ORGANIZATION OF ELECTRICITY TRANSMISSION IN VIEW OF LONG TERM ENERGY POLICY GOALS

1. ORGANIZATION OF ELECTRICITYTRANSMISSION IN VIEW OFLONG TERM ENERGY POLICY GOALS Dubravko Sabolić HEP-Transmission System Operator, Llc. The 20th Forum of the Croatian Energy Society (HED) Zagreb, 18 Nov. 2011

2. Introduction • Structure of this presentation: • Literature review on the following aspects: • TSO institutional arrangements – comparison of the “canonic” models from an economic point of view; • Critiques of the EC’s policy regarding the full ownership unbundling as an ultimate policy goal; • Legal grounds for the EC’s policy, and legal aspects of antitrust enforcement viewed (perhaps) as one of the tools used to foster a gradual movement to a fully-unbundled European space in the future. • The most important strategic challenge in front of TSOs: • The power system has to accept large quantities of new renewable generators in a relatively short time. • How can policy and politics help or harm the process? • What does the 3rd Package has to do with all this?

3. Literature on OU – Pollitt (2007a,b) Ease & efficiency of regulation Effects on market competition Aspects of privatization • Fully unbundled TSO (eq. to OU); • Legally unbundled TSO (eq. to ITO); • Independent system operator (ISO); • Hybrid ISO+TO (both fully unbundled); • Vertically integrated utility (VIU). Risk of voluntary govt. intervention Security of supply Transaction costs of unbundling Probability of foreign takeover Cost of capital Synergy & focusing effects Double margi- nalization • Compares social cost-benefit for five institutional solutions across a number of aspects. • Conclusions: • Regarding overall social cost-benefit, the OU is the best solution. • Regarding cost of capital in particular, divestiture from a considerably larger organization may lead to a certain lost of credit rating. • He notes that the system operation in the jurisdictions with most successful market development has been fully independent from generation interests, without exemptions (New Zeeland, Victoria & South Australia, Chile, Argentina, Nordic countries, UK, New York, Texas, PJM). • Countries with slow and/or unsuccessful reforms have kept the system operation function partially bundled with generation (e.g. California, Germany, France). • An apparent advantage of ITO in better investment adequacy and lower cost of capital may easily be diminished or nullified by difficulties in regulatory oversight. • Regarding the regulatory efficiency, ITO and ISO are the most demanding options, while OU and VIU are least demanding. • Regulatotry inefficiency may be a considerable problem in jurisdictions where market institutions are still developing.

4. Literature on OU – “the French school” Transaction cost savings Incentive regulation implementation Advantages of regional integration wT • BASIC MODULES OF A TSO • Short-run network externality mgmt. (dispatching, real-time congestion mgmt.) • Long-run network externality mgmt. (network development) • Coordination with neighboring TSOs. wI wA wC wN Conflicts of interests Non-discriminatory network access w – different weights • Glachant and Rious (2007), and Leveque et al. (2009): a New institutional economics approach, an attempt to rationalize the debate on OU and the 3rd Package policy set. • A modular analysis (for three basic modules of TSOs) for all the 3rd Package options, with five criteria to compare TSO organizations: • Conclusions: • OU is the best solution where a need to ensure correct price signals for investments is dominant: • in jurisdictions where interconnections with neighboring systems are good, while internal network still suffers from congestions. • ISO is the best solution where a need for an efficient coordination between neighboring TSOs is dominant: • often where interconnections are weak whereas the internal network is in a good condition. • EC has obviously valued the correct price signaling the most; hence the OU became a preferred policy option. • EC should strive to legally enforce a unified institutional form as soon as possible for the sake of better inter-TSO coordination.

5. Literature on OU – some German authors • Brunekreeft (2008) performs a social cost-benefit analysis of the OU with an emphasis on German TSOs. He makes no comparison between OU and other institutional arrangements. • Three groups of potential effects on welfare studied across several scenarios: • effects on market competition; • effects on interconnection investments; • effects on costs caused by a loss of vertical synergies. • He reports: • In most scenarios the total welfare change is positive but relatively small. • Effects on interconnection investments are surprisingly small (as large importers and large exporters need interconnectors and do not have an interest to stop TSO in constructing them). • Vertical synergy losses are very small, too. • An overall conclusion is that OU leads to an increase in social welfare. • Bolle and Breitmoser (2006) compare OU and ITO and conclude that ITO leads to lower final electricity prices (because the total costs of the system are lower than in the OU case). • However, their results were disputed e.g. by Pollitt (2007) as they were grounded on an assumption that double marginalization is completely avoided in ITO case, as opposed to the OU case, which is not realistic.

6. Literature on OU – Nardi (2009) • An empirical analysis of the OU effects on transmission capacity investments and quality of transmission network service. • The groups of European countries: • without any kind of unbundling; • with just any kind of unbundling, comprising of two subgroups: • with an ownership unbundling; • with any other kind of unbundling. • As regards total capacity investments (i.e. not only interconnection ones), the OU seemed to be performing better than other institutional arrangements. • When it comes to quality of service, it turned out that the group of countries with some form of unbundling perform better, and that among them the OU operators perform slightly worse than the others. • However, these results were indicative and not statistically significant.

7. Literature on OU –Van Cotten & Ortmann (2008) • An interesting and quite witty piece of work I justhad to put here. • Econometric analysis between the Transparency International’s CPI (Corruption Perception Index) and ownership unbundling level (modeled as a five level variable), for the EU countries. • The main statistical conclusion: • lower degree of unbundling goes with lower CPI (i.e. higher perception of corruption in a society). • Some further results: • newer EU member states have lower unbundling degree (and CPI, too, see above); • higher GDP per capita goes with lower unbundling degree. • Methodological problems (as I see them): • The CPI usage in international context with fairly different cultures may be problematic. • The funny ‘GDPpc – unbundling’ relation may be affected by the fact that just a few large and high-GDPpc countries (like Germany and France) had lower levels of unbundling at the time.

8. Literature on OU – ownership changes and financial considerations • Knyazeva, Knyazeva and Stiglitz (2009) investigate influence of ownership changes on accessibility of external financing: • they basically analyze international telecom industry from 1987 to 1999; • plausibility was checked by analyzing a multi-sector sample of European privatization deals from 1989 to 2006. • This is an extremely important topic for OU debate rationalization since an alleged detrimental effects of TSO divestiture on its financial position (and somewhat less detrimental, but still present, effects on the former VIU’s position) were among the most prominent arguments of ownership unbundling haters throughout the EU. • This work is relevant for the power industry, too, since the questions of ownership change and access to external financial sources are by no means specific neither for telecom, nor any other particular industry.

9. Literature on OU – ownership changes and financial considerations – conclusions • Full privatization is more likely to happen in: • industries with weak performances; • states with a non-French origin of legal system; • in larger and wealthier states; • Access to bank crediting has an important positive impact on future profits, investments and growth. • Performance changes around the year of ownership change are not very sensitive to past financing limitations of public sector. • Later privatization (i.e. longer active pre-privatization preparations) lead to better future performances due to an effect of “learning” an optimal privatization design in given circumstances. • Maturity of capital market in a given state matters. • Newly privatized companies carry higher information asymmetry risks (i.e. they have less reputation, being less known to the players on capital markets).  Since costs of equity are more sensitive to information asymmetry, bank loans are normally cheaper, so that an access to them can be essential. • Performances of privatized companies are not significantly better nor worse than of the ones that remained under state ownership.

10. Literature on OU – ownership changes and financial considerations – main messages • Ownership change (divestiture and/or privatization) is not all that important, so that arguments either pro or contra ownership unbundling motivated by alleged detrimental effects of it are not plausible as such. • The privatization v. state-ownership discussions cannot help in forming decisive criteria to judge for or against ownership unbundling, either. • The key factor that does matter is how a newly divested TSO (that is, if OU were decided on) would be able to raise funds to support its investment activities. • Since it is apparently not too important whether a company is eventually owned by private or public entities, a general level of capital market maturity can play certain role (and perhaps influence decision making processes in any given jurisdiction). • Of course, there can be more state-specific moments potentially important for this issue. It is important to stay rational when deliberating the decisions, though.

11. Literature on OU – Critics of the EC • There is a number of authors who dispute the EC’s right to draft such legislation as the 3rd Package is. • Thomas (2007a,b,c) • analyzes semantics of the EC policy papers, working documents, press releases and draft legislative documents that preceded the 3rd Package, • trying to prove that the EC had not sufficiently investigated and attested the grounds for such a profound political action. • His point is that the Commission had not proved sufficiently an existence of public interest high enough to justify state intervention into the rights of private ownership and free capital movement by ordering TSO divestment. • Yet, this is obviously a big blunder because policy and politics do not need any proofs. • Thus, such critiques are nothing but infertile discussions.

12. Literature on OU – constitutional dilemmas • There are more constructive works discussing basic legal issues, though. • Pielow and Ehlers (2008) study constitutional grounds for obligatory ownership unbundling in Germany, France and Netherlands. • They address the issue of fundamental rights of free ownership and movement of capital, yet they never dispute the right of the EC to take a legislative initiative even when it aims at limiting certain basic rights and freedoms. • Individual countries may have constitutional obstacles that prima facie do not allow for obligatory OU. • However, such obstacles can be pragmatically circumvented. • An example: privatization of Gaz de France, 2004: • The French Constitution of 1958 requires public services to be provided by publicly owned companies, but it does not stipulate exactly whichare these services.  This enabled a pragmatic solution to be found without a need to update the Constitution.

13. Literature on OU – EU antitrust law • Willis and Hughes (2008); Diathesopoulos (2010). • Ownership unbundling issues from the standpoint of antitrust law, policy and jurisprudence. • Some important highlights from these articles: • The EC does have an indisputable right to order ownership unbundling in individual antitrust cases, (including non-merger ones), as a proportionately measured structural remedy, on the basis of a thorough economic analysis. • The EC will likely be able of defeating any legal challenge based on alleged infringements of either: • the European Convention on Human Rights (Protocol 1, Art. 1 – the right of peaceful enjoyment of possession); • the Art. 1 of the EC Treaty – principle of subsidiarity; or • the Art. 295 of the EC Treaty – national property rights, provided that the unbundling remedy was measured in a proportion to the EC antitrust law breach in question.

14. Literature on OU – EU antitrust law, cont. • The Commission has already won a number of cases before European courts where it commanded divestitures as structural remedies under the Art. 82 (abuse of dominant position) of the Treaty. • Moreover, there were a number of the Commission’s actions under Art. 81 (anti-competitive agreements and concerted practices) of the Treaty, where it approved firms’ commitments to so-called voluntary measures. • The companies sometimes commit to such measures to avoid expensive, long lasting and risky litigations. • The most famous example: the two EC v. E.ON antitrust cases of 2008: • Wholesale market manipulation by withholding  voluntary divestment of 5.000 MW of generation plants; • Favoring affiliated generation plants while procuring system reserves  voluntary divestment of the transmission system operator (with assets). • Thus, the antitrust law enforcement powers may be viewed as a pretty powerful policy tool in the Commission’s hands.

15. So, can an optimal TSO model be idetified? • In my mind, there is not a very clear and firm conclusion that would come from the economic/legal science on the optimality of either of the three institutional settings from the 3rd Package’s menu carte. • However, the economists mostly assume that all the agents do their jobs in an efficient way, which my be contested from both theoretical and empirical grounds. • For instance, there is a number of theoretical and empirical studies establishing an inherent inefficiency of regulators (e.g. Stigler and Friedland (1962), Stigler (1972), Peltzman (1976), Ugur (2009), and many others). • Apparently, the models that are critically dependent on regulatory control may prove to be inefficient not because they were badly constructed as such, but because of regulatory failure. • Having that in mind, should the policy goal (nondiscriminatory network access) be sincere, the OU would obviously gain an advantage before other solutions, especially the ITO one. • Thus, the basic assumptions in economic analyses would have to be changed so to include regulatory imperfectness into the models.

16. So, can an optimal TSO model be idetified? • Further, • real-life TSO business within the surrounding industry is probably much to complex to be simulated by simplistic economic models; • inherited features may exert a strong influence on today’s situation and starting strategic position in the dawn of the reform. • So, since the economic science had not been able to provide a firm and indisputable answer, the problem has been easily moved to a political arena. • It was a political will, expressed through a political process within the EU, that enabled laying down the law saying that the Europe wants TSOs to become fully independent on the rest of the industry. • However, still potent countervailing political groups succeeded in softening the language of the law and producing reserve solutions. • The very organizational form of TSO business may prove to be less problematic than a political unwillingness of European countries to form larger regional independent system operators.

17. Key strategic challenges • The electricity system has to go greener. • Transmission business will have to change not only in the technical dimension, but in the business one, too, to keep up with a range of rather newish challenges, such as: • ever increasing quantity of new large renewable sources with substantial intermittency; • a need to connect generators located often in new areas where grids have not been sufficiently developed, yet; • a growing proportion of distributed generation connected to lower voltage levels, when it becomes collectively large enough to disturb the grand-scale system operation. • Thus, the systems must be upgraded both in the • physical domain; and in the • domain of the system operation philosophy. • The networks must not pose (unnecessary) barriers to the power system greenification.

18. Key strategic challenges • There’s a lot of technological challenges here, but more importantly, • the industry organization and market infrastructure will have to change even more dramatically. • For example: Today’s introduction of new green generation is supported by ample public subsidies. • This is OK since there is an imbalance in total levelized costs of electricity generated by classical plants on the one hand, and renewable ones on the other. • The pollution-related externalities have been systematically neglected ever since the first polluting generator was built. • Therefore, classical technologies still have a substantial competitive advantage at least as regards investment costs. • However, the state subsidies MUST be abandoned one day soon because the RENEWABLE SOURCES MUST BECOME NORMAL AGENTS on the electricity marketplace. They MUST be subjected to the same market mechanisms as anybody else. • To achieve that, they must become truly competitive.

19. Key strategic challenges • Apparently, one of the biggest problems (not necessary for every TSO, though) in adoption of new intermittent sources of energy is a lack of the plants technologically capable of providing ancillary services needed to physically balance the system. • Balancing of the power system, when it is organized as a free electricity market, occurs on at least two levels: • Adjusting misbalances of forward contracts on a real-time (spot) market. • The remaining misbalance, after the real-time market closure, must be removed by regulation in “true” real time. • TSOs are virtually the sole users of ancillary services, yet, they usually do not own the providing facilities. • Since TSOs have to be unbundled from generation, they themselves realistically cannot play a leading role in investments in system flexibility.

20. Key strategic challenges • Thus, flexible generation investments must come out as a result of market-driven processes. • Another form of “hidden” subsidies for new green generation is sparing them from market- and system-related obligations applied to all other participants. • E.g. the Directive 2009/28/EC gave a de facto advantage to renewable sources in grid access, subject to system operation security constraints. • Lower level pieces of legislation may introduce further special rights. E.g. in Croatia, renewable sources which are entitled to subsidies are spared from balance responsibility. They must only pay 10% of subsidies received to the TSO on the account of balancing, no matter what the actual economic value of misbalance introduced by them was. • In this way a situation where the renewable generators do not have any financial incentive to take care of balancing is created. They can just ignore the problem knowing there will be no consequences, whatsoever.

21. Key strategic challenges • Regarding the need for ancillary services to balance intermittent sources such as wind, situation may vary across the European space: • In regions with steady winds, where intermittency is milder and slower, additional requirements may not be too high. • In regions with wild and unsteady winds they can, however, be quite high. • Unfortunately, prognosis tools, which can relax the need for expensive regulation to some extent, work better in a steady wind environment, where they are less needed. • Therefore, there are regions in Europe where ancillary service capacity shortages may have a strong impact on the pace of greenification.

22. Key strategic challenges • How to cope with the balancing issue? • Assess the needs and build flexible generation plants. • In other words – LET MARKET FORCES DO THEIR JOB. • Try to use prognosis tools as much as possible for they are way cheaperand greener than new flexible generators. • However, to make it happen, the intermittent renewables MUST assume balance responsibility, i.e. they MUST start paying for misbalances they introduce so that they have incentives to invest in better production planning. • But then, to be able to control costs of it, they MUST participate in the real-time wholesale markets to balance as much as they can before regulation services must step in. (There are quite a few places in Europe where there still are no power exchanges, though.) • TSOs must also work on generation predictability. • Renewable generators MUST once becomenormal market participants.

23. Key strategic challenges • How to cope with the balancing issue? – cont. • Try to bring in some demand management, • although presently, it can count for up to some 10% of the total needs at the best. • Cooperate with other TSOs and integrate intowider geographical markets. • SYSTEM OPERATION itself has positive externalities: the more control areas join in, the more efficient use of ancillary services available inside the great area. • However, POLITICAL CONSTRAINTS are fairly tight in Europe. It is still hard to expect that USA’s multi-state system operation could develop in Europe shortly. • EC’s Regulation 1228/2003 and its descendant 714/2009 made cross-border ancillary services trading virtually impossible as they forbid capacity reservations. Thus, only dispatchable services are tradable over national borders.

24. Key strategic challenges • More on balancing issues: • What about distributed generation once it grows above certain level? • Will DSOs have to balance their areas or will the total generation be balanced by TSOs? • Imagine for example a country with almost every rooftop covered with a photovoltaic: • How will this biggish renewable generation system behave? • Imagine a country with a territory comprised of three significantly different weather zones:At least sometimes, all those photovoltaics together may behave as three rather large and almost independent intermittent power plants. • Remember: • technical balancing using regulation capacities should be preceded by real-time market balancing; • usage of ancillary services is more efficient in larger control areas. • etc... A number of further questions may be opened...

25. Key strategic challenges • Upgrading the networks: • New renewable sources of electricity may be situated in areas where there is not much population and/or historically inherited transmission networks. • Territories with quality wind or with much sun may be distant from the ones where the population rests and networks had been built. • Some system operators identify this problem as the most important for them. • Nevertheless, it is only about how many Euros must be spent to build new high voltage power lines. • However costly it might be, it is a well known activity for all the TSOs. So, the biggest problem here is how to raise money to finance it, or in other words, how to raise transmission tariffs to a sufficient level.

26. Key strategic challenges • My PERSONAL belief is that one day a further SPECIALIZATION OF WORK will probably have to occur in the electricity sector, and that basic modules of the TSO/DSO business will probably have to be vested with different specialized entities: • network functions (TRANSCOs and DISCOs): • maintaining power lines, transformers, and other “tangible” stuff; • ensuring a certain level of quality of service. • system operation (ISO companies): • real-time market operation (not necessarily by TSOs – other independent agents may step in as well); • providing system services (maintaining frequency and voltage, etc.)  dealing with increased intermittency of generation belongs here; • managing short-term congestion (by dispatching) and long-term congestion (by system development and investments); • inter-TSO co-operation in all the aspects listed above. • Otherwise, the sector may end up in a situation where everyone does everything, and that cannot possibly be good.

27. Key strategic challenges • In a word, despite many political difficulties, a necessity to introduce green sources on a large scale will eventually push Europe to what they do in the USA: • wire businesses will do wire business; • there’ll be large regional ISOs managing the systems; • which in turn would foster market integration and enable better transmission of price signals towards market players. • However, this will take some time, I believe at least two decades. • Meanwhile, the EU’s policy towards system operators will continue to pressure the states to divest TSOs: • law making as a principal policy tool; • antitrust campaigns as an efficient auxiliary tool. • The EC energy policy goals are nowadays primarily influenced by a growing political and public awareness of problems with polution and the future of energy supply. • The recent policy goals regarding TSOs, expressed through the 3rd Package, were somehow formulated as if the law makers had that in mind.

28. Conclusions • THE most challenging issue in front of the TSO industry is running the system with a big and ever growing share of inherently intermittent generators. • THAT is what is essentially still pretty UNKNOWN to us. • We will still be expected to keep network availability on the same level and even enhance it. • We will not be tolerated for having multiple blackouts a year. • We will not be tolerated to ban intermittent renewable sources penetration, either, because nobody really cares they’re intermittent. (Intermittency? Is that some kind of exotic bird?) • Therefore, the philosophy of doing our business will have to adapt very rapidly because society already has big expectations. • The electricity transmission functions have always been deemed a ubiquitous invisible infrastructure of the society, and they will have to go on just like this.