Analysis: The Opening of European Markets to Competition: The Root Cause of Soaring Electricity Prices
In recent months, the sharp rise in electricity prices has understandably sparked strongreactionsfrom residents and businesses, who are seeing their energy bills skyrocket.
François Mirabel, University of Montpellier
She also cites analyses by experts in the electricity sector, who point to numerous factors to explain this increase. These include the war in Ukraine, soaring fossil fuel prices, the sharp risein carbon priceson theCO2 market,reduced nuclear capacitydue to maintenance, andlow water levelsin reservoirs…
These reasons are certainly undeniable, and an emergency plan is currentlybeing discussed in Brussels; however, beyond the current economic situation, there are also longer-term explanations. These stem from the reforms implemented as part of the opening of European electricity markets to competition in the early 2000s, a topic wehave been studyingfor several years.
AT THE ROOTS OF A MAJOR UPHEAVAL
More than 20 years ago, the electricity market in France was opened up to competition. Article 90of the 1957 Treaty of Rome mandated this opening, which was ultimately formalized under a1996 European directive. This directive provided for gradual competition and marked the end of EDF’s monopoly: other suppliers must be able to sell electricity to both households and businesses.
Very quickly, the European Commission’s Directorate-General for Competition concluded that there was insufficient competition, with too few alternative electricity suppliers. France, which came under particular scrutiny, responded by passing the New Organization of the Electricity Market Act (NOME)in 2010,a movewelcomed by the Ministry of Finance, then led by Christine Lagarde. Two mechanisms were then introduced in France: Regulated Access to Historic Nuclear Energy (ARENH) and a new method for calculating Regulated Electricity Sales Tariffs (TRVE), which are the prices at which the incumbent operator, EDF, must sell electricity.
Their rationale is rooted in the work of economists William Baumol, John Panzar, and Robert Willig, and inthe bookthey published in 1982 on the “contestability” of markets. The idea? If it is not possible to challenge a market leader’s dominance, prices will remain higher than the optimal level achieved in a competitive market. The priority would therefore be to ensure that entry (as well as exit) into markets remains free and unrestricted, and that potential competitors benefit from the same economic conditions for production as established firms.
AN IDYLLIC VISION
To many, applying this analysis to the electricity sector seemed obvious: to ensure market competition, competitors must have access to the nuclear electricity generated by EDF, which is produced at a cost significantly lower than that of its competitors. This is where ARENH comes in: EDF must sell approximately one-quarter of its nuclear electricity production (100 TWh/year) to its competitors each year at a fixed price of 42 euros per MWh, close to the production cost of EDF’s nuclear power plants. This mechanism was viewed, particularly by the authorsof the Champsaur Commission report, as the condition enabling the entry of new competitors and, ultimately, lower prices for consumers.
This idyllic vision of the ARENH remains highly questionable, however, when the system is evaluated in light of another well-known phenomenon that economists call the “double markup.” In the past, EDF sold its electricity directly to consumers at a price that reflected production costs. Now, EDF sells its electricity to suppliers—the first margin—who in turn resell it to consumers—the second margin—which clearly seems to be a source of inefficiencies.
In implementing this new system, the regulator undoubtedly gambled that the supposed benefits of competition would eventually prevail and drive prices down; unfortunately, that did not happen.
PRICES OUT OF STEP WITH COSTS
That’s not all: the 2010 NOME Act went a step further by establishing a new method for calculating TRVEs, again with the aim of making it easier for competitors to enter the market.
Historically, rates were based on EDF’s production costs: the Energy Regulatory Commission (CRE) assessed EDF’s accounting costs and then allocated them across its customer base. The NOME Act was then enacted with a clear objective, as reiterated by the judge presiding over interim relief proceedings at the Council of State in a decision dated January 7, 2015:
“The economic contestability that the new tariff-setting mechanism is intended to ensure consists of the ability of an existing or new competitor to EDF in the electricity supply market to offer, within that market, rates that are equal to or lower than the regulated tariffs.”
A new method for calculating TRVEs, known as the “stacking” method, has been developed. This involves incorporating the procurement costs of alternative electricity suppliers into the calculation, thereby linking TRVEs to wholesale electricity prices. This amounts to indirectly calculating the TRVE increases necessary for competitors to be competitive and enter the market.
In other words, the TRVE rates that EDF offers its customers are no longer tied to its production costs but are now linked to competitors’ procurement costs. The TRVE rates thus effectively become a benchmark price against which competitors can compete (this is referred to as “tariff contestability”). This seems like an anomaly.
FUNDAMENTAL REFORM OR JUST PATCHWORK SOLUTIONS?
In response to the sharp rise in electricity prices since June 2022, additional measures have been implemented to stabilize the market. The ARENH scheme wasextendedas of April1, and EDF is now required to sell 120 TWh to competitors (equivalent to one-third of its nuclear production). At the same time, the government has implemented a price cap thatlimits the increase in TRVE tojust4%, at an estimated cost to the public treasury of over 20 billion euros.
Nevertheless, the system appears to us to have shown significant limitations. Consumers are subject to thevolatilityof a wholesale market price that can fluctuate within a single year from 80 euros/MWh to peaks of over 1,000 euros/MWh for an essential commodity. We believe it would be desirable to return to a much more centralized organization of the electricity sector, where regulated retail prices would once again be based on production costs.
Crucial issues related to public service missions—including pricing, security of supply, energy independence, reducingCO2 emissions, and promoting renewable energy—appear to require strong government oversight and planning. These demands are at the heart of public calls for a secure electricity supply at regulated and fair prices.
In this context, a fundamental overhaul of the electricity sector’s structure must be undertaken. Energy ministers from the European Union’s member states have recentlybegun discussions. It remains to be seen whether this will result in nothing more than a few quick fixes.
François Mirabel, Professor of Energy and Transportation Economics, University of Montpellier
This article is republished fromThe Conversationunder a Creative Commons license. Readthe original article.