market shares. In 2012, they have supplied around 400GWh to end user customers. We obtain the average hourly demand of alternative suppliers for forward products by dividing their total output by the number of hours in one year (8,760). 14

16 3.27 The volume of the regulated products will be fixed in advance by RAE, which results in a vertical supply curve. RAE also sets a starting price, which should avoid extremely low prices that would not cover costs of PPC to produce the corresponding energy The demand volume is also constrained since the purchase volumes to which alternative suppliers are eligible for are limited by the consumption of the customers they expect to serve in the short run. Therefore, demand curve is also vertical below a certain price level. Above a certain price level, the demand is downward sloping representing alternative sources of procurement of energy (e.g. spot or forward markets) and the associated risks Figure 1 shows the supply and demand in this auction market as well as the resulting equilibrium. In this graph, the price is unique and all the actors are paying or get paid the clearing price found in the equilibrium between the aggregated demand and the aggregated supply. Figure 1: Auction market and price formation with floor price and constrained demand Impact of volume parameters on the price formation 3.30 Since the supply is fixed by RAE and is therefore inflexible, the price formation is sensitive to the eligible volumes. If the maximum eligible volume of the alternative suppliers is higher than the volume set up for the auction volume, the price discovery will work efficiently. On the contrary, if the auctioned volume exceeds the amount of eligible volumes, then the price will be set by the starting price Figure 2 illustrates the price formation in these two situations. 15

17 Figure 2: Price formation according to the supply and demand position 3.32 Given a large gap between auctioned volumes (1,200MW) and the current eligible volumes (~50MW), the auction price will very likely be determined by the starting price and the auction mechanism will have limited impact on the price formation. Setting the starting price correctly becomes extremely crucial. 8 Importance of the starting price definition 3.33 Because of the high volumes to be auctioned, the price is likely to be set at the starting price, at least in the first auctions where the market shares of alternative suppliers are likely to remain small..in this conditions, the starting price becomes the key parameter defining the auction outcome and the auction mechanism becomes equivalent to a regulated price for lignite and hydro power determined at the starting auction price However, RAE has not yet published the details of the methodology it envisages to compute the starting price and on its expected level. It is important to have a public discussion on such methodology led by RAE. 8 This reasoning assumes a pay-as-cleared mechanism (where, a unique clearing price is paid or received by all market participants), but it would still hold under the pay-as-bid mechanism envisaged by RAE (whereby each alternative supplier would have to pay the price he bids), See for instance Baldick R., Single clearing price in electricity markets", University of Texas at Austin, 18 February

18 3.35 In France, where a similar mechanism for a regaled access to the baseload energy was introduced (ARENH), the methodology to calculate the ARENH price was the centre of debates. first at the Parliament when the law was passed, and then when the price was fixed. The price was initially fixed by the Ministry, 9 and now it is now up to the regulator to propose a new methodology. The methodology to compute the price and its parameters can lead to very different results. For instance, it depends on: whether an accounting or economic method is used; what costs are covered, for instance if new investments to maintain and keep up with emission standards, or to prepare replacements are taken into account; or what assumptions about the lifetime of the plants and the cost of capital are taken, etc Table 2 below shows the range of the nuclear cost estimates. Estimates may vary from 32 /MWh to 90 /MWh, depending on the methodology used, as well as on some underlying assumptions. More information regarding the different approaches is available on our report to PPC published in July 2014 about the lessons from the French experiences of regulated access to wholesale base-load energy. Table 2: Historical nuclear cost estimates for the period Methodology Cost of new Nuclear (EPR) Current Economic Cost Includes extension life time investment Current Cost Accounting Champsaur method includes amortized capital and extension of life expectancy investments Consistency with regulated tariffs Principle Compute the cost of newly built sites with the best available technologies Compute a rent paid to use the park rather than build it. It means financing a new building of identical production facilities Especially takes into account the depreciation, remuneration of no depreciated capital and cost increase of replacement Compute the average rent to manage and maintain historic existing nuclear plants in condition until its closing on the period Correspond to the implicit current cost of historic nuclear park taken into account in regulated tariffs 2010/ MWh sources EDF 10 54, Cour des Comptes 11 Cour des Comptes Champsaur commission 12 Champsaur commission Ministries in charge of energy, i.e. Ministère de l économie, des finances et de l industrie et Ministère de l écologie, du développement durable et de l énergie Les coûts de la filière électronucléaire jan 2012 Cour des comptes page 385. Les coûts de la filière électronucléaire jan 2012 Cour des comptes page 283. «Rapport de la commission sur le prix de l accès régulé à l électricité nucléaire historique (ARENH)», March 2011 page

19 3.37 Furthermore, the calculation of the starting price should also take into account the impact of the capacity mechanism: the ongoing reform of the capacity mechanism should integrate the introduction of NOME-type products and its features may have impact on the starting price definition. Effect of the pay-as-bid pricing mechanism 3.38 As mentioned before, RAE proposes to use pay-as-bid auctioning system to price products for alternative suppliers. As opposed to the pay-as-cleared mechanism, in the pay-as-bid pricing system, a successful bidder pays the price it actually bid for the product he has acquired. Therefore, in principle, there should not be a single price for the product In the short term, the choice of a pay-as-bid mechanism has little impact, as one would expect that all suppliers will bid at the starting price. However, the choice of a pay-as-bid mechanism may still raise questions in the longer term when the demand increases above the supply. In such situation, the pay-as-bid mechanism could have unintended consequences having negative impact on the efficiency of allocation and eventually on the development of the retail competition This is because of the bidding incentives created by the pay-as-bid mechanism. In theory, in a market where participants have perfect information and foresight, they should be able to anticipate the lowest price at which the product may be acquired, i.e. the clearing price. Bidders who value the product above the anticipated clearing price would bid as low as possible, while trying to be above this price. However, in practice, it might be difficult to correctly anticipate the clearing price, as the market may not be fully transparent and is evolving rapidly. In addition, the mechanism we are considering is a new mechanism, with heavy regulatory intervention and uncertainty We illustrate the consequences of that on an example below. Figure 3 illustrates the price formation in a market with a pay-as-bid mechanism, in which four participants bid prices P1, P2, P3, P4. As this is the pay-as-bid mechanism, these prices reflect the expectation of each participant of the clearing price rather than their willingness to pay for the product. In this example, the fourth participant bid at a too low price, and will not acquire the product. 18

20 Figure 3: Price formation with a pay-as-bid mechanism 3.42 Thus, the mechanism may lead to different prices for the same product, although all participants may have the same willingness to pay for it. In our case, the bidders are suppliers, who will take into account the price at which they buy their base-load energy to set their retail price. Thus, the pay-as-bid mechanism will create structural differences in the drivers of the pricing of their retail offers for a given period. In our example, the bidder 3 will be able to offer a better retail price than the two other successful bidders 1 and 2, who will have more difficulties then to gain market shares The mechanism may also lead to inefficient outcomes because of the incorrect anticipation of the clearing price. For example, bidder 4 might have the willingness to pay for the product that is similar or higher than other bidders. Nevertheless, he may not receive the product if he underestimates the clearing price because of the imperfect information Consequently, the pay-as-bid pricing may not be the best solution to foster competition in the retail market. We also note that many other auction mechanisms for electricity supply often use the pay-as-cleared mechanism: that is the case in day-ahead market coupling, in VPP auctions in France or in CESUR auctions in Spain 13, which are auctions where Spanish suppliers may buy power to deliver to small consumers at regulated rates, which are used as a benchmark in electricity bills. 13 See Auction rules of the CESUR mechanism, article 2.2 of the Annex 1: 19

21 E Assessment of the general principles of the design 3.45 Below we assess the high level principles of the RAE mechanism against the four key criteria defined above. Based on the analysis earlier in this section, the high level principles of the RAE mechanism have two main consequences: In the short term, before the alternative suppliers gain significant market shares, the expected excess of the supply of auctioned forward products over the demand would result in the price of the auctioned products set at the starting price. This makes the methodology of the starting price extremely important in the short term. In the long term, when the alternative suppliers gain market shares and the auction price increases above the starting price, the pricing mechanism of the RAE mechanism will become important Below we assess the expected performance of the RAE mechanism against the identified criteria in the short-term and in the long-term. Short-term performance of the RAE mechanism 3.47 In the short term, the excess of supply over demand of the products puts major stakes on the definition of the starting price. The starting price should be determined correctly and set a floor that ensures PPC may fully cover its costs, while allowing alternative suppliers to offer competitive retail offers. At this stage, stakeholders clearly lack information and transparency on the methodology that will be used. One may expect that the choice of the starting price will have the following impacts on the economic performance of the mechanism: Development of retail competition. In case the starting price of the product is set too low, this may create conditions for the development of the retail competition in the short term, as new entrants may be able to acquire cheap products and to make competitive retail offers in the first periods of the mechanism operation. Impact on end customers. In the short term, a low starting price in the RAE mechanism may the customers of the alternative suppliers to enjoy a favourable retail price. However, this could be at the detriment of the PPC s end consumers. A low starting price obliging PPC to sell at a loss may make PPC unable to recover its costs at the existing retail tariffs. To maintain its viability, it may have to pass the excess cost onto its remaining customers. Thus, the customers remaining with PPC (because of the inertia of switching, such customers will likely represent a large share) may end up paying higher bills. Valuation of PPC. If the starting price is set too low and does not fully cover PPC costs, PPC will be obliged to sell at a loss, which will jeopardise its value and financial viability. The impact on the valuation of PPC will have a direct impact on the Greek State, as the main shareholder of PPC, through revenues and as it plans to privatise 30% of the company. A loss in PPC revenues will have direct consequences on the national budget and on Greek citizens. 20

22 Legal/EU compatibility. The Commission may have significant concerns if the low starting price results in an obligation for the historical operator to sell at a loss. Such obligation could have consequences on the competition in the electricity wholesale markets. Retail suppliers will prefer purchasing power sold through the RAE mechanism to power produced by other generators and sold in the wholesale market. It could thus undermine the wholesale competition and business cases of existing power plants and new investments. The mechanism may be deemed discriminatory and contradictory to the legislation in force in Greece and EU. Long-term performance of the RAE mechanism 3.48 In the long-term, one may expect that the demand for forward products would sufficiently develop and the auction price would be set above the starting price. This increase in the price of the forward products and the use of pay-as-bid pricing mechanism may have the following consequences on the economic performance in the long-term: Development of retail competition. The increase of the price of the RAE mechanism from a low starting price to the market-based price may create an abrupt change in the cost structure for the new entrants, undermining the ability of the RAE mechanism to create sound and sustainable conditions for competition. Impact on the end customers. In the longer term, because of the pay-as-bid pricing, suppliers who have obtained energy in the auction through the lowest bid may not have the incentive to pass this gain through to the consumers in terms of lower retail prices. This is because other alternative suppliers will have higher baseload costs and will exert little competitive pressure. Valuation of PPC. In the long-run, the increase of shares of alternative suppliers will deteriorate the consumer base of PPC. Furthermore, as alternative suppliers will target the most profitable consumers (those who pay bills ), the customer base remaining with PPC will become less profitable This assessment is summarised in Table 3 below. 21

23 Table 3: Assessment of the general principles of the design Criteria Short-term assessment Long-term assessment Development of retail competition + - Impact on end consumers +/- - Valuation of PPC -- - Legal / EU compatibility - F Conclusion of this section 3.50 At first sight, the mechanism chosen by RAE presents several advantages as compared to other options that were envisaged. In particular, the auction-based allocation of the product could in theory reveal the value of the base-load products for alternative suppliers, and help establishing a competitive forward market. However, the analysis raises major concerns with regards to the high-level design of the measure: The volumes to be auctioned and volumes to which alternative suppliers are eligible are unlikely to create a competitive environment to reveal a price that reflects the value of the base-load product for alternative suppliers; This disequilibrium strengthens the importance of setting correctly the starting price. However, there is a total lack of transparency on the methodology envisaged by RAE to define the starting price; Uncertainty around the starting price definition raises major concerns about the ability of the mechanism to create a competitive environment in the long term and about the valuation of PPC. The latter point is a major issue in the short term, with the project to privatise 30% of PPC. Undermining the value of PPC will have impacts on the Greek national budget, and on Greek citizens. 22

24 Section 4 Analysis of the specific features of the mechanism proposed by RAE A Introduction 4.1 In addition to the high level design of the mechanism discussed in the previous section, the consultation document published by RAE provides more detailed features of the mechanism. These features include the rules for product definition, payment and control of the volumes. These features determine key incentives for market participants to use the mechanism efficiently and to avoid taking advantage of the flaws in the RAE mechanism in an opportunistic way with negative impact on the mechanism efficiency. 4.2 This section discusses and analyses the detailed rules of the mechanism, to the extent they are known: First, we describe the specific rules of the mechanism; Second, we analyse the effects generated by these features, especially in terms of incentives for market participants; Then, we assess these features against the criteria defined in section 2. B Description of the specific rules of the mechanism 4.3 Below we describe the specific rules of the RAE mechanism, in particular: Process of acquiring and using forward products; Financing conditions; Definition of rights to acquire forward products; Control of volumes and penalty regime; Price differentiation coefficients; and Repurchase obligation on PPC. Process for acquiring and using forward products 4.4 Below we summarise the process for acquiring and using the forward base-load energy products envisaged by RAE. The auctioned products are packets of base-load energy that the supplier will be able to sell to consumers. 23

25 4.5 Suppliers purchase forward products from PPC in auctions for yearly and quarterly contracts. The auctions occur about 5 weeks before the start date of delivery. The dates of the auctions and the variety of contract durations are intended to allow suppliers to constantly keep forward products for their customers in their portfolio. 4.6 The schedule of auctions is as follows: the first auction for yearly contracts (800 MWh/h) and quarterly contracts (400 MWh/h) will take place on February 20, These delivery periods of these contracts will be April 1, 2015 to March 31, 2016 and April 1, 2015 to June 30, 2015, respectively. There will be three more auctions for quarterly contracts to provide 1200 MWh/h for the twelve-month period of April 1, 2015 to March 31, Once the supplier has purchased the forward product, they also have the right to transfer it to another supplier who 1) satisfies the participation requirements of holding a license for domestic interconnected supply and 2) are registered as participants of the Trading System. The transfer is eligible to occur up to 14 days before the start of the next calendar month. The supplier must notify the counterparty contractor and LAGIE of the transfer. They may also sell it back to PPC, who is obliged to repurchase the forward product. The repurchase obligation is described later in this section. 4.8 The forward products purchased or obtained through a transfer can be nominated for the use to LAGIE 10 days prior to the beginning of the month. In this case, the nominated amounts of energy will be deducted from the total amount of energy the supplier needs to produce or purchase to satisfy the consumption of its customers. 4.9 The process is summarised in Figure 4. Figure 4: Process for acquiring and using forward products Financing conditions 4.10 RAE envisages several specific conditions for the suppliers who wish to acquire the forward products: Advanced payment. Suppliers who win the forward product must make an advanced payment at the auction. This deposit is paid to the counter party seller through LAGIE and is worth 1% of the amount of the final bid multiplied by the amount of energy assigned to the supplier. 24

26 Payment for the use of the products. In order to maintain the right to use the forward product for the next calendar month (nomination), the supplier must pre-pay an advance payment to LAGIE 10 days before the beginning of the month. This amount is 50% of the total payment. The rest is paid during the weekly and monthly final settlement of cash flows. The payment for the use of the products takes into account the price differentiation coefficients as described below. Definition of rights to acquire forward products 4.11 As explained briefly in Section 3 above, the access of the retail suppliers to forward products will be conditional on the size of each provider s customer portfolio. The rights of use will be based on the load of its customers in the off-peak hours More specifically, the amount of the rights is defined by the supplier s historical consumption in the off-peak period between 00:00 to 10:00 from Monday to Friday (weekdays) and 00:00 to 24:00 on Saturday and Sundays (weekends). This amount is calculated using the same month of the previous year as the month of the auction The specific calculation differs depending whether suppliers have an hourly meter or not: For suppliers with an hourly meter, the energy consumption during the period of minimum consumption is recorded from the same month of the previous year. The top 20 hourly measurements are dropped from the calculation. The maximal hourly consumption during off-peak hours with the exception of 20 maximum hours determines the level of consumption the supplier has the right to use for all hours of the next month. For suppliers with non-hourly meters, the average hourly consumption of the interconnected system during off-peak hours is used as a proxy to determine the base consumption and is adjusted to account for the number of hours in the period of minimum consumption. Control of volumes and penalty regime 4.14 The actual rights are determined via LAGIE using the relevant measurements and data provided by DEDDIE 14 for consumers without hourly measurements (profile and coefficient method of DEDDIE) LAGIE performs the ex-post control of the volumes acquired by the alternative suppliers. In doing this, LAGIE compares the volumes of forward products acquired and nominated by a supplier with the actual consumption of the supplier s customers. We present below the details of the volume control regime as presented by RAE. However, these details require further clarification by RAE. 14 Hellenic Electricity Distribution Network Operator S.A. 25

27 If the volumes of forward products nominated by the supplier exceed the quantities of rights to acquire the forward product calculated on the basis of the ex-post consumption measurements by less than 15%, then LAGIE would return the extra product to PPC without penalty for the supplier. The corresponding pre-payment and deposit paid by the supplier will be fully reimbursed. We understand that the excess of the nominated energy above the eligible rights calculated ex-post will be settled by the supplier at the market price (SMP). If the amount of nominated energy exceeds the eligible rights calculated ex post by more than 15%, then the return of the product is realised with a fine. In that case, the corresponding pre-payment paid by the supplier is reimbursed, but the deposit is retained. We understand that 20% of the deposit is still reimbursed in case of the expost volume control of the weekend period This penalty regime is illustrated in Figure 5. Figure 5: Penalty regime Source: FTI-CL Energy, based on RAE 4.17 For consumption without hourly measurements, the tolerance level is increased from 15% to 30%. Price differentiation 4.18 The price paid by the alternative retail suppliers for the forward product will be based on the auction price. However, RAE mechanism additionally introduces price differentiation. This means that for each supplier, the price at which he/she acquires the product from PPC will be different from the auction price by the price differentiation coefficient that depends on the consumer category the supplier is using the energy for. Table 4 below presents the price differentiation coefficients proposed by RAE. 26

28 Table 4: Price differentiation coefficients Consumer category Price differentiation coefficient High voltage load during off-peak hours > 100MW 70% a) High voltage load during off-peak hours < 100MW b) Medium voltage with annual consumption > 13 GWh 90% Medium voltage with annual consumption < 13 GWh 100% Low voltage 130% Source: RAE 4.19 Thus, if a supplier has obtained a price of 60 /MWh in the auction, he/she will pay to PPC only 42 /MWh (-30% on the auction price) for the base-load energy acquired for HV consumers, but it will pay 78 /MWh (+30% on the auction price) for the same base-load product if it is acquired based on LV consumers load According to RAE, this price differentiation rule is supposed to ensure that the benefits of the regulated market are directly passed down to consumers. Repurchase obligation on PPC 4.21 PPC is obliged to repurchase forward products within a certain strictly regulated framework. For instance, consumers who have the ability to manage their loads may acquire forward products based on their off-peak consumption, but they consume less during peak hours and are in a position to resell the energy from the forward products Given that PPC continues to hold a high a share of the low voltage consumers (who mostly do not have the ability to manage their load), an obligation is imposed to PPC, as their supplier, to buy back part of the forward product of independent suppliers. For independent suppliers who wish to avail themselves of this option, PPC is obliged to buy back that part of the forward product corresponding to the remaining hours when consumption of the customers is lower and when they may have excess of energy supply through the forward products The repurchase is centrally monitored through LAGIE, at a price fixed per hour, based on the current price of the day-ahead market. However, the revenue of independent supplier from the repurchase transaction remains regulated. The price the supplier receives for the resell of the products may not exceed the amount that it has originally paid to PPC for the acquisition of the rights, increased by 20%. The repurchase process is carried out through the LAGIE, during the daily clearance of DAS. C Analysis of the effect generated by these specific rules 4.24 Various details of the RAE mechanism defining the products and setting the rules for payment and volume control affect the incentives received by market participants willing to acquire these products, as well as their ability to benefit from potential flaws in the mechanism, at the detriment of overall mechanism efficiency. Below we address several such potential issues induced by the specific rules of the RAE mechanism: 27

29 Lack of details of the volume control regime; Incentive to participate in the auction induced by the volume control; Adverse incentives due to the definition of rights to acquire forward products; and Discrimination due to the price differentiation rule. Lack of details of the volume control regime 4.25 The regime of the volume control and the associated penalty lacks clarity on its application. In particular, the mechanism needs further clarification on the definition of the return of surplus quantity and the treatment of the deposit: Return of surplus quantity. It is unclear whether the return will be treated physically (in terms of balance for the different companies) or financially. If treated physically, the return will create a risk in the management of the PPC balance as in this case PPC would be purchasing too much power in the wholesale market, at a price set too high. However, we may assume that since it is proposed to be applied ex-post, the return will be treated financially. In such a case, the settlement price for the return should be clearly defined. Treatment of the deposit in the penalty regime. As far as we understand RAE s proposal, only a share of the 1% deposit will be kept as a fine for over-procurement of forward products, but the calculation of the share remains unclear. This penalty provides very little incentive for market participants to avoid over-procurement. Indeed, the penalty applies only marginally on volumes above a high uncertainty margin of 15% (even up to 30%) and its strength, given that it is based on a share of a low 1% deposit, is very limited Comparison with the penalty regime implemented in the French ARENH mechanism 15 (see the text box below) indicates a tolerance margin much lower in France than in Greece (10% vs %) and that the penalty regime much more incentivising. 15 For further information on the ARENH mechanism functioning, please refer to our previous report for PPC on the lessons from the French experiences of regulated access to wholesale base-load energy, July

30 French experience (ARENH, under the NOME Law) In France, retailers request ARENH volumes in June of year Y for the period July Y June Y+1, based on their forecast. To avoid windfall effects due to excessive requests, the ARENH includes a retroactive adjustment mechanism in case ARENH requested volumes turn out to be higher than allowed volumes based on actual consumption during low national consumption hours. This mechanism takes the form of a compensation paid to EDF for volumes requested in excess ( surplus quantity ). As long as the surplus quantity is small (within the tolerance margin equal to the maximum between 10% of the allowed volume and 5MW), this payment is equal to the difference between the ARENH price and the spot market price (plus an interest rate). Therefore, it is equivalent to a purchase of the surplus quantity by the alternative supplier in the spot market and thus does not involve a penalty. However, if the surplus quantity exceeds the tolerance margin, the quantity requested above this margin ( excessive quantity ) is subject to additional penalties. For each MWh of the excessive quantity, the alternative supplier pays the compensation twice. Figure 6 below schematises the ex-ante and ex-post volumes of an ARENH user, excessive quantity in red is paid at the market price plus the penalties 1. Figure 6: ARENH allocation and ex-post control Source: CRE 29

31 Incentives to participate in the auction induced by the volume control 4.27 A further issue linked to the technical functioning of the mechanism is that, in our understanding, the volume control and penalty regime apply to the nominated volumes of the forward products rather than the amount acquired in the auctions. The volume control procedure compares the volumes nominated on a monthly basis with the volumes a supplier is actually entitled to. This is calculated ex-post using the real consumption of its customers As a consequence, suppliers have incentive to bid in the yearly and quarterly auctions for a larger amount than they would actually need and that they would be entitled for ex-post This has consequences for PPC, because it may face volume risk. Volumes purchased in the auction may not be representative of the volumes that will actually be used This also has consequences for retail suppliers, at least in the long run. As retail competition develops and supply and demand reach equilibrium, this adverse incentive will drive prices up and reduce the efficiency of the mechanism. Adverse incentives due to the definition of rights to acquire forward products 4.31 The rights to acquire forward products are defined taking into account only the consumption of customers during off-peak hours. In most cases, off-peak hours correspond to hours when customers consume less. However, some customers may have countercyclical consumption profiles, with less demand in peak hours than in off-peak hours (e.g. certain industrial consumers or specific usages, such as street lighting). A supplier of such customers will benefit from a surplus of energy from the regulated products as illustrated in Figure 7 below. Figure 7: Consumer with flexible or contra-cyclical consumption 30

32 4.32 The rules described by RAE allow the supplier of such consumers to keep the extra energy which may not be consumed. The supplier will then be able to sell the excess energy at a high price during peak hours on the wholesale market or to export to neighbouring countries The operation presents very limited risk for the supplier: First, according to the repurchasing obligation placed on PPC, PPC will be obliged to buy back the forward products at the wholesale market price. Second, the RAE mechanism would allow the alternative suppliers to keep the wholesale market price received in the buy back, as long as it does not represent more than 20% above the price paid for the forward products in the auction Thus, this activity could allow the supplier to extract substantial profit at the detriment of PPC and of the end consumers. If the energy is exported, the access to a supposedly cheaper energy will benefit the supplier and the foreign market players at the detriment of the Greek consumers If competition is efficient, the final beneficiary of this windfall profit should be the consumer able to consume more during off-peak than peak hours, rather than its supplier. However, this does not change the fact that this profit will be gained at the detriment of PPC and of other end consumers. Discrimination due to the price differentiation rule 4.36 The price differentiation proposed by RAE will relate the price at which the alternative suppliers acquire the product to the type of customers the suppliers serve by applying coefficients to the auction price specific to the customer type. This price differentiation rule is not well justified and may introduce price discrimination with adverse consequences for the mechanism efficiency. Price differentiation is not justified by technical characteristics 4.37 This price differentiation rule could be justified if it has reflected the difference in the cost of serving customers with different consumption profiles However, this is not the case since the product is defined as a base-load product for all categories of consumers. Given the product s definition and the way the rights are calculated, this difference in profiles is already reflected in the proportion of the consumption that may be served by the regulated product. This is demonstrated by a numerical example in the text box below Thus, in presence of price differentiation, the base-load consumer would benefit unduly from the regulated product if its bill is reduced further by a 30% discount, whereas the non-baseload consumer would be unduly penalised by a 30% increase in price for its base-load consumption. 31

33 Cost of serving customers with different profiles Let s assume that, because of the marginal costs of generation, the base-load market price (Pbase) is lower than the peak-load market price (Ppeak): Pbase < Ppeak. A consumer who consumes more in peak hours should then pay more than a consumer who consumes more, in proportion, in off-peak hours. In addition, let s assume that the price of the forward product allocated in the RAE mechanism (P*) is lower than the baseload market price, reflecting an economic advantage provided by the regulated product: P* < Pbase < Ppeak. Let s compare a theoretical industrial consumer whose consumption would be purely base-load and flat with a customer who consumes 50% more in peak hours (so its consumption is served up to 80% by base-load and up to 20% with peak products). Given the differences in profiles, the non-base-load consumer is supposed to face a higher price as it generates higher costs due to peak consumption. Figure 8: Consumption profile of the two theoretical consumers In this theoretical case, in presence of the RAE mechanism, the cost of serving the baseload consumer for the supplier will be equal to the price of the forward product P*. In the absence of the RAE mechanism, the cost of serving this suppler would be equal to Pbase. The financial advantage allowed by the regulated product could be passed on to 100% of its consumption. The cost of serving the non-base-load consumer for the supplier will be equal to (80% x P* + 20% x Ppeak) in presence of the RAE mechanism, as 20% of the consumption will have to be purchased on the wholesale market during peak hours. Without the introduction of the RAE mechanism, the cost of this customer for the supplier would be equal to (80% x Pbase + 20% x Ppeak). The financial advantage allowed by the regulated product could be passed on to only 80% of its consumption. 32