LIBERALIZATION OF THE ELECTRICITY SECTOR: THE CASE OF ITALY Maggio 2009

1. LIBERALIZATION OF THE ELECTRICITY SECTOR: THE CASE OF ITALYMaggio 2009

2. The liberalization process (1) • Liberalization/privatization of public utilities in Europe started almost 20 years ago. In Italy at the beginning of the ‘90s • Before: publicly owned vertically integrated monopolies • 1992: Enel becomes a public company owned by the government (D.L. n. 333) • 1995: an indipendent regulator (Autorità per l’energia elettrica e il gas) is set up (L. 481/95) • 1996: first European Directive concerning common rules for the internal market in electricity (EU 96/92/CE) • 1999: starts the restructuring os the electricity sector (DL 79/99 decree Bersani)

3. The liberalization process (2) • 2003: second european Directive concerning common rules for the internal market in electricity (EU 2003/54/CE) • 1999: Enel’s privatization starts: the first tranche is sold; • 2004: the Italian Power EXchange (IPEX) begins operating • July 2007: all customers are free to choose their electricity supplier

4. The liberalization process (3) Main objectives • increase productive efficiency; • reduce transfers from public funds to public utilities; A simple recepy Competition when possible, regulation when necessary But ….reality is not so easy

6. Outline • Market structure: where is competition possible? Where is regulation necessary? • Why is electricity different? • Wholesale markets • Dispatching • Transmission and distribution • Electricity retail • Future scenarios • energy and sustainability

7. Market structure (1) Distribution and metering Low voltage networks Transport and dispatching High voltage networks centrally controlled by TSO Production Technology and different inputs: water, fuel oil, carbon, gas… Retail supply to Industrial customers Retail supply to households

8. Market structure (2) Where competition: • Electricity production: wholesale markets; • Electricity retail to final customers; • Metering (possibly). In Italy it is done by the distributor.

9. Market structure (3) Where regulation: • transmission and dispatching; • distribution; • Metering (possibly)

10. Why electricity is different? (1) Distinctive attributes: • Electricity cannot be stored: need for a network operator continuously balancing physical supply and demand in the system by controlling the power flows in the netwok. Relevance of netwok congestions. • Transport: what is usually called “transport” is actually the use of a shared infrastructure by all undertakings to balance aggregate supply and demand. • Demand: demand is highly inelastic and has a seasonal pattern. Moreover, because of limitations of the electricity meters and of the data processing systems, small customers cannot be charged a price equal to the actual costs of their supply (load profiling). • Supply: capital intensive; long term investments to enter the market

11. Why electricity is different? (2) Therefore: • Wolesales markets are easly subject to market power exploitation: • High barriers to entry; • Inelastic demand; • Market splitting because of network congestion; • Coordination problems: need for a system operator and complicated information systems. • High price volatility: wholesale prices are more volality than in other commodity markets. Therefore the risk management issue is really relevant • Investments: since electricity cannot be stored it is necessary to have a capacity reserve margin to supply peak demand.

12. Wholesale markets

13. Wholesale markets (1) • Open to competition: many producers and many traders; • From 1° January 2003, no actor is allowed to produce or import more than 50% of the total amount of electric power produced and imported in Italy. • Enel has been required to reduce its generating capacity by hiving off 15,000 MW. Three new Generation Companies were created: Elettrogen, Eurogen and Interpower. • Bilateral contracts plus an organized market (Italian Power Exchange IPEX: www.mercatoelettrico.org)

14. Wholesale markets (2) • The “Power Exchange” is a non compulsory spot market where electricity transactions take place • It ensures the optimal management of the power plants belonging to several actors according to their offers; • It provides a signal of transparent price upon which both consumers and producers can take their decisions. • The core of the transactions on the IPEX is the Day-Ahead Market (MGP) where wholesale trading of energy between producers and wholesale customers takes place for each hour of the following day, given the available transmission capacity.

15. Wholesale markets (3) • Both sale (bid) and purchase (ask) offers can be submitted to the Day-Ahead Market (MGP), consisting in a pair of quantity (in Megawatthour-MWh) and unit-price (euro per MWh). • All offers refer to a specific hour and a specific geographic zone • All supply offers are ranked by increasing price order into an aggregate supply curve and all purchase bids are ranked by decreasing price order into an aggregate demand curve.

16. Wholesale markets (4)

17. Wholesale markets (5) • If transmission constraints occur (the quantity Q* exceeds the transmission capacity of the grid) the market is segmented in different geographic markets (zonal markets) and prices are differentiated by area. • Buyers pay the Single National Purchasing Price (PUN): a weighted average of the zonal prices

18. Wholesale markets (6) Example: average equilibrium prices and quantities traded in February 2007 (GME, 2007).

19. Benefits from liberalization? Efficiency

20. Benefits from liberalization? Investments in installed capacity + 11.080 MW 2002 - 2006 45% in the Nord SOURCE: TERNA 2007

21. Benefits from liberalization? Market power available capacity 2006 Production FONTE: Relazione annuale AEEG, 2007

22. Dispatching

23. Dispatching • Terna Spa: public company responsible for dispatching • Terna ownes the transmission grid • All the undertakings have to enter a contract with Terna for the dispatching service • A specific market is run by Terna to balance the system after the MGP market is closed • Prices in the balancing market are very high

24. Transmission and distribution

25. Transmission and distribution (1) • These two services are natural monopolies: transmission is done by Terna; distribution is done by local distributors General principles (Law 481/95 and 290/03): • price cap regulation; • price discrimination on geographic ground not allowed; • Price-cap applied only to opex; • Revaluation of invested capital; • Allowed return on invested capital based on long term risk-free rate; • profit sharing set at 50%;

26. Transmission and distribution (2) • Regulatory period of 4 years (2000-2003; 2004-2007) • Adjustment rule within the regulatory period: Pt = Pt-1 * (infl –x + y + DSM+ Q) • Pt is the allowed price cap at time t; • Inf is inflation; • X is the productivity rate; • Y is a measure of unexpected increase in costs due to exogenous factors; • DSM is an adjustment factor to recover costs related to demand side management regulation; • Q is an an adjustment factor to recover costs related to better quality

27. Transmission and distribution (3) Necessary steps to implement price-cap regulation: • un-bundle the existing “all inclusive” tariff; • decide how much price flexibility to leave to each distributor; • set the “price level” for the base period equal to average distribution costs; • define a compensation mechanism to take care of differences in costs among distributors; • define the productivity parameter “X”

28. Transmission and distribution 1999 2006 Transmission Transmission Distribution Commercial costs of distribution Commercial costs of supply Metering Distribution Distribution + Commercial costs of distribution Metering Fuel costs Supply + commercial cost of supply

29. National average tariff for electricity

30. Minutes of consumption lost by low voltage customers NET OF 2003 BLACK-OUT

31. Electricity retail

32. Electricity retail • European Directive 2003/54/CE: by July the first, 2007 all European Countries have fully liberalized their retail market for electricity. • The economic debate has mainly focused on two big questions: weather and how retail competition in the electricity sector could bring real benefits to European customers, expecially households, and weather and how customers should be protected by imposing universal service obligations on undertakings operating in the sector • The two questions are actually related: the desirable extent of public service obligations depends, up to a certain degree, on how competition is expected to work

33. Why retail competition? (1) Joskow (2000): Why do we need electricity retailers? Or can you get it cheaper wholesale? • The peculiar attributes of electricity supply make many of the traditional services provided by retailers in other industries irrelevant in electricity. • Retail competition brings additional costs into the system: advertising, promotion and customer service costs • A low-cost way for electricity consumers to buy directly would be the wholesale market (BES) • In this way, retail consumers can receive the benefits of competitive generation markets without incurring large increases in retailing costs.

34. Why retail competition? (2) Littlechild (2000): Why we need electricity retailers: A reply to Joskow on wholesale spot price pass-through • Joskow underestimates the role of retailers with respect to price, as opposed to quality • For most residential customers and most products, the wholesale market is not the relevant alternative • Buying directly in the wholesale market does not avoid the costs and complexities (e.g. load profiling)

35. What do retailers do in other sectors? (1) Retailers usually add value to what consumers would receive if they purchased directly in the wholesale market. How: • By transporting the product and selling at convenient locations; • By selling the product at convenient times of day and days of the week (e.g. 24 hours shops) • By providing other services that offer consumers a more convenient way to shop (e.g. internet stores)

36. What do retailers do in other sectors? (2) 4. By reducing search costs (selling a range of complementary or subsitute products in the same location); • By providing both pre-sale and post-sale information and assistance to the customers;

37. Why electricity is different? (3) Which added values from retailers? • transporting the product and selling at convenient locations; NO • selling the product at convenient times of day and days of the week (e.g. 24 hours shops) NO • providing other services that offer consumers a more convenient way to shop (e.g. internet stores) NO • reducing search costs (selling a range of complementary or subsitute products in the same location); NO • By providing both pre-sale and post-sale information and assistance to the customers on the product; NO

38. Why electricity is different? (2) More general: • There is generally no direct physical relationship between a specific generating source and a specific retail customer; • Electricity is automatically available every second over the distribution network and the supplier cannot be hold responsible for the physical delibery; • the only operator responsible for the physical delivery of electricity is the transmission system operator. The supply contract between a customer and her supplier can be seen primarily as a financial contract.

39. How can electricity retailers provide added value?A possible story (Joskow) Therefore: • The main added values by electricity retail suppliers could be a financial service of risk hedging but this is not a real issue because of poor metering • They may provide new “products”, such as green power options • Retail suppliers usually do the billing • Depending on market design, retail suppliers can be responsible for other services, such as meteringand behind the meter services (eg energy management)

40. How can electricity retailers provide added value? The other side of the coin (Littlechild) (1) According to Littlechild, Joskow underestimates the role of retailers with respect to price, as opposed to quality/behind the meter services What Littlechild calls price competition is actually competition on risk hedging: “The experience of Britain may be reasonably tipical. For the first time, electricity retailers (…) asked their customers what they wanted. Uniform fixed price, time of the day or time of the year prices, interruptible prices, Pool prices?”

41. How can electricity retailers provide added value? The other side of the coin (Littlechild) (2) Plus, Littlechild underlines the impact of retail competition on demand elasticity: “The customers meanwhile were equally active. (…) They needed to estimate their likely electricity consumption, (…) to work out load factors and seasonal variations, and their scope for load management at times of high prices” …. and on wholesale markets’ performance

42. How can electricity retailers provide added value? The other side of the coin (Littlechild) (3) An active buying side brings to a more liquid and efficient wholesale market: • competition will force retailers to be more careful in their purchasing decisions, and this active demand side will make the wholesale markets more competitive; • retailers can stimulate price responsiveness by customers: increase demand elasticity

43. What can retail competition do? (1) First we have to define a benchmark: • DSOs supply final customers • Local monopoly • Need for price and quality regulation • Possible regulation: BES plus premium if added values are demanded (eg. price hedging) • “Regulator knows all” kind of model • Auction to choose the retail supplier • Competition for the market • Price and quality determined by the auction

44. What can retail competition do? (2) EXPECTED BENEFITS - COMPETITION CAN: 1. Increase productive efficiency of retailing: • by developing innovative retailing technologies that reduce commercial costs; • by reducing the costs related to risk hedging • Increase competition in the wholesale market: eg by easing entry into the market • Increase allocative efficiency: • By transferring all costs savings along to consumers;

45. What can retail competition do? (3) EXPECTED COSTS - COMPETITION CAN: 1.Increase total costs: • By loosing economies of scope between distribution and supply • By increasing advertising and promotion costs • By increasing retailers’ profits 2. Decrease allocative efficiency: • Switching costs may give rise to market power • While new entrants can have an advantage in competing for new customers it is very hard for them to compete for old customers who are already attached to an incumben • …and any consumers who switch are likely to be less loyal, hence less valuable, ones

46. What can retail competition do? (4) Common barriers to effective competition: • institutional barriers involving metering and data aggregation; • limited unbundling of distribution and supply; • limited access to reliable information on contracts and prices.

47. Universal service obligations (USOs) (1) • the European Directive 2003/54/CE on the internal electricity market explicitly acknowledges the need for customer protection. • Namely, the Directive requires that “Member States ensure that all households customers and, eventually, small firms enjoy universal service” (art. 3, point 3) • Universal service is defined as the right: • to be supplied with electricity of a specified quality; • at reasonable, easily and clearly comparable and transparent prices

48. Universal service obligations (USOs) (2) • The interaction between universal service regulation and competition in these market segments is direct and very strong • USOs may determine the nature of competition that can be sustained in the market. • Great attention must therefore be given to the definition of USOs and to their implementation • ERGEG (European regulators’ group for electricity and gas), position paper on End Users Price Regulation: “End-user price regulation is one factor which prevents equal access of suppliers to all customers. This has a negative effect on the functioning of the competitive retail markets”

49. Universal service obligations (USOs) (3) • ERGEG, last June has published a Review on end-user price regulation in European Countries • According to this review in the electricity sector in 2006, 17 out of 28 countries surveyed had some form of retail price regulation for eligible customers (not households) • Moreover when regulated tariffs were available only a very small percentage of customers had switched to the competitive market: in most market segments more than 80% remained at regulated tariffs and in many segments this percentage was close to 100%. • Finally, only in one country (Hungary) suppliers offering regulated tariffs were chosen on the base of an open tender. What can retail competition do?

50. Future scenarios: smart grids Data management