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 the public and businesses, who are seeing their energy bills skyrocket.
François Mirabel, University of Montpellier
It 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,low nuclear capacitydue to maintenance, andlow water levelsin reservoirs…
While these reasons are certainly indisputable and an emergency plan is underdiscussion in Brussels, 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, which have been the focus of ourworkfor 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 2010 law on the New Organization of the Electricity Market, orthe NOME Law, which the French Ministry of Finance (Bercy)—then led by Christine Lagarde—welcomed. Two mechanisms were then introduced in France: Regulated Access to Historic Nuclear Energy (ARENH) and a new method for calculating Regulated Electricity Sales Rates (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 participant’s dominance, prices will remain higher than the optimal level achieved in a competitive market. The priority, therefore, would be to ensure that entry into (as well as exit from) markets remains free and unrestricted, and that potential competitors enjoy the same economic conditions of production as established firms.
IDYLLIC VISION
For many, applying this analysis to the electricity sector seemed obvious: to ensure that markets are open to 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, which is 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 key to enabling new competitors to enter the market and, ultimately, to lowering prices for consumers.
This idyllic vision of ARENH remains highly debatable, however, if we evaluate the system from the perspective 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 markup—who in turn resell it to consumers—the second markup—which clearly seems to be a source of inefficiencies.
In implementing this new system, the regulator certainly gambled that the supposed benefits of competition would eventually prevail and drive prices down; unfortunately, that did not happen.
PRICES OUT OF LINE WITH COSTS
That's not all: the NOME Act of 2010 required going even further by establishing a new method for calculating TRVEs, again with the aim of facilitating the entry of competitors into 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 among 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 rate-setting mechanism is intended to ensure consists of the ability of a competitor to EDF—whether already present in or entering the electricity supply market—to offer prices in that market that are equal to or lower than the regulated rates.”
A new method for calculating TRVEs, known as the “stacking” method, has been developed. This involves incorporating the cost of procurement from alternative electricity suppliers into the calculation and, consequently, making TRVEs dependent on 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 become, in a sense, a fixed price against which competitors can compete (this is referred to as “tariff contestability”). This seems like an anomaly.
FUNDAMENTAL REFORM OR JUST PATCH-UP MEASURES?
In response to the sharp rise in electricity prices since June 2022, additional measures have been implemented to stabilize the market. The ARENH program 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 rate cap thatlimits the increase in TRVE tojust4 percent, at an estimated cost to the public treasury of more than 20 billion euros.
Still, it seems to us that the system has shown significant limitations. Consumers are subject to thevolatilityof a wholesale market price that can swing 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, the reduction ofCO2 emissions, and the promotion of renewable energy—appear to require strong government oversight and planning. These demands are at the heart of citizens’ calls for a secure electricity supply at regulated and fair prices.
In this context, a far-reaching reform of the electricity sector’s organization must be undertaken. The energy ministers of the European Union’s member states have very recentlybegun discussions. It remains to be seen whether these will result in nothing more than a few more 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.